Competitive Price Pressures? How to React and Why.

In free markets, competition is the norm, not the exception, and that competition will limit your latitude for pricing.  When competitors lower prices or new competition enters at a lower price, many a novice manager’s gut reaction is to lower prices—but the cost of price concessions may be higher than the cost of customer losses.  Experience will temper these beginner instincts over time, but there must be easier and less costly ways to identify the proper reaction to competitive price moves than the school of hard knocks.  Perhaps we need a refreshed guide map to show how the game should be played depending on the cards one is dealt.

In an attempt to address this issue, what follows is a Strategic Price Reaction Matrix that can be used to calculate the proper response to competitive price pressure.  Kinichi Ohmea’s 3 C’s of corporate strategy—customers, competitors, and the company itself—defines the players.  The principals of competitive advantage and value-based pricing define the dimensions.  To win, the firm must earn more profits than its competitors.

Second place goes to the survivors who will live to compete again in the next round.  Losers are the firms that go under.  Given these ground rules and objectives, we can identify the optimal moves dependent on the firm’s position.

The Positions

The first obvious dimension of the Strategic Price Reaction Matrix is a measure of the relative attractiveness of the firm’s offer to customers.  We choose to examine the relative attractiveness to customers, not the absolute attractiveness, because customers make tradeoffs between offers.  Also, we are examining the whole offer, not just the price, because, in aggregate, customers will choose offers that deliver them more value after comparing both benefits and price.

If the firm’s offer is more attractive to customers than its competitors’, the firm has pricing power.  That is, the firm may be able to maintain or increase a positive price differential between its offer and its competitors’ without losing market share due to the customers perceiving that the firm’s offer delivers more benefits than its competitors.

If the firm’s offer is no more attractive to customers than its competitors’ offer, or, worse, is less attractive, then the firm will have little-to-no pricing power and price competition will be felt acutely across the firm.  In these situations, the firm must either match price reductions and manage margin erosion or otherwise cede market share.  It may be able to take steps to reduce pricing pressure, but in the short term, margins, share, or both will be reduced and the firm will have to manage these challenges until it can develop and deliver an improved offer.

The second dimension of the Strategic Price Reaction Matrix measures the relative profitability of customers.  We choose to examine the relative profitability, not the absolute profitability, because relative profitability reflects the competitive advantages of the firm, if any.  In the resource-based view of the firm, competitive advantage is created through having a unique and inimitable resource that enables the firm to deliver more benefits to customers with a smaller comparable cost increase than its competitors, or reduce costs with a smaller comparable benefits decrease than its competitors, or both simultaneously.  Either way, a competitive advantage should be reflected in the firm’s relative profitability.

If the firm’s profitability for the impacted customers is higher than the profitability which the competitor could achieve with those customers, then the firm has a competitive advantage.  The firm can use that competitive advantage to either attack a competitor’s customer base or defend its own customer base.

Alternatively, if the firm’s profitability for the impacted customers is equal or lower than the profitability that the competitor could achieve with those customers, then the firm has no competitive advantage in that market.  In this situation, the firm may be able to take actions to limit price competition, but without a competitive advantage it may be more profitable to accommodate a competitor than compete with them head-on in a price war.

The Moves

Having defined the dimensions and metrics of the Strategic Price Reaction Matrix, we identify four stances a firm should take in response to a competitive price threat depending on its situation: Attack, Defend, Mitigate, or Accommodate.

If the firm both earns stronger profits in serving the impacted customers (possess a competitive advantage) and customers perceive the offer as more attractive (possess pricing power), then the firm should attack.  In this position, the firm can leverage its value proposition to attract customers profitably.  Even if a competitor lowers prices or enters with lower prices, the firm in this position can ignore some of this price competition due to its overall value proposition of delivering more benefits after subtracting the price to capture those benefits than its competitors.  This is clearly the ideal position to attain, but not all firms can attain this position.

If the firm earns stronger profits in serving the impacted customers (possess a competitive advantage) but customers do not perceive its offering as more attractive (lacks pricing power), then defending its market position is merited. Defending the firm’s market position might require enriching its value proposition through a price reduction.  Clearly, price reductions will erode margins, but due to the firm’s relative competitive advantage it should retain a more profitable position than its competitors and the cost of this price reduction should be less challenging then the potential cost of lost market share.

If the firm does not earn stronger profits in serving the impacted customers (lacks a competitive advantage) but customers’ do perceive the offer as more attractive (possess pricing power), then the firm may find itself mitigating price competition.  In mitigating price competition, the firm will be forced to engage in some level of reacting to a competitor’s price moves, but only up to a point.  Due to the attractiveness of the firm’s value proposition, market share should be somewhat defendable without heavy price concessions through communicating the benefits of the firm’s offering.  When direct price competition does heat up, it will harm the firm as much if not more than its competitors, therefore the firm should try to manage price wars towards swift conclusions and otherwise avoid direct price competition.

Finally, if the firm both does not earn stronger profits in serving the impacted customers (lacks a competitive advantage) and customers do not perceive its offering as more attractive (lacks pricing power), then the firm will have to accommodate competitive share gains in the short term in the hopes of improving its value offering for the next cycle of competitive engagement.  In this position, the firm does not have the pricing power to ignore competitive price moves nor does it have the margin position to win a price war, therefore customer losses are likely to be less costly than margin losses.

Not all of the positions are equally attractive – yet real life doesn’t always deal you a winning hand.  Just as in a standard hand of Texas Hold ‘Em, the chances of holding the strongest hand is only one in ten.  So it is in free market competition: you won’t always have pricing power and a competitive advantage and you can’t always win every customer profitably.  Yet in an evening of playing Texas Holdem, the real winners are determined by how they read their relative situation and act accordingly.  So it is in business. Perhaps this Strategic Price Reaction Matrix will help some managers read their cards and play the game better.