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Robert Abbott
Robert Abbott
Articles (799)  | Author's Website |

Competition Demystified: Lowe’s, Home Depot and the Prisoner’s Dilemma

How companies adjust to each other to avoid damaging competition

February 07, 2020 | About:

Can there be competition and coordination among two or more companies in an industry?

That’s the issue in chapter eight of a book by Bruce Greenwald and Judd Kahn, “Competition Demystified: A Radically Simplified Approach to Business Strategy.” In it, the authors highlight a dance of sorts that might take place between Lowe’s (NYSE:LOW) and Home Depot (NYSE:HD).

For investors, this discussion should help in understanding not just how these heavyweights act and react in relation to each other, but also how tacit truces can exist in otherwise competitive markets.

As pointed out by the authors, competition occurs along many possible lines: pricing, product-line extension, store locations, relationships with suppliers and ad spending. To illustrate how complicated relationships between the two companies can be, they offered an example in which Lowe’s (NYSE:LOW) hypothetically opens a new store in a market previously served only by Home Depot (NYSE:HD):

  • Home Depot could try to force out Lowe’s by engaging in an aggressive price war. It could also open new stores in areas that had been exclusive Lowe’s territory.
  • If Lowe’s decides to fight instead of retreat, however, their defensive strategy could become costly and ineffective.
  • Thus, it would be logical for Home Depot to temper its response.
  • Yet, if it does not respond with enough resistance, Lowe’s might be encouraged to keep going into more Home Depot markets. Greenwald and Kahn wrote that if Home Depot put up a “truly fierce competitive stance,” Lowes might be deterred and never challenge Home Deport again. That would save it the costs of price-cutting and of opening stores whose main purpose was to retaliate.

From Lowe’s perspective, there are also several important considerations:

  • It might only open new stores in areas not served by Home Depot, nonoverlapping market areas. As a result, both companies could be left with healthier profit margins.
  • But what if Home Depot takes that tactic as a sign of weakness? Would Home Depot then move more aggressively into the areas it serves?

Greenwald and Kahn called this a situation that is frustrating in its complexity. Consider some of these issues (which apply to both companies):

  • What one company will do depends on how the other company interprets the other’s actions.
  • Interpretation depends on the signals sent by one company and how they are received by the other.
  • Further, interpretations are affected by each business’ culture.

As the authors noted, this resembles a situation in which mirrors reflect other mirrors, to the point of infinite regress. How are managers and investors to break out of this trap? How can the players develop a clear focus and make simplifying assumptions?

The prisoner’s dilemma

Greenwald and Kahn lead off here with the fact that most competitive races involve either price or quantity. When that competition is occurring among just a few players, price is usually the issue.

A safe first assumption is that the competing companies sell essentially the same products or services. That would certainly appear to the case with Home Depot and Lowe’s. In that case:

  • If they charge the same prices, they will divide the market evenly.
  • If they both charge high prices, then they both enjoy high profits (at least until the regulators arrive).
  • If they both charge low prices, then they will each earn less.
  • But, if one charges less while the other charges more, then it would gain market share and higher volume would offset the lower prices.
  • And the companies that keep charging a high price will see their volume shrink to the point that their profits would be the same as charging the lower prices. So they cut their prices too.

There is a name for situations like these: The prisoner’s dilemma, named after a situation in which two felons who committed a crime, are caught and then interrogated separately.

  • If the felons cooperate with each other, it’s likely they will both get off or at least get lighter sentences.
  • But if one of them confesses to police, then it is likely they will get a light sentence and the other felon will get a heavier sentence.

Therefore, there is a strong incentive for one felon to abandon the other and confess. As Greenwald and Kahn observed, it’s hard to maintain a cooperative position—for both prisoners and competitive companies. The result is called, in game theory, “noncooperative equilibrium.”

One of the tools used to analyze such situations is the humble two-by-two matrix, with two competitors and two prices. In the case of Lowe’s and Home Depot, each of the four boxes corresponds to one of the four possible outcomes and represents a decision by each of the companies. As the authors noted, each of the four boxes represents the economic consequences of both sets of pricing decisions.

They add that after a few rounds of the game, smart competitors should be able to figure out how the other will respond and adjust their actions accordingly. As a result of such exercises, by both sides, the market is likely to find some level of low-priced equilibrium.

Equilibrium

It is logical for an equilibrium, stability, to emerge when neither competitor has an incentive to change its actions. Two conditions must be present, though:

  • Stability of expectations, meaning each competitor expects the other company to stick to its current choices.
  • Stability of behavior, which means neither company can increase its profits by taking some other course of action.

While neither company is likely to engage in destructive competition (that would be good for consumers), they end up the same problem: They’re stuck in the lowest profit quadrant.

Price changes may be the most common way that companies try to increase their market share or profitability, but there are others, including:

  • Spending more on advertising.
  • Enhancing the sales force or products.
  • Longer warranties.
  • Special features.

Finally, the authors reported that companies can take actions that either reduce or lessen the impact of the prisoner’s dilemma. As they wrote, it makes deviant behavior less rewarding and cooperation less costly. These actions fall into one of two categories:

  • Structural adjustments: One of the most common ways that companies avoid potentially destructive competition is by choosing niches, whether geographic or by some other measure. For example, airlines have entered new markets and avoided problems by scheduling flights at times an incumbent airline wouldn’t contest. Think, too, of customer loyalty programs as structural adjustments.
  • Tactical responses: These refer to immediate responses, even automatic responses, to a price cut by a competitor. It comprises two parts, very quickly matching the other company’s price cut and at the same time signal it is willing to return to previous, higher prices. Many retailers, including supermarkets, have price-matching guarantees, as in: “If you find a lower price elsewhere, we will match it.” By making this commitment to consumers, companies are letting their competitors know that they will not get away with any unusual price cut.

In the next chapter, the authors will report on how Coke and Pepsi dealt with a prisoner’s dilemma in their industry.

Conclusion

In chapter eight of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” Greenwald and Kahn explained the complicated relationship between strong competitors using Lowe’s and Home Depot as an example. What is likely to emerge out of such competition is destructive price competition, which might be embraced by customers but could seriously damage the viability of both businesses.

Such a situation is known as a prisoner’s dilemma, one in which there is more reason to go one’s own way than to cooperate. But by analyzing their own and their competitor’s interests, both companies should be able to reach a tacit understanding. Such an understanding can lead to equilibrium in a market where no damaging price competition occurs. Still, companies want to expand and to do so without getting into trouble, they make structural adjustments or use tactical responses.

Investors who know and understand this dynamic will be able to read annual reports and perhaps even news reports with greater insight into the state of competition in industries.

Disclaimer: This review is based on the book, “Competition Demystified: A Radically Simplified Approach to Business Strategy” by Bruce Greenwald and Judd Kahn, published in 2005 by Portfolio/Penguin Group. Unless otherwise noted, all ideas and opinions in these reviews are those of the authors.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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