Transcript Document

Chapter 11 – Competition
– Pricing as a Game
– Analyzing a Competitive Situation & Responding to Price
Competition
Strategic Pricing
The goal of pricing strategy should be to
maximize long run profitability
Three Tactical Pricing Considerations
Competition
Costs
Pricing
Strategy
Customers
A Game of Price Competition
Payoff Matrix
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.
Competitor’s Price is:
Your
Price is:
High
Low
High
+5
-10
Low
+15
-5
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
Payoff Matrix
Competitor’s Price is:
Your
Price is:
High
Low
High
+5
-10
Low
+15
-5
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?
Understanding the Pricing Game
Sports Competition
Price Competition
• The more intense,
the better the game
• The more intense, the
worse the game
• Play as hard as you
can
• Weigh the cost of
each confrontation
• Goal is to win,
regardless of cost
• Goal is to profit
considering all costs
Three Types of Games
• Positive Sum: economic, financial or social
rewards are created as a result of
playing the game.
• Zero Sum:
the total rewards available from
playing the game are independent of
the process of play.
• Negative Sum: 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 consistent
• React quickly
• Don’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 COMPANY
DEFINING 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?
- %DP
Sales D % -10%/(60%+10%) = -10%/70% = -14.3%
~ 1714-1720
%CM’ + %DP
B/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?
- $DCM
Sales D % -1/13 = -7.7%
New $CM
B/E Sales Volume
~ 1846
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?
- $DCM
+
$D in FC
Sales D % -4.2%
~ 1915
New $CM
NEW $CM × initial unit sales
B/E Sales Volume
-1/13 + 900/(13*2000) = -4.2%
Profit Implications of Competitive (Re)Actions
Healthy’s Profit if Competitor Matches Price Change (Use Primary Elasticity ≈ -1)
New
Expected Expected Exp Var Costs
Total
Expected
Price D
Price
Demand Revenue
($9 VC/U)
Fixed Costs
Profit
$45,540
$18,630
$20,900
$6,010
10%
$22.00
2,070
$46,000
$20,700
$20,900
$4,400
0%
$20.00
2,300
Healthy’s Profit if Competitor Does Not Match Price Change (Increase Elasticity ≈ -2)
New
Expected Expected Exp Var Costs
Total
Expected
Price D
Price
Demand Revenue
($9 VC/U)
Fixed Costs
Profit
1,840
$40,480
$16,560
$20,900
$3,020
10%
$22.00
2,300
$46,000
$20,700
$20,900
$4,400
0%
$20.00
Cheapie’s Profit if Cheapie maintains/increases price (Healthy’s Increase Elasticity ≈ -2)
Healthy Cheapie’s Expected Expected Exp Var Costs
Total
Expected
Price D
Price
Demand Revenue
($9 VC/U)
Fixed Costs
Profit
10%
$20.00
2,660
$53,200
$21,280
$24,000
$7,920
0%
$20.00
2,200
$44,000
$17,600
$24,000
$2,400
10%
$22.00
1,980
$43,560
$15,840
$24,000
$3,720
Cheapie’s Profit if Cheapie decreases price (Healthy’s Increase Elasticity ≈ -2; Cheapie’s Decrease Elasticity ≈ -3)
Healthy Cheapie’s Expected Expected Exp Var Costs
Total
Expected
Price D
Price
Demand Revenue
($9 VC/U)
Fixed Costs
Profit
3,232
$58,176
$25,856
$24,000
$8,320
10%
$18.00
2,860
$51,480
$22,880
$24,000
$4,600
0%
$18.00
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
Healthy
Cheapie
Total
Healthy
Cheapie
Total
Units
$22.00
Profit
Healthy price
Units
$20.00
Profit
$18.00
$20.00
Cheapie price
Strictly according to the payoff matrix…
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?
Next Week
• Virgin Mobile Case
• Review Healthy Springs and Discuss Final Exam