What’s it: Competitive pricing is a pricing strategy in which firms use competitors or industry averages as benchmarks for pricing. They may charge higher, close, or lower prices than the average competitor. So, companies’ first task is to gather and research information about the prices competitors are charging their products.
Why do companies adopt a competitive pricing
Price is an essential factor for demand. That is why, in economics, price forms the basis of the law of supply and demand.
Customers will definitely pay attention to prices. In a competitive market, they have many options to buy. They may buy the cheapest product or the most expensive product. The purchase decision should have a justification. They buy the most affordable product because it fits their budget. Or, they buy a more expensive product because they want better features.
Benefits, as well as competitiveness, are more measurable. By taking in a few nearby competitors with relatively similar cost structures, firms can decide whether to charge below, at, or above average competitors. From there, the company can calculate how much profit it will get.
Say, the company decided on a lower price. By adopting a similar approach to competitors, lower prices should make products more competitive and attractive to customers.
Likewise, when deciding a higher price, the company should consider adding new features to justify the higher price.
How does competitive pricing work
Because it uses competitor prices as a benchmark, the company must have price information. They shouldn’t just make a price list and get information related to the product itself (be it about quality or features). It provides them more in-depth insight into the reasons why competitors charge relatively high or low prices and why consumers like them (or not).
From there, the company then chooses a strategic price point. I mean, companies determine the price at which they get the best advantage based on considerations of their product relative to the competition.
Factors to consider when adopting competitive pricing method
The competitive pricing strategy approach is often closely related to the overall business position, the competitive position it wants to build. I will discuss some of the considered factors when the company adopts it.
First is the similarity of products and target consumers. Say competitors adopt a differentiation strategy, while a company adopts cost leadership. Differentiation emphasizes unique products so that consumers are willing to pay a premium price. Meanwhile, cost leadership emphasizes a low price structure and a selling price at the industry average (or at least slightly below).
Hence, it does not make sense for a company to use its competitors’ average price as the basis for determining the selling price of its products. The company may find a relatively high price, even though it is still below the competitors’ average.
Conversely, if the products are relatively similar, it makes it easier to position the product. Say, the company charges slightly above competitors’ prices. In that case, the firm should differentiate its product to compensate for the higher price.
Second is the product life cycle. If the company sells a new product, penetration pricing is more appropriate. In this case, the company sets the price low initially and then slowly increases it. This strategy is suitable when a company must immediately establish a market position for a new product to achieve economies of scale.
The third is the size and distribution area. Both have an effect on costs. If the company insists on using it, the operation may be unprofitable.
The average competitor or just a few competitors?
Observing the entire company may not be economical. Some markets have a large number of players, while others are few. Hence, the firm may choose to base it on the closest competitors’ price. The company then takes into account the periodic movements of competitors’ prices and adjusts their selling prices accordingly.
What are the types of competitive pricing
In general, when using competitors’ prices as a reference base, firms have three options for setting prices:
- Prices above average competitors
- Prices are at or around the competitor’s average
- Prices are below average competitors
Price is above higher than average competitors.
Companies must differentiate their offerings to apply a premium price. Differentiation compensates for higher prices. If successful, consumers are interested and willing to pay more to buy the product.
Companies can use several ways to differentiate, such as:
- Giving better quality
- Providing superior customer service
- Designing a more attractive packaging
- Embedding the latest technology
- Ensuring better product availability
- Building a strong brand image
Again, the level of differentiation also depends on the target market. When most consumers are budget conscious, aggressive differentiation is less likely to succeed.
Price is at competitors’ average.
This strategy usually takes place in a competitive market. In the extreme case, in a perfectly competitive market, firms do not have price power. They will take the market price as the basis for the selling price.
Furthermore, in Porter’s competitive advantage concept, this pricing is typical for firms adopting a cost leadership strategy. The company charges the same price as the average competitor or industry.
To support profits, companies try to reduce production costs. They could take advantage of economies of scale, economies of scope or experience curves to lower costs. The lower the production costs, of course, the higher their profit.
So how do consumers choose if prices are the same between companies? In this case, the non-price factor is at play. Take the product availability factor, for example. If the price is the same and the quality is the same, you should buy a product close to your location. Hence, to build excellence, companies seek to develop a more effective distribution network to reduce costs while increasing product availability.
Price is below the average competitor.
In this case, the company uses price as the basis for competitiveness. The goal is usually to get high sales and grab a competitor’s market share.
Lower prices mean lower profits. How big is it? It depends on the company’s production costs. Suppose the firm can keep production costs lower than competitors. In that case, the profit margins may still be the same as those of competitors.
A lower price may take the form of:
- Penetration price: the firm sets a low price at first and then slowly increases the selling price. Its main objective is to build a market position. Companies usually adopt it when they enter a new market.
- Predatory price: the price is so low (below the average variable cost) that it costs the firm a loss. Its primary purpose is to repel competitors and build barriers to entry. When successful, the firm enjoys monopoly power, enabling it to raise prices.
- Loss leader: this is similar, but not as extreme as predatory prices. The company charges low but still above average variable costs.
Advantages and disadvantages of competitive pricing
Competitive pricing offers several advantages. First, the process is easier and faster to do. The company may only need to observe the prices of some players as a reference for pricing. Companies do not need market data that is as accurate as demand-based pricing or customer value pricing.
Second, it reduces vulnerability to stakeholder rejection in distribution channels. Distributors are usually more accepting of the company’s products. They expect the price to be in the range of competitors’ products, which they have been working with so far.
Third, companies are more flexible when setting prices. Companies could choose to mark their prices above, below, or equal to those of their competitors. Companies only need to answer why the price is lower, the same or higher than competitors. For example, deciding a higher price, the company needs to find justification for it, whether by adding new features or providing excellent after-sales service.
However, competitor-based pricing also has drawbacks.
First, the strategy is unsustainable in the long term. Competition and market conditions are dynamic. Say, the company is uncompetitive and shifts the marketing focus to a different segment. That will ultimately change the pricing policy completely.
Second, the company took the wrong reference point. In an extreme case, the firm averages the prices of indirect competitors instead of the closest competitors. Finally, pricing is irrelevant and may make the company uncompetitive.
Third, price and product attributes are not the only reasons why consumers buy competitors’ products. When a company fetches a lower price, consumers may be reluctant to buy its product. They perceive low prices with poor quality.
Also, other factors – apart from price and product attribute – influence consumer choices. Examples are company reputation and brand image. The same price doesn’t necessarily result in the same success if the company’s reputation is terrible.