Price wars: how to respond intelligently?

How should I react if my main competitor lowers their prices? What should I do if a new player enters my category offering much lower prices? These and similar questions are asked by thousands of companies around the world every time they face competitive pressure in their markets. This happens in consumer goods and industrial markets; no one escapes facing a situation like this at least once. So what should be done? Most of the time, companies choose the easiest alternative: lower prices to “defend” their market. However, this response almost always (if not always) results in disastrous consequences—not only for the incumbent company but for the entire category. That’s why it is crucial to understand the mental logic that should be followed to at least analyze in a structured way other possibilities before deciding to respond radically to the opportunistic move of a competitor that cuts prices to an apparently irrational level.

The cost of not responding
It is evident that if my products or services feel threatened by the arrival of cheaper alternatives—or by the price cuts of existing ones—I have two options: respond or not respond. If I stay still and don’t lower my prices, a loss of market share is imminent, which translates into a specific drop in sales and profits. Any possible response to the competitor’s action should be compared against this scenario. The threatened company must begin with a first analysis: What happens if I do not respond? How many customers will I lose? How much money does the loss of my sales and total profit represent? These questions matter because, most of the time, the loss in revenue and profit from a general price cut is greater than the value of giving up a specific segment of the market. When in 2003 the only two mobile operators in Colombia (Comcel and Bellsouth) were expecting the arrival of a third operator (Colombia Móvil, with its brand OLA), they knew it was impossible to prevent its entry; one way or another, the new player was going after a slice of the market and would not stop until it got it. For this reason, it’s no surprise that despite OLA’s aggressive introductory promotion, Comcel and Bellsouth did not respond with a general 80% tariff cut, as the new competitor had done at that time. Such a response would almost certainly have been far more costly than giving up 10% of the market in a rapidly growing industry.

Possible responses
But ignoring the competitor is not always the best alternative. Sometimes it is possible to react in selective, non-radical ways such that the cost of responding is lower than the expected loss in sales. At the end of 2004, the Colombian market for prepaid international long-distance calling cards was under strong threat from smuggled cards entering the country. Orbitel’s reaction was to launch a flanking brand called “Baratel” to compete directly with the illegal cards. This move not only minimized the cannibalization of Orbitel’s established card but also tripled revenue from prepaid international long-distance calling in the country.

The duration of the war
However, the story does not necessarily end with a strong response to competition. The company must also ask: “If I respond, will the competitor lower prices again?” The companies that dominated the Colombian cement sector (Argos, Holcim, and Cemex) lived through this situation in a price war that lasted almost a year, from late 2004 to October 2005. Trying to defend themselves from the aggressive low-price strategy of the smaller competitor Cementos Andino, the three major players responded in November 2004 with a significant 20% price cut in the markets where they felt most threatened. However, this was only the beginning of a series of back-and-forth price reductions that led to the price of a bag of gray cement dropping 65% by the end of 2005. The story ends with Argos acquiring Cementos Andino. But one must ask: How much did this war cost Argos? Will the company ever recover that “investment” that allowed it to preserve a few points of market share? Only those companies know if, when starting the war, they considered the cost of all subsequent price cuts and not just the first move.

The consequences of not responding
Now, if the company decides not to react by lowering prices after analyzing the cost-benefit tradeoff, it must ask an additional question: “If I lose market share, does my position in other markets become compromised?” In 1999, AT&T finally decided to close the price gap that separated it from new and smaller long-distance providers. Until that point, AT&T had chosen not to respond but realized that by losing traditional long-distance customers, it was also losing future customers of other telecom services (Internet, VoIP, Television, etc.). Thus, AT&T reduced its long-distance prices by 30% to slow the loss of market share. The additional money it expected from new services far exceeded the profit sacrificed in the traditional business due to the price reduction.

In summary...
How to respond when we feel threatened by the competition is not necessarily obvious. Responding to an opportunistic competitor’s price cut with a general price reduction is not always the smartest move. Sometimes it is advisable to ignore the move if the competitor is strategically weaker, or to adapt to the new rules if the opportunist has a cost advantage. But this does not mean we should always avoid responding to a price threat. There are situations where the cost of losing sales exceeds the cost of a selective price reduction. In such cases, it may be wise to defend against a strategically stronger competitor or even attack by exploiting the judgment error of a weaker competitor. Whatever the conclusion, we must at least take the time to conduct the analysis to ensure we are reacting in the best possible way.

[1] A selective response is any reaction that does not involve a general price reduction: a flanking brand, a temporary reduction to signal willingness to defend, etc.