Week 6
FOR EVERY ACTION THERE IS A REACTION
How do you think AC's customers and competitors will react to PESA and its new price?
It is a bit naïve to think that AC customers will continue buying servers at the same rate if the price is increased (from status quo to, forexample, shared value) even if overall their expenses are reduced. Management doesn’t like to front the money (and realize savings later).If you think about some of the savings we calculated earlier, they may not be really possible (like the one related to labor). In other words, itis possible that market forces will enact, as they usually do (when prices increase, the quantity demanded decreases).
It is also unlikely that competitors will not react and that the development of PESA will go unnoticed. Perhaps competitors will develop theirown software. Remember, based on the case, Ontario has deep pockets.
Anticipating market reaction is important when pricing—companies must have contingency plans for such scenarios. In this page weexplore the above two options.
Consumers ' r eac t i ons
To understand consumer reactions to different prices, in the next video I go over the demand curve and its price elasticity.
Pricing consumer reaction
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A f e w i m p o r t a n t t a k e a w a y s f r o m t h e v i d e o :
1. Comparing the breakeven demand curve to the actual demand curve can help us understand how the quantity will change inresponse to a price change, compared with the current situation.
2. Elasticity, which is defined as the % change in quantity in response to a 1% change in price, can be calculated if we have prices andquantities (that we observed in the market over time). We use the following equation (this is from B to A in the video). Note that thepercent change in price or quantity is calculated as the difference divided by the “old” value.
To reiterate, for elastic products, lowering the price usually brings about more revenues because the quantity will significantly increase.For inelastic products, raising the price will result in a small quantity decrease. But remember, whether you want to raise or lower theprice depends on other things, not just elasticities! Customers do not take kindly to being bullied by companies(https://www.cbsnews.com/news/epipen-price-hike-controversy-mylan-ceo-heather-bresch-speaks-out/) and they definitely do not likeprice gouging (remember the price of hand sanitizers early in the pandemic (https://www.nytimes.com/2020/03/27/us/coronavirus-price-gouging-hand-sanitizer-masks-wipes.html) or the price of electricity in TX during the inclement weather of February 2021(https://www.nytimes.com/2021/02/20/us/texas-storm-electric-bills.html) ).
As a side note, there are products that behave completely differently—they are super-luxury products. For these products, as pricesincrease, demand also increases. The video below, from the Wall Street Journal, explains it really well:
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Compe t i t o r s ' r eac t i ons
Competitors are unlikely to be complacent when our firm makes a radical change in the price, one that can affect our competitors’business. Similarly, we won’t be idle if our competitors snatch our customers with better offering or price. Two reactions are possible:competitors can essentially compete with us on price, or on benefits (which are translated into product features), or both. I go over each ofthem here carefully:
Price war and other problems that stem from the prisoner’s dilemma
If we lower our price, through means such as discounts or price promotions, it is usually with the aim of increasing sales and market sharein the short term. But it is likely that competitors will lower their price as well in order to recover some of the sales and market share theylost to us. Our advantage is immediately erased, and everyone is worse off. Research shows that this is true even if there is a coststructure advantage of 30% or higher (i.e. one firm can really sustain the lower prices). The consequence of such a price war is a lowermarket price which consumers see as the new normal, thus believing this should be the price from now on. It also focuses consumers’attention on the price and away from their true value of the benefits they receive from the product. Price wars are especially difficult toavoid when consumers do not differentiate between our offering and anything else that’s on the market.
The following short animated video (no narration) demonstrates the process: once one seller starts undercutting prices, the slippery slopecommences.
pricing war
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What are the other problems that stem from the prisoner’s dilemma? To answer that, let’s first understand what is the prisoner’s dilemma.We study the prisoner’s dilemma in business, and specifically in pricing, because it shows how being selfish (pursuing our own goals at theexpense of everyone else) is detrimental to all players.
What Is the Prisoner's Dilemma – Scientific American
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Remember the shape of the supply function from your economic classes? As prices go up, firms want to produce and sell more. Here is anexample that illustrates it nicely:
Olive Oyl has two oil fields, one in Texas and one in Alaska. It costs her $30 to extract a barrel in TX and $45 in AK. If the price of oil is$40 a barrel, she’ll extract from TX only (because the price is not going to cover her costs extracting from AK). But if the price of abarrel is $50 then she can extract from both.
Note in this example, Ms. Oyl’s profit margin is smaller in AK than in TX when the price of a barrel is $50, but she is still making money, soit is worth it for her to extract from both.
Now let’s get back to the oil conundrum: as firms extract more oil, the market price of barrel drops. So firms have an incentive to put a capon production and get the price to go up. However, once the price is high enough, firms have an incentive to increase production and enjoythe high profit margin. But then prices will go down again, because production is higher. And the cycle repeats itself.
Read about it more in this excellent
article from the Wall Street Journal (https://udel.instructure.com/courses/1699152/files/118085481?wrap=1) (although
from 2014, nothing unfortunately has changed since, and the analysis is very much relevant today!)
Competitors will copy our product/service
Similar to the Atlantic Computers case in which it is clear that Ontario will react somehow, competitors are pretty much guaranteed to reactto changes in our product or price. Some competitors are more blunt than others (recall Samsung copied Apple’s smart phone design),while others will come up with different solutions that may provide similar benefits (think about Chromebook as a tablet-laptop hybrid thatcompetes with both tablets and laptops). In a way, this option is better than competing on prices.
An excellent example is how Amazon priced its music service.Everyone copied Spotify in this market, some with more successthan others. Market shares in 2019 were as in the pie chart on theleft.
It is also a nice example of a pricing method called good-better-best approach, in which as the product has more features and thusoffers more benefits, the price increases. Consumers can self-selectinto whatever product/price they want.
Initially Spotify and Apple competed in the music streaming marketand when Amazon joined, it had a few decisions to make: whichproducts to offer (think of these products as a set of constraints andfeatures), and how to price these products.
In the streaming music price map you can see the different products on the x-axis and their prices on the y-axis. In the description of theproduct an x means absent and a check means present.
As you probably noticed, Amazon undercut Apple’s price for individual plan, using the same benefits. Spotify’s individual plan has morebenefits (community playlists) and is more expensive. However, note that Amazon added two more options: one on the low end at $3.99and one on the high end, at $12.99. Amazon, unlike Spotify, is also making money on the device (in the low end).
