Limit Pricing

How does a monopolist maintain its

dominant position?
How does a monopolist maintain its
dominant position?

•A cost advantage, say from holding a patent

How does a monopolist maintain its
dominant position?

•A cost advantage, say from holding a patent

•Is it possible for a firm without a cost
advantage to deter entry by competitors?
 Limit pricing with a cost
advantage
• Simplest model non-strategic.
• Incumbent has cost advantage over potential
entrants.
• Incumbent who prices above the (constant)
marginal cost of entrants faces gradual
erosion of market control. Pricing at the
entrant’s cost is called limit pricing.
• Issue examined is timing.
 Limit pricing with a cost
advantage
• In the first three examples the key simplifying
assumption is that the incumbent either continues
last period’s production or switching to limit price.
• Assume that time moves in discrete periods and
that every period for which price is above the MC
of entrants, some fixed amount of entry occurs,
shifting inward the demand curve of the
incumbent.
• Goal of incumbent is to maximize present
discounted profits by choosing a time to switch to
limit pricing.
 Discounted present value
Recall how to calculate the present value of a
stream of profits Π
Π
Π PV = ∑
∞ 1
Π= −1
t = 0 (1+ i ) t
i (1 + i )
 Limit pricing example 1
Profit maximization for a monopolist:
constant marginal cost and linear demand
P = at − bQ MC = c I

Π
MC = MR ⇒ at − 2bQ = c t
I

Π at − c I
Π
Q =
t Pt = (at + c ) Π
1
2
I M
t = 1
4b (at − c )
I
2b
 Limit pricing example 1
The incumbent can forestall entry by pricing
at the marginal cost of production for the
potential entrants. This yields a per period
profit of
Π = Q (c − c )
L
t t
L E I

where QtLsolves
P(Q ) = at − bQ = c
t
L
t
L E
 Limit pricing example 1
The incumbent chooses which period to
switch by comparing:
Π0 L
Switch in period 0 Π PV =
0

i (1 + i ) −1
Switch in period 1 Π L
Π =Π +
0
PV
M
0
1
i
Switch in period 2 Π M
Π L
Π 0PV = Π 0M + 0 + 2
(1 + i ) i (1 + i )

M
 Limit pricing example 1
• The later the switch is made, the smaller is
the incumbent's demand in the limit price
market. Traded off against the profits
earned in the periods before entry.
• The higher are interest (discount) rates, the
less the future erosion matters, and the
longer entry is allowed to continue.
 Limit pricing example 2
• This very simple story can be slightly modified to
allow the incumbent to adjust output as market
share erodes.
• As the demand curve shifts inward, the per-period
output should be reduced. Then if the incumbent
switches to limit pricing at period 2, for example,
present discounted profits are
Π M
Π L
Π 0
=Π +M 1
+ 2
(1 + i ) i (1 + i )
PV 0

• Same basic story

 Limit pricing example 3
• It seems plausible that the incumbent can use a
cost advantage to forestall entry, but what if all
firms have access to the same technology?
• If firms have constant cost, limit price means zero
profits, so best to just allow the market to erode.
• We can still tell a limit pricing story. Key is the
existence of increasing returns to scale. This might
be due to a fixed cost of production, so that unit
cost falls as production increases.
Limit pricing example 3
P
D
LRMC
LRAC
PM

QM MR Q
Limit pricing example 3
P
D
LRMC
LRAC

Entrants residual Demand

Q
QM
Limit pricing example 3
P
D
LRMC
LRAC

PL

QL MR Q
Limit pricing example 3
P
D
LRMC
LRAC

Entrants residual Demand

Q
QL
 Critique of Game Theorists
• Do these stories make sense? Each has the
basic assumption that the monopolist will
ignore the entrant
• Consider example 3: why should the
potential entrant believe that the incumbent
will continue to price at P L if entry is not
successfully blocked. Shouldn’t the two
firms engage in an oligopoly pricing game?
 An entry game
• Assume that a dominant firm operates in a
market and faces a potential entrant.
• Assume there is no commitment in pricing:
what I do today does not restrict my choices
tomorrow.
• Assume technology and demand are as in
example 3.
• This leads to a simple pricing game.
 An entry game
Profit max (Π ,0)
M

DF1
OUT
Limit price (Π L ,0)
PE
Profit max (Π , Π )
C C

IN
DF2

Limit price (Π L , loss )

 An entry game
• The inability to commit to future prices makes the
threat to price low upon entry not credible.
• Milgrom and Roberts show that limit pricing may
make sense when potential entrants do not know
the exact cost structure of the incumbant
(asymmetric information).
• This is a complicated model using a sophisticated
equilibrium concept. There can be multiple
equilibria.
 Milgrom and Roberts
• They show there may be a separating
equilibrium where the high cost firm produces
the optimal short run quantity and attracts entry,
while the low cost firm limit prices.
• There also may be a pooling equilibrium in
which both firms produce the short run optimal
amount for the low costs firm, and rivals do not
enter.
 Predatory Pricing
• The core of game theoretician's criticism of
the naïve model is that present pricing lacks
commitment.
• What about responding to entry? Can a firm
be aggressive after entry to encourage exit?
• This is called predatory pricing.
• May work if a firm can build a reputation
for being aggressive.
 Chain store paradox
• Sequential entry game with Nmarkets
• Each stage game identical
• Consider the final market ( 1 )
 Chain store paradox
Profit max (Π ,0)
M

DF1
OUT
Limit price (Π L ,0)
PE
Profit max (Π , Π )
C C

IN
DF2

Predatory (Π P , loss )
price
 Chain store paradox
• So entry is not profitable in the last period
• What about the next to last?
• Reputation has no value
• And so on, back to the N thmarket.
• Kreps and Wilson tell an asymmetric information
story about this situation. Posit the existence of
“strong” competitors who always fight entrants.
Then “weak” entrants can fight in early rounds to
deter future entry. Uses mixed strategies
 Evidence?
• Models are hard to test
• Some evidence exists that firms respond to
potential entry by sacrificing short term profits.
• United Shoe Machinery is a clear case where they
were found by US Supreme Court to be abusing a
dominant position.
• They had some time to correct their behaviour,
and they raised prices and attracted entry
• Predatory pricing has been alleged in airlines and
elsewhere.
• Wal-Mart was accused but acquitted on appeal in
Arkansas supreme court.