Lecture Notes: Limit Pricing vs. Predatory Pricing

Introduction

• Purpose: To understand the difference between limit pricing and predatory pricing.
• Importance: Many students confuse these concepts.

Key Differences

• Limit Pricing
  • Legal practice.
  • Firms set prices below the average cost of potential entrants to deter them from entering the market.
  • Firms sacrifice short-term profit maximization to maintain market dominance.
• Predatory Pricing
  • Illegal practice.
  • Firms set prices below their own average variable cost to drive competitors out of the market.
  • Once competitors are gone, firms can raise prices again.

Limit Pricing Explanation

• Objective: To deter new entrants.
• Example: Tesco worries about new supermarket entrants.
  • Tesco lowers prices using economies of scale.
  • Set prices below new entrants’ average cost but above its own.
  • Deterrence strategy: Prevents new firms from gaining market share.
• Evaluation:
  • New entrants might still enter if they offer better quality or have enough resources (e.g., Amazon).

Predatory Pricing Explanation

• Objective: To eliminate competitors.
• Illustration: Using a fictional example of Tesco vs. Dobby's newsagent.
  • Tesco reduces milk prices to 10p, below its cost, to drive Dobby out.
  • Dobby cannot sustain losses and exits the market.
  • Once Dobby exits, Tesco raises prices.
• Outcome: Dobby, unable to compete, exits the market.
• Evaluation:
  • This practice is illegal to prevent unfair market dominance, ensuring fair competition.

Conclusion

• Understanding this distinction is crucial for exams and real-world business strategy.
• Recognize legal vs. illegal practices in pricing strategies.