Strategic pricing policies

1. Firms with market power may price strategically rather than simply maximise short-run profit.
2. The three key policies are limit pricing, predatory pricing and price leadership.
3. Each trades some short-run profit for stronger long-run market power.

Limit pricing

1. Limit pricing sets price below the profit-maximising level to deter potential entrants.
2. The incumbent accepts lower short-run profit to keep the market unattractive to newcomers.
3. It works best where the incumbent has economies of scale that a small entrant cannot match.
4. The price is still set above cost, so the policy can be sustained indefinitely.
5. Large-scale production gives the incumbent an average cost of £4 per unit, while a small entrant would face an average cost of £7.
6. The incumbent sets a limit price of £5, below the entrant's £7 average cost but above its own £4.
7. A newcomer entering at £5 would lose £2 on every unit, so entry is deterred while the incumbent still earns £1 per unit.

Predatory pricing

1. Predatory pricing sets price below cost, often below average variable cost, to drive existing rivals out.
2. The firm bears short-run losses that a weaker rival cannot survive.
3. Once rivals exit, it raises price to recoup the losses as a stronger monopolist.
4. It is anti-competitive and usually illegal, so a competition authority may intervene.
5. The predator temporarily cuts price to £3 while unit cost is £5, accepting a loss of £2 per unit.
6. A weaker rival that cannot fund such losses exits, after which the predator raises price to £8 to recoup the losses.

Price leadership

1. Under price leadership, one firm sets the price and the others follow.
2. In dominant-firm leadership the largest firm sets the price that smaller rivals accept.
3. In barometric leadership the firm best at reading market conditions leads price changes.
4. This is tacit coordination that gives some gains of collusion without a formal cartel.

Consequences for competition

1. All three protect the incumbents' market power and their long-run supernormal profit.
2. Predatory pricing gives consumers very low prices in the short run but higher prices once rivals have gone.
3. Limit pricing keeps prices below the pure monopoly level but entrenches the incumbent and reduces future competition.
4. Price leadership stabilises prices but can sustain them above the competitive level, harming consumers.

Are these pricing strategies effective for the firm?

1. These strategies can be effective because each raises a barrier that protects long-run market power: limit pricing exploits an incumbent's economies of scale to make entry unprofitable, predatory pricing removes rivals the firm can outlast, and price leadership coordinates prices upward without a formal, illegal agreement.
2. But each carries costs and risks that can undermine it: limit and predatory pricing sacrifice short-run profit, predatory pricing may fail if the rival has deep reserves or re-enters once prices rise, and all three risk investigation and penalties from a competition authority, especially predatory pricing, which is usually illegal.
3. Effectiveness also depends on market structure: the strategies bite where entry barriers and sunk costs are high, but in a genuinely contestable market the mere threat of hit-and-run entry can make limit pricing pointless and price leadership unstable.
4. On balance, these policies can secure lasting market power and supernormal profit, but whether they pay off depends on the firm's cost advantage and reserves, how contestable the market is, and how likely and severe the response of a competition authority.