price reduction

Price war

Price war is a term used in business to indicate a state of intense competitive rivalry accompanied by a multi-lateral series of price reductions. One competitor will lower its price, then others will lower their prices to match. If one of the reactors reduces their price below the original price cut, then a new round of reductions is initiated. In the short-term, price wars are good for consumers who are able to take advantage of lower prices. Typically they are not good for the companies involved. The lower prices reduce profit margins and can threaten survival.

In the long term, they can be good for the dominant firms in the industry however. Typically the smaller more marginal firms will be unable to compete and will shut down. The remaining firms absorb the market share of the terminated ones. The real losers then, are the marginal firms and the people that invested in them. In the long-term, the consumer could lose also. With fewer firms in the industry, prices tend to increase, sometimes to a level higher than before the price war.

The main reasons that price wars occur were:

  • To utilize excess plant capacity. Rather than run a plant at well below its optimum capacity, firms reduce their prices so as to sell enough to keep the plant running at its optimum level.
  • Bankruptcy and survival. Companies near bankruptcy may be forced to reduce their prices so as to increase sales volume and thereby provide enough liquidity for survival.
  • Response to a competitive attack. A competitor might target your product and attempt to gain share from you by selling a product at a low price. Rather than retaliate with a matching price cut, it is usually better to introduce a fighting brand (see brand management).
  • The nature of the product. Some products, such as commodities, are very difficult to differentiate. Without unique product features, price becomes the main basis of comparison.
  • Penetration pricing. If some of the firms are employing a penetration pricing strategy, their prices will be relatively low.
  • Oligopoly. If the industry structure is oligopolistic (that is, few competitors), the players will closely monitor each others prices and be prepared to respond to any price cuts.

Reactions to Price Challenges

The first reaction to a price reduction should always be to consider the situation carefully (and metaphorically count to ten before indulging in selfrighteous retaliation). Has the competitor decided upon a long-term price reduction, or is this just a short-term promotion? If it is the latter, then the reaction should be purely that relating to short-term promotional activity (and the optimum response is often simply to ignore the challenge). All too often, price wars have been started because simple promotional activities have been misunderstood as major strategic changes.

On the other hand, if it emerges that this 'is' a long-term move then there are a number of possible reactions:

  1. Reduce price - The most obvious, and most popular, reaction is to match the competitor's move. This maintains the 'status quo' (but reduces profits 'pro rata'). If this route is to be chosen it is as well to make the move rapidly and obviously - not least to send signals to the competitor of your intention to fight.
  2. Maintain price - Another reaction is to hope that the competitor has made a mistake; although, if the competitor's action does make inroads into your share, this can rapidly lead to a loss of confidence as well as of volume.
  3. React with other measures - Reducing price is not the only weapon. Other tactics, such as improved quality or increased promotion (to improve the quality image, perhaps) may be used, often to great effect.
  4. Split the market - A particularly effective tactic (most notably used by Heublein, the owner of the Smirnoff brand of vodka) is to combine a move to increase the `quality' of the main brand at the same time as launching a `fighting brand' to undermine - by further price-cutting - the competitor's position.

Avoiding Price Wars

Avoidance is by far the best policy, but it is advice which may not always be taken if the benefits seem attractive (which, unfortunately, they may also be to the competitors). The dangers are summarized in a theory borrowed from the ethics branch of the social sciences.

Price Stickiness

An oligopolistic market has a small number of firms, each with a high concentration ratio. On the kinked demand diagram below the equilibrium point, a price war occurs. All firms in the market vary prices to be in the best market position i.e the lowest price possible by cutting costs. For firms to remain a 'player' in the market they must cut prices in line with other forms in the oligopolistic market. In other words, firms need to match price reductions by their competitors to maintain market share.

The price stickiness occurs because if the price rise, other firms will not follow and therefore, the firm will lose it's market share.on the other hand, when price falls, other firms will follow and later, the firm will find that they can not gain profit from cutting the a result, the sticky price is remained. For example, price stickiness is extremely common among the large supermarkets and as such prices, especially for commodities tend not to vary greatly between them. Many of the supermarkets monitor price changes in other supermarket chains and vary their prices accordingly until they reach the point where any further decrease in their price will affect profits.

Usually a firm will not decrease prices further if it would mean eating into pre-determined profit margins however, it is a well known fact that some supermarket chains regularly sell below cost on a small number of products (predatory pricing) to attract customers with the hope they will also purchase more lucrative products for the firm. This is really only possible in supermarkets as a customer will almost always purchase more than 10 products, with most covering the profit margin- it is therefore beneficial for the supermarket to advertise these products being sold below cost price. However, as this is seen as anti-competitive and an abuse of market position the Office of Fair Trading may step-in.

The prisoner's dilemma

The basic, imaginary, dilemma (a `philosophical problem' known for many years, and even described by Herodotus, but given this name and description by Alfred Tucker) has two prisoners accused of a crime. If one confesses and the other does not, the one confessing will be released immediately and the other jailed for 10 years. If neither confesses, each will only be held for a few months. On the other hand, if both confess they will each receive a sentence of five years. The problem, for the prisoners, is that they are not allowed to communicate with each other. The calculation is that self-interest will be best served for each by confessing, no matter what the other does. But, of course, this is a less satisfactory solution for them than if they both held out.

The position in the case of price competition, while sharing some of the features of this dilemma - especially if the participants react without thinking - is somewhat more favourable. The `prisoners' are not held incommunicado. They can exchange `signals' which indicate their intentions. Under these circumstances, the best outcome can be achieved - and often is.

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