Dynamic Limit Pricing (1)

The static model of limit pricing ignores the fact that entry is a process that takes time. When we take account of the time needed to bring new capacity to the marketplace, we highlight an important element in the dominant firm’s decision making: the tradeoff between current and future profit.

If a dominant firm sets a limit price, it can maintain its dominant position and earn a corresponding profit year after year. Alternatively, a dominant firm can set a higher price and earn a larger profit in the short run. A higher price will induce fringe firms to expand, but the expansion will not take place immediately or all at once. As in the Vebco case study, only gradually will the dominant firm lose market share to the fringe. With the loss of market share will come a loss of profit. The dominant firm faces a choice: it can earn a high profit in the short run, with eventual loss of its dominant position, or it can earn a somewhat lower profit indefinitely.

As a profit – maximizing firm, the dominant firm will choose the alternative that yields the income stream with the greatest present discounted value, using as a discount rate the opportunity cost of funds to the firm. This is the rate of return the firm could earn if it invested in a risk – free asset such as treasury bills. The greater the discount rate, the more weight the firm gives to income received in the near future and the less weight it gives to income received in the distant future.