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Number of articles have been written on Amazon and Wal-Mart’s war on book prices this holiday season. Let’s take a different look at the same story and how it can possibly help the economy and the consumers by – increasing the pie.

First, the story. Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. Wal-Mart began by marking down the prices of ten best-sellers—including the new Stephen King and the upcoming Sarah Palin—to ten bucks. When Amazon, predictably, matched that price, Wal-Mart went to nine dollars, and, when Amazon matched again, Wal-Mart went to $8.99, at which point Amazon rested…From a game-theory perspective, price wars are usually negative-sum games: everyone loses. A recent study found that, if competitors do match price cuts, industry profits can get cut almost in half. (Read more: here)

So the final prices were $9.00 (Amazon) and $8.99 (Wal-Mart). Where is the pie here?

I did some research to find out what exactly is the price elasticity of demand for books. Its a difficult number to calculate and I wasn’t very hopeful until I found this research article. This research intended to determine demand for books and was conducted in Norway. The research took into account number of demographic parameters into consideration. One of the numerous conclusion of the article was:

For our calculations, lets assume that demand is fairly elastic and it is –1.5.

So if the prices fell from $10.00 to $9.00 (say) then prices fell by 10%. Which means the books expected to be sold will increase by 15%. Which in turn means that the revenues will grow from 10X to 10.35X (9 x 1.15X). A value creation of 0.35X or 3.5%. While this number may look small in percentage terms, it is substantially big when we can find the real value of X (in 2006 3.13B books were sold) and substitute.

What Amazon and Wal-Mart have unintentionally done is to increase the total pie (the total revenues that can be earned by them). Yes, the margins may have taken a hit, but don’t we know that NPV is a better measure than IRR.

Do you think this research if conducted and analyzed in the US can change prices in the longer run? Thoughts?

A good analysis on this price war has also been done here.

When discussing game theory, particularly ‘Prisoners Dilemma’, an oft cited real life example is that of carbon emissions control by different nations. Many treaties, agreements have been signed in order to reduce harmful carbon emissions in order to prevent global warming, but without much results.

The time is ripe again to discuss the game in the same context. Barack Obama is planning to visit Copenhagen next month as a show of US’s commitment in efforts to cut down emissions. In the last Kyoto Protocol, US was the only country (among participating countries) that did not ratify the agreement. It is expected that Barack’s presence and commitment will change all that. The article says:

The United Nations’ top climate negotiator, Yvo de Boer, said Mr. Obama’s participation in the summit is "critical to a good outcome."

Assume for a second that US does agree to participate ‘actively’ in reducing carbon emissions, what can go wrong? The answer may lie in the Prisoners Dilemma. Up until now, this game was played among nations sans US and there was an incentive to cheat and not conform to the requirements. As such, countries that did not follow the guidelines were able to extract some benefits that accrued from steps taken by responsible countries. If one of the responsible ones was in fact a large one, the actions by smaller countries were not necessarily taken seriously and the gross impact was negligible. But the net impact, sum of many small countries defecting, was huge. As a result these protocols have not been very effective in curbing the emissions problem so far. See the figure to explain the situation. Note that the numbers are figurative and do not indicate any absolute values.

Now with the entry of US in the fray, the incentive to cheat by the smaller countries will actually increase! Because of US’s commitment, India and China (largest developing nations) will come under much more questioning than before. The result of this would be that these countries will start taking ‘baby’ steps to counter some of the retaliation. As a result of this, the smaller nations, in Africa, the EU, Australia will have an incentive to defect or at least reduce their commitment towards reducing carbon emissions. A lot of focus will be on the actions of more prominent countries, and steps taken by them will have a noticeable impact on the saturation level. Because smaller countries will tend to ‘free ride’ on the steps taken by bigger countries, they will probably reduce their efforts.

Are we forgetting something? Yes. This game is played repeatedly, not once. So don’t all countries have an incentive to co-operate, rather than play truant. From a bird’s eye view, yes. But the assertion can be justified only if we can properly understand the impact of retaliation by the responsible countries in the next round. What kind of punishment is imposed, in terms of sanctions, fines, etc that can prove to be a higher cost that co-operating. The problem facing the planet is grave and hopefully a situation will not play out where both players defect. But the defecting countries can be made to follow is by altering the only variable available for manipulation – the payback for defection.