Definition: Limit price is a pricing strategy in which a monopoly is selling its products below the average cost of production to discourage the entrance of new competitors in the market.
What Does Limit Price Mean?
What is the definition of limit price? Monopolists may realize extremely high profits because lacking competition they set their profit maximization level very high. However, this practice attracts new competitors that wish to enter the market and acquire a market share of the higher profits.
Therefore, monopolies implement a pricing strategy that practically limits their prices below the profit maximization level, but there are still able to realize a profit against competitive firms. Moreover, they are increasing their output to a level that a new firm would not consider entering with such unprofitable conditions.
Let’s look at an example.
Example
Company X and Company Z compete for the electricity market segment. Company X is already in the market, realizing a monopolistic profit. Company Z has collected all the necessary information and is considering entering the sector.
Company X sets its prices below the monopolistic price, i.e. below the profit maximization price where marginal revenue = marginal cost or threatens to lower its prices to discourage Company Z from entering the market. In addition, it increases the output so that consumers have no alternative but to cover their electricity needs from Company X. Under these circumstances, Company Z is reconsidering entry to the market because Company X eliminates the potential for future profits by selling at such low prices.
The only drawback of a limit price strategy is that, after a point, the threat of a lower price or a higher output or both, ceases to be a threat because competitors know that this is a strategy to deter them from entering the market. For the limit price strategy to be effective, the monopoly should produce a certain quantity whether entry occurs or not.
Summary Definition
Define Limit Price: Limit price means a monopolistic business strategy where goods are priced lower than market value in an effort to put competitors out of business.
