A-Level Economics - Firm Objectives and Pricing Policies: Limit Pricing

This document provides detailed notes on limit pricing, an important pricing policy employed by firms. It explores the objectives behind this strategy, the conditions under which it is used, and its potential consequences.

1. Introduction to Pricing Policies

Firms have various objectives when setting prices. These objectives can significantly influence the pricing strategies they adopt. Beyond basic pricing objectives like profit maximization, firms may employ specific policies to achieve certain outcomes. Limit pricing is one such policy.

2. What is Limit Pricing?

Limit pricing is a pricing strategy where a firm sets its price at a level that discourages new entrants into the market. This is often done by setting a price low enough to make it unprofitable for potential competitors to enter, or by investing heavily in capacity to deter entry.

3. Objectives of Limit Pricing

Firms employ limit pricing with several key objectives:

• Deterring Entry: The primary objective is to prevent new firms from entering the market and increasing competition.
• Maintaining Profitability: By limiting entry, the firm aims to maintain its current level of profits.
• Protecting Market Share: Limit pricing helps the incumbent firm retain its existing market share.
• Responding to Existing Competition: It can be a reactive strategy to counter the threat of potential competitors.

4. Conditions for Limit Pricing

Limit pricing is most effective under specific conditions:

• High Fixed Costs: Firms with high fixed costs are more likely to employ limit pricing. This is because they can afford to operate at lower profit margins in the short run and still be profitable in the long run.
• Low Capacity Utilization: If a firm has spare production capacity, it can lower prices to deter entry without significantly impacting profitability.
• Significant Barriers to Entry: While limit pricing itself can act as a barrier, existing barriers to entry (e.g., patents, economies of scale) make it more effective.
• Uncertainty about Future Demand: If the firm is uncertain about future demand, it may choose to limit entry to secure a certain level of sales.

5. How Limit Pricing Works

The firm sets a price that is below the average total cost (ATC) at the current level of output. This means the firm is accepting a loss per unit but aims to deter potential entrants who would face similar losses if they entered the market.

Price	Average Total Cost (ATC)	Profit/Loss	Impact on Potential Entrants
Price below ATC	Positive	Loss per unit	Discourages entry as potential entrants would face losses
Price at ATC	Zero	Zero Profit/Loss	May deter entry if potential entrants perceive low profitability

6. Consequences of Limit Pricing

Limit pricing can have several consequences for the firm and the market:

• Reduced Competition: Limit pricing can lead to a less competitive market, which may result in higher prices and lower output for consumers.
• Potential for Inefficiency: The firm may not be producing at the most efficient scale of output if it is deliberately restricting entry.
• Strategic Interaction: Limit pricing can trigger a strategic interaction with potential entrants, leading to a price war or other competitive responses.
• Market Power: Successful limit pricing can enhance the market power of the incumbent firm.

7. Example

Consider a firm that has invested heavily in a specialized production facility with high fixed costs. If the firm has spare capacity, it might choose to set a low price on its product to deter new firms from building competing facilities. Even though the firm might be making a small loss per unit, potential entrants would also face losses if they entered the market due to the firm's low price.

8. Conclusion

Limit pricing is a powerful pricing strategy that firms can use to protect their market position. However, it has potential drawbacks, including reduced competition and potential inefficiencies. The effectiveness of limit pricing depends on a variety of factors, including the firm's cost structure, market conditions, and the presence of barriers to entry.