Exam Answer: Limit Pricing

Here is a suggested answer to this question: "Explain how a firm may use limit pricing."

Limit pricing is defined as pricing by the incumbent firm(s) to deter the entry or the expansion of fringe firms. Limit pricing is a pricing strategy designed as a barrier to entry in order to protect a firm’s monopoly power & supernormal profit.

The limit price is below the normal profit maximising price but above the competitive level. This is shown in my analysis diagram. The monopolist is charging a price lower than the estimated AC for a rival. They are willing to sacrifice profits in the short run to prevent entry.

As a result, the potential rival firm may decide that the risks of entering the industry are too high – they may make a sizeable loss and might not have the resources to sustain those losses until they can reach a competitive level of average cost through scale economies.

If limit pricing is successful, then a market is likely to remain highly concentrated in the hands of one or a small number of dominant, businesses who can continue to earn supernormal profit with P>AC.