Undercutting is the expression of supply pressure
I'm always harping on supply and demand in this column. I don't want to sound like your grade 8 economics professor, but the reality is that any question in any market can be boiled down to these forces, and it's a nice, clean way of thinking about problems that can help you make the best decisions.
The old adage is that price is the balance of supply and demand, but how does it really work? Well, when you make, farm, find, or steal something that's going to end up for sale, you haven't increased the supply until you're actively trying to sell it. Once you do try to sell it, you'll likely only start to find interested buyers when you make its price lower than your competition.
Undercutting this way is how supply affects price. There's no moral or ethical consideration here -- you're dealing with a comparison shopper who isn't going to pay more for your junk than someone else's unless they're a friend or a guildie who is feeling generous. The reason the price eventually averages out is that as the products are made available for less and less money, more and more people are willing to buy them. Assuming they usually buy the cheapest, it's going to push the price back up.
Mmm ... pie
Think of the market like a pie that's being split up among all the sellers active in it. Your undercutting strategy will partly determine how big of a slice you get. One of the most important factors in how much pie you find on your plate is how large the original pie was. When the prices are low, more people buy more items, which makes the pie larger. The profit margins are lower, though, especially when you're all competing for the same base mats. This trade-off means that as the prices go down, while the pie might start off a little larger, it will eventually taper off once the profit margin per item sold starts to get closer to zero.
The other important factor is how many people are sharing the pie and who is willing to work the hardest for their piece. One thing's for sure: If you undercut heavily, you'll sell more and have to craft more. Assuming you can make, farm, find, or steal enough to keep your stock levels ahead of the demand and sold items, you can easily use undercutting heavily to move a lot more goods. This works particularly well in markets with high margin (like glyphs). Whether lowering your margins and undercutting heavily is more personal profit or not, it sure costs your competition money and that's almost as good as having money yourself.
An example of this is if a nice segment of glyphs on your realm cost something like 120g, you can make an excellent profit by mass-crafting those glyphs and posting them all at once for 40-60g. The worst case scenario for the cost of a glyph is 30g, assuming you have to trade in (or use) three Blackfallow Inks at 10g to make it.
Glyphs tend to go up in price over the long run because it takes so much time and effort to produce them that the thin margins drive opportunist auctioneers like myself to other, more profitable businesses. Every so often, though, when I drop back in to check if the prices have recovered, I'll leave a thank-you bomb in the form of a 60g glyph wall. One of my competitors might just buy everything I posted and relist them at the old prices, but whether that happens or not, the number of glyphs sold at 60g will be higher than at 120g, so even if I get undercut in 15 minutes by someone who doesn't return tells (as is the norm on my stupid server), I am more likely to see organic demand (not from my competitors) take both of our stock.
Heavy undercutting isn't the only answer
When does heavy undercutting not work? When the profit margins are slim, there is lots of demand, or the mats are very hard to find in quantity. For example, I don't undercut heavily on certain cut gems because I sell more of them then other cuts at the same undercut settings, and it's a challenge for me to find enough uncut raw gems to keep the market supplied. In fact, I have set my pricing strategy in TSM on some of them to never go below a certain profit margin, even if I get undercut. I'll just wait for the cheaper stock to get bought out. In this situation, I'd be stupid to undercut heavily because I'd constantly be out of stock, or my competition would just buy me out and relist my goods. The characteristics of this market are high profit margins and heavy demand. Another example of a market like this would be BoA enchants, but only when you're using mats that are basically impossible to farm.
I have two modes: heavy undercutting or overcutting. If the demand is so strong that I run out of stock, I stop undercutting altogether and take a smaller percent of the items sold at a higher price. If the competition is fierce (or logs in annoyingly frequently), I'll undercut deeply. The two strategies not in my playbook, however, are AH camping or price matching.
The last refuge of the incompetent
If the only way to get a slice of pie worth playing for is to stay logged in and camp the AH watching for undercuts, find another game. Hell, you'll probably make more money per hour fishing, and at least that gets you out in the world where you can look at all the nice new graphics Cataclysm brought us. Camping the AH feels like it should work because you are always the lowest price, but people don't realize that the most precious commodity in this game is attentive hours at the computer. I can AFK smelt for hours easily, but every hour I sit in front of the AH spamming my cancel and relist key in TSM is an hour I didn't use on trying to set up another business, to level another trade skill, or to find a better supplier ... or, you know, to actually play the game!
In practice, camping is a terrible business practice that makes you far less gold per hour than an actually productive activity. If you don't believe me, time yourself and do the math. See how much more business you actually get when you camp, and compare the profits on that to the profits you would have made without camping. Is that number as good as you thought it was?
Price matching is the other strategy that doesn't work. There's a whitelist on TSM that allows you to match the prices of people on that list instead of applying your normal undercutting strategy on them. Having anyone on this list is a complete waste of time, because it sends you right back to the first situation of camping the AH. The default sorting will show most recent auctions at the same price first, so the last of your little social group to log in and post will make the sale -- at least, until they fix the AH's buying interface and group all identically priced auctions on the same line.
If a friend requests that you add them to your whitelist, go ahead and do it. Friends are more important than this game, but try not to make realID friends with other auctioneers!
Maximize your profits with more advice from Gold Capped as well as the author's Call to Auction podcast. Do you have questions about selling, reselling and building your financial empire on the auction house? Basil is taking your questions at firstname.lastname@example.org.