The critical loss analysis is normally used to define the market but it also provides information on competitive pressure.
An increase in price leads to an opposite effect on profits. On the one hand, the demand will decrease and, therefore, the sales volume shrinks. On the other hand, the company receives a higher profit margin with the remaining demand. Therefore, price increases can be profitable as well as unprofitable.
The implementation of a critical loss analysis requires information on prices and variable costs.
- In the first step the critical loss analysis estimates the maximum decline in sales of monopolies, that results from a 5%-10% price increase under the condition that profits are constant.
- In addition to the critical loss, the actual loss, caused by the increase in price, will be calculated.
- Finally, the critical loss and the actual loss can be compared in order to define the relevant market. If the actual loss is less than the critical loss, the price increase can be seen as profitable and the relevant market is defined.