How much would Pepsi pay to get Coke’s secret formula?

A few days back some dastardly Coca-Cola employees got nabbed trying to sell corporate secrets to Pepsi. Pepsi turned the bad guys in and cooperated in the sting operation.

Did the executives at Pepsi give up the chance to make huge profits at Coke’s expense in order to “do the right thing?”

I had lunch with my friend and colleague Kevin Murphy yesterday. He made an interesting point: knowing Coke’s secret formula is probably worth almost nothing to Pepsi. Here is the logic.

Let’s say that Pepsi knew Coke’s secret formula and could publish it so that anyone could make a drink that tasted just like Coke. That would be a lot like what happens to prescription drugs when they go off patent and generic drug companies come in. The impact would be that the price of real Coke would fall a lot (probably not all the way to the price of the generic Coke knockoffs). This would clearly be terrible for Coke. It would probably also be bad for Pepsi. With Coke now much cheaper, people would switch from Pepsi to Coke. Pepsi profits would likely fall.

So if Pepsi had Coke’s secret formula, they wouldn’t want to give it away to everyone. What if they instead kept it to themselves and made their own drink that tasted exactly like Coke? If they could really convince people that their drink was identical to Coke, then the new Pepsi-made version of Coke and the Real Thing would be what economists call “perfect substitutes.” When two goods are essentially interchangeable in consumers’ minds, that tends to lead to fierce price competition and very low profits. Neither Coke nor the Pepsi knockoff of it would be very profitable as a consequence. With the price of Coke lower, consumers would switch away from the original Pepsi to either Coke or the new Pepsi-made Coke knockoff, which would be far less profitable than original Pepsi anyway.

In the end, both Coke and Pepsi would likely be worse off if Pepsi had Coke’s secret formula and acted on it.

So, maybe the executives at Pepsi were acting morally and honorably when they turned in the criminals stealing Coke’s secrets.

Or maybe they are just good economists.