Coca-cola and PepsiCo are the leading competitors in the market for cola product

Question

Coca-cola and PepsiCo are the leading competitors in the market for cola products. In 1960 Coca-Cola introduced Sprite, which today is the worldwide leader in the lemon-lime soft drink market. Prior to 1999, PepsiCo did not have a product that competed directly against Sprite and had to decide whether to introduce such a soft drink. By not introducing a lemon-lime soft drink, PepsiCo would continue to earn a $200 million profit, and Coca-Cola would continue to earn a $300 million profit. Suppose that by introducing a new lemon-lime soft drink, one of two possible strategies could be pursued:(1)PepsiCo could trigger a price war with Coca-cola and both would earn profits of 100 million, or (2)Coca-Cola could consent, then Coca-cola and PepsiCo would earn $275 million and $227 million respectively. Please use the extensive form represent the situation. Would introducing the new soft drink be the most profitable strategy?

Explanation / Answer

This is a classic game theory question that can be outlined by the diagram on this link: http://en.wikipedia.org/wiki/Normal-form_game
http://en.wikipedia.org/wiki/Game_theory

In a perfectly competitive market, a price war could not occur. However, the soft drink industry is a monopolistically competitive industry since these two companies control a majority of the market share.

Introducing the new soft drink would be the most profitable solution because it would be in Coca-Cola's bad interest to start a price war with PepsiCo. Therefore, Pepsi would earn $27 million more by introducing this drink than by not pursuing it.

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