The price at which a company sells its product can make or break its business. Though companies can differentiate their product through marketing, pricing strategy is also determined by forces the company cannot control. Recognizing these factors help a firm determine how best to compete given these inherent constraints.
The number of competitors in your industry will affect your pricing strategy. Economists categorize market structures into three distinct groups: perfectly competitive, oligopoly and monopoly. In a perfectly competitive market, the pricing strategy is based on supply and demand. Firms must accept the price based on these conditions. Simply put, if a firm raises its price of an identical good far above the price of other companies (the "market price"), then the firm will go out of business.
In an oligopoly--where only a handful of sellers provide a good or service--the pricing strategy depends on the lowest price on the market: This price may be lower than the market price if a price war occurs. For instance, an airline may try to gain customers by offering a ticket price for a routing like Phoenix to New York that is less than the actual cost to fly the customer. The hope is that the customer books an additional high-profit segment like New York to Albany. However, other companies cannot compete with the lowered New York to Phoenix price offered, and consequently, all other airlines lose money. Robert Carbaugh, author of “Contemporary Economics: An Applications Approach” explains that in an oligopic market, companies must engage in this type of competitive pricing strategy known as game theory to eke out a profit.
In a monopoly, pricing strategy is based on the highest price a firm can offer without engaging in price gouging. Price gouging is the act of charging a high price above the market value as a result of being one of the only sellers in the market. Price gouging is illegal under the Sherman Antitrust Act. A monopolistic firm’s pricing strategy is sometimes subject to government approval. For instance, some power companies must gain a government board’s approval before raising prices.
Firms in a perfectly competitive market are subject to a pricing strategy based on consumer demand. Irvin Tucker, author of “Survey of Economics,” writes that consumer demand is influenced by the number of substitute goods available in that market. For instance, firms selling cookies must keep an eye on the price of cupcakes: Since many consumers like cupcakes just as much as cookies, they are willing to switch to cupcakes, a substitute good, if the price of a cookie gets too high. Consumer demand is also based on income levels: Sellers of luxury sports cars will notice an increase in sales if overall income rises.
Retailers understand how their pricing strategy differs during Christmas and mid-August when children are going back to school, vs. late January and October. During peak holiday seasons, retailers offer discounts to compete with other companies, but they can still offer higher prices due to the seasonality of the economy. Similarly, retailers drop prices during times of deep economic recessions to entice consumers to spend money. If consumer confidence is low and people are reluctant to spend money, the pricing strategy changes. However, sellers of certain items may raise prices during economic recessions: Examples include low-cost goods (or items consumers purchase due to a fall in income) such as generic, store-brand canned vegetables and boxed pasta.