Surviving the Emerging Market Price Wars: Three Myths & Three Lessons - Pharmaceutical Executive


Surviving the Emerging Market Price Wars: Three Myths & Three Lessons

Pharmaceutical Executive

Deconstructing myths

The drastic price drops that occur as a consequence of competitive price wars have a destructive impact on the entire market for medicines. All the companies involved—manufacturers and distributors—see their margins decrease significantly. What is worse, most will face difficulties recovering their lost margins. The destruction is in many ways unnecessary because companies will often engage in price wars based on false assumptions—we call them myths:

1st myth: "Low prices will drive volume and therefore profit"

Guided by an appreciation of pure volume-based incentives, management may think a price decrease will increase demand for their products. However, such a cut has two consequences: A volume increase and a margin decrease. Therefore, the total impact on profits depends on the strength of the volume increase, which is determined by the elasticity of the price. Price elasticity—which is a function of the consumer's response—predicts how much demand will change when prices change.

Figure 1: The above depicts an outcome scenario where a manufacturer with a gross margin of 20% decides to decrease its price by 10%.
According to our latest research work on global pricing, most managers tend to overestimate the positive impact of a price decrease on volumes, while they underestimate the negative impact on margins. Figure 1 shows a scenario where a manufacturer with a gross margin of 20% decides to decrease its price by 10%. In order to maintain the same profit, the manufacturer would have to double the sales it had before the price decrease. This would require a price elasticity of -10 (i.e., volumes need to increase 10 times the price decrease). This is much higher than the elasticity of innovative branded products, which is typically between -0.2 and -0.7. Even generics do typically not have a price elasticity exceeding 2.5. The manufacturer, in this example, is, therefore, very likely to have a lower profit after the price decrease.

2nd myth: "Our competitor started the war, so we should react by lowering our prices"

Companies hardly ever admit or realize that they started a price war. According to Simon-Kucher's Global Pricing study, when managers were asked who started the price war, almost 90% of them answered: "It was the competitor." Some companies truly believe their business is like a battlefield, where the competitor must be destroyed. However, war and business have two key differences: (1) All wars end at some point, but in a free market, there will always be competition; and (2) There are no customers in the battlefield, so companies should focus on responding to customer needs, not destroying the competitor.

The profit loss caused by a price decrease is usually greater than the loss caused by a decrease in market share. In addition, reacting to a price decrease of the competitor with a similar price cut typically starts a vicious circle of price cuts, since the competitor will try to maintain the original price difference. For this reason, the best possible reaction when the competitor lowers prices is to not change prices. In the end, lowering prices only intensifies the price war with disastrous consequences for the profits of all manufacturers involved.

3rd myth: "When the war ends, we will increase the prices"

Most managers would agree that a price increase is never easy. There are three facts that support that this also holds true for price increases after price wars.

First, competitors always endure the attack for a longer time than what was initially estimated, making it difficult to end the war. Price wars always last more and cost more money than expected. There is never a "winner," as there will always be competitors in the market. If competitors vanish, it is only because the margins are so low that it is no longer worth competing in the market.

Second, it is very difficult to increase prices to patients used to a low-price level, especially when price is the sole attribute manufacturers focus on.

Third, a price increase will also increase margins, making the market attractive again to competitors, which means a new war may loom soon.

Brazil's biggest maker of generic drugs and hygiene products, Hypermarcas, sets a real-life example on how to exit from a price war. In 2011, Hypermarcas was immersed in a price war against other competitors by offering big discounts and granting favorable payment conditions to distributors to gain market share. As its profit margins declined, Hypermarcas made a difficult decision: reducing discounts and shortening payment terms. Some key clients suspended their orders for several months; however, as soon as they ran out of stock, they placed new orders. Following a loss of $50 million in 2011, Hypermarcas posted a net profit of $100 million in 2012.


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