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Subject ECONOMICS ____________________________________________________________________________________________________ Subject ECONOMICS Paper No and Title 3 : Fundamentals of Microeconomic Theory Module No and Title 34 : Bain’s Limit Pricing Theory Module Tag ECO_P3_M34 ECONOMICS PAPER No. : 3- FUNDAMENTALS OF MICROECONOMIC THEORY MODULE No. : 34- BAIN'S LIMIT PRICING THEORY ____________________________________________________________________________________________________ TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3. Bain’s Theory of Limit Pricing 4. Diagrammatic Representation of the Limit Pricing Model 5. Bain’s Limit Pricing and Price Elasticity of Demand 6. Summary ECONOMICS PAPER No. : 3- FUNDAMENTALS OF MICROECONOMIC THEORY MODULE No. : 34- BAIN'S LIMIT PRICING THEORY ____________________________________________________________________________________________________ 1. Learning Outcomes After studying this module, you shall be able to Know the concept of Limit Pricing Know the concept of collusive oligopoly Why collusive oligopoly tries to maximize long run profits? 2. Introduction So far we have seen the price determination under different market structures i.e. perfect competition, monopoly, monopolistic competition and oligopoly. In the perfect competition and the monopolistically competitive market structure, we have studied the effects of actual entry of new firms on the price and output decisions of the existing firms. But in monopoly and oligopoly market structures, the existing firms do not worry about the potential entry of new firms. The traditional closed oligopoly models like Cournot, Bertrand, Edgeworth and Chamberlin do not provide for entry of new firms. Under oligopoly, the number of firms assumed to be constant. It is only the reaction behavior of the existing firms to the moves of the rival is explained. But recently it has been argued by several economists that the price and output decisions of the existing firms in oligopolistic markets are affected not only by the potential entry of the firms but by the actual entry as well. The prominent economists of these findings are Bain, Sylos-Labini, Andrews, Modigliani, and Jagdish Bhagwati. Another issue that has been raised by these economists is that the objective of the firm under oligopoly is not to maximize the short run profits but to maximize the profits over the long run. The oligopolistic firm seeks to maximize the profits over the long run after allowing the entry of potential firms that affect the possibilities of profit. J. S. Bain in his pioneering work ‘A note on pricing in oligopoly and Monopoly (1949) followed by his book ‘Barriers to New Competition’ developed the theory of limit pricing. According to him, limit theory implies that firms do not maximize profit in short run because of the fear of excessive profit which induces the entry of new firms and thus reducing the profits in the long run. According to him, the oligopolistic firms do not charge the price that is equal to the short run profit maximizing price but charges a lower price so as to prevent the entry of new firms in the industry. The theory of limit pricing is also known as entry preventing pricing. The theory of Bain’s limit pricing has been further developed by Sylos-Labini, Modigliani and Jagdish Bhagwati. Let us study the theory of limit pricing in detail. ECONOMICS PAPER No. : 3- FUNDAMENTALS OF MICROECONOMIC THEORY MODULE No. : 34- BAIN'S LIMIT PRICING THEORY ____________________________________________________________________________________________________ 3. Bain’s Theory of Limit Pricing J. S. Bain in his pioneering work ‘A note on pricing in oligopoly and Monopoly (1949) followed by his book ‘Barriers to New Competition’ developed the theory of limit pricing. The theory explains as to why firms do not set the price following the marginal principle rule. According to Bain, the price is not set at the minimum point of long run average cost curve. He explained that the firms are deliberately set a price above the minimum of long run average cost in order to restrict the potential entry of new firms. Thus, 'limit price' was the highest price, which the established firms believed they could charge without inducing further entry. This price may be lower than the price set by the profit maximizing firm. This theory basically related to the case of collusive oligopoly firm. According to Bain, The limit price is determined by the The cost of the potential entrants, Market size where firms are operating The number of established firms in the industry Price elasticity of demand for the industry product and The shape of the long run average cost Curve. Assumptions: The Bain's model of limit pricing is based on some assumptions:- i. There are some established firms in the industry. ii. The market demand curve for the product is not affected by price adjustment by the existing firms or by the entry of new firms in the industry. iii. There is effective collusion among the firm which is based upon the dominant leader firm. iv. There are long run price and output adjustments. v. The leader firm fixes the limit price below which entry will not take place. vi. The other firms in the group follow unified price policy. vii. The established firms seek the maximization of their own long run growth. Under Bain's Model, he defined the limit price model as the condition for entry. The condition for entry is defined as a percentage by which established firm can increase the price above the competitive price without attracting the entry of new firms into the industry. The conditions for entry can be expressed mathematically as 푃 − 푃 퐶 = 퐿 퐶 푃퐶 Or 푃퐿 = 푃퐶(1 + 퐶) Where 푃퐿 is the limit price 푃퐶is the perfectly competitive price ECONOMICS PAPER No. : 3- FUNDAMENTALS OF MICROECONOMIC THEORY MODULE No. : 34- BAIN'S LIMIT PRICING THEORY ____________________________________________________________________________________________________ C is the percentage which the established firms may get. Suppose the firm’s sets the limit price푃퐿above the competitive price푃퐶, then each firm would earn super normal profit as price is more than average cost. If price is equal to average cost then firms are earning only normal profits. Thus, C is the percentage or a premium above competitive price which the existing firms earn by fixing the higher limit price 푃퐿. Bain assumed that the condition of entry of new firm involved for which time period which is long enough. This time period depends upon the changing conditions of demand and input prices. The more the time a firm takes to establish itself, the lesser the degree of threat posed by its entry. So, there exist a wide gap between the limit price and competitive price. This gap between competitive price and limit price is known as entry barrier or entry gap. Entry Barriers: The condition of entry by which the established firm can charge higher price as compared to the competitive price depends on the presence of various barriers to entry. The major sources of entry barriers are:- i. Product Differentiation ii. Economies of Scale iii. Absolute Cost Advantage of Established Firms iv. Large Initial Capital Requirements v. The Minimum Scale for the Efficient or Optimum Production. Let us study them in detail. i. Product Differentiation: The product differentiation gives an individual firm an advantage in terms of degree of control over the price of their product. The new entrant cannot produce the same identical product as produced by the established firms. An entrant is at a disadvantage because she has to make her product known and attract some customary buyers from the established firms. As a result, the new firm has to sell at a lower price or spend more on advertising or undertake both. Hence, the cost of the new entrant goes up. ii. Economies of Scale: There are three reasons for internal economies of scale and one of them was given by Adam Smith. a. Division of Labor and Specialization: In short run when we have some fixed factors with variable factors then by expanding variable factors alone (say number of workers) reduces the opportunities for specialization and division of labor. In this situation marginal product rises, quickly reaching its maximum and declines thereafter. But when fixed and variable factors expanded together then certain economies of scale are reaped by specialization and division of labor. If the capacity of plant is small then it is ECONOMICS PAPER No. : 3- FUNDAMENTALS OF MICROECONOMIC THEORY MODULE No. : 34- BAIN'S LIMIT PRICING THEORY ____________________________________________________________________________________________________ employing small number of workers and each workers have to perform several task in the process of production. So, he would not be able to specialize in one task as he will be engaged in several tasks together. But the scenario would be different if the size of the plant is bit large. As plant size is large it can employ large number of workers and this will allow each worker to specialize in one task and reduce the unit cost of production. b. Technological Factors: When firm increases its scale of operations, then it is possible to have more technically efficient forms of all factors. The cost of purchasing larger machine is usually proportionately less in comparison to smaller machines. For example a printer that can print 100000 papers per day does not cost 10 time as one that prints 10000 per day and nor does it require 10 times more worker and so on. Expanding usage of technological factors reduces unit cost of production. c. One Time Cost: This is the third source of increasing returns to scale where even in long run inputs do not have to be increased as the output of a product increases, for example, Research and Development cost to design a new product is incurred only once for each product. So the average total cost falls as the output increases. The effect of onetime costs is that, they cause an average costs to fall over an entire range of output.
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