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Limit pricing — the advantage of incumbency

31 October 2008

• Predatory pricing refers to the industry’s incumbent setting a low price to bank-
rupt a recent entrant. It would be a profitable strategy to the extent that the
incumbent could raise the price to some relatively high level after the predatory
episode.

• A more direct route to maintain a monopoly position would be to price at a low


level at all times to make entry not profitable in the first place. Such a pricing
policy is called limit pricing.

• Should limit pricing be sanctioned? That is, is limit pricing detrimental to


economic efficiency? Perhaps a more basic question is whether and when limit
pricing is feasible and rational. If it turns out that limit pricing is seldom if
at all a feasible and profitable strategy for the industry incumbent, then limit
pricing is no more then a figment of some populist’s imagination, and the need
for public policy to safeguard against it is merely hypothetical.

• To answer the question, we begin with the following simple model:

1. 2 firms: the industry incumbent and a potential entrant.


2. The incumbent sets output before the potential entrant is called to make
its entry and output decisions.
3. A linear demand curve: P = G − gQ.
4. Constant marginal costs of production equal to cI and cE for the incumbent
and the entrant, respectively, and possibly some fixed cost of entry equal
to F .

• If the incumbent has no advantage over the potential entrant, limit pricing does
not quite make sense, for in this case it is equally plausible that the entrant
is able to limit price the incumbent out of the industry. The concern that the
incumbent may be able to manipulate the environment to make it unattractive
for others to enter the industry arises from certain inherent advantage that
the incumbent is thought to possess due to its incumbency. But what may

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that be? A natural advantage that the incumbent may possess is its ability to
set production targets before potential entrants are able to do so. After all,
potential entrants are firms that have not yet made the necessary investment
to begin production in the given market. This tendency is best modeled by
assuming a stackelberg oligopoly, whereby the incumbent sets output level first
before the potential entrant has a chance to do just that.

• To focus on this advantage, we shall from now on assume that cI = cE = c to


rule out any advantages the incumbent may possess that are not derived from
its incumbency as such.

• As the Stackelberg follower, the potential entrant’s optimal output is governed


by the usual best response function:
G − gqI − c
qE = , (1)
2g

where qE and qI denote respectively the output levels of the entrant and the
incumbent. Industry output is

Q = qI + qE
G − gqI − c
= qI +
2g
1 G−c
= qI + .
2 2g

• Substitute Q into the demand curve


à !
1 G−c G+c 1
P =G−g qI + = − gqI . (2)
2 2g 2 2

• The net profit of the entrant reads

π E = (P − c) qE − F
1
= (G − c − gqI )2 − F,
4g

which is non-positive if and only if



1 2 G − c − 2 gF
(G − c − gqI ) ≤ F ⇒ qI ≥ ≡ qlimit . (3)
4g g

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• The condition says that if the incumbent’s output level qI is above a given
threshold, the entrant could not hope to break even. We write qlimit as the limit
quantity, an output level of the incumbent, above which the entrant is better
off not entering the industry. It is this level of output that is necessary to deter
the entry of the potential entrant. By producing at a sufficient large output
level, the incumbent drives the market price down to a low level to make entry
not profitable for the entrant.
• Meanwhile, the incumbent should never raise its output up to the point where
P falls below the marginal cost of production. Such a low price will bankrupt
the incumbent as well;
G−c G−c
P > c ⇒ G − gQ > c ⇒ Q < ⇒ qI < ≡ qmax . (4)
g g

• In the absence of any fixed cost; i.e., F = 0, qlimit = qmax . In this case limit
pricing can never feasible in this case. If there were no fixed costs involved
in setting up shop to produce in the industry, the entrant’s net profit will be
positive so long as P − c > 0. The output expansion necessary to deter entry
will be at the level where market price is driven down below the marginal cost
of production. But this cannot be a profitable strategy for an incumbent that
has no advantage other than the advantage of incumbency.
• Where F > 0, however, qlimit < qmax . There is some output level at which the
entry is deterred but also allows the incumbent a positive profit margin.
• Production exhibits increasing returns to scale if there is some fixed cost F
coupled with some constant marginal cost c. With a sizable F , the average cost
is initially at a high level, as the fixed cost may only be spread among few units.
At a larger output level, the fixed cost may be shared among many more units,
where the AC would fall to a manageable level. Only then it will be profitable
for the entrant to operate in the industry.
• Limit pricing works to the extent that by expanding output, the incumbent
drives the market price down to a low level. It will then be not profitable for the
entrant to produce at a large output level since doing so only makes the market
price fall further still.1 Limit pricing prevents the entrant to take advantage of
the assumed scale economies and eventually makes entry not attractive.
• Both the incumbent and the entrant would like to set a large output target to
force the rival to cut back production. But if one party has done so already,
it is best response for the other party to scale back output. The incumbent’s
advantage over the entrant is derived from its ability to set the output target
first to preempt the entrant from flooding the market with its own products.
1
Remember the Cournot best response function is downward sloping.

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• To see a bit more details, first recall that the greatest profit the incumbent
could possibly earn is when the firm produces at the monopoly output
G−c
Qm = ,
2g
and the entrant at a zero output level.

• If Qm already exceeds the limit quantity given in (3) ; i.e.,



G−c G − c − 2 gF
> ⇒
2g g
µ ¶
1 G−c 2
F > , (5)
g 4

it will be optimal for the incumbent to produce just this amount The potential
entrant will not enter if the incumbent produces any quantity that exceeds the
limit quantity. In this case, setting the production target equal to the monopoly
quantity suffices to deter the entry. This is called blockaded entry, a situation in
which the incumbent can simply ignore the possible entry of a potential entrant.

• In figure 1, we plot the downward sloping best response function of the potential
entrant. The best response function is truncated at qlimit since for any qI > qlimit ,
the firm is better off not entering at all. Our previous best response function is
conditional on the presumption that the firm will produce in the industry. We
did not consider the entry decision then, and hence there we have not allowed
for the possibility that the firm may choose not to enter at all.

• If the condition in (5) is met, i.e., Qm > qlimit , and if the incumbent would
choose to produce at Qm , in response the potential entrant will choose to stay
out of the industry.

• By (3), qlimit is decreasing in F , meaning that at a larger F , qlimit moves to the


left in fig.1 towards the origin. It is then easier for the incumbent to deter the
entry when scale economies are more important. When there is a larger fixed
cost, the entrant can only break even producing at a larger output level. Then
qI needs not be particularly large to make entry unattractive for the potential
entrant.

• If the inequality in (5) is not met, Qm will be to the left of qlimit as in fig. 2. In
this case, the potential entrant will find it profitable to enter if the incumbent
produces Qm units of output. The monopoly output Qm can be thought of as
the best response of the incumbent to the entrant producing 0 unit of output.
But now that the entrant’s best response to the incumbent producing Qm is
not zero unit of output, this situation cannot be NE.

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Figure 1: The entrant’s best response when entry is blockaded

Figure 2: The entrant’s best response when entry is not blockaded

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• What may be the best course of action for the incumbent then? The firm can
now be a monopolist only if it produces just up to qlimit . The resulting market
price is
à √ ! q
G − c − 2 gF
Plimit = G − gqlimit = G − g = c + 2 gF .
g
We may call this the limit price - the highest price the incumbent may charge
while still able to deter the entry. The limit price is higher at a larger fixed cost.
If there is a larger fixed cost, the entry can be deterred with just a moderate
qlimit . There can still be a fairly high market price as a result.
• The monopoly profit with limit pricing is,

π limit = (Plimit − c) qlimit


q à √ !
G − c − 2 gF
= 2 gF . (6)
g

• Alternatively, the incumbent can choose to accommodate the entry. The profit
is maximized when the firm sets output in accordance with what a Stackelberg
leader would choose to produce. Then we have
G−c
qI = ,
2g
G−c
qE = ,
4g
3G−c
Q = ,
4 g
1 3
P = G + c.
4 4
• The profit that may be earned from accommodating the entry is
1
πa = (G − c)2 . (7)
8g

• Limit pricing is preferred if

π > πa ⇒
q à √ limit
!
G − c − 2 gF 1
2 gF > (G − c)2 ⇒
g 8g
q µ q ¶
16 gF G − c − 2 gF > (G − c)2 . (8)

Figure 3 depicts the two sides of the inequality as functions of F .

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Figure 3: Limit pricing Vs Accommodating entry

• The left side of (8) begins equal to 0 at F = 0. For very small fixed costs,
the incumbent should accommodate the entry. If the fixed cost is minimal, the
potential entrant would find it profitable to enter even if it is forced produce
at a rather low level of output. The incumbent may only deter the entry by
expanding output a great deal so as to lower the entrant’s best response output
to some really low level. But in the mean time, this will drive the market price
so low that the incumbent is better off not attempting to do so.

• The left side of (8) is increasing in F if F is not too large. Then for a sufficiently
large fixed cost, it becomes optimal for the incumbent to deter the entry. That
is the case since then a moderately large qlimit , or equivalently a moderately low
Plimit , suffice to make it not attractive for the entrant to operate in the industry.

• Should limit pricing be sanctioned? If the incumbent is not allowed to ex-


pand output all the way to the limit quantity but is restricted to compete as a
Stackelberg leader, total industry output is
3G−c
Qa = ,
4 g
would would exceed the limit output if
√ µ ¶
3G−c G − c − 2 gF 1 G−c 2
> ⇒F > .
4 g g g 8

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• If the fixed cost is minimal, the limit output exceeds the Stackelberg output.
Deterring entry requires a very large limit quantity if the fixed cost is mini-
mal. But then limit pricing would not be adopted in the first place in such
circumstances.

• The condition above suggests that the Stackelberg quantity is more likely to
exceed the limit quantity at a large fixed cost. Limit pricing is precisely more
likely to be practiced under such conditions. Limit pricing should then give
rise to a lower industry output and a higher market price when it is practiced.
Consumers suffer as a result.

• But is it always better to have a lower price that is closer to the competitive price
and a higher output level that is closer to the competitive output? The answer
is certainly yes if there were no fixed costs of production at all. But if there is a
fixed cost of entry equal to F . Whether the firm should from an efficiency point
of view enter to raise output and lower price depends on how F compares with
the increase in the total gross surplus (consumer surplus + gross profits of the
firms) that its entry helps materialize. If F is less than the increase in surplus,
then the deterred entry is inefficient. The entry of the potential entrant would
have raised aggregate net surplus. If, on the other hand, F exceeds the increase
in gross surplus, the entry should not have taken place, in which case limit
pricing could actually help raise the total net surplus available to society. The
larger the fixed cost is, the greater the saving in resource due to the deterred
entry would be. Hence limit pricing is more likely to be efficient when scale
economies are very important. Conversely, limit pricing is more likely to be
inefficient when scale economies are only moderately important.

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