okay so today I wanted to delve into the difference between limit and predatory pricing it's alarming how many students often mistake one for the other and so it's really important to understand the difference between the two um one to clarify limit pricing is perfectly legal firms are allowed to limit price and two predatory is illegal the way to kind of remember by the way think about the word predator or like predatory predator kills so that's obviously not a good thing and we're going to talk about both in terms of what the theory is and why firms might want to do it let's start with limit pricing limit pricing is where a firm already in the market is now potentially worried about new firms entering the market and so what they're going to do is on purpose in the short run they will not maximize profits what they're instead going to do is set their price below the average cost of potential entrance to the market right very important to understand but it's easier to see it on a diagram and understand how they would do it so imagine for example in the supermarket industry Tesco at the moment dominate and they're now worried that because of I don't know advancements in technology because of information gaps being reduced whatever the reason is there's a genuine chance that new supermarkets could now enter the market and eat into their market share while Tesco obviously don't want that to happen so Tesco might decide you know what we're going to do we're going to now reduce our prices so that firms hopefully don't come in and the way we're going to do that is by tapping into the large economies of scale that we have available to us so let's draw that out what does that mean so if I draw out here is the AC curve let's say for the supermarket industry okay so if I draw that like this so here is the AC curve let's draw that a bit nicer so here is the AC curve for the supermarket industry something like that now Tesco because they produce so much output they're such a dominant player in the market do you guys agree that the output they produce is very very high they're somewhere over there Q1 their average cost let's say C1 is over there and I'm going to make up a number so let's say hypothetically that for Tesco their average cost is 20p okay now at the profit maximizing level of output and at the profit maximization let's assume that Tesco were charging for this particular good whatever that good might be the cost was let's say 20p they were charging£1 okay so the profit maximizing level of output would give them 80p of profit per unit okay now a new firm is considering entering the market or they think there's a chance that a new firm might enter the market now Google that new firm because they will not have as much market share as Tesco cannot bulk buy in the same quantity as Tesco they can't reduce their average cost like Tesco can so for example let's assume that their quantity would be over there at Q2 their cost then is all the way up here C2 okay let's assume that C2 happens to be 70p in other words the cost per unit for that particular firm thinking of joining the market is.7 okay what Tesco now decide to do is they go "All right well we're going to cut our price below the average cost of the potential entrance to the market." So not below our average cost so we're not going to cut it below 20p but what we will do is we'll cut it to let's say 60p so this still make profit but they're not maximizing profit they could even have cut it all the way down to 20p if they really wanted to where they make normal profit but ultimately as long as they cut it below the average cost of the potential entry into the market why are they doing this well what they're doing or they're trying to do could be summarized in one word and limit pricing could be summarized by the word deter i'm trying to put them off i'm trying to deter that firm from entering the market i don't want them to enter because they might eat into my market share because if that firm entered the market by the way and tried to charge the same price as me as Tesco they charge 60p they'd be making a a loss of 10p per unit and obviously that's not sustainable long run so hopefully it puts them off hopefully they don't actually enter the market the evaluation to that by the way is that the low price might not deter them though because they might enter and offer a better quality than Tesco in which case consumers might still switch they might be a really big firm in another industry like Amazon and be able to enter even if you offer even if they were making losses to begin with so anyways that is limit pricing and this is legal you can do this the alternative is predatory pricing this one is illegal and the best way to understand this is with a completely madeup example so those of you that are legends and have read Harry Potter I emphasize the word read and not watch the movies reading it yeah anyone that's read Harry Potter will know that one of the characters is Dobby if you haven't watched it or read it spoiler alert Dobby dies i'm really sorry yeah but anyways basically we're going to resurrect Dobby bring him back to life yeah and we're going to pretend that Dobby has decided to open up a news agent here it is this is Dobby's news agent little Dobby here now across the road from Tes from him is big bad Tesco and just want to make sure I don't get sued um Tesco not actually bad they're a real nice company it's all good yeah but just an example so Tesco are not too fond of Dobby they're like because Dobby is taking some of their market share away so imagine you're a customer and you need to buy like a loaf of bread or you need to get a pint of milk right it's just easier to go into a little news agent than to go into the massive supertore go to the right aisle and get it from there so in this completely madeup example let's assume that initially Dobby is selling £1 for his milk and Tesco are also charging £1 for their milk predatory pricing is the following tesco now decide to reduce the price of their milk to tempe so that on purpose Tesco are making a loss on every single carton of milk that they are selling so they're setting their price below their average variable cost now Tesco can do this because they can cross subsidize from other other stores they can cross subsidize from all the different kind of products that they sell that they make tons of profit on so they can absorb losses it's not a big deal for Tesco dobby has one of two options scenario number one is that Dobby keeps his price at £1 but you guys agree that there's a big difference in the price now so he will lose a lot of customers to Tesco and unfortunately for Dobby because of how many customers he ends up losing Dobby dies i'm so sorry scenario number two Tesco have a price of 10p so Dobby goes "All right bring it on." He cuts his price to 10p as well but can Dobby absorb losses in the same way that Tesco can absorb losses the answer is definitively no he cannot therefore what happens to Dobby dobby again unfortunately he dies whatever Dobby does no matter what he does he is dead he cannot compete against this large firm when they predatory price as soon as Dobby has left the market as soon as his shop has closed down what can Tesco now do they can raise their price back up to one pound in fact if they wanted to they could charge us 1 15p 1 pound 10p you have no choice now because there's less competition you have to pay the higher price for Tesco's milk this is predatory pricing and it is illegal yeah because if big firms could just keep doing this they just keep doing this they keep eliminating competition whenever a new firm opens up so the evaluation to that very easily is that it's illegal they're not allowed to do this but hopefully you now recognize the difference between what limit pricing is which is legal and what predatory pricing is which is illegal and if you get that in your exam you now know how to deal with it