March 2014

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How to avoid a price war

A one percent drop in the price of a product can slash operating profits by 12 percent to 15 percent, according to Pricing Solutions, a global pricing strategy consulting firm. So why get into it?

As per general economic definitions, markets are of three kinds—perfect competition, monopoly and oligopoly. A key feature in the third form of market structure is the concept of a price war. Oligopolistic market structures typically involve three to five firms selling homogeneous or differentiated products. In such a scenario of competition among the few, the action of one firm is likely to affect the others. Cutting the prices of the product seems to be the easiest option to increase customer base, but it causes a slash in profits. One must learn a few truths about a price war: It is easy to start, but difficult to end; it always lasts longer than expected, it rarely succeeds and it is responsible for some of the most dramatic declines in bottomline profitability.  According to a Harvard Business Review (HBR) piece, How to Fight a Price War by Akshay Rao, Mark Bergen and Scott Davis, there are two ways of responding to a price war—one, being non-price in nature and the other, being price-based.

- Don’t misread the price cut

A competitor may not always slash prices to create a long-term strategic move—there could be other reasons that govern the decision. Like in the packaged foods industry, where a change in the nutritional requirements set by the government would direct the company to produce goods as per the new guidelines. That also might mean that the company must get rid of the previous stock and so it slashes prices only to encourage the sales of the old stock. If the intent of a price cut is misunderstood, one can invite a lot of damage.

- Communicate correctly

Indulging in collusive or predatory pricing is not a good option for companies. The value of communicating strategy is that it forces competitors to understand the market situation while preparing forecasts. Revealing strategic intentions, price matching policies through public statements can sometimes help in stopping the war before it even starts.

- Check price sensitivity

Price sensitivity is essential to any effective pricing strategy and it becomes particularly important when new competitors enter the marketplace. In such a scenario, it is important for a company to deeply analyze the customers’ reactions to price change and product entry. Carrying out a research on pricing can help to forecast the short-term and long-term impact of various pricing strategies.

Sometimes, the company’s brand is well positioned and doesn’t need to respond to the price cuts. The use of complex price actions by offering bundled prices, two-part pricing, quantity discounts, price promotions, loyalty programs for products is a good way of keeping customers happy.

- Manage capacity

Price wars in the industry are usually a result of overcapacity. They are almost unavoidable when there is a significant overcapacity since everyone is fighting to maintain the same levels of costs and sales. Numerous industries have suffered chronic capacity problems—the airlines industry has often been a victim. Managing capacity correctly is a tricky issue and has many implications. However, because companies often fail to account for the possibility of overcapacity, they end up in  very costly price wars.

- Compete on quality

According to the same HBR piece, a company can compete on quality by increasing product differentiation, by adding features to a product or also through awareness of existing features and their benefits. By emphasizing on the performance risks of low-priced options, the company helps create consumer awareness. The company can also form strategic partnerships by offering cooperative or exclusive deals with suppliers, resellers, or providers of related services. This helps to strengthen relationships in the supply chain such that when there is cut-throat competition, the company can get a preference over its competitors.

- Be consistent

If competitors perceive that they will benefit from making aggressive price moves, then they will do so. It is important for the company to understand that it should respond quickly. If the company fails to do so, then its competitor will benefit substantially and in some cases, even decide to make another aggressive price move.

This pattern can continue until the company that is slow to respond almost goes out of business. Responding consistently and immediately minimizes price competition, benefits the competitor and doesn’t allow the deep discounting concept become an advantage for any one player.

Rao, Davis and Bergen say that a company must deploy simple price actions, adjust the product’s regular price in response to a competitor’s price change or a new entrant into the market.

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