Limit pricing definition
/What is Limit Pricing?
Limit pricing is the practice of setting a product or service price at a level just low enough to deter potential market entrants from competing in a market. A business engages in limit pricing when it wants to minimize the number of competitors. The price point chosen may not be the price at which a business earns the largest profit, but it does keep other companies out of the market.
How to Detect Limit Pricing
Limit pricing must be inferred, since it is not an active monopolistic act; that is, other companies may enter the market as long as they are willing to accept the low price point or have other means of differentiating their products or services. A good indicator of the presence of limit pricing is when a company builds excess capacity, and lets it be known that this extra capacity will be used to drive down prices further if any competitors have the temerity to offer competing products. These communications are frequently made through the trade press, which are most likely to be read by the competition.
Advantages of Limit Pricing
The main advantage of the limit pricing method is that a sufficiently low limit price may leave the bulk of a market to a monopolistic company. This allows the firm to maximize its sales volume, which in turn allows it to produce in volume and thereby drive down its unit costs.
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Disadvantages of Limit Pricing
There are multiple problems with limit pricing. One is that a company that successfully exercises limit pricing may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops with a new market entrant. Also, if the company does not keep its products and services at a sufficiently high level, someone could sidestep the limit price with a unique product or service offering. Another concern is that limit pricing is considered illegal in some government jurisdictions, so even giving the appearance of using limit pricing could trigger a lawsuit. And finally, a company imposing limit pricing is setting prices lower than the point at which it can maximize profits, so it may be giving away some profits on a per-unit basis.
Example of Limit Pricing
Goose Airlines operates a highly profitable route between Cleveland and Denver. A smaller airline, Chickadee Air, is considering entering the route to capture some of the market. Goose knows that Chickadee needs to charge $150 per ticket to cover its costs and operate profitably on the route. Goose, due to its larger scale and established infrastructure, can sustain profitability even if it charges $120 per ticket. To deter Chickadee, Goose lowers its ticket prices to $120, signaling that competition on this route would lead to unsustainable losses for Chickadee.
Chickadee, realizing that it cannot compete profitably, decides not to enter the market. Goose therefore maintains its monopoly on the route and eventually may raise prices again once the threat subsides. This strategy works because the dominant firm's cost advantage allows it to survive lower prices longer than a potential competitor.
Evaluation of Limit Pricing
Limit pricing is considered illegal in some jurisdictions, and may not be effective in keeping out a determined market entrant over the long term. However, it may be useful in the short to medium term in reducing the level of competition in a market.