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Pepsi Coke Case

In: Business and Management

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Section I—SIC and NAICS Codes
The Standard Industrial Classification (SIC) is a system for classifying industries by a four digit code. The Security and Exchange Commission (SEC) uses SIC codes when sorting company filings. Companies that operate in a certain industry use a specific SIC code when filing with the SEC so that the type of business is properly identified. Identifying government contracts by their SIC description. The SIC system arrays the economy into 11 divisions, that are divided into 83 2-digit major groups, that are further subdivided into 416 3-digit industry groups, and finally disaggregated into 1,005 4-digit industries. While certain governmental departments and agencies, such as the SEC, still use the SIC, it is being replaced by the six-digit North American Industry Classification System (NAICS code). The NAICS is a 2- through 6-digit hierarchical classification system, offering five levels of detail. Each digit in the code is part of a series of progressively narrower categories, and the more digits in the code signify greater classification detail. The first two digits designate the economic sector, the third digit designates the subsector, the fourth digit designates the industry group, the fifth digit designates the NAICS industry, and the sixth digit designates the national industry.

Section II—Game Theory and Hypothesis 2a
In the set-up to Hypothesis 2a, the authors discuss the notion that players learn from past experiences and have a perfect memory. They discuss a “tit-for-tat” strategy that should over time result in an attenuation of the competitive moves between players. This interaction over time should make it easier for a firm to predict the direction and nature of their rival’s next (competitive) move. The authors suggest in Hypothesis 2a that the volatility of the relationship between Coke and Pepsi’s competitive moves would attenuate over time. However, they also discuss how it can be argued that firms will engage in more radical shifts in strategies in order to gain competitive advantage. In addition, they discuss that is can be difficult for a firm to observe if an action has occurred. This could cause a player to act preemptively and may also make it difficult for rivals to respond proportionately. This can interfere with the tit-for- sequence and could cause breakdowns in the dynamic equilibrium. Testing of hypothesis 2a yielded mixed support – only two price and one in the strategy series showed a reduction in volatility while the other three variables showed an increase.

Section III— Stackelberg Leader Model
The Stackelberg leadership model is a strategic game in economics in which the leader firm moves first and then the follower firms move sequentially. In game theory terms, the players of this game are a leader and a follower and they compete on quantity. The Stackelberg leader is sometimes referred to as the Market Leader. There are some additional constraints upon the sustaining of Stackelberg equilibrium. The leader must know that the follower observes his action. The follower must have no means of committing to a future non-Stackelberg follower action and the leader must know this.

Firms may engage in Stackelberg competition if one has some sort of advantage enabling it to move first. More generally, the leader must have commitment power. Moving observably first is the most obvious means of commitment: once the leader has made its move, it cannot undo it - it is committed to that action. Moving first may be possible if the leader was the incumbent monopoly of the industry and the follower is a new entrant. Holding excess capacity is another means of commitment.

With regards to Hypothesis 3, Pepsi's competitive moves would be driven by Coke's actions, Coke is the leader and Pepsi is the follower. Once Coke has made its move, Pepsi will follow (even though Pepsi isn’t a new entrant).

With regards to Hypothesis 4, Coke's competitive moves would not follow Pepsi's actions - there is no Stackelberg model here. While Pepsi could be considered a leader, Coke will not follow. Therefore there is no follower.

Section IV— Similar Industries
A few other industries that have similar structures to the beverage industry are phone and wireless carriers (AT&T and Verizon), credit cards (Visa and Mastercard), aircraft (Boeing and Airbus) and coffee (Starbucks and Dunkin Donuts). Starbucks and Dunkin Donuts compete with each other in a very similar fashion to Pepsi and Coke. Their competitive dynamics are also very similar to that of Coke and Pepsi. Starbucks and Dunkin are certainly aware of each other’s presence and have engaged in competitive rivalry for several years. Despite the fact that Dunkin Donuts was founded 21 years before Starbucks, based on the Stackelberg model, Starbucks is the market leader. Starbucks torrid growth forced Dunkin to introduce new products at a faster pace. Dunkin was able to quickly build a loyal customer base for it’s coffee products and now it is very common for someone to favor one over the other. Similar to Coke and Pepsi, Dunkin used a blind taste test in order to proclaim that America prefers Dunkin. In addition, they target each other in their advertising. For example, Dunkin mocks Starbucks use of Italian words, “The delicious latte from Dunkin' Donuts - you order it in English, not Fritalian.” Dunkin also charges less and ran ads calling Starbucks overpriced. In retaliation, Starbucks launched an ad “Beware of a cheaper cup of coffee. It comes with a price.” In many ways they seem to drive each other’s behavior.

Section V— The five hypotheses
Hypothesis 1. Competitive moves of Coke and Pepsi would display an interdependent relationship, and this means, competitive moves would not be static, nor will they be independent of each other. –Supported

Hypotheses 2a. The volatility of the relationship between Coke and Pepsi's competitive moves would attenuate over time. – Mixed Support

Hypotheses 2b. As competitive moves become less observable, volatility of the relationship between rivals' for such moves would increase over time. -- Supported

Hypothesis 3. Pepsi's competitive moves would be driven by Coke's actions. – Rejected (pricing), supported (strategic actions)

Hypothesis 4. Coke's competitive moves would not follow Pepsi's actions. – Rejected (pricing), supported (strategic actions)

Hypothesis 5. Pepsi would initiate competitive moves that would be responded to by Coke. - Supported

Section VI – Results
The study offered several insights. Upon studying the leader-follower model with regard to pricing, insignificant results were found that Coke causes Pepsi in Philly (Pepsi dominated) or Boston (Coke dominated); However, Pepsi causes Coke in both cities. In Baltimore-Washington, where they have similar market-share, pricing was driving each other’s behavior.

The results show that the competitive dynamics between the two firms are complex, vary strategically and change over time. Awareness, reference and tit-for-tat interdependent behavior appears largely supported by the findings. It was also indicated that while the volatility in price or tactical actions tends to go down, it increases for strategic actions. The study also showed different than expected results for the leader-follower relationship. For tactical actions, Coke largely followed Pepsi. Strategically, half the time they were driving each other’s behavior and other times Coke’s behavior was driven by Pepsi. In essence, what they found was a new perspective suggesting that market leaders no not necessarily lead in competitive actions.

The authors also discuss the limitations of the study and findings that were very surprising which lead to the need for further research. Specifically, more studies are needed to test if preemption occurs as uncertainty about signals and payoffs and apprehension about ease and speed with which firms may be able to respond to their rival’s actions increase.

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