Why don’t companies lower the prices of their products below the competitor's offering?
This example does an excellent job of highlighting the effects of such “price wars”.
In 1993, Philip Morris and B.A.T. were the two companies selling cigarettes in Costa Rica, with market shares of 30% and 70%, respectively. Philip Morris catered to the premium and midrange markets, while B.A.T. sold to the value-for-money market with the cheaper cigarettes (Bensanko, 2016, p. 226).
On a Saturday morning in January of 1993, Philip Morris cut prices of their cigarettes by 40% to undercut B.A.T. prices. Philip Morris believed: (1) B.A.T. would not be able to adjust prices quickly and (2) post-holiday inventory of cigarettes would be low and B.A.T. would run the risk of sell-outs (Bensanko, 2016, p. 226).
Not only was B.A.T. able to respond quickly, but they also cut prices by 50% on the same day. What was the result? Both Philip Morris and B.A.T. held on their market shares of 30% and 70%, but they lost $8 million and $20 million, respectively (Bensanko, 2016, p. 226).
The lesson is that if a competitor can react to price changes quickly, the consequences of price-wars is detrimental to the businesses involved.
Application to Another Business
Oil and gas companies would face the same situation. They can undercut their competitors by reducing prices, but the end consequence would be to harm profit margins. If a gas company wants to increase market share, cutting prices seem like a reasonable move. However, the gas station across the street will adjust as well, nullifying the adjustment.
If a company wants to increase its market share, price adjustments are clearly not the way to go if your competition can also adjust quickly. Therefore, you must add value to your offering in other ways.
Resources
Besanko, D., Dranove, D., Shanley, M. & Schaefer, S. (2016). Economics of Strategy. (7th ed.), Hoboken: John Wiley & Sons Inc.
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