What this lesson teaches
I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.
Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms
Make a guess
A telco cuts its mobile plan prices by 20%, and its two rivals match the cut within a week. What happens to the first telco's profit?
- It probably falls, because it wins few new customers.
- It rises, because demand for mobile plans is elastic.
- It stays the same, because customers pay less but stay.
Show the answer
It probably falls, because it wins few new customers.
When rivals match, customers have no reason to switch. Every firm now earns less per customer without gaining many more.
A price cut can win sales, but its effect on profit depends on demand, costs and how rivals respond.
A firm may cut its price to win customers. If demand is price elastic, revenue rises. But profit also depends on the extra costs of producing more.
In an oligopoly, firms are interdependent: each firm's result depends on what its rivals do. If a rival matches the price cut, the firm wins far fewer customers than it hoped.
Repeated price cutting can start a price war. Each firm's demand falls and becomes more price elastic, because buyers now have cheaper close substitutes. Consumers gain from lower prices, but profits shrink and weaker firms may be forced out. From early 2023, Tesla and then BYD and other carmakers cut electric car prices in China, and the cuts squeezed carmakers' profit margins.
Because cuts are matched quickly, some oligopolies settle into price leadership: one large firm changes its price and the others follow, without any formal agreement. This avoids price wars, but prices can stay high.
Predatory pricing is a price cut aimed at a rival, not at customers. A dominant firm prices below cost, often below average variable cost, until a rival leaves, then raises prices again. Consumers gain briefly and lose later. Singapore's Competition Act prohibits abuse of a dominant position, including predatory behaviour. In 2003 the European Commission fined Wanadoo, then part of France Telecom, for selling broadband below cost to win the market.
This is why oligopolies often prefer non-price competition, such as better service or loyalty schemes, which rivals cannot copy as quickly.
- Interdependence
- Each firm's result depends on rivals' reactions.
- Price war
- AR shifts left and becomes more elastic; consumers gain, profits fall.
- Price leadership
- One firm sets the price and others follow, without an agreement.
- Predatory pricing
- Price below cost to drive a rival out, then raise it.
Worked example: A price cut when rivals respond
A firm sells 100 units at $10, with costs of $700. Cutting to $9 would sell 125 units at a cost of $800 if rivals keep their prices, but only 105 units at a cost of $730 if rivals match.
- Now: profit = $1,000 - $700 = $300.
- Rivals hold: profit = $1,125 - $800 = $325, a small gain.
- Rivals match: profit = $945 - $730 = $215, a loss of $85.
- The price cut only pays if rivals do not follow.
Watch out for this
If demand is elastic, a price cut always raises profit.
Elastic demand means revenue rises, but costs rise too, and rivals may respond. Profit can fall.
Check your understanding
Why might an oligopolist avoid cutting its price?
- Because demand for its product is always inelastic.
- Because price cuts are illegal in an oligopoly.
- Rivals are likely to match it, so it gains few customers and all firms earn less.
Show the answer
Rivals are likely to match it, so it gains few customers and all firms earn less.
Right. Interdependence means a price cut often triggers matching cuts.