Market Performance under Dynamic Limit Pricing
If entry costs are sufficiently small, the monopolist would have to expand output greatly to prevent entry. In this case, the most profitable thing for the dominant firm to do is to set a higher price and give up market share. Eventually, the market will be supplied by several firms of roughly equal size. Such markets – oligopolies – are important, because they are the most common form of real – world market. We study them in the next two chapters. Here we simply note that firms in such markets will, in general, be able to exercise some market power.
At the other extreme, if there are no entry costs at all, the market is constable. If average cost is the sane for the entrant and the dominant firm, the dominant firm will be unable to exercise any market power without losing the entire market to the entrant. The market will perform as a competitive industry, even though it is supplied by a single dominant firm.
Although perfectly contestable markets are no doubt rare, the theory of contestable markets serves to remind us of one thing: having a monopoly or a large market share is no guarantee of having monopoly power – the power to hold price above marginal cost. A large firm can only get away with what its rivals will permit. As we will see, the same is trye in oligopoly.
How are these conclusions altered when we take a dynamic view of limit pricing? If entry takes time, a dominant firm will face a tradeoff between short – term loss of dominance. Formal models show that a dominant firm in such circumstances will set a high price and gradually lower it, as entry occurs, down to the average cost of fringe firms, at this point, entry will cease. The dominant firm will exercise some market power, but the degree of market power – the excess of price over marginal cost – will fall over time. If average cost is constant and is the same for the fringe and the dominant firm, the dominant firm will eventually lower price to marginal cost. It will not be able to exercise market power in the long run.
