Are your prices too low...

Joel E. Urbany in his paper published in 2001 in HBR discussed a marketing issue... Suppose your company produces sunglasses for $7 and sells for $10. At this price it would sell 1000 units for sure. If the company reduces the price to $9.50, there is 80% probability to have a sale of 1250 items and 20% probability to have a sale of 1000 units... Then what should the firm do?

My Solution to the Question:

Well if we calculate the expected value of number of items that will be sold... it comes out to be:

E(x)=1250*0.8+1000*0.2=1200

E(Profit)=1200*(9.5-7)=$3000

in the second case and 3*1000=$3000 in the first case...

Thus in either of the cases, the profit remains the same... Then how should the company decide what to do?

The second approach is a good way to get a larger market share... even though the profit remains the same, the number of units sold increases which means that the market penetration is closer to the market potential than it was before... and this is good... because in time if the company manages the largest market share, it will become the market leader... and that has its own obvious advantages...

But the question is... how flexible are the competitors to a price reduction? If the competitors for some reason are not as price flexible, this strategy might pay off well... for example DELL with its level 0 distribution network has got a distinct competitive advantage compared to its competitors... and that's the reason it can afford significant price reduction... because DELL is aware that it's competitors aren't as price flexible...

But in case a company's competitors are almost as price flexible... any reduction in the price would lead to a price reduction by its competitors as well... eventually leading to price war... and the one who benefits is the customer... for example in 2003 when Coca Cola released 200ml bottles for Rs. 5, PepsiCo followed it by reducing the price of 300ml bottle to Rs. 6. Thus both the companies entered into a price war and the ones benefited were the customers.

Thus it is imperative for a company to analyse the product, the company's competitor's strengths and weaknesses before it takes a call on the prices...