Limit pricing is the practice of setting a product or service price at a level just low enough to deter potential market entrants from competing in a market. A business engages in limit pricing when it wants to minimize the number of competitors. The price point chosen may not be the price at which a business earns the largest profit, but it does keep other companies out of the market.
Limit pricing must be inferred, since it is not an active monopolistic act; that is, other companies may enter the market as long as they are willing to accept the low price point or have other means of differentiating their products or services.
A company engaging in this behavior can also build excess capacity and let it be known that this extra capacity will be used to drive down prices further if any competitors have the temerity to offer competing products.
Advantages of Limit Pricing
The following is an advantage of the limit pricing method:
- Reduced competition. A sufficiently low limit price may leave the bulk of a market to a monopolistic company.
Disadvantages of Limit Pricing
The following are disadvantages of using the limit pricing method:
- Complacency. A company that successfully exercises limit pricing may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops with a new market entrant. Also, if the company does not keep its products and services at a sufficiently high level, someone could sidestep the limit price with a unique product or service offering.
- Illegal. Limit pricing is considered illegal in some government jurisdictions, so even giving the appearance of using limit pricing could trigger a lawsuit.
- Margins. A company imposing limit pricing is setting prices lower than the point at which it can maximize profits, so it may be giving away some profits on a per-unit basis.
Evaluation of Limit Pricing
Limit pricing is considered illegal in some jurisdictions, and may not be effective in keeping out a determined market entrant over the long term. However, it may be useful in the short to medium term in reducing the level of competition in a market.