Sylos-Labini’s Model of Limit Pricing

Prof. Prabha Panth,Osmania University,

Hyderabad

Prabha Panth 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.

Prabha Panth 3

Assumptions1. 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 4

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

5

D

D

LAC3 (small firm)

LUpper limit PL

LAC2 (medium firm)

LAC1 (large firm)

Lower limit Ps

Pm

Pn

0Qs QL QX

Qs

SYLOS-LABINI LIMIT PRICING

Prabha Panth 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 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 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.