Managerial Application 122

Why Do Some Price Wars Never Seem to End?

In supermarkets, permanent price wars rage for items such as coffee, cola, pet foods, paper products, and frozen foods. Top-of-the-line frozen food entré prices continue to drop as H.J. Heinz, Nestlé, ConAgra, Campbell's Soup, and Kraft battle for overcrowded freezer space. In the salty snacks business, PepsiCo and Borden continue years of price warfare that has crumbled the margins of a once highly profitable business. In consumer electronics, computer manufacturers have had to contend with a marketplace that sees declining prices on a monthly, weekly, or even daily basis.

Price wars, once a tool of limited strategic value in mature businesses, are becoming a disheartening fact of life in industries ranging from autos to credit cards to steel to computers. A growing number of companies trapped into protecting investments that are too big to write off are forced to pursue market share at all costs. Worse yet, using price wars to bump off competitors is much more difficult these days because weak competitors are often acquired by firms with deep pockets, or can file for bankruptcy protection from creditors and keep operating. The only clear winners in this ongoing process of constant price warfare are consumers, who have come to enjoy and expect ever lower prices.

Businesses with high fixed costs are likely to display savage price competition. With commodity-like products, widely available price and product-quality information, and/or high fixed costs, competition to fill excess capacity can be fierce. Nowhere are the effects of savage price-cutting more evident than on the Internet, where marginal costs are often near zero. With negligible costs for downloading to new customers, free software, sometimes called "freeware, " is standard. Similarly, when distant suppliers are no more than a mouse click away, local and regional suppliers face unrelenting price competition. This is all bad news for companies, and good news for the consumer. More than ever, the customer is king!

See: Sholnn Freeman and Joseph B. White, "Auto Price War Persists with GM Expected to Introduce $2002 Cash-Rebate," The Wall Street Journal Online, January 3, 2002 (http://online.wsj.com).

Similarly, Betty's markup on price is an optimal 50 percent, because

Therefore, Betty's initial $36 price on blouses is optimal, and the subsequent $3 price increase should be rescinded.

This simple example teaches an important lesson. Despite the improper consideration of fixed overhead costs and a markup that might at first appear unsuitable, Betty's pricing policy is entirely consistent with profit-maximizing behavior because the end result is an efficient pricing policy. Given the prevalence of markup pricing in everyday business practice, it is important that these pricing practices be carefully analyzed before they are judged suboptimal. The widespread use of markup pricing methods among highly successful firms suggests that the method is typically employed in ways that are consistent with profit maximization. Far from being a naive rule of thumb, markup pricing practices allow firms to arrive at optimal prices in an efficient manner.

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