Competition Pricing

Understanding anticipating and influencing competitors’ pricing

Dr Brian Monger

Pricing a product in competition can be more difficult than pricing one isolated by its uniqueness.  In the absence of direct competition, one can estimate how a price change will affect sales simply by analyzing buyers’ price sensitivity.  When, however, a product is just one among many, competitors can wreak havoc with such sales estimates by changing their own prices.  In doing so, competitors change buyers’ alternatives to purchasing one’s product and thus manipulate what they are willing to pay for it.  For example, a company might reasonably estimate that it could double sales by pricing 20 percent below the competition.  But a 20 percent price cut would not necessarily generate such a result.  Competitors may not allow a 20 percent price cut to become a 20 percent price differential.  They may respond with price cuts of their own to narrow, eliminate, or even reverse the differential the company hoped to establish.  In doing so, they could significantly reduce the effectiveness of the price cut as a tactic for increasing sales.

The intensity of price competition and its importance in formulating strategy varies greatly from product to product.  Anyone who reads the business press is well aware that price competition is a very potent weapon in the airline industry.  A new competitor  can often capture a substantial market share within days by undercutting the prices of the established firms.  In contrast, price competition is relatively impotent as a competitive weapon in the sale of legal services.

Competition: anticipating and influencing competitors’ pricing

Two factors create a potential for intense price competition: high interbrand price sensitivity and low competitive barriers to entry and growth.  High interbrand price sensitivity’ means that much of the sales that a company gains from price cutting will be gained at its competitors’ expense.  Low competitive barriers means that new competitors can enter a market and aggressive current competitors can expand their market shares at a cost close to what established competitors must bear to maintain their shares.

While the levels of interbrand price sensitivity and competitive barriers are partly determined by factors beyond a company’s control, it can influence them with marketing efforts that create competitive advantages (or reduce disadvantages). Large companies enjoy cost advantages in advertising and distribution.  Consequently, large companies can set profitable prices knowing that most smaller ones cannot afford to undercut those prices.  Even in these cases, however, the companies are only in part insulated from the effects of price competition.  Whenever a price cut can cause changes in market share and potential price cutters have comparable or lower incremental costs than large, established companies, price can be used as a competitive weapon by aggressive smaller companies seeking added sales.

High interbrand price sensitivity and low competitive barriers create only the potential for intense price competition.  Whether intense price competition will actually occur is another question.

Evaluating the character of competitive behaviour

The greater the potential for price competition, the more important it is for management to evaluate how competitors are likely to use price in their marketing.  Pricing strategists should ask themselves two questions:

(1) What price changes is each of my competitors likely to make’? and, often more important,

(2) How will each competitor respond to my own price changes?

Answering these questions is difficult and the conclusions are uncertain, but the effort is essential.  A price change to which competitors respond unexpectedly can be financially devastating.

The first step in predicting a competitor’s pricing behavior is to define the  product/market.  A firm’s relative size in a market significantly affects its ability and incentives to pursue alternative pricing strategies.  When markets are national,  one can estimate a firm’s relative size by its national sales volume.  In markets that are more geographically segmented, however, even a very large firm may still be a small competitor in any one regional market.

Having identified a competitor’s position in a market, one can analyze its specific circumstances to predict its probable pricing behaviour.  Though the specifics will be somewhat different for every product, we can classify competitive behavior as one of four general types: cooperative, adaptive, opportunistic, or predatory.

Cooperative Pricing

‘When a few large firms share a substantial portion of sales in a market and all have viable market shares, they often make price changes cooperatively.  When one firm, the price leader, initiates a price increase, other fin-ns follow with equal price increases.  When a price increase reduces industry sales, each firm shares in the reduction, avoiding efforts to maintain its sales levels at its competitors’ expense.  Similarly, when the price leader reduces price, other firms follow and share any increased sales but do not attempt to gain sales disproportionately.  Cooperative pricers do not necessarily maintain identical prices.  Rather they change their prices in parallel, maintaining the traditional price differentials that produce stable market shares.

One reason why competitors might be willing to price cooperatively is simply recognition of a common interest.  If each firm in the industry already enjoys a viable market share and believes that its competitors could easily detect price cutting to which they would quickly respond, then each may rationally set its prices and output to maintain industry stability.  Any short run benefit from breaking with the industry, each firm may reason, would be quickly wiped out in a price war.  Explicit collusion to maintain parallel prices is blatantly illegal with both civil penalties for the fin-ns and criminal penalties for the individuals involved.  But independent recognition of mutual self-interest and its consideration in initiating or responding to price changes may be legally defensible .

The incentive to price cooperatively is strongest when companies are operating near capacity and there are high incremental costs of expanding capacity.  If a firm is producing at or near capacity, it can profit from cutting price or from failing to follow a general price increase only if it expands its capacity to accommodate the extra sales.  But if its competitors respond in kind to its uncooperative behavior, then its sales increase will be only temporary, leaving it to bear the sunk  cost of new capacity that it cannot fully utilise.

Competition: anticipating and influencing competitors’ pricing

Facing such a prospect, competitors with high incremental capacity costs and high rates of capacity utilisation usually dutifully change prices in parallel.  The exceptions occur (1) where a firm’s price cuts and expanded sales are difficult to detect, giving it enough time to recoup the cost of additional capacity before other firms respond;  or (2) where buyers who are bid away from other firms by price cutting can be bound, contractually or otherwise  to make purchases from the price cutter until he recoups his capacity costs.

A company with excess capacity is less inclined to price cooperatively.  It may still do so if the long-run benefit from maintaining the cooperaive price structure exceeds the immediate benefit from price cutting to fill the excess capacity, but the greater the excess, the more this balance tips in favor of price cutting.

Voluntary cooperative pricing is viable only when the competing firms perceive that their self-interests are similar.  In the airline industry when regulation maintained barriers to new entry, the established airlines priced cooperatively and profitably on all routes.  Competitors with similar costs and capacity utilization rates rarely undercut each other. Stability in prices and market shares was more desirable in the long run than any short-run gains from price cutting.  Following the deregulation of airlines, however, newer companies entered with low-cost, non-union labor but without a share of the market.  For them, stability was not a good thing.  Price cutting was often necessary in the short run to build market share and desirable in the long run to stimulate total market demand.  Consequently, as new airlines exploited deregulation by entering on the busiest air routes, the tradition of cooperative pricing on those routes collapsed.

While cooperative pricing requires that the largest competitors adopt it voluntarily, it is possible to maintain cooperation with only grudging acceptance by smaller firms.  The key to obtaining such acceptance is a commitment to react to uncooperative pricing swiftly and consistently.  Swiftness is required to minimise any short-term profits that the price cutters might achieve.  Consistency is required to leave no doubt about one’s intention to punish those who refuse to cooperate.

Adaptive Pricing

Most firms usually price adaptively.  They take the prices set by larger firms lace as given and make the best of them.  Like co-operative competitors, adaptive competitors change their prices to reflect the general level of industry prices.  Their behavior is not cooperative, however, because they do not share the burden of maintaining a profitable price level.  When larger competitors attempt to raise price or to maintain price in the face of declining demand, an adaptive firm does not cut back its own output to share the reduction in market demand.  It tries instead to increase its sales even though the size of the total market may be falling.  On the other hand, when the larger firms reduce price, adaptive firms may reduce their own sales in response to the lower profitability of those prices.  In each case, adaptive pricers passively respond to whatever pricing structure other firms set, making no effort to maintain the structure.  Because of their stand-offish behavior, they are often referred to as the fringe of an industry.

What makes a firm price adaptively are two beliefs held simultaneously.  First, the adaptive firm believes that its sales represent a small enough share of the market that whatever pricing and production decisions it makes, those decisions will not change the level of prices set by other firms.

Though no adaptive firm believes that its individual actions will affect the level of industry prices, the behaviour of many adaptive firms collectively does affect the prices that an industry can charge.  How much it affects those prices depends on how much the adaptive firms can change their production levels when prices change.  If a large portion of their costs is fixed or sunk, as in industries that require large expenditures for durable capital, adaptive competitors will make little immediate change in their production levels in response to price changes.  They will continue to produce even though prices fall to unprofitable levels because reducing production would have little impact on their costs.  They will also be slow to increase output by making new investments when prices increase, recognising  the vulnerability of those investments to future price decreases by more dominant competitors.  If, however, costs are overwhelmingly incremental and avoidable, as in most service industries, a price decrease will usually prompt adaptive competitors to immediately reduce output, abandoning sales that have become unprofitable at the lower price.  A price increase will prompt them to expand sales quickly because if costs are incremental and will remain avoidable, adaptive competitors take little risk in exploiting the higher prices for short-term gains.

When adaptive competitors do not substantially change their outputs in response to price changes, the larger firms in an industry can still set prices cooperatively despite the lack of cooperation from their adaptive competitors.  But if adaptive pricers can substantially adjust their outputs, then the cooperative firms can exercise little control over price.  The reason for this is straightforward.  Cooperative pricers cannot raise industry prices unless they can control industry sales.  If whenever they increase prices, they have to cut back their outputs substantially in order to compensate for large sales increases by their adaptive competitors, cooperative price increases become untenable.  Because adaptive firms are generally better able to change their rates of output in the long run than in the short-term, cooperative pricers can often raise prices despite the adaptive behavior of smaller producers.  However, they cannot maintain those prices without restricting their own sales in ever larger amounts to compensate for sales increases by adaptive fin-ns.  Even OPEC, whose cooperative members determined world oil prices for over a decade, was ultimately undermined by the entry and growth of adaptive competitors selling newly discovered oil and alternative sources of energy.

Opportunistic Pricing

Even less cooperative than adaptive pricing is opportunistic pricing.  An opportunist uses price as a competitive weapon.  If other firms raise price, the opportunistic competitor delays or foregoes a corresponding increase in a bid to gain market share.  If other firms lower price, however, an opportunistic firm immediately matches the price cut, often with great fanfare designed to capture a disproportionate share of whatever market expansion the price cut causes.

Opportunistic firms also initiate price cutting.  Such price cuts are frequently disguised as premiums (“free” luggage with a car purchase), or added value (for example, extra quantities for consumables, longer warranties for durables) while maintaining explicit prices parallel to the competition.  They also are frequently temporary and limited by the use of coupons, rebates, and “cents-off” packages.  Even when disguised, however, such tactics are effective pricing ploys that can enable the opportunist to capture market share.  Consequently, repeated opportunism often undermines a cooperative price structure by forcing everyone to cut price as a defense.

Unlike an adaptive competitor, an opportunistic competitor may expect that its behaviour could undermine cooperation in the industry, yet still choose to pursue itA firm with significantly lower incremental costs than its competitors might  expect to profit from market expansion even if competitors matched its opportunistic price.  Such reasoning is especially compelling for low-cost competitors that are new to a market.  Having few current customers, they have little revenue to protect through cooperation and much to gain from inducing buyers to try their products.  This partly explains why the new, low-cost airlines that entered the market so frequently initiated price cuts despite the fact that their competitors almost always responded in kind.

More commonly, however, opportunistic pricing cannot work if competitors immediately retaliate.  The rationale for most opportunistic pricing is a company’s belief that its competitors will not retaliate, enabling it to establish a competitive price advantage.  Sometimes that belief is simply the result of naiveté on the part of inexperienced managers who do not understand the importance of cooperation for their own benefit.  They and their industries suffer the consequences until they team.  More often, a company adopts opportunistic pricing following an informed evaluation of its competitors’ capabilities and intentions.  To understand why, you need first to understand how a company’s evaluation of its competitors’ capabilities  and intentions influences its pricing decision.

The evaluation process leading to either cooperative or opportunistic pricing, begins with the potential opportunist asking the question, Could a price cut be profitable?7 To answer, the potential opportunist examines his contribution margin, estimates how much added sales would be required to justify the lower price, and evaluates the price sensitivity of buyers in their choice among suppliers.  If he concludes that the market in general is sufficiently price sensitive to justify the price cut, or if he concludes that he could cut price selectively to a segment of buyers that is sufficiently price sensitive, then opportunistic pricing will be tempting.  Whether or not the potential opportunist gives into that temptation depends on how he thinks his competitors will respond.  The potential opportunist asks three questions:

·        Can competitors detect opportunistic pricing?

·        Can competitors effectively retaliate?

·        Are competitors willing to retaliate?

Can the competitors detect opportunistic pricing?

The first question a potential opportunist asks is whether its competitors can actually detect opportunistic pricing.  When prices are public, as for example in the airline industry, competitors can detect price cutting immediately.  But when prices are privately negotiated, usually as a discount off of a list price, price cutting can conceivably go on for some time without detection.  For example, when a salesperson gives price quotes individually to each customer, a company can often cut price without its competitors noticing until after they have already lost sales.

The lack of an effective system to detect price cutting quickly is one of the most common reasons why cooperation degenerates into opportunism.  Many firms collect data on competitors’ prices haphazardly, relying on whatever information  just happens to come to management’s attention.  Consequently, they often do not find out about price cutting, if they find out at all, until it has substantially hurt their sales and substantially helped those of the opportunistic competitor.  Even if the opportunist expects ultimately to suffer from retaliation, the profit earned during the delay may well compensate.  Moreover, delay also raises doubts about a firm’s ability or desire to defend a market.  As a result, the temptation increases  for the potential opportunist to become even more aggressive in the future.

Can competitors retaliate?

The fact that a price cut is detectable does not necessarily deter a potential opportunist.  The opportunist must also believe that competitors have the ability to retaliate effectively.  That ability may be limited for any number of reasons.  When competitors are already producing at maximum capacity, an opportunist need not fear retaliation.  Producers of IBM-compatible PCs, for example, were able to undercut IBM’s price for years because IBM could not keep up with demand.

Retaliation also requires adequate financial resources.  When discount airlines were formed following deregulation, they wisely picked markets to enter based partly on the financial strength of the competitors.  They targeted markets served by  financially weak carriers that could less afford temporary losses to defend their traditional markets.  As an opportunist becomes financially stronger, it can challenge stronger competitors.

Large buyers can often encourage opportunistic pricing among suppliers by limiting the possibility of effective retaliation.  They do so by awarding long-term contracts for large amounts of sales to the lowest bidder.    The size of the order ensures a supplier that much of its capacity will be profitably employed, thus reducing the need to capture additional sales.  Even though competitors will quickly discover the price cut, the opportunist’s guaranteed orders largely insulate it from the effects of competitors’ retaliatory pricing.  Because of this, even otherwise cooperative firms are frequently opportunistic when bidding for large orders.

In essence, competitors are not able to mount an effective retaliation unless they can make an opportunist regret his behavior.  Only if the opportunist believes that its competitors can hurt its profitability on future sales, and believes that the benefit from an opportunistic price cut would be overwhelmed by the effects of retaliation, will the threat effectively deter his opportunism.

Are competitors willing to retaliate?

In many cases, a potential opportunist may doubt a competitor’s willingness to retaliate, even though the competitor has the ability to detect a price cut and to retaliate effectively.  There are a number of reasons why a competitor with the ability to retaliate might be unwilling to do so.

  • If the segment attracted by an opportunist’s price cutting is a small portion of a competitor’s total sales and retaliation would require cutting price to all buyers, then the cost of retaliation may exceed the cost of letting the opportunist   get away with a price cut.  For example, if an opportunistic price cutter threatened to take 5 percent of a company’s sales, it might not be worth cutting price on the other 95 percent, even temporarily, to recapture the lost sales.
  • Even if a company could selectively cut price to the specific segment where it is most hurt by an opportunist, it may fear that doing so would undermine the perceived value of its product to buyers who paid more.   Given that situation, the higher-quality, higher-priced suppliers often let the more opportunistic pricers take the business awarded by competitive bid.  They do so because whatever price they bid for the large utilities’ business becomes the basis from which other utilities expect to begin their price negotiations.
  • Finally, a company may be unwilling to retaliate against opportunistic price cutting because of potential legal or regulatory difficulties.

These are outline notes from a MAANZ course.  If you are interested in obtaining the full set of notes (and a PowerPoint presentation) please contact us – info@marketing.org.au

Dr. Brian Monger is the Executive Director of MAANZ International and a Principal Consultant with The Centre for Market Development.  His profile can be found on LinkedIn.

He is available for consulting tasks and speaking engagements

Did you find this article useful?  Please let us know

Also check out other articles on http://smartamarketing2.wordpress.com

MAANZ International website http://www.marketing.org.au

Smartamarketing Slideshare (http://www.slideshare.net/bmonger)

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s