Limit Pricing

Definition

Limit pricing is a strategy used by firms to set the price of their products just low enough to deter potential entrants from entering the market. By keeping prices lower than the average costs of potential competitors, existing firms can create a barrier to entry, ensuring they maintain their market power and profitability. This practice often reflects a firm's desire to maximize long-term profits by minimizing competition.

5 Must Know Facts For Your Next Test

1. Limit pricing is often used in markets with high fixed costs and low marginal costs, where existing firms want to protect their investment.
2. This pricing strategy can lead to higher long-term prices for consumers if it successfully deters entry, as competition is reduced.
3. Firms employing limit pricing must balance setting a price low enough to deter entry while still ensuring they cover their costs.
4. Limit pricing is considered an anticompetitive behavior in some jurisdictions and may attract scrutiny from regulators.
5. The effectiveness of limit pricing depends on potential entrants' perceptions of market conditions and their ability to enter despite low prices.

Review Questions

• How does limit pricing function as a barrier to entry for potential competitors in a market?
  • Limit pricing acts as a barrier to entry by setting prices low enough that new entrants cannot achieve profitability if they were to enter the market. This approach discourages potential competitors from attempting to enter since they would face prices that do not cover their average costs. By maintaining these lower prices, established firms can secure their market position and minimize competition.
• What are some potential consequences of limit pricing for both existing firms and consumers in the market?
  • For existing firms, limit pricing can help maintain market power and ensure long-term profitability by reducing competition. However, consumers may face higher prices in the future if entry barriers prevent new competitors from joining the market. Additionally, if limit pricing is seen as anti-competitive, it could lead to regulatory scrutiny and potential legal challenges for the firms using this strategy.
• Evaluate the ethical implications of limit pricing in terms of market dynamics and consumer welfare.
  • The ethical implications of limit pricing revolve around its impact on market dynamics and consumer welfare. While it can protect existing firms from competition and allow them to recoup investments, it may also stifle innovation and reduce choices for consumers by keeping potential competitors at bay. In some cases, this could lead to higher long-term prices and decreased quality of products or services, raising concerns about whether such practices serve the best interests of consumers in a competitive economy.

Related terms

Barriers to Entry: Obstacles that make it difficult for new competitors to enter a market, which can include high startup costs, regulatory requirements, and economies of scale.

Market Power: The ability of a firm to influence the price of its product or service in the market, often determined by the level of competition and the firm's share of the market.

Predatory Pricing: A strategy where a firm lowers its prices below cost with the intent to eliminate competition, after which it can raise prices again once rivals are gone.