In tough economic times, price becomes a much larger factor in purchasing decisions. In a battle for business, price wars develop and customers can benefit greatly. But how do these wars come about?

IN PICTURES: 10 Ways To Cut Your Food Costs

Recent Price Wars
The e-book reader market price war was sparked by new entrants competing with Amazon's Kindle product. The Kindle started at $399 in 2007, and now the Kindle is priced at $139 for the lower-end model. While prices do generally decline quickly in electronics, in this case the price cut is primarily a response to competition from the Barnes and Noble's $149 Nook reader and Sony's $150 Reader Pocket Edition.

In addition, the recently introduced Apple iPad is seen as a potential competitor, although the product is not a dedicated e-book reader and carries a higher price.

In exchange-traded funds, the first shot came from a smaller competitor, the brokerage firm Charles Schwab, which was the first to offer no transaction fees when buying or selling a variety of the firm's ETFs. Previously, investors paid commissions for buying and selling ETFs, just as they did for stocks. Fidelity quickly fired back, striking its own deal with iShares to offer a choice of several no-transaction-fee ETFs for its customers. Vanguard has also moved to offer its ETFs with no transaction fee. (For related reading, take a look at 5 New ETFs You've Never Heard Of.)

What Causes Price Wars
Price wars most often strike industries where there is both heavy competition and several comparable products. Under these conditions, there is a large incentive for a competitor to cut prices in order to gain a greater share of the market. Left unchecked, a price war can spiral into a string of ever-lower price cuts that evaporate profit margins. Firms with fewer financial resources may even be put out of business.

The airline industry is a classic example of an environment for price wars. Air travel is viewed by consumers as a commodity product - transportation from point A to point B. Since the service offerings of different airlines are so similar, consumers look primarily at price when they buy. This has led to virtually continual fare wars in different markets around the world. A widespread fare war in 1992 cost the U.S. airline industry more than $4 billion in just a few months, according to The New Yorker.

Consumers and Price Wars
On the surface, lower prices mean a better deal for consumers. However, in some situations it can work the other way. If a large firm can drive competitors out of business through aggressive price cutting, then consumers are left with fewer choices in the end. The remaining firms gain more pricing power over time, since there is no longer an established set of competitors.

How Firms can Respond
Price wars are almost always bad for firms. When firms have similar cost structures, cutting prices means cutting profit margins. But a price war can be difficult to address. If a competitor undercuts a firm's prices, the firm's most natural response is to match the new low prices. However, this may prompt the competitor to cut prices again, leading to a worse situation.

An article in the Harvard Business Review argues that the best response to a price war is to try to sidestep this type of direct conflict by employing a variety of different strategies. For instance, one possible tactic is to differentiate the firm's product offering from that of the lower cost firm. If a firm can offer a product that is in some way unique or superior, then it will be in a much better position to preserve its pricing power.

The Bottom Line
Healthy competition is good, but overly aggressive price wars can have negative long-term effects for both consumers and firms. There will always be a place for a low-cost leader, but other firms can respond to price challenges more intelligently by differentiating their products and delivering a superior offering to consumers.

Catch up on your financial news; read Water Cooler Finance: The Ups And Downs Of A Double-Dip Recession.

Related Articles
  1. Economics

    Explaining Manufacturer’s Suggested Retail Price

    The manufacturer’s suggested retail price (MSRP) is just what it describes – the price manufacturers recommend that retailers charge for their goods.
  2. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  3. Personal Finance

    What to Collect: Apple Watch vs. Luxury Watches

    The "iWatch" is a new player in the luxury watch world. But will it stand the test of time? Some points for collectors to ponder.
  4. Stock Analysis

    2 Reasons PepsiCo's Snacks Division is Crucial to Its Growth

    Understand the recent trends in the North American snacks market. Learn about the top two reasons why PepsiCo's snack division is crucial to its growth.
  5. Personal Finance

    Alpaca vs. Cashmere: Which Luxe Wool Is the Best?

    Winter is coming. Which of these luxury threads is most worth the price (and how to distinguish true luxe from cheap imitations).
  6. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  7. Investing Basics

    Tiny House Movement: Making Market Opportunities

    The tiny house movement throws all assumptions about household budgeting and mortgage management out the window, and creates new market segments too.
  8. Investing Basics

    A Gluten-Free Makeover For A Supermarket Near You

    The gluten-free diet is changing the food choices of a large number of consumers, and the food industry is taking note and making the needed adjustments.
  9. Mutual Funds & ETFs

    Top 4 Consumer Defensive Mutual Funds

    Discover which mutual funds in the consumer defensive market are top-rated funds, and learn why investors may be drawn to these mutual funds.
  10. Budgeting

    The Psychology Behind Why People Buy Luxury Goods

    Luxury goods are a great example of how irrational we can be; a decent and sturdy handbag can be purchased for $50, yet people will still spend thousands to buy a brand name. Why?
  1. Why did Target's (TGT) expansion into Canada fail so quickly?

    Target (TGT) decided to expand north into Canadian markets in 2011. By 2013, it had built 133 stores across several Canadian ... Read Full Answer >>
  2. What does marginal utility tell us about consumer choice?

    In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction ... Read Full Answer >>
  3. What are some common ways product differentiation is achieved?

    There are many ways to achieve product differentiation, some more common than others. Horizontal Differentiation Horizontal ... Read Full Answer >>
  4. What role does the OEM (original equipment manufacturer) play in the finished product?

    Original equipment manufacturers (OEMs) do not typically play much of direct role in determining the finished product. However, ... Read Full Answer >>
  5. What is the difference between an OEM (original equipment manufacturer) and a VAR ...

    An original equipment manufacturer (OEM) is a company that manufactures a basic product or a component product, such as a ... Read Full Answer >>
  6. Is the retail sector also affected by seasonal factors?

    Generally speaking, the retail sector is highly seasonal. Almost invariably, sales in the retail sector are highest in the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!