Introduction to Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability
Competition-based pricing is the second-most-popular price-setting approach. Managers sometimes refer to this approach as strategic pricing, although it's not particularly strategic. When taking this approach, a firm simply checks out its competition's price and then sets the price of its own product at about the same level, plus or minus a few percent. Once again, this approach has the virtue of being simple: It's an easy way to make a pricing decision without having to conduct any thorough market research. It also seems relatively safe: By setting a price close to the rival's and adjusting with it, a firm does not risk losing its market share to the competition.
However, setting one's own price solely on the basis of competition's price can cause two problems, either of which can cost a company dearly.
The worst risk is that competition-based pricing lulls the price setter into passivity. Managers can be so taken by this pricing approach that they lose sight of their own pricing responsibilities. To them, pricing involves nothing more than monitoring competitors' prices and making some timely adjustments on their own price based on the competition's price. Maybe this is what managers mean when they say the invisible hand sets their prices. This might seem like a low-risk strategy, but unfortunately sometimes the competition decides to set its prices the same way. When this kind of double-mirroring occurs, prices not just for the company but for the entire industry can easily fall out of sync with current demand.
Other times, price-matching can lead to a game of chicken. Everyone knows that setting a low price is the easiest, fastest way to gain market share. The trouble is that one rarely encounters a company that does not want a larger market share: In any given industry, if you added up all the market share targets of each company, the sum would most likely far exceed 100%. Obviously, something has to give. If all the firms in an industry become overzealous about meeting their market share targets, prices can easily slip into a downward spiral that can hurt not just the company but the industry as a whole. The competition for market share between the two aerospace giants Boeing and Airbus in the mid- and late 1990s offers an example of this risk. At the time, Airbus was consistently gaining market share and had surpassed its self-determined "survival threshold" of 30% of new global commercial airplane orders. Boeing decided to respond. It would "beat back Airbus and retain supremacy in the commercial-jetliner industry,"3 and fearlessly guard its 60% market share. Boeing and Airbus began competing vigorously, "making every bid a battleground." Each would slash its price by at least 20% off the list price to grab an order. For example, to bid for ValueJet's order of 50 100-passenger airplanes in 1995, Boeing reportedly brought its price for Boeing 737s down from the list of $35 million, below its rock-bottom price of $22 million, all the way to $19 million.4
The outcome was quite predictable: huge losses all around. Boeing temporarily won the share battle for new airplane orders. However, the victory came at a horrendous cost. Boeing suffered its first annual loss in 50 years in 1997, and by the following year, the company was forced to take more than $3 billion of pretax charges for the foul-up. Between 1996 and 1998, the profit margin of Boeing's commercial jetliners fell from 10% to less than 1%—a lower margin than a corner grocery store.
We are not suggesting that firms should never compete on price to gain market share. As we show in Chapter 3, "The Art of Price Wars," price wars are a legitimate strategy. However, we are suggesting—and advocating throughout this book—that firms should learn how to compete as intelligently on price as they do on every other aspect of their business. Adam Smith's invisible hand works only if the economic agents in the market are driven by their own enlightened self-interest to pursue their own maximum economic gain. Boeing's decision to build extraordinarily complex aerospace vehicles at a lower margin than a corner grocer was not enlightened self-interest.