Bains Limit Pricing

According to Bain the limit price is set by {a)the cost of the potential entrants,  {b)price elasticity of demand for the product sold by that industry, {c)the market size, {d)the number of established firms and {e)the level and shape of the Long-run Average Cost,revenue curve

Limit price J. S. Bains Oligopoly Long-run Average Cost

Fig. states that DD' is a market demand and MR is corresponding revenue curve. A firm is assumed to be collusive oligopoly firm. LACEF refers to the Long-run Average Cost of existing firm. LACEF == LMCEF. In order to maximise' short-run profit a firm will set the price at LMCEF == MR. it is achieved at point E in the figure. It is a short-run profit maximising price equal to PM. But it could be seen that price PM > LACPE which means price is higher than the Long-run Average Cost of potential entrant firms. It will attract new firms in the industry and' as a result an existing firms will start losing their market share creating uncertainty about the level of precise demand for their product. Now, if firm set price at PL level (PL == LACPE) they will sell Q2 units of output.

The reason is that PL is lower than PM. The established existing firm still earn profit because PL is still greater than LACpE. Now the potential entrant. firm will not interested in this industry as price PL equals their "long-run average cost (PL = LACPE). Still if they enter the industry, it will increase supply of product thereby further reducing price of the product in the market. And newly entered firm will face losses. Thus Price PL is known as a limit price as it is the price set by existing firms for limiting entry of new firms in the industry. At his PL price existing firms still earns some profit. The profit margin per unit will be PPL is lower compared to the earlier monopoly price PPM. The total profit made by existing firm is PP~B which is less that short-run maximum price PPMHE. Thus existing firms are sacrificing some short-run profit, as they expect they would be more than compensated in the long-run.

The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time According to Bain, there are five major barriers to such entry 'of potential firms. They are: a) Absolute cost advantage b) Product differentiation c) Optimum production d) Large initial capital requirements e) Economies of scale