Other Pricing Policies (Cambridge (CIE) A Level Economics): Revision Note

Limit pricing

• Limit pricing occurs when a firm sets a price below the short-run profit-maximising level to deter new firms from entering the market

  • Common in monopolies and oligopolies

Why do firms use limit pricing?

• Prevents entry by making the market appear unprofitable

• Protects long-run supernormal profit

• Acts as a barrier to entry

Key features

• The price is set low enough to discourage entry, but high enough to still earn profit

• Firms often:

  • Increase output

  • Exploit economies of scale

• More effective when:

  • Barriers to entry are already high

  • Incumbent firms have cost advantages

Limitations

• Firms sacrifice short-run profit

• May not work if:

  • New firms have lower costs

  • Market demand is growing rapidly

• Difficult to sustain in the long run

What is price leadership?

• Price leadership occurs when one dominant firm (price leader) sets the price, and other firms (followers) adjust their prices accordingly

  • Common in oligopolistic markets

Types of price leadership

• Dominant firm leadership → largest firm sets price

• Barometric leadership → most informed firm sets the price

• Collusive leadership → firms informally agree on a leader

Key characteristics

• Firms avoid price wars

• Prices are relatively stable

• Competition shifts to:

  • Non-price factors (branding, quality, advertising)

Diagram analysis

• The price leader (Firm A):

  • Produces where MCₐ = MR

  • Sets price at Pₐ from the demand curve

• The follower (Firm B):

  • Has higher costs → its profit-maximising price would be Pᵦ

  • But must match Pₐ to remain competitive

• Therefore:

  • Firm B earns lower profit (or may make losses)

  • Firm A gains a cost advantage

Evaluation of price leadership

Predatory pricing

• Predatory pricing occurs when a firm deliberately sets a very low (often below cost) price to force competitors out of the market

Why do firms use predatory pricing?

• Eliminate existing competitors

• Deter potential entrants

• Increase market power

Key features

• Prices may fall below average cost (AC)

• Firms make short-run losses

• After rivals exit:

  • Firm raises prices

  • Earns supernormal profit

Limitations

• Very expensive strategy (requires financial reserves)

• Competitors may:

  • Survive (e.g. government support)

  • Retaliate with price cuts

• Often illegal under competition law

• Hard to prove in practice