What is limit pricing?

Limit pricing (LP) is a form of low-price strategy used by an existing company to intimidate potential competitors away. The price is set just low enough, so potential competitors do not expect to recoup their average cost. No matter how much they offer on the market. LP is a pre-entry strategy to prevent potential competitors trying to enter the market. NB: in order limit pricing to work incumbent must have some cost advantage over new entrants (see assumptions below). Further, it usually does not violate competition act. Assumptions: 1. New entrants assume that incumbents will keep output level at pre-entry level (Zero conjectural variation) 2. There must be cost advantage for incumbent (The big player in the market) 3. Assume perfect information about the demand curve and cost curve Interpretation of these assumptions: the management of the potential entrant can’t ex ante estimate how much the price will fall ex post, i.e. after entry! The same applies to existing companies in the market – this is important for determining the correct limit price.