3.4 Pricing strategies and contestable markets Flashcards
What are the characteristics of a contestable market?
-Contestable markets exist when there are low barriers to entry and exit, allowing new suppliers to come into a market and provide competition. The market is said to have low sunk costs. New firms can quickly enter an industry where supernormal profits can be made and exploit them before leaving the industry - hit and run profit
What are sunk costs?
Costs which are not recovered if a firm leaves the industry:
- R&D
- Asset write offs
- Closure and projects cancelled
- Loss of reputation and good will
What conditions are required for markets to be contestable?
- Pool of businesses willing and able to enter market
- No entry or exit costs
- Equal access to available industries
- High rates of consumer switching
What are the features of a contestable market curve?
- Generally lower prices
- If monopolies operate at profit maximising output new entrants may undercut the firm and lower market prices and profits.
- The price of the monopoly is at profit max, with high supernormal profits and prices.
- New entrants are likely to have price an output somewhere between the profit maximising and normal profit points in order to make short run profits - the more contestable, the more likely it is to be close to the limit price
What are some key points?
- Threat of how entry affects day to day firms
- Firms making supernormal profit vulnerable
- Likely to behave more competitively
- Outcome will resemble perfect competition regardless of number of firms since incumbents behave as if it was there
- Competition policies such as liberalisation of markets help open up an industry to new suppliers.
What are some types of barriers to entry and exit?
- Economies of scale
- Vertical integration
- Brand loyalty
- Control of suppliers and technology
- Expertise, goodwill and reputation
- Hostile takeovers
- Product differentiation
- Capacity expansions
- Predatory pricing
What policies may increase contestability?
Banning cross subsidisation
Requiring incumbents to provide network access
Removing legal barriers to entry
Preventing mergers and acquisitions, especially vertical integration
Reducing protectionist measures.
What is price competition?
Price wars common in oligopolistic markets as firms battle to secure market share at expense of rivals. Many examples in markets as diverse petrol retailing, food grocery, low cost airlines and funeral services - wars lead to short run increase in sales and revenues but not be in long term commercial interest
Includes low cost airlines, petrol retailers, mobile phone tariffs, meal deals, supermarkets, etc.
Who are the winners/losers of price competition?
Winners - regular consumers who see increased surplus
Managers - sales revenues increase if demand price elastic leading to higher sales bonuses
Losers - shareholders - prolonged price wars lead to lower profits
suppliers - may get squeezed if firms use monopsony power
smaller firms - cannot absorb losses from price wars
government - declining corporation tax revenues
What are the 2 most basic pricing strategies?
-Lowering prices - win market share with lowering prices. If rivals copy price cuts may start price war and market share stays same. Kinked demand curves and payoff matrix can show how higher profits or may not lead to market share rising
Increasing pries - increasess profit but if rivals do not copy may lose market share and revenues and profits fall - use payoff matrix and kinked demand again
What is price discrimination?
Exploiting elasticies - only works for monopolies and cannot work if able to resell?
What is limit pricing?
Creating artificial barrier to entry by charging higher price firm can set preventing new firms from entering the market and making profits. Incumbents have EofS there is limited effect on their profit but will make losses for new firms so they maintain market share.
May reduce profit in short run and displease as shareholders - have to use past reserves due to the loss
What is predatory pricing?
Setting prices below average variable costs to force rivals out of the market and achieve market share. Would mean firms work at losses to drive other firms out of the market so profits are lost - shareholders displeased and have to use past reserves
Use a cost/revenue diagram to show forcing prices below the AVC
What is non price competition?
Product - innovates new products, quality, design, durability and service
Promotion - advertising, brand awareness, loyalty schemes and deals
Place - availability e.g. shops and internet
Promoting brand, quality, design look and feel, environmental image, after sales services, other marketing factors
Innovation, quality of service, free upgrades, exclusivity and loyalty schemes, branding, sales promotions
What are some other ways of non price competition?
Tacit collusion - matching prices with rivals agree prices to keep market shares
Overt collusion - agreeing on prices or quantities produced to keep market shares - illegal and leads to penalties
Mergers - gains market share by buying opposition - EofS and lowers costs - quick but expensive and may lead to DofS in long run
De-mergers - reverses DofS or releases capital for investment by splitting firm into sections - makes firm look weak and unsuccessful to investors
Patents - protects products from rivals copying - only for 20 years
