My company essentially invented a certain product category many years ago and for about 3 years we were the only company offering this digital product. Because we were the first and only, the we grew fast and quickly this product became our number one seller. It essentially funded us as we were bootstrapped. About 3 years into it a larger competitor came into the market and undercut us by offering the same product at around 50% to 90% less than we were offering it. The product is digital, so pricing is rather arbitrary, but the prices we were originally selling it for were very reasonable and most would agree that the competitor's pricing, while cheap, greatly devalues the product itself. (A common theme with this particular company.) Every since then, we have been hit hard and have lost a huge amount of market share to this competitor. From the vendors that sell this product through my company I hear 2 sides: 1. We should not lower our prices to be like them. Instead we should raise quality and keep the prices the same. (While this sounds ok, the idea of raising quality isn't really applicable in this situation. While we have some control over it, we don't have that much control.) 2. Other say we need to lower prices to compete. In fact, there are some vendors that sell the same product through our company at a higher price and sell the same product through the other company at the much lower price. With our company, we allow the vendors to set their own prices, but the other company does not. They force all vendors to follow their lower pricing points. In the last year or so, the other company has actually crept up its pricing to be closer to ours. So, wondering... should we drop our prices to match or beat theirs? Or, should we keep them the same? Thoughts?
If your product is truly better undercutting the undercutter is a good temporary marketing strategy.
Just make sure your business can afford to do so. Their business model might allow them to simply charge less because of efficiency factors that you might have. Or your prices might simply be a bit higher for what your market is willing to pay or considers justified.
Pricing strategy needs to be aligned with brand, product, and channel strategy. Whatever you do with your pricing, you need to make sure it aligns with those very tightly. I've seen companies with really good product get themselves totally sideways in the mind of the consumer (and the retailer) by not keeping this in mind. I can't tell if this matters in your particular market/product category. But if you had three years lead, perhaps you have what it takes to seize the high ground as the innovator in your category and maintain your prices, assuming you have a pipeline of new products to justify the leadership position.
I think it is really important not to erode value in the face of customers. A good friend of mine runs a company called Undeground Cellar that got taken onto Y-Combinator. The ethos is they are taking a novel approach to preventing price and brand erosion in the wine industry.
I realise yours is a digital product, but I would certainly think about tangibles you can offer before getting caught in a price war. Lots of studies have shown that something + free is perceived as more valuable (watch Robert Cialdini - 6 Keys to Persuasion) https://www.youtube.com/watch?v=cFdCzN7RYbw and just try to mix it up a bit.
At least that way you can always drop your prices later, but right really cool customer service emails or a really nice follow up to your customers. Something the big guns can't do - you would be surprised how loyal some customers will be.
Just my two cents.
You have two issues to sort out here....
1) You were the only game in town until the competitor came along, and guess what, the prices got lower. This is normal and natural in the evolution of companies and their competing products. Eventually, at least once competitor decides to make an issue of pricing. Indeed you have a choice to make. I often advise my clients this way: If you have a great product, and it's priced higher than your competition, you must provide your marketplace with a way to view your product as worth the price. If you cannot to this, then by default, you must lower your prices and by doing so, give up much of your profit.
2) Your competitor's pricing has crept up to meet yours. Without any real indicators blaring to me the truth, I'm betting (from experience) your competitor temporarily lowered their price to gain market share (successfully) but did it at such a low price, they cannot make a profit on the customers they gained. This means you should keep your higher pricing and repeatedly broadcast to your marketplace that you have a superior product at a higher price. Doing this successfully means your competitor will be doing business in an unprofitable zone and will not be able to sustain this for long...and will either come up to meet your pricing or suffer from damaging lack of profitability and cash flow.
I suggest you take the strategy of forcing your competitor to either suffer or meet your price. Please do not lower your price, or lose profit, unless you are unable to publicly justify your product as superior!
Good Luck and get cracking on justifying to your marketplace that your product is superior and worth the additional price!