The term limit pricing refers to a strategy that entails establishing a price for a product or service that makes it unprofitable for potential competitors to enter the market. While some economists consider limit pricing an anticompetitive practice, others believe consumers benefit from this approach.
Often used by monopolistic corporations, limit pricing involves a strategy whereby a product or service is priced at a level that is lower than the company's marginal cost at its optimal level of production, or at a level that is just low enough to make entry unprofitable for potential competitors.
Companies have several options when establishing a selling price for their product or service. For example, if a company wants to maximize their profits, they would establish a price where:
Marginal Cost = Marginal Revenue, or MC = MR
Note: Keep in mind the company's average cost will be much lower than their marginal cost. That's why the above equation maximizes profit. When marginal cost is greater than marginal revenue, the company will start to lose money with each sale.
Companies can also choose to establish a pricing strategy known as limit pricing. With this approach, the company is operating at a level of production that is lower than their maximum output; they have excess capacity. At this level of production, their marginal revenue will be much greater than marginal cost. When pricing a product at this level, the company is making more money on each sale, but they're not maximizing their total profits because they're operating at a level that is below their optimal output.
Economists argue limit pricing is good for consumers. Since the company's marginal revenue at lower levels of production is lower than when MR = MC, the approach actually keeps prices lower for consumers. Only two factors will influence the company's decision to institute a limit pricing strategy:
anti-competitive practice, confidentiality agreement, conflict of interest, dividing markets, price fixing, bid rigging, group boycott, disparagement, dumping, exclusive dealing, Sherman Antitrust Act of 1890, Clayton Antitrust Act of 1914, Federal Trade Commission Act of 1914, resale price maintenance