Predatory pricing

From Academic Kids

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 bankrupt. The predatory pricer then has fewer competitors or even a monopoly, allowing them to raise their prices above what the market would otherwise bear.

In many countries, including the United States, predatory pricing is considered an anti-competitive practice 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.

Contents

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 they drop their prices below cost, because they have a larger market share to begin with. Furthermore, they will not be able to recoup these losses because when they raise their prices to high levels, it provides a strong incentive for another firm to re-open the market and undercut them.

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

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 incumbant 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 to make a profit from.

External links

Reference

  • Luis M. B. Cabral: Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000, page 269.
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