Bains limit pricing model:
Bain formulated his 'limit-price' theory in an article published in 1949. The theory explains as to why firms do not set the price following MR = MC principle, at a level where MR < 0. He concluded that traditional theory failed to explain this because it suppressed an important factor in the pricing decision, namely, the threat of potential entry. Traditional theory was concerned with actual entry, which resulted in the long-run equilibrium of the firm and industry. Bain argued that price was not set at the minimum point of LAC. His explanation was that the firms deliberately set a price above minimum LAC in order to keep the potential entrants away. Thus, 'limit price' was the highest price, which the established firms believed they could charge without inducing entry.
Bain considers entry as the establishment of a new firm, which builds or introduces new productive capacity that was not used for production in the industry before. The 'condition of entry' was defined as the margin by which established firms could raise their price above the competitive price level persistently without attracting entry. That is,
where = PL limit price.
PC = competitive price under pure condition.
E = 'Condition of entry'.It is the premium accruing to the established firms in an industry from charging a price PL > PC.
Bain distinguishes four main barriers to entry - product differentiation barrier, absolute-cost advantage of established firms, economies of scale and large initial capital requirements. In addition to these, there could be legal barriers. These are exogenous and if they exist, firms can charge any price without the fear of attracting new entrants. In the analysis, we would deal with first four barriers only.
Product-differentiation Barrier:
The preference of buyers, attached to various existing brands, creates barriers to the entry of a new firm. An entrant is at a disadvantage because she has to make her product known and attract some customary buyers from the established firms. As a result, the new firm has to sell at a lower price or spend more on advertising or undertake both. Hence, the cost of the new entrant goes up.