Limit Pricing and Entry Deterrence

1
Lecture 14
ECON 312 Industrial Organization for 291

• Limit Pricing and Entry Deterrence
• 2005-2006

2
Predation, Predatory Pricing, and Limit Pricing

• Stackelberg leader chooses output first
• entrant believes that the leader is committed to
  this output choice
• entrant has decreasing costs over some initial
  level of output
• (In this sense we could call the model one of
  limit output)

3
A Limit Pricing Model
Then the entrants residual demand is R1 D(P)
- Q1
By committing to output Qd the incumbent
deters entry. Market price Pd is the limit price
These are the cost curves for the potential
entrant
/unit
With the residual demand R1, the entrant can
operate profitably.Entry is not deterred by the
incumbent choosing Q1.
At price Pe entry is unprofitable
R1
The entrant equates marginal revenue with
marginal cost
MCe
The entrants residual demand is Rd D(P) - Qd
Pd
ACe
Assume that the incumbent commits to output Q1
Assume instead that the incumbent commits to
output Qd
Then the entrants marginal revenue is MRd
Pe
D(P) Market Demand
Rd
MRd
Quantity
Q1
qe
Qd
Qd
4
Limit Pricing (cont.)

• The strategy of committing to output QD may be
  aimed either at eliminating an existing rival or
  driving out a potential entrant.
• Either way, several questions arise
• Is limit pricing more profitable than other
  strategies?
• Is the output commitment credible?
• If output is costly to adjust then commitment is
  possible
• why should this property hold?
• even if it holds, is monopoly at output Qd better
  than Cournot?

5
Limit Pricing (cont.)

• Question?
• Why is it better to have a guard dog than a
  security guard?
• Why is it a good idea to have good locks and
  carry a big stick or your keys in your hand if
  you are walking alone at night?