Limit Pricing - Study Note

Limit Pricing Where a firm has certain advantages that provide barriers to entry, but those barriers are not high enough to block out competition completely, it might be able to sustain a market skimming situation by adopting a 'limit pricing' policy. In order to deter entry on the part of rivals, the limit price will be set at a level which reflects the firm's competitive cost advantage but falls short of that which would ensure short-run profit maximization. Dorward (1987) has pointed out that successful limit pricing requires a homogeneous product market, price leadership or collusion on the part of a few dominant firms, and a policy of long-run profit maximization on the part of both established firms and potential entrants. The models developed to determine the limit price are based on the so-called 'Sylos postulate', which assumes that potential entrants will expect established firms to maintain their existing output levels when new entry occurs, and that this is known to be the case by those firms. The effect of this is to restrict new entrants to operating on that section of the demand curve below and to the right of the existing limit-price output; and it is assumed that the new entrant will merely be able to serve the residual demand created by lowering price below the limit price, which it could only do at a loss. Interested readers are referred to Dorward (1987) for a graphical illustration of a limit price in the case of an absolute cost advantage, and one with the benefit of economies of scale, together with a critical discussion of the models and assumptions. Product Line Pricing A 'product line' can be defined as a range of related products', and the supplier of such a range is faced with a number of pricing problems. While the theoretical approach to be adopted by the firm in such circumstances is easily stated, namely, that profitability can only be viewed in relation to the range as a whole, and therefore the price for each individual product within the range should be fixed at the level which maximizes the profitability of the range as a whole, there is no practical way to translate this into the reality of the market place. In the absence of prescriptive solutions, we can only point to two additional factors which need to be taken into consideration by the decision maker: 1. Joint products. If two or more of the products in the range are joint products, i.e. they necessarily result from a common production process, their prices cannot be considered in isolation. In essence, this situation represents a microcosm of product line pricing - the price set for each individual product from the process should ideally result in a demand which will absorb all the available units, and leave none unsold. For example, if the production of X cannot take place without a given quantity of Y also being produced, profits would be suboptimized if the firm manufactures in order to satisfy the demand for X at a particular price, and the concomitant production of Y is not fully absorbed by the market because the price set for Y fails to generate sufficient demand. 2. Interdependent demand. If two or more products in the range are substitutes, or complement each other in any way, then a relation might exist between the demand for the different products. The effect of a price change on one product could be felt in the demand for another. Again, this situation emphasizes the basic point of product line pricing, namely, that profitability is inextricably linked with the line as a whole, and individual products cannot be looked at in isolation.