EXHIBIT 7-1 Thoughtfully Reacting to Price Competition
Managing Conflict Thoughtfully
Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.
Sun Tzu1
The sixth, and final element, of the Value Cascade is Price Competition. A gap occurs between actual and potential value realization when a firm makes pricing decisions that fail to anticipate the response of competitors to those decisions.
Ironically, there is little issue here for firms that operate in markets with so many competitors, each with a small market share, that there is no potential to manage it. Those firms need merely remain alert to changes in market prices and adjust prices quickly, as described in Chapter 6, when the reference value changes. Managing price competition becomes more challenging, and an unnecessary gap in profitability becomes much more likely, when a firm’s market share is large enough that competitors react to its decisions.
The ramifications of competitive reaction can be substantial. Recall the description in Chapter 1 of how Alamo Rent A Car went quickly from being the most profitable rental car company to one suffering losses because it failed to anticipate the reaction of competitors to what may, otherwise, have been a financially sound growth strategy. In contrast, large airlines flying to multiple destinations made a wise decision when they introduced frequent flyer programs in an attempt to blunt the effect of lower prices from small, low-cost competitors. Of course, the small competitors could also offer frequent flyer programs offering the same number of points per mile of travel, but they could not offer the ability to accumulate points as rapidly nor could they offer the same variety of destinations once an award level was attained. Thus the relative inability of lower-cost competitors to react with an offer of equal value enabled larger competitors to create a much-needed source of competitive advantage.
Price competition is a “game,” as defined by game theorists, because the ultimate outcome resulting from any move that you make depends upon how your competitors react to it. Making the right choices in a game is very different from making the right choices to solve a puzzle—such as how to make a product more efficiently. Moreover, competitive pricing is a type of game that requires skills foreign to many managers. What most of us know about competition has been learned from sports, academics, and perhaps from participating in intracompany sales contests. The rules for success in these types of competition are quite different from those for success in pricing. The reason, in technical jargon, is that the former are all examples of “positive-sum” games, whereas price competition is usually a “negative-sum” game.2 Understanding the difference between positive-sum and negative-sum games is crucial to making sound pricing decisions that contribute to profitability and business value.
Positive-sum games are those in which the very process of competition creates benefits. Consequently, the more prolonged and intense the game—in sports, academics, or sales—the greater the rewards to the players. The winner always finds playing such games worthwhile and even the loser may gain enough from the experience so as not to regret having played. In fact, people and companies with a healthy attitude toward these activities often seek opportunities to challenge themselves. A strong competitive spirit is a criterion commonly used to identify job candidates with high potential for success not only in sports, but also in scientific research. It is also indicative of people likely to be successful in sales if the firm creates a competitive culture that honors those who excel in meeting or exceeding sales goals.
Unfortunately, that same gung-ho attraction to competition can be quite unhealthy when applied to negative-sum games: those in which the process of competition imposes costs on players. Warfare, labor strikes and dueling are negative-sum games because the loser never benefits from participation and even the winner may end the confrontation badly wounded. The longer the conflict drags on, the greater the cost it imposes on the players. Price competition is usually a negative-sum game, since the more intense price competition is, the more it can undermine the value of the market over which one is competing. That is likely to be the case where total market demand is increased very little by lower prices and competitors have similar cost structures. Therefore, price competitors do well to forget what they learned about competing from sports and other positive-sum games, and to try instead to draw lessons from what are, hopefully, less familiar competitive games such as warfare.
Students of actual warfare, who are cognizant of its costs do not make the mistake of equating success with winning battles. Sir Basil Liddell Hart, author of more than 30 books on military strategy, offers advice to political and military leaders that marketers would do well to note:
Fighting power is but one of the instruments of grand strategy—which should [also] take account of and apply . . . financial pressure, diplomatic pressure, commercial pressure, and . . . ethical pressure, to weaken the opponent’s will. . . . It should not only combine the various instruments, but also regulate their use as to avoid damage to the future state of peace.3
In short, winning battles is not an end in itself, and warfare is certainly not the only means to an end. In the same vein, winning sales is not an end in itself and reducing prices is not the only, and is rarely the most cost-effective, means for winning new customers.
For marketers, as for diplomats, warfare should be a last resort, and even then the potential benefits of using it must be weighed against the cost. Fortunately, there are many positive-sum ways for marketers to compete. Creating new products, creating new ways to deliver service, communicating more effectively with customers about benefits, and increasing the efficiency of operation are all positive-sum forms of competition. Precisely because they create profits rather than dissipate them, building capabilities for positivesum forms of competition is the basis of a sustainable competitive strategy. Price competition may also be part of an overall profitable growth strategy. But competing on price alone can succeed at best only in the short term until competitors find it threatening enough to react.
Unfortunately, many managers erroneously believe that the key to financial success is first to win market share, after which profits will follow (see box “Market-Share Myth” below). When many competitors pursue this same strategy, they engage in mindless negative-sum competition, which does little more than destroy profitability for everyone. Fortunately, there are competitive strategies that can increase, or at least maintain, the value of markets through positive-sum competition. Rather than attracting customers by taking less in margin, positive-sum strategies attract customers by offering them new sources of value or by meeting their needs in new ways that create value more cost effectively. Recall our discussion of Exhibit 1-3 in Chapter 1, where we contrasted Product-led versus Customer-led offer development. Companies grow both top-line revenue and bottom-line profit simultaneously when they can create new sources of customer value without adding as much to cost, or when they can reduce costs without equally reducing the value, enabling them to reduce prices to win sales without reducing margins below those of competitors.
A common myth among marketers is that growing market share is the key to profitability. If that were true, the largest airlines in North America would be the most profitable while the small upstarts would be struggling. In fact, for most of the last few decades, the opposite has been the case.i The source of this myth is a demonstrable correlation between market share and profitability.ii But as any student of statistics should know, correlation does not necessarily imply a causal relationship.
A far more plausible explanation for the correlation is that both profitability and market share are caused by the same underlying source of business success: a sustainable competitive advantage in meeting customer needs more effectively or in doing so more efficiently.iii When a company has a competitive advantage, it can earn higher margins due to either a price premium or a lower cost of production. That advantage, if sustainable, also discourages competitors from targeting the company’s customers or from effectively resisting its attempts to expand. Consequently, although a less fortunate company would face equally efficient competitors who could take market shares with margin-destroying price competition, a company with a competitive advantage can sustain higher market share even as it earns higher profits. Market share, rather than being the key to profitability, is, like profitability, simply another outcome of a fundamentally well-run company.
Unfortunately, when management misperceives the symptom of a poor strategy (insufficient or declining market share) as a cause and seeks it by some inappropriate means, such as price cutting, the expected increase in profitability doesn’t materialize. On the contrary, a grab for market share unjustified by an underlying competitive advantage will usually reduce the company’s own and its industry’s profitability. The ultimate objective of any strategic plan should not be to achieve or even sustain sales volume, but to build and sustain competitive advantage. Profitability and, in many cases, market share growth, will follow. In fact, contrary to the myth that a higher market share causes higher profitability, changes in profitability usually precede changes in market share, not the other way around. For example, Walmart’s competitive advantages made it the most profitable retailer in the United States long before it became the largest, whereas several of its key competitors’ poor profitability preceded by many years their loss of dominant market share. This pattern of changes in profitability leading, not following, changes in market share is equally visible in the automobile, steel, and banking industries.
A strategic plan based on building volume, rather than on creating a competitive advantage, is essentially a beggar-thy-neighbor strategy—a negative-sum game that ultimately will only undermine industry profitability. Every point of market share won by reducing margins (either by offering a lower price or by incurring higher costs) invariably reduces the value of the sales gained. Since competitors can effectively retaliate, they probably will—and at least partially eliminate any gain in share while reducing the value of a sale even further. The only sustainable way to increase relative profitability is by achieving a competitive advantage that will enable you to increase sales and margins. In short, the goal of a strategic plan should not be to become bigger than the competition (although that may happen) but to become better. Such positive-sum competition, rather than undermining the profitability of an industry, constantly renews it.iv
(i) “Global Earnings Scoreboard: Most Recent 12 Months Reported,” Airline Weekly, January 9, 2017.
(ii) Robert D. Buzzell, Bradley T Gale, and Ralph Sultan, “Market Share—a Key to Profitability”, Harvard Business Review (January 1975).
(iii) Robert Jacobson and David Aaker, “Is Market Share All That It’s Cracked Up to Be?” Journal of Marketing 49 (Fall 1985), pp. 11–22; Richard Schmalensee, “Do Markets Differ Much?” The American Economic Review 75(3) (June 1985), pp. 341–351; William W. Alberts, “The Experience Curve Doctrine Reconsidered,” Journal of Marketing 53 (July 1989), pp. 36–49; Cathy Anterasiun, John L. Graham, and R. Bruce Money, “Are U.S. Managers Superstitious about Market Share?” Sloan Management Review (Summer 1996), pp. 67–77; Linda L. Hellofs and Robert Jacobson, “Market Share and Customers’ Perceptions of Quality: When Can Firms Grow Their Way to Higher Versus Lower Quality?” Journal of Marketing 63 (January 1999), pp. 16–25; J. Scott Armstrong and Kesten C. Green, “Competitor-Oriented Objectives: The Myth of Market Share” International Journal of Business 12(1) (2017), pp. 115–134.
(iv) For evidence that there are profit leaders in the bottom and middle ranges of market share almost as frequently as in the top range, see William L. Shanklin, “Market Share Is Not Destiny,” Journal of Business & Industrial Marketing 4 (Winter–Spring 1989), pp. 5–16; and “The ‘Myth of Market Share’: Can Focusing Too Much on the Competition Harm Profitability?” at Knowledge@Wharton, January 24, 2007.
When competitors cannot immediately or cost-effectively duplicate new ways of creating value, a company that creates those new ways achieves a “competitive advantage.” Unfortunately, some managers completely misunderstand the concept of competitive advantage and its importance for long-term profitability. We hear them report that they have a “competitive advantage” in having more stores than the competition, more knowledgeable salespeople, or higher quality. None of these is a competitive advantage unless they also enable the firm to deliver value more cost-effectively than their competitors can or convince their customers to pay a premium for the extra value delivered. Offering customers a more attractive offer by accepting a lower margin than the competition may be a sales advantage, but it is not a sustainable competitive advantage, since competitors can easily match it and because it reduces the return from investing in other, non-price means to win sales.
How can a firm achieve competitive advantage? Sometimes it’s by luck. Oil companies in the Middle East, for example, enjoy oil fields from which oil can be more cheaply extracted than from those in Manitoba, Norway, or Kazakhstan.4 Often, advantage comes from moving first on a new idea. By winning a patent, by gaining economies of scale, or by preempting the best locations, a firm may achieve an advantage that would be more costly for a later entrant to match. Uber has built a lead in car hire by investing heavily in technology—both current technology and in what will be required in the future for driverless cars—thereby increasing the potential value and cutting the cost of car services. Once frequent users had downloaded its app, it became much more costly for potential competitors to acquire customers or to recruit drivers.
More often, competitive advantages are carved out of the efficient management of a firm’s value chain. Michael Porter, the Harvard competition guru, cites three ways that companies can proactively manage operations to achieve competitive advantage:5
Whole Foods is an example of a company that has created competitive advantage with “needs-based positioning.” The company defined a higher standard for acceptable ingredients in foods and acceptable practices in dealing with food suppliers. The standard appeals to food buyers who are exceptionally concerned about the source and quality of ingredients when purchasing foods and personal care products. More importantly, those people are willing to pay more for products that meet Whole Foods’ high standards. In North America, the company has essentially replaced a cottage industry of small “health food” stores carrying a limited selection of items with large stores carrying a “purer” substitute for practically anything one could find in a regular grocery store. As regular grocers have expanded the number of products they offer for this segment, Whole Foods has been able to expand its offers as well to maintain a large portion of each customer’s shopping basket. Although the company has suffered during economic downturns when a smaller share of the market is willing to pay the Whole Foods price premium, the company’s sales and profits recover equally as strongly during business cycle recoveries. Consequently, the advantage created by the company’s unique positioning has enabled it to outperform the traditional grocery retail segment on both profit margins (EBITDA/Revenue) and growth over the long term.
The U.S. beer industry offers a classic case of “access-based positioning,” with firms both widening and narrowing their geographic reach to achieve competitive advantage. Companies with a national presence, such as Anheuser-Busch InBev enjoys a huge competitive advantage in purchasing television advertising space at low national rates. It leverages that advantage to overwhelm smaller regional competitors with a volume of advertising that they cannot afford to match. The growth of smaller regional competitors is limited by the need to rely on local cachet and word-of-mouth promotion to operate profitably.
MathWorks is a prime example of a focus-based supplier. The Massachusetts-based company has developed a capability to develop mathematical algorithms that enable other companies’ equipment or software to operate more efficiently. In some cases, an end-user might buy an algorithm— which can be delivered on a thumb drive—to enable their CAD (Computer Aided Design) equipment to operate better or a manufacturer might license an algorithm from MathWorks to include in the original design of its product. By focusing its business purely on the solution of complex math problems, MathWorks mathematicians gain experience and cross-industry insight that similarly skilled employees of a less specialized company could not duplicate.
These examples illustrate that the key to achieving sustainable profitability is to manage the business for competitive advantage. Unfortunately, many companies in competitive markets still focus on revenue growth, which they pursue by trying to be all things to all people, rather than focusing on creating value more cost-effectively. Porter calls the failure to achieve either a value or a cost advantage “getting stuck in the middle.” When such companies are exposed to competitors, some of whom offer higher quality or service while others offer lower prices, the firm’s profitability gets squeezed, despite its size.6
In the absence of a relative cost advantage, it is ultimately suicidal to drive growth with price. During the internet technology bubble of the late 1990s, hundreds of internet retailers and willing investors were hoping to prove this statement wrong. They accepted lower, even negative, margins simply to build share in the belief that ultimately the high value-add from the online shopping experience would make them profitable. They ignored a simple economic principle: Competition drives out profitability except for those with a source of advantage that prevents competitors from fully matching their costs or their value proposition. As a result, most of the early online visionaries went bankrupt, at huge cost to their investors despite the growth of the internet as a platform for doing business.
There were a few exceptions, namely, those internet newcomers who could create online advantages that later competitors could not duplicate. eBay, for example, enjoys margins and profitability that exceed those of both online and bricks-and-mortar competitors, not just because of the high value of trading online but because of the greater difficulty any lower-priced competitor would face in trying to duplicate its online offerings. Once eBay gained a large user-base advantage, it became nearly impossible for any competitor to duplicate the value it offers traders. PayPal is a similar story. It attracted customers quickly because it satisfied a strong unmet need for greater security when making purchases from previously unknown online retailers with no known address. But no consumer or retailer needs a second service like that one, so its first-mover advantage was huge. A new competitor would likely have to pay for incentives to induce people to sign and use it rather than remain with PayPal, creating a large barrier to entry.
The measure of a firm’s competitive advantage is its relative gross margin per sale, not its market share. We focus on gross margin, not operating margin, because gross margin is a measure of the value of an incremental sale. A large firm with relatively low gross margin can be expected to shrink, even when competing with a much smaller firm that is nonetheless more efficient in creating value. The latter firm’s greater margin per incremental sale can fund more marketing activities that will ultimately undermine the market share of the larger firm. That is exactly what happened to the “big three” U.S. auto companies when smaller Japanese and Korean rivals entered the North American market with lower costs and higher gross margins per car. Despite starting with a much higher market share, the big three could not afford to match what these new entrants could profitably invest in marketing, dealer incentives, and customer service to acquire more customers at the expense of the larger competitors.
The airline industry tells a similar story. The low-cost structure of some discount airlines makes them advantaged competitors in many markets, even when competing against larger airlines, because their low cost-per-seat-mile generates higher gross margins even after accounting for its lower prices. Consequently, this cost advantage allowed some of the so-called “low-cost carriers” (LCCs) to grow at the expense of their larger competitors. In the long run, however, a firm’s ability to acquire market share is limited to those market segments it can acquire and hold with a higher gross margin than competitors can. As these LCCs expanded into serving major airports, with their high gate costs and ground delays, the size of advantage diminished for many of these airlines. In fact, as their cost advantages narrowed, many LCCs have instead invested in new offers such as in-air Wi-Fi, premium boarding and seating, and expansion of their networks to compete on value, not just price.
Many managers are so fully aware of the risks of price wars and the importance of competing from a position of strength that they think coolly and logically before initiating price competition. It is much harder for most of us to think logically about whether or how to respond when we are already under attack. Consequently, we will discuss in step-by-step detail how to analyze a competitive situation and formulate responses in price-competitive markets that are not of your making.
When is it financially more prudent to accommodate a competitive threat, at least in the near term, until you can improve your capabilities, than to retaliate? Thinking through this question does much more than prepare you, intellectually and psychologically, to make the best competitive response. It also reveals weakness in your competitive position. If you do not like how often you must accommodate a competitor because your company cannot fight the threat successfully, you will begin searching for a competitive strategy that either increases your advantage or moves you further from harm’s way.
Exhibit 7-1 illustrates the complex flow of thinking required to make thoughtful decisions about reacting to price competition. The exhibit begins with the assumption that one or more competitors have cut their prices or have introduced new products that offer at least some of your customers more value for their money. How should you respond? Marketing theorists usually argue that one should never respond, since there are better, positive-sum ways to compete on product or service attributes. While that is often true, the time to have explored and implemented those ideas is usually long before a low-priced competitor is a threat. By the time the threat is obvious, a firm’s strategic capabilities are fixed in the short run. The question at hand is whether to respond with price when threatened with a loss of sales by a lower-priced competitor. To determine whether a price response is better than no response, one must answer the following questions and explore the interrelationships illustrated in Exhibit 7-1.
Although the need to ask this question might seem obvious, many managers simply stop thinking rationally when threatened. They match any price cut without asking whether the cost is justified by the benefit, or whether the same benefit could be achieved by structuring a more thoughtful response. In Chapter 9, we describe how to calculate the amount of sales that would need to be at risk (the Reactive Breakeven Sales Change) before the act of matching a competitor’s price reduction justifies the cost. If we conclude that reacting to a price change is cheaper than losing the sales, then it may be a good business decision. On the other hand, if a competitor threatens only a small portion of your sales, the sales loss associated with ignoring the threat may be much less than the cost associated with retaliation. Since the threat is small, the cost of cutting the price on all of your sales in order to prevent the loss of some sales to a competitor is likely to be unwise. Within a market or market segment that can be targeted for pricing by a competitor, the larger a firm’s total market share the less profitable it will be to cut prices to win the business of more price-sensitive customers.
It is also important to be realistic about how much of the projected sales loss is really preventable. When a new grocery chain opens with lower prices,
EXHIBIT 7-1 Thoughtfully Reacting to Price Competition
the established competitors can surely reduce the sales loss by matching its prices. Still, even if they match, some people will shift to the new store simply because it is newer or more convenient to where they live. They will not return even if the competitor’s price advantage is eliminated.
By constraining an organization’s competitive reactions to only those that are cost-effective, managers also force their organizations to think about how to make their price reactions more cost-effective. Following are some principles that can substantially reduce the cost of reacting to a price threat.
Focus your reactive price cut on only those customers likely to be attracted by the competitor’s offer. This requires developing a “flanking” offer that is attractive or available only to the more price-sensitive buyer. Often, such an offer can be developed in a short period of time, since it involves merely eliminating some element of the product or service not highly valued by the price-sensitive segments. During the recession in 2009, consumers began migrating to cheaper house brand grocery and cleaning products while supermarkets began promoting them more aggressively. This contributed to an 18 percent decline in revenues for Procter & Gamble. In response, the company introduced flanking brands, like Tide Basic detergent at prices 20 percent lower than the original brands.7 Many analysts have questioned the wisdom of this move, but there is an obvious benefit: it prevents some of the defection to house brands and gives P&G the ability to eliminate the flanking brands when consumers again feel able to pay for its more value-added brands.
Focus your reactive price cut on only the incremental volume at risk. A cheaper competitor will often be unable to entirely replace an incumbent’s business, but will be able to gain a share of its competitor’s business. For example, if a smaller independent television network, such as the CW Network in North America, cuts its ad rates, advertisers are not going to abandon the large networks like NBC or Fox. They are, however, going to be more likely to divert some dollars to CW from the big networks. A big network could neutralize that threat by offering to discount its ad rates to the level of the independent network’s rates just for the amount of advertising likely to be diverted. One way this could be structured is as a discount for all purchases in excess of, say, 80 percent of the prior year’s purchases or expected purchases. These types of contracts are common not just for advertising, but also for drugs and medical supplies sold to health maintenance organizations (HMOs). Retaliatory discounts applicable only to the incremental volume at risk are also common when pricing to retailers and distributors.
Focus your reactive price cut on a particular geographic area or product line where the competitor has the most to lose, relative to you, from cutting the price. A dominant cement manufacturer in an Asian country (disguised as “Country A”) began a drive to grow its share in a neighboring country (“Country B”) by building its own unloading facility there and acquiring new mixing capacity, after which it undercut prices in the newly entered market. What the company from Country A failed to think through was the fact that its high prices and high share in its home market left it vulnerable to retaliation. The incumbent leader in Country B reacted by flooding its competitor’s home market, driving cement prices down by 26 percent in just one year.
Raise the cost to the competitor of its discounting. If the competitor’s price move is limited only to new customers and the competitor has a market of existing customers, it may be possible to retaliate without cutting your own price at all. Consider retaliating by educating the competitor’s existing customers that they are being treated unfairly. A client of ours did this simply by making sales calls to its competitor’s most profitable accounts. In the process of the call, the salesperson casually suggested, “You are probably paying about $X for this product now.” When the customer questioned this, the salesperson confessed that he really did not know what they were paying but had surmised the figure based on the prices that his competitor offered recently to some other accounts, which he named. In short order, the customer was on the phone with its incumbent supplier demanding similar discounts, and the competitor quickly backtracked on its aggressive offers. Even in consumer markets, it is sometimes possible to appeal to customers’ sense of fairness or civic pride to convince them to reject a discounter. Small, local retailers have successfully done this to prevent big-box retailers from opening stores in Vermont that would no doubt hurt the less efficient, but traditional, local retailers.
Retailers frequently use a related tactic of widely promoting a policy that promises to match the price of low-priced competitors. If a competitor advertises a lower price, then the retailer offers to refund the difference to any of its customers paying a higher price within a reasonable time period, say 30 days following the sale. Only a few very price-sensitive buyers will take the time to gather evidence of the lower advertised competitor prices, and then ensure that the sales receipt for their purchased model matches precisely the competitor’s advertised model—all for merely the value of the price differential, often relatively small. However, the price-matching policy is not targeted at all buyers, or even just price-sensitive buyers; instead, it is a signal to other retail competitors of the futility of aggressive price-discounting strategies. After the substantial reduction in margins they incur by heavy discounting, their competitors simply neutralize the advantage by rebating to customers the difference. The result is that these deep-discount competitors are better off playing by the rules of established non-price competition in the category. In North Carolina, the Big Star and Winn-Dixie supermarket chains both announced price-matching policies to “meet or beat” the prices of aggressive rival Food Lion. Two years later, the number of products with essentially the same prices across these three competitors increased significantly, and the prices for these products increased as well.8
Leverage any competitive advantages to increase the value of your offer as an alternative to matching the price. The key to doing this without simply replacing a price war with a quality or service war is to make offers that are less costly for you to offer than for your competitor to match. If, for example, you have much better quality, offer a better warranty. If you have more service centers in more locations, offer faster service. Major airlines respond to price competition from smaller upstarts by offering increased frequent flyer miles on newly competitive routes. Because of their large route systems, frequent flyers accumulate miles faster and enjoy more choices of destinations than anything the small competitors could offer other than price. Moreover, the more sophisticated yield management systems of the large airlines minimized the cost of such programs more effectively than smaller carriers could.
If any of these options is less costly than simply allowing the competitor to take some sales, it is worth continuing to pursue the idea of possibly reacting, rather than ignoring, a lower-cost competitor. Otherwise, it is almost always better to preserve margins at the expense of market share, spending the added cash flow from those margins on other ways to improve your cost-effectiveness or your ability to add value that justifies a price premium.
Matching a price cut will do you no good if the competitor will simply reestablish the advantage. Ask yourself why the competitor chose to compete on price in the first place. If that competitor currently has little market share relative to the share that could be gained with a price advantage, and has no other way to attract customers, then it has little to lose from bringing price down as low as necessary to gain sales. This is especially the case where large sunk costs create substantial “exit barriers.”
At one point, a pharmaceuticals company ask us to recommend a pricing strategy to defend against a new entrant. Management was initially surprised when we told them that defending their sales with price was unwise. Only after thinking about the problem from the competitor’s standpoint did we fully understand the competitive dynamics they faced. Customers had no reason to try the competitor’s new drug without a price advantage, since it offered no clinical advantages. The new entrant had absolutely nothing to lose by taking the price down, since it had no sales anyway. Given that the huge investment to develop and test the drug was entirely sunk but that the manufacturing cost was small, winning sales even at a low price would be a gain. The conclusion was obvious that the competitor would cut price as often as necessary to establish a price advantage. If our client insisted upon preventing the new competitor from gaining significant market share, they would have risked destroying the value of the market.
Think about the total cost of a price war, not just the cost of the first shot, before concluding that the cost to defend the sales at risk is worth bearing. Unfortunately, the pharmaceutical client described above did not take our advice, instead resolving to do whatever was necessary to prevent the new entrant from gaining a significant foothold in any major pharma market. By the end of the competitor’s first two years in the market, it had largely succeeded in retaining more than 80 percent market share. It did so at the cost, however, of an average wholesale price decline of more than two-thirds. The devastating effect on profit contribution led to a complete review of what had happened and recognition that they could not afford to repeat such a mistake in the future.
Partisans of pricing for market share would no doubt disagree with our reluctance to use price defensively, especially when one is already in a stronger market position. Large market-share companies, they will argue, are sometimes better capitalized and, thus, better able to finance a price war than are smaller competitors. Although price cutting might be more costly for the large-share firm in the short run, it can sometimes bleed the competitor financially until it is forced to withdraw. The reason defensive pricing failed in the case of our pharma client was, they would argue, that the competitor had many other profitable drugs that could subsidize its losses on its new launch. If the competitor had relied on that one drug’s profitability for survival, it would have succumbed and been a lesson to others not to challenge our client’s market leadership in the future.
Although such a “predatory” response to competition sounds good in theory, there are two reasons why it rarely works in practice. First, predatory pricing is a violation of U.S. and European antitrust laws if the predatory price is below the predator’s variable cost. Such a pricing tactic may in some cases be a violation when the price is below the average of all costs.9 Consequently, even if a large competitor can afford to price low enough to bankrupt its smaller competitors, it often cannot do so legally. But, even putting legal issues aside, predation is cost-effective only if the predator gains some competitive advantage as a result of winning the price war. This occurs in only two cases: when eliminating a competitor destroys an important differentiating asset (for example, its accumulated goodwill with customers); or when it enables the predator to gain or maintain such a cost advantage (such as economies of scale) that it can profitably keep its prices low enough to discourage new entrants.
Unless driving a low-cost competitor into bankruptcy somehow destroys the assets of that competitor, a newly capitalized entrant can purchase the assets of the bankrupt competitor, operate at a lower cost base, and initiate price-based competition against the large firm now itself financially weakened by the cost of the first price war. Repeated price wars to defend market share eventually weakens market leaders financially to the point where they are vulnerable. For decades, the largest airlines in America fought price wars with new entrants, most of which bought cheap, older planes and had much lower labor costs, often from non-union labor. The market leaders still managed to drive many of those new entrants from the market by operating at a loss where they faced competition. Still, they all eventually succumbed to bankruptcy. Eventually however, they learned from the lesson. Rather than spending money on money-losing price wars, they reduced capacity in markets where competition made operations unprofitable, invested in more fuel efficient planes than the old ones flown by many low-cost competitors, and more creatively segmented their markets to reduce the cost to compete for price-sensitive customers (by eliminating fees to agents and such amenities as free bag check, food, and pillows).
The key to surviving a negative-sum pricing game is to avoid confrontation unless you can structure it in a way that you can win, and calculate that the likely benefit from winning exceeds the likely cost. It simply makes no sense to match competitor’s price discounts unless one can do so at a cost that is less than what one would lose from ceding some market share.
To recognize such situations, however, a manager must think rationally, remember that this is a negative-sum game, and suppress the understandable emotional reaction to never back down.
Does the value of the markets at risk justify the cost of a response? Some sales have a value that far exceeds the contribution directly associated with them. Take this example from the competitive PC and peripherals market in 2004. Following Dell Computer’s introduction of a new line of computer printers, Hewlett-Packard (HP) immediately severed its relationship to supply HP printers to Dell, signaling the strategic importance to HP of its printer business. HP strengthened its response by cutting its PC prices to match Dell’s, where Dell had much more to lose. Finally, HP realized that Dell’s printer strategy had its own limitations. Dell sourced its printers and cartridges from a third-party supplier, Lexmark, limiting Dell’s typical cost advantage. So HP defended its lucrative printer business, not with price, but with aggressive product innovations. It introduced new printer models, including digital printing with greater savings for corporate customers that led to higher revenues and overall printer market share gains.10
Retaliatory price cuts are all too often justified by vague “strategic” reasons unrelated to profitability. Before approving any retaliatory price cut for strategic reasons, two things should be required. The first is a clear statement of the long-term strategic benefit and risks. The benefit can be additional sales in this market in the future. It can be additional immediate sales of complementary products, such as sales of software and peripherals if one wins the sale of a computer. It can be a lower cost of future sales because of a competitive cost advantage resulting from the added volume. The risks are that a targeted price cut will spread to other customers and other markets, and that competitors will react, again creating a downward price spiral that undermines profits and any possibility of long-term gain.
The second requirement to justify a strategic price cut is a quantitative estimate of the value of the strategic benefit. This need to quantify often encounters resistance because managers feel that the task will delay response to an imminent threat. Usually, however, rough estimates are all that is necessary to achieve enough precision to make a decision. A company told us that they always defended price in the institutional segment of their market because sales in that segment drove retail sales. While the relationship was no doubt true, the magnitude of the effect was important given that pricing to the institutional segment had fallen to less than manufacturing cost. A simple survey of retail customers about how they began using the product revealed that only about 16 percent of retail sales were driven by institutional sales. We then estimated the cost of maintaining those sales by retaining all of the client’s current institutional sales and compared that with the cost of replacing those sales through expenditures on alternative forms of promotion. That simple analysis drove a complete change in the institutional pricing strategy. Moreover, as institutional prices rose, “leakage” of cheap institutional product into the retail chain market declined, producing an additional return that had not been anticipated.
All wars, whether shooting wars or price wars, occur because someone made a terrible mistake. Since wars are negative-sum games, it is always the case that the loser would have been better off not to capitulate, or at least to retreat to fight another day on better terms. This is the reason that the skills of a diplomat are as important for managing negative-sum conflict as are the skills of a general. This does not mean that one should be friendly with one’s competitors or even fair. Diplomats are not always nice, but they manage information and expectations to achieve their goals without unnecessary confrontation. If they find it necessary to use force, they seek to limit its use to the amount necessary to make their point. In the diplomacy of price competition, the meaning that competitors ascribe to a move is often far more important than the move itself.
The decision to cut price to gain a customer may have radically different long-term effects, depending upon how the competitor interprets the move. Without any other information, the competitor would probably interpret the move as an opportunistic grab for market share and respond with defensive cuts of its own. If, however, the discount is structured to mimic exactly an offer that the same competitor made recently to one of your loyal customers, the competitor may interpret the cut as reflecting your resolve to defend that segment of the market. As such, the cut may actually reduce future opportunism and help stabilize industry prices.
Consider how the competitor might interpret one more alternative: your price cut is totally unprovoked but is exceptionally large, more than you have ever offered before and probably more than is necessary to take the business. Moreover, it is preceded by an announcement that your company’s new, patented manufacturing process not only added to capacity but also substantially reduced incremental manufacturing costs. In this case, an intelligent competitor might well interpret the price cut as fair warning that resistance against your grab for market share will be futile.
Managing information requires collecting and evaluating information about the competition, as well as communicating information to the market that may influence competitors’ moves in ways desirable to your own objectives.
Many companies operate with little knowledge of their competitors’ prices and pricing strategies. Consequently, they cannot respond quickly to changes. In highly competitive markets, such ignorance creates conditions that invite price warfare. Why would an opportunist ever cut price if it believed that other companies were willing to retaliate? The answer is that the opportunist’s management believes that, by quietly negotiating or concealing its price cuts, it can gain sufficient sales volume to justify the move before the competitors find out. This is especially likely in industries with high fixed costs (or high-percentage contribution margins) and during peak seasons when disproportionate amounts of business are at stake.
To minimize such opportunistic behavior, competitors must identify and react to it as quickly as possible.11 If competitors can react in one week rather than three, the opportunist’s potential benefit from price cutting is reduced by two-thirds. At the extreme, if competitors could somehow react instantly, nearly all benefit from being the first to cut price could be eliminated. In highly competitive markets, managers “shop” the competitors’ stores and monitor their advertising on a daily basis to adjust their pricing12 and the large chains maintain communication systems enabling them to make price changes quickly in response to a competitive threat. As a consequence, by the time most customers even learn what the competition is promoting in a given week, the major competitors have already matched the price.
Knowledge of competitors’ prices also helps minimize a purchasing agent’s ability to promulgate misinformation. Frequently in business-to-business markets, price wars begin without the intention of any competitor involved. They are caused by a purchasing agent’s manipulation of information. A purchasing agent, frustrated by the inability to get a better price from a favored supplier, may falsely claim that he or she has been offered a better deal from a competitor. If the salesperson doesn’t respond, a smart purchasing agent may give the threat more credibility by giving the next order to a competitor even without a price concession. Now the first company believes that its competitor is out “buying business” and will, perhaps, match the claimed “lower price” on future orders to this customer, rewarding this customer’s duplicitous behavior. If the first company is more skilled in price competition, it will not match the “lower price,” but rather will retaliate by offering the same discount to other good customers of the competitor. The competitor will now see this company as a threat and begin its own cuts to defend its share. Without either competitor intending to undermine the industry price level, each has unwittingly been led to do so. The only way to minimize such manipulation is to monitor competitors’ prices closely enough so that you can confidently predict when a customer is lying.13
Even when purchasers do not lie openly, their selective communication of information often leaves salespeople with a biased perspective. Most salespeople think that their company’s prices are too high for market conditions. Think about how a salesperson is informed about price. Whenever the salesperson loses a piece of business, the purchaser informs the salesperson that the price was “too high.” When he or she wins the business, however, the purchaser never tells the salesperson that the price was unnecessarily low. The purchaser says the job was won with “the right price.” Salespeople get little or no information about how much margin they may have left on the table.
There are many potential sources of data about competitors’ prices, but collecting those data and converting the data into useful information usually requires a formalized process. Many companies require that the sales force regularly include information on competitors’ pricing in their call reports. Having such current information can substantially reduce the time necessary to respond to opportunism since someone collecting information from multiple salespeople and regions can spot a trend much more quickly than can an individual salesperson or sales manager. Favored customers can also be a good source of information. Those that are loyal to the company, perhaps because of its quality or good service, do not want their competitors to get lower prices from another source. Consequently, they will warn the favored supplier when other suppliers issue new price sheets or when they hear that a competitive supplier is discounting to someone else. A partnership with such a customer is very valuable and should be treated as such by the seller.
In highly competitive markets, the information collected should not be limited to prices. Understanding plans and intentions is equally important. We recently worked with a client frustrated by the low profitability in its service industry, despite record revenue growth. In the process, we learned that the industry had suffered from overcapacity but recently had experienced multiple mergers. What was the purpose of those mergers? Was it to gain cost efficiencies in manufacturing or sales that would enable the new company to offer low prices more profitably? Or was it to eliminate some inefficient capacity, enabling the merged company to consolidate its most profitable customers in fewer plants, eliminating the need to win incremental business? We found answers to those questions in the competitor’s briefings to securities analysts, causing our client to rethink its own strategy.
Trade associations, independent industry monitoring organizations, securities analysts, distributors, and technical consultants that advise customers on large purchases are all good sources of information about competitors’ current pricing moves and future intentions. Sometimes trade associations will collect information on prices charged in the prior week and disseminate it to members who have submitted their own prices. Monitoring prices quoted at trade shows can also be another early tip-off. In retail businesses, one can simply “shop” the competitive retailers on a regular basis. In the hotel industry, nearby competitors regularly check their competitors’ prices and room availability on particular nights by calling to make an unguaranteed reservation or checking an online hotel booking site. If price competition is important enough as a determinant of profit in an industry, managers can easily justify the cost to monitor it.14
It is usually much easier for managers to see the value of collecting competitive information than it is for them to see the value in knowingly revealing similar information to the competition. After all, information is power. Why should anyone want to reveal a competitive advantage? The answer: So that you can avoid having to use your advantage in a negative-sum confrontation.
The value of sharing information was obvious, after the fact, to a company supplying the construction industry. Unlike most of its competitors as well as most economists, the company accurately predicted a recession and a construction slowdown looming on the horizon. To prepare, the company wisely pared back its inventories and shelved expansion plans just as its competitors were continuing to expand. The company’s only mistake was to keep its insight a secret. Management correctly felt that by retrenching more quickly than its competitors, it could weather the hard times more successfully, but when competitors desperately cut prices to clear bloated inventories, the entire industry suffered. Had the company publicly shared its insight, which would have thus discouraged its competitors from overexpansion, its own financial performance would have been more profitable even though relatively less outstanding. The lesson: It is often better to earn just an average return in a profitable industry than to earn an exceptional return in an unprofitable one.
Even company-specific information—about intentions, capabilities, and future plans—can be useful to reveal unless doing so would preclude achieving a first-mover advantage into a new market. Such information, and the information contained in competitors’ responses, enables a company to establish plans “on paper” that are consistent with competitors’ intentions, rather than having to reach consistency through the costly process of trial and error.
The key to profitably using price as a weapon is to convince competitors to capitulate. A Japanese company invited the two top operations managers of its American competitor to the opening of its new plant. After attending the opening ceremony, the company took all guests through the highly automated facility. The American managers were surprised to see the process so highly automated, all the way to final packing, since quality control usually required human intervention at many points in the process. When asked about this, the Japanese hosts informed the guests that this plant was the first to use a new, proprietary process that essentially eliminated the major source of defects. They also indicated that development of the process had taken them more than a decade.
On the way home, realizing now what could be done, the American engineers were eagerly speculating about how this improvement might be achieved and how much they should ask for in a budget to pursue research. They also wondered why their Japanese counterparts would reveal the existence of such an important trade secret. Within a few months they got their answer. The Japanese competitor announced a 20 percent price cut for exports of this product to the American market. If you were the American competitor with a large market share, how would knowledge of this trade secret change your likely response? In this case, the American company wisely chose to “adapt” rather than “defend.”
Although the information disclosures discussed here are the most common, they are hardly comprehensive. Almost every public decision a company makes will be gleaned for information by astute competitors.15 Consequently, companies in price-competitive industries should take steps to manage how their moves are seen by competitors, just as they manage the perceptions of stockholders and securities analysts. For example, will competitors in a highly price-competitive industry interpret closure of a plant as a sign of financial weakness or as a sign that the company is taking steps to end an industrywide overcapacity problem? How they interpret such a move will probably affect how they react to it. It is in the company’s interest to supply information that leads competitors to reach a more favorable interpretation. Think twice, however, before disseminating misleading information that competitors will ultimately discover is incorrect. You may gain in the short run, but you will undermine your ability to influence competitors’ decisions and, therefore, to influence price competition in the long run.
We have been discussing the benefits of avoiding negative-sum competitive confrontation, but some companies have clearly built successful strategies for profitable growth based primarily on winning share by undercutting the prices of their competitors. Did not Walmart become the largest, while still very profitable retailer, in America, and did not Ryanair become the largest and most profitable airline in Europe, primarily based upon the promise of lower prices? Yes, and understanding the special circumstances that enabled them to grow profitably despite offering lower prices is necessary for anyone trying to replicate such success. Every company that succeeds in growing profitably with a low-price strategy must first create a business model that enables it to cut incremental costs below those of its competitors. Walmart did so by creating an efficient distribution network and managing inventory more efficiently than its competitors. Ryanair did so by, among other things, building a non-union workforce and flying planes to underutilized airports. So long as each could attract customers with a price difference smaller than its cost advantage, it could win customers without reducing industry profitability. Or, to put it another way, when Walmart or Ryanair won a customer from a competitor, it was not a negative-sum game. In fact, by serving customers more cost-effectively, these companies actually earned profits from each customer above those earned by their higher-priced competition—making their competitive efforts a positive-sum game.
However, a competitive cost advantage was not by itself enough to win market share profitably. All of these companies must also orchestrate a campaign of information to convince their competitors that their cost advantages are decisive. Eventually, even companies that grow through price competition usually recognize that unless they can continue to grow faster than competitors, price cutting cannot be a profitable growth strategy indefinitely. Consequently, they ultimately shift their strategies toward adding more value in ways that enable them to sustain their large market shares without having to sustain such a large price advantage indefinitely.
Under what conditions are the rewards from aggressive pricing large enough to justify a low price growth strategy? There are only four:
Before embarking on a price-based strategy, ask which of these four points describes your rationale and recognize that a growth strategy can rarely be built on price alone or sustained indefinitely.
No other weapon in a marketer’s arsenal can boost sales more quickly or effectively than price. Price discounting— whether explicit or disguised with rebates, coupons, or generous terms—is usually a sure way to enhance immediate profitability. However, gaining sales with price is consistent with long-term profitability only when managed as part of a marketing strategy for achieving, exploiting, or sustaining a longer-term competitive advantage. No price cut should ever be initiated simply to make the next sale or to meet some short-term sales objective without being balanced against the likely reactions of competitors and customers. The key to profitable pricing is building and sustaining competitive advantage. There are times when price cutting is consistent with building advantage, but it is never an appropriate substitute for it.
1. Sun Tzu, The Art of War, Chapter IV, “Disposition of the Army,” 5th century B.C.
2. For more on the practical applications of game theory, see Adam Brandenburger and Barry Nalebuff, Competition (New York: Doubleday, 1996); Rita Koselka, “Evolutionary Economics: Nice Guys Don’t Finish Last,” Fortune, October 11, 1993, pp. 110–114; and Kenichi Ohmae, “Getting Back to Strategy,” Harvard Business Review (November– December 1988), pp. 149–156.
3. B. H. Liddell Hart, Strategy (New York: Meridian, 1967), p. 322.
4. Gordon Kristopher, “Crude Oil’s Total Cost of Production Impacts Major Oil Producers,” Market Realist, January 13, 2016.
5. Michael E. Porter, “What Is Strategy?” Harvard Business Review (November–December 1996), pp. 60–78. See also Michael E. Porter, Competitive Strategy (New York: The Free Press, 1980), p. 34.
6. Porter, op. cit., pp. 41–43. A firm can become large without getting “stuck in the middle” simply by taking on multiple segments. The segments must be managed, however, as a conglomerate of focused businesses rather than as a one-size-fits-all marketing organization. Procter & Gamble is an excellent example of a large company that nevertheless carefully targets each product to meet the needs of a particular focused segment.
7. Ellen Byron, “Tide Turns ‘Basic’ for P&G in Slump,” Wall Street Journal, August 6, 2009.
8. Akshay R. Rao, Mark E. Bergen, and Scott Davis, “How to Fight a Price War,” Harvard Business Review (March–April 2000), pp. 107–116.
9. See the discussion on predatory pricing in Chapter 12.
10. “As Alliances Fade, Computer Firms Toss Out Playbook,” Wall Street Journal, October 15, 2002, p. A1; “Dude, You’re Getting a Printer; Dell’s Printer Business Is Puny Next to HP’s, But It’s Quickly Gaining Ground,” Business Week Online, April 19, 2004, p. 12.
11. Note that this principle applies in the other direction as well. If competitors quickly follow price increases, the cost of leading such increases is vastly reduced. Consequently, companies that wish to encourage responsible leadership by other firms would do well to follow their moves quickly, whether up or down.
12. See Francine Schwadel, “Ferocious Competition Tests the Pricing Skills of a Retail Manager,” Wall Street Journal, December 11, 1989, p. 1.
13. Another useful tactic that can control such duplicitous behavior in U.S. markets is to require the customer, in order to get the lower price, to initial a clause on the order form that states the customer understands this is “a discriminatorily low price offered solely to meet the price offered by a competitor.” Since falsely soliciting a discriminatorily low price is a Robinson–Patman Act violation, the purchasing agent is discouraged from using leverage unless he or she actually has it.
14. For more guidance on collecting competitive information, see “These Guys Aren’t Spooks, They’re Competitive Analysts,” Business Week, October 14, 1991, p. 97; and Leonard M. Fuld, Competitor Intelligence: How to Get It—How to Use It (New York: Wiley & Sons, 1985).
15. For a comprehensive and insightful survey of the research on communicating competitive information, see Oliver P. Heil and Arlen W. Langvardt, “The Interface Between Competitive Market Signaling and Antitrust Law,” Journal of Marketing 58(3) (July 1994), pp. 81–96.