Should Antitrust Agencies be Concerned about Limit Pricing?

Limit Pricing is a fascinating yet widely unexplored concept in economics classes. When teaching our students about how monopolists and/or firms with market power make their decision regarding output and prices, it usually follows a simple premise – firms choose the level of output to maximize profits, which occurs where marginal revenue equals marginal cost, which is then evaluated at consumers’ willingness to pay.

\max_{Q} \pi=TR-TC \Longrightarrow MR-MC=0 \Longrightarrow Q \quad s.t.\quad MR=MC

And yes, if barriers to entry are significant enough for the monopolist to be completely comfortable with pricing above the competitive level and restricting output, that’s the behavior we would expect. But what if there is a potential competitor trying to enter this market? Then maybe the present monopolist isn’t really optimizing by following this simple exercise, because even though it decides to restrict output at this level, the potential entrant may produce some output of their own and lower price.

In this case, the present day monopolist (hereon referred to as the incumbent) will aim to charge the highest possible price (i.e. the closest to the original profit-maximizing price) such that it is unprofitable for the entrant to successfully produce any level of output, and therefore deterring entry. There are a few assumptions necessary for the incumbent to be able to engage in such strategic decision making: (i) incumbent has market power; (ii) products are homogeneous; and (iii) incumbent has perfect information over entrant’s cost structure, but it does enrich the simplistic view of monopolist’s decision  making purely on the presence of significant barriers to entry.

So back to the initial question of this post: “Should antitrust/competition agencies be concerned about limit pricing?” My takeaway is that first we need to understand what is the difference between harming a competitor and harming competition.

A firm is harming a competitor if a horizontal competitor is worse off after the strategic decision made by the former.

A firm is harming competition if by choosing a particular strategy it harms the market mechanism that guarantees that equally efficient competitors are able to compete in the same market should they choose to do so.

It is possible that by harming competition a firm may also harm a competitor; but not all harm to competitors consist of an antitrust issue. Sometimes it is competition itself that will harm a competitor.

Thus far, we understand the entrant is being harmed by the incumbent’s decision to limit price. In order to establish whether competition agencies should be concerned with limit pricing it is necessary to establish if competition itself was harmed. And the answer is: sometimes, but not always.

If the incumbent can limit price and still be profitable in this market, then there is no harm to competition. If the entrant were just as efficient as the incumbent, pricing below the competitive level but above cost should still allow the entrant to profitably operate in this market. The result is then lower prices and higher quantity, which raises consumer welfare and is in fact pro-competitive. In this case, the mere threat of entry was able to move this market to a better aggregate outcome.

However, if the limit price causes the incumbent to incur loss, then an equally efficient competitor would not be able to compete in this market, and therefore this strategy is harming competition itself and it becomes and antitrust matter, a violation of Sherman Act \S 2 as an attempt to monopolize or monopolization.

Notice that the threshold of cost involves the incumbent’s own cost and not the entrant’s, since the main issue here is whether competition and not a competitor is being harmed. It is also one of the hardest antitrust violations to prove, because it requires the premise that what started out as a strategic barrier to entry has somehow managed to become structural, and that the incumbent will be able to raise prices in the future for a non-transitory period of time and be able to recoup losses.

Bottom line, limit pricing is more likely to increase rather than diminish welfare. The market mechanisms in place make it so that even if the incumbent continues to be a monopolist, it has its market power capped by the threat of entry. It is certainly possible that it may go too far and constitute an antitrust violation, but even then it is perhaps too hard to prove.

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