GRADUATE SCHOOL POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Sta. Mesa, Manila

WRITTEN REPORT FOR

MANAGERIAL ECONOMICS
ADVANCE TOPICS IN BUSINESS STRATEGIES (Part 1)

BY:
LEA L. NAAG
 ADVANCE TOPICS IN BUSINESS STRATEGIES

SUBTOPICS:

 Limit pricing to prevent entry

 Theoretical basis for limit pricing
 Linking the pre-entry price to post entry price
 Learning curve effects
 Raising rival's cost to lessen competition
 Vertical foreclosure

Limit Pricing to Prevent Entry

Limit pricing is the practice of setting a product or service price at a level just low
enough to deter potential market entrants from competing in a market.

A business engages in limit pricing when it wants to minimize the number of

competitors. The price point chosen may not be the price at which a business
earns the largest profit, but it does keep other companies out of the market.

Strategies are most likely going to be found in imperfectly competitive markets

Today some of the industries and sellers follow it to earn surplus profits. In this
market scenario, the seller enjoys the luxury of influencing the price in order to
earn more profits.

Figure 1: Sample schedule for a monopolistic seller

If a monopolistic seller wants to sell more units, it can decrease the price. Since,
the price changes, the marginal revenue also changes, as more units sold, the
marginal revenue decreases the same as the price. A company that is looking to
maximize its profits will produce up to the point where marginal cost equals
marginal revenue.
Marginal revenue is important because it is a crucial indicator regarding the most
ideal level of activity a company should undertake. It is mathematically most ideal
for a company to produce goods until marginal revenue is equal to marginal cost;
selling goods beyond this level usually means more costs are incurred than
revenue received for each good.

Like other related concepts, marginal revenue can be graphically depicted. We

have the price at the Y axis and the quantity at the X axis.

Figure 2: Graph for limit pricing

You’ll see here in Figure 2 that the marginal revenue curve is downward sloping
unlike in the perfectly competitive environment where marginal revenue curve is
horizontal since the price doesn’t change. This time, it is downward sloping
because the price changes as the quantity demanded changes. 
Figure 3: Schedule showing MR = MC

Referring to figure 3, the monopolistic seller should continue producing until

MC=MR, a point at which they should keep production constant. This is because
producing an extra unit beyond this point will create a higher marginal cost for the
firm than the marginal revenue it creates (the cost will be greater than the profit).

Figure 4: Graph for Limit Pricing from the Sample Monopoly Schedule

Analyzing the Figure 4, Q1 is the profit maximizing level of output which is at

output level 3. The Price is 12 (P1), that’s the price the monopoly sells its
goods/services, and the cost at that level is 8 (C1), as seen here in the average
cost curve. You’ll see that the monopolistic seller is getting an abnormal profit at
points A, B, C1 and P1. 
Looking at the schedule (Figure 3), at the profit maximizing level where MR =
MC, the Price is 12, average cost is 8, total cost is 24, Total revenue is 36, so the
seller is getting an abnormal profit of 12. 

Because of that abnormal profit, new firms will show interest to get a share in this
abnormal profit. They would be joining this market dominated by the monopolistic
seller. Because of this threat, the monopolistic seller will then set a limit price to
deter these new firms from entering the market.

How will they do it?

They will set it lower than their original price of 12, so in this schedule (Figure 5)
that price is 9. 

Since they decreased the price, the monopolistic seller will increase the level of
production, quantity demanded will increase for this firm.

Figure 5: Schedule showing the limit price

In this scenario, the profit decreased to 4 (Figure 5). It is lower than their original
profit at 12, but they are still getting a normal profit after setting the limit price.
They are willing to sacrifice the abnormal profits they are usually getting so that
these new firms will be discouraged from entering the market. Of course, the new
firms will also set their price not higher than 9, set by the monopolistic seller, in
that case, if the new seller’s average cost is also 9, they will just barely survive
the market and would eventually leave the market. 

Limit pricing strategy of the monopolistic seller kills the new firms and will
eventually leave the market. The concept of limit pricing is banned and illegal
nowadays in most countries. Kasi may economic theory tayo that when firms
have to compete for customers, it leads to lower prices, higher quality goods and
services, greater variety, and more innovation. But, if a country is dominated by
monopolies, then its power can harm society by making output lower, prices
higher, and innovation less than would be the case in a competitive market.
 Predatory pricing

Predatory pricing is pricing below marginal cost in the hope of knocking out rival
producers and subsequently raising prices to obtain monopoly profits. 

Like any limit pricing strategy, predatory pricing involves a trade-off between
lower current prices and profits in return for higher subsequent prices and profits.
 
Predatory pricing, not only causes others to leave the market, but it also restricts
entry for others. Since this is the purpose of predatory pricing, it is banned in
many places because it is considered a violation of competition laws.

However, in many cases it is difficult to prove a business is actively trying to

implement predatory pricing rather than just partaking in normal competition.

Example:

1. If you had a competitor that was selling a TV at 10,000, and you sold the same
TV at 5,000 (while taking a loss) because you knew they couldn't beat your price, you're
inacting in predatory pricing.

So, what’s the difference between limit pricing and predatory pricing? 

 Limit Pricing is a strategy used by the existing supplier to restrict new entrants
currently out of the market. On the other hand, predatory pricing is a strategy that one
supplier uses to out the other supplier existing in the market.
 Under limit price, the supplier will have to earn lower profits to keep out the new
entrant, but under predatory pricing, it is not required.

Predatory pricing practices are illegal in the United States under the Sherman
Antitrust Act.
 Learning Curve

A learning curve is a mathematical concept that graphically depicts how a

process is improved over time due to learning and increased proficiency.

The learning curve theory is that tasks will require less time and resources the
more they are performed because of proficiencies gained as the process is
learned. Most people usually get better at doing something the more they do it.
The time and resources spent to do something the first time is probably higher
than the time and resources spent on performing the same task for the 100th
time.

It is characterized as a constant percentage decline in average costs as

cumulative output increases

The theory of the learning curve is based on the simple idea that the time
required to perform a task decreases as a worker gains experience.

The basic concept is that the time, or cost, of performing a task (e.g., producing a
unit of output) decreases at a constant rate as cumulative output doubles.

The original model was developed by T. P. Wright in 1936 and is referred to as

the Cumulative Average Model or Wright's Model.

Figure 6: Learning curve function

Figure 7: Schedule showing X- Quantity and Y – Average Labor Cost

Plotting the Cumulative output in the X axis and the cumulative average labor
cost in the Y axis, we will see the learning curve (Figure 8). The learning curve is
downward sloped. In the visual representation of a learning curve, a steeper
slope indicates initial learning that translates into higher cost savings, and
subsequent learnings result in increasingly slower, more difficult cost savings.

Figure 8: Learning Curve

So, what happens when two firms compete with the same product? A learning
curve is important because it can be used as a planning tool for business
strategies to understand when operational efficiencies may occur.

For example (Figure 9), Firm A is the new firm and firm B is the incumbent
monopolist. Firm B has been in the industry for a very long time, producing lots of
goods at a lower average cost per unit. Firm A is new in the market, produces
lesser goods and at a higher average cost per unit compared with Firm B.

Figure 9: Comparison between Firm A and Firm B in Learning Curve

If firm B’s average cost is at 9 and Firm A is 15. Firm B sets the price at 15. Firm
A will set it at 15 too. Unfortunately, if the average cost of Firm A is 15 too, new
seller is barely surviving while the monopolistic seller is gaining profits. 

So, this green area (figure 9) is the profit of the incumbent monopolist.

If Firm B maintains a price level at which firm A will endure, average cost for A
will decrease at a higher rate than for B. That's because of the steeper slope for
lower cumulative level of output even if firm B has produced more output than
firm A.

However, Firm B has anticipated this scenario, they will set a limit price to vanish
firm A from the market. Firm A will be forced to reduce its price, therefore
incurring losses.

Firm A will ultimately leave the market.

 Raising Rival's Cost to Lessen Competition

Raising rivals' costs is a concept or theory in United States antitrust law

describing a tactic or device to gain market share or exclude competitors. The
origin of the concept has been attributed to Professors Aaron Director and
Edward H. Levi of the University of Chicago Law School, who wrote briefly in
1956 that a firm with monopoly power can decide to impose additional costs on
others in an industry for exclusionary purposes.

For example, a capital-intensive firm might agree with a union to impose higher
wages in the industry, to the disadvantage of labor-intensive rivals.

Vertical Foreclosure

It is a type of anti-competitive behavior. Vertical foreclosure can create a vertical

monopoly, in which one company controls every other company in the entire
supply chain
Example: 

1. Your company purchases from a supplier that supplies both your company and
several competitors with raw materials. Your company then uses its leverage over the
supplier to receive a discount when it buys raw materials, and reduces quantity and
raises prices when its competitors buy raw materials.
2. The same company may own a logging business, a lumberyard, the furniture
factory and a retail store.

Legal ramifications of business strategies designed to lessen competition

Antitrust laws are “pro-competition,” intended to ensure that businesses have the
ability to compete in an open marketplace where they can try to provide goods
and services of higher quality at lower prices.

The Philippines has general antitrust laws that prohibit unfair competition, and
arrangements and combinations aimed to restrain trade or prevent by artificial
means free competition in the market.

There are also laws that govern specific industries and arrangements, and which
prohibit specific acts such as price fixing, illegal combinations, hoarding,
profiteering, tying, coordination, abuse of market power, predatory behavior, and
other arrangements in such industries.

Limit pricing is considered illegal in some jurisdictions. Predatory pricing violates

antitrust laws, as its goal is to create a monopoly. Anti-trust laws prohibit vertical
foreclosure when it creates an illegal monopoly that harms consumers.

The PCA also prohibits businesses with significant market share (more than 50
percent) or market dominance from using their positions to eliminate or
undermine competition. Examples of prohibited conduct include: - businesses
selling their goods below costs for the purpose of damaging competitors -
imposing high barriers to new competitors - directly or indirectly imposing unfair
purchase or selling prices on other businesses.

Consequences from non-compliance (Source: Philippine Competition Act)

1. Penalties of up to PHP 250 million

2. Imprisonment between 2 to 7 years under the PCA or up to 15 years
under other existing competition related laws
3. Increased spending on legal costs and sanctions
4. Civil and criminal law suits Damage to business reputation
5. Loss of confidence from customers, stakeholders