The Concepts of Limit and Predatory Pricing

Topics: Strategic entry deterrence, Game theory, Economics Pages: 7 (1934 words) Published: December 18, 2011
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

Price, cost
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 bears £40m sunk cost to enter market However, in reality the Sylos postulate is a naive assumption and the credibility of the incumbent’s threat of maintaining Q* post-entry is questionable. In Fig.2, for example, a rational incumbent would prefer to accommodate rather than fight entry; i.e. entry deterrence is a non-credible threat.

Fig.4 – Game theory analysis of strategic entry deterrence – credible commitment is £30m sunk cost However, by making an additional irreversible investment in production capacity greater than £20m, the incumbent can “signal” it’s commitment to the limit output/price level, giving credibility to its threat.

Empirically there is a lack of evidence demonstrating limit pricing as widely-used or an effective strategy. Surveys by Smiley (1988), however, do reveal evidence, albeit limited, of this strategy being used. A predatory pricing strategy may be considered if subgame perfect – i.e. the present value of profits earnt after rivals exit outweigh the present value of profits sacrificed (or losses sustained) because of predation. However, its practicality is highly debated. Chicago school economists doubt that predators can be sure whether long-run benefits will outweigh short-run losses or can convince rivals they will pursue predation until forcing exit. Furthermore, even if forced out, when prices rise, the rival may return/new rivals may emerge negating the predation strategy. McGee (1958) suggests that even if predatory pricing is subgame perfect it is a dominated strategy, as mergers are always more profitable. It is also unclear why one firm would exit first; for, a counter-predatory pricing strategy could be used by the rival(s). However, the “long purse” theory argues that if firms have differing credit access, then one may be able to sustain losses for longer. However, this requires credit market imperfections, such as the prey being imperfectly informed of the predator’s financial conditions.

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