Limit pricing

3 key takeaways

• Limit pricing involves setting prices just low enough to discourage new competitors from entering the market while still maintaining profitability.
• The strategy is used to protect market share and prevent new entrants by making it financially unviable for them to compete.
• Limit pricing requires a careful balance, as prices must be low enough to deter entry but not so low that they significantly reduce the incumbent’s profits.

What is limit pricing?

Limit pricing is a preemptive pricing strategy where an established firm (the incumbent) sets its prices at a level low enough to discourage potential competitors from entering the market. The incumbent leverages its existing market position, cost advantages, and economies of scale to sustain lower prices, making it difficult for new entrants to compete profitably.

Example

A dominant airline may set its ticket prices just above its cost of production, leveraging its established customer base and operational efficiencies. Potential new airlines, without the same scale and cost advantages, may find it unprofitable to enter the market at these low prices, thus being deterred from entry.

Key features of limit pricing

Strategic pricing

Limit pricing involves setting prices strategically below the short-term profit-maximizing level to prevent new entrants from seeing the market as an attractive opportunity. The prices are low enough to reduce the potential profitability for new firms but still allow the incumbent to cover costs and earn a reasonable profit.

Cost advantages

For limit pricing to be effective, the incumbent must have significant cost advantages over potential entrants. These advantages can come from economies of scale, superior technology, established brand loyalty, or efficient production processes. These cost advantages enable the incumbent to sustain lower prices without incurring losses.

Market signals

By setting lower prices, the incumbent sends a strong signal to potential entrants that the market is not lucrative. This discourages new firms from entering, as they anticipate difficulties in competing against the established firm’s pricing strategy.

Deterrence and sustainability

The primary goal of limit pricing is deterrence. The incumbent aims to maintain its market position by making entry unattractive. The strategy is sustainable as long as the incumbent can maintain lower prices without significantly harming its profitability or financial health.

Benefits of limit pricing

Market protection

Limit pricing helps incumbents protect their market share by preventing new competitors from entering. This allows them to maintain dominance and control over the market.

Long-term profitability

While limit pricing may reduce short-term profits compared to higher pricing strategies, it ensures long-term profitability by keeping potential competitors at bay. This reduces the risk of price wars and market share erosion.

Competitive advantage

By leveraging cost advantages and economies of scale, incumbents can create a competitive barrier that is difficult for new entrants to overcome. This strengthens their market position and ability to dictate market terms.

Challenges and criticisms of limit pricing

Profit reduction

Setting prices too low can lead to reduced profit margins for the incumbent. Balancing between deterring entry and maintaining profitability can be challenging.

Regulatory scrutiny

Limit pricing can attract regulatory scrutiny and be viewed as anti-competitive behavior. Authorities may investigate and penalize firms engaging in practices deemed to unfairly stifle competition.

Risk of new entry

If new entrants have access to innovative technologies or disruptive business models that significantly lower their costs, limit pricing may fail to deter them. The strategy’s effectiveness depends on the incumbent’s ability to maintain its cost advantages.

Short-term focus

While limit pricing focuses on deterring entry, it may neglect other strategic priorities such as innovation, customer satisfaction, and market expansion. Firms must balance limit pricing with broader business objectives.

Related topics

• Predatory pricing: Learn about the aggressive pricing strategy where a firm sets very low prices to eliminate competitors, which is often considered illegal.
• Economies of scale: Understand how cost advantages achieved through large-scale production can support limit pricing strategies.
• Barriers to entry: Explore various factors that prevent new competitors from entering a market and how firms can create or leverage these barriers.

Limit pricing is a strategic tool used by incumbent firms to protect their market share and deter new entrants by setting prices low enough to make entry unattractive. While it offers significant benefits in maintaining market dominance, it also presents challenges and risks that firms must carefully manage to ensure long-term success.