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Price war is "commercial competition characterized by the repeated cutting of prices below those of competitors". One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new round of reductions starts. In the short term, price wars are good for buyers, who can take advantage of lower prices. Often they are not good for the companies involved because the lower prices reduce profit margins and can threaten their survival.
In the medium to long term, price wars can be good for the dominant firms in the industry. Typically, the smaller, more marginal firms cannot compete and must close. The remaining firms absorb the market share of those that have closed. The real losers, then, are the marginal firms and their investors. In the long term, the consumer may lose too. With fewer firms in the industry, prices tend to increase, sometimes higher than before the price war started.
The main reasons that price wars occur are:
- Product differentiation: Some products are, or at least are seen as, commodities. Because there is little to choose between brands, price is the main competing factor.
- Penetration pricing: If a merchant is trying to enter an established market, it may offer lower prices than existing brands.
- Oligopoly: If the industry structure is oligopolistic (that is, has few major competitors), the players will closely monitor each other's prices and be prepared to respond to any price cuts.
- Process optimization: merchants may incline to lower prices rather than shut down or reduce output if they wish to maintain the economy of scale. Similarly, new processes may make it cheaper to make the same product.
- Bankruptcy: Companies near bankruptcy may be forced to reduce their prices to increase sales volume and thereby provide enough liquidity to survive.
- Predatory pricing: A merchant with a healthy bank balance may deliberately price new or existing products in an attempt to topple existing merchants in that market.
- Competitors: A competitor might target a product and attempt to gain market share by selling its alternative at a lower price. Some argue that it is better to introduce a new rival brand instead of trying to match the prices of those already in the market.
Reactions to price challenges
The first reaction to a price reduction should always be to consider carefully. Has the competitor decided upon a long-term price reduction? Is this just a short-term promotion? If it is the latter, then the reaction should be that relating to short-term promotional activity, and the optimum response is often simply to ignore the challenge. Too often, price wars have been started because simple promotional activities have been misunderstood as major strategic changes.
But if it seems that it is a long-term move then there are many possible reactions:
- Reduce price: The most obvious, and most popular, reaction is to match the competitor's move. This maintains the status quo (but reduces profits pro rata). If this route is to be chosen it is as well to make the move rapidly and obviously - not least to send signals to the competitor of the intention to fight.
- Maintain price: Another reaction is to hope that the competitor has made a mistake, but if the competitor's action does make inroads into a merchant's share, this can soon mean customers lose confidence and a subsequent a loss of sales.
- Split the market: Branch one product into two, selling one as a premium and another as a basic. This effective tactic was notably used by Heublein, the former owner of the Smirnoff brand of vodka.
- React with other measures - Reducing price is not the only weapon. Other tactics can be used to great effect: improved quality, increased promotion (perhaps to improve the idea of quality).
Avoiding price wars
Avoidance is by far the best policy, but it is advice which may not always be taken if the benefits seem attractive to others (which they may also be to competitors).
In oligopoly markets prices can become 'sticky' because if the price rises, competitors will not follow the rise. So the merchant will lose its market share to its competitors on lower prices. But if the price falls, other players will merchants will follow suit if they can. At some point, merchants find that they can not gain profit if they cut the price further— so the sticky price remains.
Price stickiness is extremely common among large supermarket chains and prices, especially for commodities, tend not to vary much between them. Many of the supermarkets monitor price changes in other supermarket chains and vary their prices accordingly until they reach the point where any further decrease in their price will affect profits.