Book Excerpt: The Price Advantage

If you have ever imagined that aggressively reducing prices to gain share and increase profits might be a sound strategy for your business, think again. The best-run companies go to almost any lengths to avoid price wars, for a host of compelling reasons. Even if you have a dominant cost advantage—by this we mean costs at least 30 percent below the competition—reducing prices can trigger a suicidal price war. Competitors often quickly follow price cuts because no one wants to lose customers, volume, or share.


Low price advantages over competitors are usually short-lived. Attempts to boost market share by dropping prices normally lead to retention of traditional shares at lower price levels, rather than increased share. In a skirmish in the PDA market, for example, a 50 percent price cut by Palm was matched in a matter of days by major competitor Handspring. Similarly, it took luxury retailer Saks less than a week to match (and exceed) a 40 percent price cut on designer clothes by rival retailer Neiman Marcus.


Amid a price war, customers' price expectations and price reference points are distorted, and these price perceptions remain damaged long after the war ends. A $199 New York-to-Los Angeles round-trip fare was widely available during a summer airfare battle a few years ago. Afterward, tens of thousands of travelers came to believe that $199 was the correct and acceptable price for that trip, and after the war was over many still refused to take that trip again unless fares returned to that level. Weak vacation flight demand during the subsequent summer confirmed that the war had moved travelers' reference points lower.

These developments are consistent with research on price psychology and price recall. Consumer research shows that the lowest price someone pays for a product is remembered longest and remains a reference point for a long time—often for life. Maybe that is why so many remember how little they paid for their first gallon of gasoline. The point, of course, is that the low prices accompanying price wars influence a customer's perception of what is a reasonable price long after the war ends.


Customers also become more sensitive to price and less sensitive to benefits during a price war. If you provide a superior product, you probably tend to charge a higher price than competitors. Customers buy your product because they perceive that its benefit advantage more than outweighs the price premium they pay. As long as customers focus on these benefits, superior suppliers can sustain the price premium, as discussed in The Price Advantage, second edition, in Chapter 4 titled "Customer Value."

Price wars often upset the crucial price/benefit balance. As price wars play out, suppliers emphasize price more, bombarding customers with price rather than benefit messages. The inevitable result is that customers become more and more price sensitive—and less and less benefit sensitive. Even when a price war ends, the price/benefit seesaw does not automatically tip back the way it was before. The personal computer industry is an excellent example. Despite a steady stream of quantum performance improvements, evidence shows that an ever-increasing portion of personal computer buying decisions are made strictly on a lowest-price basis. Price wars change customers—usually adversely, often forever.


Price war combatants often hope that the battle will bring an industry shakeout, but this rarely happens. Although managers often justify taking part in a price war by claiming it will knock out weak competitors and rationalize the industry, there are at least two problems with this approach:

1. Regulators or the courts may construe such a strategy as illegal predatory pricing—that is, pricing with the intent of forcing a competitor out of business. (The Price Advantage, second edition, Chapter 9, "Legal Degrees of Freedom" and Appendix 2, "Antitrust Issues" offer a fuller discussion of the legal issues surrounding pricing.)

2. Emotions kick in during price wars, leading companies to stay in a business years after it stops making economic sense for them to remain. In a segment of the electrical controls industry, companies engaged in a price war for five years, each enduring huge annual losses, yet not a single competitor exited. Even when a weak competitor does call it quits, its capacity often stays. Take a key subset of the fractional horsepower electric motor industry: brutally competitive, chronically price-embattled, 20 to 30 percent excess capacity, and most competitors not even earning their cost of capital over the past decade. Not a pretty picture; not an industry that you would expect entrepreneurs to be lining up to enter. But that is exactly what happened. Every time a competitor decided to leave this industry, new players snatched up that player's assets for 25 cents on the dollar. Then the capacity reemerged and operated on a lower cost basis than before.

As these examples suggest, preventing and avoiding price wars should be high on every company's list of strategic priorities. Price wars destroy huge chunks of company and industry profits, and almost never provide a business with an advantage. Price wars often cause irreversible damage to the customer base and seldom alleviate an industry's structural or capacity problems.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from The Price Advantage, Second Edition by Walter L. Baker, Michael V. Marn, and Craig C. Zawada. Copyright (c) 2010 by McKinsey & Company, Inc.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE