How do firms respond to price wars?

The starting point for this paper is the observed empirical patterns in U.S. crude oil industry in the wake of the OPEC initiated price war that commenced in December 2014. We observe that, in line with theoretical expectations, there was a decrease in entry of shale oil wells in the wake of the price war. However, contrary to expectations, the U.S.-based shale oil firms experienced productivity growth (i.e., greater oil per well) in the wake of the price war. We sought to examine why and how firms adapt to the price war. We outline a simple model to sharpen the intuition behind our theory. We show that prices, the fixed cost of entry (drilling a well), and the returns to process R&D (that reduce the variable cost of production) together determine the profit maximizing decision of firms. In the regime before the price war, increases in price-cost margins coupled with the greater relative returns to drilling wells leads the shale producers to maximize the drilling of wells and ignore opportunities to engage in cost-reducing R&D (subject to an arbitrary but binding budget constraint). In the wake of the price war, however, the decision calculus shifts as price-cost margins turn negative and increase the relative value of cost-reducing R&D. This results in firms eschewing drilling wells in order to save on fixed costs and shift spending toward R&D. Results using data on oil production in the U.S. at the well-level lend support for our theory. We further explore the mechanisms behind the productivity growth of shale oil firms. The paper concludes with implications for understanding the drivers of innovation and change in technological trajectories.