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. Read more…