The objective of this essay is to “use economic theory and illustrative examples to outline the circumstances under which a price war could come about and the likely consequences for the participating firms and their consumers”. A price war is a period in which multiple firms competing within the same market will react to the other firms lowering of price by lowering their own price. They have short-term and long-term advantages and disadvantages.
There are many reasons for which a price war may occur, in all cases the reason for starting the price war is different but the reason for its continuation is not to lose sales. They are when a firm attempts to maximise capacity, for survival purposes, in oligopoly markets, where there are homogeneous products and when a firm adopts a penetrative pricing strategy.
“Excess capacity refers to a situation where a firm is producing at a lower scale of output than it has been designed for” Excess capacity http://stats.oecd.org/glossary/ detail.asp?ID=3209 [accessed 10th December 2006] If a firm has spare capacity to produce more of a good it is likely they will use this spare capacity to profit maximise but to achieve this they will have to lower prices to increase quantity demanded (see appendix item A). As they have decreased their prices, other competitors will likely drop their prices so as not to loose customers, creating a price war.
Companies who face bankruptcy may try to lower their prices so to attract more consumers and increase sales volume. However, if they cannot manage to increase volume enough to cover the fall in contribution then it will fail to cover its variable costs and will be forced to leave the market. Other firms may recognise that the company is in trouble and in a bid to force the company out the market and not to loose their own customers will drop their prices below that of the company facing bankruptcy.
An oligopoly is where “a small number of firms share a large portion of the market” Economics Handbook, David Gray and Peter Clarke. In an oligopoly price is usually stable and constant as competing firms will not wish to lower price as its competitors will also drop theirs and so all they have achieved is lowering their profit margins (see appendix item B). However, one firm may believe it stands to gain from a price-cut by believing they can under-cut the competition through economies of scale or other factors such as slow market reaction. A price war will begin as firms will drop theirs to avoid loosing customers.
If in a market the goods are homogenous meaning they are the same for example utility services then price is one of the only means for a firm to distinguish it from others. In this situation a consumer will always purchase the lower priced product. This cause’s fierce pricing competition as each firm will try to maintain sales by dropping their price below the other competitors.
“Penetration pricing involves the setting of lower, rather than the higher prices in order to achieve a large if not dominant market share” Pricing strategies http://www.tutor2u.net/business/marketing/pricing_strategy_penetration.asp [accessed 10th December 2006]. If this occurs the other firms in the market will recognise this and drop their own prices to stop that firm from gaining a dominant market share.
The firm adopting this strategy may then also drop their prices to try continuing their pricing strategy causing a price war. This strategy can also be used to try and force firms out of the marketA price war causes more competition between firms, it has both positive and negative aspects for the consumers and the participating firms but these are different in the short-term and long-term. Competition is seen as a positive thing in any command economy.
The short-run benefits for the consumer are obvious as firms lower their prices they will receive a better deal this can be seen in a movement along the demand curve, there will also be more consumer’s demanding the product for that lower price (see appendix item C). They are also likely to see improvements to the augmented products associated with the good as firms try to compete through non-pricing strategies. These services are things such as warranties, loyalty cards and other ‘extras’.
The short-run effects upon the firms in the market are negative. Firm’s profits are reduced as the price of the good is reduced (see appendix item D). All firms in the industry will be forced to improve their productive efficiency to reduce total average cost, in an attempt to retain profit-margins whilst prices fall. They may also wish to attempt a heavier marketing campaign to try to distinguish itself from the other firms, but this incurs further costs for the firm. Firms are also likely to undergo a faster pace of invention and innovation as they differentiate themselves. Some firm’s in the market will be able to use their economies of scale to combat lower prices. But, other firms will not have such efficiencies and will not be able to afford variable costs and will therefore exit the market immediately (see appendix item E).
The long-run affects of a price war are that a lot of firms will leave the market, this causes the demand curve to move back to its original position, which increases market-clearing price creating a long-run equilibrium and so normal profits are re-established. This is a negative aspect to the consumer’s who will have to pay more than they have in recent periods, they are also more likely to try and shop round to find the best deal. The good itself is likely to have seen technological advances as firms competed to have the most innovative product. There will also have been improved services for the consumers. The firms left in the market are likely to have better control of costs; this allows them to increase the contribution towards profits as the average total cost has been reduced of the product.
In conclusion, a price war can be initiated for many reasons such as efficiency by filling up spare capacity, as a means for survival, in intense rivalry in oligopoly markets, to differentiate a product and to build up brand name or force other firms out of the market. However, the consequences are usually very similar, some firms will emerge as dominate and others will leave the market. This can have both good effects and bad effects as consumers will initially be happy with lower prices but when the long-run equilibrium comes into effect they will search harder for bargains. They will also see improvements made to the product and services. The surviving firms do well from the price war; they are likely to see higher demand for their product, as there are fewer competitors.
They also are likely to achieve greater productive efficiency and so greater profit margins. “Vigorous competition between firms is the lifeblood of strong markets and is a central to productivity and growth in the economy”
International Competitiveness (2001) UK Labour GovernmentBibliography•Hardwick, Khan, Langmead (1994) An Introduction to Modern Economics 4th Edition•Lipsey, Forrest, Olsen (1993) An Introduction to Positive Accounts•Hunt, Sherman (1990) Economics An Introduction to traditional and radical views•Sloman, John (2000) Economics 4th Edition•Begg, David (2005) Economics 8th Edition•Sloman, John and Sutcliffe, Mark (2004) Economics for Business 3rd Edition•http://www.tutor2u.net [accessed 10th December]•http://en.wikipedia.org/wiki/Wiki [accessed 10th December]•Price War, What is it good for? http://mba.tuck.dartmouth.edu/pages/faculty/koen.pauwels/pdf/Price%20War%20what%20is%20it%20good%20for.pdf [accessed 10th December]References•Excess capacity http://stats.oecd.org/glossary/ detail.asp?ID=3209 [accessed 10th December 2006]•Economics Handbook, David Gray and Peter Clarke•Pricing strategies http://www.tutor2u.net/business/marketing/pricing_strategy_penetration.asp [accessed 10th December 2006]•International Competitiveness (2001) UK Labour GovernmentAppendixItem AAs the firm increases the supply through using the spare capacity, supply curve shifts left from S1 to S2 as a result the market clearing price falls but quantity increases.
Shifts in supply curve http://www.auhy69.dsl.pipex.com/images/dd202/b2p.jpg [accessed 10th December 2006]Item BIn this diagram you can see that in an oligopoly market it is unfavourable for the oligopoly firms to change their price, so it becomes static.
Price Competition in Oligopoly Market, Foundations of Economics Handbook (2006) David Gray and Peter ClarkeItem CA Movement along the demand curve will increase the quantity demanded but reduce selling price.
Demand and Supply www.investopedia.com/university/economics/economics3.asp [accessed 10th December 2006]Item DAs the price is set lower from P1 to P2