Types of price competition

Firms can adopt different prices strategies and tactics to increase sales, generate revenue, and add to profits.

Which type of strategy is used depends upon the market structure the firm operates in.

Price takers

Firstly, if the firm operates under conditions of 'perfect competition' the firm is a price taker and must take the price set in the market.

For example, while no actual firms can be considered as operating under the strict criteria of perfect competition, some markets resemble perfect competition.

For example, small coffee growers in Kenya have no power to set the price for their coffee beans. Coffee bean prices are set in the global commodity markets, and a single producer must take whatever the market price is at the time.

Price makers

However, for price makers - those operating under monopolistic competition, oligopoly, pure monopoly, and firms with some monopoly power - the ability to set their own price provides them with the ability to make their own pricing decisions.

Price wars

Firms operating in markets with few competitors - notably oligopolists - may reduce their price in order to gain market share. However, this can result in competitors also reducing their prices - hence, neither firm gain. This creates a temptation to collude to raise prices together.

Predatory pricing

Price makers can also attempt to make life difficult by pricing so low that existing firms are driven out of the market. This practice is called predatory pricing (also known as 'destroyer pricing). This could be achieved by setting price below the average variable cost (AVC) of production.

If a business sets its price below its average variable cost (AVC) it is likely that courts or competition regulators would deduce it is undertaking predatory pricing. In order to avoid shutting down, a firm must at least cover its AVC.

Diagram showing predatory pricing

If it can be proved that a firm is doing this it likely to end up in court, given that predatory pricing is unlawful in most legal jurisdictions. It would seem that the only 'rational' reason for reducing price below AVC is to attack a rival.

Limit pricing

Limit pricing is similar, but argued to be less aggressive than predatory pricing. It concerns the attempt to prevent (limit) new firms from entering a given market by setting a price that does not lead to profit maximisation, but is not set below AVC (as in the case of predatory pricing).

However, it is likely to limit new entrants, and while it can be argued that it is anti-competitive, the fact is that existing firms usually have a cost advantage over potential entrants derived from economies of scale.

Price obfuscation

Price obfuscation is an increasingly common practice associated with the rise of the internet. While the internet has enabled prices to be compared more easily, and to this extent provides a benefit to consumers, prices can be set to confuse buyers - perhaps deliberately.

For example, while internet advertising promising low prices will attract website traffic to the relevant website, as consumers make their way through the viewing and ordering process, the price slowly rises, so that, by final check-out, the price is (perhaps considerably) higher than the starting point (the initial internet in-page advert or banner.)

Price discrimination

Price discrimination is the practice of charging different consumers (or the same consumer under different circumstances) different prices for the same good or service.

Cost-plus pricing

Cost-plus pricing is a common pricing method used by a large number of firms operating in different sectors of an economy. As early as the 1930s, cost-plus pricing seemed to be the dominant pricing strategy pursued by actual firms1. This contrasted with the accepted theory at the time - namely, that price would be determined by both demand and supply (cost) considerations. Cost-plus pricing is a pricing method which only takes into account production costs, and not demand factors, or the price charged by competitors.

Cost-plus pricing starts with the costs of production (per unit) and then adds a fixed amount (or fixed percentage) mark-up to generate a required level of profit from each unit sold. For this reason, cost-plus pricing is also called 'mark-up pricing'.

The calculation of cost can be based on all the identified costs of production – called ‘full-cost’ pricing, which considers both fixed and variable costs, or just on the ‘direct’ variable costs of production – called ‘contribution’ or ‘direct cost’ pricing.

Example

Below is a hypothetical cost calculation for a firm producing hand-made wooden cabinets and using a full-cost approach.

Cost plus pricing

The advantages of cost-plus pricing

  1. Cost-plus pricing is very simple to understand and straightforward to implement - the mark-up may become a ‘rule of thumb’ in particular industries and applied across a wide range of products. 
  2. It allows for costs to be covered, and guarantees a profit.
  3. The use of a mark-up allows for negotiation around the percentage (rather than negotiating the final price).
    Cost-plus pricing can help solve the problem of information failure - in the absence of market intelligence setting price based on cost means that the mark-up formula can be seen as a convenient way to fill the information gap.

Disadvantages of cost-plus pricing

Although cost-plus pricing has many advantages, it can be criticised in several ways.

  1. Firstly, it does not take changing market conditions into account. There may be times when demand is buoyant, and increased profits may be justifiable. Prices are not customised and individual variations in how customers value products (and hence how much they are prepared to pay) is not considered. As an example of failing to factor-in market conditions, cost-plus prices make no allowance for price elasticity of demand, or cross elasticity of demand, or to changes in these as market conditions change.
  2. As a result of this, the price set ignores the true ‘value’ of a product to the customer.
  3. While it does guarantee a profit, it does not guarantee that profits are maximised.
  4. Given this, cost-plus pricing can be seen to be anti-competitive if the method (or model) is shared by all competitors in an industry. In this respect many oligopolies fall back on cost-plus pricing as it avoids the risk associated with a price war.
  5. It may encourage firms to inflate production costs. This may be common with the pricing of government contracts. If this case, resources may be used inefficiency and result in higher tax levels.


Costs, revenue and profits

How are profits determined?

Costs
Oligopoly

What are the disadvantages of oligopoly?

Oligopoly
Game theory

How does game theory explain oligopoly?

Game theory

1. Hall, R. L., and C. J. Hitch. “Price Theory and Business Behaviour.” Oxford Economic Papers, no. 2, 1939, pp. 12–45. JSTOR, www.jstor.org/stable/2663449. Accessed 14 Mar. 2021.

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