Chapter 11
Competition

Managing Conflict Thoughtfully

Pricing against competition is more challenging and hazardous than pricing a unique product.¹ In the absence of competition, managers can anticipate the effect of a price change entirely by analyzing buyers’ price sensitivity. When a product is just one among many, however, competitors can wreak havoc with such predictions. Price discounting in competitive markets—whether explicit or disguised with rebates, coupons, or generous payment terms—is almost a sure bet to enhance immediate sales and profits. It is easy to become seduced by these quick highs and fail to recognize the long-term consequences. The price cut that boosts your sales today will invariably change the industry you compete in tomorrow. Frequently, that change is for the worse.

In the early 1990s, Alamo was the most profitable (as a percentage of sales) and fastest growing rental car company in America, despite being only the fifth largest. Its low-cost operating model enabled it to dominate leisure rental markets such as Florida and Hawaii. But Alamo’s management was impatient for growth and had the cash to pursue it. Within the United States, the largest and most lucrative rental car segment was business travel that originated at airports. Alamo figured that even if it could win only a small share of that market by undercutting the rates offered by Hertz and Avis, it could generate a lot of profit given its low overhead costs per car.

That was not to be, for reasons that in retrospect were entirely predictable. Alamo succeeded in pursuing individual, budget-conscious business travelers, but not the large corporate accounts that comprised the most volume. Alamo had neither the facilities nor the experience to woo and satisfy business travelers who wanted first and foremost a quick getaway. Alamo’s success was built on its capacity and expertise at handling large crowds that arrived on charter flights and in tour groups. Its high profits reflected its low overhead costs to serve that segment.

Still, in 1992, Alamo slashed rates and began moving to on-airport locations in cities beyond its core markets. In doing so, Alamo underestimated its own vulnerability. Hertz and Avis had apparently realized that they knew nothing about serving large tour groups efficiently, nor did they want them creating backlogs that would frustrate their valuable business clientele. But once Alamo began using its profit to attack their market, it was bound to prompt a response. The response was swift. Within two years, Hertz opened the largest car rental facility in the world in Alamo’s biggest market, Orlando, Florida, with 66 counters and luggage-transfer stations that made life easier for tourists with lots of stuff in tow. To fill this facility, Hertz began undercutting Alamo’s deals with European tour operators, who proved much more willing to switch suppliers to save a few dollars per car than were Hertz’s corporate business customers that Alamo was trying to woo. That year, Alamo’s profits fell into the red. The company was sold the next year.²

The lesson here is not that a profitable company should not attempt to grow share. The lesson is that a company needs to make competitive decisions that leverage its competitive advantages and minimize its vulnerabilities. This is not to argue that underpricing the competition is never a successful strategy in the long run, but the conditions necessary to make it successful depend critically upon how customers and competitors react to it. The goal of this chapter is to provide guidelines for anticipating those reactions, influencing them, and integrating them into a long-term strategic plan.

Understanding the Pricing Game

Pricing is like playing chess; those who make moves one at a time based upon what they see in front of them will invariably be beaten by those who envision the game several moves ahead. Like chess, pricing is a “game,” as defined by game theorists, because outcomes depend not only on a company’s own pricing decisions but also on how customers and competitors respond to them. Unfortunately, pricing strategically for sustainable profitability is a type of game requiring skills foreign to many marketing and sales managers. What most of us know about competition we learned from sports, academics, and perhaps from intracompany sales contests. The rules for success in these types of competition are quite different from those for success in pricing. The reason, in technical jargon, is that the former are all examples of “positive-sum” games, whereas pricing is a “negative-sum” game. Understanding the difference is crucial to playing the pricing game successfully.³

Positive-sum games are those in which the very process of competition creates benefits. Consequently, the more prolonged and intense the game—in sports, academics, or sales—the greater the rewards to the players. The winner always finds playing such games worthwhile and even the loser may gain enough from the experience so as not to regret having played. In fact, people with a healthy attitude toward these activities often seek opportunities to challenge themselves. Such a strong competitive spirit is a criterion commonly used to identify job candidates with potential for success in sales.

Unfortunately, that same gung-ho attraction to competition is quite unhealthy when applied to negative-sum games: those in which the process of competition imposes costs on players. Warfare, labor actions, and dueling are negative-sum games because the loser never benefits from participation and even the winner may end the confrontation wounded. The longer the conflict drags on, the more likely it is that even the winner will find that playing was not worth the cost. Price competition is usually a negative-sum game since the more intense price competition is, the more it undermines the value of the market over which one is competing.⁴ Price competitors do well, therefore, to forget what they learned about competing from sports and other positive-sum games, and to try instead to draw lessons from less familiar competitions such as warfare or dueling.

Students of actual warfare, who are cognizant of its cost, do not make the mistake of equating success with winning battles. Lidell Hart, author of more than 30 books on military strategy, offers advice to political and military leaders that marketers would do well to note:

In short, winning battles is not an end in itself, and warfare is certainly not the only means to an end.

For marketers, as for diplomats, warfare should be a last resort, and even then the potential benefits of using it must be weighed against the cost. Fortunately, there are many positive-sum ways for marketers to compete. Creating new products, creating new ways to deliver service, communicating more effectively with customers about benefits, and reducing the costs of operation are all positive-sum forms of competition. Precisely because they create profits, rather than dissipate them, building capabilities for positive-sum forms of competition is the basis of a sustainable strategy. Competing on price alone is at best a short-term strategy until competitors find it threatening enough to react.

Competitive Advantage: The Only Sustainable Source of Profitability

How can companies become strong competitors? Unfortunately, many managers erroneously believe that the measure of competitive success is market share (see Box 11-1). That may be a successful strategy if only one firm attempts to pursue it. When many competitors pursue this same strategy, they engage in negative-sum competition, which does little more than destroy profitability for everyone. Fortunately, there are strategies that promote positive-sum competition. Rather than attracting customers by taking less in profit,

these strategies attract customers by creating more value or more operating efficiency. They involve either adding to the value of what is offered without adding as much to cost or reducing costs without equally reducing the value offered.

We call these sources of profitable growth competitive advantages because competitors cannot immediately duplicate them, except at a higher cost. Many managers completely misunderstand the concept of competitive advantage and its importance for long-term profitability. We hear them report that they have a “competitive advantage” in having more stores than the competition, more knowledgeable salespeople, or higher quality. None of these are competitive advantages unless they also enable the firm to deliver value more cost-effectively than one’s competitors can. Offering customers a more attractive offer by accepting a lower margin than the competition may be a sales advantage, but it is not a sustainable competitive advantage.

How can a firm achieve competitive advantage? Sometimes it’s by luck. Aramco, the Saudi oil company, enjoys oil fields from which oil can be more cheaply extracted than from those in Alaska, the North Sea, or Kazakhstan. Often, advantage comes from moving first on a new idea. By winning a patent, by gaining economies of scale, or by preempting the best locations, a firm may achieve an advantage that would be more costly for a later entrant to match. Zipcar built a 10-year lead in the hourly car rental segment, branding itself as a green alternative to car ownership. It invested heavily in technology that automated the car rental process and created both user and community goodwill that has facilitated placement of its products as well as a strategy for placing cars in high traffic areas that increase member utilization. While the traditional rental car companies have their sights on this growing market, Zipcar’s loyal base and experience will not be easily overcome, even by well-funded competitors.⁶

More often, competitive advantages are carved out of the efficient management of a firm’s value chain. Michael Porter, the Harvard competition guru, cites three ways that companies can proactively manage operations to achieve competitive advantage.⁷

• Needs-Based Positioning—based on serving the needs of only a particular customer segment or niche, which enables the firm to tailor its operations to meet the unique needs of that segment more cost-effectively.
• Access-Based Positioning—based on the company’s ability to gain access to customers in unique ways. Access can be a function of geography or customer scale. For example, serving a uniquely wide or narrow geographic market, based on the firm’s cost structure, can create a unique cost and service advantage.
• Variety-Based Positioning—competing in industries by choosing selected activities as part of strategically designed value chains, including coalitions with strategic partners that coordinate or share value chains to give a company a shared cost or differentiation advantage.

The Flip Video digital video recorder, now owned by Cisco Systems, is a recent example of a simple product effectively using needs-based positioning to outmaneuver much larger and experienced rivals. Flip Video is based on the simple premise that in this age of YouTube and information sharing, the most important attributes a video recorder must have for many consumers are portability and simplicity. The Flip Video is the size of a mobile phone, has a very simple user interface (with five buttons including on/off), and easily attaches to computers through a built-in USB arm. Introduced in 2007, the Flip Video has surpassed more than two million unit sales based largely on word of mouth and favorable media reviews, while the market leaders have seen video recorder sales flatten in 2008 and into 2009.⁸

The U.S. beer industry offers a classic case of “access-based positioning,” both widening and narrowing of geographic reach to achieve competitive advantage. Companies with a national presence, such as Anheuser-Busch InBev and MillerCoors, enjoy a huge competitive advantage in purchasing television advertising space at low national rates. They have leveraged that advantage to eliminate smaller, national competitors. Even while smaller national competitors have struggled to survive, microbrewers have multiplied and prospered by pursuing a different geographic strategy. Companies such as Smuttynose Brewing in Portsmouth, New Hampshire, and Old Dominion in northern Virginia, rely on a local caché and word-of-mouth promotion to operate small but profitable businesses.

Microsoft’s operating software strategy offers a good example of “variety-based positioning.” As the desktop computer market emerged, Microsoft famously chose to focus not on producing complete desktop computer systems, like Apple or IBM, but only on producing the operating system—the strategic gateway to the proper functioning of computer hardware. As traditional public utilities have come under competitive pressure, they have looked for opportunities to gain cost or product advantages by coordinating activities into combined value chains. The local electric company has become a consolidator of direct mail, which it mails along with the monthly bill. Its incremental mailing costs are lower than for traditional mailers (since a bill has to be sent anyway), and it can promise that a higher percentage of recipients will actually open the envelope rather than file it in the wastebasket.

As these examples illustrate, the key to achieving sustainable profitability is to manage the business for competitive advantage. Unfortunately, most companies in competitive markets are driven by a focus on revenue growth, which they pursue by trying to be all things to all people, rather than by a focus on creating value more cost-effectively. Porter calls the failure to achieve either a value or a cost advantage “getting stuck in the middle.” When such companies are exposed to competitors, some of whom offer higher quality or service while others offer lower prices, the firm’s profitability gets squeezed despite its size.⁹

In the absence of a competitive advantage, it is suicidal to drive growth with price. During the Internet technology “bubble” of the late 1990s, thousands of Internet retailers and willing investors were hoping to prove this statement wrong. They accepted lower, even negative, margins simply to build share in the belief that ultimately the high value of the Internet would make them profitable. They ignored a simple economic principle: Competition drives out profitability except for those with a source of advantage that prevents competitors from fully matching their costs or their value proposition. As it turns out, the companies with the competitive advantages for competing on the Web (name recognition, low cost of customer acquisition, economies of scale) are exactly those who have the advantages in bricks and mortar space.

There are a few exceptions, namely, those Internet newcomers who could create advantages that competitors could not duplicate. eBay, for example, enjoys margins and profitability that exceed those of both online and bricks-and-mortar competitors, not just because of the high value of trading online, but because of the difficulty, those price-cutting competitors would face in trying to duplicate its online offerings. The value of an auction is directly related to the size of the base of participants in it (like the value of a telephone network). Once eBay gained a large user base advantage, it became impossible for any competitor to duplicate the value it offers traders. Similarly, Amazon has carefully created profiles of buyer preferences along with their credit and mailing information that for many people makes shopping on Amazon a more efficient and pleasant experience than shopping with either an online or traditional competitor.

Reacting to Competition: Think Before You Act

Many managers are so fully aware of the risks of price wars and the importance of competing from a position of strength that they think coolly and logically before initiating price competition. It is much harder for most of us to think logically about whether or how to respond when we are already under attack. Consequently, we will discuss in step-by-step detail how to analyze a competitive situation and formulate responses in price-competitive markets that are not of your making.

When is it financially more prudent to accommodate a competitive threat, at least in the near term until you can improve your capabilities, than to retaliate? Thinking through this question does much more than prepare you, intellectually and psychologically, to make the best competitive response. It also reveals weakness in your competitive position. If you do not like how often you must accommodate a competitor because your company cannot fight the threat successfully, you will begin searching for a competitive strategy that either increases your advantage or moves you further from harm’s way.

Exhibit 11-1 illustrates the complex flow of thinking required to make thoughtful decisions about reacting to price competition. The exhibit begins with the assumption that one or more competitors have cut their prices or have introduced new products that offer at least some of your customers more value for their money. How should you respond? Some theorists argue that one should never respond since there are better, positive-sum ways to compete on product or service attributes. While that is often true, the time to have explored and implemented those ways was usually long before a competitive price threat. At the time of the threat, a firm’s strategic capabilities are fixed in the short run. The question at hand is whether to respond with price when threatened with a loss of sales by a lower-priced competitor. To determine whether a price response is better than no response, one must answer the following questions and explore the interrelationships illustrated in Exhibit 11-1.

1. Is there a response that would cost less than the preventable sales loss? Although the need to ask this question might seem obvious, many managers simply stop thinking rationally when threatened. They match any price cut without asking whether the cost is justified by the benefit, or whether the same benefit could be achieved by structuring a more thoughtful response. In Chapter 10, we introduced formulas for financial analysis of a reactive price change. If we conclude that reacting to a price change is cheaper than

losing the sales, then it may be a good business decision. On the other hand, if a competitor threatens only a small portion of your expected sales, the sales loss associated with ignoring the threat may be much less than the cost associated with retaliation. Since the threat is small, the cost of cutting the price on all of your sales in order to prevent the small loss is likely to be prohibitive. Sometimes the cost of retaliation exceeds the benefits even when the competitor is larger.

It is also important to be realistic about how much of the projected sales loss is really preventable. When a new grocery chain opens with lower prices, the established competitors can surely reduce the sales loss by matching its prices. Still, even if they match, some people will shift to the new store simply because it is newer or more convenient to where they live. They will not return even if the competitor’s price advantage is eliminated. Similarly, companies in business markets sometimes unadvisedly delay lowering prices to their most loyal customers even as market conditions are forcing them to lower prices to others. Once those customers learn, often from a competitor’s sales rep, that their loyalty has been taken advantage of, matching price is unlikely to win them back. On the contrary, it may simply confirm that they have been gouged.

By constraining an organization’s competitive reactions to only those that are cost-effective, managers also force their organizations to think about how to make their price reactions more cost-effective. Following are some principles that can substantially reduce the cost of reacting to a price threat.

• Focus your reactive price cut on only those customers likely to be attracted by the competitor’s offer. This requires developing a “flanking” offer that is attractive or available only to the more price-sensitive buyer. Often, such an offer can be developed in a short period of time since it involves merely eliminating some element of the product or service not highly valued by the price-sensitive segments. During the recession in 2009, consumers began migrating to cheaper house brand grocery and cleaning products while supermarkets began promoting them more aggressively, resulting in an 18 percent decline in revenues for Procter & Gamble. In response, the company introduced flanking brands, like Tide Basic detergent at prices 20 percent lower than the original brands.¹⁰ Many analysts have questioned the wisdom of this move, but there is an obvious benefit: it prevents some of the defection to house brands and gives P&G the ability to kill this new competitor when consumers again feel able to pay for its more value-added brands.
• Focus your reactive price cut on only the incremental volume at risk. A cheaper competitor will often be unable to entirely replace an incumbent’s business, but will be able to gain a share of its competitor’s business. For example, if a smaller independent television network, such as the CW Network in North America cuts its ad rates, advertisers are not going to abandon ABC, NBC, CBS, or Fox. They are, however, going to be more likely to divert some dollars to CW from the big networks. A big network could neutralize that threat by offering to discount its ad rates to the level of the independent network’s rates just for the amount of advertising likely to be diverted. One way this could be structured is as a discount for all purchases in excess of, say, 80 percent of the prior year’s purchases or expected purchases. These types of contracts are common not just for advertising, but also for drugs and medical supplies sold to health maintenance organizations (HMOs). Retaliatory discounts applicable only to the incremental volume at risk are also common when pricing to retailers and distributors.
• Focus your reactive price cut on a particular geographic area or product line where the competitor has the most to lose, relative to you, from cutting the price. For example, Taiwan Cement Corporation (TCC) began a drive to grow its share in the Philippines by building its own unloading facility there and acquiring new mixing capacity, after which it began undercutting Philippine prices. What TCC failed to think through was the fact that its high prices and high share (38 percent) in Taiwan left it vulnerable to retaliation. Cemex, the share leader in the Philippines but with only small share (5 percent) in Taiwan, reacted the next year by exporting more cement to Taiwan than TCC was exporting to the Philippines, driving the price from $58 per ton to $43 per ton in just one year.

• Raise the cost to the competitor of its discounting. If the competitor’s price move is limited only to new customers and the competitor has a market of existing customers, it may be possible to retaliate without cutting your own price at all. Retaliate by educating the competitor’s existing customers that they are being treated unfairly. A client of ours did this simply by making sales calls to its competitor’s most profitable accounts. In the process of the call, the salesperson casually suggested, “You are probably paying about $X for this product now.” When the customer questioned this, the salesperson confessed that he really did not know what they were paying but had surmised the figure based on the prices that his competitor offered recently to some other accounts, which he named. In short order, the customer was on the phone demanding similar discounts, and the competitor quickly backtracked on its aggressive offers. Even in consumer markets, it is sometimes possible to appeal to customers’ sense of fairness or civic pride to convince them to reject a discounter. Small, local retailers have successfully done this to prevent Wal-Mart from opening stores in Vermont that would no doubt destroy the less efficient, but traditional, local retailers.

  Retailers frequently use a related tactic of widely promoting a policy that promises to match the price of low-priced competitors. If a competitor advertises a lower price, then the retailer offers to refund the difference to any of its customers paying a higher price within a reasonable time period, say 30 days following the sale. Only a few very price-sensitive buyers will take the time to gather evidence of the lower advertised competitor prices, and then ensure that the sales receipt for their purchased model matches precisely the competitor’s advertised model—all for merely the value of the price differential, often relatively small. However, the price-matching policy is not targeted at all buyers, or even just price-sensitive buyers; instead, it is a signal to other retail competitors of the futility of aggressive price discounting strategies. After the substantial reduction in margins they incur by heavy discounting, their competitors simply neutralize the advantage by rebating to customers the difference; these deep-discount competitors are better off playing by the rules of established nonprice competition in the category. In North Carolina, the Big Star and Winn-Dixie supermarket chains both announced price-matching policies to “meet or beat” the prices of aggressive rival Food Lion. Two years later, the number of products with essentially the same prices across these three competitors increased significantly, and the prices for these products increased as well.¹¹

• Leverage any competitive advantages to increase the value of your offer as an alternative to matching the price. The key to doing this without simply replacing a price war with a quality or service war is to make offers that are less costly for you to offer than for your competitor to match. If, for example, you have much better quality, offer a better warranty. If you have more service centers in more locations, offer faster service. Major airlines respond to price competition from smaller upstarts by offering increased frequent flyer miles on newly competitive routes. Because of their large route systems, frequent flyers accumulate miles faster and enjoy more choices of destinations than anything the small competitors could offer other than price. Moreover, the more sophisticated yield management systems of the large airlines minimized the cost of such programs more effectively than smaller carriers could.

If any of these options is less costly than simply allowing the competitor to take some sales, it is worth continuing to pursue the idea of a response, using the question on the right side of Exhibit 11-1. If, on the other hand, it would cost more to respond than to accept the sales loss, one should continue to examine the option of not responding, using the questions on the left-hand side.

2. If you respond, is your competitor willing and able to cut price again to reestablish the price difference? Matching a price cut will do you no good if the competitor will simply reestablish the advantage. Ask yourself why the competitor chose to compete on price in the first place. If that competitor currently has little market share relative to the share that could be gained with a price advantage, and has no other way to attract customers, then it has little to lose from bringing price down as low as necessary to gain sales. This is especially the case where large sunk costs create substantial “exit barriers.”

At one point, we had a pharmaceuticals company ask us to recommend a pricing strategy to defend against a new entrant. Management was initially surprised when we told them that defending their sales with price was unwise. Only after thinking about the problem from the competitor’s standpoint did they fully understand the competitive dynamics they faced. Customers had no reason to try the competitor’s new drug without a price advantage since it offered no clinical advantages. The new entrant had absolutely nothing to lose by taking the price down, since it had no sales anyway. Given that the huge investment to develop and test the drug was entirely sunk but that the manufacturing cost was small, winning sales even at a low price would be a gain. The conclusion was obvious that the competitor would cut price as often as necessary to establish a price advantage. It our client insisted upon preventing the new competitor from gaining significant market share, they would destroy the value of the market.

3. Will the multiple responses required to match a competitor still cost less than the avoidable sales loss? Think about the total cost of a price war, not just the cost of the first shot, before concluding that the cost is worth bearing to defend the sales at risk. If our pharmaceuticals’ client had retaliated and closed the price gap enough to keep the competitor from winning sales, the competitor would simply have to cut its price further. The process would have continued until one or the other stopped it, which was likely to be our client, who had much more to lose from a downward price spiral. If our client was ultimately going to let the competitor have a price advantage, it was better to let them have it at a high price than at a low one. Once the competitor gained some sales, it too would have something to lose from a downward price spiral. At that time, an effort to stop the discount and redirect competition to more positive-sum activities, such as sales calls, product improvement, and patient education, would be more likely to succeed.

4. Is your position in other (geographic or product) markets threatened if a competitor is successful in gaining share? Does the value of the markets at risk justify the cost of a response? Some sales have a value that far exceed the contribution directly associated with them. Following Dell’s introduction of a new line of computer printers, Hewlett-Packard (HP) immediately severed its relationship to supply HP printers to Dell, signaling the strategic importance to HP of its printer business. HP also retaliated by cutting its PC prices to match Dell’s, where Dell had much more to lose. Finally, HP realized that Dell’s printer strategy had its own limitations. Dell sources its printers and cartridges from a third-party supplier, Lexmark, limiting Dell’s typical cost advantage. So HP defended its lucrative printer business, not with price, but with aggressive product innovations. It introduced new printer models, including digital printing with greater savings for corporate customers, that led to higher revenues and overall printer market share gains.¹²

Retaliatory price cuts are all too often justified by vague “strategic” reasons unrelated to profitability. Before approving any retaliatory price cut for strategic reasons, two things should be required. The first is a clear statement of the long-term strategic benefit and risks. The benefit can be additional sales in this market in the future. It can be additional immediate sales of complementary products, such as sales of software and peripherals if one wins the sale of a computer. It can be a lower cost of future sales because of a competitive cost advantage resulting from the added volume. The risks are that a targeted price cut will spread to other customers and other markets, and that competitors will react, again creating a downward price spiral that undermines profits and any possibility of long-term gain.

The second requirement to justify a strategic price cut is a quantitative estimate of the value of the strategic benefit. This need to quantify often encounters resistance because managers feel that the task is too onerous and will require unnecessary delay. Usually, however, rough estimates are all that is necessary to achieve enough precision to make a decision. A company told us that they always defended price in the institutional segment of their market because sales in that segment drove retail sales. While the relationship was no doubt true, the magnitude of the effect was important given that pricing to the institutional segment had fallen to less than manufacturing cost. A simple survey of retail customers about how they began using the product revealed that only about 16 percent of retail sales were driven by institutional sales. We then estimated the cost of maintaining those sales by retaining all of the client’s current institutional sales and compared that with the cost of replacing those sales through expenditures on alternative forms of promotion. That simple analysis drove a complete change in the institutional pricing strategy. Moreover, as institutional prices rose, “leakage” of cheap institutional product into the retail chain market declined, producing an additional return that had not been anticipated.

How Should You React?

Competitive pricing strategy involves more than just deciding whether or not to react with price. It also involves deciding how to adapt your company’s competitive strategy to the new situation. Exhibit 11-2 summarizes the strategic options and when to use them. In addition to the costs and benefits of retaliation that are weighed using the process described in Exhibit 11-1, this exhibit introduces the concept of strategic “weakness” and “strength.” These concepts refer to a competitor’s relative competitive advantage. Competitive “weakness” and “strength” have little to do with market share, despite the common tendency to equate them. Before its bankruptcy filing in 2009, the high cost structure of General Motors made the company a relatively weak competitor in the automobile market, despite a high market share, because (at least in the North American automobile market) it had higher incremental costs per dollar revenue than its major rivals. In contrast, the low-cost structure of Southwest Airlines makes it a stronger competitor, even when competing against larger airlines, because its low cost per seat mile generates higher profits despite its lower prices.

When you decide that retaliation is not cost-effective, one option is simply to ignore the threat. This is the appropriate response when facing a “weak” competitor, with no competitive product or cost advantages. In that case, the amount of your sales at risk is small and is likely to remain so. In these same circumstances, some authors and consultants recommend a more aggressive option—commonly known as the “deep pockets” strategy—and pursue it to their own detriment. Their logic is that even if retaliation is too costly relative to the immediate sales gained, a large company can win a price war because it can afford to subsidize losses in a market longer than its weak competitor can. Two misconceptions lead people down this dead-end path. One is the meaning of “winning.” This is no doubt a strategy to successfully defend market share, but the goal, at least for a publicly owned company, is not market share but profit. The second misconception is that by destroying a weak competitor one can actually destroy competition. Often the assets of the bankrupt competitor are bought cheaply by a new competitor now able to compete from a lower cost base. Even if the assets are not bought, elimination of a weak competitor serving the price-sensitive segment of the market creates the opportunity for a stronger competitor to enter and use that as a basis from which to grow. Consequently, a costly strategy to kill weak competitors makes sense only in an already unprofitable industry where a new entrant is unlikely to replace the one eliminated.

When a price-cutting competitor is relatively “strong” and the cost of retaliation is greater than the value of the sales loss prevented, one cannot afford simply to ignore the threat and proceed as if nothing had changed. A strong competitor who is gaining share is a threat to survival. To maintain a profitable future, one must actively accommodate the threat with changes in strategy. This is what Sears faced as Wal-Mart’s network of stores grew to include Sears’s traditional suburban markets. There was simply no way that Sears could match Wal-Mart’s prices, given Wal-Mart’s famously efficient distribution system and Sears’s more costly locations.

Sears’s only logical response was to accommodate Wal-Mart as a competitor in its markets. Accommodating a threat is not the same as ignoring or confronting it. Accommodating means actively adjusting your own competitive strategy to minimize the adverse impact of the threat while reconciling yourself to live with it. Sears opted to eliminate its lower-margin product lines, remaking its image as a high-fashion retailer that competed less with Wal-Mart and more with traditional department stores.

A European industrial manufacturer took this same rack when it learned that an American company that previously exported product to Europe was about to build production capacity in the United Kingdom, with a generous government subsidy. Realizing that defending its market directly would produce nothing but a bloody price battle, the company refocused its marketing strategy away from the more price-sensitive segments, while creating incentives for less price-sensitive segments to sign longer-term contracts. As a result, the American firm’s sales were focused in the least desirable segment where price-sensitive customers made it more vulnerable to a price war than were the traditional European competitors. Accommodating the competitor’s entry was costly, but much less so than a futile attempt to prevent the entry with price competition.

The only situation in which it makes sense to use an attack response is when the competitor is weaker and the attack is cost justified. One reason this is rare is that it usually requires a misjudgment on the part of the competitor, who attempts to use price as a weapon from a position of weakness. That is exactly what Linens ‘n Things tried to do, with flashy “sales” and “closeouts” designed to build same-store traffic after its 2006 leveraged buyout. Bed Bath & Beyond, its stronger competitor, matched the discounts and increased its 20-percent-off mail coupons. Lacking the capital to fight a sustained price war, Linens ‘n Things filed for bankruptcy in 2008.¹³

More common is the case where the price-cutting competitor is strong, or at least as strong as the defending companies whose sales are under attack. Often because of the attacker’s strategic strength, the amount of sales at risk is so great that a vigorous defense is cost justified. The purpose of a “defend” response is not to eliminate the competitor, but rather simply to convince the competitor to back off. The goal is to get the competitor to recognize that aggressive pricing is not really in its financial interest and to refrain from it in the future. This is often the position taken by established airlines in competition with new entrants on a route, many of which have lower cost structures. The defender is careful to limit the time period and the depth of its price responses, signaling a willingness to return prices to prior levels as soon as the competitor withdraws the threat. Sometimes these battles last no more than a few days or weeks, as competitors watch to see if the defender can fashion a cost-effective defense.

Partisans of pricing for market share would no doubt disagree with the restrained approach that we have prescribed. Large market-share companies, they would argue, are often better capitalized and, thus, better able to finance a price war than are smaller competitors. Although price-cutting might be more costly for the larger firm in the short run, it can bankrupt smaller competitors and, in the long run, reestablish the leader’s market share and its freedom to control market prices. Although such a “predatory” response to competition sounds good in theory, there are two reasons why it rarely works in practice. First, predatory pricing is a violation of U.S. and European antitrust laws if the predatory price is below the predator’s variable cost. Such a pricing tactic may in some cases be a violation when the price is below the average of all costs.¹⁴ Consequently, even if a large competitor can afford to price low enough to bankrupt its smaller competitors, it often cannot do so legally. Second, and more important, predation is cost effective only if the predator gains some competitive advantage as a result of winning the war. This occurs in only two cases: when eliminating a competitor destroys an important differentiating asset (for example, its accumulated goodwill with customers) or when it enables the predator to gain such a cost advantage (such as economies of experience or scale) that it can profitably keep its prices low enough to discourage new entrants. In the absence of this, new entrants can purchase the assets of the bankrupt competitor, operating at a lower cost base and competing against a large firm now itself financially weakened by the cost of the price war.

An example of the long-term futility of price competition occurred in the club warehouse segment of retailing. As market growth slowed in the mid 1990s, club retailers all tried to grow by gaining market share, although none had the competitive advantage to justify such growth. For example, Sam’s Club (operated by Wal-Mart), Pace (operated by Kmart), and Costco each opened large warehouse locations within months of each other in El Centro, California, a small city of only 75,000. Costco invaded one of Pace’s strongholds in Anchorage, Alaska, by building not one, but two club warehouses. Pace retaliated by building a second club warehouse in Anchorage— leading to significant overcapacity in a minor market. Pace invaded Sam’s Club’s home turf in Dallas, Texas, with plans for a new club warehouse; Sam’s Club retaliated immediately by building three more Dallas club warehouses (in addition to six existing locations), locating one next to the Pace store under construction. To attract customers to these new stores, each cut margins precipitously, as charges were filed alleging predatory pricing below cost. By the end of the decade, of eight original club warehouse competitors two to three emerged “victorious”—Sam’s (which acquired most of the Pace locations) and Costco (which merged with Price Club); BJ’s remained a smaller regional survivor. The exit of the failed club warehouses left behind many huge empty warehouses. It also left a lot of disappointment among the “winners.” Even five years later, Sam’s Club stores have never recovered their profitability, and have fallen far short of the performance of the traditional Wal-Mart stores.¹⁵

The key to surviving a negative-sum pricing game is to avoid confrontation unless you can structure it in a way that you can win and the likely benefit from winning exceeds the likely cost. Do not initiate price discounts unless the short-term gain is worth it after taking into account competitors’ long-term reactions. Do not react to a competitor’s price discounts except with price and nonprice tactics that cost less than accommodating the competitor’s behavior would cost. If managers in general were to follow these two simple rules, far fewer industries would be ravaged by destructive price competition.

Managing Competitive Information

The key to managing competition profitably is diplomacy, not generalship. This does not necessarily mean being “Mr. Nice Guy.” Diplomats are not always nice, but they manage information and expectations to achieve their goals without unnecessary confrontation. If they find it necessary to use force, they seek to limit its use to the amount necessary to make their point. In the diplomacy of price competition, the meaning that competitors ascribe to a move is often far more important than the move itself.

The decision to cut price to gain a customer may have radically different long-term effects, depending upon how the competitor interprets the move. Without any other information, the competitor would probably interpret the move as an opportunistic grab for market share and respond with defensive cuts of its own. If, however, the discount is structured to mimic exactly an offer that the same competitor made recently to one of your loyal customers, the competitor may interpret the cut as reflecting your resolve to defend that segment of the market. As such, the cut may actually reduce future opportunism and help stabilize industry prices.

Consider how the competitor might interpret one more alternative: your price cut is totally unprovoked but is exceptionally large, more than you have ever offered before and probably more than is necessary to take the business. Moreover, it is preceded by an announcement that your company’s new, patented manufacturing process not only added to capacity but also substantially reduced incremental manufacturing costs. In this case, an intelligent competitor might well interpret the price cut as fair warning that resistance against your grab for market share will be futile.

Managing information to influence a competitor’s expectations, and to accurately form your own expectations, is the key to achieving goals without unnecessary negative-sum confrontation. Managing information requires collecting and evaluating information about the competition, as well as communicating information to the market that may influence competitors’ moves in ways desirable to your own objectives.

Collect and Evaluate Information

Many companies operate with little knowledge of their competitors’ prices and pricing strategies. Consequently, they cannot respond quickly to changes. In highly competitive markets, such ignorance creates conditions that invite price warfare. Why would an opportunist ever cut price if it believed that other companies were willing to retaliate? The answer is that the opportunist’s management believes that, by quietly negotiating or concealing its price cuts, it can gain sufficient sales volume to justify the move before the competitors find out. This is especially likely in industries with high fixed costs (high percentage contribution margins) and during peak seasons when disproportionate amounts of business are at stake.

To minimize such opportunistic behavior, competitors must identify and react to it as quickly as possible.¹⁶ If competitors can react in one week rather than three, the opportunist’s potential benefit from price-cutting is reduced by two thirds. At the extreme, if competitors could somehow react instantly, nearly all benefit from being the first to cut price could be eliminated. In highly competitive markets, managers “shop” the competitors’ stores and monitor their advertising on a daily basis to adjust their pricing¹⁷ and the large chains maintain communication systems enabling them to make price changes quickly in response to a competitive threat. As a consequence, by the time most customers even learn what the competition is promoting in a given week, the major competitors have already matched the price.

Knowledge of competitors’ prices also helps minimize a purchasing agent’s ability to promulgate misinformation. Frequently in business-to-business markets, price wars begin without the intention of any competitor involved. They are caused by a purchasing agent’s manipulation of information. A purchasing agent, frustrated by the inability to get a better price from a favored supplier, may falsely claim that he or she has been offered a better deal from a competitor. If the salesperson doesn’t respond, a smart purchasing agent may give the threat more credibility by giving the next order to a competitor even without a price concession. Now the first company believes that its competitor is out “buying business” and will, perhaps, match the claimed “lower price” on future orders to this customer, rewarding this customer’s duplicitous behavior. If the first company is more skilled in price competition, it will not match the “lower price,” but rather will retaliate by offering the same discount to other good customers of the competitor. The competitor will now see this company as a threat and begin its own cuts to defend its share. Without either competitor intending to undermine the industry price level, each has unwittingly been led to do so. The only way to minimize such manipulation is to monitor competitors’ prices closely enough so that you can confidently predict when a customer is lying.¹⁸

Even when purchasers do not lie openly, their selective communication of information often leaves salespeople with a biased perspective. Most salespeople think that their company’s prices are too high for market conditions. Think about how a salesperson is informed about price. Whenever the salesperson loses a piece of business, the purchaser informs the salesperson that the price was “too high.” When he or she wins the business, however, the purchaser never tells the salesperson that the price was unnecessarily low. The purchaser says the job was won with “the right price.” Salespeople get little or no information about how much margin they may have left on the table.

There are many potential sources of data about competitors’ prices, but collecting those data and converting the data into useful information usually requires a formalized process. Many companies require that the sales force regularly include information on competitors’ pricing in their call reports. Having such current information can substantially reduce the time necessary to respond to opportunism since someone collecting information from multiple salespeople and regions can spot a trend much more quickly than can an individual salesperson or sales manager. Favored customers can also be a good source of information. Those that are loyal to the company, perhaps because of its quality or good service, do not want their competitors to get lower prices from another source. Consequently, they will warn the favored company when competitors issue new price sheets or when they hear that someone is discounting to someone else. A partnership with such a customer is very valuable and should be treated as such by the seller.

In highly competitive markets, the information collected should not be limited to prices. Understanding plans and intentions is equally important. We recently worked with a client frustrated by the low profitability in its service industry, despite record revenue growth. In the process, we learned that the industry had suffered from overcapacity but recently had experienced multiple mergers. What was the purpose of those mergers? Was it to gain cost efficiencies in manufacturing or sales that would enable the new company to offer low prices more profitably? Or was it to eliminate some inefficient capacity, enabling the merged company to consolidate its most profitable customers in fewer plants, eliminating the need to win “incremental business.” We found answers to those questions in the competitor’s briefings to securities analysts, causing our client to rethink its own strategy.

Trade associations, independent industry monitoring organizations, securities analysts, distributors, and technical consultants that advise customers on large purchases are all good sources of information about competitors’ current pricing moves and future intentions. Sometimes trade associations will collect information on prices charged in the prior week and disseminate it to members who have submitted their own prices. The airlines’ computerized reservations systems give the owners of those systems an advance look at all price changes, enabling them to respond even before travel agents see changes. Monitoring price discussions at trade shows can also be another early tip-off. In retail businesses, one can simply “shop” the competitive retailers on a regular basis. In the hotel industry, nearby competitors regularly check their competitors’ prices and room availability on particular nights by calling to make an unguaranteed reservation. If price competition is important enough as a determinant of profit in an industry, managers can easily justify the cost to monitor it.¹⁹

Selectively Communicate Information

It is usually much easier for managers to see the value of collecting competitive information than it is for them to see the value in knowingly revealing similar information to the competition. After all, information is power. Why should anyone want to reveal a competitive advantage? The answer: so that you can avoid having to use your advantage in a negative-sum confrontation.

The value of sharing information was obvious, after the fact, to a company supplying the construction industry. Unlike most of its competitors as well as most economists, the company accurately predicted a recession and construction slowdown looming on the horizon. To prepare, the company wisely pared back its inventories and shelved expansion plans just as its competitors were continuing to expand. The company’s only mistake was to keep its insight a secret. Management correctly felt that by retrenching more quickly than its competitors, it could weather the hard times more successfully, but when competitors desperately cut prices to clear bloated inventories, the entire industry suffered. Had the company shared its insight and discouraged everyone from overexpansion, its own financial performance, while perhaps relatively less outstanding, would have been absolutely more profitable. It is usually better to earn just an average return in a profitable industry than to earn an exceptional return in an unprofitable one.

Even company-specific information—about intentions, capabilities, and future plans—can be useful to reveal unless doing so would preclude achieving a first-mover advantage into a new market. Such information, and the information contained in competitors’ responses, enables a company to establish plans “on paper” that are consistent with competitors’ intentions, rather than having to reach consistency through the painful process of confrontation.

• Preannounce price increases. One of the most important times to communicate intentions is when planning a price increase. Even when a price increase is in the independent interest of all suppliers, an attempt to raise prices will often fail. All may not immediately recognize that an increase is in their interest, and some may hope to gain sales at the expense of the price leaders by lagging in meeting the increase. Other times, an increase may not be in the competitor’s interest (perhaps because its costs are lower), meaning that any attempt to raise prices will ultimately fail. Consequently, before initiating a price increase that it expects competitors to follow, a firm’s management should publicly explain the industry’s need for higher prices and, if possible, announce its own increase far in advance of the effective date. As we discussed in Chapter 4, this “toe in the water” approach enables management to pull back from the price increase if competitors do not join in. This approach can be repeated multiple times until competitors understand that a price increase won’t go through without them.

• Show willingness and ability to defend. When threatened by the potential opportunism of others, a firm may deter the threat by clearly signaling its commitment and ability to defend its market. When major carriers realized that Southwest Airlines’ model for serving mid-size airports directly might in fact be a more profitable one than their “hub and spoke” models, many announced that they would duplicate Southwest’s strategy with services such as “Continental Lite” and United’s “Ted.” Soon after the announcement, Herb Kelleher, the founder and then CEO of Southwest, announced after a visit to Boeing that he had taken options to buy three Boeing 767 jets. When asked why he was taking those options, given that Southwest had always flown Boeing 737s exclusively, Kelleher replied, “In case I need ‘em.” He followed by indicating that the 767s would be the most efficient jets for flying between the hub cities of bigger carriers who might be tempted to challenge Southwest.

• Back up opportunism with information. While an opportunistic price cut to buy market share is usually shortsighted, it is sometimes an element of a thoughtful strategy. This is most often the case when a company uses pricing to leverage or to enhance a durable cost advantage. Even companies with competitive advantages, however, often win only pyrrhic victories in battles for market share. Although they ultimately can force competitors to cede market share, the costs of battle frequently exceed the ultimate value of the reward. This is especially true when the war reduces customer price expectations and undermines loyal buyer–seller relationships.

The key to profitably using price as a weapon is to convince competitors to capitulate. A Japanese company invited the two top operations managers of its American competitor to the opening of its new plant. After attending the opening ceremony, the company took all guests through the highly automated facility. The American managers were surprised to see the process so highly automated, all the way to final packing, since quality control usually required human intervention at many points in the process. When asked about this, the Japanese hosts informed the guests that this plant was the first to use a new, proprietary process that essentially eliminated the major source of defects. They also indicated that development of the process had taken them more than a decade.

On the way home, realizing now what could be done, the American engineers were eagerly speculating about how this improvement might be achieved and how much they should ask for in a budget to pursue research. They also wondered why their Japanese counterparts would reveal the existence of such an important trade secret. Within a few months they got their answer. The Japanese competitor announced a 20 percent price cut for exports of this product to the American market. If you were the American competitor with a large market share, how would knowledge of this trade secret change your likely response? In this case, the American company wisely chose to “adapt” rather than “defend.”

Although the information disclosures discussed here are the most common, they are hardly comprehensive. Almost every public decision a company makes will be gleaned for information by astute competitors.²⁰ Consequently, companies in price-competitive industries should take steps to manage how their moves are seen by competitors, just as they manage the perceptions of stockholders and securities analysts. For example, will competitors in a highly price-competitive industry interpret closure of a plant as a sign of financial weakness or as a sign that the company is taking steps to end an industrywide overcapacity problem? How they interpret such a move will probably affect how they react to it. Consequently, it is in the company’s interest to supply information that helps them make a favorable interpretation. Think twice, however, before disseminating misleading information that competitors will ultimately discover is incorrect. You may gain in the short run, but you will undermine your ability to influence competitors’ decisions and, therefore, to manage price competition in the long run.

When Should You Compete on Price?

We have been discussing the benefits of avoiding negative-sum competitive confrontation, but some companies clearly benefit from underpricing their competitors. Did not the Japanese automakers in the 1970s, Wal-Mart in the 1980s, and Dell Computer in the 1990s build their strategies around gaining share with lower prices? Yes, and understanding the special circumstances that enabled them to grow using price is necessary for anyone trying to replicate such success. For each of those companies at the times and places they used price to grow, price competition was not a negative-sum game. Every one of these successful price competitors first created business models that enabled them to cut incremental costs below those of their competitors. So long as each could attract customers with a price difference smaller than its cost advantage, it could win customers without reducing industry profitability. In fact, by serving customers more cost-effectively, these companies actually earned profits from each customer in excess of those earned by the competition—making their competitive efforts a positive-sum game.

However, a competitive cost advantage was not by itself enough to succeed. All of these companies also orchestrated a campaign of information to convince their competitors that their cost advantages were decisive. Their competitors wisely allowed them to maintain attractive price differentials, at least temporarily, until the competitors could figure out how to replicate those costs. Eventually, even these companies recognize that unless they can continue to cut costs faster than competitors, price-cutting cannot be a profitable growth strategy indefinitely. Consequently, they ultimately must shift their strategies toward adding more value in ways that enable them to sustain their large market shares without having to sustain a price advantage indefinitely.

Under what conditions are the rewards of aggressive pricing large enough to justify such a move? There are only four:

1. If a company enjoys a substantial incremental cost advantage or can achieve one with a low-price strategy, its competitors may be unable to match its price cuts. Wal-Mart, Dell, and Southwest Airlines created low-cost business models that enabled them to grow profitably using price. In some markets, there may be an “experience effect” that justifies aggressive pricing based on the promise of lower costs. By pricing low and accumulating volume faster than competitors, a firm reduces its costs below those of competitors, thus creating a competitive advantage through low pricing.
2. If a company’s product offering is attractive to only a small share of the market served by competitors, it may rightly assume that competitors will be unwilling to respond to the threat. The key to such a strategy, however, is to remain focused. Enterprise Rental Car managed to grow quite large before any major competitor responded because Enterprise stuck to serving off-airport customers.
3. If a company can effectively subsidize losses in one market because of the profits it can generate selling complementary products, it may be able to establish a price differential that competitors will be unable to close. Microsoft, for example, priced its Windows software very low relative to value in order to increase sales of other Microsoft software that runs on it. Amazon.com’s rationale for its low pricing on books was to build up a body of loyal customers to which it could sell a broad range of other products.
4. Sometimes price competition expands a market sufficiently that, despite lower margins and competitors’ refusals to allow another company to undercut them, industry profitability can still increase. Managers who take this course are assuming that they have insight that their competitors lack and are, in effect, leading the industry toward pricing that is, in fact, in everyone’s best interest. Before embarking on a price-based strategy, ask which of these your rationale is and recognize that the strategy can rarely be built on price alone or sustained indefinitely.

Summary

No other weapon in a marketer’s arsenal can boost sales more quickly or effectively than price. Price discounting— whether explicit or disguised with rebates, coupons, or generous terms—is usually a sure way to enhance immediate profitability. However, gaining sales with price is consistent with long-term profitability only when managed as part of a marketing strategy for achieving, exploiting, or sustaining a longer-term competitive advantage. No price cut should ever be initiated simply to make the next sale or to meet some short-term sales objective without being balanced against the likely reactions of competitors and customers. The key to profitable pricing is building and sustaining competitive advantage. There are times when price-cutting is consistent with building advantage, but it is never an appropriate substitute for it.