How many times have you walked into a store with a sign that reads, “we price-match all competitors” — or seen that policy in an online store? Price-matching is the practice of selling your goods at the same price as your competitors if the competition offers consumers a lower price than you do. An obvious implication is that any business with that practice is in an extremely competitive market. A non-obvious implication is that price-matching might be extremely anti-competitive behavior.
Suppose a market where there are only two firms, Firm A and Firm B. Further, suppose that both firms sell the same, exact, homogeneous good; it costs each firm $5 dollars to produce the good and they currently sell it for $30. In the current market conditions, each firm is selling 100 units for a total profit of $2,500. Assume that you are the owner of one of those firms and that your self-interested goal is to maximize your profits (in a legal way). How can you beat the competition?
It is in your self-interest to offer a better price to consumers. Why? If you lower your price, you will capture the market. That is, if you offer the same good as the other firm but at a lower price, the individuals who were buying from your competitors will now buy from you. So you lower your price to, let’s say, $20 and you increase your profits — you are now selling 200 units for a total profit of $3,000. Recall that the Law of Demand states that when the price of a good falls, the quantity demanded increases, so you might end up selling even more than 200 units of output — increasing your profits by a bigger amount.
Now, your competition realizes what your strategy is. So they have no other choice but to lower the prices of their goods if they want to sell their product. But they reason the same way as you, and they lower their price by even more than you did. And once you notice what they are doing, you sell your good for cheaper. And this cycle continues until each of you is selling the good as low as you can. That is, until the cost of production equals the price that you’re charging: $5. At a market price of $5, you each sell 100 units for a total profit of $0.
For those interested, what I just described is the Bertrand economic model for oligopolistic markets.
But wait a second. You started out making a profit of $2,500 and, through the forces of competition, ended with a profit of $0. You don’t like that. How do you avoid it?
Let’s go back to when the price was $30. Now you know that your competitors might lower their prices by an arbitrarily small margin and attract your customers. You also know that that competitive cycle ends with your profits going down to $0. So you come up with a strategy to keep your competitor from lowering prices: you institute a policy that reads, “we meet or beat any price.” You decide to engage in price-matching.
An ingenious way to eliminate competition while masquerading as an extremely competitive business. If the other firm lowers his prices to $20, he won’t gain any customers, since customers that see the price of $20 can just go into your store and buy it at that same price. If he lowers the price to $20, he ends up selling the same amount of units, 100, but decreases his profits to $1,500 — as a self-interested, profit-maximizing firm he won’t want to lower his profits.
The incentive to compete has been dampened. Neither firm engages in price-cutting, you end with $2,500 in profits instead of $0, and you’re satisfied.
The moral of the story is that things are not always what they seem: Price-matching might be anti-competitive behavior.
However, there is still a way for a self-interested, profit-maximizing firm to increase profits, even if the competition is price-matching. And that is by being more cost-efficient than the competition. If your firm finds a way to be more cost-efficient, by producing the good for, say, $1 instead of $5, then you can sell the good at a price that’s lower than the cost of production of your competitors, gain market share, and increase your profits.
As Thomas Sowell wrote, “Most of the great fortunes in American history have resulted from someone’s figuring out how to reduce costs, so as to be able to charge lower prices and therefore gain a mass market for the product. Henry Ford did this with automobiles, Rockefeller with oil, Carnegie with steel, and Sears, Penney (JC Penney), Walton (Walmart) and other department store chain founders with a variety of products.”
In the end, competition thrives. Which translates into lower prices, which translates into consumers buying more goods and services, which translates into an increased standard of life.