The Price Strategy Simulator

Anatomy of a Price War
Hewlett-Packard / Compaq vs. Dell

Run the Price War Simulation

by Michael Bean
mbean@forio.com

In September 2001, Hewlett-Packard acquired Compaq for around $25 billion in HP stock. Investors hated the idea. Both HP's and Compaq's stock fell about 25% in few days after the announcement, so the deal was quickly valued under $20 billion. The New York Times described the deal as bringing together two struggling computer companies into one giant with twice the problems.

During merger discussions, representatives from both HP and Compaq talked about the $2.5 billion dollar yearly cost savings that would result from the merger.

It surprised me that there was so much money to be saved by combining two huge companies. Even before merging HP and Compaq were each big enough to capture any economies of scale in PC manufacturing. A study by McKinsey showed that up to 40% of mergers fail to capture identified cost synergies. But assuming that they succeeded in saving $2.5 billion, on combined sales of $87 billion, $2.5 billion means they will improve profitability by about 3%. Why all this emphasis on cost savings? Why not talk about revenue growth or new technologies?

The problem faced by HP and Compaq was the same problem faced by Gateway and IBM-that is, Dell Computer. Over the past few years, Dell has created an extraordinary competitive advantage by becoming the most efficient PC manufacturer.

Dell's efficiency comes from two factors. First, they sell directly to their customers so their distribution channels are simple and cheap (no dealer markup). Second, they build-to-order, which keeps inventories low. Low inventories mean that, when Intel drops the price of its processors, Dell doesn't have a lot of the old expensive processors sitting around. Dell can reduce the prices on its computers faster than its competitors because the components that make up those computers are the latest and cheapest. So far, no other PC maker has been able to match Dell's cost structure.

In February 2001, Dell launched a campaign to become the largest competitor in the PC industry. It announced that it was intentionally undercutting competitors' prices by 10% to quickly grab market share. That announcement, along with the well-known fact that Dell has a cost advantage over its competitors, was a signal to the rest of the PC industry that if others tried to match Dell's prices they would be playing a game they couldn't win.

Dell's announcement and strategy is similar to the "low priced guarantee" announcement popular among electronics retailers. A low priced guarantee tells your competitors, "If you try to undercut our prices, we will drop ours even further." Of course, this kind of threat has to be backed up by the ability to actually sustain low prices without going out of business. The ability to sustain low prices is exactly what Dell has and why they are difficult to beat.

From a game theory perspective, the problem is a little like the Prisoner's Dilemma, except that in the classic prisoner's dilemma, each party has the same to lose but, in this game, Dell knows that HP with Compaq has more to lose. A threat by HP and Compaq to match Dell's prices isn't credible because HP and Compaq can't sustain losses forever.

From a game theoretic perspective, HP's and Compaq's dilemma can be represented as a 2 x 2 matrix:

And this game isn't played just once. It's repeated over and over, where the outcome from the last round becomes the status quo for the next round. As long as Dell has a lower cost structure Dell will always win when HP and Compaq compete on price.

Looking at the news after Dell's announcement, you can see how the price war played out. In April 2001, after the February price cuts, Dell became the world's largest PC maker, surpassing Compaq in market share. In May, HP and Compaq responded to Dell with price cuts of their own, throwing all competitors into the lower-right quadrant.

Experience Compaq's and HP's Pain for Yourself

We've created a simple simulation that is tuned to roughly represent Dell, HP and Compaq. In the simulation you play a company that is about the size of HP or Compaq (pre-merger) and your competitor is about the size of Dell. In the game, you compete only on price, the market perceives your computers as being of equal quality. Market demand for computers is price-sensitive.

Your goal is to maximize cumulative profit over six months. Each month, your competitor, who like Dell and has lower manufacturing costs than you, will try to undercut your prices by 10%.

Try playing through the game a couple times. You should discover that you have very little room to maneuver. Either increasing or decreasing prices results in lower cumulative profit over the four quarters

Playing a game you can't win isn't much fun, so we've made it possible to change the rules. You can alter the simulation assumptions, turn yourself into Dell and your competitor into IBM, if you like. You can even alter the assumptions to make the simulation look like your own business.

The Anatomy of a Price War

The difficulty with price wars is that they look deceptively simple: lower prices and sales go up. Simple pricing models look like the diagram on the right.

The problem with this model is that price is a complicated product attribute. Changing prices affects cost per unit sold because fixed costs are spread across all units sold and the number of units sold should increase if prices drop. Also, your competitors are affected by and will respond to your price changes.

Ignoring Feedback

Surprisingly, like the simplistic pricing model, many pricing models ignore feedback. These incomplete models assume that price affects sales once-and-forever and the market immediately reaches equilibrium.

Although each relationship in a competitive pricing system is simple (for example, revenue = our price x sales), the feedback within the system makes determining the optimal strategy difficult (for example, sales = competitor's price / our price x market sensitivity x demand so our revenue = our price x (competitor's price / our price x market sensitivity x demand).

The diagram above shows eight feedback loops. This is only a simple two competitor model. Increasing the number of competitors exponentially increases the dynamic complexity because each competitor has its own strategy and can respond to a strategic change of any other competitor.

How to Win a Price War

The first step to winning a price war is understanding your competitive landscape. Carefully analyze your customers, competitors, and your own company, with special emphasis on cost structures and strategic positioning. Customer analyses can reveal what, besides prices, motivates your customers to buy your product or service. Competitor analyses will help you estimate their pricing limitations and objectives.

Differentiating by factors other than price can reduce the effectiveness of price competition. Introducing new features, or emphasizing non-price features to customers can reduce their prices sensitivity (You can experiment with the effect of emphasizing features in the price strategy simulator by altering your model assumptions on price sensitivity. Try changing price sensitivity to 1 and see what affect that has on Dell's success.)

If the price-competitive products are perceived to be of lower quality than your own brand, consider launching a new, low-priced brand that can compete directly with your low-priced competitor. This allows you to compete effectively with price sensitive customers without damaging the brand of your existing product lines.

Make your strategic intent clear through media announcements. Consistently apply your strategy over time. If you have cost advantages, or other competitive advantages, make sure that your competitors know about them. This makes it clear to your competitors what will happen if they change their prices.

Finally, reward competitors for eliminating discounts by matching with price increases of your own. This will be consistent with a tit-for-tat strategy and it encourages a return to industry profitability.

Often the most sensible approach to winning a price war is to do nothing. This is especially true if your competitor is pricing below total unit cost. A McKinsey study found that optimal prices for incumbents can be as much as 20 percent higher than the ones they actually set. And that study ignores the long-term feedback relationships in prices. If you include feedback in your pricing strategy, the optimal price would be even higher.

There is at least one clear benefit that resulted from the HP and Compaq merger. Both Compaq and HP were in an unwinnable price war with Dell. By merging, at least Compaq and HP stopped competing with each other.