Pricing strategies and contestable markets

Question 1

If a firm’s objective is profit maximisation, what output will it choose?

Answer 1

where marginal revenue equals marginal cost

Question 2

If a firm’s objective is revenue maximisation, what output will it choose?

Answer 2

where marginal revenue is zero

Question 3

If a firm’s objective is sales maximisation (subject to covering opportunity cost), what output will it choose?

Answer 3

price = average cost

Question 4

If a firm wants to demonstrate commitment to corporate social responsibility, what two alternative pricing strategies might it choose?

Answer 4

1. Keep price lower than it would otherwise to increase access to its products.
2. Maximise profits then use some of the profit to benefit the community.

Question 5

Define cost-plus pricing.

Answer 5

where firms set price by adding a mark-up to average cost

Question 6

Why might firms use cost-plus pricing rather than profit or sales or revenue maximisation?

Answer 6

Because don’t actually know the precise shape/level of their revenue and cost curves

Question 7

Which market is likely to have higher mark-ups:
* differentiated products, or
* homogeneous products?

Answer 7

differentiated products

Question 8

Which market is likely to have higher mark-ups:
* oligopoly, or
* competitive market?

Answer 8

oligopoly

Question 9

Why might a firm initiate a price war?

Answer 9

to drive weaker firms out of market so improving its market share

Question 10

What is the danger to a firm initiating a price war?

Answer 10

Everyone else cuts prices, no one goes out of business, so the firm (and others) gets lower profits.

Question 11

Define predatory pricing.

Answer 11

an anti-competitive strategy in which a firm sets a price below average variable cost to try to force rivals out of the market

Question 12

What is the Areeda-Turner principle?

Answer 12

That if a firm is setting price below average variable cost then its strategy is deemed predatory and therefore illegal (in UK, EU and US at least)

Question 13

What is the limit price?

Answer 13

highest price that an existing forms can set without enabling new forms to enter market and make profit

Question 14

State six key factors that create barriers to entry.

Answer 14

1. economies of scale
2. high fixed costs
3. cost advantages
4. government regulation
5. switching costs
6. network effects

Question 15

What three factors might create cost advantages?

Answer 15

1. control over raw material
2. control over supply chain
3. location

Question 16

Name a form of government regulation that creates a barrier to entry.

Answer 16

patent

Question 17

State two forms of switching costs.

Answer 17

1. time needed to learn new product
2. penalties for ending current contract

Question 18

What is a network effect?

Answer 18

Where people use a product because many others do, eg Microsoft Teams or Adobe’s pdf format

Question 19

What is a contestable market?

Answer 19

market in which existing firm makes only normal profit as it can’t set higher price without attracting entry, due to no sunk costs and no barriers to entry

Question 21

What is hit-and-run entry?

Answer 21

where firm enters market to take short-run supernormal profits, knowing it can exist without incurring costs

Question 22

Give two examples of a contestable market.

Answer 22

1. A domestic air route between two destinations can easily be entered by another firm with a spare aircraft.
2. Travel industry, now that we have the internet so consumers can easily compare costs and book.