1. Chapter 11 – Competition Pricing as a Game
Analyzing a Competitive Situation & Responding to Price Competition

2. Three Tactical Pricing Considerations
Strategic Pricing
The goal of pricing strategy should be to maximize long run profitability
Three Tactical Pricing Considerations
Competition
Costs
Pricing
Strategy
Effective pricing is profit-driven pricing. Profit-driven pricing integrates considerations of costs, customers, and competition to arrive at an optimal strategy that seeks to maximize long-term profitability. The process for developing an effective pricing strategy starts with an understanding of costs, consumer price sensitivity, and competition. A thorough knowledge of these concepts leads to the development of appropriate strategic objectives for all marketing decisions, including pricing. From the objectives, the firm sets more concrete and time specific strategic goals. Finally, tactics are the specific actions a firm takes to achieve its goals.
Customers

3. A Game of Price Competition Payoff Matrix
Game theory assesses competitive situations where the outcome of a participant's choice of action depends critically on the actions of other participants, applied to war, business, and biology.
Competitor’s Price is:
High
Low
High +5
-10
Topic: Managing Competitive Interactions
Learning Objectives
This slide is intended to be the introductory slide to the competitive game, “Win as Much as You Can”. It Illustrates how even well informed managers can make decisions that sub-optimize profits in the midst of competitive pricing interactions
Teaching Recommendations
Competitive pricing strategy is one of those critically important topics which, unfortunately, is distant enough from the experience of many students that it can easily slip past them unappreciated. A suggested approach for teaching this section, which draws students in as active participants in the competitive process, is based on game theory principles and begins with discussion of a simple competitive game called "Win as Much as You Can." The game is based on game theory. Instructors who do not wish to invest the time to actually play the game can merely describe it and move directly to a discussion of the competitive behavior. However, allowing students to actually participate in the game generates enthusiasm for the remaining discussion.
To play the game, the class should be divided into groups, consisting of one referee and two teams of two or three players each. The more groups you form the better, as this increases the chance of getting a greater variety of examples of the different strategies teams might adopt. Game instructions, ballots, and instructor's notes are located in the supplemental teaching material section. (Instructions and ballots can be reproduced and distributed to the players.) If time permits, it generally makes sense to let play continue for at least six and as many as 10 rounds before ending the game and conducting the post-game analysis.
Different teams have employed different strategies in pursuit of their objective to win as much as they could. Some have pursued a strategy of direct price competition. Others have resisted the temptation to cut price and have adopted more cooperative postures toward their supposed competitors. Some teams have cooperated unilaterally, eschewing any direct communication between themselves and their competitors. Others, however, may have conspired, sometimes getting caught and sometimes not.
Your
Price is:
Low
+15 -5

4. Win as Much as You Can
Each market consists of a referee & 2 teams of 2-3 people.
Teams have 5 minutes to plan initial strategy & 1 minute to make decisions for each subsequent round. Each team’s strategy is submitted to the referee as a folded piece of paper.
The referee collects moves at the end of each round; announces results; keeps records of meetings between representatives from opposing teams; and keeps records of profits & losses.
Play will continue until I call it to a halt. Teams compete not just with their direct competitor but with all teams in all markets.
Representatives of opposing teams can meet during any round. A request to meet must be initiated through the referee. The other team may refuse to meet. Only 1 representative per team may participate in the meeting. Any topic may be discussed.
* WARNING: Any communication directly with competitors about prices or other elements of competition is strictly forbidden under US and EC antitrust laws. Even indirect communication about prices may be treated as evidence of possible collusion which, combined with other evidence of collusive intent, could result in an antitrust indictment.

5. A Game of Price Competition Payoff Matrix
Competitor’s Price is:
High
Low
High +5
-10
Your
Price is:
Topic: Managing Competitive Interactions
Learning Objectives
This slide is intended to be the introductory slide to the competitive game, “Win as Much as You Can”. It Illustrates how even well informed managers can make decisions that sub-optimize profits in the midst of competitive pricing interactions
Teaching Recommendations
Competitive pricing strategy is one of those critically important topics which, unfortunately, is distant enough from the experience of many students that it can easily slip past them unappreciated. A suggested approach for teaching this section, which draws students in as active participants in the competitive process, is based on game theory principles and begins with discussion of a simple competitive game called "Win as Much as You Can." The game is based on game theory. Instructors who do not wish to invest the time to actually play the game can merely describe it and move directly to a discussion of the competitive behavior. However, allowing students to actually participate in the game generates enthusiasm for the remaining discussion.
To play the game, the class should be divided into groups, consisting of one referee and two teams of two or three players each. The more groups you form the better, as this increases the chance of getting a greater variety of examples of the different strategies teams might adopt. Game instructions, ballots, and instructor's notes are located in the supplemental teaching material section. (Instructions and ballots can be reproduced and distributed to the players.) If time permits, it generally makes sense to let play continue for at least six and as many as 10 rounds before ending the game and conducting the post-game analysis.
Different teams have employed different strategies in pursuit of their objective to win as much as they could. Some have pursued a strategy of direct price competition. Others have resisted the temptation to cut price and have adopted more cooperative postures toward their supposed competitors. Some teams have cooperated unilaterally, eschewing any direct communication between themselves and their competitors. Others, however, may have conspired, sometimes getting caught and sometimes not.
Low
+15 -5

6. Diagnosing the Game
What different strategies are employed in the game?
What were the specific factors that lead different teams to pursue different strategies?
Which strategies represent stable equilibria?
What types of conditions tempt firms to use price cutting in an attempt to gain sales?
Different teams have employed different strategies in pursuit of their objective to win as much as they could. Some have pursued a strategy of direct price competition. Others have resisted the temptation to cut price and have adopted more cooperative postures toward their supposed competitors. Some teams have cooperated unilaterally, eschewing any direct communication between themselves and their competitors. Other, however, have conspired. When teams have conspired, they sometimes got caught; but sometimes they didn't.
Which strategies appeared to be more effective and why? Which for the short-term? Which for the long-term? Which of the cells represent more stable "equilibrium" market states and which tended to be less stable?
Answer: The off diagonal elements are unstable.
A good way to summarize competitive behavior is simply to discuss the conditions which tempt firms to use price cutting in an attempt to gain sales. These include:
1. Multiple competitors. Generally, the more competitors there are, the greater the temptation.
2. Some customers, won from a competitor with a lower price, won't return to competitor when he later matches that lower price.
3. Relatively small market share.
4. Relatively high contribution margin (low variable costs).
5. Relatively high excess capacity.
6. An unusually large order.

7. Understanding the Pricing Game
Sports Competition
Price Competition
The more intense, the better the game
Play as hard as you can
Goal is to win, regardless of cost
The more intense, the worse the game
Weigh the cost of each confrontation
Goal is to profit considering all costs
Pricing is a "game" because success depends not only on a company's own pricing decisions, but also on how customers and competitors respond to them. Most of us think we know how to play games, since we have had lots of experience with sports and other types of civilized competition. But pricing is a totally different type of game. Consider the contrasts in this slide.
The reason for this difference is that sports, as well as most other competitions that people encounter in civilized societies, such as competitions for grades in school and sales competitions at work, are all of a particular type called positive-sum games. A positive-sum game is one in which the very process of competing creates added benefits. The more prolonged and intense the game, the greater the benefits. We all feel better about winning a hard fought game of racquetball or tennis or football--when the score keeps changing back and forth--than winning one that was easy. Similarly, in competing for grades, we learn more regardless of the grade actually received if we put our heart into the competition and give it our best shot. Unfortunately, managers sometimes carry this same "gung-ho" attitude into price competition, with disastrous consequences. Pricing is not like sports or competition for grades. Pricing is a negative-sum game more like warfare or dueling than like a sport.

8. Three Types of Games Positive Sum: Zero Sum: Negative Sum:
economic, financial or social rewards are created as a result of playing the game.
the total rewards available from playing the game are independent of the process of play.
economic, financial or social rewards are destroyed as a result of playing the game.

9. The Rules of Diplomacy: Competing in a Negative-Sum Environment
Make intentions and capabilities clear
Be consistent
React quickly
Don’t hold a grudge
Many managers approach competitive pricing with the same attitude they approach going to battle or war. A point in lost market share is ground lost to the enemy; they are determined to win it back. They rally their troops with slogans of: “We’re number one, and we’re going to stay that way.” But treating pricing as war is dangerous, a negative-sum game, in which all players are harmed by playing.
Success in pricing requires mastering not the art of war, but the art of diplomacy. Diplomacy is the art of making plans, manipulating information, and choosing confrontations wisely so as to achieve objectives with minimum conflict. There are 4 principles to diplomacy, and they apply directly to competitive pricing situations:
Make intentions and capabilities clear -- signal to competitors which markets you intend to defend, and how you intend to compete to keep customers loyal in those markets.
Be consistent -- one of the important principles of game theory is that the history of your actions and your reputation as a competitor in the market is important. If you appear to randomly or opportunistically discount price competitors don’t know what to expect, and will end up retaliating on price, inviting price instability.
React quickly -- this is a key principle of effective signaling to inform competitors quickly when they have crossed over into markets or accounts that are important. The opposite it true as well, to ignore competitors when they threaten markets or accounts that are unimportant.
Don’t hold a grudge -- the key to most competitive pricing situations is pricing stability among competitors; diplomats never approach competitors emotionally,

10. Competitive Response Tool
Topic: Competitive Response
Key Learning Points for Students
Highlight the logic behind a strategic response to competitive pricing moves
Teaching Recommendations
It is useful to illustrate this tool using a recent price war that can be found though Google. Illustrate the various moves made by the competitors and evaluate them based on the suggested moves in the framework

11. Options for Reacting to Price Competition
Actively adjust competitive strategy.
Exhibit
Aggressively attack & eliminate “bad” competitor
Aggressively defend against “bad” competitor

12. When to Avoid Price Competition?
When you don’t have a cost advantage!
Or you do have significant differentiation.
When incremental costs are high, demand is inelastic, &/or supply is constrained.
In oligopoly markets, competitors have the most to lose from a price war & can easily arrive at a tacitly collusive pricing equilibrium.
“Good” competition shifts from price to brand building (advertising) or product innovation
When there are multi-market direct competitors, price wars can escalate & extend to all markets.

13. When to Engage in Price Competition?
If necessary to punish or signal to a “bad” competitor, potential entrant, or single-market competitor.
When you have no significant differentiation, multiple competitors, low incremental costs, high sunk costs (& excess capacity), perishable supply, &/or elastic demand.
Low-cost competitors are key beneficiaries of a price war.
A high-price, high-quality competitor can benefit from initiating a price cut if its relative margins have become too large (i.e., weak value position).
Moderate-to-high-price, high-quality competitors do not benefit from reacting to a high-price competitor’s price cuts.

14. HEALTHY SPRING WATER COMPANY DEFINING THE PRICE-VOLUME TRADEOFF FOR A PRICE INCREASE
What is the maximum % sales loss that Healthy Spring could tolerate before a 10% price increase would fail to make a positive contribution to its profitability? And what is the unit break-even sales volume?
- %DP Sales D %
%CM’ + %DP B/E Sales Volume
-10%/(60%+10%) = -10%/70% = -14.3% ~
2. Repositioning as a premium water will require upgrading the packaging, changing from plastic bottles to glass bottles that are "safety sealed" to insure cleanliness until the covering is removed in the customer's home. These changes will add $1.00 per bottle to the variable cost of sales. What is the new breakeven volume with the 10% price increase?
- $DCM Sales D %
New $CM B/E Sales Volume
-1/13 = -7.7%
~ 1846
3. Repositioning the water as a premium product will require an advertising and promotion budget increase of $900 daily. What is the maximum sales loss that Healthy Spring could tolerate before a 10% price increase would fail to increase net profit? That is, what is the break-even sales change including the incremental fixed cost of advertising?
- $DCM $D in FC Sales D %
New $CM NEW $CM × initial unit sales B/E Sales Volume
-4.2%
~ 1915
-1/ /(13*2000) = -4.2%

15. Profit Implications of Competitive (Re)Actions
Healthy’s Profit if Competitor Matches Price Change (Use Primary Elasticity ≈ -1)
Price D
New Price
Expected Demand
Expected Revenue
Exp Var Costs ($9 VC/U)
Total
Fixed Costs
Expected Profit
10%
$22.00
2,070 0%
$20.00
2,300
$45,540
$18,630
$20,900
$6,010
$46,000
$20,700
$4,400
Healthy’s Profit if Competitor Does Not Match Price Change (Increase Elasticity ≈ -2)
Price D
New Price
Expected Demand
Expected Revenue
Exp Var Costs ($9 VC/U)
Total
Fixed Costs
Expected Profit
10%
$22.00 0%
$20.00
1,840
$40,480
$16,560
$20,900
$3,020
2,300
$46,000
$20,700
$4,400
Cheapie’s Profit if Cheapie maintains/increases price (Healthy’s Increase Elasticity ≈ -2)
Healthy Price D
Cheapie’s Price
Expected Demand
Expected Revenue
Exp Var Costs ($9 VC/U)
Total
Fixed Costs
Expected Profit
10%
$20.00 0%
2,660
$53,200
$21,280
$24,000
$7,920
2,200
$44,000
$17,600
$2,400
10%
$22.00
1,980
$43,560
$15,840
$24,000
$3,720
Cheapie’s Profit if Cheapie decreases price (Healthy’s Increase Elasticity ≈ -2; Cheapie’s Decrease Elasticity ≈ -3)
Healthy Price D
Cheapie’s Price
Expected Demand
Expected Revenue
Exp Var Costs ($9 VC/U)
Total
Fixed Costs
Expected Profit
10%
$18.00 0%
3,232
$58,176
$25,856
$24,000
$8,320
2,860
$51,480
$22,880
$4,600

16. Exhibit 1: Payoff Matrix under Different Pricing Scenarios1
6. Construct a payoff matrix that summarizes unit volumes and profit for Cheapie with prices at $18 and $20 and for Healthy with prices at $20 and $22. What are the take-aways?
Exhibit 1: Payoff Matrix under Different Pricing Scenarios1
Healthy
Cheapie
Total
Units
$22.00
Profit
Healthy price
$20.00
$18.00
price
Strictly according to the payoff matrix…
1. If Healthy sets its price at $20, Cheapie maximizes profit with a:
$ price
2. If Healthy sets its price at $22, Cheapie maximizes profit with a:
3. Given that Cheapie will try to maximize profit, what price should Healthy set?
4. What is the major concern facing Healthy if it keeps its price at $20.00?

17. Next Week Virgin Mobile Case
Review Healthy Springs and Discuss Final Exam