limit+pricing,+predatory+pricing,+raising+rivals+costs

There are many ways in which a firm can limit competition, thereby raising its own long-run profits. Three of these strategies are discussed below: limit pricing, predatory pricing, and raising rivals’ costs.

LIMIT PRICING

Monopolists to inhibit or deter entry or expansion by fringe firms use limit pricing. The incumbent firm sets a price that is below the monopoly level. By doing this, the potential profits in the market are limited. Limit pricing is illegal in many countries.

The incumbent firm raises production to the point that the entrant’s quantity produced to satisfy the market will not make any profits. If there are any costs associated with entry, even slight costs, the entrant will choose not to enter since there will be no profits.

The incumbent also raises production to appear as a low-cost firm, even if it is in fact a high-cost firm. Usually low cost firms are able to increase production and not lose profits. Monopolies, even if they may lose some profits initially, will want to increase production to appear as low cost so new entrants have a difficult time matching the assumed cost structure. This behavior is derived in a Bayesian-Nash equilibrium.

The graph below represents limit pricing, along with the entrant’s residual demand curve. P^M and Q^M represent the quantity and price used by the monopoly before a new entrant comes into the market. The line D^M is the demand curve of the market. When the incumbent chooses to limit the price, it raises its production quantity, yet stays on the market demand curve. The limit price and quantity are represented by P^L and Q^L. The entrant’s residual demand is the market demand D^M) minus the amount (Q^L) produced by the incumbent. For this particular depiction, since the entrant’s residual demand lies below the average cost curve, entry is not profitable.

Limit Pricing and Residual Demand

PREDATORY PRICING

Limit pricing focuses on preventing potential competitors from entering the market, while predatory pricing focuses on eliminating competitors. The predator firm will lower its prices below its own marginal costs in order to drive out the competition. Once the “prey” firm has left the market, the predator firm can raise its prices back to or higher than they were before the predatory pricing was put in place. This strategy is an offset of current profits for higher future profits, but is only beneficial if the present value of the future profits offset the current losses.

The theory of predatory pricing makes sense and has an element of truth to it, at least to non-economists. In 1992, the Cato Institute published a policy analysis of predatory pricing calling it a myth, stating in the previous 35 years, there had not been a single clear-cut example of predatory pricing. The policy analysis states that competitors that are either unwilling or unable to lower their own prices make claims of predatory pricing. The analysis also stated the legal restrictions on price-cutting, as an attempt to limit predation, are protectionist and anti-consumer.

A classic case that is studied as an example of predatory pricing is Standard Oil lowing its prices in order to eliminate the Pure Oil Company as a competitor. In 1958 economist John McGee wrote an article focused on Standard Oil. His conclusion was that Standard Oil did not engage in predatory pricing. He said it would be irrational for a large firm to take this on as a strategy. As large firms are usually considered the predator, it can also be assumed that the large firm would have the most to lose since they sell the highest volume. If the price is set below the average cost, profits are being lost on every sale. The large volume of sales experienced by the large firm would cause the firm to lose a lot of money. McGee also stated there is great uncertainty on how long the price war would last. It would be foolish for a company to purposefully lose money for an undetermined length of time.

RAISING RIVALS’ COSTS

Some companies will choose to increase its own profitability by raising its rivals’ costs in order to make the rivals less competitive. This strategy does not focus internally at the product or the cost structure, but focuses externally at the competition. In order for this strategy to be successful, the predatory firm must be able to purchase a key input at a cost lower than the rivals must pay for the key input.

“The weakest link in these theorists' chain of reasoning is their inadequate treatment of potential counterstrategies by rivals. All methods of raising rivals' costs depend on the ability of a predator to secure contracts that exclude its rivals. Such a result requires that the predator's rivals and its suppliers remain ignorant about its intentions” (Boudreaux, 1988).

An example of this would be Tropicana wanting to raise rivals’ costs by purchasing exclusive rights to all oranges. The competition would then have to purchase from Tropicana. This would increase the costs at the rival firms.

MULTIPLE CHOICE QUESTIONS

1. Preventing potential competitors from entering the market is generally defined as a. Limit Pricing b. Predatory Pricing c. Raising Rivals’ Costs d. Monopoly Pricing

2. A firm that lowers its price in order to eliminate competition is practicing a. Limit Pricing b. Predatory Pricing c. Raising Rivals’ Costs d. Monopoly Pricing

3. An article published by the Cato Institute calls ________________ a myth. a. Limit Pricing b. Predatory Pricing c. Raising Rivals’ Costs d. Monopoly Pricing

4. Being able to purchase key inputs as a lower costs than the competition is part of the strategy of a. Limit Pricing b. Predatory Pricing c. Raising Rivals’ Costs d. Monopoly Pricing

5. All of the following are examples of strategies firms adopt in order to limit competition and increase long-run profits, except a. Limit Pricing b. Predatory Pricing c. Raising Rivals’ Costs d. Monopoly Pricing

ANSWERS 1. a. Limit pricing is used by firms to limit the entrance of new competitors by lowering prices to make the market less appealing. 2. b. Predatory pricing is done by firms at the expense of current profits. The price is lowered below marginal costs, creating short-term losses, in the hope that the competition will leave and prices can then be raised once again above marginal costs. 3. b. The policy analysis done by Cato Institute states there are no clear-cut cases to prove predatory pricing is a reality. 4. c. Raising rivals’ costs requires a firm to have control of a key input that the competition also needs in order to regulate the rivals’ costs. 5. d. Limit pricing, predatory pricing, and raising rivals’ costs are all strategies used to limit competition in a market and increase a firms profits.

RESOURCES

http://stats.oecd.org/glossary/detail.asp?ID=3246 Carlton D. and Perloff M.: "Modern Industrial Organization" Fourth Edition, 2005 Harrington Jr., J.E. Pricing when the Potential Entrant is Uncertain of its Cost Function, Econometrica, Vol. 54, No. 2. (Mar., 1986), pp. 429-437 http://www.cato.org/pubs/pas/pa-169.html http://www.cato.org/pubs/regulation/regv13n3/reg13n3-boudreaux.html Baye, M.R.: “Managerial Economics and Business Strategy” Fifth Edition, 2006