Lecture 13 Competition and Pricing

1. Lecture 13 Competition and Pricing

2. Motivation questions • What motivate a company to cut price? • Why is a price war harmful? • 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?

3. 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

4. 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

5. 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.

6. “Negative-sum game” Illustrated • Prisoner’s dilemma Prisoner A Confess Does not confess Confess Prisoner B Does not confess

7. 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)

8. 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

9. 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

10. 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

11. 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”

12. 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, Taiwan 1990s, 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.

13. 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

14. 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

15. Next Lecture • Product Lifecycle pricing