The Concepts of Limit and Predatory Pricing
Discuss the concepts of limit and predatory pricing. Explain how imperfect knowledge of other firms’ costs or financial conditions can lead to limit or predatory pricing.
Limit pricing is when an incumbent firm sets a “low price with the purpose of deterring entry”. Predatory pricing is when an incumbent sets an “‘irrationally’ low price [possibly below cost] so other firms can’t compete” forcing existing firms to exit the market. Both pricing strategies require at least two periods: the first to deter entry/force exit of a rival; the second to reap the benefits of lower competition. Although both are examples of illegal anti-competitive behaviour, only the latter is usually pursued with litigation.
In order to engage in limit pricing, an incumbent requires either an absolute or scale cost advantage over its rivals. This strategy can be analysed as a variant of Stackelberg competition; with the incumbent setting output to maximise its own profit, forcing potential entrants to operate on a residual demand curve. The limit pricing model relies on predatory behaviour “lock in”, so that rivals believe that the incumbent will maintain pre-entry output production regardless of their actions – the “Sylos postulate”.
In the absolute cost advantage case there is a single incumbent with a fringe of price-taking potential entrants. In the case of scale cost advantages (Fig.1), as firms need to be sizeable to benefit from scale economies, there is only one potential entrant whose long-run average cost function is LRACe.
Market
demand
Residual
demand
LRAC
Price, cost
P*
Q*
Quantity
Fig.3 – Limit pricing to deter entry: economies of scale
The incumbent commits to output Q*, limiting price at P*. If the Sylos postulate holds, then the entrant faces a residual demand curve Re – the demand function to the right of Q*. As Re lies below LRACe at all output levels, the entrant abstains from entering unprofitably.
Fig.3 – Game theory analysis of strategic entry deterrence – entrant
Limit pricing is when an incumbent firm sets a “low price with the purpose of deterring entry”. Predatory pricing is when an incumbent sets an “‘irrationally’ low price [possibly below cost] so other firms can’t compete” forcing existing firms to exit the market. Both pricing strategies require at least two periods: the first to deter entry/force exit of a rival; the second to reap the benefits of lower competition. Although both are examples of illegal anti-competitive behaviour, only the latter is usually pursued with litigation.
In order to engage in limit pricing, an incumbent requires either an absolute or scale cost advantage over its rivals. This strategy can be analysed as a variant of Stackelberg competition; with the incumbent setting output to maximise its own profit, forcing potential entrants to operate on a residual demand curve. The limit pricing model relies on predatory behaviour “lock in”, so that rivals believe that the incumbent will maintain pre-entry output production regardless of their actions – the “Sylos postulate”.
In the absolute cost advantage case there is a single incumbent with a fringe of price-taking potential entrants. In the case of scale cost advantages (Fig.1), as firms need to be sizeable to benefit from scale economies, there is only one potential entrant whose long-run average cost function is LRACe.
Market
demand
Residual
demand
LRAC
Price, cost
P*
Q*
Quantity
Fig.3 – Limit pricing to deter entry: economies of scale
The incumbent commits to output Q*, limiting price at P*. If the Sylos postulate holds, then the entrant faces a residual demand curve Re – the demand function to the right of Q*. As Re lies below LRACe at all output levels, the entrant abstains from entering unprofitably.
Fig.3 – Game theory analysis of strategic entry deterrence – entrant
References: * Dixit, A. K., 1979. "A Model of Duopoly Suggesting a Theory of Entry Barriers", The Bell Journal of Economics, Volume 10, Issue 1, p21 * Hinde * Lipczynski, J. et al., 2009, Industrial Organization: Competition, Strategy, Policy 3rd Edition * Normam, G * Pepall, L. et al., 2008, Industrial Organization: Contemporary Theory and Empirical Applications 3rd Edition * Pepall, L * Possajennikov, A., 2011, Lecture 12 - Entry Deterrence * Spence, A [ 2 ]. Pepall, L. et al., 2008, Industrial Organization: Contemporary Theory and Empirical Applications 4E - p269 [ 3 ] [ 5 ]. Dixit, A. K., 1979. "A Model of Duopoly Suggesting a Theory of Entry Barriers", The Bell Journal of Economics, Volume 10, Issue 1, p21 [ 6 ] [ 11 ]. McGee, 1958, cited in Pepall, L. et al., 2008, Industrial Organization: Contemporary Theory and Empirical Applications 3E – p302 There are weaknesses to McGee’s argument, such as mergers having to be made public and may be prohibited by regulators [ 12 ]. Possajennikov, A., 2011, Lecture 12 - Entry Deterrence [ 13 ] [ 15 ]. Based on Milgrom and Roberts (1982) model, cited in Pepall, L. et al., 2008, Industrial Organization: Contemporary Theory and Empirical Applications 4E – p302 [ 16 ] [ 17 ]. Pepall, L. et al., 2008, Industrial Organization: Contemporary Theory and Empirical Applications 4E – p304