A price cut must cover its extra costs and survive rivals' responses.
A price cut can raise sales, but its profit effect depends on the revenue response, additional costs and rivals' reactions. Elastic demand can support higher revenue over a relevant price change; it does not guarantee greater profit. In an interdependent market, a rival may match the cut, reducing the sales gained. Persistent price competition can benefit consumers through lower prices while squeezing margins and potentially affecting quality or investment. A low price alone does not prove an exclusionary intention or a legal infringement.
- Revenue
- Total revenue is price multiplied by quantity sold. A lower price must attract enough extra sales to raise revenue.
- Profit
- Profit is revenue minus relevant cost. Extra sales can also add costs, so higher revenue is not enough to prove higher profit.
- Rival response
- If competitors match the cut, the firm may win fewer of their customers than it expected.
Look beyond the immediate price
Evaluation
A prolonged price cut may affect quality or investment as well as current buyers. Predatory pricing can involve deliberately pricing below cost to exclude rivals, with the aim of charging higher prices once competition weakens. A low observed price alone does not establish that intention or a legal infringement.
| Scenario | Price | Sales | Revenue | Relevant cost | Profit |
|---|---|---|---|---|---|
| Initial | 10 | 100 | 1000 | 700 | 300 |
| Rivals do not match | 9 | 125 | 1125 | 800 | 325 |
| Rivals match | 9 | 105 | 945 | 730 | 215 |
Worked example: A price cut when rivals respond
A firm initially sells 100 units at $10 with total relevant cost $700. If rivals hold prices, a cut to $9 would sell 125 units with cost $800. If rivals match, sales would be only 105 with cost $730. All figures cover the same period.
- Initial profit is 100 x 10 - 700 = $300.
- If rivals hold prices, profit becomes 125 x 9 - 800 = $325: a $25 gain.
- If rivals match, profit becomes 105 x 9 - 730 = $215: an $85 fall.
- The recommended action depends on the likely rival response and relevant costs, not just observing that the firm can sell more after cutting price.
Watch out for this
More units sold after a price cut proves the cut increases profit.
Calculate revenue and cost, and consider whether the demand response persists when rivals act.
Check your understanding
In the matched-price case above, what is profit?
- $945.
- $325.
- $215.