Oligopoly pricing, limit pricing

1. Sylos-Labini’s Model of
Limit Pricing
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. • This model is based on Price Leadership of the
large and most efficient firm in Oligopoly.
• Sylos Postulate: A Behavioral assumption
regarding expectation of new, potential
entrants.
a) New firms expect that old firms will not change
the P and Q. So its entry increases total Supply,
reduces the price.
b) Established firms assume that new firms will not
enter if fall in P < their own LRAC.
2Prabha Panth

3. Assumptions
1. Oligopoly with a price leader.
2. Market D curve is given, with unitary ed.
3. Homogeneous product,
4. Three firms – one small, one medium, one large.
5. Economies of scale – small firms have high AC,
large firms have lower AC (more efficient).
6. Large firm is the Price Leader, but allows small
firm to make profit.
7. Limit pricing to prevent entry of new firms.
Prabha Panth 3

4. Limit Price Fixation:
• Normal rate of profit earned by all firms.
Pi = ATC (1+r), where
Pi=minimum acceptable price for the ith size firm
ATC = Average total cost of ith size firm,
r = normal rate of profit
Prabha Panth 4

5. 5
D
D
LAC3 (small firm)
LUpper limit PL
LAC2 (medium firm)
LAC1 (large firm)
Lower limit Ps
Pm
Pn
0
Qs QL QX
Qs
SYLOS-LABINI LIMIT PRICING

6. • There are 3 firms of different sizes in this
oligopoly.
• LAC3 is of the smallest firm, has highest LAC, least
efficient.
• LAC1 of largest firm, most efficient, is the Price
Leader.
• Has to fix a price that earns some profits even for
the smallest firm.
– PL is the upper limit price and Ps is the lower limit
price.
– At PL, abnormal profits even for small firm (PL > LAC3)
Prabha Panth 6

7. • If new firms enter the industry, supply
increases,
• P falls to Ps, quantity to QX.
• New firms produce OQs = QLQX.
• New firms are small scale, with LAC3.
• P = Ps, so they earn only normal profits.
• This prevents their entry into the industry.
• After new firms withdraw, existing firms raise
the price back to PL.
Prabha Panth 7

8. • Criticism:
– New firms need not be small scale. Could be
large scale.
– Downward sloping D –curve, all types of
elasticity of demand exist.
– No empirical evidence.
– No reason why all firms should have constant
costs.
– Myopia of new firms, they should realise that
limit price will be set.
Prabha Panth 8