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Definition of a Price War:
A price war occurs when two or more companies compete fiercely over the price of a good or service by continuously reducing their prices to gain or protect their market share or build barriers to entry.
If you live in the US, you may have benefited from the price war among cell phone providers between 2016 and 2017. AT&T, Verizon, T-Mobile and Sprint cut their rates and provided plans with unlimited texting and data to gain your business. Price wars occur when one company reduces its price with the intent of gaining revenue or market share. Competing companies retaliate by lowering their prices to meet or exceed the first company’s price with the intent of protecting their sales. The initiating company responds by reducing its price again. The competition follows up with another price cut, creating a downward price spiral. Price wars are fiercest when there are a few companies competing for the same business. Each is interdependent, which means the companies do not reach a decision without considering the reaction of the others.
Price wars are common among airlines, particularly when an airline enters a new market and offers an attractive price to gain a foothold. Other airlines serving the market usually meet or beat the new airline’s fare.
Price wars are most common with oligopolies. An oligopoly is a market structure with a few companies that dominate their market. Prices in oligopolies are normally sticky. Companies operating in an oligopoly fear lowering their price and inciting a price war, but they also hesitate raising their price because customers can purchase a substitute from a competitor.
Who wins when there is a price war? Initially consumers win. In the long-run consumers may lose if prices fall far and long enough to drive competitors out of business. In this case, the winner is the surviving firm who gains monopoly power. Ultimately, consumers lose because the dominant company could increase prices above their initial level. This behavior is illegal if the company instigated a price war with the intent of driving its competition out of business. This is predatory pricing. Predatory pricing begins when management knows that it can endure a price war longer than its competition, and it is willing to sustain short-term losses to gain monopoly power.
Most price wars do not result from predatory pricing. For example, it is not illegal for a company to reduce its prices because it is a more efficient producer or has negotiated a better contract with its supplier. Competitors may respond by cutting their prices, thereby starting a price war. Inefficient producers may be forced to exit the industry, but not because of any illegal activity by the more efficient company. Predatory pricing is very difficult to prove because the prosecution must prove intent. In the United States, The Federal Trade Commission is responsible for prosecuting predatory pricing cases. It has never successfully prosecuted a company for predatory pricing.
Price competition in oligopolies may result in a price war where all companies lose, so the management of an oligopoly prefers to avoid competing in price. Instead they compete in other ways such as product differentiation and improving efficiency.
Dig Deeper With These Free Lessons:
Market Structure Part II - Monopolistic Competition and Oligopoly
Market Structure Part I - Perfect Competition and Monopoly
Supply and Demand - Consumers and Producers Reach Agreement
Changes in Demand - When Consumer Tastes Change