Bain’s Limit-Pricing Theory

Abstract

Bain formulated his limit-price’ theory in an article published in 1949,1 several years before his major work Barriers to New Competition which was published in 1956. His aim in his early article was to explain why firms over a long period of time were keeping their price at a level of demand where the elasticity was below unity, that is, they did not charge the price which would maximise their revenue.2 His conclusion was that the traditional theory was unable to explain this empirical fact due to the omission from the pricing decision of an important factor, namely the threat of potential entry. Traditional theory was concerned only with actual entry, which resulted in the long-run equilibrium of the firm and the industry (where P = LAC). However, the price, Bain argued, did not fall to the level of LAC in the long run because of the existence of barriers to entry, while at the same time price was not set at the level compatible with profit maximisation because of the threat of potential entry. Actually he maintained that price was set at a level above the LAC ( = pure competition price) and below the monopoly price (the price where MC = MR and short-run profits are maximised). This behaviour can be explained by assuming that there are barriers to entry, and that the existing firms do not set the monopoly price but the ‘limit price’, that is, the highest price which the established firms believe they can charge without inducing entry.