Competing on Price: Avoid the Red Queen
Monday, July 27, 2015
I'm constantly amazed to see so many companies prioritizing cost reductions in their business strategies. In many cases, the goal of reducing expenditures is diametrically opposed to long-term profitability. For all but the most inept industry, reductions in cost basis requires these firms to make painful trade-offs:
- They source inferior components.
- They reduce quality controls.
- They replace highly skilled employees with lower-skilled staff.
- They apply shrink rays to their products.
Such methods should be seen as one-time fixes that provide short-term increases in revenue in exchange for long-term decreases of the same.
Every time a company removes what its customers love about its products (in order to compete on price), it reduces its comparative advantage. Fewer of its customers will be willing to pay a premium for its goods. Over time, the business will discover that its customer base will shift from those who are loyal to its brand to those who prioritize price above all else (the technical term for this type of consumer is "cheapskate").
While the firm may be able to eke out meager levels of accounting profit, it will be unable to generate any real economic profits.
The red queen hypothesis suggests that companies should constantly adapt in order to survive, but I argue that they should consider not adapting as part of a race to the bottom. As a firm's competitors concentrate on cost reductions, its products will naturally increase in comparative utility. Simply staying put while competitors furiously reduce customer value is a surefire way to increase a firm's reputation as a premium producer. This assumes, of course, that consumers can determine the relative quality of each product.
Yes, premium products can exist in highly competitive markets. Anyone who wishes to argue the point can see that the Apple's IPhone is but one example.
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