Dynamic Limit Pricing (II)

Three factors determine which alternative will yield a dominant firm the greatest present discounted value. The first factor is the difference between the limit profit the firm will earn if it sets a low price and the larger short – run profit it will earn if it sets a high price. The second factor is the rate at which the dominant firm loses market share and therefore profit to the fringe if the fringe begins to expand. The third factor is the discount rate.

Here we can draw on the conclusions of the static limit price model. If the market is the large and entry costs are small, the limit price will near marginal cost and the limit profit will be small. The smaller the per – period limit profit, the more likely it is that the dominant firm will achieve a greater present discounted value income stream by taking a larger short – run profit and giving up market share over the long run. If the market is large enough and entry costs are small enough, the dominant firm will prefer to take such short – run profits as it can get, even at the expense of market share. Dominant firms are most likely to take the money and run in large markets with easy entry.

Fringe Expansion Rate

In many cases, the maximum rate at which fringe firms can increase their output will depend on technology factors. The rate at which fringe firms do increase their output will be affected by the profit to be gained after entry, which is what motivates expanding firms. If the dominant firm sets a price far above the limit price it, it can expect entry to be more rapid than if it sets a price only slightly above a limit price.