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?

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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.

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