12.4. Competition-Based Pricing

Where there is fierce and direct competition between suppliers to a market, firms will often adopt competition-based pricing strategies.

Price leadership. This will tend to occur where firms are reluctant to start a price war by cutting their prices. They will therefore tend to price their products in line with those charged by their competitors. In some cases, a dominant firm may take on the role of price leader, and rival firms will raise or cut prices as dictated by the dominant firm. Price leadership tends to occur in markets dominated by a handful of large and powerful suppliers, such as petrol retailing.

Destroyer pricing. A more drastic version of penetration pricing, destroyer pricing is used when the objective is to destroy the sales of competitors' products, or to warn off new entrants to the market. Trading losses resulting from destroyer pricing strategies cannot usually be maintained for long. Freddie Laker, owner of Laker Airways in the 1980s, accused large airlines of operating destroyer pricing on transatlantic air routes, causing his business to collapse.

12.5. Problems with Demand- and Competition-Based Pricing

Cost-based pricing ignores the influence of the market conditions of consumer demand and supply on price. Conversely, the main problem with price setting with reference to market conditions is that it may ignore the production costs which a firm must at least cover through sales revenues if it is to survive.

As long as a firm is able to cover its variable costs of production in the short run, it can continue production and carry on with objectives such as launching a new product or expanding market share. However, a firm cannot go on making a loss indefinitely. Eventually it must be able to pay for its fixed costs of production, namely rent, rates, and overheads. In the long run, therefore, pricing decisions must take into account total costs, including fixed costs, as well as market conditions. If a firm is only able to cover its costs by setting its product price higher than rival products, then to make sales and survive, it will need to examine the scope for cost-cutting and increasing productivity.

Test Questions

1.	The break-even level of output in a firm can be found at the point at which:
A.	Total Sales Revenues = Business Start-up Costs
B.	Total Sales Revenues = Total Costs
C.	Total Sales Revenues = Indirect Costs
D.	Total Sales Revenues = Direct Costs
2.	If a business plans for a ‘margin of safety’, it has planned to:
A.	Increase its cash holdings in a bank account
B.	Produce at the break-even level of output
C.	Produce an output greater than break-even
D.	Produce any output where sales revenue covers direct costs
3.	A firm which produces wide-screen televisions has fixed costs of £500,000. The variable cost per TV is £500. If each TV is sold for £1,000, how many TVs must the firm produce and sell to break even?
	A. 5,000	B. 100	C. 1,000	D. 500
	Questions 4 and 5 are based on the following information: fixed costs per year = £30,000, variable cost per CD game = £15
4.	If the firm produces 10,000 CD games, what will be the average cost per unit?
	A. £15	B. £5	C. £21	D. £18
5.	If the firm plans to earn a contribution of £25 per unit sold, the price it must charge for each CD game will be:
	A. £ 40	B. £43	C. £50	D. £46
6.	A firm produces and sells 40,000 units annually. Variable costs per unit are £2, while fixed costs total £100,000. If the firm adds a 20% mark-up for profit, each unit will sell for:
	A. £5.40	B. £4.50	C. £2.40	D. £3.00
7.	Which of the following is unlikely to be an important objective of penetration pricing strategies?
A.	Increasing market share
B.	Launching a new product in a competitive market
C.	Maximising sales revenue
D.	Maximising short-term profit
8.	You are a business manager in a large, well-established firm. A new firm has entered the market and threatens to reduce your market share. Which of the following pricing strategies would you advise your organisation to adopt in the short term?
A.	Market skimming
B.	Destroyer pricing
C.	Price discrimination
D.	Contribution pricing
9.	Suggest and explain a pricing strategy a firm could adopt to launch a new product. How might established firms in the same market adapt their pricing strategies in the face of the new competition? Using examples, explain the term ‘price discrimination’. Explain why a holiday company may offer foreign holidays at bargain prices within a few days of their departure dates.
10.	A small firm producing candles has fixed costs of 60,000 pounds per year and variable costs of 50 pence per candle. Each candle is sold for 2.50 pounds. How many candles must the firm produce and sell each year to break even? How much profit would the firm earn if it produced and sold 80,000 candles each year? Use the above mentioned information to draw a break-even graph for levels of output between 0 and 80,000 candles. Mark the area of profit and loss. Explain, using examples, why break-even analysis and the use of break-even charts are so useful to new and existing businesses.