The wrong pricing strategy can destroy corporate value faster than almost any other business mistake. And when industries are about to be deregulated, managers habitually adopt ill-conceived pricing policies that are almost guaranteed to damage their companies and erode services to customers and the community.

These flawed pricing policies—common among deregulating telecommunications, transportation, and utility companies as well as other businesses—represent efforts to hang on to customers. Managers cut prices preemptively to fend off new rivals and then launch full-fledged price wars in hopes of outlasting attackers and emerging victorious from the rubble. This, at any rate, is the hope; the reality is usually quite different.

One example of such pricing behavior comes from the Chilean telecommunications sector, which deregulated in 1994. Before then, Empresa Nacional de Telecomunicaciones (Entel) had been the sole provider of domestic and international long-distance services, but with the coming of deregulation Entel had to compete against seven rivals. At first, hoping to keep its customer base intact, it joined in a price war. By the end of 1994, rates for calls from Chile to the United States had fallen by about 95 percent, and domestic long-distance rates had collapsed similarly (Exhibit 1). Despite the price cuts, Entel lost nearly 70 percent of the domestic long-distance market and more than half of the international one. After 1994 Entel stopped competing on price. Differentiating itself from competitors on the basis of service and broad product offerings, it began charging a premium over the rates of its largest rival. New entrants continued to threaten Entel's international business, but by the late 1990s the company had recovered some of its domestic long-distance market share.

Germany's electricity market provides another example. After deregulation, in 1998, some of the country's largest incumbent utilities cut prices preemptively to dissuade customers from jumping to Yello Strom, an aggressive new competitor. Within two years, the average market price of energy had dropped by about 30 percent. As a result of these price cuts, incumbent suppliers saw their profits tumble—a high price to pay for an attempt to keep the customer base intact. Prices rebounded in 2001 as even attackers complained of low or nonexistent margins. At the year's start, Yello, for instance, raised its prices by 18 percent, including an energy tax that accounted for three percentage points of the increase.

Lower prices for customers are among the primary goals of most deregulation efforts. Of course, increased competition can indeed prompt former monopolies to search for greater efficiencies, thus reducing costs and, potentially, prices. But if misguided policies spur struggles that bring prices below the level needed to cover costs, neither companies nor consumers win, since the former may be so crippled that they can no longer guarantee basic supplies and services to the latter. And if a price war succeeds in destroying all attackers, a shattered market will be left with little competition.

Optimal prices for incumbents can be as much as 20 percent higher than the ones that they actually set

In most cases, established companies launch price wars believing that once the dust has settled, prices will rise again. But psychologically and politically, it can be far more difficult to orchestrate a price increase than a price cut. Throw a stubborn attacker into the mix, and incumbents can find themselves trapped in unsustainable rate structures. In our analysis, optimal prices for incumbents can be as much as 20 percent higher than those they actually set. Even then, average market prices will likely fall from monopoly levels, and incumbents must be prepared to lose some of their customer base. Nonetheless, if the right factors influence their pricing decisions, they and the market will remain healthier.

Four factors

An examination of deregulated markets, mostly in Europe, has taught us that the incumbents' managers tend to make the same mistakes when they address the problem of pricing. As deregulation starts, they feel the pressure of many unaccustomed challenges: for the first time, they must think about growth, regulatory strategies amid competition, cost cutting, organizational change, and so on. Overwhelmed by such problems, the managers see pricing chiefly as a tool to protect market share and don't put enough effort into devising profitable pricing policies.

Often the incumbents misinterpret or ignore four key factors that should influence their pricing strategies: competitors' prices, switching rates, customer value, and cost to serve. When all of these factors are weighed correctly, incumbents often find that they can actually charge a premium over attackers' rates, and this discovery may well be the key to their continued profitability.

1. Competitors' prices

In the deregulating markets we have examined, the most important influence on pricing decisions is competitors' prices. For customers, especially in mass markets, the newcomers' price is the major element differentiating competitors. Often, however, the incumbent focuses on the wrong attacker: in an extreme example from Austria, mobile-phone attackers that mistakenly saw even the established telephone network as a competitor drove mobile-phone rates lower than their terrestrial counterparts when the incumbent followed suit. More often, when facing multiple attackers, incumbents almost by default worry about the lowest price being offered rather than the most relevant. Incumbents, in setting their own prices, should focus on those of the competitor that is best known in the market and has the greatest chance of luring away customers. Price elasticities, price transparency, and customer perceptions of individual companies are quite uncertain at the start of liberalization. Hence incumbents may erroneously focus on undercutting the lowest price charged by any competitor, regardless of its ability to attract customers.

What is more, a former monopolist generally underestimates its competitors: believing that it can outlast any of them, it sets prices without fully anticipating the speed and vehemence of their pricing reactions. Incumbents are often unpleasantly surprised by how long the competition can sustain low prices even when they fall below the cost to serve. In Germany, for instance, incumbents in various sectors underestimated the staying power of new rivals such as Yello. The result: aggressive price reductions that drained profits.

2. Switching rates

As soon as the customers of a monopoly can choose another supplier, some of them will inevitably do so, and others will follow if the incumbent charges more than its rivals. This switching rate is a second factor that must be weighed in setting price levels in newly liberalized markets, though incumbents actually tend to overestimate the amount of switching that price differentials are likely to trigger.

These inflated estimates are based on the often exaggerated ideas of executives at incumbent companies about how much time their customers spend mulling over their services. In reality, many customers see them as commodities that are hardly worth thinking about at all. As a result, comparatively few customers even consider switching unless the advantages, such as a large price differential, heavily outweigh the bother of changing providers. The fears of such managers are often generated by horror stories they hear from other deregulated markets, but they usually fail to notice the high premiums charged by the incumbents there. Companies that act upon anecdotal information about switching rates, without considering these premiums, can make faulty pricing decisions.

In Germany, the energy incumbents worried when Yello, in 1999, launched one of the largest advertising campaigns in the country's history in an attempt to sign up 1.3 million customers. A year later, the attacker had only about 400,000 of them. Just 1 to 2 percent of private customers in the German energy market have switched since the coming of deregulation, in 1998. The relatively small price differentials were only one factor: in addition, monthly energy bills were generally low; the potential difference in payments didn't justify the effort needed to compare offers and switch; and there were structural obstacles to switching, such as lengthy notice periods for cancellation. Our analysis of several markets in the years after liberalization shows that incumbents charging a 5 percent premium endured switching rates that actually never exceeded 2 percent of the customer base a year (Exhibit 2). After peaking immediately following deregulation, the rate actually fell. Of course, as price premiums increase, so does the likelihood that a larger proportion of customers will jump to an attacker.

3. Customer value

Few things are more dear to the hearts of incumbents than their customer base, but the quixotic effort to retain a 100 percent market share leads them to misunderstand the value of their customers. In the prevalent view, all of them have the same high value, but that just isn't right: their individual value varies according to such considerations as the size of the price premiums they are willing to pay before they fly into the arms of competitors, how much additional revenue they can produce through cross-selling, and the cost of reacquiring them. Although an ex-monopoly must keep a substantial share of the market, keeping all of it is impossible.

Fortunately, one of the factors that determine the value of customers is their readiness to jump to the competition. If a customer is the kind of person who switches easily, retention efforts are better directed at others, since the likelihood of success is small. But for incumbents that have spent so much time in a monopolistic world, it is hard to accept the idea that likely switchers have a lower value and can be shed with only a marginal impact. Managers must understand that it is better to lose fickle customers than to keep them at unrealistically low prices—an approach that cuts margins earned from all customers, even those who are less price sensitive.

Traditional volume-driven customer strategies usually reflect inexperience in acquiring (or, in this case, reacquiring) customers, for as monopolies, the incumbents didn't have to worry about attracting them. Incumbents tend to assume that a customer, once lost, is lost forever.

4. Cost to serve

The final factor that incumbents often misjudge is the true cost of serving individual customers. In a controlled market, incumbents generally calculate their prices by adding an acceptable profit margin to their total costs rather than taking the time to determine the cost of serving individual customer segments. Faced with competition, incumbents set aside even their rudimentary estimates as they rush to meet or beat competitors' rates. Pricing below cost can work only in the short term. It is a safe bet that prices will start rising again once the market settles.

An incumbent's own costs should serve as an absolute short-term price minimum. Until more accurate price information is announced, the costs of competitors can be used as a proxy for their likely price structures. In the electricity sector, for example, an attacker's costs can be reasonably estimated by taking the generation or purchase cost of the electricity and adding grid fees and an estimate of fixed costs such as overhead.

Making reasoned decisions

By intelligently evaluating the four factors, incumbents can make more reasoned decisions about how to revise their pricing policies in the face of increased competition (see sidebar, "Using the factors"). Rather than blindly undercutting attackers, incumbents can safely charge private customers and most commercial accounts a premium that secures their business, avoids costly price wars, and preserves the market.

But this premium is not without complications. First, of course, the incumbent must be willing to shed a portion of its customer base, probably as much as 20 percent in the first year. Determining the acceptable level of customer losses early helps managers ride out the first shock of lost market share. Still, the situation should be monitored closely. As concrete data begin to accumulate, some assumptions may prove to be incorrect, so prices will have to be adjusted. In addition, incumbents should include in their pricing policies certain triggers—such as levels of market share or competitors' prices—that would initiate changes in policy. Conditional pricing can free managers to turn their attention to other important issues.

Of course, closer attention to pricing isn't of benefit solely to companies in deregulating markets: the model distilled from them can be adapted to other situations characterized by intense price competition. Structural changes and cyclical shifts in markets or industries that are already competitive, for example, often inspire companies to defend their market position through price cuts. Moreover, companies in price-sensitive sectors of e-commerce—particularly business-to-consumer (B2C) companies struggling to acquire customers—are prone to some of the same mistakes that deregulating incumbents make.

Pricing is an important value lever, but many managers in deregulating markets have trouble determining the right price for products and services. These managers, misinterpreting or ignoring the four factors that inform rational price setting, embark on self-destructive attempts to keep customers at any cost. They must learn a tough lesson: that to optimize value, it is necessary to lose customers.