When it comes to price wars, Wharton marketing professor Z. John Zhang can’t help but notice that companies in the West and companies in China are quite literally worlds apart. 

In the West, Zhang says, a price war is something to be avoided. The outbreak of a price war is thought to have disastrous consequences for companies and is viewed as the failure of managerial rationality. This prevailing philosophy was once highlighted in a Fortune magazine article that asked, “What are price wars good for?” The answer? “Absolutely nothing.”

In China, where companies have earned a reputation for starting price wars, the outbreak of a price war is considered a legitimate and effective business strategy.

In the last 10 years particularly, according to Zhang, businesses in China have initiated price wars in a wide range of industries, including consumer electronics, home appliances, personal computers, mobile telephones and, most recently, automobiles. And like leaders of legendary battles, price war warriors who happen to be CEOs often become vaulted idols in China, revered by aspiring managers who are eager to enter the price war battlefields and return victorious — which, in price war lingo, means earning the most customers, capturing the greatest market share and driving up profits.

When Zhang began to analyze the sharp contrasts in attitudes toward price wars in China and the West, the price war landscape raised an intriguing question: “Are those Chinese companies simply lucky survivors in chaotic price wars, or do they know something about how to wage price wars that their Western counterparts do not?”

In a recent paper titled, “The Art of Price War: A Perspective from China,”

Zhang and co-author Dongsheng Zhou, a marketing professor at the China Europe International Business School in Shanghai, answer that question by analyzing two price wars that took place in China in the mid-1990s, one in the color television industry and another in the microwave oven industry. Using what he calls an Incremental Breakeven Analysis (IBEA), Zhang looks at the incentives facing firms that initiate and fight a price war, which by definition always involves a deep price cut. Step by step, Zhang and Zhou analyze the “art of price war,” and draw a conclusion that may make Western companies think in a more sophisticated way about price war battles.

“Our study has convinced us that luck has nothing to do with being a victor in a price war,” write the researchers. “Good planning and execution are the keys to winning. In other words, Chinese companies do seem to know something about price wars that executives in the West do not, or have forgotten.”

Growing vs. Mature Markets

Two important factors in understanding price war distinctions are first, the state of each area’s market and second, the price sensitivity of consumers in each area.

“Chinese companies do have a lot more experience with price wars, which are widely reported business events,” says Zhang. “They are good at it. In the past 10 years, what triggered (the price wars) is the fact that the markets in China are growing. This business environment provides many profitable opportunities for [companies] to engage in price wars and to hone their skills. In a growing market, there are all different companies competing — some good, some bad — and the industry finds a way to consolidate. The only way to do that is a price war, where you bring down the prices and squeeze out the inefficient [companies].”

But the Western market is a more mature market, offering what Zhang calls “oligopolistic competition among mostly equals.” In lieu of price wars, this so-called mature market “encourages more finesse in devising marketing strategies” which may help explain why price wars are so frowned upon.

When it comes to customers’ price sensitivity in a price war, the Holy Grail would be customers who are extremely price sensitive — and therefore more likely to respond quickly to dropping prices. “Chinese consumers are very price sensitive,” says Zhang. “When you lower a price, you make more sales, a lot more sales. In China, anytime you lower the price a little bit, you do draw a larger buying audience.”

Consumers in U.S. markets, however, are not as price sensitive, he says. “I think the U.S. market is more layered. When you lower the price, you gain some sales” but not on the scale triggered by the price-sensitive Chinese consumers.

Understanding the price war mentality is important not only for Western companies who compete with Chinese companies and products on their own turf, but for companies who do business in China. “One must understand how Chinese companies use price wars as a strategic weapon to be able to see them coming, to fight price wars effectively or to avoid them altogether,” the researchers write.

Color TVs

Zhang and Zhou chose examples from China’s color TV and microwave oven industries to analyze price war strategies. The goal was to answer these questions:

  • How do Chinese companies assess their business environment to identify the opportunity for a price war? This question assumes that they do not just randomly start a price war.

  • How do they decide whether and when to start a price war?

  • How do Chinese companies prepare for and execute such a war? 

According to Zhang and Zhou, China’s color TV industry was highly fragmented in early 1996, with more than 130 manufacturers. Only 12 had annual sales of over half a million units, and only four had annual sales of more than one million units. On average, most manufacturers sold less than 120,000 sets. “They all slogged along because a vast majority of these companies were owned by local governments and they were protected in their local markets. Thus, there was very little room for any ambitious Chinese company to expand their sales and to achieve scale economies through market entry or mergers and acquisitions,” the authors say. Also, China’s TV market was a “two-tier market:” Foreign brands served the high-end market and held a dominant position in China; local brands competed with each other in the low-end market.

A company called Changhong, led by CEO Ni Runfeng, was considered the largest and most efficient color TV producer in China, with 17 production lines and a manufacturing capacity that was at least double that of the next-largest one. Changhong was also the largest manufacturer of many key TV components — plastic injections, electronic components and remote controls — which would turn out to be a key factor in the company’s strategy. Another factor was Changhong’s location in Sichuan, a less developed region in China that offered cost advantages to the company. This resulted in a 20% net profit margin for the TV manufacturer that was far above most of its domestic rivals.

According to Zhang and Zhou, Changhong’s position as the strongest domestic TV manufacturer did not promise long-term security. In fact, the company’s success had made it a recent target of foreign manufacturers. “Lured by the sheer size of the China market, foreign investments in the Chinese TV industry were red-hot,” Zhang and Zhou write. “All 10 of the largest TV manufacturers in the world at the time were rapidly expanding their production in China…. One business plan prepared by a large global color TV manufacturer boldly suggested that in three years, by investing some $3 billion in China, the company could destroy Changhong, the largest local competitor.”

Clearly, Zhang and Zhou say, “Changhong had to worry about its long-term survival and it had to find ways to increase its market share quickly to shore up its future.” Through a series of interviews, surveys and analyses, the company came to a conclusion that “would startle any Western executive: A price war was the weapon of choice.”

Why this strategy? First, Zhang and Zhou say, at a time when there was less fiscal assistance from the government, a price war would put small, inefficient domestic TV manufacturers at a disadvantage. Changhong knew these manufacturers would suffer and drop out of the market because of low margins or lost sales. Second, a price war also created havoc for foreign competitors, especially the Japanese. “Low prices and mud wrestling with a Chinese manufacturer could … only erode their brand equity and undermine their brand image.” Plus, any drastic pricing change required approval from foreign parent firms, which could be a lengthy process that worked to Changhong’s advantage in a price war. For those reasons, Changhong did not expect any significant price cut by foreign manufacturers, at least not initially.

In addition, a price war in 1996 would also take advantage of Changhong’s huge inventory — one million units — and its reliable supplies of key components. “With an uncertain future but ample ammunition, Changhong thus found it an opportune time to stir up the industry with an unprecedented price war,” the authors write. On March 16, 1996, Changhong announced a price reduction of 8% to 18% for all of its 17-inch to 29-inch color TVs.

The result? Changhong’s overall market share increased from 16.6% to 31%, with the greatest increase seen in the 25-inch TV market, which jumped from about 21% to slightly more than 45%. Changhong’s gain resulted from decreases in domestic brands (only 42 of the 59 local brands that sold in China’s largest department stores survived after the price war) and foreign brands (domestic market share increased to around 60% by the end of 1996, compared to 36% when the price war began).

“In 1997, eight out of the top 10 best-selling brands in China were Chinese, and three local players, Changhong, Konka, and TCL, became the best-selling color TV brands in China,” the authors write. “Thus, the first-ever large-scale price war in China drastically changed the landscape in the industry in favor of Chinese companies, and the CEO of Changhong, Ni Runfeng, became a hero for Chinese national industries.”

Microwave Ovens

The microwave oven industry in China was also a ready candidate for a price war, but for different reasons. According to Zhang and Zhou, Galanz, a microwave oven manufacturer since 1933, reported a 25% market share in China in 1995. The company was on a healthy growth trajectory, seen as more focused than its chief competitor, Whirlpool-Xianhua. The majority of the company’s senior management preferred to maintain the company’s high profit margins (30% to 40%) through a safe, steady growth strategy. But after intense discussions, a minority advocated for a price war and the CEO agreed. The gamble paid off. From 1996 to the end of 2000, Galanz initiated five major price wars and, as a result, became the world’s largest microwave oven maker, with nearly 30% of the worldwide market and 76% of the Chinese market.

Why did Galanz ultimately choose the price war strategy? According to Zhang and Zhou, the microwave oven market was about to grow substantially as “a significant portion of Chinese households were ready to modernize their kitchens.” Galanz “estimated that significant price reductions would increase sales by about 100%.” In addition, Galanz was looking after its future, hoping that a price war would consolidate the industry by weeding out the smaller players “before they had a chance to grow.”

Finally, a well-planned and executed price war could significantly benefit Galanz in terms of establishing its cost advantages in the marketplace. How? By cutting its prices, Galanz would substantially increase it sales and take customers away from weak competitors; this would then help Galanz reduce its unit cost through scale economies in “production, distribution and components sourcing, which, in turn, would make the price cut more profitable in the first place.”

Galanz went into the price war with ample supplies, running its production lines on a three-shift, 24-hours-a-day schedule two months before it launched the first price war in August, an off-peak selling season that took the market by surprise. “You have to pay attention to the tell-tale signs of price war,” says Zhang. “When the competition is thinking of initiating one, they have to do preparation — accumulate inventory, ramp up production, work on distribution channels — because they need to make sure they have the products to occupy the market when the price goes down.”

The strategy worked during five different price wars. Sales increased, unit prices dropped, profits climbed. Key to the company’s success was “a simple and systematic way of setting its price to drive volume,” says Zhang. “It set its price at the break-even level for its nearest competitors. During the price wars, Galanz’s price would even go significantly lower than this break-even point. Using this strategy, Galanz always made rivals reluctant to cut prices, and thus it always stayed ahead of competition in capturing more volume.”

Key to any price war is “lowering your prices in a substantial way,” adds Zhang. “When you actually use the price as an instrument, you have to lower it 10% to 20%, a substantial gap. Lowering it 1% or 2%? No one will say you have a price war.”

Ultimately, price wars can change the consumer landscape. Says Zhang: “When the price wars began, the microwave oven was considered a luxury good. Only well-to-do families had a microwave oven in the kitchen. Then, after a few rounds of price wars, everyone has a microwave oven.” 

The Incremental Breakeven Analysis (IBEA)

Using these two examples, Zhang and Zhou developed a formula to help companies plan and execute a price war. The formula helps determine the break-even sales price point and important variables necessary to initiate a price war, including the size of the price cut and the reduction in marginal costs relative to the price reduction. Called the Incremental Breakeven Analysis (IBEA), the formula shows that price wars are not driven by luck but are the result of careful planning and execution, Zhang says. “As with any other business strategy, the usefulness of price wars depends on the circumstances.”

By plugging the numbers from the Galanz price war into the IBEA formula, Zhang and Zhou argue that “initiating the price war was the rational thing to do…. The value of IBEA goes far beyond that simple calculation, of course. Some rigorous analyses of the formula will help us to understand the incentives facing a firm in initiating a price war.”

The formula also helps explain why more mature markets in the U.S. don’t start as many price wars — although Zhang did point out that there have been recent price wars in the airline and computer industries, with mixed results. While the computer price wars seem successful, the price wars in the airlines industry “have had a disastrous result. No one is making money, though that has begun to be resolved as the industry consolidates and the number of companies that compete is reduced.” Or, as Zhang and Zhou note in their paper: “A firm can gain a larger market share when less cost-effective firms in an industry are weeded out. A price war will put strains on all firms in an industry. However, less efficient firms will buckle first and surviving firms will fatten their market shares.”

A price war does not necessarily have to be a long one. “A ‘shock and awe’ strategy can quickly convince an inefficient rival to get out of the way, as any resistance is either futile or fatal,” Zhang and Zhou suggest. And although a price war typically succeeds when there is an increase in market share, “not all bets are off if a firm cannot increase its market share by starting a price war. Another important factor in a firm’s price war calculus is the change in the industry demand. When a price war breaks out — even if all competing firms in the market are equally efficient and they all follow suit cutting their prices so that no firm can gain any additional market share — firms can still benefit from price wars if they expand the industry demand sufficiently.”

Which brings Zhang and Zhou back full circle to understanding why there are more price wars in less mature markets. “There is nothing intrinsically Chinese, as far as we can detect, about the calculus that the Chinese executives use in planning and executing price wars,” the authors note. “What is intrinsically Chinese, however, is the fact that a whole generation of Chinese executives have grown up in a business environment characterized by growing markets, heterogeneous firms with a wide distribution of cost-efficiencies, and new technologies with significant scale economies. This business environment provides many profitable opportunities for them to engage in price wars and to hone their skills, whereas in Western markets, oligopolistic competition among mostly equals in mature markets encourages more finesse in devising marketing strategies. In both cases, firms are weighing the same factors, [although] making different strategic choices in the end.”

The Art of Price War: a Perspective from China