CHAPTER FIVE

PRICING STRATEGY

Dec 8, 2024 ECONOMICS OF INDUSTRY

 Introduction
2

 The prices whether fixed by the firms itself or by

someone else say market or the government are
the most important parameters and they
determine total sales or revenue and then profits.
 A consumer also makes purchases of goods and
services to satisfy his/her needs.
 In this chapter we will address
 what price is
 what are the objectives and the precondition for
pricing;
 what general situations for pricing decisions;
 what the strategies of pricing and price leadership
are?
 Concept of price
3

 Price is the value of commodities in the

market that place in exchange of it.
 Value of anything exchanged for
satisfaction and utility, includes tangible
and intangible factors.
 Price is a value for a certain good/service
determined by
 the willingness and ability of buyers to buy
and
 willingness of the producers/ sellers to sell it
in the market if it is on competitive market.
 Contd…
4

 Marketers need to understand the value

consumers derive from a product and use this
as a base for pricing a product (if we are
customer oriented).
 How much quantity of a commodity he/she
buys depends on
 the price of that commodity and
 the prices of other goods and services
 Price is a sacrifice to one who pays
(consumers) but it is gain to one who receives
it (sellers).
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 Contd…
5

 But the question is who makes or determines

the prices which are beneficial (acceptable) by
buyers and sellers
 Therefore, pricing is important aspect in
marketing of goods and services.
 For example, the price a farmer receives from
agricultural products is depends largely on the
distribution channel used to sell the product.
 For farmers, one of the major attractions of
direct marketing is the opportunity of gaining
control over the prices they can charge.
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 Objective of price determination
6

1. Short – term profit maximization:

 This approach is common in companies that are boot
scraping, as cash flow is the overriding considerations.
 It is also common for smaller companies hoping to
attract venture funding by demonstrating profitability
as soon as possible.
2. Short – term revenue maximization:
 This approach seeks to maximize long-term profits by
increasing market share and lowering costs through
economy of scale.
 For a well funded company, or a newly public company,
revenues are considered more important than profits in
building investor confidence.
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 Contd…
7

3. Maximize quantity:
 It may be to focus on reducing long-term
costs by achieving economies of scale.
 This approach might be used by a company
well-funded by its founders and other ‘close’
investors.
 To maximize market penetration.
 Particularly appropriate when we expect to
hence a lot repeat consumers.
 The plan may be to increase profits by
reducing costs.
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 Contd…
8

4. Maximize profit margin:

 most appropriate when we expect to have a lot
repeat customers.
 to up sell existing customers on higher- profit
products down the road.
5. Quality leadership:
 use price to signal high quality in attempt to
position the product as the quality leader.
6. Partial cost recovery:
 an organization that has other revenue sources
may seek only partial cost recovery.
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 Contd…
9

7. Survival:
 in situations such as market share decline and
overcapacity, the goal may be to select a price that will
cover costs and permit the firm to remain in the market.
8. Differentiation:
 at one extreme, being the low cost leader in a form of
differentiation from the competition.
 At the other end, a high price signals high quality and
/or a high level of service.
9. Status quo:
 the firm may seek price stabilization in order to avoid
price wars and maintain a moderate but stable level of
profit.
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 Preconditions for Price Determination
10

 small firms often do not have well-conceived

pricing plans.
 And many such firms seem to panic (or ignore
the problem) when large discount-oriented
retailers enter their trading areas-or become
more aggressive.
 Pricing is always a difficult decision.
 Often a price that is too low makes people perceive
our program as being inconsequential and not worth
the trouble of purchasing.
 On the other hand, a price set too high can also be
negative for our (as seller) rate of payments.
 Here are some of the factors that we need to consider:
11

1. Positioning:
 If we are running a discount store, we are always going to
be trying to keep our prices as low as possible.
 if we are positioning our product as an exclusive luxury
product, a price that is too low may actually hurt our
image.
2. Demand Curve:
 How will our pricing affect demand? We are going to have
to do some basic market research to find out this, even if
it is informal.
 Depend on the answer of people, the firm can chart /draw
a basic curve that says at X price, percentage will buy, at
y price, percentage will buy and at Z price percentage
will buy.
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 Contd…
12

3. Cost:
 calculates the fixed and variable costs associated with the
product or service up to the end of the process.
 A cost associated with each item sold or service delivered
 Many entrepreneurs under – estimate this and it gets them
in to trouble.
 Variable costs are cost items that directly related to
production … plants, seeds, fertilizer, labor, packing etc.
 Fixed costs are cost items that do not vary with
production volume, such as rent, taxes, management
salaries, and cost of capital ( machinery).
 the price of an item ( goods and services) should at least
cover variable costs in the short run and need to cover
both variable and fixed costs in the long run.
 Contd…
13

 After the prices are settled (established) based

on the desired gross margin for each product.
 it is often necessary for the smart marketer to
adjust the prices to match the marketing strategy.
 One might want to lower prices of certain goods
and services to
 Meet competition,
 Attract customers to the retail outlet, or
 Sell products that may have been damaged
overstocked or seasonal.
 To reflect the value a unique product, a special service,
or a prestige image.
 Contd…
14

4. Environmental factors:
 Understand the nature of legal or other
constraints on pricing.
 what possible actions might our
competitors take? Will too low a price
from us starting a price war?
 Find out what external factors may
affect our pricing.
 When we consider for the change in
prices, it is necessary to calculate the
impact of such a reduction or increase
 Steps for Price Determination
15

 Even if there is no single recipe (instructions) to

determine pricing, the following is a generally
known sequence of steps that might be followed
for developing the pricing of a new product:
1. first step: developing marking strategy.
2. The second step is estimating the demand
curve:
3. Third step is calculating cost of production:
4. The fourth step is setting pricing objectives
5. The final step is determine pricing using
information collected in the above steps.
 Contd…
16

 These steps are interrelated and are not

necessarily performed in the above order.
 firm must consider the implications of its
pricing on the pricing decisions of
competitors.
 Setting the price too low may risk a price war
that may not be in the best interest of either
side.
 On the other hand, setting the price too high
may attract a large number of competitors who
want to share the profit.
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 General Situations for Pricing Decisions
17

A. When a firm must set a price for the first time.

 This will be obviously a very difficult situation for pricing.
B. When a firm considers initiating price change.
 There may be many reasons that force the firm to change its
price.
 The sudden change in demand for that product,
 change in cost of production,
C. When competition initiates a price change.
 The type of price strategy that the firm should adopt for this
depends on the nature of its market situation whether it is
competitive, monopolistic or oligopolistic.
D. When a firm produces several products that have inter-
related demands and /or costs.
 In this situation the firm has to take decisions simultaneously
on the prices of the products which are interrelated together.
 Contd…
18

 M. Alfred has elaborated such pricing

decisions based on certain attributes such as
1. types of product- whether it is consumer or
industrial good
2. type of competitive situations – competitive,
monopolistic or oligopolistic
3. age of the product – new or existing product
4. nature of the product – single, joint or multi
product
5. Variation in capacity – utilizing the existing capacity
or anticipating new capacity.
 Contd…
19

 For pricing decision one has to define the price of a

product very carefully as it is not free from
ambiguity. Issues like
 Special discounts,
 special offers,
 methods of payment (short run /long run) amounts
bought and transportation charges………….has to be
considered
 Generally, the situations below are major
considerations on which pricing decisions depend
and in fact, which make the decisions quite complex
 risks and uncertainty in the market faced by a firm,
 the nature or type of the price to be fixed, and
 Pricing Strategies and Approaches
20

 Since it is related to product positioning, pricing is an

important strategic issue. To set the specific price level that
achieves our pricing objectives managers may use several
pricing methods. The methods that may use for pricing are:
1. Price lining:
 features products at a limited number of prices, reflecting
varying product quality or product lines.
 This strategy can help smart marketers sell top quality products
at a premium price and an “economy line”.
 can also make shopping easier for consumers and sellers
2. Single pricing:
1. charges customers the same price for all items.
2. Items are packaged in different volumes based on the single
price for which they would be sold.
3. The strength is being able to avoid employee error and facilitate
the speed of transactions.
 Contd…
21

3. Loss – leader pricing:

 a less than normal margin on an item is taken to increase
customer traffic.
 The loss-leaders should be well-known, frequently purchased
items.
 The idea is that customers will come to buy the “leaders”
and will also purchase regularly priced items (products).
 If the customers only buy the “loss-leaders” the marketer is
in trouble.
4. Odd – ending pricing:
 odd-ending prices are set just below the birr figure, example
set price birr 4.99 per kilogram instead of birr 5 per kilogram.
 Some customers believe (perceive) that odd-ending prices to
be substantially lower than prices with even-ending.

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 Contd…
22
5. Quantity discount pricing:
 A quantity discount is given to encourage customers to buy a
large amount of that product like birr 5 per unit and birr 9 for two
units.
6. Volume pricing:
 This uses the consumer’s perception to the business’s advantage,
and no real discount is give to customers, instead of selling a
single item for birr 2.50 two are priced for birr 4.99 or birr 5.00.
7. Cumulative pricing:
 Price discount is given based on the total volume purchased over a
period of time.
 The discount usually increases as the quantity purchased increases.
 This type of pricing has a promotional impact because it rewards a
customer for being a loyal buyer.
 Even if the above strategies are widely used and have
been proven effectively, smart marketers should not be
limited to these strategies.
 Addition approaches for pricing:
23

1. Premium pricing:
 use a high price where there is uniqueness about the
product or service.
 This approach is preferable where a substantial
competitive advantage exists.
 Such high prices are charged for luxuries items like
high quality hotel rooms, business class flights and
soon.
2. Economy pricing:
 this is a no frills low price.
 The cost of marketing and manufacturing are kept at
a minimum.
 Super markets often have economy brands for soups,
soft drinks, and related items.
 Contd…
24

3. Penetration pricing:
 the price charged for products /services is set
artificially low in order to gain market share.
 After the objective (brand building for market share)
is achieved, the price is increased.
 It is most appropriate when demand is expected to be
highly elastic.
4. Skim pricing:
 This approach setting high price and selling to those
customers who are less price sensitive.
 It is appropriate when demand is expected to be
relatively inelastic (the customers are not highly price
sensitive).
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 Contd…
25

5. Product line pricing:

 Where there is a range of products / services, the pricing
reflect the benefits of parts of the range.
 For example, car wash service; basic wash birr 5.00, wash
and wax birr 8.00, and the whole package birr 10.00.
6. Optional products pricing:
 Companies will attempt to increase the amount customer
spend.
 once they start to buy optional ‘extras’ increase the
overall price of the product or service.
 For example, air lines may charge for optional extras like
guaranteeing a window seat or reserving a row of seats
next to each other with friends or families or some other
groups.
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 Contd…
26

7. Captive product pricing:

 This pricing strategy is widely used when products are
complements and companies will charge a premium price
where the consumer is captured.
8. Promotional pricing:
 pricing to promote a product is a very common application
and widely used strategy.
 For example buy five gets one free or gaining more through
lottery.
9. Geographical pricing:
 is evident where there are variations in price in different areas
of consumption of that product or service.
10. Value pricing:
 This strategy is used when and where external factors such as
recession or increased competition forces companies to
provide ‘value’ products and services to retain sales.
 Price Leader Ship
27

 Price leadership is an observation made of oligopolic

business behavior in which one company is usually the
dominate competitor among several leads the way in
determining prices, the others soon following.
 Classical economic theory holds that price stability is
ideally attained at a price equal to the incremental
cost of producing additional units.
 Price leadership has been grown popularly in industrial
economics for a long period of time and it backs to
Stigler (1947) and Markham (1951).
 Rotemberg and Saloner (1990) define price leadership
as “one of the firms announces a price change in
advance of the date that which the new price will take
effect.
 Cost and Preconditions for Price Leadership
28

 There may be direct and indirect costs of price leadership.

 The cost will be more when the firm first makes an attempt
for price leadership.
 Typically, a company trying to be a price leader will first
increase prices.
 Competitors will not automatically respond. They will wait to
see if the firm is committed to the price increase.
 There are no guarantees when we are asserting price
leadership. i.e. the leader may lose some business initially
to commit the increase.
 A contingency plan should accompany the leadership
strategy too stylishly reverse if it is unsuccessful.
 If it is works it will take a series of selling cycles before
competitors feel comfortable with the leader and start
reacting more appropriately and sooner.
 Contd…
29

 The other way to achieve price leadership is to

create pricing momentum (changing price in a
rapid fire, unpredictable way to get the attention of
competitors).
 Selecting a spectrum of products for promotion and
making price changes as transparent as possible
are the two essential things.
 Using pricing momentum to become a price leader
is a high wire act.
 A mix of price increases, decrease and promotional
pricing over relatively short period of time will
eventually capture market attention and encourage
competitors to follow the leader.
 Contd…
30

 To establish the position of price leader, two conditions

must be fulfilled.
A. The first condition is that company (firm)
must have sufficient market share to
influence the market.
Even if it has not absolute limit, the
norm would typically be between 35-39%
or over.
B. The second condition is to invest the time
and resources needed to thoroughly to
understand the market place.
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 Contd…
31

 In addition to the above conditions, the following

should be noted about price leadership:
 the firm must have enough presence to influence pricing
 Formal market intelligence is required to avoid disaster.
 price move should have a contingency plan to recover if it
does not succeed.
 price move should be accompanied by targets to measure
success or failure.
 The firm must understand the cost of price leadership.
 Overtime, if successful, the short-term costs will decline
as competitors respond more quickly and appropriately.
 Benefits must be evaluated and measured to ensure
continuing commitment to price leader ship.
 Models of Price Leader Ship
Barometric price leader ship
32

 In this model a particular firm is accepted by the

other firms in the industry as the best judge of
when to change price.
 The firms themselves are assuming asymmetric
information, in that they believe that the leader has
knowledge or ability that they do not have.
 during a period of stability in methods of production
a firm with particular expertise in a marketing may
be seen as price leader.
 during a period of rapid technological change, a firm
more highly regards as a production innovator will
be watched more closely by other firms for signals .
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 Contd…
33

 If the ultimate price - once the firms have responded

to the leader – is close to what it would have been
under competitive situations, then there is generally
considered to be nothing anti-competitive about this
type of behavior in an industry.
 Barometric price leadership known for
 occasional switching between firms in the role of price
leader;
 the occurrence of upward price leadership only in
response to increased industry costs or demand;
 occasional and sometimes substantial time lags in the
price response of followed firms; and
 occasional rejection by the rest of the market of price
changes initiated by the price leader firm.
 Dominant firm and competitive fringe
34

 Other models characterized price leadership in terms of

industries where the distribution of firm sizes is highly
skewed.
 Dominant firm that exists alongside a competitive fringe
of much smaller firms, typically supplying a relatively
standardized product.
 Market performance then depends on
 relative cost and
 ease of market entry.
 Since it acts as price setter, the dominant firm’s price
cuts will be matched by the competitive fringe.
 On the other hand, if barriers to entry are low, the price
leader’s ability to exercise market power will be
constrained by the entry of additional fringe suppliers.
 Collusive pricing
35

 It consists of agreement among a group firms to charge

the same or similar prices for the same or similar
products or services.
 Agreements for which documentary evidences can be
found, which can occur only if the agreement is explicit.
 Arguably, price leader ship also involves collusion, either
explicit or tacit
 Coordination of pricing was viewed as likely to be feasible
only in industries that are
 highly oligopolistic,
 where products are close substitutes,
 where barriers to entry exist, and
 where firms face similar cost conditions.

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 Contd…
36

 pricing behavior may be collusive when firms

viewed as taking decision over a number of
time periods, in contrast to the single - period
approach of earlier static models.
 Rotemberg and Saloner observe that the
barometric and dominate firm models are often
inappropriate for industries in which there are
a number of more or less equally sized players
selling differentiated products.
 In such industries one would expect at least
some degree of strategic behavior.
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 Predatory pricing
37
 This normally involves the use or the threat used by the
dominant firm - or the firm attempting to become dominant - of
one of the following variables: price, quantity supplied, or
quality.
 In particular predatory pricing is a strategy that calls for
reduction of price to below the short - term profit maximizing
position, so that other firms are driven out of the market or
weakened to the point of being taken over by the dominant firm.
 any price below average variable cost (AVC).
 At any price between P1 and P2 the firm is covering its short run
variable cost. It can remain in business in the short run although
there will be a loss in each unit, the excess of price over average
variable cost will partly offset average fixed cost.
 At any price below P2, the firm may be engaged in predatory
pricing.
 Graphically
38
 Contd…
39

 Two separate – though related – debates in relation to

predation deserve our attention.
 The first is theoretical based around the Chicago School
argument that, in the absence of barriers to entry and under
conditions of perfect information, predation can not occur.
 The second is practical, empirical and legal, and rests on the
need for competition law to distinguish between illegal
predation and legitimate business practice aimed at gaining
competitive advantage.
 Let us assume a firm that incurs losses in the short run, with
the expectation of driving out or taking over its competitors
so that in the long run profits will have to make up for the
short run losses.
 However, in the absence of barriers to entry, there is
nothing to stop new firms from continuing to enter.
 Contd…
40

 Perfect information has similar effect to the

absence of entry barriers.
 If the dominant firm’s decision makers
know that it will be able to improve its long
- run position by predation, then so will the
other firms and /or consumers.
 predatory activity of the dominant firm to
monopolize the market, may support the
competition and prevent monopolization.
-----------------////////////--------------------
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 Price Discrimination
41

 This occurs where identical products are sold in

different markets at different prices to different
groups of consumers.
 Price discrimination opens up another option to
the monopolist, expanding its range of choices.
 The firm must be at least as profitable as in the
situation where it charges a single price; it
cannot be worse off. If it were, it would choose to
charge the single price.
 Following the work of Pigou (1932), it is
customary to distinguish three types of price
discrimination.
 Consumer surplus
42

 Consumer
surplus is the
extra benefit a
consumer gains
when the price
they actually
pay is less than
they would be
prepared to
pay.
 First degree price discrimination
43

 It occurs when each unit of output is sold

at a different price.
 The firm / seller captures the entire
consumers surplus
 The market by selling each unit of output
at its maximum demand price.
 It sells at the highest possible that
individual customers willing / prepare to
pay
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 Graphically
44
 Second degree price discrimination
45

 The price that the consumer charged/ pays

varies according to their consumption level.
 It the consumer consumes greater level of
the product or service they pay less and the
vise versa.
 It is charging different prices for different
quantity purchase. Like telephone service,
consumer durability.
 demand curves of all the consumers are identical
 A single rate is applicable for a large no of
buyers.
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 Graphically
46
 Third degree price discrimination
47

 This is the most common, when the firm

divides customers into two or more
groups.
 Charges different prices without that
much difference in quality of service or
product.
 For example, for a plane flight business
class or economic class, urban versus
rural, residential versus industrial or
depend on age, sex or occupation like
student, public employs or business
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men
 Graphically
48
 Barriers to Entry
49

 Free entry and exist is the key assumption

that gives competitive markets desirable
properties.
 Ease on entry and exist plays a critical role in
determining market structure and the
subsequent performance of firms.
 Perfect competition is a benchmark
commonly used to evaluate the performance
of markets.
 Roughly speaking, a market is contestable if
entry is quick and costless. In short, there
must be no barriers to entry or exist.
 Contd…
50

 Barriers to entry are any structural, durable

feature of a market or its infrastructure that
inhibits the ability of outsiders to enter and
compete with established insiders.
 Literally, a barrier to entry is anything that
prevents and entrepreneur form instantaneously
creating a new firm in a market.
 It implies, for example, that the cost of - hiring
labor or the cost of building a plant is an entry
barrier.
 Moreover, it implies that any industry in which
entry takes time has a barrier to entry.
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 Contd…
51
 The economic theories predict the erosion of profits
by entry only in the long run.
 Thus, one reasonable approach is to focus on long -
run barriers to entry.
 If there are many firms that can enter with identical
cost curves and face identical prices, then no one
firm can succeed in the long run at earning profits.
 Only by having some advantage over new entrants
can a firm earns persistently higher profits.
 A logical definition of a long run barrier to entry is a
cost that must be incurred by a new entrant that
incumbents do not.
 Contd…
52
 The consequence of high barriers is that
 incumbents will be able to earn persistently high profits
even in the long run, and
 the size of these profits reflects the height of the
barriers which help to sustain them.
 computing the height of barriers to entry is an
inherently conjectural exercise. coz
 post entry profits are not easy to measure
 barriers to entry is that they are likely to be” entrant
specific” to some extent.
 Some entrants are more capable than others, and
some will pursue innovative strategies while others
content themselves with imitating the actions of
incumbents.
 Contd…
53

 According to Bain (1965), there are four

elements of market structure that act
as barriers to entry:
1.Economics of scale

2. Absolute cost advantages

3. Product differentiation

4. Capital cost requirements

 Economics of scale:
54

 firm’s average cost may remain constant,

rise, or fall as its output expands.
 If average cost falls as output increases,
the firm is said to have economies of scale
(or increasing returns to scale);
 if average costs do not vary with out put, it
has constant returns to scale; and
 if average cost rises with output, the firm is
said to have diseconomies of scale
( decreasing returns to sale).
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 Graphically
55

COST
PER
UNIT LAC

Q0 Q1 Q2 QUANTITY
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 A measure of scale Economies
56

 Economies of Scale exist if average cost

falls as output expands.
 As long as marginal cost is below average
cost, economies of scale exist.
 This relationship suggests that a natural
measure of scale economies is the ratio of
average to marginal cost.
 If s=AC/MC, then economies of scale exist if
s>1, constant returns to scale exists if s=1,
and diseconomies of scale exists if s<1.
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 Contd…
57

 Assume for the moment that capital markets work

perfectly so that entrants can raise sufficient capital to
finance entry as long as entry is profitable.
 Also, assume that all firms have access to the same
technology.
 Under these conditions, economies of scale act as a
barrier to entry if there is room in an industry for only a
small number of firms, each of which produces enough
out put to minimize average cost.
 If each firm has the long run average cost curve shown in
the figure, it must produce and sell at least Q1 units of
output, the MES, to produce at the lowest possible cost.
 How many firms of at least the MES can exist in an
industry depends on the position of the market demand
curve.
 Contd…
58

COST COST
PER PER
UNIT UNIT
LMC
A LMC B
LAC
LAC

A
R
A
R M
M R
R
QUANTITY QUANTITY
 Contd…
59

 In figure A Demand is sufficiently low

that one firm can satisfy demand at
lowest average cost.
 In fig B however, several firms could
produce and sell enough out put to
minimize average cost.
 Thus, economies of scale are a more
significant barrier to entry in the first
case than in the second.

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 Contd…
60

 The key to understanding the argument about

economies of scale as a barrier to entry is to
recognize that existing, or incumbent, firms have
already built MES plants.
 When the MES is large relative to demand,
potential entrants must think carefully about the
effect of entry on the market price of the product.
 If incumbent continue to produce the same amount
of out put after entry as they did before entry,
entry of another firm at the MES may well derive
price below average cost, leading to economic
losses.
12/08/2024
 Contd…
61

 There are many reasons to expect firm’s

average costs to decline, at least
initially, as its output expands.
 One is that fixed setup costs don’t vary
with the level of output.
 Average costs tend to fall with increased
output for a second reason.

12/08/2024
 Absolute cost advantages
62
Cost per
unit

P2 LRAC-
entrant

LRAC-
incumbent
P1

Quantity
 Contd…
63

 For simplicity it is assumed that average cost is

constant for both incumbent firms.
 Established firm can produce at a lower
average cost for any given level of out put.
 Consider any price above P 1 but below P2. At
such a price and established firms makes
positive economic profits.
 however, a potential entrant can not make a
profit unless prices rise above P 2 .
 Thus, the absolute cost advantage of
incumbent firms acts as a barrier to entry.
 Contd…
64

 Firms already in the industry may

 control a crucial input
 be able to borrow investment funds at lower
interest rate than potential entrants.
 they may have access to superior
production technologies
 perhaps protected by patents may have
built plants in the most desirable locations
 entrants may have to pay more for scarce
inputs, such as raw materials, managerial
talent, or research personnel.
 Product differentiation
65

 Product differential (firm produce similar but

not identical products) can create a long run
barrier to entry.
 For example, consumer good will tend
toward established brand names may make
it more difficult for a new brand to enter.
 Of course, an advantage may accrue to the
first firm to introduce a new product.
 That firm may have a first mover advantage:
the first firm to enter incurs lower marketing
costs because it faces no rivals.
 Capital cost requirements
66
 High capital costs, one of the structural
barriers to entry, could have been included
with the absolute cost advantage barrier.
 The horizontal average cost curves indicate
that the per unit advantage of established firm
is the same at small and large quantities of
output.
 Capital costs, by contrast, are closely
connected with economies of scale.
 In general, the larger the minimum efficient
scale, the larger will be the amount of financial
capital required to enter at the MES.
 Contd…
67

 A potential entrant in an industry with

high capital costs must therefore turn to
the capital market for funds.
 If new firms have to pay a higher interest
rate on borrowed funds that established
firms.
 Furthermore, the effect of this
differential in interest rates will be
greater the more capital investment a
firm needs to finance to enter at the
efficient size. 12/08/2024
 Contd…
68

 Economics have identified at least three reasons

for such a differential
 Risk:
 Creditors may charge new firms a higher interest rate to
compensate for a higher risk of bankruptcy and default
on loans.
 Entrants tend to be small relative to all firms in an
industry
 transaction costs:
 Large firm can spread these fixed costs over a large
volume of securities because they tend to issue new
securities in relatively large amounts.
 loan market imperfections: they may not precisely
determine the optimal allocation of funds.