In the spring of 1992, the airline industry was in dismal shape, debilitated by the recently ended recession and an overreliance on discounting. So American Airlines announced a new “value pricing” plan, which entailed cutting fares while replacing complex discounts with a simple, four-tier price system. It assumed that its competitors would follow suit, stabilizing prices in the industry. Instead, T.W.A. and USAir announced even bigger fare cuts, which American matched and, in some cases, surpassed. The other major carriers had no choice but to go along, and the industry found itself in the middle of a full-fledged price war. In a matter of months, the airlines collectively lost four billion dollars.
That was, as one business professor put it, “the mother of all pricing battles.” But at bottom it was just like other price wars: all the companies involved got hurt. So you might wonder why Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. Wal-Mart began by marking down the prices of ten best-sellers—including the new Stephen King and the upcoming Sarah Palin—to ten bucks. When Amazon, predictably, matched that price, Wal-Mart went to nine dollars, and, when Amazon matched again, Wal-Mart went to $8.99, at which point Amazon rested. (Target, too, jumped in, leading Wal-Mart to drop to $8.98.) Since wholesale book prices are traditionally around fifty per cent off the cover price, and these books are now marked down sixty per cent or more, Amazon and Wal-Mart are surely losing money every time they sell one of the discounted titles. The more they sell, the less they make. That doesn’t sound like good business.
It’s easy to see how price wars get started. In industries where a lot of competitors are selling the same product—mangoes, gasoline, DVD players—price is the easiest way to distinguish yourself. The hope is that if you cut prices enough you can increase your market share, and even your profits. But this works only if your competitors won’t, or can’t, follow suit. More likely, they’ll cut prices, too, and you’ll end up selling the same share of mangoes, only at a lower price. From a game-theory perspective, price wars are usually negative-sum games: everyone loses. A recent study found that, if competitors do match price cuts, industry profits can get cut almost in half.
The best way to win a price war, then, is not to play in the first place. Instead, you can compete in other areas: customer service or quality. Or you can collude with your putative competitors: that’s why cartels like OPEC exist. Or—since overt collusion is usually illegal—you can employ subtler tactics (which economists call “signalling”), like making public statements about the importance of “stable pricing.” The idea is to let your competitors know that you’re not eager to slash prices—but that, if a price war does start, you’ll fight to the bitter end. One way to establish that peace-preserving threat of mutual assured destruction is to commit yourself beforehand, which helps explain why so many retailers promise to match any competitor’s advertised price. Consumers view these guarantees as conducive to lower prices. But in fact offering a price-matching guarantee should make it less likely that competitors will slash prices, since they know that any cuts they make will immediately be matched. It’s the retail version of the doomsday machine.
These tactics and deterrents don’t always work, though, which is why price wars keep breaking out. Sometimes it’s rational: when a company is genuinely more efficient than its competitors, lowering prices is usually a smart move. (That’s how competition is supposed to work.) More often, price wars are reckless gambles. In crowded markets, smaller competitors sometimes figure—wrongly—that they can cut prices and win extra business without the bigger players’ noticing. Also, many executives are obsessed with market share, even at the expense of profit, and slashing prices will often win customers in the short run. Hubris, too, plays a role: executives tend to believe that their competitors will crack first. Such price wars are like games of chicken, and typically end just as badly.
Amazon and Wal-Mart hardly seem reckless, though. So why did they go to war? The answer is that they didn’t, really. Sure, Wal-Mart is making a statement that it’s a player in the online world, but the real goal of this conflict isn’t to lure readers away from Amazon, and it isn’t to get people to buy one of those ten books. It’s to lure them online, away from big booksellers and other retailers, and then sell them other stuff. Usually, price wars wreak havoc because they erode the pricing power of an entire business. But, because this price war involves just ten items, its impact on revenue will be small, and outweighed by the positive effects of all the publicity. (It has garnered publicity because it involves books. A big banana price war has been raging in Britain, but you probably haven’t heard about it.) It’s textbook loss-leader economics.
Outraged book publishers and booksellers are making exaggerated claims about how the discounts will devalue books and wreck the industry. But they’re right about one thing. The real competition in this price war is not between Wal-Mart and Amazon but between those behemoths and everyone else—and the damage everyone else is incurring is deliberate, not collateral. Wal-Mart and Amazon have figured out how to fight a price war and win: make sure someone else takes the blows. ♦
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