COMPETITION AND

PRICING
The Origin of Price Wars

 The purpose of all war is ultimately peace.

 Firm enters into price wars to drive competitors out of a market and then
increase its price and gain higher profit.
 A price war may weaken a competitor, it is hard to kill an established
organization and permanently remove industry capacity.
 Higher profits earned by a firm in a market will only invite other competitors
to enter or re-enter that market.
 Price wars are generally illogical.
 If any one firm raises its prices without its competitors raising their prices
simultaneously, customers will switch brands, and that one firm will lose
market share and profits.
Prisoner’s Dilemma
Structural Drivers

 Any rational executive in any industry should understand that

price reductions that encourage destructive retaliation should
be avoided, and all price wars would cease.
 Price wars break out anyway.
 (Food Industry)
Five structural drivers to price
competition

 Number of Competitors
 Industries with fewer competitors tend to be able to monitor one
another’s pricing practices and respond appropriately
 With many competitors, it becomes prohibitively costly to monitor the
pricing actions of all competitors.

 Competitors’ Managerial Maturity

 Mature competitors are better positioned to both anticipate competitors’
response to prices and be aware of competitors’ pricing practices.
 High Fixed Costs and Low Marginal Cost
 Industries facing high fixed costs but low marginal costs often face extreme
pressure to lower prices to capture marginal revenue. Because marginal costs
are low (and in some cases zero), most marginal revenue can be added directly
to the overall corporate bottom line.
 Industry Maturity and Economic Savings
 companies may be willing to price low in new industries in the hopes of gaining
future cost saving from
 Economies of scale
 Economies of learning
 Economies of scope
 Economies of scale : refers to the cost savings that a firm can gain
that depend on the size of the firm as measured by its long-run,
sustainable rate of output. As production volume increases, fixed
incremental costs that arise from product development or capacity
increases can be spread over a larger number of units, reducing the
long-run average cost.

 Economies of learning: refers to reductions in cost that come from

experience, as
measured by accumulated output.

 Economies of scope : refers to the production cost reductions as the

breadth of a
firm’s activities increases.
 Industry Maturity and Network Externalities
 companies may be willing to price low in new industries in the hopes of
gaining future cost savings from economies in scale, scope, or learning.
 Even user share can drive network externalities, as it does
for social networking websites like Facebook, LinkedIn, and Skype.
 Network externalities can drive price wars in industries facing two-sided
markets or highly profitable complementary goods markets.
 Products that benefit from network effects are marketed by a firm under
high motivation to increase the number of customers on its network.
Reacting to Price Reductions

 It is often better to be a small competitor in a profitable industry than a

large competitor in an unprofitable industry.
 Three issues can be considered when calibrating a response to a
competitor’s price action.
 DIRECT COSTS AND BENEFITS
 SECONDARY CONSEQUENCES
 STRATEGIC POSITION
DIRECT COSTS AND BENEFITS

 Direct COST
 Identifying the exact nature of the revenue at risk of loss
 Which market segment is at risk?
 Which customers are at risk of defecting to the competitor?
 How much of the revenue from those customers is placed at risk by the
competitor’s price reduction?
 Which specific products’ sales are at risk? What business area is at risk?
 What is the probability that the specific revenue at risk will be lost?
 Are there other factors that may imply that the risks of losing revenue are still low
after a competitor’s price reduction?
 BENEFITS
 What is the probability of retaining those sales after matching a
competitor’s price move?
 What profits would be gained by responding?
 What is the strategic importance of the specific revenue at risk?
 Does a foothold within the market threaten other revenue streams?
 Will blocking a competitor on the revenue at risk prevent that competitor
from leveraging an entry point into other domains within the customer
base?
Secondary Consequences

 A price reduction in one situation may affect sales outside of the

specific opportunity at risk.
 The firm’s response to a price reduction by a competitor by matching
that price reduction may lead to further rounds of price reductions.
 Price concessions in one opportunity may enable other customers to
demand a similar price concession in other situations.
 The competitive nature of business and the desire to win every
opportunity yields a managerial inclination to match or beat any
competitor’s price reduction.
Strategic Position

 Price reductions by a competitor may be driven by a difference in

competitive advantage.
 When a competitor has a cost advantage, its ability to reduce prices and
remain profitable is greater than the original firm’s ability to follow suit.
 Firms at a cost disadvantage have a higher strategic interest in raising
industry-level prices—or at least not lowering them—than those with a
cost advantage.
 As such, a firm may be better off averting a price war and granting market
share concessions rather than entering into a war that it cannot win.
Reacting to Price Reductions
Initiating Price Reductions

The general who wins the battle makes many calculations in his
temple before the battle is fought. The general who loses makes
but few calculations beforehand.
 There are strategic reasons for imitating a price reduction.
 Price may be a strategic focus of the firm, stripping out costs to serve a
larger market at a lower price point and capture a significant market share.
 When a firm determines that it is in its best interest to resolve the price-to-
value trade off in favour of its customers,
 it should gauge the likely competitive response prior to executing its
strategy.
Price as a Strategic Focus

 Southwest, IKEA, and Wal-Mart all share a common focus of reducing costs
and prices simultaneously to profitably take market share and enter unserved
and underserved markets.
 Using price as a strategic focus in a radical form of customer orientation, the
need and willingness to pay of customers determine every attribute of the
firm’s operations and products.
 The firm manages its only value proposition by determining to enter a market
only if the customer’s willingness to pay can be met profitably with a product
that it can make and distribute at a lower cost.
 If not, firms like IKEA walk away from that specific market opportunity rather
than try to convince customers to pay a higher price for the product.
Gauging Competitive Response

reducing prices or increasing the price-to-value trade-offs faced by customers

Will the Competitor React at All?
What Options Will the Competitor Actively Consider?
Which Options Will the Competitor Most Likely Choose?
Two facts make this process effective:
(1) Surveys show that most companies use rudimentary analytical techniques
in determining a competitive response and therefore their competitive
responses will be somewhat predictable.
 (2) Most companies follow a predictable pattern in reacting to a competitor’s
move; and therefore, executives can anticipate a competitor’s future reactions
by studying its past reactions.
Will the Competitor React at All?

 Four lines of inquiry will enable executives to gauge the likelihood of a

competitor response:
 (1) Will your rivals see your pricing action?
 (2) Will competitors feel threatened?
 (3) Will mounting a response be a priority?
 (4) Can your rivals overcome organizational inertia?
What Options Will the Competitor Actively
Consider?

 he single most common counteraction is to introduce a “me-too”

product or matching a price change, both of which are highly obvious
responses.
 A large portion of managers will consider what their business unit did
the last time that it faced a similar situation.
 To a smaller degree, managers might consider the actions by other
business units, seek board or expert advice, or defer to the specific
experience of the executive in charge.
Which Options Will the Competitor Most Likely
Choose?

 A large number of competitors will not participate in an examination of

their response based on game theory.
 When a competitor evaluates its options, it is likely to consider the
financial effects of different outcomes.
 Executives can uncover the option that they can anticipate that
competitors will perceive as the best, and therefore the one that
competitors are most likely to choose.
Managing Price Actions

Speak softly and carry a big stick

 Price wars are potentially extremely destructive.
 if a war has been initiated Firms may be able to act to limit its spread.
 Two techniques in particular have been widely demonstrated to
mitigate the potential of a pricing action to deliver negative
repercussions. These are
 Price signalling
 tit-for-tat pricing.
Price Signalling

 Firms communicate a strategic pricing action to their competitors

indirectly.
 Price signalling can be used both for managing price reductions while
limiting them potential for the breakout of a war.
 1) The price change must be announced in a highly public forum
 2) the reasons for the price action must be credible.
 Firms should cite credible reasons for the price change
Tit-for-Tat Pricing

 Tit-for-tat pricing is an extreme form of price followership in which a

firm matches its competitor’s price actions at every stage of the game.
 Tit-for-tat pricing removes price as a strategic dimension of
competition.
 The point of tit-for-tat pricing isn’t to destroy enemies but to convince
them that the battle is not worth fighting.