Foreign Prices Undercutting Domestic Chinese Prices. Yes, You Read That Right.

Call me weird, but I have always been fascinated by the pricing of goods and, in particular, price elasticity. The following two examples have always fascinated me:

1. My old law firm represented a surgeon whose income fell in one year from around $450,000 to around $40,000 after an industry-wide change in insurance reimbursement. The industry talked of how this change might lead to a tiny decline in surgeon income, but, clearly, the tiny decline was not across the board.

2. During the Asian crisis of 1997, I read an article in a Korean newspaper discussing the decline in Korean imports. Imports were down across the board, let's say 40% (I am making up that number because I just do not remember). But, and here's the kicker, the market for quinces (I think it was quinces) from New Zealand (or was it Australia?) had disappeared entirely. In other words, it had gone from tens of millions of dollars to zero. Just plain zero. The Asian crisis had completely destroyed that one market for goods.  

Fascinating article in the Economic Observer the other day, entitled, "Are Foreign Manufacturers Undercutting Domestic Competitors?" The article focuses on how foreign companies are cutting their China prices on high end equipment so as to maintain or gain market share as compared with their Chinese competitors. I find this fascinating because there is so often an implicit assumption that foreign companies can never undercut Chinese companies on price, particularly within China.

The article focuses on electrical equipment pricing:

The quoted price of a K1-level electric cable manufactured by an American company was around ten million yuan per ton. However, after Chinese companies developed a substitute to be sold at around five million yuan per ton, the American price dropped to 2.8 million yuan per ton, almost immediately.

“We never expected that they would cut the price by over 70 percent,” said an anonymous source from the China Machinery Industry Federation.

The power transmission and distribution field has also witnessed similar price-cutting practices. Prices of certain products have decreased by around 30 percent in the past two years.

Previously, the prices of mid to high-end equipment manufactured by GE, Siemens, AREVA and ABB were consistently 30 to 50 percent higher than the prices of their Chinese counterparts. But, after significant cuts, the prices of foreign equipment dropped well below the prices set by domestic manufacturers.

Prices are falling across the board because Chinese company innovation has taken away the ability of foreign companies to price as though there is no competition:

According to a source from the China Electrical Equipment Industry Association, Chinese innovation in mid and high-end equipment has ended the price setting privileges of foreign manufacturers. They now find it difficult to charge unreasonably high prices.

The price changes are shifting the distribution of market shares. Some foreign manufacturers have maintained their market share by reducing prices while those who are unwilling to do so are losing it.

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The price war has also blurred the price division between Chinese and foreign companies. Before, the quoted prices of all foreign manufacturers were visibly higher than those of domestic manufacturers. Foreign companies largely competed amongst themselves. But now, the price war has affected all manufacturers, both foreign and domestic.

Now here's the most interesting part: foreign companies have a sizable advantage on costs because they have already paid for their innovation:

Faced with the same pressure to reduce prices, foreign companies still have a sizable advantage.

According to an anonymous high-level executive with Pinggao Electrical, the entire electrical equipment industry is under immense pressure because even though some companies can still earn a profit with price cuts, the profit margins of other Chinese companies have been reduced to almost nothing.

An expert from the China Machinery Industry Federation has observed that much of the high-end equipment manufactured by foreign companies were mature products before entering the Chinese market. Consequently, foreign manufacturers invest very little in research and development; thus, their costs are very low. But things are different with Chinese companies. They have to invest large sums of money in research and development to produce substitute products, resulting in higher costs.

My firm has an American client who is thriving in China for reasons similar to those set forth above. This client makes a piece of manufacturing equipment for around $10,000 and then sells it for around $100,000. It has no competition and it probably never will. Let me explain.

The equipment my client sells is last generation equipment and nobody buys it in the developed world any more. In the developed world, companies spend one million dollars or more for the latest and greatest. But in China and in a few other developing markets, there is still demand for the considerably cheaper machine my client makes. But what is so interesting about my client's business is that he is able to sell his machines for hundreds of thousands less than what anyone else would be able to sell similar machines and he is able to do that because he long ago fully funded all of his fixed costs for things like R&D and building a factory.

I have written about this business before, but I am now wondering how many other such businesses there are out there. How common is it that foreign companies have a price advantage simply by having been around before there was really much of a China market for their products?