T

58

SMART Pmcmo

high-tech the transaction, there's no escaping the law of the free

lunch. As Peter Drucker once said that prot is the price of survivat
5
.
. _ wings
.
_ For by 50me0ne.5
booner
or later,
all those ClllCl\E1'!
must be paid
eer.

_ The A1: of Price Wars

Endnotes
lH I Varian
'
,.
2
on How the Web Challenges Managers, .. Mclunsey
Quarterly, jun,

l
>
l

Alexa.com, September 24, 2009

Sun Tzu, The Art of War

Qua.ntcast.com, September 26, 2009,

in

35F"). Gwenda, Fi hti

F t

Piiblnhmiveeklytitify20035 an

. I

d F

'

"'

gum wllPd the '3lPlW1t----

--

lbid.
'\"'5l<)- Ed The Idaho Business Itetzicw, "Cheesy: What can the Boise cheesecake
Factory Teach You About Marketing Strategy? Plenty" (December 25 0005)
all
R
"U13,-9

"T0 ght and conquer all your battles is not supreme excellence; supreme excellence consists in breaking the enemy's
resistance withoutghting. "

'
. -- Hey There, Want Some
.
Tampa Tribune
Business
News,
Free Gas?"

5h=""P="i=Y- Maw. and Ariely. Zero as a Special Price The Tme Value or Free
Products, Marketing Science (November 2007); 745_
lIbid., 757.

American marketing experts usually see price wars as a strategy of

last resorta choice for the truly desperate or the deeply crazed.
The price war is regarded as a lcincl of nuclear option, a quick way to
not only destroy the competition, but also blow yourself upand
maybe even ruin the protability of your industry Forever. From the
Pe0pleExpress airfare wars of the 19805 to various price-slashing
schemes by mindless dotcoms in the late 19905, plenty of evidence
seems to support the conventional wisdom. As an old Fortune magazine article put it, "What are price wars good for? Absolutely noth-

ing."2 Faced with the possibility of a price war, most experts have long

"How about Free? The Price Point Tl t I T

Knowledge@Wharton (March 4,2009). la

'

I d

'

..

S ummg n usmes on The" Heads

"R" h,lF]l;ell:1I:lfl:y ghigggglfree

'
V
.. New Y0,-1;
Software, Microsoft
Looks to iahool,
Ibid.
l4"How about Free? The Price
.
. That Is Tuming
_
_ on Their Heads"
Point
Industnes

agreed that the best response is to just say N0: The best way to
escape a damaging price war is not to jump into the fray at all."3

But somebody Forgot to send the manual to the world's fastestgrowing industrial power. During the past 15 years, hundreds of rms
in China have fought large-scale price wars in a wide range of indus-

Kno\vledge@\Vharton, (March 4, 2009),

tries, including consumer electronics, home appliances, personal

'5Tossed by a Gale The Economist, (May 14, 2009).

computers, mobile phones, telecommunications equipment, airlines,

and, most recently, automobiles. Certainly, some campaigns have

is -

..
. .
0;;>\\'cb
Sites For-Prot Approach to World News" New York Times,

gone badly, as a Western observer would have predicted. However, a

"\Vorldp0st.com marketing materials.
59

60

SMART PRICING

CHAPTER 3 ~ THE Arrr or PRICE \\,\ns

5"P*'l5l"E "umber Oi Companies have thrived despite aggressive

plays in which they dropped their prices by as much as 50%. In some
cases, companies have even advanced all the way from being one of a
number of players in their own province to the world leader in a particular category, largely on the strength of a sustained campaign of

61

First, simply For cultural reasons, the Chinese may be more open
to price wars than Westem businesses. The Chinese tend to think ol'
business competition in military tenns. No one should be surprised
that rms in a country where executives routinely draw strategic
inspirations from Sun Tzu's ancient classic The Art of War might have
a different perspective on price wars. Executives in China commonly
talk about the business arena as the "battleground," and they aren't

price wars.

Its easy to dismiss their successes as the outcome of a kind of

blind, Darwinian scramble in which a few lucky companies survived;
It is possible to win at Russian roulette, tooat least for a few rounds.
But that isnt whats happened. A closer look reveals that these companies knew exactly what they were doing. In fact, over the past 15
years, Chinese companies have reinvented the price war, transforming what had been a tactic of last resort into an art.

speaking metaphorically: The very word for strategy in Chinese,

zhanlue, means battle plans" or "combat strategies."

This mental link between business and war is not just a habit of
the executive suite. The popular press has made heroes of some of
the generals who have won price wars and given extensive coverage
to some of their more celebrated battles. Make a keyword search of
price war" in one Chinese newspaper database, and you'll find more
than 13,000 articles on the subject in the past decade, many of which
characterize the executives who initiated the price war as courageous,
decisive generals.

Why Chinese Businesses Like Price Wars

Despite the fact that Cliinese-led price wars have becnme 3

familiar terror to Vvestern marketers, many practitioners and pricing

However, the main reason Chinese marketing strategists wage

experts are still genuinely puzzled as to why Chinese businesses like

to play such a dangerous game. "Why cant they just lo\ver the price
by 10% or even 20%?" many Western marketers moan. That way,
they could keep their damned price advantage and do much better
for themselves, ton,"

price wars doesnt have anything to do with Sun Tzu or glory on the

IFS 11 good question, but few marketing scholars have looked

seriously for an answer. Westem academics journalists and executives have all tended to see the Chinese-led price wars not as the

out competition and build a commanding market share in a short

period of time:

marketing "battlefield." Its because so many Chinese companies

have learned that, when faced with either a broad eld of young, hungry competitors in their home province or well-entrenched, betterlinanced competitors abroad, a price war can be a great way to shake

Q In 1995, IBM, Compaq, and HP were the three best-selling PC

brands in China, and they all looked invincible. Three years
later, the top live PC brands in China were all locals who had
fought their way up through price wars.

outcome of a deliberate strategy, but as the invisible hand of the

market at \vorkthe inevitable result of low-cost goods flooding a
hlgh-priced market, a phenomenon BusinessWcek once called "the
three scariest words in U.S. industry: the China price. Although
it's easy for a Westerner to look at shelf after shelf of lo\v-priced
Chinese goods and see value mindlessly destroyed, the truth is very
different.

'

~ In 1999, something similar began to happen to the mobile phone

business. Motorola, Nolcia, and other foreign brands dominated
Chinas mobile phone market whereas local brands held less
than 5% of the market. Four years later, after a series of intense
price wars, the local brands held more than 50% of the market.

62

SMART Parcmc

" I? 5?-1905: Chlely, 8 local automobile company with only 10 years

0 lstryy; launched several rounds of price wars and beat
many g 0 a players to take the fourth-biggest market share in
China Now Cher) might be preparing for a similar assault on
the U.S. market.
How much of this success should we ascribe to strategy and how
much to luck and pluck? A close look at two early price wars that took
place in China in the l990srst among color television builders and
second among microwave oven manufacturerssuggest5 that luck
has had little to do with the price wan"iors' success. If Chinese companies are crazy when it comes to pricing, theyre crazy like a for;

Color TVs
In early 1996, China's color TV industry was highly fragmented,
The country had 130 manufacturers. Most sold fewer than 120,000
units a year. Only 12 had annual sales of more than half a million
units, and 4 of the 12 had annual sales of more than 1 million units. As
a result, most manufacturers operated inefficiently and few could
take advantage of economies of scale. However, the competitors all
slogged along because local governments owned a vast majority of
these companies and protected them within their local markets.
For ambitious TV company CEOs, this local support made the
game both harder to lose and harder to winha_rder to loge because
ofprotection at home, but harder to win because the competition was

Cuarran 3 ~ Tr-IE Am" or Pruca Waas

63

domestic products was comparable to that of foreign brands, local

brands generally competed with one another in the low-end market.
People who owned an import seldom considered local brands.
Local TV manufacturers were also beginning to feel squeezed. In

late 1995, despite provincial support and protection, large-scale smuggling of color TVs from abroad had begun to drag down prices. To
make matters worse, import tariffs were slated to go down in 1996 from
60% to 50% for small-screen color TVs and from 65% to 50% for largescreen color TVs. Foreign manufacturers, lured by the sheer size of the
market, were making huge investments inside China: All 10 of the
w0rlds largest TV manufacturers were rapidly expanding their local
producon. Analysts estimated that in two years time, if the global
manufacturers attained their announcements, capacity would grow to
10 million units. Experienced and well financed, these newcomers
were expected to flood the market with high-quality goods produced by
cheap domestic labor and drive out the local brands. One large global
color TV manufacturer predicted that in three years time, it would
destroy Changhong, the largest local competitor.
But Changhong had other plans.
With 1'7 production lines concentrated in one place, Changhong
ran the largest and most efficient color TV factory in China. Its capacity at that time was at least double that of the second-largest Chinese
manufacturer. Changhong was also the largest manufacturer of many
key TV components, such as plastic injections, electronic parts, and

also protected. Boxed in, TV manufacturers couldn't create greater

scale economies either by entering other regional markets or by seek-

remote controls. As a highly vertically integrated company located in

Sichuan, one of China's less developed regions, Chanegliong also

ing mergers and acquisitions.

enjoyed huge cost advantages and earned the highest prot margin of
all domestic color TVs. The net prot margins for Changhong stood
at nearly 20%, far ahead of most domestic rivals.

The potential for upward mobility to higher-end sales was also

blocked. At the time, China's color TV market had two tiers. Foreign

brands served the upper segment of the market and enjoyed 3 20%
price premium over local brands. Despite that premium, foreign
brands-]apanese brands, in particularstill held a dominant position in China, especially in urban markets. Although the quality of

Despite being the strongest domestic TV manufacturer, Changhong was far from complacent. Changhongs CEO, Ni Runfeng,
spent several months in late 1995 and early 1996 weighing alternative
strategies to increase the company's market share. The top executives

64

SMART Prncmc

at the company, including Ni, talked with a number of pricing

experts, carried out marketing surveys in various regions, and closely
examined the survey data. Through these interviews, surveys, and
analyses, they collectively came to a conclusion that would startle
most Western marketers: They needed to launch a price war.
_

more temporary nature. In early 1996, Changhong had an inventory

billion RMB. Changl1ong's efficiency suffered because of the huge
inventory. However, this ready supply of a large quantity of color TVs

other domestic competitor to ramp up its production if demand

surged as expected. As the largest domestic color TV manufacturer,
Changhong had built a very close relationship with key component
suppliers in the color TV industry. After it launched the war, Changhong could still count on reliable supplies of key components for its
production. This was especially true for color TV kinescopes, a key

enough increase in sales to offset their lost profit, ceding Changhong

would never even have the chance to respond.

Changhong had other reasons for confidence. It was the first
color TV manufacturer to be listed on China's stock market. It
enjoyed a high level of brand awareness and a high-quality image
among domestic brands. It also had a lower cost structure compared
to the local competition. Changhong had other advantages, too, of a

provided the ammunition Changhong would need to initiate a price

war to boost sales volume.
At that moment, Changhong was also better prepared than any

A signicant price cut would also put premium-price foreign

competitors in a bind. If they stayed out of the fray, Changhong
would gain market share. If they fought back, they would leave a lot
of money on the table from their loyal high-end customers without

decision-likely a lengthy processmany of the foreign companies

65

of around one million units, with a total estimated value exceeding 2

As risky as it sounds to Western ears, the logic was compelling.

Domestically, a price war would put the small, inefficient domestic
TV manufacturers between a rock and a hard place: They could
either cut their price and suffer a significant loss of margin or maintain their price and suffer a signicant loss of volume. In either case,
they would have to struggle mightily to survive. Changhongs timing
was also good because the rules of the game just changed. Beijing
now was pushing the local governments that had previously backed
these small players to tighten their scal policies. Provincial enthusiasm for propping up their local heroes would become even weal-(er if
Changhong could inflict quick and costly damage.

a cost advantage. Third, they would risk eroding their brand equity
and undermining their brand image as a premium product. This was
assuming the foreign giants even had time to decide whether to parry
the blow. Changhong believed that, given their pricing structure and
the need to get their home offices to approve such a major strategic

Cmrrsn 3 - Tm-1 Arrr or Prue:-: Wins

component for color TVs, which were ooding the market at that
moment. Eight local kinescope manufacturers in early 1996 had a
combined 1.25 million units of inventory according to one estimate,
and Changhong could tap a significant number of those units as it
ramped up production.
Finally, in early 1996, Chinas color TV sales were on the verge of
taking off. With a significant drop in the price of color TVs, the industry demand could expand significantly, and Changhong would be
well-positioned to capture a major chunk of that new demand.
After careful analysis, Changhong executives concluded that it
didn't need a huge price cut for a price war to he effective. A 10% cut

l
l

would enlarge its price advantage against foreign brands Ep about 30%
(before the price war, the price gap between local and foreign brands
was around 20%) and put many domestic rivals in the red. The price cut
was also affordable for Changhong, given its prewar 20% profit margin.
On M arch 26, 1996, Changhong fired the first shot, announcing a
price reduction of 8%l8% for all its 17- to 29-inch color TVs, leading to price reductions ranging from 1,000 to 850 RMB.
The price war evolved mostly as Changhong had expected. All
domestic TV manufacturers, especially the small ones, were Shocked

66

Samar Pmcrxc

and angered by Changhongs price reduction. However, they reacted

with hesitation. Initially, most local players decided to stay out of the
fray. Most had been caught by surprise, as intended. They were not
prepared for the price cut and were unsure how to respond. Many
also underestimated the possible impact of a price war because different brands dominated different regions. Others, mostly stateowned enterprises (SOEs) such as Panda and SVA, had high costs per
unit and a thin prot margin. They could not match an 8%18%
price cut. None of the four biggest domestic players (Konka, Panda,
SVA, and Peony) followed suit until June 6, 1996, when Konlta
announced a price cut of up to 20%. Panda and Peony pinned their
hope on government intervention instead, to stop Changhongs "reckless" pricing behavior. Panda's executives were also distracted with
preparations for the company's initial public offering in Hong Kong

in May 1996.
Foreign brands also responded to Changhong's price reduction as
Changhong had predicted. Two of the leaders, Sony and Panasonic,
decided to take the high road: They would focus on quality and functionality, not on price. Maybe this would have worked in a mature
market where their brand names were established, but in fastchanging China, it tumed out to be the wrong call.
Some domestic manufacturers reacted more thoughtfully to
Changhongls price cut. TCL, a medium-size TV manufacturer at that
time, was the first. On April 1, it announced a price cut of
120300BMB. Xiahua, another medium-size player, announced a
price cut of 10%. However, because of the capacity constraint and the
shortage of key components, most of Changhongs rivals could cut
prices for small TVs only.
Finally, as an added bonus, Changhongs decision to initiate the
price war generated a barrage of publicity throughout the country,
which had a very positive impact on its sales.

A few months into the price war, Changhongs overall market share
increased from 16.68% to 31.64%, with its share in the 25-inch marl-cet

Cnarrea 3 - THE .-\F.T or Pmca \\ ans

57

jumpin from 20.76% to 45.25%, and its share in the 29-inch market
increasiong from 14.37% to 17.15%. Big domestic manufacturers that
did not try to match Changhong saw their market shares dwindle.
Panda's market share dropped from 7.6% to 5.8%, and SVA's market
share dropped from 5.5% to 2.6%. The more nimble benefited 501116
medium-size local players, particularly TCL and Xiahua, that followed
5ui|; quickly with their own price cuts increased their market share by
more than 2%. At the same time, the scores of all small domestic players lthose with annual sales of less than 200,000 l""lll5l 5'-lffered In the
rst quarter of 1996, China's 100 largest department stores carried 59
local brands. By April, this number dropped to 42, while the small
players combined market share dropped m0I'6 1111" 15%Foreign brands suffered as well. Before the price war, imports and
joint venture Products accounted for 64% of the market. By the end of
1996, the market share of domestic products had grown from 35% t0
almost 60%. By 1997, 8 of the top 10 best-selling TV brands; 1n Clhmazi
were Chinese. The top three color TV brands belonged to t tree 00
phye,-5, Q1-;;mghQng_ Konka, and TCL, with market shares of 35%;
15%, and 10% respectively Only two foreign brands, Panasonic an
Philips, remained in the top ten, each with only 0% of the market.
Not surprisingly, the media made CEO Ni a national hero, a sort
of General Patton in a business suit.

The Microwave Oven Industry

The Experience of Calanz, a microwave oven manufacturer, also

suggests that Chinese price wars are won by the savvy. 110i ll? lul<)L555 than 0% of Chinese urban households owned microwave
ovens in 1995. A microwave oven was a luxury item. and the total mt
sales in that year were about one million. The prot margin were V67)
high for manufacturers at the time (30%-40%) and attracleclan ';";
ible number of new entrants to the industry. Between 1990 F111 1
alone, the number of microwave oven producers grew from 28 to 115-

68

SMART PRICING

Calanz had entered the microwave oven business in 199:2. By

1994, the company had built a market share of 10%, about 100,000
units at that time. By 1995, the Guangdong company had won a market share of 25%, as shown in Table 3.1. Galanz had become a formidable competitor through a recruitment strategy that drew talent
from all over China. It had purchased an advanced production line
from ]apan and was now well equipped to respond quickly to market
changes and other new Opportunities,
TABLE 3.1

Ga|anzs Sales Information for 1995-2003

Year

Sales Volume

fin *0oo)

Crwrren J - Tue Am" or Palcz Wans

69

it encountered many problems in its varied China operations and

could not pay sufficient attention to W-X. In addition, Whirlpool's
head office in China, then its Asia-Pacic office, and finally its U.S.
headquarters each had to ratify N-X's key decisions, a process that
often took three months.

Despite the perceived advantages, executives at Calanz did not

take the plunge until August 1996. Senior executives had long and

heated debates on the risks and benefits of launching a price war. The
majority of senior managers at the time opposed the price war strat-

Ln:-111 Market

]|1t]Mm-keg

egy and preferred a safer strategy of maintaining the current high

Sham

Share

profit margins. In the end, the CEO made the call: He sided with the

1995

200

25.1%

1996

650

34.5%

1997

2,000

47.6%

1998

4,000

61.4%

15%

niflcant number of Chinese households were ready to modemize

I999

6,000

67.1%

20%

2000

10,000

76.0%

30%

200 1

12,000

70.0%

35%

2002

13.000

70.0%

40%

2003

16,000

68.0%

44%

their kitchens with the purchase of a microwave oven, along with

other appliances. Strategists at Galenz realized that its focus on highend households and high margins today could preclude the companys espansion into that vast new market tomorrow. They estimated
that significant price reductions could increase sales by about 100%.

minority and ordered his team to prepare for war.

Although the company was certainly on a healthy growth trajec-

tory, C-alanz made the decision for a number of reasons. First, a sig-

The company's major competitor in 1996 was \\'hirIpQQl_Xian[ma

(WX), a joint venture formed in May 1995 between Whirlpool and
Xinhua, a sizable Chinese manufacturer. Whirlpool held the majority

interest. In early 1996, Calanz and W-X each owned about 25% of the
market--.l1are in the microwave oven market, far more than the other
small manufacturers. However, relative to \V-X, Calanz had 3 clemadvantage: It was a more focused company with a streamlined decision-making process. Whirlpool, by contrast, was new to the Chinese
market (it entered in late 1994) and still learning the ropes. It had
four joint ventures in four different cities with four different Chinese
partners in four different product categories (microwave ovens, air
conditioners, refrigerators, and washing machines). Understandably,

Second, as one of the largest manufacturers in China, Calanz

saw an opportunity to reorganize the industry for sustainable future
growth. Yu Yaochang, the vice president of Galanz, recalls that one

of the purposes of the rst price war was to consolidate the industry
by marginalizing small, inefficient players before they had a chance
to grow and also to discourage even more new entrants; Maintaining
a high profit margin strategy, on the other hand, would encourage
even more new entries and hide inefficiencies going forward.
Third, and perhaps most important, a well-planned and executed
price war could help Calanz establish its cost advantages in the marketplace. Besides winning Calanz a greater market share, a substantial increase in the company's sales could reduce its unit cost through

70

SMART Prnczmc

CHAPTER :1 ' THE ART OF PRICE IVARS

scale economies in production, distribution, and components sourcing, which would make the price cut protable. But the company
needed to make sure that the increased efficiencies would outpace
the price cut and increase its total protability. Galanz believed that it
had a chance to do this if it was deliberate and meticulous in planning
and executing the price war.

increased after the price cut. Even for products in which the magnitude of the price cut was bigger than the company's initial prot margin, Galanz still profited because of cost reductions. By the end of

1996, Galanz's market share had increased from 25% to 34.5%.

The huge success of the rst price war convinced the executives
F

Two months before launching the campaign, Galanz began to run

its production lines on a three-shift, 24-hour-a-day schedule so that it
had ample inventory to meet the expected surge in demand. Galanz
picked August to start the price war because it was the off-peak 59]]ing season. Manufacturers generally cut back their production and
distribution about that time. Starting a price war at that sleepy time of
year would catch their competitors off guard.

In August 1996, Galanz announced a steep price reduction of

40% on some of its key models and an average price reduction of
20.1%. All major Chinese media reported the news of Galanzs opening salvo. Retailers embraced the price war with open arms because it
could help them build store traffic and sell more of their other products. In many cases, they were even willing to take lower prot margins, 8% instead of the usual 20%, on Calanz products during the
price-war period, to boost traffic even further.
Competitors were caught unprepared and dazed.
In :1 number of cases, Calanz's price-reduction levels on some
products were higher than their own gross prot margins. Most of the
small manufacturers did not respond quickly because they believed
that Calanz was simply dumping excess inventory in a low selling season. As expected, W-X was also slow on the draw.
The outcome of the rst price war could not have been more positive for Calanz. Before the price war, Calanz's gross prot margins
were close to 40%. After the price war, sales had increased by about
200%, and the average unit cost shrank approvimately 50%. The combined gain in scale and share meant that Galanzs net prots actually

71

at Galanz that a deliberate price war was a viable strategy, not only in
the short term, but also for the long run. From October 1997 to October 2000, C-alanz initiated four more price wars and executed them
with increasing sophistication. In each round, Calanz cut its prices

substantiallyby double-digit percentages (still up to 40% in some

cases). The sales increases were also substantial, at 100%-200%. As a
result, the company became more and more dominant (see Table
3.1}. In each round of price wars, Calanz achieved an average unit

cost reduction of about 30%-40%, making the price war essentially

"free," even in per unit terms. Because of those victories, the Chinese

media treated Calanz as an ever-victorious army and its executives as

conquering generals.
The numbers might look random, but the generals were actually

dropping their prices with surgical precision, to inict the maximum

damage on their competitors. Since the rst price war. Galanz had
adopted a simple and systematic way to set its price to drive volumes.
Before the price war, it had always set its price at the break-even
point of its nearest competitor. For example, if the second player's
annual sales were 2 million units, Calanz would set its pdce at the
break-even level for those 2 million units. During a price war, Calanz
would lower its price below the opponents break-even point, which
was still above its own break-even price. Using this strategy, Galanz
always kept its strongest rivals reluctant to cut prices, while picking
up market share from the weakest fish. The strategy succeeded brilliantly. About 120 microwave oven manufacturers were in the market
in 1996. By 2003, the three largest manufacturers dominated more
than 90% of the market.

.5.
7
r

72

Srrxrrr Pnrcmc

\.

Breaking Out By Breaking Even

CHAPTER 3 - THE AM or Pmcr-; Warts

73

war was the rational thing to doand looked positively brilliant afterward, when sales actually rose by 200%.

Price wars aren't always a winning strategy. Even in China, firms

sometimes initiate price \vars on impulse and bring ruin on them-

The whole art of price war is implicit in the IBEA. The formula in

selves and their industry, just as American marketing textbooks wam.

Figure 3.1 illustrates that it is more tempting for a company to initiate

However, these cases demonstrate that price wars can be a potent,

effective marketing strategy when deployed with forethought and skill
and under the right circumstances.

,1

a price war, a deep price cut, if it faces a small Aq, the threshold
increase in sales required for a rm to prot from the price cut. With
a small Aq, it does not take much sales increase for a company to

jump over the hurdle and benet from a price cut. Therefore, the

company should have more incentive to use price as a weapon and to

What constitutes the right circumstances? The calculations that

executives at Calanz and Changhong made t into a simple framework Westem executives are familiar with in a different context:
incremental break-even analysis (IBEA)a simple equation used to
set prices that also contains almost everything an executive needs to
know to plan, execute, and ght a price war.

initiate a price war. This means that if \ve look for industries where Aq

is small we know where a price war is more likely to break out and

which firms have the most incentive to initiate it.

A

A price war always starts with a firm initiating a deep price cut in
an industry, as Changhong (lll'.l with color TVs and Calanz did with
microwaves. When a firm initiates such a price cut, it expects to benet from higher volume, either right a\vay or at some point in the
future. In the short term, the firm can benet only if its sales go up
sufficiently to offset the lost prot per unit. That's where IBEA comes
in handyit identifies how much sales need to increase to make up

Ap-(l-cm)Ac

q _ cm-AP + ( 1-cm)Ac
Denitions:
Aq Breakeven sales increase in percentage
Ap Magnitude ol a price cut
cm Contribution margin in percentage (before the price cut)

A c Reduction in marginal costs in percentage due to the pnca cut

Figure 3.1

Incremental break-even analysis

for the contribution margin sacrificed by the price cut.

IBEA analysis exposes an important truth about who leads price
wars. Although price wars are often thought of as an underdog strat-

The Calanz case is a good illustration. While planning for the rst
price war, Galanz reduced its product price by as much as 40%. At

egythe marketing equivalent of the Hail Mary passthe strategy is

the time, the company had a contribution margin (cm) of about 40%,
or cm = 40%. The company forecast that the price cut could generate
enough volume to achieve unit cost savings (Ac ) of 30%40%, or on
average Ac = 35%. By plugging all these numbers into the formula,
its clear that if the sales of Calanzs products increased by more than
90.5% as a result of the 40% price cut, its prot would be higher after
the price cut than before. Here, Aq = 90.5% is the threshold increase
in sales required for Galanz to prot from the 40% price cut. Galanz
expected its sales to increase by 100%. Therefore, initiating the price

actually most effective when the most efficient compejitor in a high-

margin industry executes it. If the initial prot margin is high, only a

t
l

small increase in sales is needed for a rm to benet from a price cut.

This explains why the rst price wars were color TVs and microwave
ovens and why all subsequent price wars in China happened in what
were initially high-margin industries such as consumer electronics,
home appliances, personal computers, mobile phones, telecommuni-

cations equipment, cable TV, and automobiles. It also explains why

Chinese companies tend to start price wars when they enter \-Vestern

l
r

74

Sm/tar Pnrcmc

CHAHER 3 - Tue Am or PRICE Warts

75

markets. With their cost advantages and favorable exchange rate,

every business in the West looks like a high-margin business!

twice. For that reason, we rarely see rms with a dominant market

The formula also claries the role scale plays in price wars. As the
reduction in marginal costs (Ac in the fonnula) gets bigger, the percentage in added sales required to break even (Aq) declines, This
means that price wars are more likely to break out in industries with
signicant scale economies. The industries in China that have been
plagued by price wars all have signicant scale economies. Even in
the West, price wars are up in industries with significant scale
economies, such as PCs, electronics, and airlines.

Tlre timing is also critical. A rm has a better chance to increase

its market share if the competition is unable or unwilling to react
swiftly. A clumsy, half-hearted response from the competition gives
the war-initiating rm the time and space to ll distribution channels
and to occupy new sales territories. As discussed earlier, both Changhong and Calanz carefully considered competitive reactions and the
most opportune time to fire the first shot.

share start a price war.

Third, even if competitors react swiftly by bringing down their

own prices, an astute rm can increase its market share if it is prepared. As competing firms lower their prices, the rms that gain
market share will be the ones that have products on hand to sell. A
rm that has prepared for a price warby increasing its inventories,

A larger reduction in marginal costs (Ac) decreases the breakeven point (Aq), suggesting that the rm that is more skillful in taking
advantage of its scale is most likely to be the one that initiates a price
war, all else being equal. Both Changhong and Calanz were rms that
consciously and skillfully exploited scale economies to their own benefit. Price wars are also more likely in industries with little product
differentiation. In a highly differentiated industry, customers would
require a huge incentive to switch from one nn to another, resulting
in a higher break-even hurdle in most cases. In China, price wars
almost always break out when products in the industry become stan-

ramping up its production, cornering strategic resources, secunng

distribution channels, or boosting its production capabilitieswill
be best positioned to increase its market share. Changhong and
Calanz both made elaborate preparations in all H1058 ti\illl95
before they fired their rst shot, while competitors were caught
napping.

dardized, leaving little room for further technology innovations and

Fourth, a firm can gain a larger market share when less cost-

quality improvements.

effective rms in an industry are weeded out. A price war strains every
firm in an industry. When less efficient rms buckle rst, the survivors
fatten their market shares. Clearly, this factor was crucial to Changhong
and Calanz, who made explicit calculations to consolidate their respec-

As a rm must generate enough sales increase to offset the perunit loss to benefit from a deep price cut, we can further look into
the art of price \var by examining how a firm can generate the
required sales increase. A rm can cross the threshold sales increase
in three ways, either through a signicant market share increase, a

tive industries and achieved that objective. Looking more broadly, this
motivation has repeatedly surfaced as a cause of war. With the relative
youth of the Chinese market, its many industries, and wide range in
sophistication and operating efficiency, it is not surprising tl1atCl1i
has more price wars than the West.

signicant increase in the industry demandor both. Thus, there are

a number of things that a rm can do here in planning and executing
a price war. First, to the extent that it is easier for a small market
share rm to increase its market share, a rm with a small market

Through many price wars, Chinese executives have also leilmed

share may be better positioned to use price as a weapon and to initiate a price war, while a big market share rm may want to think

that to weed out rms that are not cost-efficient, they do not necessarily need to fight a prolonged, bloody campaign. A shock and awe"

'76

Samar Pmcmc

C1-i.urn-:n 3 - THE Anr or PRICE Wirns

77

strategy ca quic
' kjy convince
~
~
.
th
inefficient
rivals
to get out of the way if
ey perceive that resistance is either futile or fatal. Both Changhong
and Calan
d
' '
.
_
W
.
This
thls In
Planning and
executmg
their Price
WW5-3
_ exP lafnasonlly elfc-I
nnese
companies
are gung
ho about
charging
pnce 30%-50% lower than competition, instead of a entle
'l~

circumstances often occur in other emerging-market economies-not just China and, not even necessarily in another of the emerging
market giants. A major technological innovation anywhere can lead
to huge gaps in an industry's scale economies everywhere. For exam-

10% 9" 20% l0Wer when they invade a market

man J
' in the W
' esgt .
However,
'
'
even the C cpmpames might have a reason to wage n P;-ice war

toy but is now undercutting the market share of regular telephone

service and even video conference networks.

'
- market share. Another rmpnn
_
Y an u $@ltt01ncrease
their

tam factor m rm,- Price war calculus is the change in aggregate

product demand. When a price war breaks out even if all competing

rms in the m 1< is t at: equally efficient

- and all follow suit. by cutting

their e

es so
,
- fl
a no rm Ca Em" 3") ildtlltlonal market share, rms
ca; still benet from price wars if the action sufficiently expands the
in
the ust
mlykd fmran d_ In (tlhe West, people tend to forget the days when
.
TVS arde s for mun ,"me products such as l'TllCI0\\r3ve
O\,en5_ color
, ill!
re ngera t ors \\ I ere growing

at a fast page and the total

glemand for them was price elastic. In China, consumer goods prouction is
' s til] a high
' - growth business
. high
.
_
with
price
elasticity;
Lower th e pnce
' for a popular consumer good and you can Hood the
market with new consumers,
For th'

'

ls reason m the commg Yea-Y5, as growth levels off, we

expect to observe fewer price wars and more focus on nonpr-ice com
Petl0I1i1t least in China.

Forward, March
Asfaraswec an d etect, there IS- nothing
- intnnsically
- . .
Chinese in
the calculus that Chinese executives use to plan and e
t tl '
_
xecu e reir
price wars. The fact is, Chinese companies compete in an environ
ment charact ' d b v
~
.
_
_
wide d. t _b Ema f l growing mafhcts, heterogeneous firms with a
IS ri u on o cost efficiencies,
~
_ with
_ sig_
I
and new technologies
nicant scale 8C0n0mie5perfet weather for a P rr~ce war. S.l1Tll.1 gr

ple, engineers in tiny Estonia built Skype, which began almost as a

Price wars aren't for everyone. In Western markets, oligopolistic

competition among equals in mature markets encourages more subtle
marketing strategies. However, as with any other strategy, a price war
can be useful in particular circumstances. A company can take a
rational approach to plan and execute a price war when such opportunities arise.
Defenders should not be discouraged either. just as winning a
price war is not an exclusively Chinese talent, losing a price war is not
intrinsically American. High-margin companies faced with the terror
of the "China price" can anticipate what might follow and preempt it.
Such moves can be quite successful. For example, Philip Morris, per-

haps worried that cigarette prices would soon be cut by generic brands
and knowing that Rjfl had low prot margins because of a heavy debt

load from its recent leveraged buyout, cut its prices by 20% in April
1993, effectively neutralizing both its new and old competition for the
near future.

IBEA suggests two broad principles for ghting a price war. First,
as Sun-Tzu put it in his Art of War, the highest realization of warfare
is to attack the enemy's plans" so that one can subjugate "till: enemy's
army without ghting." Translating this to a price strategy, companies
should do two things that discourage a competitor from starting and
benefiting from a price war: increase the hurdle (Aq) competitors
face to discourage them from thinking about price cutting in the rst
place, and differentiate the product enough to make substitution
difficult.