ABSTRACT

To deter entry, the monopolist must lower its price sufficiently to ensure that the potential entrant's residual demand curve lies everywhere below the potential entrant's average cost curve. Also, following a strict short-run profit-maximizing strategy is likely to result in the entry of new firms or the capacity expansion of smaller established firms, not to mention the loss of market share to close substitute products. This chapter develops a model to explain why rational firms may adopt a limit pricing policy. Limit pricing theory begins with the logical assumption that rational firms should maximize long-run, not short-run, profits. In the original limit pricing models, one critical assumption was the Cournot assumption that the monopolist would maintain its output even after entry occurred. Potential entrants gain some information from observing the behavior of the monopolist, but initially, they do not know whether they are facing a strong or weak monopolist.