The Race to the Bottom - American Marketing Association

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The Race to the Bottom


	By The McKinsey Quarterly

	1. Introduction

The wrong pricing strategy can destroy corporate value faster than almost any other business mistake. And when industries are about to be deregulated, managers habitually adopt ill-conceived pricing policies that are almost guaranteed to damage their companies and erode services to customers and the community.

These flawed pricing policies—common among deregulating telecommunications, transportation, and utility companies as well as other businesses—represent efforts to hang on to customers. Managers cut prices preemptively to fend off new rivals and then launch full-fledged price wars in hopes of outlasting attackers and emerging victorious from the rubble. This, at any rate, is the hope; the reality is usually quite different.

One example of such pricing behavior comes from the Chilean telecommunications sector, which deregulated in 1994. Before then, Empresa Nacional de Telecomunicaciones (Entel) had been the sole provider of domestic and international long-distance services, but with the coming of deregulation Entel had to compete against seven rivals. At first, hoping to keep its customer base intact, it joined in a price war. By the end of 1994, rates for calls from Chile to the United States had fallen by about 95 percent, and domestic long-distance rates had collapsed similarly (Exhibit 1). Despite the price cuts, Entel lost nearly 70 percent of the domestic long-distance market and more than half of the international one. After 1994 Entel stopped competing on price. Differentiating itself from competitors on the basis of service and broad product offerings, it began charging a premium over the rates of its largest rival. New entrants continued to threaten Entel’s international business, but by the late 1990s the company had recovered some of its domestic long-distance market share.

Germany’s electricity market provides another example. After deregulation, in 1998, some of the country’s largest incumbent utilities cut prices preemptively to dissuade customers from jumping to Yello Strom, an aggressive new competitor. Within two years, the average market price of energy had dropped by about 30 percent. As a result of these price cuts, incumbent suppliers saw their profits tumble—a high price to pay for an attempt to keep the customer base intact. Prices rebounded in 2001 as even attackers complained of low or nonexistent margins. At the year’s start, Yello, for instance, raised its prices by 18 percent, including an energy tax that accounted for three percentage points of the increase.

Lower prices for customers are among the primary goals of most deregulation efforts. Of course, increased competition can indeed prompt former monopolies to search for greater efficiencies, thus reducing costs and, potentially, prices. But if misguided policies spur struggles that bring prices below the level needed to cover costs, neither companies nor consumers win, since the former may be so crippled that they can no longer guarantee basic supplies and services to the latter. And if a price war succeeds in destroying all attackers, a shattered market will be left with little competition.

In most cases, established companies launch price wars believing that once the dust has settled, prices will rise again. But psychologically and politically, it can be far more difficult to orchestrate a price increase than a price cut. Throw a stubborn attacker into the mix, and incumbents can find themselves trapped in unsustainable rate structures. In our analysis, optimal prices for incumbents can be as much as 20 percent higher than those they actually set. Even then, average market prices will likely fall from monopoly levels, and incumbents must be prepared to lose some of their customer base. Nonetheless, if the right factors influence their pricing decisions, they and the market will remain healthier.

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2001 MarketingPower.com Inc. Contents used by permission of The McKinsey Quarterly.

Table of Contents

1.	Introduction
2.	Four Factors
3.	Reasoned Decisions
4.	Using the Factors