Coca-Cola vs. Pepsi: A strategic game of substitutes

Hitesh Arora

(The following article is the winner of this year's 'Economics Alive' competition for year 12 economics students)

The photo captures two iconic beverage brands, Coca-Cola and Pepsi, side by side on a store shelf. This everyday scene actually teaches us some interesting economic ideas: substitute goods as well as game theory.

In the realm of economics, Coca-Cola and Pepsi are classic examples of substitute goods. These products are so closely related that consumers often switch between them based on factors like taste preference, price, or availability. As a result, changes in the price of one can directly impact the demand for the other. This dynamic represents the essence of substitute goods and their role in influencing consumer choices.

However, we can observe that the prices of these two substitute goods are exactly the same at £1.69. We can think of Coca-Cola and Pepsi as players in a game, much like a game of chess. This is where game theory comes into play. We can use a payoff matrix to visualise the reason for this.

Let's assume that Coca-Cola and Pepsi both opt for a high-price strategy, which means they'll achieve good sales and generate substantial revenue. We can say they both earn £2 billion in revenue. However, if Coca-Cola chooses a low price while Pepsi maintains a high price, Coca-Cola will capture extra customers from Pepsi, resulting in increased sales and revenue. In this scenario, Coca-Cola would make £3 billion, and Pepsi would only make £1 billion.

Conversely, if the roles were reversed, Pepsi would earn £3 billion in revenue, while Coca-Cola would only make £1 billion. Assuming that demand is inelastic, if they both choose a low price, the quantity will only increase by a smaller percentage, leading to an overall reduction in their revenue (e.g., £1 billion each in revenue). This serves as an example of firms colluding, where they agree to fix prices to keep them high, allowing both to maximise their revenue.