Objectives and pricing policies of firms

Two passengers sit side by side on the same flight. One paid four times what the other did. A supermarket sells bread below cost on its opening week and quietly raises the price a year later. A large brewer changes its prices and every rival follows within days. None of this fits the simple picture of a firm that sets one price where marginal cost equals marginal revenue. Firms pursue more than one objective, and they have more pricing tools than a single price, and both are examinable.

What firms are trying to achieve

The traditional assumption is profit maximisation: the firm produces where marginal cost equals marginal revenue, with MC rising, because at any lower output one more unit would add more to revenue than to cost, and at any higher output it would add more to cost. It is the right starting point, but firms have other objectives. Survival comes first for a new firm or one in a downturn, and may mean accepting losses or cutting prices to hold on to customers. Profit satisficing means aiming for a satisfactory level of profit rather than the maximum, which happens when managers, who run the firm, have different interests from shareholders, who own it: managers make enough profit to keep shareholders content and pursue their own goals with the rest. This is the principal-agent problem.

Two objectives are defined precisely and appear on diagrams. Revenue maximisation means producing where total revenue is as large as possible, which is where marginal revenue is zero: one more unit would add nothing to revenue. Managers may prefer it because their pay, status or bonuses are linked to sales revenue. Sales maximisation means producing the largest output possible without making a loss, which is where average revenue equals average cost, so the firm earns only normal profit. A firm might choose it to win market share, gain economies of scale or deter entrants. The order is always the same: the profit-maximising output is the smallest, the revenue-maximising output is larger, and the sales-maximising output is largest of all.

Price discrimination

There are three degrees. First-degree, or perfect, price discrimination charges every consumer the maximum they are willing to pay, so the firm captures all the consumer surplus; it is approached by auctions and by individually negotiated prices. Second-degree price discrimination charges different prices according to the quantity bought, as with bulk discounts, lower rates for units above a threshold, or 'buy two, get one free'. Third-degree price discrimination charges different prices to different groups of consumers, separated by age, time, location or status, such as student and pensioner discounts, peak and off-peak fares, or different prices in different countries. It is the most common form and the one most often examined.

Three conditions must hold. The firm must have some price-setting power, since a price taker cannot charge anyone above the market price. It must be able to separate consumers into groups with different price elasticities of demand. And it must be able to stop resale between the groups, or those who buy cheaply would sell to those charged more. The firm then sets the higher price where demand is less elastic and the lower price where it is more elastic, and maximises profit by making marginal revenue equal to marginal cost in each market.

The consequences are mixed, which is why questions ask candidates to assess them. Consumers in the higher-price market lose consumer surplus, which becomes profit. But some consumers in the lower-price market, such as students, off-peak travellers or buyers in poorer countries, can now afford a good they could not buy at a single price, so total output may rise and some people gain access. Higher profit may fund investment and innovation, or may simply be distributed to owners. And price discrimination can keep a service running that would not cover its costs at any single price, as with some rural transport, which benefits everyone who uses it.

Other pricing policies

Limit pricing means setting a price low enough to deter new firms from entering, at or just below the average cost a new entrant would face. The incumbent, which usually has lower costs because of economies of scale, gives up some short-run profit to protect its market in the long run. Predatory pricing goes further: a firm cuts price below its own average variable cost, making deliberate losses, to force a rival out of the market, and then raises prices once the rival has gone. It is illegal in most countries, but proving it is difficult, because a low price can also be fierce but legitimate competition. Price leadership occurs in oligopoly when one firm sets the price and the others follow, either because the leader is dominant or because it is trusted to read market conditions well. It lets firms coordinate prices without any formal agreement, a form of tacit collusion.

Price elasticity of demand links pricing to revenue. On a normal downward-sloping demand curve, demand is elastic above the midpoint and inelastic below it, so a firm raises revenue by cutting price in the elastic range and by raising it in the inelastic range, and revenue is maximised at the midpoint, where MR is zero. A profit-maximising firm with market power always produces in the elastic range, since MR must be positive to equal a positive MC. In the kinked demand curve model of oligopoly, demand is elastic above the current price, because rivals will not follow a price rise, and inelastic below it, because rivals will match a cut. A price rise therefore loses a lot of revenue and a price cut gains very little, so the firm keeps its price where it is. The kink creates a vertical gap in the MR curve, and marginal cost can move up and down within that gap without the profit-maximising price changing.