In many market structures, firms must make careful decisions about the prices they charge for their goods and services. Pricing strategy is not simply about covering costs or maximising short-term profit; it is also about shaping the competitive environment, deterring potential entrants, and securing long-term market power. The link between pricing behaviour and the level of contestability in the market is especially important for understanding how firms act.
A contestable market is defined as one where entry and exit are easy and costless, meaning there are no significant sunk costs and new firms can quickly enter when prices are high and leave without major losses when conditions change. In a perfectly contestable market, even a monopolist would be forced to behave as if it were in perfect competition, since any attempt to set prices above competitive levels would invite immediate entry. While in reality very few markets are perfectly contestable, the concept remains powerful in showing how the threat of entry can influence pricing decisions.
P1 - Would be price set by profit maximising
P=AC - would be the firm setting a price set to sales maximisation
P=MC - would be the firm setting the price to be allocative efficient (although from the firms perspective they would not peruse this)
P=ACmin - would be the firm setting the price to be productive efficeint (again the firm may not want to set this)
Cost-push pricing happens when firms raise prices because their production costs increase, such as higher wages, raw material costs, or energy prices. Rather than absorbing these costs through lower profits, firms pass them on to consumers. This often leads to cost-push inflation, where the general price level rises even without stronger demand. For instance, if oil prices rise, transport and manufacturing costs increase, and firms respond by charging more for goods and services.
By contrast, cost-plus pricing is a deliberate strategy where firms set prices by adding a fixed mark-up to average production costs. For example, if it costs £10 to produce a good and the firm adds 20%, the selling price is £12. This guarantees cost coverage but ignores demand and competitive pressures.
One prominent pricing strategy linked to contestability is limit pricing, where an incumbent deliberately sets prices below its short-run profit-maximising level to discourage new firms from entering. By lowering prices to a level that only a highly efficient incumbent can sustain, potential entrants anticipate losses and stay out of the market. Predatory pricing goes even further: firms temporarily set prices at extremely low levels, sometimes below marginal cost, in order to drive existing rivals out of the market. Once competitors have exited, prices can be raised again to restore profitability. Although effective in deterring competition, predatory pricing is often illegal under competition policy due to its anti-competitive intent.
Limit pricing is a pricing strategy employed by incumbent firms to deter entry into a market. Unlike predatory pricing, where prices may be set below cost to drive existing competitors out, limit pricing involves setting prices just low enough to make the market appear unprofitable for potential entrants, but still above the incumbent’s cost level. By signalling that only firms with very high efficiency could survive at such low prices, incumbents discourage entry without having to incur losses themselves.
The effectiveness of limit pricing depends heavily on the contestability of the market. If barriers to entry are low and sunk costs minimal, the threat of new competitors is high, so incumbents have an incentive to engage in limit pricing to maintain their market share. In contrast, in markets where barriers are significant, the need for limit pricing diminishes because entry is already unlikely.
For example, in the UK supermarket industry, large incumbents like Tesco or Sainsbury’s may strategically price staple goods, such as bread or milk, at very low levels, signalling to potential entrants that profit margins in the sector are thin. Similarly, in the airline industry, dominant carriers have been observed reducing fares on contested routes, making it unattractive for smaller airlines to establish a foothold.
Limit pricing illustrates the strategic role of pricing beyond simple profit maximisation: firms weigh up short-term sacrifices in profit against the long-term benefit of deterring competition. For regulators, the challenge lies in distinguishing between legitimate competitive pricing that benefits consumers and strategic limit pricing that restricts market contestability.
Other strategies include penetration pricing, where firms set a low initial price to build market share quickly, especially in markets where brand loyalty or network effects are important. Once a strong consumer base has been established, prices may be raised. Conversely, price skimming involves initially charging a high price for a new or innovative product, targeting consumers with inelastic demand, before gradually reducing the price to capture more price-sensitive customers over time. Each of these strategies is shaped by how easy it is for new firms to enter and compete.
The theory of contestable markets suggests that the behaviour of incumbents is influenced as much by the threat of competition as by actual competition. For example, even a firm with monopoly power might choose to price close to average cost if it knows that excessive profits would attract rapid entry. The higher the contestability of a market, the more closely firms’ behaviour mirrors that of perfect competition, even if there are only one or two firms in the market.
The Areeda–Turner principle is a legal and economic test used to determine whether a firm’s pricing behaviour can be considered predatory. Developed in the 1970s by U.S. economists Phillip Areeda and Donald Turner, the principle argues that prices should be deemed predatory if they are set below a firm’s average variable cost (AVC). This is because AVC represents the shutdown price: the minimum price a firm must charge to cover its variable costs in the short run. No rational profit-maximising firm would continue to sell below AVC unless its aim were to drive competitors out of the market, since it would be making a loss on each unit produced. By contrast, prices above AVC but below average total cost may still be rational, as the firm covers some fixed costs while remaining competitive. The Areeda–Turner rule has been influential in competition policy because it provides a clear benchmark for assessing whether aggressive pricing reflects anti-competitive intent or merely intense competition.
The theory of contestable markets is important because it links market structure to outcomes differently from traditional models. In standard theory, a monopoly is expected to restrict output and charge higher prices, generating allocative inefficiency and deadweight loss, while perfect competition is seen as both allocatively and productively efficient.
The contestable market hypothesis shifts the emphasis from the number of firms in the market to the threat of potential competition. If a market is perfectly contestable, meaning there are no sunk costs and firms can enter or exit freely, even a monopoly will behave as if it were in perfect competition. In order to avoid attracting new entrants, the incumbent must charge a price close to average cost and produce efficiently. This ensures both allocative efficiency (resources directed to their most valued uses at prices reflecting costs) and productive efficiency (production at the lowest point on the cost curve).
An additional implication is that X-inefficiency does not exist in perfectly contestable markets. X-inefficiency arises when firms in less competitive markets allow costs to rise above the minimum possible level, often due to a lack of competitive pressure. However, in a contestable market, the constant threat of entry forces firms to eliminate waste and operate at maximum efficiency. Managers cannot afford to let costs drift upwards, as higher-than-necessary costs would make it easier for new entrants to undercut them.
In practice, though, very few markets achieve perfect contestability, because sunk costs, brand loyalty, and other barriers to entry reduce the disciplining effect of potential competition. This means that while the contestable market model predicts no X-inefficiency, real-world markets often do exhibit it to varying degrees.
The airline industry provides a strong applied example of the interaction between pricing strategies and contestability. In the UK, low-cost carriers such as easyJet and Ryanair compete aggressively on price, offering fares that can be far below the cost levels seen in traditional full-service airlines. This is partly due to their lower cost structures, but it also reflects the contestability of certain routes. Barriers to entry in aviation are lower than in the past because planes can be leased rather than purchased outright (reducing sunk costs), and landing slots on some routes can be contested.
When a new airline attempts to enter a profitable route, incumbent firms often respond with sharp price cuts. Ryanair, for instance, has been known to slash fares drastically on routes where a competitor appears, making it unprofitable for the new entrant to sustain operations. Once the rival exits, prices may be raised again. This behaviour mirrors the logic of limit pricing and shows how pricing can be used strategically to maintain dominance.
At the same time, contestability in the airline industry is imperfect. Significant sunk costs remain in the form of marketing, brand reputation, and the need to secure landing slots at busy airports. This means incumbents retain advantages that prevent perfect competition from arising. Nevertheless, the industry demonstrates how the threat of entry exerts downward pressure on fares and encourages incumbent firms to adopt pricing strategies designed to deter or neutralise new rivals.
The level of contestability differs sharply when comparing the airline industry with sectors such as supermarkets or digital platforms. In the supermarket industry, sunk costs are relatively high. Building a new store network, investing in supply chains, and establishing strong brand loyalty all create significant barriers to entry. New firms face difficulty entering because incumbents such as Tesco, Sainsbury’s, or Asda already benefit from economies of scale and long-established customer relationships. This means the threat of entry is relatively weak, and incumbents do not face the same discipline from potential rivals as firms in more contestable industries. As a result, while supermarkets engage in pricing strategies like discounting and loyalty schemes, these are often aimed more at competing with existing rivals than deterring new entrants.
Digital platforms such as Amazon, Google, or Facebook highlight another extreme. These markets often appear contestable at first glance as the cost of starting an online platform is relatively low, and entry does not require heavy investment in physical capital. However, they become highly incontestable due to network effects and data advantages. Once a platform achieves critical mass, users are locked in by convenience, habit, or the inability to transfer their data. This creates powerful barriers to entry that make pricing strategies less about deterring potential entrants and more about monetising market dominance.
The comparison illustrates that contestability is not just about the number of firms in the market but about the ease with which new firms can enter and challenge incumbents. Airlines demonstrate moderate contestability, where pricing plays a strategic role in deterring new rivals. Supermarkets are far less contestable due to heavy sunk costs and economies of scale, while digital platforms show how network effects can make a seemingly open market effectively closed to new entrants.