Dynamic Limit Pricing (II)

In fringe firms can increase their output rapidly and take market share away from the dominant firm quickly, the dominant firm the gain little by setting a high price. High short – run profits will evaporate quickly, as will market share. When fringe firms can expand rapidly, a dominant firm is more likely to hold the price down and retain market share. Discount Rate

The third factor that determines the dominant firm’s choice is the discount rate. When the discount rate is high, current income can be invested at relatively high rates of return. The opportunity cost of postponing current income for future income is high. If the discount rate is high enough, the dominant firm will prefer to take a greater profit in the short run and give up market share.

On the other hand, if the discount rate is low, the rate of return at which the extra short – run profit could be invested is small. The dominant firm will attach almost much importance to profit to be earned in the distant future as to current profit. If the discount rate is low enough, the dominant firm will prefer to take a lower profit in the short – run and hold on to market share.

Tradeoff

Of course, the dominant firm does not face an either –or decision. It can initially set a high price and then lower it toward the limit price. It would give up some market share to the fringe but maintain a dominant position over the long haul. The three factors just discussed – the profit to be gained in the short run, the rate of fringe expansion, and the discount rate – will determine how rapidly a dominant firm will bring the price down to the limit level. The case of OPEC from 1973 through 1985 which we will discuss in detail in chapter 5 seems to fit this scenario.