Effect of deregulation on pricing strategy

When industries deregulate, their managers face unfamiliar challenges. Price wars are often the unfortunate—and unnecessary—result.

McKinsey Quarterly - Strategy - Strategic Thinking

AUGUST 2001 • Andreas Florissen, Boris Maurer, Bernhard Schmidt, and Thomas Vahlenkamp

In This Article

• Exhibit 1: Pricing panic
• Exhibit 2: Consumers are reluctant to switch
• Sidebar Exhibit: A model for optimal pricing

The wrong pricing strategy can destroy corporate value faster than almost any other business mistake. And when industries are about to be deregulated, managers habitually adopt ill-conceived pricing policies that are almost guaranteed to damage their companies and erode services to customers and the community.

These flawed pricing policies … represent efforts to hang on to customers. Managers cut prices preemptively to fend off new rivals and then launch full-fledged price wars in hopes of outlasting attackers and emerging victorious from the rubble. This, at any rate, is the hope; the reality is usually quite different. …

One example of such pricing behavior comes from the Chilean telecommunications sector, which deregulated in 1994. Before then, Empresa Nacional de Telecomunicaciones (Entel) had been the sole provider of domestic and international long-distance services, but with the coming of deregulation Entel had to compete against seven rivals. At first, hoping to keep its customer base intact, it joined in a price war. By the end of 1994, rates for calls from Chile to the United States had fallen by about 95 percent, and domestic long-distance rates had collapsed similarly (Exhibit 1). Despite the price cuts, Entel lost nearly 70 percent of the domestic long-distance market and more than half of the international one. After 1994 Entel stopped competing on price. Differentiating itself from competitors on the basis of service and broad product offerings, it began charging a premium over the rates of its largest rival. New entrants continued to threaten Entel's international business, but by the late 1990s the company had recovered some of its domestic long-distance market share.

Lower prices for customers are among the primary goals of most deregulation efforts. … But if misguided policies spur struggles that bring prices below the level needed to cover costs, neither companies nor consumers win… And if a price war succeeds in destroying all attackers, a shattered market will be left with little competition.

In most cases, established companies launch price wars believing that once the dust has settled, prices will rise again. But psychologically and politically, it can be far more difficult to orchestrate a price increase than a price cut. … In our analysis, optimal prices for incumbents can be as much as 20 percent higher than those they actually set. …[Incumbents] must be prepared to lose some of their customer base. Nonetheless, if the right factors influence their pricing decisions, they and the market will remain healthier.

Four factors

An examination of deregulated markets, mostly in Europe, has taught us that the incumbents' managers tend to make the same mistakes when they address the problem of pricing. …

Often the incumbents misinterpret or ignore four key factors that should influence their pricing strategies: competitors' prices, switching rates, customer value, and cost to serve. When all of these factors are weighed correctly, incumbents often find that they can actually charge a premium over attackers' rates, and this discovery may well be the key to their continued profitability.

1. Competitors' prices

In the deregulating markets we have examined, the most important influence on pricing decisions is competitors' prices. … More often, when facing multiple attackers, incumbents almost by default worry about the lowest price being offered rather than the most relevant. Incumbents, in setting their own prices, should focus on those of the competitor that is best known in the market and has the greatest chance of luring away customers. …

What is more, a former monopolist generally underestimates its competitors: believing that it can outlast any of them, it sets prices without fully anticipating the speed and vehemence of their pricing reactions. Incumbents are often unpleasantly surprised by how long the competition can sustain low prices even when they fall below the cost to serve. …

2. Switching rates

As soon as the customers of a monopoly can choose another supplier, some of them will inevitably do so, and others will follow if the incumbent charges more than its rivals. This switching rate is a second factor that must be weighed in setting price levels in newly liberalized markets, though incumbents actually tend to overestimate the amount of switching that price differentials are likely to trigger.

These inflated estimates are based on the often exaggerated ideas of executives at incumbent companies about how much time their customers spend mulling over their services. … [Comparatively] few customers even consider switching unless the advantages, such as a large price differential, heavily outweigh the bother of changing providers. …

… Our analysis of several markets in the years after liberalization shows that incumbents charging a 5 percent premium endured switching rates that actually never exceeded 2 percent of the customer base a year (Exhibit 2). After peaking immediately following deregulation, the rate actually fell. Of course, as price premiums increase, so does the likelihood that a larger proportion of customers will jump to an attacker.

3. Customer value

Few things are more dear to the hearts of incumbents than their customer base, but the quixotic effort to retain a 100 percent market share leads them to misunderstand the value of their customers. In the prevalent view, all of them have the same high value, but that just isn't right: their individual value varies … Although an ex-monopoly must keep a substantial share of the market, keeping all of it is impossible.

Fortunately, one of the factors that determine the value of customers is their readiness to jump to the competition. If a customer is the kind of person who switches easily, retention efforts are better directed at others, since the likelihood of success is small. … Managers must understand that it is better to lose fickle customers than to keep them at unrealistically low prices—an approach that cuts margins earned from all customers, even those who are less price sensitive.

Traditional volume-driven customer strategies usually reflect inexperience in acquiring (or, in this case, reacquiring) customers, … Incumbents tend to assume that a customer, once lost, is lost forever.

4. Cost to serve

The final factor that incumbents often misjudge is the true cost of serving individual customers. In a controlled market, incumbents generally calculate their prices by adding an acceptable profit margin to their total costs rather than taking the time to determine the cost of serving individual customer segments. …

An incumbent's own costs should serve as an absolute short-term price minimum. …

Making reasoned decisions

By intelligently evaluating the four factors, incumbents can make more reasoned decisions about how to revise their pricing policies in the face of increased competition (see sidebar, "Using the factors"). Rather than blindly undercutting attackers, incumbents can safely charge private customers and most commercial accounts a premium that secures their business, avoids costly price wars, and preserves the market.

But this premium is not without complications. First, of course, the incumbent must be willing to shed a portion of its customer base, probably as much as 20 percent in the first year. Determining the acceptable level of customer losses early helps managers ride out the first shock of lost market share. … In addition, incumbents should include in their pricing policies certain triggers—such as levels of market share or competitors' prices—that would initiate changes in policy. Conditional pricing can free managers to turn their attention to other important issues.

Of course, closer attention to pricing isn't of benefit solely to companies in deregulating markets: the model distilled from them can be adapted to other situations characterized by intense price competition. …

Pricing is an important value lever, but many managers in deregulating markets have trouble determining the right price for products and services. These managers, misinterpreting or ignoring the four factors that inform rational price setting, embark on self-destructive attempts to keep customers at any cost. They must learn a tough lesson: that to optimize value, it is necessary to lose customers.

Using the factors

The optimal price for a product or service—the price that can help assure profitability and long-term financial health—can't be revealed solely by the four key factors (competitors' prices, switching rates, customer value, and cost to serve) that should influence pricing in deregulating markets. It is also necessary to determine the relationships among these factors, which must be linked to the optimal price premium. We have devised a model that shows incumbents the size of the price premiums they can charge when new competition arrives (exhibit).

First, the model sets a demand curve against profit margins, or price less cost. Demand for the services of an incumbent, as represented by its customer base, is steady until its prices rise higher than those of the most formidable—in other words, not necessarily the cheapest—attacker in its market. At this point, demand will start to decline. The slope of the declining demand curve is primarily a function of the market's switching rate; the more likely customers are to switch, the steeper the slope will be.

Second, the model charts the total marginal contribution, or revenues less cost, against the margin. At both extremes, the total marginal contribution is zero. Where price equals cost to serve, the margin is zero, and no matter how many customers are served, the total marginal contribution is also zero. At the other extreme, the price and the marginal contribution are so high that all customers switch. The curve, which is easy to model, shows that the total marginal contribution peaks somewhere beyond the line representing the main attacker's price. At this level, the incumbent charges a premium that maximizes the total current marginal contribution and accepts the inevitable loss of some market share.

But the premium level that maximizes the current marginal contribution doesn't take into account future customer value, including any additional margins that would result from price premiums in the future, profit potentially generated from cross-selling, and the cost of reacquiring customers. Incorporating future customer value into the model has the effect of moving the optimal price lower, assuming that there are unrealized benefits in retaining more of a company's customers. This final price helps to secure a company's future earnings while still preserving a price premium that makes current operations profitable.

About the Authors

Andreas Florissen is a consultant and Thomas Vahlenkamp is a principal in McKinsey's Düsseldorf office, and Boris Maurer is an associate principal and Bernhard Schmidt is a consultant in the Berlin office.