Price Wars in International Business

Keywords: price wars economics,

Introduction

‘Price wars’ are characterized by competing firms struggling to undercut one another’s prices (Assael, 1990). Price wars are a universal phenomenon that touches nearly every industry – telecommunication, retail, airlines, groceries. A scenario of price wars comes into existence in a market situation wherein a number of players compete to gain a larger share of the market by primarily reducing the price of goods or services that they are selling. Companies find price as a logical weapon of choice because it is easy to change fast (Kalra, Raju and Srinivasan, 1998). In the short run, this may seem profitable as it helps the organization gain a larger market share by higher market penetration. The customers also stands to gain from these price wars in the short run, as they are able to benefit from the downward spiral of prices offered by the competing firms. However, in the long run, price wars prove to be suicidal for the firms engaging in it and for their customers too. Price wars in the long run lead to a number of smaller firms to shut down, as they cannot continue to operate at such low profit margins like dominant firms can. This leads to a reduction in the number of players in the market, which in turn might lead to an increase in prices of the goods / services to a level higher than it was before the onset of the price wars. Thus no matter who wins , the combatants all seem to end up worse off than before they joined battle ( Akshay Rao, Mark Bergen & Scott Davis , 2000) Despite this fact , price wars are becoming more common and fiercer in their intensity.

While multiple causes such as change in strategy within a set of oligopolists , demand fluctuations , financial situation of the initiator, price image improvement or industry rationalization can be attributed to initiation of a price war , however, research shows that most price wars are caused either by wrong assessment of market signals or misunderstanding of your competitor’s motives. When price war is used as deliberate tactic, firms need to assess their financial situation and weigh the cost of a price war on present vs future gains and losses (Meghan Busse, 2002).

The threat of price war is real in today’s global and ultra competitive market. Since price wars affect profitability and the very survival of companies, they need to be prepared to meet this challenge. Companies that have survived price wars have invariably broken free from the “lowest cost” syndrome and focussed on innovation and creative ways to reinvent and reframe the way to do business.

Why do price wars start?

Profit maximization and market penetration are the key parameters that determine the success of a firm. In their battle to capture customers , companies use a variety of tactics, however price appears to be a weapon of choice as it is fast to execute and reversible (Akshay Rao, Mark Bergen & Scott Davis , 2000).

Price wars occur due to a variety of reasons not restricted to any one industry or to the lowest priced supplier. In market segments where product differentiation in a number of goods is not very evident price becomes one of the most important customer decision points (Exhibit 1). Firms try to reduce the price of goods / services to attract a larger customer base with the low price acting as a penetration price helping the firm gain greater market share. Niche industries or those with high product differentiation are less susceptible to price manipulations while industries with low capacity utilization and a declining demand or where a few large customers have the ability to influence prices are more prone than others to price wars (Exhibit1).

Economists provide a number of reasons for price wars to exist. Many companies across industries have avoided competition by working collaboratively as cartels to raise prices and profits. Stigler (1964) argued that cartel profits induce cheating or entry. This in turn leads to a price war, and the collusion disintegrates as was evident in the bromine price wars (Margaret Levenstein, 1997). While some cartels succeed, others fail due to misjudgment of competitor reactions, inability to monitor competitor price and output levels, incorrect interpretation of market information, entry of new market players or as a result of technological changes. The threat of price wars has been used by cartels to induce individual firms to cooperate and join the cartel (Friedman, 1971); while at times it has been used by firms as an instrument to punish and to keep their profitability secure. On the other hand, game theorists have argued that price wars may be necessary for cartel stability, and that they occur in response to exogenous shocks(Green and Porter [1984], Abreu, Pearce, and Stacchetti [1986] . Julio J Rotemberg and Garth Saloner (1986) support a contrarian view that price wars arise from business cycle fluctuations even with perfect information.

Oligopolistic markets witness greater price wars as the competitor firms can keep a close watch on the price at which other firms are selling their goods/ services. Within a set of oligopolists, price war signifies a change in strategy and non cooperative behavior. In the airline industry price wars occur when there is idle capacity and low demand, however due to cyclical nature of the industry where demand fluctuations are common, price wars also occur both during low and high demand periods (Saloner, 1986; Haltiwanger and Harrington, 1991). In response to price cuts, competitors reduce their prices further to attract customers, thus marking the beginning of a downward price spiral. Dominant firms that are cash rich resort to predatory pricing to create barriers to entry and by creating an ‘artificial’ competitive environment for the new entrants to drive them out whereas , in the case of financially weak firms the cost of present gains through increased sales outweighs the erosion of future value that a price war may bring to it .

It is mistakenly believed that all price wars are generally started by the lowest priced competitor; even highest priced suppliers can start price wars as part of their business strategy. In a stable market share environment the “perceived benefits to price relationship” can be expressed linearly with customers able to choose price points for the benefits they desire. However, in unstable market share environments this equilibrium is disturbed by the share gainers through perceived value enhancement of the product or service at same or lower price points. In their effort to capture additional market share, the premium supplier provides the new enhanced value product/ service at lower prices and starts a price war.

Why do firms avoid entering a price war?

Price is the most sensitive economic lever in business (Robert Garda, Michael Marn, 1993) and profits of firms are directly impacted by a decline in average price levels. Firms need to realize that price elasticity’s arising from additional sales volume due to a decrease in the price of a good / service is not enough to compensate for the decline in prices resulting from a price war. When the fight is on price alone, this effect of additional volumes is short lived as your competitors will follow suit in cutting prices. Price wars are counter intuitive, in order to attract a pool of ‘price sensitive’ customers, why would firms reduce their price to levels at which economic sustainability may be tough? In such scenarios, success for a firm or its competitor is short lived if price is the only differentiating factor for the customer to decide.

Price wars invariably bring about a change in customer perception. Customer perception of a price versus the benefit derived from a good / service is instrumental in deciding the success for the firm and in turn continued customer loyalty. Low prices that result from a price war lead to a lower anchor price (reference price) in the minds of a customer. The customer gets used to being serviced at a certain low price as a result of the price war. When firms that did engage in the price war try and revert to the higher pre price war levels they face customer resistance with customers re-analyzing perceived benefits versus the new prices and seeking other cheaper alternatives . The low prices accompanying price wars influence a customer’s perception of what is a “reasonable” price long after the war ends (Garda and Marn, 1993). In the airline price wars of the 1990s, prices of air tickets were cut in an attempt to draw a greater pool of travelers. While the airline sector suffered major losses , when the same airlines tried to increase fares , a large number of customers did not accept the price rise because they had a lower ‘reference price’ associated with the price of air travel (Busse, 2002).

Price wars are instrumental in unbalancing the “perceived value – price ” correlation that exists in a market. It causes customer’s perception to the above becoming skewed towards price sensitivities at the cost of benefits and quality of goods/ services. In such situations industries run the risk of seeing a collapse in demand levels once prices stop falling. It is therefore in the interest of firms to emphasize the value benefit to the client instead of the price benefit. By correctly understanding the amount and value of incremental benefits being offered firms create long term financial benefits and sustainable advantage. Premium brand firms avoid entering price wars thus protecting their brand equity by using selective pricing options, loyalty programs or like McDonald by creating alternate packaging for burgers (as value meals) when threatened by Taco Bell’s pricing.

Firms involved in predatory pricing employ this tactic to move towards a more monopolistic market condition where they can be the price setters and push weak competitors to exit the market. However, firms wanting to engage in price wars for this reason need to remember that strong laws and regulations exist to protect smaller players in the market. Thus it is always advisable for a firm to stay away from a price war. A price war does not help any firm in the long run and neither does it help the industry grow on the whole.

Conclusion

The paper focuses on price wars as an industry wide phenomenon brought about not only by external market conditions but also by internal characteristics of firms like it’s financial health, position in the market and even at times as part of a well thought market strategy. Invariably price wars impact profitability of the industry, with both initiators and followers in a price war end up without any sustainable advantage and an erosion of their economic value.

Companies do not always to respond by retaliatory price cuts as any such move erodes their brand equity, they instead want to focus more on quality as against price as a determinant of value. Even for customers, while such price cuts may appear beneficial in the short term, ultimately they lead to a risk of poor quality products/ services.

Because price wars are so destructive economically, all prudent organizations need to be prepared to handle such eventualities. Over time it is seen that while prevention is the best cure, there are some key steps companies have to take to prevent the onset of such an environment. Managers need to continuously re-examine their pricing initiatives to ensure that their actions do not contribute to any competitive misread and the creation or extension of a price war in the industry (Garda and Marn, 1993). By creating price leadership, companies avoid price cuts and retain profit margins by using different tactics from predatory pricing, financial punishment and diplomacy to rein in errant companies trying to initiate a price war . Finally price wars can never be won, the victor and the vanquished both suffer the effects to different degrees.