BAIN’S LIMIT PRICING MODEL

Prof. Prabha Panth,Osmania University,

Hyderabad

Prabha Panth 2

Limit pricing• Traditional theory only discusses actual entry,

not potential entry of new firms. This leads to normal profits in the long run in perfect and monopolistic competition.

• According to Bain:Firms do not maximise profits in the short run

due to fear of potential entry of new firms attracted by the maximum profits.

This will reduce their long run profits.

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Limit pricingSo Oligopoly firms fix a P that does not maximise

their revenue, i.e. P is fixed on the Inelastic part of D-curve.

• Limit Price: highest price that existing firms charge without fear of attracting new firms.

“Entry preventing” price, acts as barrier to entry of new firms.

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• Assumptions:1. There is a determinate long run industry D-curve, 2. Collusion among existing oligopoly firms,3. Limit pricing. Price set depends on:

a. Estimated costs of potential entry,b. Market elasticity of D,c. Shape and level of LAC (constant costs)d. Size of the market,e. Number of firms in the industry

4. Established firms seek long run profits.5. Uncertainty above the limit price, as new firms

enter.

C, R

0

Pm

Q

B

A

PLPc

Qm Q1 QL Qc

D = AR

MR

C

C1m

e .>

1

e =

1

e <

1

Figure 1

LACp = LMCp

LACc = LMCc

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In figure 1:• Downward sloping AR, MR curves.• Constant cost industry, LAC is horizontal straight line.

LAC = LMC1) PC firm: P = oPc. Equilibrium at B, Q= Qc. Normal

profits as AR = LACc.2) Monopoly firm: P = Pm. Equilibrium at m, MC=MR,

MC. Q = Qm. Abnormal profits = PcPmA m.3)Limit Price firm: price fixed at Pl > Pc, but < Pm.

Point of entry of potential firms. Abnormal profits = PcPl CC1 < Monopoly profits, but > perfect competition.

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• Monopoly price is fixed at the elastic part of the demand curve.

• Monopoly firm makes large abnormal profits. • This attracts new firms, and monopoly loses

its market. Area of uncertainty.• If firms fix a price < Pm but > Pc, • They still earn some abnormal profits, but not

maximum profits.

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• At this price, D curve is inelastic, i.e. MR <0.

• Prevents new entry, as at this price, new firms make only normal profits.

• Oligopoly market remains stable.