Lecture 13 Competition and Pricing

Motivation questions1. What motivate a company to cut price?2. Why is a price war harmful?3. 1999, Sprint announced 5 cents nighttime long-distance rate MCI matched ATT offered 7 cents all day Sprint was forced to drop price further ATT’s stock price dropped 4.7% the day of announcement. MCI stock price dropped 2.5% Sprint stock price fell 3.8%

What could have ATT done in 1999 to prevent Sprint from cutting price?

If Sprint has already cut the price, what could have been done by ATT to win the war?

Classifications of Competitive Behavior

Cooperative pricing monopolistic competition recognize a common interest

Adaptive pricing small firms take prices set by large firm

Opportunistic pricing use price to gain market share

Predatory pricing a firm use low price attempting to punish another firm or drive

it out of business Limit pricing

Discourage the entry of potential competitors

Understanding Pricing Game Incentives for undercutting price

Evil intention extra market share and opportunistic profit if not immediately

retaliated by competitors especially true for industries with high fixed cost and peak

seasons

Good intentions A firm strategically changes the way business is done

Office Depot A firm offers additional feature without increasing price A firm misreads the change in market share A firm overreacts to a competitor’s limited and focused price

reduction with an across-the-board price reduction

If you cut price for good intentions, make sure your competitors do not misinterpret your intentions

Price war is “negative-sum” game Economic disaster

Difficult to increase profits by reducing price Coca-Cola, 1% reduction means $20million reduction in operating profit

No gain if immediately retaliated by competitors Cutting price rarely drives competitors out of business

Psychological trauma Lower consumer reference price Reduce consumer sensitivity to quality Train loyal consumers to switchers

Depending on how competitors interpret your move, your price cut that boost sales today will radically change the industry you compete tomorrow! That change is forever.

“Negative-sum game” Illustrated

Prisoner’s dilemma Prisoner A

Confess Does not confess

Prisoner B

Confess

Does not confess

Winning “negative-sum” battles requires

management forward-looks future behavior of competitors and consumers and resulting profitability.

a process of 3 steps: Step 1: make long-term plans (to prepare for

future price war) Step 2: diplomatically communicate with your

competitors (to avoid price war) Step 3: wisely choose confrontation (to win price

war)

How to Fight the Price War?

Step 1: develop long-term plans to prepare for price war

Setup market intelligence to understand competitors Information on competitors

What: price structure, transaction price, history of price moves, cost, capacity

How: sales force, favored consumers, trade associations, list future prices, ghost shop, distributors, technical consultants, securities analysts

Information on demand What: future growth of the market

Develop price leadership Will be discussed in Federated Industries

Build up sustainable competitive advantages

Step 2: legally “communicate” with your competitors to avoid price war

Reveal that your intention of price cut is temporary and not threatening

excess inventory over capacity future growth of the market introduction of a simple version of the existing product

Reveal your capability of fighting a price war cost advantage future expansion plan willingness to fight back

Winn-Dixie, Big Star and Food Lion

Pre-announce price increases American Airline

Tools for competitive signaling Match price cut immediately A discount mimic exactly your competitor’s offer Test the water (American Airline)

Announce new, patented manufacturing process Japanese manufacturer

Announce intentions, capabilities and future plans Show willingness and ability to defend

1990s Chrysler minivan Publicize a competitor’s opportunism Legal suit Price structures carry signaling messages

Bundled price Two-part price that reward additional business End-of-year rebates rather than quantity discount Functional discounts

Step 3: wisely choose confrontation (to win price war)Non-price actions Focus on the other 3 Ps.

1997 Malaysian Ritz-Carlton Alert customers to risk poor quality

Fedex “absolutely and positively be there”

Price-related actions Change consumer choice

1980, McDonald “value meal” Cut price selectively

Sun Country Airlines Develop a fighting brand

1990, Kao Corporation and 3M Offer new package and lock in future sales

“buy one, get one free”

Match the price cut Match price cut but protect profit

HP, IBM, “fee PCS” Do it quickly to avoid future cut

Retreat It may be wise to cede market share

1980s, Intel dropped DRAM, Taiwan1990s, 3M withdrew from videotape

General principle, response should be focused and in kind (tit-for-tat). When competitors move back to rational price, show immediate support.

When is it profitable to initiate a price cut?

Aggressive (opportunistic) pricing is profitable when incremental cost advantage

Wal-Market, Southwest, Dell products attractive to a small share of market

ATT vs. Sprint will not catch immediate attention

Federated Industries related products can be cross-sold in the future

Microsoft demand is still growing at the product growth stage have excess capacity (keep excess capacity)

Key: justify your price cut to avoid price war

Take-aways from today’s lecture

Price war is a “negative-sum” game. In the long-run, it hurts every players in the industry.

Winning price war requires Step 1: develop long-term plans (to prepare for future

price war) Step 2: diplomatically communicate with your competitors

(to avoid price war) Step 3: wisely choose confrontation (to win price war)

Decision on initiating or matching price cut should be made based on long-term consequence

Next Lecture

Product Lifecycle pricing