Meaning
Market trends describe the long term decline of the benchmark price used to signal the value of a commodity or service. When reference price erosion occurs, the initial list price of a product becomes less relevant as the market adopts a lower standard through frequent discounts and competition. This process forces manufacturers to either innovate or accept reduced margins to maintain their market share.
It is restricted to established goods where a stable price history exists for comparison.
Value Perception
Consumer expectations shift toward lower price points as a product matures in the marketplace. Because reference price erosion reduces the premium a brand can charge, it can lead to a commoditization of the entire category. This change makes it difficult for a company to re-establish a higher price without making significant changes to the product offering.
Competitive Response
Rival firms often use aggressive pricing strategies to enter a new territory or gain ground on an incumbent. During the period of reference price erosion, these discounts become the new normal for the industry as all participants are forced to match the lower rates. This cycle can result in a permanent shift in the profitability of the sector.
Margin Compression
Profitability is threatened when the cost of production remains stable while the selling price continues to fall. In a market suffering from reference price erosion, the distance between the manufacturing cost and the retail price narrows. Firms must then focus on operational efficiency to survive at the lower price level.
