Limit Pricing

Definition

Limit pricing is a strategy used by established firms to deter new entrants into a market by setting the price of their products or services low enough to make it unprofitable for potential competitors to enter. This tactic leverages the firm’s ability to absorb lower profits in the short term to maintain market power and protect its position. By keeping prices below a certain level, firms can signal to potential entrants that the market is not lucrative, thus influencing competition and maintaining an oligopolistic structure.

5 Must Know Facts For Your Next Test

1. Limit pricing is often employed in markets where a few firms dominate, as these firms have more flexibility in setting prices without losing significant market share.
2. This pricing strategy relies on the assumption that new entrants are unable or unwilling to compete at the lower price set by established firms.
3. By using limit pricing, established firms can maintain higher profit margins over time as they deter competition, thereby prolonging their market control.
4. Firms may lower prices temporarily to deter entry but can raise them again once they believe the threat of entry has passed.
5. The effectiveness of limit pricing depends on how credible the established firm's threat is; if potential entrants believe that prices will remain low, they are less likely to enter.

Review Questions

• How does limit pricing influence the behavior of potential new entrants in an oligopolistic market?
  • Limit pricing serves as a deterrent for potential new entrants in an oligopoly by signaling that the market may not be profitable. When established firms set their prices low enough, it creates a perception that entering the market would lead to losses. This can discourage new competitors from attempting to enter since they may recognize that competing against established firms at these lower prices would be challenging, allowing existing firms to maintain their market dominance.
• Evaluate the potential risks and benefits for an established firm using limit pricing as a competitive strategy.
  • The primary benefit of limit pricing is the ability to deter competition and maintain market share without engaging in price wars. However, there are risks associated with this strategy. If an established firm sets prices too low for too long, it may erode profits and reduce its ability to invest in innovation or improvement. Additionally, if potential entrants do not perceive the pricing as credible or sustainable, they may still choose to enter the market, undermining the intended effect of this strategy.
• Critically assess how limit pricing affects overall market efficiency and consumer welfare in oligopolistic markets.
  • Limit pricing can lead to decreased competition, which may reduce overall market efficiency as fewer firms operate within the space. While consumers might initially benefit from lower prices, over time, the lack of competition can result in stagnation in product quality and innovation. Furthermore, if established firms eventually increase prices after deterring entry, consumer welfare could decline. Thus, while limit pricing might protect current firm profits, it can create long-term disadvantages for consumers by reducing choice and potentially leading to higher prices in the future.

Related terms

Oligopoly: A market structure characterized by a small number of firms that have significant market power, leading to interdependent decision-making regarding pricing and output.

Market Power: The ability of a firm to influence the price of its product or service in the market, often associated with the level of competition and the number of available substitutes.

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