Limit Pricing

Definition

Limit pricing is a strategic pricing strategy used by incumbent firms to deter potential entrants from entering a market by setting the price of their product just low enough to make it unprofitable for newcomers. This approach is based on the idea that if potential competitors perceive low profitability in the market, they are less likely to enter, thereby allowing the incumbent to maintain its market power. The effectiveness of limit pricing often depends on the perceived costs and potential profits that entrants might face.

5 Must Know Facts For Your Next Test

1. Limit pricing is used primarily by firms with significant market power as a way to protect their profits and prevent new competition.
2. The strategy relies on the perception of potential entrants regarding the profitability of the market; if they believe profits are too low due to limit pricing, they may decide not to enter.
3. It creates a situation where incumbent firms sacrifice some short-term profits in order to maintain long-term market dominance.
4. Limit pricing can lead to less innovation in an industry as incumbents focus more on deterring competition rather than competing aggressively through improvements.
5. This strategy can also be risky; if an incumbent sets prices too low for too long, they may not have enough revenue to sustain operations in the face of unexpected costs.

Review Questions

• How does limit pricing serve as an entry deterrent for potential competitors in a given market?
  • Limit pricing acts as a deterrent by setting prices at a level that discourages new entrants from perceiving potential profitability. When incumbents lower their prices strategically, they signal to potential competitors that entering the market would likely result in lower profits or losses. This psychological barrier often keeps new firms from investing resources into entering an already competitive marketplace.
• Compare and contrast limit pricing and predatory pricing in terms of their objectives and implications for market competition.
  • Limit pricing aims to prevent entry by making the market appear less profitable for potential entrants, while predatory pricing involves temporarily lowering prices below cost to drive out existing competitors. The key difference lies in their long-term objectives; limit pricing seeks to maintain market power without aggressive behavior towards rivals, whereas predatory pricing could lead to monopolistic practices that harm overall competition if successful. Both strategies affect market dynamics but do so with different approaches and consequences.
• Evaluate the long-term effects of limit pricing on innovation and consumer welfare within an industry.
  • Limit pricing can negatively impact innovation because it reduces the incentive for incumbents to invest in research and development when they are primarily focused on deterring entry rather than competing through innovation. Additionally, while consumers may benefit from initially lower prices, the lack of competition could lead to stagnation in product quality and variety over time. In the long run, this could ultimately reduce consumer welfare as firms become complacent without the pressure of new entrants pushing for improvements.

Related terms

Barrier to Entry: Obstacles that make it difficult for new competitors to enter a market, including high startup costs, stringent regulations, and established brand loyalty.

Predatory Pricing: A strategy where a company sets prices extremely low with the intent of driving competitors out of the market, which can lead to long-term negative consequences for competition.

Market Power: The ability of a firm to influence the price of its product or service in the marketplace, often due to a lack of competition or high demand.