Industrial Economics: Threat of Price War - Essay Example

? Industrial Economics: Threat of Price War Introduction “When a company wants to increase its market share, usually the easiest way is to reduce prices, which increases product sales”(Price war, 2011). The above strategy will force competitors also to reduce the prices of their products. Thus price war is a phenomenon in which organizations compete each other by reducing the prices of their products to increase their market share. Even though price wars are good for the consumers, it is not so for the organizations. As a result of reduction of prices, profits of the organizations may come down. In a heavily globalized and competitive business world, price wars often occur between different firms to gain control in the market. For example, James Quinn (2012) has pointed out that “Ocado is to cut its prices on a range of products in a bid to steal a march on rivals such as Tesco in the battle for online supermarket delivery customers” (Quinn, 2012). Price wars affect the market in many ways. “There's nothing wrong with offering two different products at two different prices for two different markets, as long as the products really are different”(Brodsky, 2012). However, price wars often occur in the same market and that also with respect to similar products. Price wars can discourage potential competitors from entering a market. This paper analyses how a threat of price war can discourage entry by potential competitors and the actions that might help an organization to make price war threat credible. How a threat of price war can discourage entry by potential competitors? “A price war breaks out when entrants arrive. During the price war, the entrants' price is below the incumbent's price. It is even below the entrants' costs”(Elzinga & Mills, 1999, p.4). Entry into a new market is extremely difficult for an organization especially when the market was highly competitive. It should be noted that even though the number of market players are increasing as a result of globalization and liberalization, the number of potential consumers remains almost the same. In other words, it is difficult for new entrants to create new customer base. They have to canvass the customers of their competitors. However, existing customers may not switch over to a new entrant unless they were convinced either by the quality or by the prices of the competing products. Compared to the entrant, an incumbent may have some advantages also. Long run average cost (LRAC) of the entrant could be more than that of the incumbent which is evident from the following graph. (Industrial economics – Lecture 9: Barriers to entry and entry deterring strategies, slide 4) Incumbent will be able to reduce LRAC because of; Access to superior technology, Hold patents, Trade secrets, Exclusive ownership/control over factor inputs and Cheaper sources of finance etc. Thus it is easy for the incumbent to reduce the prices. (Industrial economics – Lecture 9: Barriers to entry and entry deterring strategies, slide 5) Economies of scale is another factor which causes problems to the entrant. Economies of scale refers to the cost advantages that an organization obtains due to expansion. It should be noted that it is easy for the incumbent to control the expansion cost because of its better awareness in the market. On the other hand an entrant may be forced to pay more cost for expansion because of its lack of knowledge about the market. From the above graph is evident that the new entrant will have to pay a higher absolute cost (AC) penalty if it wishes to enter this market which can make the entry unprofitable. Limit pricing is another strategy used by incumbents to block the entry of entrants. Limit pricing is nothing but charging prices below the monopoly prices which is described in the graph below. It should be noted that the incumbent was charging monopoly prices earlier. The threat from new entrants forced them to adjust the prices based on the market demand. It is difficult for the entrant to reduce the price below the prices of incumbent because of higher LRAC and lower economies of scale. (Industrial economics – Lecture 9: Barriers to entry and entry deterring strategies, slide 12) Switching cost is a big factor which prevents customers from approaching a new company for product and services (Klemperer, 1989, p.405). For example, computers users who are working on Windows platform may not switch over to Linux or Macintosh because of the switching costs. It is not necessary that all the applications working on Windows platform may work on other platforms. Under such circumstances, users may force to spent more money for purchasing applications compatible with new platforms such as Linux or Mac. Actions that might help an organization to make price war threat credible The e-book reader market price war was sparked by new entrants competing with Amazon's Kindle product. The Kindle started at $399 in 2007, and now the Kindle is priced at $139 for the lower-end model. While prices do generally decline quickly in electronics, in this case the price cut is primarily a response to competition from the Barnes and Noble's $149 book reader and Sony's $150 Reader Pocket Edition (The Pros And Cons Of Price Wars, 2010). The above example clearly suggests that price wars can help new entrants in many ways. Price wars can help organizations to develop new products. It should be noted that Amazon was the dominant player in online book market until recent times. However, the entry of new players helped Amazon to develop new technologies such as e-book reader or Kindle. It is impossible for organizations to keep on reducing the prices of existing products beyond certain limits. There is no point in selling a product below its actual cost price in the name of price wars. Price wars can help organizations to improve its service quality. Because of price wars, “a retailer may choose to increase its service level, which includes all the non-price attributes, such as the company’s reputation, delivery time, refund scheme, warranty period, and customer service”(Zyga, 2009). Increased service quality may increase the brand value and reputation of the company and thereby its acceptance in the market. Even though price wars are good for the consumers, it is not so for the organizations. If not managed carefully, price wars may bring more harm than good. Even though price wars can increase the market share of a company, it can reduce profits and the company might face losses ultimately (Pineres, n. d., p.2). “The basic rule is that you must sell your product for more than it costs you” (Understanding the benefits and effects of price changes, 2012). There is no point in securing more markets by reducing the prices beyond certain levels. In short, there should be a compromise between the margin of profits and reduction of prices. There is no point in selling a product at or below the level of its actual cost price. Chun-Hung et al. (2009) pointed out that “a price wall can effectively prevent big drops in both market share and profit” (Chun-Hung et al., 2009, p.331). “A unique feature of a price war is that pricing interactions occur at a much faster rate than previously. Intensive price interactions make price a more easily accessible attribute, which, as a result, increases its importance as a purchase criterion” (Van Heerde et al., 2009, p.504). Price wars can convert inactive consumers into active consumers. It is a fact that higher prices are unaffordable to average consumers. When price reduction occurs on certain commodity, even ordinary consumers may enter the market. In short, price wars have the ability to increase the consumer base in a market. If price wars are good for “absolutely nothing,” of course, no firm should ever initiate them. If a firm does, it must be driven by insanity. In that case, “the best way to escape a damaging price war is not to jump into the fray at all”(Zhang, 2010, p.17). The above statement could be true in western countries since these countries are facing immense manpower shortage. However, in the case of heavily populated countries such as China and India, the case is entirely different. These countries have huge manpower resources and therefore manpower cost in these countries is extremely low compared to that in western countries. So they can reduce the prices of their products much below than that in western countries because of low production cost. In other words, new entrant companies should evaluate the target market business climate properly before starting price wars. For example, China or India can reduce the prices of their products in western market whereas American or European companies cannot reduce the prices of their product in China or India beyond certain limit. Western countries such as America and Europe have technological superiority whereas Asian countries such as India and China have manpower superiority. It should be noted that iPhone is selling rapidly in Asian market even though the prices are high. This is because of the fact that no Indian or Chinese smartphones are capable of competing with iPhone. However, Korean company Samsung has recently introduced Galaxy S2 series of smartphones which is causing big challenges to iPhone. Apple forced to reduce the prices of iPhone because of the challenges from Galaxy S2. Now, Apple is trying to develop iPhone 5 series in order to meet the challenges raised by Galaxy S2. In short, companies should assess their strengths and weaknesses judiciously before entering a price war with others. How a threat of a price war can deter entry by potential competitors in different markets? The threat of price wars can affect different markets differently which is evident from the following graph. In an imperfectly competitive market, barrier to entry is more compared to a perfect market. The monopolistic or oligopolistic firms may not allow competitors to enter into their territories. The price will go up in such markets because of the huge power of monopolistic firms in such markets. Usually price wars may not take place in imperfectly competitive markets because of the inability of the competitors to challenge the power of monopolistic or oligopolistic firms. On the other hand, in a perfectly competitive market, supply will go up because of the excessive number of suppliers and therefore prices may come down. In fact price wars usually occur only in perfectly competitive markets. (Typology of market structures: summary, p.13) From the above graph it is evident that profit will become maximum when MR=MC. Moreover, monopoly helps firms to set the price above the actual cost price. Conclusions Price wars often occur when a firm tries to increase its market share or when a new firm tries to enter a new market. Price wars are always good for the consumers since they get better products for cheaper prices. However, it is not so for the firms as they have to sacrifice their profit for canvassing more customers. It is impossible for a firm to sell its products below the actual cost price for a longer period. However, in order to establish in a market, new entrants often forced to reduce the prices beyond the limits, at least for a temporary period. Price wars help organizations to develop new technologies and innovate new products. Thus the reputation or the brand value of the organization increases a lot as result of the price war. At the same time, before entering a price war with competitors, a firm should realistically analyze its merits and demerits. Companies from cheap labor oriented countries such as China and India can reduce the prices of their product in the market of expensive labor oriented countries such as America and Europe. However, westerners cannot think in terms of reducing the prices of their products in Asian countries beyond certain limits. Westerners have technological superiority whereas Asian countries have manpower superiority. In short, a firm should enter in a price war with competitors only after the realistic analysis of its strengths and weaknesses. References 1. Brodsky N. 2012. How to Avoid the Price-War Trap. [Online], Available at: http://www.inc.com/magazine/201107/norm-brodsky-small-business-advice-dealing-with-low-priced-competitors.html [Accessed on 31 January 2012] 2. Chun-Hung C., Tsan-Ming C & Duan L. 2009. Price Wall or War: The Pricing Strategies for Retailers. IEEE Transactions on Systems, Man & Cybernetics: Part A, Mar2009, Vol. 39 Issue 2, p331-343. EBSCOHost 3. Elzinga KG & Mills DE. 1999. Price Wars Triggered By Entry. International Journal of Industrial Organization, 17 (1999) 179-198. [Online], Available at: http://people.virginia.edu/~dem9j/webpage/Price%20Wars.pdf 4. Industrial economics – Lecture 9: Barriers to entry and entry deterring strategies. 5. Klemperer, P.1989. Price wars caused by switching costs. Review of economic studies, 1989 (56). P.405-420. 6. Price war, 2011, [Online], Available at: http://www.investopedia.com/terms/p/price-war.asp#axzz1kuZQtS1P [Accessed on 31 January 2012] 7. Pineres M.G. n.d., Consumption price wars. [Online], Available at: http://www.inpsicon.com/elconsumidor/archivos/pricewar.pdf [Accessed on 31 January 2012] 8. Quinn J.2012. Ocado set for price war with Tesco. The Telegraph. 31 January 2012. 9. The Pros And Cons Of Price Wars, 2010. [Online], Available at: http://financialedge.investopedia.com/financial-edge/0810/The-Pros-And-Cons-Of-Price-Wars.aspx#axzz1l0ITV7jc [Accessed on 31 January 2012] 10. Typology of market structures: summary 11. Understanding the benefits and effects of price changes, 2012. [Online], Available at: http://www.lloydstsbbusiness.com/support/businessguides/price_changes.asp [Accessed on 31 January 2012] 12. Van Heerde H.J., Gijsbrechts E and Pauwels K. 2009. Winners and Losers in a Major Price War. Journal of Marketing Research. Vol. XLV (October 2008), 499–518 13. Zyga L.2009. Strategies for Retailers Fighting Price Wars [Online], Available at: http://www.physorg.com/news152964558.html [Accessed on 31 January 2012] 14. Zhang Z.J. 2010. The Art of Price War: A Perspective From China. International Journal of China Marketing Vol. 1(1) 2010. Read More