How to Win a Price War in a Duopoly Market?

Case Type: business competition, competitive response; organizational behavior.
Consulting Firm: AlixPartners first round full time job interview.
Industry Coverage: None

Case Interview Question #01065: Two companies (Your client and its competitor) are the only players in an industry and produce exactly the same product. Your client is the pioneer in the industry and has controlled 70% of the market for many years. Their competitor (with 30% market share) has always followed price changes initiated by your client. Recently though, the competitor has aggressively lowered prices by 15% and has cut into your client’s market share reducing it to 60%. Your client’s profit margins are only 14%, so they are hesitant to match the price cut, but they are afraid that they will continue to lose market share if they don’t.

Assume that there is no threat of new competitors entering the market and that there are no substitute products. All inputs are commodities and are readily available. The end-users are sophisticated and make their purchasing decisions based mostly on price. How has the competitor managed to cut prices so dramatically and still make money? And what would you advise your client to do in response to competitor’s price cut?

Additional Information: (to be provided only if interviewee asks probing questions)

* Industry growth has historically been 5% per year, but has flattened out completely in the last year.
* There are many buyers of the product and the price of this product is a negligible input cost for them.
* Your client and its competitor both are financially strong divisions of larger unrelated companies.
* Raw materials make up 50% of the total cost of producing this product. All other costs are fixed.
* Both your client and its competitor use essentially the same process and have very similar cost structures.
* Capacity can only be modified in large increments and the competitor brought on a new production line 6 months ago.

Possible Answer:

This case is all about capacity utilization with some game theory and defies most frameworks. Trying to apply Porter’s five forces or an equivalent model will lead to series of “no, that’s not an issue” comments from the interviewer. Don’t get caught up trying to figure out what the product is – it doesn’t matter in this case! It cannot be differentiated.

Analysis

* Industry growth has flattened out completely in the last year, so the total market size is constant.
* Market share for your client fell from 70% to 60%, so their production output fell by about 10/70 = ~14%.
* Since 50% of the total cost is variable, 50% must be fixed.
* A 14% drop in volume would therefore equate to a (14% * 50%) = 7% increase in average unit cost for your client (fixed unit costs increase!).
* Although specific cost data for the competitor is unknown, the increase in volume they have experienced has reduced their fixed unit cost in much the same way.
* When the competitor increased market share from 30% to 40%, its volume increased by 33%.
* If we assume that the competitor has a similar variable cost component of 50%, then their average fixed unit costs would have gone down by approximately (33% * 50%) = 16.5% as they spread their fixed costs over a larger volume.

Question #1: How has the competitor managed to cut prices so dramatically and still make money?

The competitor had an overcapacity problem and figured that they could make more money with higher volume by cutting prices. The 16.5% fixed unit cost reduction offset the 15% price cut they incurred and their volume increased 33% so they came out way ahead.

Question #2: What would you advise your client to do in response to competitor’s price cut?

The rest of the solution is in game theory. Advise your client to match the competitor’s price and follow their price changes to show them that they cannot undercut your price. Aggressively try to regain customers who were recently lost by offering extra inducements to try to get back lost market share. Since your client is still the market leader, they have a slight cost advantage and can fare better in a price war.

Once the competitor is made to understand this, advise your client to incrementally raise prices and make sure the competitor follows. Since there are many buyers and the product cost is only a small contributor to their overall costs, it is unlikely that the buyers will respond negatively to the price increases.