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Some aspects of price strategy
OAfEGA, The Int. J1 of M g m t Sci., Vol. 2, No. 4, 1974
Some Aspects of Price Strategy K ROSCOE DAVIS University of Georgia, Athens, Georgia (Received December 1973: in revised form January 1974)
A firm's success, within a rapidly growing and dynamic market, depends upon its ability to respond to market demand and to react to competitive forces. A key factor determining success is the pricing policy employed by the firm. Product pricing, however, is not simple; supply and demand, as well as the interaction and reaction of competitors, must be taken into consideration. By simulating a competitive market environment, however, a firm should be able to evaluate different pricing strategies prior to employing a strategy in practice. The goal of this research was to propose a simulation model to serve this purpose. Particularly, the objective was to demonstrate that if an industry can be characterized as one in which cost as well as price decline with cumulative volume, a pricing policy leading to market dominance exists. A simulation model is desirable for evaluating the proper pricing strategy for achieving such a market position.
INTRODUCTION I N SO ME industries it has been noted t h a t the m a n u f a c t u r i n g costs of a p r o d u c t follow a declining curve as c u m u l a t i v e v o l u m e increases. W h e n this decline is p l o t t e d g r a p h i c a l l y on a log-log scale, the resulting curve is referred to as a " l e a r n i n g curve". Stated in t h e simplest o f terms, a n d based on the l o n g - t e r m a c c u m u l a t i o n o f relative data, t h e consistent t r e n d o f all learning curves shows t h a t the m o r e that is learned a b o u t a p r o d u c t ( t h r o u g h the actual m a n u f a c t u r i n g process), the less it will cost to m a k e the p r o d u c t . L e a r n i n g curves, s t a n d i n g alone, offer little in the way o f d e t e r m i n i n g a strategic m a r k e t i n g policy. H o w e v e r , if learning curves can be related to c o r r e s p o n d i n g price curves, then a m e a n s exists for f o r m u l a t i n g a m a r k e t strategy. Thus, if it can be shown t h a t the characteristic p a t t e r n in price decline, for a p a r t i c u l a r industry, is related to the c u m u l a t i v e n u m b e r o f units p r o d u c e d , then a c o s t - p r i c e - v o l u m e r e l a t i o n s h i p exists f r o m which a strategy can be f o r m u l a t e d . I f b o t h cost decline a n d price decline can be related to cumulative volume, then m a r k e t share b e c o m e s an i m p o r t a n t factor in f o r m u l a t i n g a pricing strategy. 515
Davis--Some Aspects of Price Strategy
THE PROBLEM AREA Cost/volume and price/volume relationships In fast-growing and dynamic markets, such as that for electronic components, there is a readily observable tendency for prices (and, implicitly, costs) to decline. Firms active in these markets are often dismayed by this tendency toward price declines. Figs 1 and 2 show the price patterns for two typical electronic components. Note that in both cases price tends to decline by some characteristic amount each time the accumulated volume doubles. 1954
5000 4~
I000
.2
1955
1960
1965
~
90%
1967
slope
" " - ...70% slope
g
1.00
(D
I
0"30 I0
I
1oo
"%'-
I
I,oo0,ooo
IO,O0O
Total occumulafed volume
( thousand units)
FIG. 1. Silicon transistor price curve. 1960
1955
1.00,
90% sl~
80% slope
g _
70%
I0
I00
"" "" -..
g o.~ 0.05
P
I
I000
-'~
30OO
Total accumulated volume (million units}
FIG. 2. Germanium diode price curve.
During the early developments of the market, the price declines about 10 per cent (90 per cent slope) each time the industry volume doubles. As the market matures, a 60 to 40 per cent price decline exists (40 to 60 per cent slope). When the market stabilizes, a 30 per cent price decline (70 per cent slope) appears to be typical. 5t6
Omega, Vol. 2, No. 4 If we superimpose a hypothetical cost cur~'e (assume a 70 per cent learning curve) over the price curves, we can note some rather interesting cost-price relationships. Let's take the silicon transistor as an example (Fig. 1). Based upon our assumed cost curve, it could be concluded that when the silicon market initially developed price was below cost (this is generally true of many technologically-based products when a product is first introduced); losses existed. As volume increased, the profit margin became positive--price was declining at a slower rate (10 per cent) than costs (30 per cent). Increasing profit margin, however, could not continue indefinitely--if price did not decline as fast as cost, then competitors would be attracted to the market. Thus, we would expect at some point that price would begin to decline faster than cost. This is what happens when a market matures. For the silicon market, maturity occurred around 1960 when the industry volume reached approximately 170,000,000 units. This steep price decline most likely discouraged any additional competitors and eliminated less effective competitors. Since price cannot decline faster than cost indefinitely, the silicon market had to stabilize at some point. We can note that around 1965 this occurred; the price curve established a slope approaching the 70 per cent cost slope. Profit margins thus stabilized with price declining at approximately the same rate as cost. Examination of the germanium diode market (Fig. 2) will reveal that the price curve for that market has a pattern similar to the silicon transistor. Based upon these two rudimentary cases we thus could conclude that cost-pricevolume relationships do exist--particularly for the electronics industry.
Market share and profitability If we accept the fact that cost, as well as price, declines with cumulative volume, then market share becomes an important factor in developing a market strategy. In a growing market the growth rate of the market will determine the rate at which costs will decline--for all competitors. For example, if the market is growing at 30 per cent, then each competitor should experience a 30 per cent decline in cost, assuming each maintains the same relative market share. To improve profitability a competitor thus must gain market share. Increased profitability thus implies maintaining a pro rata share of the growth in the market plus taking additional market shares from competitors. A took at two hypothetical cases will highlight the important role market share plays. First, let's examine the case where two competitors, A and B, are moving down parallel cost curves and are holding market share. This is shown in Fig. 3. The curve for market price versus cumulative volume is plotted on the solid line, and the cost curves for competitors A and B are shown in broken lines. For 1972 the market price and costs for the competitors are shown by the points market "72". Competitor B, who has a higher market share (higher cumulative volume to date) and lower cost, enjoys a large profit margin (PMB72). Since competitors A and B maintain their respective market share between 517
Davis--Some Aspects of Price Strategy ~,~.~ 7 Mfkoei' price
•,
"~
AV M
2 ~
~
=
/Cost
compet,tor A
Price, cost
|
"~
|
!
, ~ ~73
F ~
I"
AVB
A73 f B75
~. ~ ~
~. Cost competitor O
=,
Cumulofive volume
FIG. 3. Two competitors (A, B) hold market share.
1972 and 1973, their percentage increase in volume will be the same, indicated by AVA and AVB. Since cumulative volume is plotted on a logarithmic scale, equal percentage increases in Va, VB, and VM will be represented by an equal linear distance along the cumulative volume scale; these are designated by three equal distances, A VA, A VB, and A VM (it should be recognized that Fig. 3 is a log-log plot though it is not presented on logarithmic paper). During 1973, each competitor works diligently and innovatively to reduce costs. The costs decline in an orderly manner and profit percentage at the end of the year is the same as in 1972. This is shown as PMB73 for competitor B and PMA73 for competitor A. Now consider the case where the same competitors, A and B, are competing in the market, but one competitor increases his market share. This is shown in Fig. 4. In this case, competitor B has increased his market share over competitor A in 1973 (this is indicated by the large AVB as compared to AVA). Since competitor B diligently pursued cost reductions as his volume increased, he is able to convert increased cumulative volume into lower cost in 1973. The result is a profit margin PMB73, which is larger than he enjoyed in 1972. To increase his market share, competitor B had to take market share from competitor A. The volume increases for loss in profit margin for competitor A, AVA thus is smaller than that of competitor B, AV a. The result is a loss in profit margin for competitor A ; indicated by LA73. By increasing market share, competitor B not only improved his profit margin, but forced competitor A into a loss position. Competitor A's willingness to remain competitive is reduced by competitor B's increase in market share. 518
Omega, Vol. 2, No. 4 Market price
,
T PM
+'--..
|
'72 ~ '73
c=, =mOe, ,or
Price, COSt
I
/xv,,_..
I
~.
I L._
~
Tx |
/B73
",~
"
Cost competitor B i=
Cumulative
volume
FIG. 4. Two competitors (A, B) with competitor B increasing market share.
Growth rate, capacity, and market share Growth rate and capacity--if an industry is characterized as one in which cost and price are related to cumulative volume, then market growth rate and production capacity become important factors in determining a market strategy, particularly if the market growth is very rapid. If physical volume is growing rapidly, changes in competitive position can occur very rapidly if competitors fail to recognize the necessity for investing in production capacity. If the physical volume of a product is growing rapidly, the effect is near-term and substantial. For a true growth product, volume can double in a short period of time. For example, if physical volume is growing at 10 per cent annually, then the industry volume will double in seven years. Although physical volume is important, most firms view market growth in terms of dollars rather than physical units. It is important to consider both physical volume change as well as dollar volume change. If we assume we are in a rapid growth market (dollar growth rate is 26 per cent) and that industry prices are declining at a rate between 20 per cent and 30 per cent (recall that the silicon transistor market experienced such a price decline), then the total industry physical volume will double every 18 months. For a competitor to maintain his market position, he thus must recognize and be willing to invest in production capacity. In order to gain market share he must be willing to increasingly make capital investments. To enter into a rapid growth market by investing in market share, thus implies becoming committed to a rapidly escalating series of investments which spiral in dollar amounts until industry growth slows. Growth rate and market share--Though a rapid growth market may be demanding in terms of capital investments, some competitive advantages can 519
Davis--Some Aspects of Price Strategy quickly be gained in such a market. With a rapid growth rate, the dollar costs per unit produced decline substantially for the industry as a whole, since the industry volume doubles in a short period of time. If a competitor can rapidly gain market share, his costs should decline much more quickly than the industry average. He thus can gain a dominant market position in a short period of time. For example, if a competitor with zero share of the market could take only 50 per cent of the market growth, then he would have 25 per cent of the total market if the market volume doubled in four years (10 per cent dollar g r o w t h - 30 per cent price decline). Thus, during the growth stage of a product, a competitor can gain key competitive advantage by pursuing market share through willingness to invest in productive capacity. Pricing and market structure The strategies available for obtaining a dominant market share are dependent upon the characteristics of the particular market. The market for electronic components is relatively oligopolistic. Essentially, there are several large firms and a host of smaller firms that compete for different market segments. Because of the high fixed cost of production facilities, each competing firm attempts to sell to the limit of its operational capacity. The industry as a whole sells at relatively uniform price levels, and price cuts are usually met quickly by the competition. Assuming that a consumer will continue to purchase from a given competitor if the competitor's price is at or near the industry price, the distribution of market share across all competitors within the electronics market will remain fixed even in a growth market. This is true, however, only if each competitor can meet the capacity requirements for his pro rata share of the growth of the market. Under such market circumstances, the key to market dominance is to influence competitors' decisions relating to investing in future production capacity. This can be accomplished by a significant price reduction. Because capacity decisions are dependent upon future profit expectations, a firm should be able to influence competitors' capacities by deliberating lowering the price structure of the market.
THE
SIMULATION
MODEL
From the overview of the problem area, it can be concluded that if a market is one in which both costs and price decline with the cumulative volume, then the pricing policy employed by a firm is a key mechanism for maximizing the long-run profits of the firm. The analysis suggests that a firm should seek a dominant market position during the growth phase of a market by becoming a strong price "leader". Obviously, such a strategy can result in substantial foregone profit, or substantial losses. Such a price strategy might be difficult to 520
Omega, Vol. 2, No. 4
reconcile in the short run. However, by simulating the competitive environment it should be possible to demonstrate the potential long-term benefits (or lack of benefits) of a price leader strategy. By simulating the competitive environment an additional benefit can be derived--different pricing strategies can be evaluated. An aggressive pricing strategy can be employed during the growth phase of the market, while a more relaxed strategy can be employed as the market matures or as a firm gains a dominant market position. The question that might be answered, however, is what strategy should be employed in order to maximize profits over the life cycle of a product. The simulation model should suggest the desired strategy. Given that a desired strategy can be identified, a question that can be asked is: How sensitive is the strategy to changes in market growth rate, or lead time for adding production capacity ? A capability to perform a sensitivity analysis thus would be desirable--the simulation model should provide this capability. Model assumptiona and structure Work is currently in progress to develop the proposed model. At the current phase of development the model includes the following relationships and assumptions: I. The market consists of 8 competitors. For each competitor, costs, market shares, and cumulative production volume can be pre-definable. 2. A total available market can be specified with different growth rates for different stages of the market. In addition, a modeler should have the capability to specify the product life cycle. 3. The total cost/unit associated with market declines with accumulated volume according to cost-volume learning concepts. 4. A modeler has the ability to set market price. 5. Competitors react to the market price by making two decisions each time period--a current decision and a future capacity decision. On the basis of the current profit margin and capacity each competitor decides how many units to produce in the current period. On the basis of their projection of costs/unit and the market price, competitors decide how much additional capacity to add. Capacity additions, however, are not brought "on stream" until some time period in the future.
CONCLUSION From the theory it has been demonstrated that a "price leader" policy may be desirable if an industry is characterized as one in which cost as well as price decline with cumulative volume. By employing an aggressive pricing policy a firm should be able to capture market shares from competitors--particularly if competitors can be discouraged from adding production capacity. Caution, 521
D a v i s - - S o m e Aspects o f Price Strategy however, should be used in e m p l o y i n g the policy. If a m a r k e t has reached a m a t u r e phase, an aggressive price r e d u c t i o n might lead to substantial losses since the m a r k e t g r o w t h has slowed. By using the p r o p o s e d s i m u l a t i o n model, however, a firm should be able to e x p l o r e this as well as other questions.
BIBLIOGRAPHY l. BACKMANJ (1961) Pricing: Policies and Practices. Studies in Business Economics 71, National Industrial Conference Board, New York. 2. HEGEMAN GB (1968) The computer and forecasting of market demand and prices. Advances in Chemistry Series 88. American Chemical Society. 3. HIRSCHMANWB (1964) Profit from the learning curve. Harv. Bus. Rev., 125-129. 4. PATTONWF (1969) Predicting Production Costs with Learning Curves. Defense Industry Bulletin, 5-10. 5. SCHUMACKERRL (1971) Factors affecting the improvement curve in manufacturing: an empirical study. Proceedings of the Seventh Annual Conference of the Southeastern Chapter. Institute of Management Sciences, Blacksburg, Virginia, 21-23 October. 6. SHRADERRW (1970) Product Phased Program Planning. Working paper presented at the l l t h American Meeting of the Institute of Management Sciences, Los Angeles, California.
522
Some Aspects of Price Strategy K ROSCOE DAVIS University of Georgia, Athens, Georgia (Received December 1973: in revised form January 1974)
A firm's success, within a rapidly growing and dynamic market, depends upon its ability to respond to market demand and to react to competitive forces. A key factor determining success is the pricing policy employed by the firm. Product pricing, however, is not simple; supply and demand, as well as the interaction and reaction of competitors, must be taken into consideration. By simulating a competitive market environment, however, a firm should be able to evaluate different pricing strategies prior to employing a strategy in practice. The goal of this research was to propose a simulation model to serve this purpose. Particularly, the objective was to demonstrate that if an industry can be characterized as one in which cost as well as price decline with cumulative volume, a pricing policy leading to market dominance exists. A simulation model is desirable for evaluating the proper pricing strategy for achieving such a market position.
INTRODUCTION I N SO ME industries it has been noted t h a t the m a n u f a c t u r i n g costs of a p r o d u c t follow a declining curve as c u m u l a t i v e v o l u m e increases. W h e n this decline is p l o t t e d g r a p h i c a l l y on a log-log scale, the resulting curve is referred to as a " l e a r n i n g curve". Stated in t h e simplest o f terms, a n d based on the l o n g - t e r m a c c u m u l a t i o n o f relative data, t h e consistent t r e n d o f all learning curves shows t h a t the m o r e that is learned a b o u t a p r o d u c t ( t h r o u g h the actual m a n u f a c t u r i n g process), the less it will cost to m a k e the p r o d u c t . L e a r n i n g curves, s t a n d i n g alone, offer little in the way o f d e t e r m i n i n g a strategic m a r k e t i n g policy. H o w e v e r , if learning curves can be related to c o r r e s p o n d i n g price curves, then a m e a n s exists for f o r m u l a t i n g a m a r k e t strategy. Thus, if it can be shown t h a t the characteristic p a t t e r n in price decline, for a p a r t i c u l a r industry, is related to the c u m u l a t i v e n u m b e r o f units p r o d u c e d , then a c o s t - p r i c e - v o l u m e r e l a t i o n s h i p exists f r o m which a strategy can be f o r m u l a t e d . I f b o t h cost decline a n d price decline can be related to cumulative volume, then m a r k e t share b e c o m e s an i m p o r t a n t factor in f o r m u l a t i n g a pricing strategy. 515
Davis--Some Aspects of Price Strategy
THE PROBLEM AREA Cost/volume and price/volume relationships In fast-growing and dynamic markets, such as that for electronic components, there is a readily observable tendency for prices (and, implicitly, costs) to decline. Firms active in these markets are often dismayed by this tendency toward price declines. Figs 1 and 2 show the price patterns for two typical electronic components. Note that in both cases price tends to decline by some characteristic amount each time the accumulated volume doubles. 1954
5000 4~
I000
.2
1955
1960
1965
~
90%
1967
slope
" " - ...70% slope
g
1.00
(D
I
0"30 I0
I
1oo
"%'-
I
I,oo0,ooo
IO,O0O
Total occumulafed volume
( thousand units)
FIG. 1. Silicon transistor price curve. 1960
1955
1.00,
90% sl~
80% slope
g _
70%
I0
I00
"" "" -..
g o.~ 0.05
P
I
I000
-'~
30OO
Total accumulated volume (million units}
FIG. 2. Germanium diode price curve.
During the early developments of the market, the price declines about 10 per cent (90 per cent slope) each time the industry volume doubles. As the market matures, a 60 to 40 per cent price decline exists (40 to 60 per cent slope). When the market stabilizes, a 30 per cent price decline (70 per cent slope) appears to be typical. 5t6
Omega, Vol. 2, No. 4 If we superimpose a hypothetical cost cur~'e (assume a 70 per cent learning curve) over the price curves, we can note some rather interesting cost-price relationships. Let's take the silicon transistor as an example (Fig. 1). Based upon our assumed cost curve, it could be concluded that when the silicon market initially developed price was below cost (this is generally true of many technologically-based products when a product is first introduced); losses existed. As volume increased, the profit margin became positive--price was declining at a slower rate (10 per cent) than costs (30 per cent). Increasing profit margin, however, could not continue indefinitely--if price did not decline as fast as cost, then competitors would be attracted to the market. Thus, we would expect at some point that price would begin to decline faster than cost. This is what happens when a market matures. For the silicon market, maturity occurred around 1960 when the industry volume reached approximately 170,000,000 units. This steep price decline most likely discouraged any additional competitors and eliminated less effective competitors. Since price cannot decline faster than cost indefinitely, the silicon market had to stabilize at some point. We can note that around 1965 this occurred; the price curve established a slope approaching the 70 per cent cost slope. Profit margins thus stabilized with price declining at approximately the same rate as cost. Examination of the germanium diode market (Fig. 2) will reveal that the price curve for that market has a pattern similar to the silicon transistor. Based upon these two rudimentary cases we thus could conclude that cost-pricevolume relationships do exist--particularly for the electronics industry.
Market share and profitability If we accept the fact that cost, as well as price, declines with cumulative volume, then market share becomes an important factor in developing a market strategy. In a growing market the growth rate of the market will determine the rate at which costs will decline--for all competitors. For example, if the market is growing at 30 per cent, then each competitor should experience a 30 per cent decline in cost, assuming each maintains the same relative market share. To improve profitability a competitor thus must gain market share. Increased profitability thus implies maintaining a pro rata share of the growth in the market plus taking additional market shares from competitors. A took at two hypothetical cases will highlight the important role market share plays. First, let's examine the case where two competitors, A and B, are moving down parallel cost curves and are holding market share. This is shown in Fig. 3. The curve for market price versus cumulative volume is plotted on the solid line, and the cost curves for competitors A and B are shown in broken lines. For 1972 the market price and costs for the competitors are shown by the points market "72". Competitor B, who has a higher market share (higher cumulative volume to date) and lower cost, enjoys a large profit margin (PMB72). Since competitors A and B maintain their respective market share between 517
Davis--Some Aspects of Price Strategy ~,~.~ 7 Mfkoei' price
•,
"~
AV M
2 ~
~
=
/Cost
compet,tor A
Price, cost
|
"~
|
!
, ~ ~73
F ~
I"
AVB
A73 f B75
~. ~ ~
~. Cost competitor O
=,
Cumulofive volume
FIG. 3. Two competitors (A, B) hold market share.
1972 and 1973, their percentage increase in volume will be the same, indicated by AVA and AVB. Since cumulative volume is plotted on a logarithmic scale, equal percentage increases in Va, VB, and VM will be represented by an equal linear distance along the cumulative volume scale; these are designated by three equal distances, A VA, A VB, and A VM (it should be recognized that Fig. 3 is a log-log plot though it is not presented on logarithmic paper). During 1973, each competitor works diligently and innovatively to reduce costs. The costs decline in an orderly manner and profit percentage at the end of the year is the same as in 1972. This is shown as PMB73 for competitor B and PMA73 for competitor A. Now consider the case where the same competitors, A and B, are competing in the market, but one competitor increases his market share. This is shown in Fig. 4. In this case, competitor B has increased his market share over competitor A in 1973 (this is indicated by the large AVB as compared to AVA). Since competitor B diligently pursued cost reductions as his volume increased, he is able to convert increased cumulative volume into lower cost in 1973. The result is a profit margin PMB73, which is larger than he enjoyed in 1972. To increase his market share, competitor B had to take market share from competitor A. The volume increases for loss in profit margin for competitor A, AVA thus is smaller than that of competitor B, AV a. The result is a loss in profit margin for competitor A ; indicated by LA73. By increasing market share, competitor B not only improved his profit margin, but forced competitor A into a loss position. Competitor A's willingness to remain competitive is reduced by competitor B's increase in market share. 518
Omega, Vol. 2, No. 4 Market price
,
T PM
+'--..
|
'72 ~ '73
c=, =mOe, ,or
Price, COSt
I
/xv,,_..
I
~.
I L._
~
Tx |
/B73
",~
"
Cost competitor B i=
Cumulative
volume
FIG. 4. Two competitors (A, B) with competitor B increasing market share.
Growth rate, capacity, and market share Growth rate and capacity--if an industry is characterized as one in which cost and price are related to cumulative volume, then market growth rate and production capacity become important factors in determining a market strategy, particularly if the market growth is very rapid. If physical volume is growing rapidly, changes in competitive position can occur very rapidly if competitors fail to recognize the necessity for investing in production capacity. If the physical volume of a product is growing rapidly, the effect is near-term and substantial. For a true growth product, volume can double in a short period of time. For example, if physical volume is growing at 10 per cent annually, then the industry volume will double in seven years. Although physical volume is important, most firms view market growth in terms of dollars rather than physical units. It is important to consider both physical volume change as well as dollar volume change. If we assume we are in a rapid growth market (dollar growth rate is 26 per cent) and that industry prices are declining at a rate between 20 per cent and 30 per cent (recall that the silicon transistor market experienced such a price decline), then the total industry physical volume will double every 18 months. For a competitor to maintain his market position, he thus must recognize and be willing to invest in production capacity. In order to gain market share he must be willing to increasingly make capital investments. To enter into a rapid growth market by investing in market share, thus implies becoming committed to a rapidly escalating series of investments which spiral in dollar amounts until industry growth slows. Growth rate and market share--Though a rapid growth market may be demanding in terms of capital investments, some competitive advantages can 519
Davis--Some Aspects of Price Strategy quickly be gained in such a market. With a rapid growth rate, the dollar costs per unit produced decline substantially for the industry as a whole, since the industry volume doubles in a short period of time. If a competitor can rapidly gain market share, his costs should decline much more quickly than the industry average. He thus can gain a dominant market position in a short period of time. For example, if a competitor with zero share of the market could take only 50 per cent of the market growth, then he would have 25 per cent of the total market if the market volume doubled in four years (10 per cent dollar g r o w t h - 30 per cent price decline). Thus, during the growth stage of a product, a competitor can gain key competitive advantage by pursuing market share through willingness to invest in productive capacity. Pricing and market structure The strategies available for obtaining a dominant market share are dependent upon the characteristics of the particular market. The market for electronic components is relatively oligopolistic. Essentially, there are several large firms and a host of smaller firms that compete for different market segments. Because of the high fixed cost of production facilities, each competing firm attempts to sell to the limit of its operational capacity. The industry as a whole sells at relatively uniform price levels, and price cuts are usually met quickly by the competition. Assuming that a consumer will continue to purchase from a given competitor if the competitor's price is at or near the industry price, the distribution of market share across all competitors within the electronics market will remain fixed even in a growth market. This is true, however, only if each competitor can meet the capacity requirements for his pro rata share of the growth of the market. Under such market circumstances, the key to market dominance is to influence competitors' decisions relating to investing in future production capacity. This can be accomplished by a significant price reduction. Because capacity decisions are dependent upon future profit expectations, a firm should be able to influence competitors' capacities by deliberating lowering the price structure of the market.
THE
SIMULATION
MODEL
From the overview of the problem area, it can be concluded that if a market is one in which both costs and price decline with the cumulative volume, then the pricing policy employed by a firm is a key mechanism for maximizing the long-run profits of the firm. The analysis suggests that a firm should seek a dominant market position during the growth phase of a market by becoming a strong price "leader". Obviously, such a strategy can result in substantial foregone profit, or substantial losses. Such a price strategy might be difficult to 520
Omega, Vol. 2, No. 4
reconcile in the short run. However, by simulating the competitive environment it should be possible to demonstrate the potential long-term benefits (or lack of benefits) of a price leader strategy. By simulating the competitive environment an additional benefit can be derived--different pricing strategies can be evaluated. An aggressive pricing strategy can be employed during the growth phase of the market, while a more relaxed strategy can be employed as the market matures or as a firm gains a dominant market position. The question that might be answered, however, is what strategy should be employed in order to maximize profits over the life cycle of a product. The simulation model should suggest the desired strategy. Given that a desired strategy can be identified, a question that can be asked is: How sensitive is the strategy to changes in market growth rate, or lead time for adding production capacity ? A capability to perform a sensitivity analysis thus would be desirable--the simulation model should provide this capability. Model assumptiona and structure Work is currently in progress to develop the proposed model. At the current phase of development the model includes the following relationships and assumptions: I. The market consists of 8 competitors. For each competitor, costs, market shares, and cumulative production volume can be pre-definable. 2. A total available market can be specified with different growth rates for different stages of the market. In addition, a modeler should have the capability to specify the product life cycle. 3. The total cost/unit associated with market declines with accumulated volume according to cost-volume learning concepts. 4. A modeler has the ability to set market price. 5. Competitors react to the market price by making two decisions each time period--a current decision and a future capacity decision. On the basis of the current profit margin and capacity each competitor decides how many units to produce in the current period. On the basis of their projection of costs/unit and the market price, competitors decide how much additional capacity to add. Capacity additions, however, are not brought "on stream" until some time period in the future.
CONCLUSION From the theory it has been demonstrated that a "price leader" policy may be desirable if an industry is characterized as one in which cost as well as price decline with cumulative volume. By employing an aggressive pricing policy a firm should be able to capture market shares from competitors--particularly if competitors can be discouraged from adding production capacity. Caution, 521
D a v i s - - S o m e Aspects o f Price Strategy however, should be used in e m p l o y i n g the policy. If a m a r k e t has reached a m a t u r e phase, an aggressive price r e d u c t i o n might lead to substantial losses since the m a r k e t g r o w t h has slowed. By using the p r o p o s e d s i m u l a t i o n model, however, a firm should be able to e x p l o r e this as well as other questions.
BIBLIOGRAPHY l. BACKMANJ (1961) Pricing: Policies and Practices. Studies in Business Economics 71, National Industrial Conference Board, New York. 2. HEGEMAN GB (1968) The computer and forecasting of market demand and prices. Advances in Chemistry Series 88. American Chemical Society. 3. HIRSCHMANWB (1964) Profit from the learning curve. Harv. Bus. Rev., 125-129. 4. PATTONWF (1969) Predicting Production Costs with Learning Curves. Defense Industry Bulletin, 5-10. 5. SCHUMACKERRL (1971) Factors affecting the improvement curve in manufacturing: an empirical study. Proceedings of the Seventh Annual Conference of the Southeastern Chapter. Institute of Management Sciences, Blacksburg, Virginia, 21-23 October. 6. SHRADERRW (1970) Product Phased Program Planning. Working paper presented at the l l t h American Meeting of the Institute of Management Sciences, Los Angeles, California.
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