Why the price wars in Chinese e-commerce might end up becoming a race to the bottom for the companies involved.

When you were a child, your parents might have warned you to be careful what games you play lest you get hurt. The same advice might be needed for some of China’s biggest retailers as of late. It started on 13th August when Liu Qiangdong, chairman and founder of online retailer 360buy, announced that the company would price home appliances 10% lower than their competitors Gome and Suning. Shortly after this, Suning vice executive Li Bin announced that all items sold by Suning will be cheaper than those sold by 360buy. Not to be outdone, Gome then announced that it would sell, “All commodities 5% cheaper than Jingdong [360buy’s online store ]!” Since these three are among China’s largest retailers, the stakes in these statements are high.

We can use “game theory,”, a tool economists use to analyze firm interactions, to see where these promises might lead. To keep things simple, let’s suppose that there are only two firms – let’s say 360buy and Suning – and that they both promise to price 10% lower than their competitor (allowing for three firms each offering different discounts leads to the same conclusion but complicates matters). Let’s also suppose that both firms credibly commit to this policy – they will follow it no matter what. Doing so requires that the firms suffer an even greater cost by not following the policy than following it. As far as I know, none of the three firms has discussed the consequences if they deviate from the policy (more on this below), but to keep things simple let’s assume they pay a very large fine.

Applying game theory involves finding each player’s “best response” to the other player. Let’s start by placing ourselves in Suning’s shoes. Suppose 360buy is currently charging a price P for a particular appliance. What is my best response? I don’t want to charge any price above 0.9*P because I will have to pay the very large fine. I also don’t want to charge any price below 0.9*P because then I will lose more on each sale than necessary. So my best response is 0.9*P. Let’s turn now to 360buy’s best response. Given that Suning now charges 0.9*P what is my best response? I don’t want to charge anything above 0.9*0.9*P = 0.81*P or I will have to pay the very large fine. I also don’t want to charge anything below this or I will lose more on each sale than necessary. Therefore, my best response is to charge 0.81*P.

For those of you thinking ahead you already see where this is headed. We now need to go back to Suning and ask for its best response to 360buy charging 0.81*P. If we apply the same logic, it will charge 0.9*0.81*P = 0.729*P. But applying the same logic again, 360buy’s best response to this will be to charge 0.9*0.729*P = 0.6561*P. If we go through this process enough times we will get close to a price of zero. Game theory tells us that if both firms credibly commit to this policy, they will end up nearly giving away their merchandise.

It is speculated that the firms’ intentions are to drive the others from the market. Whether this is a good objective is a topic for a different article, but it is consistent with our game theory analysis – the game inexorably leads each firm to undercut the others’ prices. Just like a game of “chicken” in which two cars drive straight toward each other until one “blinks” and veers to the side, this game can only end when all but one of the firms gives up and exits the appliance market. Otherwise, they all continue to suffer losses.

This brings us back to whether these firms are credibly committed to this policy. Will they really continue to honor lower prices when they are practically giving away their products? Cracks are already appearing. According to Etao, a web portal for online retailers, 360buy has only slashed prices on 6% of its major home appliances and Gome on only 17%. These firms may have already looked ahead to the end game and decided that they didn’t like the game they were playing.

Note: The game that China’s retailers are playing bears a strong resemblance to the “meet or beat” clause commonly employed by firms. However, that game has a very different outcome. I will discuss that in my next posting.

Prof Brian Viard is Associate Professor of Strategy and Economics at Cheung Kong Graduate School of Business. He explores the workings of economics in everyday life and business in China through this fortnightly column.