Limit Pricing

Definition

Limit pricing is a strategy employed by a monopolistic or oligopolistic firm to deter potential competitors from entering the market. By setting a price just low enough to make entry unprofitable for new firms, the incumbent firm can maintain its dominant position and avoid the threat of competition.

5 Must Know Facts For Your Next Test

1. Limit pricing is a strategy used by dominant firms to deter potential competitors from entering the market.
2. The incumbent firm sets a price that is just low enough to make it unprofitable for new firms to enter, allowing the dominant firm to maintain its market position.
3. Limit pricing is often used in markets with high barriers to entry, such as those with significant economies of scale or high start-up costs.
4. By limiting prices, the dominant firm sacrifices some short-term profits to protect its long-term monopolistic or oligopolistic position.
5. Limit pricing is a form of strategic behavior that is commonly observed in both monopolistic and oligopolistic market structures.

Review Questions

• Explain how limit pricing is used as a barrier to entry in a monopolistic market.
  • In a monopolistic market, the incumbent firm can use limit pricing to deter potential competitors from entering the market. By setting a price that is just low enough to make entry unprofitable for new firms, the monopolist can maintain its dominant position and avoid the threat of competition. This strategy sacrifices some short-term profits but allows the monopolist to protect its long-term market power and continue charging higher prices in the future.
• Describe the relationship between limit pricing and oligopolistic market structures.
  • In an oligopolistic market, where a few firms dominate the industry, limit pricing can be a strategic tool used by the incumbent firms to maintain their market position. By setting prices at a level that makes it difficult for new firms to enter and compete profitably, the oligopolists can deter potential competitors and preserve their collective market power. This behavior is a form of strategic interaction between the dominant firms, as they seek to protect their market share and avoid the threat of increased competition.
• Analyze how limit pricing can be used to create and sustain barriers to entry in a market.
  • Limit pricing is an effective strategy for creating and sustaining barriers to entry in a market. By setting a price that is just low enough to make it unprofitable for new firms to enter, the incumbent firm can discourage potential competitors from entering the market. This preserves the dominant firm's market position and allows it to continue charging higher prices in the long run, even if it means sacrificing some short-term profits. Limit pricing is particularly effective in markets with high start-up costs or significant economies of scale, as these barriers make it difficult for new firms to enter and compete profitably with the established player.

Related terms

Barriers to Entry:

Barriers to entry are factors that make it difficult or costly for new firms to enter a market and compete with established players, allowing the incumbent firm to maintain a monopolistic or oligopolistic position.

Monopoly:

A monopoly is a market structure in which a single firm is the sole provider of a product or service, with no close substitutes, and has the ability to set prices and control output.

Oligopoly:

An oligopoly is a market structure in which a few firms dominate the industry, and their decisions and actions can significantly impact the market as a whole.