Forty years ago a German economist, Reinhard Selten, published a working paper with the title “The chain store paradox”. It was simple and profound and showed a discomfiting disconnect between the fashionable mathematical tools known as “game theory” and the recommendations of common sense.
This is the set-up. Imagine a chain store with 20 branches, one in each of 20 small towns. Lacking any competition, these branches charge high prices and are lucrative. In each town, an entrepreneur is considering opening a rival shop. These 20 local entrepreneurs will, one by one, decide whether to compete against the chain store or to sink their capital into something else.
Much depends on the chain store’s response to a competitor. The chain store could be aggressive, ruthlessly slashing prices. That would make life painful for both retailers. The entrepreneur, finding herself committed to a low-margin business, would wish she’d invested her money in something else. Or the chain store could be accommodating, letting prices stay high and sharing a profitable market. So what will happen?