by Donald V. Potter

Leaders of companies enjoying high margins are likely to feel satisfied when times are good and profits are high.

This is a good time, though, to scrutinize the situation. Why are margins high? The answer is important for anticipating the future.

A company enjoying above-industry margins probably has a competitive advantage (often a below-average cost position) that may be sustainable. If margins are high for the entire industry, though, hostility may lie ahead.

High Industry Margins Create Attractive Target

Any industry with real price increases for several years is ripe for hostility because these price increases lead to high margins.

Real price increases mean that prices are rising faster than inflation and usually faster than costs. Since a portion of the total cost is always fixed, costs should not increase as rapidly as unit volume. If the market is growing, then, prices rising with inflation-and certainly rising real prices-will inflate margins.

High margins create an opportunity for new competitors who can in some way unbundle the product or can persuade customers to forego the premium for a brand name. Certainly, the new competitor will offer a lower price.

Competitors Undercut Market

The growth of a low-price competitor sets the stage for market hostility. This competitor will get some business from price-sensitive customers. Then, with a toehold in the market, it will begin to grow, adding volume, improving its economies of scale, upgrading its product line, and building a reputation.

Once enough share is lost, market leaders will have to respond by dropping their prices to meet the challenge. When that happens, the market price will collapse and hostility will begin.

In the airline industry, hostility began when the major carriers cut prices in response to People Express, which had achieved a 6% market share. In computers, hostility began when Compaq cut its prices by 30% to meet faster-growing clone manufacturers. The tobacco industry appears to have entered hostility recently when Philip Morris cut prices for its Marlboro brand by 20% after discount brands had taken a 36% market share. In fact, prices in many grocery categories were falling in 1993 as branded products reacted more aggressively to the rapid share growth of cheaper private labels.

Why Market Leaders Wait

The mystery is why market leaders allow an initially insignificant competitor to grow into a market threat. Our research shows that market leaders often fall into “The Leader’s Trap”.

Initially, market leaders may not take a new entrant seriously: its share is too small or its products too “cheap” to pose a threat. American car and motorcycle manufacturers, for example, both reacted with disdain to the early Japanese imports. As the new player grows, market leaders may reason that only their weaker competitors are threatened. After all, the new entrant is taking share from the
second tier of competitors in the market, not from the leaders. Initially that is true-but the discounting competitor is gaining strength, and share is shifting. Eventually, market leaders hope to maintain their margins by holding up prices even as share declines.

But these leaders are only postponing the inevitable. Products of the discounting competitors improve as these companies grow. Then pressure for lower prices will come from increasing numbers of customers who will no longer pay the premiums of the better-established brands.

Quick Response Can Minimize Damage

“By holding prices up, a leader maximizes its damage.”

By holding prices up until customers force them down, an industry leader maximizes the damage to its own market position. Formerly loyal customers shop around, with success. Furthermore, customers may be antagonized by the market leader’s reluctance to meet price competition. With old buying habits broken and customer relationships strained, industry leaders will find it expensive to recapture the lost market share.

Market leaders face an ironic dilemma. Once a low-priced player expands in the market, hostility is all but inevitable – but it is the market leader who actually triggers that hostility by dropping its prices. Yet by avoiding that painful step as long as possible, the market leader actually makes hostility worse for itself. A better response is to counter a discounter early, as soon as share begins to shift, before it can gain strength and customers can become restless.

Closing Thought

Any competitor growing faster than the market leader poses a direct threat to the leader. Sooner or later, the leader will see the faster-growing competitor in its own backyard.

(Note: This Perspective was written in the context of the economy in 1993. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

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Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.