Problem
Client: Recently, HP announced that it had reached the #1 spot in world-wide shipment of PCs, displacing Dell to the #2 position. This was corroborated by research reports from both Gartner and IDC. Gartner estimated that HP shipped 9.652 million units, or 16.3 percent of the total, while Dell shipped 9.541 million, or 16.1 percent. IDC called it closer, estimating 9.831 million units for HP and 9.803 million units for Dell, both equivalent to a 17.2 percent market share. This has Dell mighty worried. You have been hired to strategize Dell’s pricing policies going forward, so that Dell regains the number one spot. How would you like to go about doing it?
Solution
(Note: The client's / interviewer's words are in italics, and the consulant's words are in bold.)
Consultant: So, the goal is to increase market share, right? How about Dell’s profitability? Does Dell want to increase its profitability as well?
Client: As it happens, we are happy with their current profit margins which have been steady at 6.36% for the last 3 years. We would like to focus on gaining market share back from HP, because we are worried that losing the #1 spot gives us negative buzz in the industry, and we believe a superior pricing strategy will help us get back our number 1 spot. In the process, if our net margins further improve, that will be great.
Consultant: What is Dell’s current pricing strategy? Is there any other information as to how HP came up from behind as the number one firm?
Dell sets pricing for its different market segments differently. We segment our market within US and Americas into corporate and US Consumer. Outside US, we segment our markets by geography into EMEA and Asia Pacific-Japan. Our revenue data for these market segments for the last three FYs are as follows:
So, two-thirds of our revenue come from the Americas, and half of our revenue comes from Americas’ business customers. This includes both North and South America. The primary battle grounds are these corporate customers, and here, Dell is experiencing some switching to HP. Further, in the consumer segment overseas, HP is nibbling away at Dell’s market share by offering low priced Compaq computers coupled with aggressive marketing and advertising. So, we have two segments to worry about: the corporate customers in US and elsewhere in North America, and also the individual consumers outside of US, primarily in Asia Pacific – Japan.
OK, that clarifies part of my question. First let’s examine the corporate market segment. What is Dell’s pricing strategy, and what is HP’s? Further, what are the reasons customers are switching to HP? What has Dell done to counter the switching so far, and why is it not working?
Dell follows the Dell direct model of serving its customers directly. So, we have a direct sales force. What HP has been doing with large corporate customers is servicing them with HP Services, which includes hardware, software, and services. When HP gets big services contracts, it bundles its hardware with its software and services, making it a more attractive proposition for customers to switch from Dell to HP, when it comes to hardware upgrades.
Interesting. What has Dell done to counter this so far?
Well, Dell’s business strategy includes its mastery over its supply chain. We believe that we are a low-cost producer, and we pass on these savings to our customers. In congruence with this strategy, we have been lowering our prices aggressively to match with HP’s and other competitors, across all segments.
You mentioned all segments. Isn’t the corporate segment different from the consumer segment? Has Dell done any study on the demands from the corporate segment vis-à-vis the consumer segment?
Yes, we have found that the corporate customer is not as price sensitive as the consumer segment. Further, they value services, like five nine (99.999%) uptime and reliability, and are willing to pay a higher price for that.
Yet, Dell has been cutting prices aggressively for the corporate segment?
Yes, otherwise, we might lose market share not just to HP, but also to other low-cost competitors like Acer, Fujitsu, and IBM Lenovo.
From what you just mentioned, the corporate segment is relatively price insensitive, specially compared to the consumer segment. In other wards, the corporate segment is fairly price inelastic. So, Dell should rethink its low-cost strategy with this segment, and in fact, it might come out ahead by raising prices, coupled with beefed up services. Typically, price takers in a market have no other option but to maximize profit where marginal revenue equals marginal cost, but firms with some market power can come out ahead by going for a price discrimination strategy to extract as much consumer surplus as they can. So, Dell should have a two or three tier pricing for corporate customers, based on SLAs (Service Level Agreements), to extract as much consumer surplus as it can, and will be able to compete more effectively with HP in these higher-priced, services sensitive, customer bases. Also, this will create better mind-share in the corporate segment in due course, and your corporate customers will not perceive Dell to be a low-cost supplier of computers but as a true value added services provider. This pricing discrimination, if done carefully, will increase not only profits from the extra consumer surplus extracted from the customers, but will also increase market share by getting customers back from HP.
Sounds economically doable. We will consider that, specially for the larger accounts. We certainly don’t want to come across as a “cheap” supplier, though for the SMB segment, it works beautifully. Now, how about the consumer segment in Asia Pacifc-Japan, where we are loosing to HP’s Compaq brand, not to mention other low-cost players like Acer and Fujitsu?
It is clear that the consumer segment is fairly price elastic. So, Dell should be aggressive in cutting prices, which I am sure it is already doing. In fact, what it is doing is following the profit maximization formula of marginal costs equal to marginal revenue equal to price. As marginal costs decrease year over year, marginal revenue decreases as well, and total revenues are probably holding up because of increased sales year over year. However, this segment is also not in the domain of "perfect competition", since firms are competing based on branding, advertising, and of course aggressive pricing. So, Dell does not have to be a "price taker" and just have a "agressively cut prices to match the competition" strategy. In fact, if we assume Dell has some kind of market power based on its distinct "Dell" brand, it can get more customers , if it follows a price discrimination strategy of charging a price which is below the price point where marginal revenue equals marginal cost. Albeit, products sold at lower prices can not be same as products sold at higher prices, so new product introductions may be required.
Interesting. You introduced two concepts, which are related to each other. Let us go slowly. Can you explain how Dell can gain customers by charging a price below the price point where marginal revenue equals marginal cost? We can take up the idea of new product introductions later, once we are clear on this. In fact, why don't you draw how Dell's marginal revenue and marginal cost curves look like, and what the price points currently are, and what you recommend that Dell do?
Yes. it can be argued that Dell enjoys some market power, however feeble, because of the "Dell" brand. Also, as I mentioned earlier, with advertising similar to HP's "Compaq" brand advertising, it is reasonable to assume that Dell's market power by virtue of an increasingly recognizable "Dell" brand will only increase over time, over the next few years. So, I would like to start by drawing a downward sloping demand curve which Dell faces. This curve is almost horizontal, since prices are fairly elastic. However, unlike perfect competition where a firm faces an infinitely elastic demand curve which is horizontal, here the demand curve is downward sloping, which signfies Dell's market power, however feeble.
Can I proceed with this reasonable hypothesis about Dell's market power in the highly elastic consumer market segment in Asia Pacific - Japan?
Yes, you may.
Now, let me draw out the Marginal Revene (MR) and Marginal Cost (MC) curves as shown below.
As per the normal formula for price maximization or MR = MC, the two curves intersect at Q0, and from the demand curve, the corresponding price is P0. So, P0 is the price that Dell should be charging to maximize profit, as per MR = MC.
However, if Dell charges price P0, consumers who would buy the same good at P1 will be out of the market, since the market price P0 is higher than their reservation price of P1. So, in effect, these potential customers will be locked out of the market, if P0 is the only price charged to customers. P1, as a price point, is still higher than the corresponding marginal cost point, though. So, selling to these customers at P1 will still earn Dell a profit, and this profit will not be available if the simple profit maximization formula of MR = MC is always used.
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