Conditions and Consequences of a Price War.
The objective of this essay is to "use economic theory and illustrative examples to outline the circumstances under which a price war could come about and the likely consequences for the participating firms and their consumers". A price war is a period in which multiple firms competing within the same market will react to the other firms lowering of price by lowering their own price. They have short-term and long-term advantages and disadvantages.
There are many reasons for which a price war may occur, in all cases the reason for starting the price war is different but the reason for its continuation is not to lose sales. They are when a firm attempts to maximise capacity, for survival purposes, in oligopoly markets, where there are homogeneous products and when a firm adopts a penetrative pricing strategy.
"Excess capacity refers to a situation where a firm is producing at a lower scale of output than it has been designed for" Excess capacity http://stats.oecd.org/glossary/ detail.asp?ID=3209 [accessed 10th December 2006] If a firm has spare capacity to produce more of a good it is likely they will use this spare capacity to profit maximise but to achieve this they will have to lower prices to increase quantity demanded (see appendix item A). As they have decreased their prices, other competitors will likely drop their prices so as not to loose customers, creating a price war.
Companies who face bankruptcy may try to lower their prices so to attract more consumers and increase sales volume. However, if they cannot manage to increase volume enough to cover the fall in contribution then it will fail to cover its variable costs and will be forced to leave the market. Other firms may recognise that the company is in trouble and in a bid to force the company out the market and not to loose their own customers will drop their prices below that of the company facing bankruptcy.
An oligopoly is where "a small number of firms share a large portion of the market"
There are many reasons for which a price war may occur, in all cases the reason for starting the price war is different but the reason for its continuation is not to lose sales. They are when a firm attempts to maximise capacity, for survival purposes, in oligopoly markets, where there are homogeneous products and when a firm adopts a penetrative pricing strategy.
"Excess capacity refers to a situation where a firm is producing at a lower scale of output than it has been designed for" Excess capacity http://stats.oecd.org/glossary/ detail.asp?ID=3209 [accessed 10th December 2006] If a firm has spare capacity to produce more of a good it is likely they will use this spare capacity to profit maximise but to achieve this they will have to lower prices to increase quantity demanded (see appendix item A). As they have decreased their prices, other competitors will likely drop their prices so as not to loose customers, creating a price war.
Companies who face bankruptcy may try to lower their prices so to attract more consumers and increase sales volume. However, if they cannot manage to increase volume enough to cover the fall in contribution then it will fail to cover its variable costs and will be forced to leave the market. Other firms may recognise that the company is in trouble and in a bid to force the company out the market and not to loose their own customers will drop their prices below that of the company facing bankruptcy.
An oligopoly is where "a small number of firms share a large portion of the market"
References: Excess capacity http://stats.oecd.org/glossary/ detail.asp?ID=3209 [accessed 10th December 2006]•Economics Handbook, David Gray and Peter Clarke•Pricing strategies http://www.tutor2u.net/business/marketing/pricing_strategy_penetration.asp [accessed 10th December 2006]•International Competitiveness (2001) UK Labour GovernmentAppendixItem AAs the firm increases the supply through using the spare capacity, supply curve shifts left from S1 to S2 as a result the market clearing price falls but quantity increases. Shifts in supply curve http://www.auhy69.dsl.pipex.com/images/dd202/b2p.jpg [accessed 10th December 2006]Item BIn this diagram you can see that in an oligopoly market it is unfavourable for the oligopoly firms to change their price, so it becomes static. Price Competition in Oligopoly Market, Foundations of Economics Handbook (2006) David Gray and Peter ClarkeItem CA Movement along the demand curve will increase the quantity demanded but reduce selling price. Demand and Supply www.investopedia.com/university/economics/economics3.asp [accessed 10th December 2006]Item DAs the price is set lower from P1 to P2 through a price war the firm 's profit margins are reduced. Competition (modified) http://www.tutor2u.net/economics/content/topics/competition/competition.htm [accessed 10th December 2006]Item EIf a company fails to cover its variable costs it will leave the mark immediately. Competition http://www.tutor2u.net/economics/content/topics/competition/competition.htm [accessed 10th December 2006]