Limit Pricing and the Banking Industry

Abstract

A MAJOR ADVANCE in the theory of imperfect competition has been the recognition that established firms may take into account possible actions by potential as well as by existing competitors. In particular, the theory of limit pricing suggests that established firms in imperfectly competitive markets may limit the prices they charge in order to deter market entry by potential competitors. The mere existence of potential entrants thus has a procompetitive effect on the market, to the extent that established firms opt to limit prices below those that they would otherwise charge. Although the importance of the limit-pricing hypothesis to antitrust policy has been recognized for some time, direct tests of it have not been forthcoming. This is not surprising, given the extreme difficulty in obtaining a direct measure of the threat of entry relevant to the limit-price decision. In addition to an appropriate theoretical framework, such a task requires knowledge of the potential entrants relevant to each limit-price decision. In most industries, such information is not available, and even if it were, the lack of variability in the number and type of potential entrants facing limit pricers would make empirical investigation impossible. These problems, however, are much less severe in certain areas of the banking industry. In states that allow branch banking, entry into local banking markets often