Misperception of the Dynamic Environment - Coursework Example

Shrinking product life-cycles, globalization and internationalization, and intense competition in the markets have increased the complexity in the markets. This has led to firms trying out various strategies to capture a sizeable market share. Price wars hence represent severe forms of competitive forces at the market place causing heavy losses (Heil & Helsen, 2001). Price wars depend upon the market structure which could be oligopoly, highly fragmented or growth oriented. While some believe that early entry can give the firm an edge over competitors as it would mean monopoly and locking-in the customers, others contend that aggressive strategies can also lead to increasing returns. Price wars can be applicable in certain industries and for some time but overall price wars are considered as dysfunctional behavior especially in industries which experience rapid growth and sudden behavior (Langley, Paich & Sterman, 1998). Misperception of the dynamic environment A study found that misperceptions of feedback (MOF) can make the decision makers misperceive the dynamic environments which can in turn affect the pricing strategy of the company. At the same time, prices can also be based on competition in the industry. At times costs become the only determinants of the competitor price when the competitive situation and the market forces are totally ignored. A fixed markup over the costs is applied and as the costs fall, the competitor price also falls (Langley, Paich & Sterman, 1998). Sometimes, the firm may fix its objective on achieving a certain percentage of the market share and fix its price accordingly. In such cases, the mark-up is cut aggressively when there is excessive capacity and gains a market share during the boom phase but it leads to bigger bust as the market saturates. It has also been found that in trying to reduce prices, companies increase the delivery times of the products but this drives away the customers who change over to price sensitive bargain hunters. The firm thus increases the elasticity of the demand curve, increases its vulnerability to price competition and initiates a price war. When Apple Computers faced severe shortages of its products and when its orders remained unfilled, it reduced the prices by as much as 40% on some items that were in short supply. As a result even IBM made similar decisions in the PC market, initiating price war. Two banks may also offer identical accounts but there are high transaction costs involved in closing one account and opening another with a competitor (Klemperer, 1989). The same situation was faced by People Express Airlines (PEA). They offered low fares and excellent service which led to a rapid growth but they faced staff shortages (Langley, Paich & Sterman, 1998). They went in for rapid hiring which meant compromising on employee experience and other operational problems leading to a decline in customer service. As suggested by Heil and Helsen, companies forego their competitive advantage, fall victim to substitutes and even face bankruptcy. There was a shift in the customer-mix and there customers were now exclusively made up of price sensitive discretionary travelers. When competitors cut prices, the PEA had no other attractiveness in its services and was soon on the brink of bankruptcy. Hence, when price war is the only objective, the benefits cannot be reaped for long. These are the difficulties that in pricing decision according to MOF. Models of price wars Firms sometimes can observe only their own outputs and not their rivals’ outputs and then a tacit collusion among firms leads to price war due to demand shocks. This is an imperfect monitoring model and according to Heil and Helsen, such price wars can occur only during economic downturns. In cyclical models firms observe all variables. When demand is high there is temptation to under-cut and by cheating during economic-boom times, the firm can capture a huge market share. According to this price cuts most likely occur in good times. Then there is the learning model in which unknown demand parameters are random variables. These unknown demand parameters remain constant for a while and then there is a permanent shift. The players adjust their prices and this triggers a price war. Hence price war takes place when demand slumps. Capacity utilization At the same time, South West Airlines (SWA) continued expansion has forced other airlines to bring about a major change in their in their cost structures by developing new low-cost services in short-haul markets. This in turn led to a correction in the industry’s long-haul pricing structure where at times airlines were forced to offer prices lower than their costs. They have been able to create and sustain a price war because SWA flies its planes 20 to 30 percent more hours than other major airlines. They have fewer employees per aircraft, fly fewer passengers per employee and have more available seat miles per employee (Pfeffer, 2005). They do not use the standard hub-and-spoke model like most carriers but have the a point-to-point route network and is thus able to minimize the domino effect of flight delays thereby maximizing asset utilization (Kearney, 2008). Thus, they have capitalized on the restriction imposed on them and created a differentiation in their services. Merely reducing prices can lead others to do the same and end up in bankruptcy as in then case of PEA. Price war triggered by entry Price wars have several theories where some attribute low prices to unexpected demand shocks (Elzinga & Mills, 1999). Some contend that price wars are strategic temporary reversions to competitive pricing by colluding firms and some others believe that price wars are low-price outcomes in equilibria with mixed strategies. All these theories suggest that low price is unrelated to entry strategies. Klemperer’s theory of price war suggests that low prices are triggered by actual entry in markets. Since their customers would incur switch-over costs, so to keep these costs low for their customers, they offer temporary discounts from prevailing price levels. This results in a price war and once the firm establishes its clientele, the prices are raised and the price war stops. This too has not been found to be sound because new customers may develop because of price war but there is no evidence of customers switching because for switching it is necessary that customers have heterogeneous set-up costs. Another model was developed which shoes that eventual entrants bring down the prices after a single manufacturer has enjoyed the first-mover advantages (Elzinga & Mills, 1999). The dealers incur set-up costs but since the goods are homogenous the dealers can buy the goods only from one manufacturer at a time. Thus a price war breaks when entrants arrive. The entrants keep their price even below their costs to attract the dealers. This may induce some of the dealers to switch to the new entrants as the goods are homogenous. Once the entry is complete and all the dealers have attached themselves to a supplier, the price war ends and the price of the good increases. Problems in price wars Both the consumers and the company face problems. The consumers may initially gain in cheaper products but ultimately have to face inferior quality standards. Society suffers from suboptimal allocation of resources. Damages occur as firms seem to lack an understanding of the market and industry conditions leading to a price war such as market growth, concentration of market shares and over-competing. When a company is affected by price war, it also involves the other stakeholders like the shareholders, distributors, customers and suppliers. In the short term it leads to profit erosion and in the long-term it tarnishes the image of the company and even may force it go bankrupt. When consumers get used to lower prices, their reference price for the brand involved lowers and then they are unwilling to pay higher prices. Price wars can wreak havoc for resellers as in the case of the price war between Pepsi and Coke. Distribution channels get affected as in the case of the laser printer industry. When market share is fragmented, consumers buy products based on the price. Price war can take place when a new brand is introduced. This new brand can be an extension of a parent brand which is one of the leading brands in a related category. When they followed an aggressive marketing launch it triggers price war. Conclusion It can thus be surmised that there are different situations in which price wars can occur. It may be due to the market structure or even due to miscalculations or misperceptions of the dynamic market conditions. Price wars can be triggered due to new entrant in an established market especially when the goods are homogenous. Price wars benefit neither the different stakeholders nor the company nor the society. Price war can occur in monopoly, oligopoly or in fragmented markets. Switching costs are high which affect the dealers and resellers. Some models suggest that price war occurs during economic downturn while it can also occur during good times. It is very difficult to sustain price war which necessarily requires retaining product or service differentiation. References: Elzinga, KG & Mills, DE 1999, Price wars triggered by entry, International Journal of Industrial Organization, vol. 17, pp. 179-98. Heil, OP & Helsen, K 2001, Toward an understanding of price wars: Their nature and how they erupt, Intern. J. of Research in Marketing, vol. 18, pp.83–98. Kearney, AT 2008, Are you more capable than your competitors are ruthless? Retrieved online 30 November 2008, from http://www.atkearney.com/main.taf?p=5,1,1,118,3 Klemperer, P 1989, Price wars caused by switching costs, Review of Economic Studies, vol. 56, pp. 405-420. Langley, PA Paich, M & Sterman, JD, 1998, Explaining Capacity Overshoot and Price War: Misperceptions of Feedback in Competitive Growth Markets, Retrieved online 30 November 2008, from http://www.systemdynamics.org/conferences/1998/PROCEED/00026.PDF Peffer, J 2005, Producing sustainable competitive advantage through the effective management of people, Academy of Management Executive, vol. 19, no. 4 Read More