Chapter 11 – CompetitionChapter 11 – Competition– Pricing as a Game

– Analyzing a Competitive Situation & Responding to Price Competition

Strategic PricingStrategic PricingThe goal of pricing strategy should be to

maximize long run profitability

CostsCosts

CustomersCustomers

Pricing Strategy

Three Tactical Pricing Considerations

CompetitionCompetition

A Game of Price Competition A Game of Price Competition Payoff Matrix

+5 -10

+15 -5

Competitor’s Price is:

High Low

YourPrice is:

High

Low

Game theory assesses competitive situations where the outcome of a participant's choice of action depends critically on the actions of other participants, applied to war, business, and biology.

Win as Much as You Can• Each market consists of a referee & 2 teams of 2-3 people.• Teams have 5 minutes to plan initial strategy & 1 minute to make decisions for

each subsequent round. Each team’s strategy is submitted to the referee as a folded piece of paper.

• The referee collects moves at the end of each round; announces results; keeps records of meetings between representatives from opposing teams; and keeps records of profits & losses.

• Play will continue until I call it to a halt. Teams compete not just with their direct competitor but with all teams in all markets.

• Representatives of opposing teams can meet during any round. A request to meet must be initiated through the referee. The other team may refuse to meet. Only 1 representative per team may participate in the meeting. Any topic may be discussed.

* WARNING: Any communication directly with competitors about prices or other elements of competition is strictly forbidden under US and EC antitrust laws. Even indirect communication about prices may be treated as evidence of possible collusion which, combined with other evidence of collusive intent, could result in an antitrust indictment.

A Game of Price Competition A Game of Price Competition Payoff Matrix

+5 -10

+15 -5

Competitor’s Price is:

High Low

YourPrice is:

High

Low

Diagnosing the Game

• What different strategies are employed in the game?

• What were the specific factors that lead different teams to pursue different strategies?

• Which strategies represent stable equilibria?• What types of conditions tempt firms to use price

cutting in an attempt to gain sales?

Sports Competition Price Competition

Understanding the Pricing Game

• The more intense, the better the game

• Play as hard as you can

• Goal is to win, regardless of cost

• The more intense, the worse the game

• Weigh the cost of each confrontation

• Goal is to profit considering all costs

Three Types of Games

• Positive Sum:

• Zero Sum:

• Negative Sum:

economic, financial or social rewards are created as a result of playing the game.

the total rewards available from playing the game are independent of the process of play.

economic, financial or social rewards are destroyed as a result of playing the game.

The Rules of Diplomacy: Competing in a Negative-Sum Environment

• Make intentions and capabilities clear

• Be consistentBe consistent

• React quicklyReact quickly

• Don’t hold a grudgeDon’t hold a grudge

Competitive Response Tool

Options for Reacting to Price Competition

Actively adjust competitive strategy.

Aggressively attack & eliminate “bad” competitor

Aggressively defend against “bad” competitor

When to Avoid Price Competition?

• When you don’t have a cost advantage!• Or you do have significant differentiation.• When incremental costs are high, demand is inelastic,

&/or supply is constrained.• In oligopoly markets, competitors have the most to lose

from a price war & can easily arrive at a tacitly collusive pricing equilibrium.– “Good” competition shifts from price to brand building

(advertising) or product innovation• When there are multi-market direct competitors, price

wars can escalate & extend to all markets.

When to Engage in Price Competition?

• If necessary to punish or signal to a “bad” competitor, potential entrant, or single-market competitor.

• When you have no significant differentiation, multiple competitors, low incremental costs, high sunk costs (& excess capacity), perishable supply, &/or elastic demand.

• Low-cost competitors are key beneficiaries of a price war.• A high-price, high-quality competitor can benefit from

initiating a price cut if its relative margins have become too large (i.e., weak value position).– Moderate-to-high-price, high-quality competitors do not benefit

from reacting to a high-price competitor’s price cuts.

HEALTHY SPRING WATER COMPANYDEFINING THE PRICE-VOLUME TRADEOFF FOR A PRICE INCREASE

1. What is the maximum % sales loss that Healthy Spring could tolerate before a 10% price increase would fail to make a positive contribution to its profitability? And what is the unit break-even sales volume?

- %PSales %

%CM’ + %PB/E Sales Volume 2. Repositioning as a premium water will require upgrading the packaging, changing from

plastic bottles to glass bottles that are "safety sealed" to insure cleanliness until the covering is removed in the customer's home. These changes will add $1.00 per bottle to the variable cost of sales. What is the new breakeven volume with the 10% price increase?

- $CM Sales % New $CM B/E Sales Volume

3. Repositioning the water as a premium product will require an advertising and promotion budget increase of $900 daily. What is the maximum sales loss that Healthy Spring could tolerate before a 10% price increase would fail to increase net profit? That is, what is the break-even sales change including the incremental fixed cost of advertising?

- $CM + $ in FC Sales % New $CM NEW $CM × initial unit sales B/E Sales Volume

-10%/(60%+10%) = -10%/70% = -14.3% ~ 1714-1720

-1/13 = -7.7% ~ 1846

-4.2% ~ 1915

-1/13 + 900/(13*2000) = -4.2%

Profit Implications of Competitive (Re)Actions

Price New Price

Expected Demand

Expected Revenue

Exp Var Costs ($9 VC/U)

TotalFixed Costs

Expected Profit

10% $22.00 2,0700% $20.00 2,300

Healthy’s Profit if Competitor Matches Price Change (Use Primary Elasticity ≈ -1)

Price New Price

Expected Demand

Expected Revenue

Exp Var Costs ($9 VC/U)

TotalFixed Costs

Expected Profit

10% $22.000% $20.00

Healthy’s Profit if Competitor Does Not Match Price Change (Increase Elasticity ≈ -2)

Healthy Price

Cheapie’s Price

Expected Demand

Expected Revenue

Exp Var Costs ($9 VC/U)

TotalFixed Costs

Expected Profit

10% $20.000% $20.00

Cheapie’s Profit if Cheapie maintains/increases price (Healthy’s Increase Elasticity ≈ -2)

Healthy Price

Cheapie’s Price

Expected Demand

Expected Revenue

Exp Var Costs ($9 VC/U)

TotalFixed Costs

Expected Profit

10% $18.000% $18.00

Cheapie’s Profit if Cheapie decreases price (Healthy’s Increase Elasticity ≈ -2; Cheapie’s Decrease Elasticity ≈ -3)

$45,540 $18,630 $20,900 $6,010$46,000 $20,700 $20,900 $4,400

1,840 $40,480 $16,560 $20,900 $3,0202,300 $46,000 $20,700 $20,900 $4,400

2,660 $53,200 $21,280 $24,000 $7,9202,200 $44,000 $17,600 $24,000 $2,400

3,232 $58,176 $25,856 $24,000 $8,3202,860 $51,480 $22,880 $24,000 $4,600

10% $22.00 1,980 $43,560 $15,840 $24,000 $3,720

Healthy Cheapie Total Healthy Cheapie Total       

Units$22.00

Profit

Healthy price

Units$20.00

Profit           

$18.00 $20.00 Cheapie price

1. If Healthy sets its price at $20, Cheapie maximizes profit with a: $ price

2. If Healthy sets its price at $22, Cheapie maximizes profit with a: $ price

3. Given that Cheapie will try to maximize profit, what price should Healthy set? $ price

4. What is the major concern facing Healthy if it keeps its price at $20.00?  

6.   Construct a payoff matrix that summarizes unit volumes and profit for Cheapie with prices at $18 and $20 and for Healthy with prices at $20 and $22.  What are the take-aways?

Exhibit 1: Payoff Matrix under Different Pricing Scenarios1

Strictly according to the payoff matrix…

Next Week

• Virgin Mobile Case• Review Healthy Springs and Discuss Final Exam