How ease of entry changes the behaviour of firms

Overview

Limit pricing, effect of increased contestability on efficiency in a market and predatory pricing.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse how the ease of entry into a market changes the pricing behaviour of the firms already in it.

   Model answer

   Where entry is easy, an incumbent that sets price well above average cost creates the very profit that will attract a rival, so the profit it earns today is bought at the cost of losing market share tomorrow. The rational response is to hold price near the level that yields only normal profit, giving up the short-run margin in order to keep the market to itself. Where entry is difficult, no such trade-off exists and the incumbent sets the price that maximises current profit, which is well above cost. The same firm with the same costs and the same demand therefore prices quite differently according to how easily it can be joined.

2. 2

   What is limit pricing?

   Model answer

   Limit pricing is setting a price low enough that a potential entrant would not find entry profitable, while remaining high enough for the incumbent to do better than it would after entry had occurred. The incumbent sacrifices some current profit in order to preserve its position.

3. 3

   Explain the trade-off an incumbent faces when deciding whether to set a limit price.

   Model answer

   Charging the profit-maximising price yields the most money in the current period but invites entry, after which the incumbent must share the market and accept a lower price permanently. Charging the limit price yields less now but preserves the whole market at that price indefinitely. The incumbent should limit price when the value of the future profits it protects exceeds the current profit it gives up, which depends on how long the market will last, how likely entry really is, and how much share it would lose.

4. 4

   How does contestability affect the level of profit a firm can sustain in the long run?

   Model answer

   The more contestable the market, the closer long-run profit is driven towards normal profit, because any margin above it is an invitation to enter that the incumbent cannot afford to issue. In a perfectly contestable market only normal profit survives, exactly as under perfect competition, even though the market may contain only one or two firms.

5. 5

   Analyse the effect of increased contestability on efficiency in a market.

   Model answer

   Allocative efficiency improves because the incumbent must bring price down towards marginal cost, so output expands and part of the deadweight loss is removed. Productive efficiency improves because a firm with no cushion of supernormal profit cannot survive with costs above the minimum, so organisational slack and X-inefficiency are squeezed out. The effect on dynamic efficiency is ambiguous: the pressure to innovate rises, but the retained profit available to fund research falls, and an innovation that can be imitated immediately by an entrant may not be worth developing at all.

6. 6

   What is predatory pricing, and how does it relate to contestability?

   Model answer

   Predatory pricing is setting price below the cost the firm avoids by not producing, in order to force a rival out and recover the losses later through higher prices. It relates to contestability because it is a way of manufacturing a barrier where none exists naturally: if a potential entrant believes the incumbent will price predatorily on arrival, the expected return from entering falls below the sunk cost and the raid is not attempted, so the market ceases to be contestable even though nothing about its technology has changed.

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