limit+pricing

=Limit Pricing= Fenstermaker, Eric Bittle, Curtis

Limit pricing has similarities to predatory pricing, in that a dominant firm sets prices in order to clear the field and/or create barries to entry. Limit pricing goes further, entirely clearing the playing feild and blocking all entry. This strategy is usueally use by a monopolist or members of an oligopoly. Rather than controlling prices directly, limit pricing increases output to the point where prices in the market drop to levels lower than new entrants can afford to charge.

Illustration of a successful limit pricing strategy.
Two companies are competing for a market segement. Both companies have perfect information. Company A is already in the market and is making a monopolistic profit. Company B is considering entry into the market segment to take some of the profits from company A. Company A is not keen on the idea. So, to discourge company B from entering the market, company A begins to sell its products below the monopolistic price (or threatens to sell its products below the monopolistic price if company B decides to enter the market). This action would reduce or eliminate any potiental future profits company B would make if it entered the market segment. Ultimately company B decides the profit margins are to low and forfeits entering the market segment. Company A continues making monopolist profits. An unseccessful limit pricing strategy can occurs if one of the firms involved cannot make the rational link between costs and future profits.

**PRINCIPLE**
"For limit pricing to effectively prevent entry by rational competitors, the pre-entry price must be linked to the post-entry profits of potential entrants."¹

Key concepts that are related to limit pricing and link the pre-entry price to the post-entry profits:¹

**Commitment Mechanisms**
These occur when a company already in the market makes a decision about production possibilities. In a game, the incumbent company has first mover advantage. The company deciding whether or not to enter the market has to wait and see what the incumbent will do. Once the incumbent makes a decision the new entrant can decide whether to enter the market or stay out (for game theory, see links below). The commitment element of this idea exists when the incumbent company "commits" to an action, locking itself into place. The second company now can make the most profitable decision for itself.

**Learning Curve Effects**
If a company wants to enter a market segment they are going to have a learning curve, as the company does not have knowledge from past experiences to help them make more profitable decisions. After the starting period such a company will have gained knowledge that will allow them to produce at a more profitable level. If the initial learning curve cost is too high it could stop a potiential competitor from entering the market.

**Incomplete Information**
This concept considers the the amount of knowledge a company has when entering the market. If members of the company are not aware of all of the competitions costs, they can face many (financial) problems.

Reputation Effects
This concept moves us back to game theory, i.e. the reputation a company has in the market segement. as concerns responding to competition.

Finitely Repeated Cames, etc, Coordination Games , Sequential Move Games

**Questions**
1) Choose the most appropriate answer: a) predatory pricing is largely concerned with setting quantities; limit pricing is concerned with setting prices b) predatory pricing is concerned with setting prices; limit pricing is largely concerned with setting output to affect prices c) both predatory pricing and limit pricing are largely about setting quantiites

2) True or False: For the limit pricing strategy to be succesful; The pre-entry entry profits must be linked to the post-entry prices in the minds of potential entrants.

3) The following key concepts should be taken into account when attempting a limit pricing strategy: a) Incomplete information b) Two-part pricing c) Reputation effects d) a and c e) b and c

4) True or Fales: Limit pricing is commonly seen in perfectly competitive markets.

5) True or False: Incomplete information is not an important factor of limit pricing?

6) What aspect of limit pricing is concerned with the knowledge a company gains after entering a market? a) Incomplete information b) Learning curve effects c) Reputation effects d) Commitment Mechanisms

7) What aspect of limit pricing is concerned with the how a company responds to the other companies in the market segment? a) Reputation effects b) Learning curve effects c) Incomplete information d) Commitment Mechanisms

Answers
1) b - preditory pricing will cause a firm to drop sell price below MC to drive out the competition. Therefore B is the correct answer. 2) False. Pre-entry price must be linked to post-entry profits in the minds of potential entrants. 3) d - Two-part pricing is a pricing strategy for a firm with market power not a limit price strategy. 4) False. Limit pricing occures in markets with highly dominant firms. 5) False - if a company is not aware of all of the cost a firms has in the market, entry into the market can be much more expensive then intended, eroding away profit margins possibly leaving the in the red or causing the company to halt operations. 6) B - Learning curve effects, this is the time it takes to learn about the industry after you enter the industry. For example a firm in the industry could make more profits then a firm entering the industry because that firm has insider knowledge of the market where as the firm entering the market does not have that same knowledge. 7) A - The reputation effect is how one company responds to other companies in the industary, that company's reputation.

**References**
1. Baye, M. R. (2006) //Managerial Economics and Business Strategy.// New York, NY: Mcgraw- Hill Irwin 2. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=gls&c=dsp&k=limit%20pricing