In limit pricing models a dominant firm maximizes its profits by chosing a price that is low enough to discourage some but perhaps not all entrants into the market. If the entry price of each prospective firm is clearly defined then the theory of limit pricing is simple.
Consider first the case of a homogeneous good. Let EPi be the entry price of the i-th firm. Let Q(P) be the demand function for the good at price P. For simplicity at this point let us assume that if there are n firms in the market each will get 1/n of the sales.
Given this dependence of sales upon the price one can construct the relationship between profit and price. This relationship might be as shown below.
In this case the firm would maximize profits when it sets its price just below the entry price of a second firm. It would then be the only seller in the industry and thus technically a monopoly but not a monopoly that is detrimental to the economy.
It may be that the relationship between profit and price is as is shown below.
In this case the firm would price just below the entry price of a third firm thereby allowing the second firm to enter the market but keeping the third firm out.
(To be continued)
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