Limit pricing and cost signalling Flashcards
Explain the concept of limit pricing
An incumbent firm sets a low price (or produces a high quantity) to signal to potential entrants that the market is not profitable. Its essentially a signalling mechanism in which the incumbent can reveal its type (low-cost or high-cost) through its actions (output level) to deter or accommodate entry.
What is the two-period game in the context of limit pricing?
In the two-period game, Firm 1 (the incumbent) is in the market alone in period 1 and must decide on an output level. Firm 2 considers entering in period 2. The incumbent’s pricing or output in period 1 is used to signal its cost structure and deter entry.
What happens if the potential entrant, Firm 2, enters the market in period 2?
If Firm 2 enters in period 2, both firms engage in Cournot competition, where they choose quantities simultaneously to maximize profits, assuming the other firm’s quantity is fixed.
How are profits calculated in the two-period model?
Profits for the incumbent are collected in both periods and are a function of its cost and output. The entrant collects profit only in the second period. The Cournot and monopoly profits are considered in the calculations.
How does the incumbent’s cost structure affect its strategy?
A high-cost incumbent is better off retaining monopoly status in period 1, while a low-cost incumbent can deter entry by setting a quantity that would not be profitable for a high-cost firm, signaling its low-cost advantage.
What are the strategic implications of the incumbent’s actions in period 1?
The incumbent’s output level in period 1 signals to the potential entrant about its cost structure. This influences the entrant’s decision to enter the market and shapes the overall market dynamics.
