Pricing in practice

It seems clear that in practice most firms do not know the shape of their revenue and cost curves with any great precision. It might thus be argued that they cannot actually adopt any of these rules, and need to find alternative ways of devising a pricing strategy.

One such approach would be to make a series of small (marginal) changes and observer the effects over time, thereby moving gradually towards whatever objective the firm wishes to attain. However, if you were to ask managers how they decide on price, many of them would probably say that they use cost-plus pricing (sometimes known as mark-up pricing). In other words, they calculate average cost at their chose output level and then add on a mark up to being them up to some profit per unit. Indeed, when in 1996 the Bank of England conducted a survey of British companies to see how they set their prices, 37% said they set prices using a mark-up pricing rule.

Does this nullify the profit-maximising hypothesis? No necessarily. Saying that a firm sets price as a mark up on average cost leaves a very important question unanswered: namely, what determines that size of the mark up that the firm can add to average cost?

The Bank of England survey also discovered that firm in markets in which there are few competitors set higher mark ups than those in markets in which there were more firms. Mark-ups were also higher in markets where there were differentiated products than in markets producing homogeneous ones.

This pattern of behaviour is entirely compatible with the profit-maximising hypothesis, where mark ups are expected to be lower in the presence of a high degree of competition. In other words, mark up pricing may be a strategy used by the firms to find the profit maximising level of output.

Summary

  • In practice, firms may not know their cost curves with any degree of accuracy
  • By making marginal changes and observing the effects, they may be able to move towards the price that would achieve their chosen objective
  • Many firms use mark-up, or cost-plus, pricing, adding a profit margin to average cost
  • The size of the mark up may depend upon the degree of competition in the market and the extent to which the product is differentiated
  • This is consistent with profit maximisation

Price wars

Another finding of the Bank of England’s survey was that firms were very strong in saying they wished to avoid price wars. This could be expected from the kinked demand curve model, where firms in an oligopoly realise that price reduction is likely to be matched by rivals, leaving all firms with lower profits but having little effect on market shares.

And yet, price wars do break out from time to time. For example, in May 2002 a price war broke out in the UK tabloid newspaper market. It was initiated by the Express, but the main protagonists were the Mirror and the Sun, which joined in after a couple of weeks. The Mirror cut its price from 32p to 20p, and the Sun from 30p to 20p.

After a week at these lower prices, the editor of the Sun was serving champagne to in the newsroom in celebration. Their reading of the situation was that the Mirror has not expected the Sun to follow the price cut. Three weeks after the Mirror’s price cut, it put its price back up again, followed by the Sun. Analysts and observers commented that the only gainers had been the readers, who had enjoyed three weeks of lower prices.

Why should firms act in this way? The Mirror argued that it was trying to rebrand itself, and capture new readers who would continue to read the paper even after the price returned to its normal level. This may hint at the reason for a price war – to affect the long-run equilibrium in the market. The Sun’s retaliation was a natural defensive response to an aggressive move.

In some cases, a price war may be initiated as a strategy to drive a weaker competitor out of the market altogether. The motivation then is clear, especially if the initiator of the price war ends up with a monopoly or a near-monopoly position in the market. It could be argued that this represents and attempt to maximise profits in the long run by establishing a monopoly position.

Predatory pricing

Perhaps the most common context in which price wars have broken out is where an existing firm or firms have reacted to defend against the entry of new firms into the market.

One such example occured in 1996, in the early years of easyJet, the low-cost air carrier, which was then trying to become established. When easyJet started flying the London-Amsterdam route, charging its now well-known low prices, the incumbent firm (KLM) reacted very aggressively, driving the price down to a level just below that of easyJet’s. The response from easyJet was to launch legal action against KLM, claiming it was using unfair market tactics.

So-called predatory pricing is illegal under English, Dutch and EU law. It should be noted that, in order to declare an action illegal it is necessary to define that action very carefully – otherwise it will not be possible to prove the case in courts. In the case of predatory pricing, the legal definition is based on economic analysis.

Recall the shut down price of a firm, where price is below long run average variable costs. The courts have backed this theory, and state that a pricing strategy should be interpreted as being predatory only if the price is set below long run average variable costs, as the only motive for remaining in business at that price is to drive competitors out and achieve market dominance. This is known as the Areeda-Turner principle, and is widely used in US federal and state courts in predatory pricing cases, to establish the presumption of predatory practices.

On the face of it, it would seem that consumers have a lot to gain from such strategies through the resulting lower prices. However, this is a short run gain. A successful predator who drives out the opposition will recoup profits to a larger extent than they were lost due to its monopoly position in the long run.

Having said that, the low-cost airlines survived the attempts of the established airlines to hold onto their market shares. Indeed, in the post 9/11 period, which was a tough one for airlines for obvious reasons, the low-cost airlines flourished while the more conventional airlines went through a very difficult period indeed.

In some cases, the very threat of predatory pricing may be sufficient to deter entry by new firms, if the threat is a credible one. In other words, existing firms need to convince potential entrants that they, the existing firms, will find it in their best interests to fight a price war, otherwise the entrants will not believe the threat. The existing firms could do this by making it known that they had surplus capacity, so that they would be able to increase output very quickly to drive down the price.

Whether entry will be deterred by such means may depend in part on the characteristics of the potential entrant. After all, a new firm may reckon that, if the existing firm finds it worth sacrificing profits in the short run, the rewards of dominating the market must be worth fighting for. It may therefore decide to sacrifice short-term profit in order to enter the market – especially if it is diversifying from other markets and has resources at its disposal. The winner will then be the firm that can last the longest; but clearly this is potentially very damaging for all concerned.

Limit pricing

An associated but less extreme strategy is limit pricing. This assumes that the incumbent firm has some sort of cost advantage over potential entrants, for example economies of scale.

Suppose a firm facing a downward sloping demand curve is making healthy supernormal profits, and the natural barriers to entry to this market are weak. The supernormal profits will attract other firms into the market. Given the cost conditions, the incumbent firm is enjoying the benefit of economies of scale, but producing below the minimum efficient scale.

If a new firm joins the market, producing at a relatively small scale, the price of the product is pushed down from P1, the profit maximising price, to P2 due to higher output. This cuts into the monopolists supernormal profits. The new firm is just covering average costs, so is making normal profits and feeling justified on entering the market.

One way in which the firm could have guarded  against this entry would be by charging a lower price than P1 to begin with. For example, if the firm has set its price to P2 to begin with, the entry of the new firm would have pushed price to below P2, and without the benefits of economies of scale, the new firm would make losses and exit the market. In any case, if the existing firm has been in the market for some time, it will have gone through a process of learning by doing, and therefore will have a lower average cost curve than the entrant. This makes it more likely that limit pricing can be used.

Thus, by setting a price below profit-maximising level, the original firm is able to maintain its market position in the long run. This could be a reason for avoiding making too high a level of supernormal profits in the short run, in order to make profits in the longer term.

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

So, limit pricing is the highest price an existing firm can set without enabling new  firms to enter the market and make a profit.

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