Limit price
Encyclopedia
A limit price is the price
set by a monopolist
to discourage entry into a market
, and is illegal in many countries. The limit price is the price that a potential entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. Such a pricing strategy is called limit pricing.
The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition
.
The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response
. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. Another example is to build excess production capacity as a commitment device.
for good X at market price P is given by:
Suppose there are two potential producers of good X, Firm A, and Firm B. Firm A has no fixed costs and constant marginal cost
equal to
. Firm B also has no fixed costs, and has constant marginal cost equal to 
, where 
(so that Firm B's marginal cost is greater than Firm A's).
Suppose Firm A acts as a monopolist. The profit-maximizing monopoly price charged by Firm A is then:
Since Firm B will never sell below its marginal cost, as long as
, Firm B will not enter the market when Firm A charges 
. That is, the market for good X is an effective monopoly if:
Suppose, on the contrary, that:
In this case, if Firm A charges
, Firm B has an incentive to enter the market, since it can sell a positive quantity of good X at a price above its marginal cost, and therefore make positive profits. In order to prevent Firm B from having an incentive to enter the market, Firm A must set its price no greater than 
. To maximize its profits subject to this constraint, Firm A sets price 
(the limit price).
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
set by a monopolist
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
to discourage entry into a market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
, and is illegal in many countries. The limit price is the price that a potential entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. Such a pricing strategy is called limit pricing.
The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...
.
The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response
Best response
In game theory, the best response is the strategy which produces the most favorable outcome for a player, taking other players' strategies as given...
. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. Another example is to build excess production capacity as a commitment device.
Simple Example
In a simple case, suppose industry demandDemand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
for good X at market price P is given by:
Suppose there are two potential producers of good X, Firm A, and Firm B. Firm A has no fixed costs and constant marginal cost
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...
equal to
. Firm B also has no fixed costs, and has constant marginal cost equal to , where (so that Firm B's marginal cost is greater than Firm A's).Suppose Firm A acts as a monopolist. The profit-maximizing monopoly price charged by Firm A is then:
Since Firm B will never sell below its marginal cost, as long as
, Firm B will not enter the market when Firm A charges . That is, the market for good X is an effective monopoly if:Suppose, on the contrary, that:
In this case, if Firm A charges
, Firm B has an incentive to enter the market, since it can sell a positive quantity of good X at a price above its marginal cost, and therefore make positive profits. In order to prevent Firm B from having an incentive to enter the market, Firm A must set its price no greater than . To maximize its profits subject to this constraint, Firm A sets price (the limit price).