Predatory pricing

Predatory pricing is the practice of a dominant firm selling a product at a loss in order to drive some or all competitors out of the market, or create a barrier to entry into the market for potential new competitors. The other firms must lower their prices in order to compete with the predatory pricer, which causes them to lose money, eventually driving them from the market. The predatory pricer then has fewer competitors or even a monopoly, allowing it to raise prices above what the market would otherwise bear.

In many countries, including the United States, predatory pricing is considered anti-competitive and is illegal under antitrust laws. However, it is usually difficult to prove that a drop in prices is due to predatory pricing rather than normal competition, and predatory pricing claims are now quite difficult to prove due to high legal hurdles designed to protect legitimate price competition.

The concept of predatory pricing

Predatory pricing through sharp discounting is not beneficial to a business in the short run, as it may result in a price war and will cause loss of revenue and/or profits. Yet businesses may engage in predatory pricing because it may pay dividends in the long run.

This is because competitors who are not as financially strong as the predator will suffer even more, either due to loss of business or reduced profit margin caused by the aggressive price competition. The predation continues until the competitor is driven to failure and forced to leave the market. After the weaker competition has been driven out, the surviving business can raise prices above competitive levels (to "supra competitive pricing"). The business hopes to thereby reap revenues and profits that will more than offset the losses during the predatory pricing period.

In essence, the predator undergoes short-term pain for long-term gain. The predator, to succeed, must therefore have sufficient strength (financial reserves) to endure the initial lean period.

The strategy may fail, however, if targeted competitors are not as weak as expected, or if competitors driven out are replaced by other competitors. In either case, this forces the predatory pricing period to become prolonged until possibly even the predator itself is forced to forfeit the expected gain.

Therefore, this strategy could only hope to succeed either when the predator is substantially stronger than the competition, or when barriers to entry of new competitors are high. Such barriers will prevent new entrants to the market from replacing others driven out, thereby allowing the supra competitive pricing to prevail for a sufficient period of time to more than make up for the short-term losses incurred by the predator.

Legal aspects of predatory pricing

In many countries legal restrictions may preclude this pricing strategy, which may be deemed anti-competitive. In the United States predatory pricing practices may result in antitrust claims of monopolization or attempts to monopolize. Businesses with dominant or substantial market shares are more vulnerable to antitrust claims. However, because the antitrust laws are ultimately intended to benefit consumers, and discounting results in at least short-term net benefit to consumers, the U.S. Supreme Court has set high hurdles to antitrust claims based on a predatory pricing theory. The Court requires plaintiffs to show a likelihood that the pricing practices will not only affect rivals but also competition in the market as a whole, in order to establish that there is a substantial probability of success of the attempt to monopolize. (Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 113 S. Ct. 2578, 2589 (1993) ^*. If there is a likelihood that market entrants will prevent the predator from recouping its investment through supra competitive pricing, then there is no probability of success and the antitrust claim would fail. In addition, the Court established that for prices to be predatory, they must be below the seller's cost.

In Canada, Section 50(1)(c) of the Competition Act prohibits companies from selling products at unreasonably low prices which is either designed or has the effect of eliminating competition or a competitor. Section 50(1)(b) of the Act prohibits selling products in one area of Canada at prices lower than in another are with the intent or the effect of eliminating competition or a competitor. The Bureau of Competition has established Predatory Pricing Guidelines defining what is considered to be unreasonably low pricing.

Criticism of the theory of predatory pricing

Some economists claim that true predatory pricing is rare because it is an irrational practice, and laws designed to stem the practice only inhibit competition. This stance was taken by the US Supreme Court in the 1993 case Brooke Group v. Brown & Williamson Tobacco, and the FTC has not successfully prosecuted any company for predatory pricing since.

Proponents of the theory that predatory pricing is irrational point to the fact that it must be a larger firm that engages in the practice, in order to be able to withstand the losses longer than its competitors. However, a larger firm will lose more money when it drops its prices below cost, because it has a larger market share with which to begin. This, however, doesn't address the scenario where a large company attempts to break into a new market. Furthermore, it will not be able to recoup these losses because when it raises its prices to high levels, it provides a strong incentive for another firm to re-open the market and undercut it.

In addition, the competitors of a firm that engages in predatory pricing know that the predatory pricer cannot keep down their prices forever, and thus they must only play chicken in order to remain in the market.

Thomas Sowell explains why predatory pricing is unlikely to work:

Obviously, predatory pricing pays off only if the surviving predator can then raise prices enough to recover the previous losses, making enough extra profit thereafter to justify the risks. These risks are not small.

However, even the demise of a competitor does not leave the survivor home free. Bankruptcy does not by itself destroy the fallen competitor's physical plant or the people whose skills made it a viable business.^* The major assuption made here is that the shutdown competitors can spring back into business immediately after prices rise enough to make business profitable again. If the bankrupt business's equipment is sold, and the employees are now employed elsewhere, new competition will face the normal barriers to entry in the market.

Critics of the predatory pricing theory support their case empirically by arguing that there has been no instance where such a practice has led to a monopoly. Conversely, they argue that there is much evidence that predatory pricing has failed miserably. For example, Herbert Dow not only found a cheaper way to produce bromine, but he defeated a predatory pricing attempt by a government-supported German cartel, Bromkonvention, who objected to his selling in Germany at a lower price. Bromkonvention retaliated by flooding the US market with below-cost bromine, at an even lower price than Dow's. But Dow simply instructed his agents to buy up at the very low price, then sell it back in Germany at a profit but still lower than Bromkonvention's price. In the end, the cartel could not keep up selling below cost, and had to give in. This is used as evidence that the free market is a better way to stop predatory pricing than government regulation such as anti-trust laws.^*

Thomas Sowell argues:

It is a commentary on the development of antitrust law that the accused must defend himself, not against actual evidence of wrongdoing, but against a theory which predicts wrongdoing in the future. It is the civil equivalent of "preventive detention" in criminal cases — punishment without proof.^*

Support for the theory of predatory pricing

Since the early 1980s, economic models based on game theory and the theory of imperfect information have suggested that predatory pricing can be rational and profitable under certain circumstances. For instance, by increasing production and lowering costs below price, a firm may convince its competitors that it has a lower cost of production than them, causing them to leave the market based on the conclusion that it would not be profitable for them to compete; this is known as low-cost signalling. Also, by pricing aggressively the incumbent firm will acquire a reputation for being "tough", this may deter potential entrants in the future. Another explanation for predatory pricing may be where long term success will require a large market share from early on (e.g. market for computer operating systems), usually markets with significant switching costs. By pricing aggressively to start with, even pricing below cost, firms can ensure a base of customers in the future from whom to make a profit.

However, to date, no empirical example has yet been demonstrated of successful predatory pricing practice by a corporation.

External links

DiLorenzo, Thomas. The Myth of Predatory Pricing Cato Institute Policy Analysis No. 169 (1992) Executive Summary
Australian Competition and Consumer Commission page on predatory pricing: http://www.accc.gov.au/content/index.phtml/itemId/322986
Predatory Pricing, a New Theory: http://econserv2.bess.tcd.ie/SER/1999/essay02.html
Patrick Bolton, Princeton University (see paper "Predatory Pricing: Strategic Theory and Legal Policy"): http://www.princeton.edu/~pbolton/
Features: Herbert Dow and Predatory Pricing
Canada Bureau of Competition, Predatory Pricing Enforcement Guidelines: http://www.competitionbureau.gc.ca/internet/index.cfm?itemID=1746&lg=e
Federal Trade Commission Letter to Alabama House of Representatives, states government's position on predatory pricing issues: http://www.ftc.gov/be/v040005.htm
Brief of the United States as amicus curiae in 3M v. LePage's U.S. Supreme Court case http://www.ftc.gov/os/caselist/3mvlepage/040602amicusbrief.pdf

References

Areeda, Phillip and Turner, Donald F. , "Predatory Pricing and Related Practices Under Section 2 of the Sherman Act", Harvard Law Review, Vol. 88, p. 697 (1975).
Areeda, Phillip E. and Hovenkamp, Herbert, Antitrust Law, pp. 723-745 (2nd Ed. 2002)
Cabral, Luis M. B., Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000, p. 269
McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958)

Anti-competitive behaviour