Consider Coke and Pepsi’s decision of whether to advertise during the Super Bowl

Question

Consider Coke and Pepsi’s decision of whether to advertise during the Super Bowl or not. If neither company advertises during the Super Bowl, the two companies split the market and earn $50 million each. If they both advertise, they again split the market, but profits are lower by $10 million since each company must bear the cost of advertising. Yet if one company advertises while the other does not, the one that advertises attracts customers from the other. In this case, the company that advertises earns $60 million while the company that does not advertise earns only $30 million. Given this information, what is each company’s dominant strategy? What level of profits will following this strategy lead to for both firms? Will both firms advertise or not? What would have to happen to change your answer?

Explanation / Answer

Pay-off matrix is as follows.

A dominant strategy is the strategy chosen by one firm irrespective of strategy chosen by the other firm. Here,

Coke will Advertise whether Pepsi Advertises or not, since profit is higher ($40 million > $30 million, $60 million > $50 million). Therefore, Coke's dominant strategy is to Advertise.

Pepsi will Advertise whether Coke Advertises or not, since profit is higher ($40 million > $30 million, $60 million > $50 million). Therefore, Pepsi's dominant strategy is to Advertise.

When both firms chooses to Advertise, the relevant equilibrium outcome is the pay-off cell (Advertise, Advertise) where both firms earn $40 million profit. This is the Nash equilibrium.

However, the answer will change if both firms collude (cooperate) and decides Not to advertise, which will maximize joint profit so that each firm will earn a higher profit of $50 million.

(Values in $ Million) PEPSI Advertise Don't Advertise COKE Advertise (40, 40) (60, 30) Don't Advertise (30, 60) (50, 50)

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