Managerial economics studies the ways in which firms can set ideal pricing to maximize profit. In a very real sense, businesses are always at war fighting battles with one another. Businesses compete for resources and customers. The wages one business pays for labor affect what other businesses have to pay, and the price one business charges its customers affects the price other businesses charge.
Here are three weapons that help you fight these battles.
Penetration pricing
Firms use penetration pricing to quickly establish a large market share. In order to attract customers, the firm establishes a very low price. This is a useful strategy for a new firm entering a market.
Effective penetration pricing requires a very elastic demand for the good. Because customers are very responsive to price changes, establishing a low price leads to a large increase in quantity demanded. Later, if you’re successful in establishing customer loyalty, you can raise the price.
In addition to attracting new customers, an effective penetration price leads to lower per unit costs if economies of scale are present. By quickly attracting customers, you can establish a large market share leading to economies of scale that become a barrier to entry for other firms thinking about entering the market.
Penetration pricing is also used to sell complementary products. For example, a low penetration price on a game console can lead to more sales of compatible games that have high mark-ups.
You need to take into account several factors before using penetration pricing. First, consider whether your firm is able to produce enough output to satisfy customers. If you run out of product to sell, customers are likely to be dissatisfied with you.
Second, price can’t be associated with quality. If customers associate a low price with poor quality, they won’t buy the product. Finally, if rivals meet the lower price you charge, the advantages of penetration pricing are negated.
Limit pricing
Firms use limit pricing to prevent other firms from entering the market. Limit pricing occurs when the firm establishes a price below the profit-maximizing level. The lower price leads to a higher quantity demanded, leaving very little residual demand for a new firm to satisfy.
The illustration shows limit pricing. Initially, the market is a monopoly, so the market-demand curve, D, corresponds to the firm’s demand curve, d. The marginal-revenue curve associated with a linear demand curve starts at the same point on the vertical axis and is twice as steep as the demand curve. The monopoly’s marginal-revenue curve is labeled MR.
Given typical average total cost and marginal cost curves, the profit-maximizing monopolist produces the quantity q0, based on marginal revenue equals marginal cost, and charges the price P0. The monopolist’s economic profit per unit is the difference between price and average total cost as represented by the double-headed arrow labeled ð/q.
The positive economic profit the monopolist earns attracts new firms. If these firms enter the market, the existing firm’s profit decreases or perhaps even disappears. So, to discourage entry, the monopolist charges a lower price, PL. At this price, the monopolist must produce qL to satisfy consumer demand.
Firms considering whether or not to enter the market now see an entirely different situation. The potential demand for an entering firm equals the market demand minus the quantity, qL, provided by the current firm. The entrant’s residual demand curve is represented by dE and the associated marginal revenue curve is MRE.
The entering firm would then produce where its marginal revenue equals marginal cost. (For the moment, assume the entering firm has exactly the same costs as the current monopoly.) The entering firm’s profit-maximizing quantity and price are qE and PE. But at this output level, price equals average total cost, so the entering firm earns zero profit.
Thus, the new firm has no incentive to enter the market, and the original firm has succeeded in keeping rivals out.
Predatory pricing
Predatory pricing is used to drive existing rival firms out of a market. With predatory pricing, a firm establishes a price that’s below its marginal cost. After the rival leaves the market, the remaining firm, or predator, raises price in order to increase its profit. The predator in essence is trading a temporary short-run loss for higher future profit.
Predatory pricing depends upon the correct assessment of the relative health of the predator and prey. The predator is assuming that it’s healthier than the prey and can withstand the temporary losses better than the prey. If the predator is wrong in this assessment, predatory pricing can backfire and leave the predator vulnerable.
Successful predators establish a reputation as tough, perhaps even ruthless, rivals. This reputation is likely to deter future entry so that you can realize additional benefits.
Sometimes, the right price is as simple as the price associated with a mutually beneficial exchange. Both the customer and the firm are willing to buy and sell at that price. But as a business manager, you want to find the price that maximizes profit — that is, your right price.