Price wars

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Erasmus University

Rotterdam School Of Management

Price wars

by Vlada Butcyk

Rotterdam

15/11/2011

Introduction

There is a well-known law of nature: “the fittest survive” but it is not only about animals and plants, it also applies to humans and all sides of their lives including economic one. The world is developing in direction of mind power but people and companies still try to find their strong points and the best strategy to win in the struggle for survival.

Price war is one of strategies of companies to become a leader. It is assumed as a progressive and often sharp reduction by competitors in prices of goods and services sold on the homogeneous market. It is not an invention of the modern world, this tactic of the fight came into existence with the emergence of business and capital.

Since the economic world doesn't stand still but develops, markets are growing and competition is increasing. Under such conditions companies more and more use price wars as a key to the victory. Being the member of this kind of war can as make the company a leader in the market as leads it to a bankruptcy. The difference between results is obviously too high to underestimate the war. Therefore it is literally essential to know for companies how to operate in wartime.

Firstly, we will provide readers with the general information about what price war is, what reasons of its start exist and how companies can act. Secondly, we will analyze the exact case of price wars in hotel industry to clarify some important points.

Thus, this paper covers an explanation of the nature of price wars and aims to answer the following question: what are the best actions in time of price war?

1. Price war

Historical report As it was mentioned above, price wars is not a recent phenomenon, it has been existing since the appearance of business and competition. But the beginning of wide use can be considered the 19th century when the Standard Oil became the leader of its sector. This American integrated oil producing, transporting, refining, and marketing company concluded a secret agreement with the local railway company which gave him high discounts on cargo carriages. Apparently, this measure reduced costs of the oil company and helped it to decrease prices so that other companies had to leave the market making the Standard Oil a monopolist.

Another huge example is the price war among Johnson & Johnson and Bristol-Myers in 1975. J&J's brand Tylenol priced 50% higher than aspirin seemed to give a great opportunity for Bristol-Myers. In June 1975 it introduced Datril with the “same pain reliever, same safety as Tylenol” but the price was 35% lower than those of the rival. J&J was faster: it not only cut prices to the competitor's level, but also issued credits memorandums to reduce prices on existing stocks in stores. As a result sales of Tylenol rocketed but Datril never achieved more than 1% market share (Al Ries, Jack Trout, Marketing Welfare, 1997).

Another classic example is a fight between Harley-Davidson and Japanese manufacturers. In the late eighties and early nineties such companies as Suzuki, Kawasaki, Honda and Yamaha entered the American market of motorcycles. Being designed and build with better performance, handling and quality they rapidly attracted attention of American customers and deprived Harley-Davidson of its top position. In reply the latter appealed to the government to establish quotas on supplies of the former. But 4 years later Harley-Davidson asked the government to eliminate this limits since it managed during this period to create a cult product which position will never be undermined (H. Ong).

Furthermore, price wars are very common in newspaper industry, the most famous of which is the one took place in 1993 in Great Britain. The first step in this war was made by R.Murdoch who decreased the price on Times from 45 penny to 30. Then he continued reduction to 20 penny. The nearest rivals responded by the same reduction but after a while raised a price again because of irreplaceable losses. Through the lack of capabilities News International also had to enhance a price a little bit but it was still the lowest. Despite the troubles the company finally gained new readers and increased a market share from 17% in 1993 to 30% in 2000 (Newspaper industry, 2003).

Not only studying the previous economic history we can encounter such examples, presence gives us not less interesting cases. For instance, nowadays we can observe how the fight on two fronts of Amazon against Wal-Mart and Barnes & Noble is emerging. It was started this spring-summer by progressive price reduction of the former in comparison with Wal-Mart's prices and introducing a variety of new Kindles which prices are at least half lower than those of B&N. Nobody knows how it will end but analytics predict the victory of Amazon thereby frightening the rivals.

Mentioned cases not only prove the topicality of the problem of price wars, but also present some tactics of action at price war. Therefore it is time to say exactly what a price war is and how to deal with it.

1.1 Determination of a price war

Price war is a multi-lateral series of price reduction entailed by intense market competition. It can be described by the following situation: aggressive firm cuts a price and a rival slashes own one in return too. Starting from imperceptible actions it can escalate into a full-blown price war.

Emergency of price wars has its own reasons. The first reason is the behavior and underlying intentions of interested firms. Despite the number of firms entered the price war and the fact whether it is a result of intended actions, players admit the fact that the main motive for starting or accepting a price war is to increase sales, market share and, as a result, a bottom line. The second aspect is market or industry structures and strategy-affecting event that can enhance the probability of starting a war and influence features of a price war such as intensity, length and etc.

Taking into account reasons factors leading to price wars they can be divided in some categories. During the classification attention was paid exactly to several facts: whether the price war occurred in context of market entry or under oligopoly conditions and whether the price war was intended or started accidentally. In the case when the price war is a result of an information scarcity or misunderstanding we can talk about spontaneous wars. For instance, managers of a company launch a new promotional strategy with discounts for selected distributors which has only short-term nature, but managers of a rival company take it as a beginning of a price war and with their help it becomes a truth. But where intention can be assumed, we see two different situations: limit pricing occurs usually with entry, predatory pricing - in oligopoly.

Having the fear of emergency of new players in the market a firm can prevent it by using the strategy of limit price. It implies that an incumbent firm influences the entrant's perception of the profitability of the entry by setting a price intentionally (before entry occurs) below the maximum-profit level. A huge role here is played by asymmetry of information. Typically the established firm has an access to almost complete information, so limited information about incumbent's characteristics and level of market demand allows making uncertain forecasts and gives an opportunity to execute defense strategies by the incumbent.

Aiming at driving competitors out of the market, companies tend to use the strategy of “predator”. It implies lowering price to the level of costs and even lower switching to dumping. It is assumed that at a certain moment losses of a competitor will be so huge that it will have to leave the market. The result of successful strategy application is a monopoly headed by an aggressive company.

1.2 Effects of price wars

Price wars are often initiated in the modern world. That's why it is very important for managers to be aware of consequences which can be results of a price war. Consider them from two sides: positive and negative.

1.1.1 Positive effects

The main goal of price wars is to increase profit of an aggressive company by getting a larger market share or becoming a monopolist. Escaping rivals a company gets freedom of action and can price a product however it pleases thereby enhancing its bottom line.

As for customers, they also benefit by such kind of wars. Indeed, because of price reduction they can buy a usual product at the lower price. But this benefit exists usually only in the short run.

1.1.2 Negative effects on firms

Apart from these obvious positive results there are some reasons for companies to avoid price wars.

1) Not only profit declines but even losses can occur.

2) Resources are being depleting including morale and motivation (Durц and Sandstrцm, 1986, p.66).

3) Stock value is declining due to negative evaluation and rating (Heil and Helsen 2001, p.86; Rao et Al 2000, p.108).

4) Customers tend to defer their purchases anticipating lower prices.

5) Customer's price sensitivity increases what leads to an increase in dependency of firms on pricing as a competitive instrument.

6) Damage to brand equity: price-cutting policy designs an image of a low-priced company which creates doubts among customers on the quality of company's products.

1.1.3 Negative effects on customers and the public

Bringing a positive effect on customers price wars also have negative impact on their life.

Firstly, the decline in companies' profits entails the lack of resources for investment in innovations and R&D what adversely affect the quality of producing goods.

Secondly, participants firms' staff in many cases faces redundancies as a cost-cutting strategy.

Furthermore, buying products of a company acting aggressively customers facilitate the establishment of monopoly. Since the monopolist tends to increase prices on its products, the customer has to make a purchase at the price higher than that one before the price war.

1.2 Possible tactics

As a reader can notice price wars have a great impact not only on warriors but also on ordinary customers and this impact varies a lot. In order to not fail such war and benefit more than lose it is necessary to plan future actions. Here we will provide a reader with some basic strategies offered by two professors of the University of Minnesota's Carlson School of Management, Akshay R. Rao and Mark E. Bergen (2000).

Knowing irretrievable effects of participation in a price war the authors stress on preferableness of preventing the war - to stop the war before it starts. It can be achieved by revealing company's strategic intentions and capacity: price-matching policy, everyday low pricing, accessible information about a company, its profit and costs and etc. Such announcements will inform rivals that a company prefer to compete on another aspects.

In negative effects of the war we told that there is damaging impact on perception of a company and quality of its products. Thus in segments where quality has higher importance for customers the best response to starting price war is to focus on non-price features of the product such as delivery, quality of product and service to justify the difference in prices in comparison with rivals.

Sometimes it is better to cooperate with other companies in the market to prevent setting a monopoly, e.g. collusively rise prices. Moreover, preventively company should focus on long-run contracts with customers and suppliers.

Aforementioned methods are examples of non-pricing strategies. If a company still decided to use pricing its actions should be well-planned. A firm can use complex price actions: bundle products and set a special price, two-part pricing, price promotions or loyalty programs for products.

Furthermore, another option has a place in the list of possible strategies: launch a new product/brand. The idea is that a company introduces a product/ brand/ new package which will compete in the challenged by competitors segments. It will protect an initial product from negative effects of price wars.

Finally, a company can lower a price in return to the same level as rival did or put it lower than competitor's one facilitating the further development of the war. It is advisable for a company choosing this strategy to have several product markets and reliable sources of funding to be able to keep a low price longer than competitors can.

There are a lot of other works which are trying to answer the question “how to win in a price war”. The number of such articles shows that there is no the best strategy which should be applied everywhere. Use of a certain tactic depends on different factors which have to be taking into account.

2. Price war in hotel industry

In order to clarify some mentioned points and present a possible way of acting in price war, we chose the example took place in 1997 in hotel industry. Also we provided the description with application of general concepts of game theory.

2.1 Description of the situation

Malaysia whose the third source of profit is tourism faced the dramatically decreasing market: 1997 was the year of the Asian financial crisis. Started from the Thai baht devaluation it of course touched the Malaysian ringgit which value was dramatically reduced to about a half its value a few years earlier. Along with a huge number of forest fires in this period the crisis has led to the decrease of number of tourists. Apparently this period was a rough time for service sectors especially depending on the level of tourism.

What did the hotel operators do to attract customers? Under conditions of increasing costs and decreasing number of customers they dropped their room rates thus started a price war. Trying to slash prices these hotels had to cut their costs. Of course, it influenced the level of rendering services: no flowers, no everyday laundry and the staff scarcity. Consequently, the attempt of cost-cutting had a negative impact on brand equity: hotels started to be seen as low-cost companies, which led to influx of customers, fullness of rooms, rise in the level of noise and drop in customer satisfaction.

Surprisingly, described actions were common not for all hotels. The only hotel which chose a completely different way of reacting was the Ritz-Carlton. Unlike its rivals the hotel increased the level of room rates, but at the same time it accompanied it with the increase in the level of services: music and fresh flowers every day were common things; design of rooms was improved, they introduced a “bath menu” of drinks and snacks which was served along with butler-drawn baths. Besides, it offers different kinds of discount coupons and after five nights guests received an embroidered pillowcase. Moreover, the hotel's general director, James McBride, changed the way of communicating with customers: he posted his cellular phone number in newspaper ads, so people could connect him directly for reservation. Such measures not only prevented the Ritz from losses and its brand equity from any damage to Ritz's brand equity but helped it to benefit from this crisis and enhanced the level of perceived quality of services.

price war strategy effect

2.2 Analysis of the case

Introduced case is a usual example of a price war under conditions of oligopoly. The beginning of the war was given by bad circumstances of environment made hotels search for ways of survival. The most hotels in the described case chose the strategy of “predator”. Indeed, they decreased their prices in order to gain attention of customers and get a larger market share hurting rivals. Moreover, these hotels make negative effects mentioned previously more obvious. Here we see most part of them: decline in quality, staff redundancies, damage of brand equity and so on.

2.2.1 Model of non-cooperative game

Combined rivals of the Ritz Carlton in one imaginary Company A, we can analyze this game from the perspectives of non-cooperative game theory. Why non-cooperative? Because this case is characterized by independent decision-making process and has all five ingredients constructed the game. Let analyze these ingredients:

1) Players.

There are two players in this game: rival hotels united in Company A and our hotel Ritz Carlton, which we will further call as RC.

2) Strategies/ actions

Each player has to choose one strategy from two possible at each stage of the game. Firstly, Company A decides if it will start a price war (W) or not (N). If it chooses N the game will end. But if it still cuts prices, RC has to make decision choosing between to enter the war (E) or to steer clear of the fray (S).

3) Payoffs

Payoffs for each decision of players vary. If the game ends after the decision of A not to start the war, each player will earn the same amount of money as they had similar positions on the market before the financial crisis, and in case of absence of specific actions they will have equivalent losses. If A starts the war and RC enters, their payoffs will also be equal, but higher than in the previous case as they will be able to attract customers whose they can lose because of the financial crisis. Finally, if the players act in different ways, i.e. A chooses W, but RC chooses S, payoffs will also differ: the payoff of A < the payoff of RC.

4) Information structure.

Both sides know strategies of each other, what each player does and what everybody will get. Hence, we have the game with perfect information.

5) Rules of the game.

In this game we have sequential decision-making process, i.e. firstly decision is being made by the Company A, and then RC chooses between E and S knowing the decision of the previous player.

2.2.2 Reaction functions

Furthermore, actions of the players can be described by reaction functions. Assume that it is price competition on the market with substitute products. Thus we have two lines with positive slopes. The strategy of price war used by rivals of the Ritz-Carlton can be reflected as a shift of its reaction function to the left (1). After the action of the Company A, RC decides to invest money in advertising, so because of increase in sales linked with this process (Figure 4), its reaction function moves up (2). As it was mentioned in the description to the situation, the slash in the prices of the company A damaged its brand equity and led to decline in sales, what consequently led to increase of RC's profit. Thus this process can be interpreted as negative spillover for the company A, but positive one for RC, which entails that RRC continues moving up.

Now let's identify types of strategies of our players.

Investment of player 1 is extent of price reduction (that's why the left reaction function of A represents high level of investments).

It is a hard investment as it results in aggressive behavior (price reduction). In our SPE the company acts aggressively using high level of investment in order to create aggressive response and get a larger market fraction. This strategy reflects the idea of the Top Dog strategy.

But the second player (RC) also acts trying to maximize its payoff. So its investment can be determined as extent of advertisement, that's why the higher reaction function of the player reflects high level. It is soft investment as it leads to passive response. In our game it acts passively using high level of investment, thus its strategy can be identified as Fat Cat strategy.

Looking at the Figure 3 we can notice that the strategy of RC of not entering the price war is the best which it can choose in conditions of price war, because in this case the hotel increases its profit, what won't happen if it enters the war (RRC goes down leading to decline in profit).

Conclusion

During their existences companies face a huge number of obstacles which they have to overcome to stay alive. A start of price war is one of such obstacles whose importance can't be neglected since participation in this war can as make a company a leader as lead it to bankruptcy.

All economists exploring this phenomenon appeal to be very careful and make a reasonable decision. Firstly, managers should find out the nature of the price war started against his company: if it is intended or just a result of spontaneous events and has only short-term intension. In the second case managers should, put it simply, just relax and wait for the end of this actions. But if the first case occurs, it is time to be subtle and creative.

In the chapter with general information we provided reader with information about possible tactics in the period of price war. A reader can notice that exactly non-price actions are mostly emphasized. Choosing price strategies is an obvious way of acting. They can be applied but in very careful way. A company making this decision should assess objectively its capacity and possibility to keep low price longer than its rivals. But in all cases it is better firstly to pay attention to non-price methods of fight because it is a smarter way which is able to bring considerable advantages in the long-run as it was shown in the example.

Bibliography

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