In oligopolistic markets each of the few large firms, whether they act collusively or singly, will appraise the barriers to entry that is the importance of the threat of potential entrants, and will set a price low enough to forestall entry.
If costs are the same for all established firms, they can arrive at the limit price sooner or later by independent action, via trial and error.
Collusion is not necessary if costs and efficiency are identical, although with collusive action the limit price will be arrived at quicker and with less danger of ‘spoiling the market’ by triggering off a price war.
However, if efficiencies differ among established firms, the limit price will be set by the most efficient, least-cost, firm.
The threat of potential entry, defined by the strength of barriers to entry, is crucial in pricing decisions. There is a recognized double interdependence between existing firms, and between them and potential entrants. The actual competition is taken into account either by various competitive devices (price, advertising, product style) if costs are similar and efficiencies the same, or via collusion, if costs and efficiencies differ between established firms. Potential competition is dealt with by charging the limit price.
We said that the estimate by the established firms of the strength of barriers is summarized in what Bain calls ‘the condition of entry’. Recall that this is defined as the percentage by which established firms can raise their price above the competitive level (Pc) without attracting entry
E = PL – PC / PC
where E = condition of entry
Pc = competitive price (= LAC)
PL = limit price
Rearranging the above formula we obtain
PL = Pc (1 + E)
In this form we see that the price limiting entry is determined by the competitive price (= the LAC of the most efficient firm) and the premium E which is a measure of the barriers to entry.
If entry is easy, barriers are non-existent (or negligible). Thus E = 0, and hence
PL = Pc = LAC
That is, if barriers are not present the price actually set will be the competitive price, which is equal to the LAC of the most efficient firm. If barriers exist E > 0 and hence
PL > PC
That is, the firms will be able to charge a price PL which will be higher than Pc and they will be earning abnormal profits (since PL > LAC), although these may be absorbed by higher selling costs or other inefficiencies which develop gradually if firms are protected behind high barriers from ‘outside’ competition.
The competitive level of price is equal to the LAC of the most efficient firm. The long- run-cost curve is L-shaped: long-run costs are approximately constant as the firm size exceeds the minimum optimal scale. The LAC (= Pc) includes a normal profit, that is, a normal return to capital, taking also into account any risk particular to the product and process employed by the firm. Thus E is a premium, a margin above the long-run competitive price.
In the real world, firms have differentiated products and different efficiencies. Firms have different demands and different costs. However, the industry concept can be maintained. The ‘industry’ includes products for which a stable relative price-quality pattern emerges. As Hicks and Samuelson have shown, such a group of products can be treated as one for demand purposes.
In practice it has been observed that there are products which can be classified within a ‘broad commodity group’ which may for all practical purposes be characterised as a distinct ‘industry’; because, in fact, there is a tendency for the pattern of production (within such a broad commodity group) to stabilize in settled conditions into a conventional product-pattern with a corresponding conventional price-pattern. Of course, the price-quality pattern will not in fact remain strictly stable, but the degree of stability is adequate to justify the retention of the ‘industry’ concept and to proceed in analysis on a partial equilibrium approach.
Thus in equilibrium the price is not unique. There is a cluster of prices reflecting the differences in product-quality and costs. Under these conditions the ‘condition of entry’ (E) may be measured specifically as the maximum gap between price and the minimal cost of the most efficient firm(s) at which entry is forestalled
The condition of entry (E) is measured by the long-run gap between minimal cost and price which the most favoured firms can reach without attracting entry. (Bain, Barriers to New Competition). The less efficient firms will be making ‘concurrent price elevations’. The entry-gap between price and minimum cost will be the one observed when all established firms elevate their prices concurrently by similar amounts or proportions, maintaining any customary competitive price differentials. (Bain, Barriers to New Competition).
There are many potential entrants. But the one that is crucial for the pricing decision of the established firms is the potential firm with the lowest costs as compared with the other potential entrants. Thus the relevant entrant is the ‘most-favoured’ entrant in the sense that he has the lowest costs and thus will be the first to enter once the price-cost difference is sufficient to grant him a profitable existence.
In summary, the price is set by the firm which has the lowest cost. This firm acts as the leader, and sets the price at a level adequate to forestall entry. The less efficient firms will be followers. Prices may differ to reflect traditional product differences. But the price-cluster is formed on the basis of the entry-preventing policy of the most-favoured leader-firm.