The Price Strategy Simulator

Anatomy of a Price War

Hewlett-Packard / Compaq vs. Dell
by Michael Bean
In September 2001, Hewlett-Packard acquired Compaq for around $25 billion in HP stock.
Investors hated the idea. Both HP's and Compaq's stock fell about 25% in few days after the
announcement, so the deal was quickly valued under $20 billion. The New York Times described
the deal as bringing together two struggling computer companies into one giant with twice the
problems.
During merger discussions, representatives from both HP and Compaq talked about the $2.5
billion dollar yearly cost savings that would result from the merger.
It surprised me that there was so much money to be saved by combining two huge companies.
Even before merging HP and Compaq were each big enough to capture any economies of scale
in PC manufacturing. A study by McKinsey showed that up to 40% of mergers fail to capture
identified cost synergies. But assuming that they succeeded in saving $2.5 billion, on combined
sales of $87 billion, $2.5 billion means they will improve profitability by about 3%. Why all this
emphasis on cost savings? Why not talk about revenue growth or new technologies?
The problem faced by HP and Compaq was the same problem faced by Gateway and IBM-that
is, Dell Computer. Over the past few years, Dell has created an extraordinary competitive
advantage by becoming the most efficient PC manufacturer.
Dell's efficiency comes from two factors. First, they sell directly to their customers so their
distribution channels are simple and cheap (no dealer markup). Second, they build-to-order,
which keeps inventories low. Low inventories mean that, when Intel drops the price of its
processors, Dell doesn't have a lot of the old expensive processors sitting around. Dell can
reduce the prices on its computers faster than its competitors because the components that make
up those computers are the latest and cheapest. So far, no other PC maker has been able to
match Dell's cost structure.
In February 2001, Dell launched a campaign to become the largest competitor in the PC industry.
It announced that it was intentionally undercutting competitors' prices by 10% to quickly grab
market share. That announcement, along with the well-known fact that Dell has a cost advantage
over its competitors, was a signal to the rest of the PC industry that if others tried to match Dell's
prices they would be playing a game they couldn't win.
Dell's announcement and strategy is similar to the "low priced guarantee" announcement popular
among electronics retailers. A low priced guarantee tells your competitors, "If you try to undercut
our prices, we will drop ours even further." Of course, this kind of threat has to be backed up by
the ability to actually sustain low prices without going out of business. The ability to sustain low
prices is exactly what Dell has and why they are difficult to beat.
From a game theory perspective, the problem is a little like the Prisoner's Dilemma, except that in
the classic prisoner's dilemma, each party has the same to lose but, in this game, Dell knows that
HP with Compaq has more to lose. A threat by HP and Compaq to match Dell's prices isn't
credible because HP and Compaq can't sustain losses forever.
From a game theoretic perspective, HP's and Compaq's dilemma can be represented as a 2 x 2
matrix:









And this game isn't played just once. It's repeated over and over, where the outcome from the last
round becomes the status quo for the next round. As long as Dell has a lower cost structure Dell
will always win when HP and Compaq compete on price.
Looking at the news after Dell's announcement, you can see how the price war played out. In
April 2001, after the February price cuts, Dell became the world's largest PC maker, surpassing
Compaq in market share. In May, HP and Compaq responded to Dell with price cuts of their own,
throwing all competitors into the lower-right quadrant.
Experience Compaq's and HP's Pain for Yourself
We've created a simple simulation that is tuned to roughly represent Dell, HP and Compaq. In the
simulation you play a company that is about the size of HP or Compaq (pre-merger) and your
competitor is about the size of Dell. In the game, you compete only on price, the market perceives
your computers as being of equal quality. Market demand for computers is price-sensitive.
Your goal is to maximize cumulative profit over six months. Each month, your competitor, who
like Dell and has lower manufacturing costs than you, will try to undercut your prices by 10%.
Try playing through the game a couple times. You should discover that you have very little room
to maneuver. Either increasing or decreasing prices results in lower cumulative profit over the
four quarters
Playing a game you can't win isn't much fun, so we've made it possible to change the rules. You
can alter the simulation assumptions, turn yourself into Dell and your competitor into IBM, if you
like. You can even alter the assumptions to make the simulation look like your own business.
To run the simulator log on to
http://broadcast.forio.com/sims/pricing/

The Anatomy of a Price War






The difficulty with price wars is that they look deceptively simple: lower prices and sales go up.
Simple pricing models look like the diagram on the right.
The problem with this model is that price is a complicated product attribute. Changing prices
affects cost per unit sold because fixed costs are spread across all units sold and the number of
units sold should increase if prices drop. Also, your competitors are affected by and will respond
to your price changes.
Ignoring Feedback
Surprisingly, like the simplistic pricing model, many pricing models ignore feedback. These
incomplete models assume that price affects sales once-and-forever and the market immediately
reaches equilibrium.
Although each relationship in a competitive pricing system is simple (for example, revenue =our
price x sales), the feedback within the system makes determining the optimal strategy difficult (for
example, sales =competitor's price / our price x market sensitivity x demand so our revenue =
our price x (competitor's price / our price x market sensitivity x demand).

The diagram above shows eight feedback loops. This is only a simple two competitor model.
Increasing the number of competitors exponentially increases the dynamic complexity because
each competitor has its own strategy and can respond to a strategic change of any other
competitor.
How to Win a Price War
The first step to winning a price war is understanding your competitive landscape. Carefully
analyze your customers, competitors, and your own company, with special emphasis on cost
structures and strategic positioning. Customer analyses can reveal what, besides prices,
motivates your customers to buy your product or service. Competitor analyses will help you
estimate their pricing limitations and objectives.
Differentiating by factors other than price can reduce the effectiveness of price competition.
Introducing new features, or emphasizing non-price features to customers can reduce their prices
sensitivity (You can experiment with the effect of emphasizing features in the price strategy
simulator by altering your model assumptions on price sensitivity. Try changing price sensitivity to
1 and see what affect that has on Dell's success.)
If the price-competitive products are perceived to be of lower quality than your own brand,
consider launching a new, low-priced brand that can compete directly with your low-priced
competitor. This allows you to compete effectively with price sensitive customers without
damaging the brand of your existing product lines.
Make your strategic intent clear through media announcements. Consistently apply your strategy
over time. If you have cost advantages, or other competitive advantages, make sure that your
competitors know about them. This makes it clear to your competitors what will happen if they
change their prices.
Finally, reward competitors for eliminating discounts by matching with price increases of your
own. This will be consistent with a tit-for-tat strategy and it encourages a return to industry
profitability.
How to Win a Price War
1. Carefully analyze your customers, competitors, and your own
business.
2. Differentiate through non-price factors such as features or quality.
3. Launch a low-price brand to avoid damage to your existing brand.
4. Make your strategic intent and competitive advantages obvious to
your competitors.
5. When competitors relent, match their price increases with your own
price increases.
Often the most sensible approach to winning a price war is to do nothing. This is especially true if
your competitor is pricing below total unit cost. A McKinsey study found that optimal prices for
incumbents can be as much as 20 percent higher than the ones they actually set. And that study
ignores the long-term feedback relationships in prices. If you include feedback in your pricing
strategy, the optimal price would be even higher.
There is at least one clear benefit that resulted from the HP and Compaq merger. Both Compaq
and HP were in an unwinnable price war with Dell. By merging, at least Compaq and HP stopped
competing with each other.