Limit Pricing

Definition

Limit pricing is a strategy employed by firms to set the price of their products low enough to deter potential entrants from entering the market while still maintaining profitability. This approach is particularly relevant in markets where barriers to entry are significant, as it helps established firms protect their market share and limit competition. By setting prices at a level that is unprofitable for new entrants but sustainable for themselves, firms can create an environment that discourages competition and preserves their market dominance.

5 Must Know Facts For Your Next Test

1. Limit pricing is a way for incumbent firms to maintain their market position by reducing the attractiveness of the market for potential entrants.
2. This pricing strategy often involves setting prices just below the average cost that new entrants would incur, making it unprofitable for them to compete.
3. Limit pricing relies on credible threat; established firms must convince potential entrants that they will sustain low prices to deter entry.
4. In markets with significant barriers to entry, limit pricing can be a crucial tactic for firms looking to solidify their dominance.
5. The effectiveness of limit pricing can depend on factors such as consumer demand elasticity and the overall cost structure of potential competitors.

Review Questions

• How does limit pricing function as a barrier to entry in competitive markets?
  • Limit pricing acts as a barrier to entry by establishing a price point that is too low for potential competitors to profitably match. Incumbent firms set their prices at this lower level to dissuade newcomers from entering the market. When new entrants perceive that they cannot cover their costs at this price, they are discouraged from investing in entry, allowing established firms to maintain market control.
• Discuss how an incumbent firm's ability to implement limit pricing is influenced by its market power.
  • An incumbent firm's ability to successfully implement limit pricing is heavily influenced by its market power. If a firm holds significant market power, it can set prices lower than what new entrants can afford without jeopardizing its own profitability. This is possible because such firms typically have lower average costs and more significant resources compared to potential entrants. Thus, their ability to maintain a profitable price while deterring competition hinges on their existing strength in the market.
• Evaluate the implications of limit pricing on consumer welfare and market efficiency in industries with high barriers to entry.
  • Limit pricing can have mixed implications for consumer welfare and market efficiency. While it may protect consumers from higher prices due to reduced competition in the short term, it can also lead to long-term inefficiencies. By discouraging new entrants, limit pricing limits innovation and keeps prices artificially low without incentivizing improvements in product quality. This scenario may ultimately lead to a stagnant market where consumer choices are reduced, undermining overall welfare in the long run.

Related terms

Barriers to Entry: Obstacles that prevent new competitors from easily entering an industry or area of business, which can include high startup costs, regulatory requirements, and strong brand loyalty among consumers.

Market Power: The ability of a firm to influence the price of its product or services in the market, typically through control over supply or demand.

Price Discrimination: A pricing strategy where a firm charges different prices for the same product to different consumers based on their willingness to pay.