Pricing Strategies (Edexcel A-Level Economics A): Revision Notes

Pricing Strategies

Introduction

Firms operating in markets with imperfect competition face an important strategic decision about how to price their products. Unlike firms in perfectly competitive markets, which must accept the market price, firms with some market power can influence the price they charge. The pricing strategy a firm chooses depends on the objectives it wants to achieve. This might be maximising profits, but firms may also pursue other goals such as maximising revenue, increasing market share, or demonstrating corporate social responsibility.

Pricing rules

Firms with market power face a downward-sloping demand curve for their products. This means they are not price-takers like firms in perfect competition. Instead, they can choose different combinations of price and output depending on their objectives. There are several possible pricing rules that firms might follow.

Profit maximisation

When a firm aims to maximise profits, it follows the standard profit-maximising rule. This means the firm produces output where marginal revenue equals marginal cost ($MR = MC$). At this output level, the firm is adding as much to revenue as it is to costs with each additional unit, so profit is at its maximum.

In practice, the firm will identify the output level where $MR = MC$, then charge the price that consumers are willing to pay for that quantity (found on the demand curve). This pricing rule is the one typically assumed in economic analysis of firm behaviour.

Revenue maximisation

The economist William Baumol suggested that in some situations, managers might pursue revenue maximisation rather than profit maximisation. This can happen when there is a separation between ownership and control in a firm. Shareholders own the company, but professional managers make day-to-day decisions. These managers may have some freedom to pursue objectives other than pure profit maximisation.

A revenue maximiser will produce where total revenue is at its highest point. This occurs when marginal revenue equals zero ($MR = 0$). Beyond this output level, selling additional units would actually reduce total revenue. This strategy results in higher output and lower prices compared to profit maximisation.

Sales maximisation

Some firms may aim to maximise their volume of sales whilst still covering their costs. This strategy involves producing at the output level where price equals average cost ($P = AC$). At this point, the firm clears the market and covers all its costs, including opportunity costs, but makes no supernormal profit.

This strategy results in even higher output and lower prices than revenue maximisation. However, producing beyond this point would result in losses because the price would fall below average cost.

Allocative efficiency

From society's perspective, allocative efficiency occurs when price equals marginal cost ($P = MC$). At this point, resources are allocated in the most efficient way possible, with the value consumers place on the product matching the cost of producing it.

However, there is no obvious reason why a firm would voluntarily choose this pricing rule, as it provides no particular advantage to the firm itself. In fact, it would likely result in lower profits than the alternatives.

Corporate social responsibility

Firms may also consider corporate social responsibility when setting prices. This means they might deliberately refrain from charging the highest price the market could bear. One way of demonstrating commitment to social responsibility is to set a 'fair' price for products.

However, this raises questions about what is genuinely the best approach. A firm might gain more positive publicity by maintaining its prices at normal levels and then using some of the profits to benefit the community in other ways.

Pricing in practice

In reality, most firms do not have precise knowledge of their revenue and cost curves. This makes it difficult for them to adopt the theoretical pricing rules described above. Instead, firms need practical methods for setting prices.

Cost-plus pricing

A common approach used by many firms is cost-plus pricing (sometimes called mark-up pricing). With this strategy, firms calculate their average cost at their chosen output level, then add a mark-up to generate some profit per unit.

Does cost-plus pricing contradict the profit-maximising hypothesis? Not necessarily. Whilst it appears different from the theoretical $MR = MC$ rule, the key question is: what determines the size of the mark-up that firms add to average cost?

In other words, firms may use cost-plus pricing as a practical strategy to move towards the profit-maximising level. They experiment with different prices and observe the effects, gradually iterating towards the optimal price-output combination through trial and error.

Price wars

Another finding from the Bank of England survey was that firms strongly wished to avoid price wars. In oligopoly markets with a kinked demand curve, firms recognise that price reductions are likely to be matched by rivals. This leaves all firms with lower profits but has relatively little effect on market shares.

Price wars: an example

Despite firms' general desire to avoid them, price wars do occasionally break out. In the early 2020s, UK supermarkets engaged in price-cutting behaviour on selected popular products to attract customers from their rivals. The aim was to consolidate or increase market shares.

When rival supermarkets began to match these price reductions or introduce their own cuts, profits started to erode. This occurred during a period when online shopping was rising, making it a less profitable time for traditional supermarkets. The experience suggests that the benefits from price-cutting behaviour may not help the firms involved in the long run.

Why initiate a price war?

In some cases, a price war is initiated as a strategic move to drive weaker competitors out of the market altogether. The motivation becomes clear if the initiator ends up with a monopoly or near-monopoly position. This could be argued to represent an attempt to maximise profits in the long run by establishing a dominant market position.

Predatory pricing

Perhaps the most common context where price wars emerge is when existing firms react to defend their market against the entry of new competitors. This can involve predatory pricing – an anti-competitive strategy where a firm sets its price below average variable cost to force rivals out of the market and achieve market dominance.

Areeda-Turner principle

The courts have supported economic theory regarding predatory pricing. They argue that a pricing strategy should be interpreted as being predatory if the price is set below average variable costs. The only motive for remaining in business whilst making such losses would be to drive competitors out and achieve market dominance. This is known as the Areeda-Turner principle (after the US case where it was first established).

At first glance, consumers might appear to benefit from the resulting lower prices. However, a predator that successfully drives out the competition is likely to recoup its losses by raising prices back to profit-maximising levels afterwards. Therefore, any consumer benefit is short-lived.

Threat of predatory pricing to deter entry

Sometimes the mere threat of predatory pricing may be sufficient to deter entry by new firms, provided the threat is credible. Existing firms need to convince potential entrants that they will fight a price war if entry occurs. Otherwise, potential entrants will not believe the threat.

A new firm may calculate that if the existing firm sacrifices profits in the short run, the rewards from dominating the market must be worth fighting for. It may therefore decide to sacrifice short-term profit to enter the market, especially if it is diversifying from other markets and has resources at its disposal. The winner will be the firm that can last the longest, but clearly this is potentially very damaging for all concerned.

Limit pricing

A less extreme strategy than predatory pricing is limit pricing. This assumes that the incumbent firm has some form of cost advantage over potential entrants, perhaps due to economies of scale.

Consider a firm facing a downward-sloping demand curve that is maximising profits. If the firm sets output at the profit-maximising level and charges the corresponding price, it will earn healthy supernormal profits. Suppose the natural barriers to entry in this industry are weak. These supernormal profits will attract potential entrants.

Given the cost conditions, the incumbent firm is enjoying the benefit of economies of scale. If a new firm enters the market on a relatively small scale, the immediate effect on price can be analysed. When the new firm's output is added to the incumbent's output, total market supply increases, pushing the price down.

The new firm, producing on a relatively small scale, is just covering average cost and making normal profits. It feels justified in having joined the market. The original firm is still making supernormal profits, but at a lower level than before. The entry of the new firm has competed away part of the original firm's supernormal profits.

Setting a lower price

One way the incumbent firm could have guarded against entry is by setting a lower price to begin with. For example, if it had set output at a higher level and charged a correspondingly lower price, a new entrant joining the market would push the price down to a level below their average cost. Without the benefit of economies of scale, the new entrant would make losses and exit the market.

By setting a price below the profit-maximising level, the original firm is able to maintain its market position in the longer run. This could be a rational strategy, avoiding making excessively high supernormal profits in the short run in order to make sustainable profits in the longer term.

Notice that such a strategy need not be carried out by a monopolist alone. It could also occur in an oligopoly, where existing firms jointly seek to protect their market against potential entry.

Barriers to entry and exit

The existence of barriers to entry into a market is especially important in monopoly markets. These barriers enable firms to maintain their market position. Without barriers to entry, the market could become contestable, meaning it would be vulnerable to competition from new entrants.

Some key factors that create barriers to entry include:

• Economies of scale
• High fixed costs
• Cost advantages
• Government regulation
• Switching costs
• Network effects

Some of these barriers arise from government regulation (creating 'legal barriers'). Others emerge from the set-up costs of the market or from cost considerations. There may also be physical barriers. Importantly, some of these barriers are natural, reflecting the nature of the product or market conditions. However, there may be situations where existing firms take strategic action to maintain their position by limiting the extent to which the market is contestable.

Economies of scale

Economies of scale can act as a significant barrier to entry for new firms. If a monopoly firm faces substantial economies of scale, and the minimum efficient scale is close to the extent of market demand, then the firm will always be able to produce at lower cost than any potential entrant. This makes it difficult for new firms to join the market profitably.

In this case, the market is likely to be a natural monopoly, so it would not be contestable. The existing firm's cost advantage, arising from producing at large scale, protects it from competition.

High fixed costs

Situations where firms face substantial economies of scale often involve high fixed costs relative to marginal costs. If a potential entrant knows it needs to invest heavily in set-up costs before being able to produce, this may deter entry.

Existing monopoly firms may be able to consolidate their position by taking strategic action to affect their fixed costs and deter entry. Heavy investment in research and development can make it difficult for potential entrants to become established in a market. They would need to undertake high expenditures before being able to compete with the existing firm. Such strategic action is an attempt to prevent contestability.

Cost advantages

A monopoly firm may hold some absolute cost advantage over potential entrants. For example, the firm may have control over a key input needed for the production process. This could be control over a raw material or a supply chain. Alternatively, the firm might have a locational advantage, being situated close to suppliers of a key input or to the market for the good itself.

Such a market would only be contestable if new entrants could find a way of overcoming the cost advantage of the incumbent firm.

Government regulation

In some cases, a firm may have legal protection against competition. A common example is the patent system, whereby a firm may be protected from competition for a period following the introduction of a new innovative product.

The aim of such government action is to encourage research, development and innovation in product development. Such a market could become contestable when the patent expires, allowing other firms to produce similar products.

Switching costs

In some cases, the barrier to entry arises because a firm's customers face high costs in switching to a new substitute product. Such costs may occur because a consumer has signed a contract for a fixed term, or simply because of brand loyalty.

Network effects

Some goods or services have significant network effects. This occurs where people use a product because they know many others also use it. For example, Adobe Acrobat's .pdf format is so widely used that it would be difficult for a new firm to introduce a different file format successfully.

A market where there are substantial network effects may not be readily contestable. The existing firm benefits from the widespread adoption of its product or standard, making it very difficult for new entrants to compete.