Tag Archives: Prisoner’s Dilemma

Coke and Pepsi’s Uncivil Cola Wars-Case Study Analysis

Money is better than poverty, if only for financial reasons–Woody Allen

Besides understanding economies of scale, the next area you need to master is understanding the prisoner’s dilemma and how companies coexist or compete within barriers to entry.

The case readings were presented here:http://wp.me/p1PgpH-yl

Remember that if the links do not work, then the materials are in a folder in the VALUE VAULT. Simply email Aldridge56@aol.com and request a key.


The case study discussion in a PDF because of financial tables. Go here: http://www.yousendit.com/download/M3BsM25ITmFsMHhESjlVag

 Pepsi and Coke’s Uncivil Wars

Chapter 9 in Competition Demystified: Uncivil Cola Wars: Coke and Pepsi Confront the Prisoner’s Dilemma

What are the sources of competitive advantages in the soda industry?

First we should look at industry structure. The cola companies buy raw materials of sugar, sweeteners and flavorings from many suppliers then they turn the commodities into a branded product which consists of syrup/concentrated combined with water and bottles. The companies are joined at the hip with their bottlers/distributors who then sell to many retail outlets.  Selling bulky and heavy beverages lends itself to regional economies of scale advantages.

The soda companies cannot operate successfully unless their bottlers and distributors are profitable and content whether company-owned or franchised.

The existence of barriers to entry indicates that the incumbents enjoy competitive advantages that potential entrants cannot match. In the soft drink world, the sources of these advantages are easy to identify. First, on the demand side, there is the kind of customer loyalty that network executives, beer brewers and car manufacturers only dream about. People who drink sodas drink them frequently (habit formation), and they relish a constancy of experience that keeps them ordering the same brand, no matter the circumstances.

Both Coke and Pepsi exhibit the presence of barriers to entry and competitive advantage—stable *ROE can be influenced by whether bottlers’ assets are off or on the balance sheet

Second, there are large economies of scale in the soda business both at the concentrate maker and bottler levels. Developing new products and advertising existing ones are fixed costs, unrelated to the number of cases sold. Equally important, the distribution of soda to the consumer benefits from regional scale economies. The more customers there are in a given region, the more economical the distribution. A bottler of Coke, selling the product to 40% to 50% of the soda drinkers in the market area, is going to have lower costs than someone peddling Dr. Pepper to 5% to 56% of the drinkers.

During the “statesmen” era of Pepsi and Coke, what actions did each of the companies take? Why did they help raise profitability?

Note the stability of market share and ROE. ROE dipped in 1980 and 1982 as Pepsi and Coke waged a price war. Yet, market shares did not change as a result of the price war—both companies were worse off. Pepsi gained market share in the late 1970s versus Coke. Coke was slow and clumsy to respond.

Price wars between two elephants in an industry with barriers to entry tend to flatten a lot of grass and make customers happy. They hardly ever result in a dead elephant. Still, there are better and worse ways of initiating a price contest. Coke chose the worst. Coke chose to lower concentrate prices on those regions where its share of the cola market was high (80%) and Pepsi’s low (20 percent). This tactic ensured that for every dollar of revenue Pepsi gave up, Coke would surrender four dollars.

Coke luckily developed New Coke which allowed it to attack Pepsi in its dominant markets in a precise way—minimizing damage to Coke’s profits–and force a truce in the price wars.

They made visible moves to signal the other side that they intended to cooperate. Coca-Cola initiated the new era with a major corporate reorganization. After buying up many of the bottlers and reorganizing the bottler network, it spun off 51% of the company owned bottlers to shareholders in a new entity, Coca-Cola Enterprises, and it loaded up on debt for this corporation. With so much debt to service, Coca-Cola Enterprises had to concentrate on the tangible requirements of cash flow rather than the chimera of gaining great hunks of market share from Pepsi. PepsiCo responded by dropping the Pepsi Challenge, toning down its aggressive advertising and thus signaling that it accepted the truce. Profit margins improved. Operating profit margins went from 10% to 20% for Coca-Cola. Pepsi gain was less dramatic but also substantial.

Both companies focused on ROE rather than market share and sales growth.

The urge to grow, to hammer competitors and drive them out of business, or at least reduce their market share by a meaningful amount, had been a continual source of poor performance for companies that do have competitive advantages and a franchise, but are not content with it.

Chapter 8 in Competition Demystified, Games Companies Play, Discussion Part 1

Only free men can negotiate; prisoners cannot enter into contracts. Your freedom and mine cannot be separated. –Nelson Mandela
Chapter Eight’s questions was first discussed: http://wp.me/p1PgpH-uG

More on Prisoner’s Dilemma: http://perspicuity.net/sd/pd-brf.html

Chapter 8: Games Companies Play: A Structured Approach to Competitive Strategy, Part 1: The Prisoner’s Dilemma Game

QUESTION: Describe in a few sentences the dynamics of a prisoner’s dilemma game with two competitors of a similar size and the likely equilibrium in the real world of Lowes and Home Depot.

The essence of price competition among a restricted number of companies is that although there are large joint benefits to cooperation in setting high prices, there are strong individual incentives for firms to undermine this cooperation by offering lower prices and taking business away from the other competitors.

Competitive situations of this sort take the name of prisoner’s dilemma because they imitate the choices faced by two or more accused felons. If those, who participate in a criminal activity, are caught, and are then interrogated separately–if they all cooperate with one another and refuse to confess–there is a strong probability that they will bear the charge, and they can expect a light sentence.  But each of them can negotiate a deal with the police for even less jail time if he confesses and testifies against his confederates. The worst case is for an accused to maintain his innocence but have one of his confederates confess. Given these alternatives, there is a powerful temptation to abandon the group interest and confess.

Regarding Lowes and Home Depot, who face a prisoner-like dilemma in how they interact and respond to each other, for every issue, the outcome of any action by Lowes depends upon how Home Depot chooses to respond and vice versa.

Assume that the offerings of these competing firms are basically equivalent, then, so long as they charge the same for their product, the competitors divide the market equally. If they all charge a high price, relative to their costs, then they all earn high profits. If they all charge a high price, relative to their costs, then they all earn high profits. If they all charge a low price, they will divide the market, but now each of them earns less. However, if one firm decides to charge a low price while others charge more, we can assume that the firm with the low price captures a disproportionately large share of the market. If the additional volume more than compensates for the smaller profit per unit due to the lower price, then the firm that dropped its price will see its total profits increase. At the same time, the firms that continue to charge a high price should see their volume drop so much that their profits will be less than if they also charge the low price.

So it is no wonder that to maintain their cooperative position is difficult, both for the accused felons and for competitive firms. The usual outcome is what referred to in game theory as a “non cooperative equilibrium.”


Equilibriums are outcomes that are stable because no competitor has an obvious incentive to change its action. These equilibriums depend on two conditions:

Stability of expectation

Each competitor believes that the other competitors will continue to adhere to their present choices among the possible sources of action

Stability of behavior

Given the stability of expectations, no competitor can improve its outcome by choosing an alternative course of action. These two conditions work together; if no competitor has a motive to change its current course of action (stability of behavior), than no change will occur, confirming the stability of expectations. The most common form of competitive interactions is where there are large joint benefits from cooperation but strong individual incentives to deviate.

The reply to the second question on Chapter 8 will be posted next in Part 2

Chapter 8 in Competition Demystified: Games Companies Play–Questions

The Prisoner’s Dilemma is a short parable about two prisoners who are individually offered a chance to rat on each other for which the “ratter” would receive a lighter sentence and the “rattee” would receive a harsher sentence. The problem results from the fact that both can play this game — that is, defect — and if both do, then both do worse than they would had they both kept silent. This peculiar parable serves as a model of cooperation between two or more individuals (or corporations or countries) in ordinary life in that in many cases each individual would be personally better off not cooperating (defecting) on the other.

Chapter 8:  A Structured Approach to Competitive Strategy, Part 1: The Prisoner’s Dilemma Game

This chapter has no HBR Case Study but it is important to understand. A great supplement to this chapter and to understanding Game Theory is the book, The Art of Strategy (A Game Theorist’s Guide to Success in Business and Life) by Avinash K. Dixit and Barry J. Nalebuff, the authors of Thinking Strategically.


  1. Describe in a few sentences the dynamics of a prisoner’s dilemma game with two competitors of a similar size and the likely equilibrium in the real world of Lowes and Home Depot.
  2. When a competitor wants to be “deviant,” how can others in the market control the deviant’s behavior?

I will post the discussion next week.