Introduction
Predatory pricing is a controversial strategy where a company sets its prices below cost to eliminate competitors, establish market dominance, and then raise prices to recoup losses. While some see it as aggressive competition, others view it as anti-competitive behavior that harms consumers in the long run. In this article, I will explore predatory pricing, its economic and legal implications, real-world examples, and mathematical models to determine its impact.
Table of Contents
Defining Predatory Pricing
Predatory pricing occurs when a firm intentionally lowers its prices to drive competitors out of the market. This strategy usually unfolds in two phases:
- Market Undercutting: The dominant firm incurs losses by setting prices below cost.
- Recoupment Phase: Once competition is eliminated, the firm raises prices to monopolistic levels.
For predatory pricing to succeed, the firm must have deep financial resources to withstand losses while competitors struggle.
Legal Framework and Antitrust Laws
In the U.S., predatory pricing falls under antitrust regulations, primarily governed by the Sherman Act (1890) and the Clayton Act (1914). The Federal Trade Commission (FTC) and the Department of Justice (DOJ) investigate claims of predatory pricing.
To establish predatory pricing legally, two key elements must be proven:
- Below-Cost Pricing: The firm must set prices below an appropriate measure of cost.
- Recoupment Possibility: The firm must have a high probability of recouping losses by charging supra-competitive prices later.
Economic Models of Predatory Pricing
Predatory pricing can be analyzed through various economic models, such as the Areeda-Turner Test, Long-Purse Theory, and Game Theory Models.
The Areeda-Turner Test
Areeda and Turner (1975) proposed a cost-based test to determine predatory pricing. They argued that any price below the marginal cost should be considered predatory. However, since marginal cost is difficult to measure, average variable cost (AVC) is often used as a proxy:
where:
- = Average Variable Cost
- = Total Variable Cost
- = Quantity produced
If a firm’s price falls below AVC, it may indicate predatory pricing.
Long-Purse Theory
This theory suggests that financially strong firms can engage in predatory pricing because they can sustain losses longer than their competitors.
Game Theory and Strategic Entry Deterrence
Game theory helps analyze predatory pricing through the concept of strategic deterrence. Consider a two-player game where Firm A (dominant firm) and Firm B (new entrant) compete.
If Firm A prices low, Firm B must decide whether to exit or compete. If Firm B exits, Firm A raises prices later, demonstrating a classic sequential-move game.
Real-World Examples of Predatory Pricing
Several high-profile cases illustrate predatory pricing:
Amazon and E-Books (2010s)
Amazon sold e-books at a loss to capture market share from competitors like Barnes & Noble. Publishers argued that this behavior threatened competition, leading to lawsuits and regulatory scrutiny.
Walmart’s Local Pricing Strategies
Walmart has been accused of pricing below cost to drive out local retailers in smaller markets.
Impact of Predatory Pricing
The impact of predatory pricing can be analyzed in both the short-term and long-term.
| Impact | Short-Term Effects | Long-Term Effects |
|---|---|---|
| Consumers | Lower prices, increased purchasing power | Higher prices once competition is eliminated |
| Competitors | Financial losses, potential bankruptcy | Industry consolidation, fewer choices |
| Market | Increased price competition | Monopolistic pricing, reduced innovation |
Identifying Predatory Pricing: Key Indicators
Regulators use several indicators to detect predatory pricing:
- Sustained Below-Cost Pricing: Consistently pricing below AVC.
- Intent to Eliminate Competitors: Internal documents revealing anti-competitive intent.
- Market Entry Barriers: High barriers preventing new entrants after predation.
Mathematical Example of Predatory Pricing Strategy
Consider a scenario where Firm A incurs losses to push Firm B out.
- Firm A’s cost structure:
- Fixed Cost (FC) = $100,000
- Variable Cost per unit (VC) = $5
- Quantity (Q) = 20,000 units
- Average Variable Cost (AVC) = $5
- Firm A’s aggressive pricing strategy:
- Selling price per unit (P) = $4
- Total Revenue (TR) =
- Total Cost (TC) =
- Profit (Loss) =
This loss may be acceptable for Firm A if it expects to eliminate Firm B and later raise prices.
Defending Against Predatory Pricing
Businesses can adopt various defensive strategies:
- Efficiency-Based Competition: Enhancing operational efficiency to sustain lower prices.
- Legal Action: Filing antitrust complaints with regulatory bodies.
- Product Differentiation: Creating unique value propositions to avoid price wars.
Conclusion
Predatory pricing remains a contentious issue in business and economics. While it provides temporary consumer benefits, it often results in long-term monopolistic practices that harm the market. Understanding the legal and economic perspectives helps businesses and policymakers navigate this complex issue. Firms must balance competitive pricing with ethical business practices to ensure a healthy marketplace.
