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Bain's Limit Pricing Theory
Bain's Limit Pricing Theory
Subject ECONOMICS
TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Bain’s Theory of Limit Pricing
4. Diagrammatic Representation of the Limit Pricing Model
5. Bain’s Limit Pricing and Price Elasticity of Demand
6. Summary
1. Learning Outcomes
After studying this module, you shall be able to
2. Introduction
So far we have seen the price determination under different market structures i.e. perfect
competition, monopoly, monopolistic competition and oligopoly. In the perfect
competition and the monopolistically competitive market structure, we have studied the
effects of actual entry of new firms on the price and output decisions of the existing
firms. But in monopoly and oligopoly market structures, the existing firms do not worry
about the potential entry of new firms. The traditional closed oligopoly models like
Cournot, Bertrand, Edgeworth and Chamberlin do not provide for entry of new firms.
Under oligopoly, the number of firms assumed to be constant. It is only the reaction
behavior of the existing firms to the moves of the rival is explained.
But recently it has been argued by several economists that the price and output decisions
of the existing firms in oligopolistic markets are affected not only by the potential entry
of the firms but by the actual entry as well. The prominent economists of these findings
are Bain, Sylos-Labini, Andrews, Modigliani, and Jagdish Bhagwati. Another issue that
has been raised by these economists is that the objective of the firm under oligopoly is
not to maximize the short run profits but to maximize the profits over the long run. The
oligopolistic firm seeks to maximize the profits over the long run after allowing the entry
of potential firms that affect the possibilities of profit.
J. S. Bain in his pioneering work ‘A note on pricing in oligopoly and Monopoly (1949)
followed by his book ‘Barriers to New Competition’ developed the theory of limit
pricing. According to him, limit theory implies that firms do not maximize profit in short
run because of the fear of excessive profit which induces the entry of new firms and thus
reducing the profits in the long run. According to him, the oligopolistic firms do not
charge the price that is equal to the short run profit maximizing price but charges a lower
price so as to prevent the entry of new firms in the industry. The theory of limit pricing is
also known as entry preventing pricing. The theory of Bain’s limit pricing has been
further developed by Sylos-Labini, Modigliani and Jagdish Bhagwati. Let us study the
theory of limit pricing in detail.
Under Bain's Model, he defined the limit price model as the condition for entry. The
condition for entry is defined as a percentage by which established firm can increase the
price above the competitive price without attracting the entry of new firms into the
industry. The conditions for entry can be expressed mathematically as
𝑃𝐿 − 𝑃𝐶
𝐶=
𝑃𝐶
Or 𝑃𝐿 = 𝑃𝐶 (1 + 𝐶)
Suppose the firm’s sets the limit price𝑃𝐿 above the competitive price𝑃𝐶 , then each firm
would earn super normal profit as price is more than average cost. If price is equal to
average cost then firms are earning only normal profits. Thus, C is the percentage or a
premium above competitive price which the existing firms earn by fixing the higher limit
price 𝑃𝐿 . Bain assumed that the condition of entry of new firm involved for which time
period which is long enough. This time period depends upon the changing conditions of
demand and input prices. The more the time a firm takes to establish itself, the lesser the
degree of threat posed by its entry. So, there exist a wide gap between the limit price and
competitive price. This gap between competitive price and limit price is known as entry
barrier or entry gap.
Entry Barriers: The condition of entry by which the established firm can charge higher
price as compared to the competitive price depends on the presence of various barriers to
entry. The major sources of entry barriers are:-
i. Product Differentiation
ii. Economies of Scale
iii. Absolute Cost Advantage of Established Firms
iv. Large Initial Capital Requirements
v. The Minimum Scale for the Efficient or Optimum Production.
Let us study them in detail.
i. Product Differentiation: The product differentiation gives an individual firm
an advantage in terms of degree of control over the price of their product. The
new entrant cannot produce the same identical product as produced by the
established firms. An entrant is at a disadvantage because she has to make her
product known and attract some customary buyers from the established firms.
As a result, the new firm has to sell at a lower price or spend more on
advertising or undertake both. Hence, the cost of the new entrant goes up.
ii. Economies of Scale: There are three reasons for internal economies of scale
and one of them was given by Adam Smith.
c. One Time Cost: This is the third source of increasing returns to scale
where even in long run inputs do not have to be increased as the output
of a product increases, for example, Research and Development cost to
design a new product is incurred only once for each product. So the
average total cost falls as the output increases. The effect of onetime
costs is that, they cause an average costs to fall over an entire range of
output.
iv. Large Initial Capital Requirements: In order to set up a new firm, the firm
needs large amount of initial capital which may be difficult for the new firms
to mobilize. Banks may be reluctant to finance new business and the capital
market could be almost inaccessible to the new entrants. This acts as a barrier
to the entry of firms in an industry.
Suppose, the firms set the price PL which is equal to the long run average cost of the
potential entrants firms i.e. LACPF then firms are ready to sell OQL units of output. At this
price, the established collusive oligopolistic firms are still earning profits as this price is
still more than their long run average cost i.e. LACEF. This price is beneficial for the
already established collusive oligopolistic firms but not for the new rivals firms. It is not
beneficial for the new firms to enter the market as the price is equal to their long run
average cost i.e. LACPF. As price is equal to average cost they are just earning normal
profits. If these new firms would enter the market then the supply of the product would
increase and for a given price this increase in supply results in fall in the prices below
their average cost of production. Thus, the post entry price would be less than the average
cost of the potential entrants. So, if the potential firms enter at this price then they are
incurring losses as post entry price is less than their long run average cost. This price
would act as entry preventing price or the limit price. Therefore, the price P L is the limit
price which the established firms can charge without inducing entry. At this price, the
established collusive oligopolistic firms are still earning profits but this profit is less than
the profit that they are incurring at the monopoly price i.e. PmAEmB>PmACPL.
The another important feature of Bain's limit pricing theory is that if the market demand
and the cost conditions allows the monopoly price to be less than the limit price then the
oligopolistic firms would charge the monopoly price to maximize their short run profits.
This price not only maximizes the short run profits but also serve to prevent potential
entrants and maximizes the long run profits.
We have seen that Bain was able to explain why collusive oligopolistic firms charge price
below the short run profit maximizing price. This is because of threat of potential entry of
new firms. These firms want to prevent the new entry to ensure long run maximum
profits.
6. Summary
According to Bain, limit theory implies that firms do not maximize profit in short run
because of the fear of excessive profit which induces the entry of new firms and thus
reducing the profits in the long run. According to him, the oligopolistic firms do not
charge the price that is equal to the short run profit maximizing price but charges a lower
price so as to prevent the entry of new firms in the industry. The theory of limit pricing is
also known as entry preventing pricing.
According to Bain, the price is not set at the minimum point of long run average cost
curve. He explained that the firms are deliberately set a price above the minimum of long
run average cost in order to restrict the potential entry of new firms. Thus, 'limit price'
was the highest price, which the established firms believed they could charge without
inducing further entry. This price may be lower than the price set by the profit
maximizing firm. This theory basically related to the case of collusive oligopoly firm.
Bain's theory states that if the established collusive oligopolistic firms charge the
monopoly price, they are incurring huge profits as price is more than long run average
cost. But if firms set the price which is equal to the long run average cost of the potential
entrants then the established collusive oligopolistic firms are still benefiting but not the
new entrants. This is so because at this price the established collusive oligopolistic firms
are incurring profits as price is more than their long run average cost. But the same is not
true for potential entrants. At this price, then new entrants are just earning normal profits
because their long run average cost is equal to the price. The important aspect of the
Bain's limit pricing theory is that Bain tried to explain the phenomenon of oligopolistic
firms in some industries keeping their price at a level of demand where price elasticity of
demand is less than unity. The theory of Bain’s limit pricing has been further developed
by Sylos-Labini, Modigliani and Jagdish Bhagwati.
The another important feature of Bain's limit pricing theory is that if the market demand
and the cost conditions allows the monopoly price to be less than the limit price then the
oligopolistic firms would charge the monopoly price to maximize their short run profits.
This price not only maximizes the short run profits but also serve to prevent potential
entrants and maximizes the long run profits.