Why Price War is Not Price Competition4 min read

If you want to sell something at $10 but no one buys from you, what would you do?

Like every other firm, you will probably choose from one of two options:

  1. Lower your price.

  2. Make your product (seem) better.

In a perfectly competitive market, option 2 is literally not an option. Producers all sell identical products and consumers know it for a fact. So in a perfect competition, you are left with option 1.

But hang on. Aren’t firms in perfectly competitive markets price takers? Why would they be able to control the price?

That is a fantastic question. The answer is that price taker is a result, not a hard and fast rule. Consider a free market in equilibrium: quantity demanded equals quantity supplied.

demandequalsupply

At this equilibrium, producers do not want to sell below the market price. They can already sell whatever amounts they can produce at the current price (because we assume each PC firm produces an insignificantly small quantity). Lowering prices will just hurt their revenue.

Producers do not want to sell above the market price for two reasons. Their goods are identical to competitors (i.e. perfect substitutes) and consumers have perfect information (of where the best deals are). Increasing the price will cause the quantity demanded for their product to drop to zero.

As a result, firms in a PC market are price takers. Not because they cannot adjust the prices of their goods, but because doing so will be bad for them.

But consider what happens when price is not in equilibrium. In particular, let us look at the case when price is above equilibrium.

priceabove

There is a surplus in the market because quantity supplied exceeds quantity demanded. What happens now? Producers faced with surpluses that they cannot sell at the current price will actively lower their prices to try to sell their goods.

This process is called competition. And since producers here are clearly competing in terms of price, it’s also called price competition.

Competition is an ongoing process in markets to restore equilibrium. When price is below equilibrium, consumers compete to get the goods by offering to pay higher prices. When price is above equilibrium, as in the example above, producers compete to sell their goods by offering lower prices.

Does Price Competition Only Exist in Perfect Competition?

Certainly not. Monopolistic Competitive firms compete with each other by price in the long run because there are no barriers to entry and product differentiation can be replicated. The result of this is that MPC firms only make normal profits in the long run.

In an Oligopoly, firms tend to avoid price competition because there is no incentive to do so. For a PC firm, it price competes to sell its surpluses that aren’t getting sold at the existing price. For a new MPC firm entrant, price competition allows them to take a share of the existing firm’s demand and supernormal profit.

There’s nothing in it for an oligopolist. The high degree of interdependence means that any price adjustments will be matched closely by rivals. Better to maintain the status quo of P > MC and earn supernormal profits.

The Exceptions

Enters the price war. Price war is a short term strategy of undercutting rivals’ prices with the purpose of gaining market share. It might even mean lowering prices to below marginal cost and taking a loss in the short run. Short run profit maximisation is no longer the firm’s objective.

So what could prompt a firm to start a price war?

When it thinks it will win and that the status quo is unsustainable. For instance, it might think that the industry’s barriers to entry are being eroded, or demand and supply conditions are changing and that drastic actions are needed for the firm to survive in the long run. A recent example of this happening that I discussed in the Econoception Newsletter is the car rental market.

The car rental market faces increasing threat from smartphone apps, which allow users to book private cars. Many analysts fear the oligopoly would not last long and Mark Frissora, the ex-CEO of Hertz had resorted to a price war. Download and read the newsletter to find out more.

Price War is Not Price Competition

Price competition takes place in perfect competition to restore equilibrium in markets. It can also happen in the long run in MPC markets. On the other hand, oligopolists seldom compete through price because they won’t benefit from it.

But they do sometimes resort to price wars when circumstances compel them to.

Till next time, dream economics.

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