Question

Explain the economic basis for limit pricing, and identify the conditions under which a firm can profit from such a strategy. Try these

Short answer

The economic basis for limiting pricing is prohibiting rivals from entering the market so that the existing firm can continue enjoying its maximized profits.

The existing firm can implement such a strategy when it experiences a threat of losing market share to a new entrant.

Step-by-step solution

Explaining the economic basis for limit pricing

A limit price (or limit pricing) is a price or pricing strategy where a supplier adds products at a price lower than the average cost of production or at a price low enough to make it unprofitable for other players to enter the market. It is the strategy that is most likely going to be found in imperfectly competitive markets such as oligopolies and monopolies. The effect can be more pronounced if the existing firm can exploit significant economies of scale.

Conditions under which firm can profit

• Presence of super-normal profits

Limit pricing occurs when a firm reduces its price to deter new entrants from joining the market. New firms may be attracted to enter an industry if there is the presence of super normal profits. The strategy can be adjusted to limit entry if the incumbent maximizes profits. Lowering prices increases production and deepens market saturation. This makes it even harder for new companies to get started. The combination of rising and low prices in this market serves as a barrier to entry for new companies that find the market unprofitable and difficult. As existing companies become more saturated, new entrants will have less opportunity to use it.

• Pricing below the normal profit-maximizing price

One can choose to raise prices in the long run and return to their profit-maximizing strategy. The limit price is below the normal profit maximization price. It is above the competitive level. The company is trying to find a lower price than its competitors' estimated unit prices at the time, so existing companies are willing to sacrifice some profit in the short term to avoid entry. As a result, potential competitors may decide that the risk of entering the industry is too high. They can suffer significant losses and may not have the resources to absorb them until they can achieve a competitive average cost level through economies of scale. If the limit pricing is successful, the market may continue to be in the hands of one or a few dominant companies that can continue to generate above-average profits.