Harvard Business School Working Knowledg e Archive

How to Fight A Price War: Analyzing the Battleground

9/5/2000
Most managers will be involved in a price war at some point in their careers, and it's never too early to prepare, write Akshay R. Rao, Mark E. Bergen and Scott Davis in the Harvard Business Review. In fact, managers and companies that conduct intelligent analyses of the theater of operations may find they have more options than they think.

"Price wars," write Akshay R. Rao, Mark E. Bergen and Scott Davis, "are a fact of life—whether we're talking about the fast-paced world of 'knowledge products,' the marketing of Internet appliances, or the staid, traditional business of aluminum sidings. If you're not in a battle currently, you probably will be fairly soon."

In "How to Fight a Price War," they caution that price wars are not simply a matter of responding to a competitor's aggressive price move with one of your own. Instead companies should consider all of their options, including defusing the conflict, retreating or, if a battle is unavoidable, fighting it with an arsenal of weapons beyond just price cuts themselves.

In this excerpt, Rao, Bergen and Davis suggest careful analysis of four crucial areas as the key to knowing which path to take.

It's necessary to understand why a price war is occurring—or may occur. But it's also critical to recognize where to look for resources in battle. It's important to carefully analyze your customers, company, competitors, and other players within and outside the industry that may have an interest in how the price war plays out.

Customers and Price Sensitivity
A thoughtful evaluation of customers and their price sensitivities can provide valuable insights about whether one should fight a competitor's price cut with a price cut in kind or with some other strategy. Consumers are frequently unaware of substitute products and their prices, or they may find it difficult to make comparisons among functionally equivalent alternatives. For instance, prior to AT&T's 7-cents-a-minute plan, consumers faced a bewildering set of pricing options for long-distance phone service. AT&T charged 15 cents per minute per call with no monthly fee; or 10 cents per minute with a $4.95 monthly fee. MCI offered nighttime rates of 5 cents a minute, daytime rates of up to 25 cents a minute, and a monthly fee of $1.95. Sprint charged 5 cents per minute for nighttime calls, rates of up to 10 cents per minute for other calls, and a $5.95 monthly fee. The cost of determining the best plan when customers are unsure about their calling patterns is simply too high for a low-involvement decision like long-distance phone service. A company that wanted to compete on price could choose to simplify. That's exactly what Sprint did. It simplified its price schedule to 10 cents a minute so customers could compare its rates to those from MCI and AT&T.

Some consumers are more sensitive to quality than price, for a variety of reasons. Industrial buyers are often willing to pay more for on-time delivery or consistent quality because they need those features to make their businesses run smoother and more profitably. The very rational belief that poor quality can endanger one's health is an important reason that branded drugs command the prices they do relative to generic drugs. And snob appeal allows Davidoff to sell matches at $3.25 for a box of 40 sticks to cigar connoisseurs. The basic lesson is that different customer segments exhibit different levels of price sensitivity for different products at different times. Businesses that adopt a one-size-fits-all approach to pricing do so at their peril.

Company Abilities
Company factors such as cost structures, capabilities, and strategic positioning should also be examined carefully. Cost structures may be affected by changes in technology or business practices, which in turn may tempt a company to cut prices in a manner that will trigger a price war. For example, consider the implications of outsourcing. It's probably true that it is cheaper to buy rather than make something in-house, because the invisible hand of the marketplace will lower the acquisition price of a product. But the cost of manufacturing something in-house is largely sunk and fixed. When that product is purchased on the market, its acquisition cost is a variable one. In other words, integration can lead to a cost structure with a higher fixed-cost component and a lower variable-cost component. Consequently, the company with the lower variable costs may be tempted to reduce prices and start a price war. But even though the lower variable costs give the company an advantage, it should carefully consider whether a price war is consistent with its strategic posture. The company's lower variable costs should be used to start a price war only when it will result in the neutralization or the exit of an undesirable rival. Consider, too, the coherence of your pricing strategy and your ability to execute it. The actions of one participant engaged in a fierce price war in the utility industry is telling: The company's senior management group asked its top manager to increase market share by 20%, return prices to profitable levels, and stabilize them. Confronted with apparently conflicting goals, the manager chose the easiest goal—build market share—which he achieved by lowering prices, thus exacerbating the price war. The directive to the manager was confusing, his resulting actions baffled competitors, and that led to considerable uncertainty and increased price turbulence in the market. When the soft costs (managerial time and attention) of changing prices through a complex supply chain were factored in, the cost of the increased market share was very dear. The essential insight that should emerge from this exercise is whether a simple price cut is the best option given one's cost structure, capacity levels, and organizational competence.

Competitors' Response
An analysis of competitors—their cost structures, capabilities, and strategic positioning—is equally valuable. Industrywide price reductions may be appropriate under certain circumstances. But many unprofitable price wars happen because a company sees an opportunity to increase market share or profits through lower prices, while ignoring the fact that competitors will respond. Market research may reveal that sales increases following a price cut justify the action, but this same research often simply ignores competitors' price responses.

Businesses need to pay attention at the strategic level to the twin questions of who will respond and how. Smart product managers recognize the need to understand the competition and empathize with them. They project how competitors will set prices by carefully tracking historical patterns, understanding which events have triggered price changes in the past, and by tracking the timing and magnitude of price responses. They monitor public statements made by senior executives and published in company reports. And they keep their eyes peeled for activity in resource markets: competitors that acquire a new technology, labor force, information system, or distribution channel, or that form a new brand alliance, will probably make some kind of a price move that will affect other players in the industry. This sophisticated environmental scanning identifies possible adversaries and their likely modus operandi.

But which competitors should you watch? Identifying competitors often has important pricing implications. For instance, Encyclopedia Britannica discovered that its chief rival is not Grolier's Encyclopedia but Microsoft. Britannica seemed oblivious to this important competitor for several years until a steady erosion in encyclopedia sales alerted the company to startling developments in technology that changed the way consumers get information. Its books once costs thousands of dollars; Britannica now offers free access to its database on the Web and derives its revenues from banner ads, not consumers. A company's direct competitors that share the same technology and speak to the same markets are important rivals. But indirect competitors that satisfy customer needs through the use of different technologies and that have completely different cost structures are perhaps the most dangerous. In fact, direct competitors such as major airlines frequently coexist quite peacefully. Examining their pricing-decision rules suggests why. U.S. Department of Transportation studies indicate that when one hub-based airline enters another's hub, it typically does not engage in price-based competition because it fears retaliation in its own hub. Conversely, price wars may often be started by a company from an entirely different industry, with a radically different technology, whose cost advantages give it enough leverage to enter your market and steal your share.

The process of identifying competitors also reveals the strengths and weaknesses of current and potential rivals. This has important implications for how a company competes. It is generally wise to not stir a hornet's nest by starting a price war with a competitor that has a significantly larger resource base or a reputation for being a fierce price warrior. When analyzing your competition, carefully determine who they are, how price fits with their strategic position, how they make pricing decisions, and what their capabilities and resources are.

Contributors, Collaborators, and Other Interested Parties
Finally, it is important to monitor other players in the industry whose self-interest or profiles may affect outcomes. Suppliers, distributors, providers of complementary goods and services, customers, government agencies, and so on contribute significantly to the consumption experience, including product quality, the sales pitch, and after-sales service. They often wield considerable influence on the outcome of a price war—directly or indirectly. Sometimes these contributors may provide the impetus for, or may indirectly start, a price war. Motorola discovered as much when it introduced low-priced cellular phones in China and Brazil. Soon Motorola observed that the street price for its phones had dropped substantially in the United States. Distributors were diverting products bound for China and Brazil to the profitable U.S. and European markets; sometimes the products never even left the dock. Motorola's distributors had created a "gray market" because Motorola had given them a reason to believe that prices in the United States were too high.

Sometimes contributors can help reduce price competition by enhancing the product's value, as Intel does for computer manufacturers; assisting with marketing, as airline frequent-flyer programs do for credit-card companies; and limiting the exposure to competing products, as MITI has done for Japanese companies facing international competition at home. Smart managers must carefully consider other players and their interests (profit margins for suppliers and distributors, commissions for sales representatives, and so on) before starting a price war or joining one.

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Excerpted from the article "How to Fight a Price War" in the Harvard Business Review, March-April 2000.

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Akshay R. Rao is an associate professor and coordinator of the doctoral program in the department of marketing at the University of Minnesota's Carlson School of Management in Minneapolis.

Mark E. Bergen is an associate professor of marketing at the Carlson School.

Scott Davis is principal and founder of Strategic Marketing Decisions, a consultancy in Sacramento, California.