Other Pricing Policies (A‑Level 7.8)
Link to the key concept “margin”. All the policies below illustrate how firms use marginal decision‑making – weighing the extra profit from a price change against the extra cost or strategic benefit – to influence price, output and the long‑run market structure. Each policy therefore has implications for allocative and productive efficiency and may attract government intervention.
1. Limit Pricing
Definition
A strategic move by an incumbent in a market where entry is possible. The incumbent sets a price just high enough to cover its average variable cost (AVC) but low enough that a potential entrant cannot cover its average total cost (ATC). The aim is to deter entry while avoiding a loss‑making position.
Conditions for success
- The incumbent has a lower marginal (or average variable) cost than any potential entrant.
- Entry costs (capital, technology, brand building) are sufficiently high.
- The market is concentrated enough for the incumbent to influence price.
- Potential entrants are price‑sensitive and cannot sustain losses for long periods.
Welfare effects
- Consumer surplus (CS): falls because price is set above the competitive level.
- Producer surplus (PS): the incumbent retains a portion of the surplus that would otherwise be eroded by entry.
- Dead‑weight loss (DWL): arises from the reduction in total output relative to the perfectly competitive equilibrium.
Diagram suggestion
Draw the incumbent’s MC and AVC curves, the market demand curve, and the entrant’s ATC curve. Mark the limit price PL above AVC but below the entrant’s ATC, showing the reduced output QL and the resulting DWL.
Assumptions & limitations
- Firms have perfect information about costs and entry barriers.
- Incumbent can sustain a short‑run profit sacrifice.
- Entrants cannot obtain financing to bear temporary losses.
Evaluation (including the “margin” concept)
- **Effectiveness:** Works best for a dominant firm or monopoly with large economies of scale; less likely in a competitive oligopoly where rivals can match the low price.
- **Margin trade‑off:** The incumbent sacrifices part of its margin (short‑run profit) to protect a larger long‑run margin (market power).
- **Legal perspective:** Not automatically illegal; however, competition authorities may investigate if the price is “abnormally low” and there is evidence of intent to exclude competitors.
- **Risk:** Mis‑judging entry costs can trigger a price war, eroding profits for all firms.
2. Predatory Pricing
Definition
An incumbent deliberately sets a price below its own AVC (or ATC) with the intention of driving existing rivals out of the market, after which it can raise prices to recoup losses.
Key conditions
- The predator has a substantial cost advantage or deep financial resources.
- Rivals are unable to sustain prolonged losses.
- Barriers to re‑entry are low, so rivals can return once prices rise.
Welfare effects
- CS falls sharply because price is pushed below marginal cost.
- PS may increase in the long run if the predator successfully eliminates rivals and later raises price above marginal cost.
- Initial DWL is large (price < MC); a second DWL may appear later if monopoly pricing follows.
Diagram suggestion
Show market demand, MC and ATC of the predator, and the rival’s ATC. Mark a price PP below both firms’ AVC, indicating loss‑making sales for the predator and the rival, and later a possible price rise above MC after exit.
Assumptions & limitations
- Predator can endure losses long enough for rivals to exit.
- Rivals cannot obtain external financing or government support.
- Market does not have strong regulatory oversight.
Evaluation (margin & legal)
- **Effectiveness:** High in markets with large fixed costs and a dominant firm; low where rivals have similar cost structures or can obtain financing.
- **Margin decision:** The predator accepts a negative short‑run margin to secure a larger future margin.
- **Legal status:** Generally illegal under competition law as an abuse of dominance (e.g., EU Article 102, US Sherman Act).
- **Risk:** The predator may never recover losses if rivals survive or if regulators impose heavy fines.
3. Price Discrimination
Definition
Charging different prices to different consumers (or groups) for the same product where the price differences are not justified by differences in cost.
Three degrees (Cambridge syllabus)
| Degree | Key feature |
|---|
| First‑degree (perfect) | Each unit sold at the maximum price the individual buyer is willing to pay. |
| Second‑degree | Price varies with the quantity purchased (bulk discounts, versioning, two‑part tariffs). |
| Third‑degree | Different groups are charged different prices (students, seniors, geographic markets). |
Conditions for feasibility
- Firm has some market power (imperfect competition).
- Ability to segment the market and prevent resale between segments.
- Segments have different price elasticities of demand.
Numerical illustration (third‑degree)
Suppose a firm faces two segments:
- Students: PS = $8, quantity demanded QS = 120 (elastic demand).
- Adults: PA = $12, quantity demanded QA = 80 (inelastic demand).
If a single price of $10 were charged, total output would be 150 units (CS = $600, PS = $300). With discrimination the firm sells 200 units, earning PS = $ (8·120 + 12·80) – 10·200 = $1 200 – $2 000 = $‑800? (Correction: assume MC = $6 per unit.)
Total revenue = 8·120 + 12·80 = $960 + $960 = $1 920.
Total cost = MC·Q = 6·200 = $1 200.
Producer surplus = $720, higher than the $300 under a uniform price. Consumer surplus falls for adults but rises for students, and total output increases, reducing DWL.
Welfare effects
- CS may fall for high‑price segments and rise for low‑price segments; the net change depends on the size of each segment.
- PS usually rises because the firm captures more of the consumer surplus.
- If discrimination leads to a higher total output than a uniform price, overall DWL can be reduced.
Diagram suggestion
Draw a single market demand curve and MC. Show two price‑elasticity segments with separate demand curves (or a kinked demand) and indicate the two prices and quantities. Highlight the change in CS, PS and the possible reduction in DWL.
Assumptions & limitations
- Perfect information about each consumer’s willingness to pay.
- No arbitrage between segments.
- Legal restrictions may apply (e.g., utility price caps, anti‑discrimination law).
Evaluation (margin & legal)
- **Effectiveness:** Powerful when the firm can identify distinct elasticities and enforce segmentation.
- **Margin decision:** The firm expands its margin by converting consumer surplus into producer surplus.
- **Legal perspective:** Generally lawful, but certain forms (e.g., price discrimination based on protected characteristics) can breach competition or equality legislation.
- **Limitations:** Difficult to prevent resale; costly to maintain separate pricing structures.
4. Price Leadership
Definition
A form of tacit collusion where one firm (the “leader”) sets the market price and other firms (the “followers”) conform without an explicit agreement.
Common forms (Cambridge syllabus)
| Form | Typical leader | Basis for leadership |
|---|
| Dominant‑firm price leadership | Large firm with the lowest marginal cost | Cost advantage; followers match price to avoid loss. |
| Barometric price leadership | Firm most sensitive to market conditions (often the most informed) | Followers use the leader’s price as a signal of market trends. |
| Collusive price leadership | Firms meet informally and agree on a price, then announce the leader’s price publicly | Explicit coordination, though hidden from regulators. |
Conditions for emergence
- Market is oligopolistic with a few interdependent firms.
- Firms can observe each other’s prices easily (e.g., published price lists).
- There is a clear cost leader or an information‑rich firm.
Welfare effects
- CS is reduced relative to a competitive outcome because price is set above marginal cost.
- PS increases for all firms in the cartel‑like arrangement.
- DWL arises from the gap between price and MC.
Diagram suggestion
Show market demand, MC, and a price line set by the leader above MC. Indicate the resulting quantity and the dead‑weight loss triangle.
Assumptions & limitations
- Firms act rationally and can monitor each other’s prices.
- No explicit agreement is needed; tacit coordination must be credible.
- Followers must believe that deviating would trigger a price war.
Evaluation (margin & legal)
- **Effectiveness:** Helps firms avoid destructive price wars and maintain higher margins.
- **Margin decision:** Each firm accepts a lower marginal profit than in pure competition but secures a higher average margin.
- **Legal perspective:** While not illegal per se, competition authorities may view price leadership as evidence of tacit collusion, especially in highly concentrated markets.
- **Risk:** If the leader’s cost advantage disappears or a follower doubts the tacit agreement, a price war may erupt.
5. Price Fixing
Definition
An explicit agreement between two or more firms to set the price of a product or service at a particular level, or to coordinate price changes.
Typical forms
- Setting a common price ceiling or floor.
- Agreeing on a uniform discount or surcharge.
- Coordinating the timing of price increases or decreases.
Welfare effects
- CS is markedly reduced because price is kept above the competitive level.
- PS rises for the colluding firms.
- Large DWL results from the restriction of output below the efficient level.
Diagram suggestion
Draw market demand, MC, and a horizontal price line at the collusive price > MC. Show the resulting quantity and the DWL triangle.
Assumptions & limitations
- Firms can communicate and enforce the agreement.
- There is no effective monitoring by competition authorities.
- All participants are willing to bear short‑run profit sacrifices to maintain the arrangement.
Evaluation (margin & legal)
- **Effectiveness:** Guarantees higher margins for participants as long as the cartel remains undetected.
- **Margin decision:** Firms accept a coordinated, higher price to secure a stable, elevated margin.
- **Legal status:** Illegal in virtually all jurisdictions (e.g., EU Competition Law, US Sherman Act). Penalties include heavy fines, damages actions and imprisonment.
- **Risk:** High probability of detection, whistle‑blowing, and severe sanctions; internal monitoring costs can outweigh benefits.
6. Price Wars
Definition
A situation in which rival firms repeatedly cut prices in an attempt to increase market share, often leading to very low or even loss‑making prices.
Typical causes
- Entry of a low‑cost competitor.
- Excess capacity in the industry.
- Strategic attempts to drive weaker rivals out.
Welfare effects
- CS rises in the short run as price falls toward marginal cost.
- PS falls for all firms because margins are squeezed.
- When the war ends, the market often consolidates, leading to higher prices and a larger DWL than before the war.
Diagram suggestion
Show the demand curve, MC, and two price lines: the initial competitive price, the lower price during the war (close to MC), and the post‑war monopoly price. Highlight the shift in CS, PS and the long‑run DWL.
Assumptions & limitations
- Firms have sufficient cash reserves to sustain losses.
- Consumers respond only to price, not to quality or brand.
- Regulators do not intervene early (e.g., under “predatory pricing” rules).
Evaluation (margin & macro link)
- **Effectiveness:** Can be used as a short‑run entry deterrent, but is costly for all participants.
- **Margin decision:** Firms accept negative margins temporarily to achieve a larger future margin via reduced competition.
- **Macro implications (A‑Level link):** Persistent price wars can depress industry‑wide profits, affect employment and may trigger macro‑economic concerns such as deflationary pressure.
- **Regulatory response:** Competition authorities may step in if prices fall “below cost” and appear aimed at eliminating rivals.
Key Takeaways
- All six policies illustrate how firms manipulate the margin between price and marginal cost to achieve strategic objectives.
- Limit pricing deters entry by setting a price just above AVC but below an entrant’s ATC; it involves a short‑run margin sacrifice.
- Predatory pricing goes further, pricing below AVC to force rivals out; it is usually illegal because it abuses dominance.
- Price discrimination captures more consumer surplus when market segments have different elasticities; it can improve total output and reduce DWL but requires effective segmentation and may be regulated.
- Price leadership is a form of tacit collusion that stabilises prices and margins but can attract competition‑law scrutiny.
- Price fixing is an explicit collusive agreement, illegal in almost all jurisdictions, and creates large DWL.
- Price wars temporarily raise consumer surplus but erode producer margins and often end in higher long‑run prices after industry consolidation.
- Understanding the conditions, welfare impacts, and legal environment for each policy enables students to evaluate their effectiveness and anticipate possible government intervention.