Optimal control in limit pricing under uncertain entry

Abstract

The limit pricing theory (Friedman 1979, Gaskins 1971, Kamien and Schwartz 1971) proposes a control theory model of determination of an optimal entry preventing price by a supplier of a market when potential entrants exist and it may not be optimal to maximize immediate or short term profits. The supplier here may be a firm or a cartel comprising a group of tacitly cooperating firms. This is often referred to as a dominant firm, since the potential entrants, sometimes appearing as a composite rival, have in general a smaller share of the total industry market. For the dominant firm or cartel, the optimal policy must balance high short term profits associated with the pursuit of monopoly pricing against the loss of long term profits due to entry of additional suppliers attracted by the high price.