The Cost Effectiveness of a Price Response

Pricing decisions operate within a dynamic, uncertain and competitive landscape. They can have a lasting impact on an organization’s long-term profitability and growth strategy. New and existing market players are constantly shifting their pricing strategies, and the incumbent must be able to understand the competitor’s motivations, weigh alternatives and act accordingly. The big question is when and how to respond. For a price response to be successful, it must be sustainable in the long run and viable after responses by competitors. Competitors should not be able to respond in a way that erodes the incumbent’s competitive advantage.

Let’s explore this further and look at two different scenarios that require a price response.

Scenario 1: Responding to a price cut by a competitor

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The incumbent can be threatened by a competitor’s price cut. The first instinct might be to lower their own prices; but, this needs to be systematically analyzed:

  • How will the competitor’s price cut effect the incumbent’s sales volume, revenue or profit?
  • Would it be possible to prevent the effect on sales volume, revenue or profit through a price cut?
  • Is the cost of not responding higher than the cost of a price reduction in terms of sales volume, revenue or market share?
  • Is the competitor likely to cut prices again?

The incumbent should only respond with a price cut if, after considering the above questions, the cost of a price reduction is less than the cost of losing sales from not taking any action.

Price responses must align with strategic goals. If the end goal is to keep one’s share of the pie or capture a bigger share, inadvertently cutting prices and initiating a price war in response to competitor’s prices might erode margins and make the pie smaller for the market as a whole.

Scenario 2: Responding to a price increase by a competitor

Again, this must be approached systematically. Understanding the motivations behind the competitor’s price increase is critical here. The competitor might be increasing prices for several different reasons:

  •  Increased costs
  •  To better capture differentiated value of their product or service
  • Shifting from a market penetration strategy designed to capture volume to a price skimming strategy designed to capture higher margins

Once the incumbent understands the competitor’s motivations, based on the differentiated value of their own product or service as well as their strategic goals, a choice can be made whether to take advantage of their own relatively lower prices and capture increased market share, or to capture higher margins by matching the competitor’s price.

A price response must not be a knee-jerk reaction. It requires understanding and self-reflection to weigh the differentiated value of the product or service offering, and one's own strengths and weaknesses against the competitive landscape. There might be instances when the best course of action is no action at all. Granted doing nothing is extremely hard to do. But the only way an incumbent can maintain their competitive advantage is to look into the future and make pricing decisions today that align with their long-term strategic goals. Sometimes you just might have to lose a few battles to win the war.