Predatory pricing, also known as undercutting, is a pricing strategy in which a product or service is set at a very low price with the intention to achieve new customers (Loss leader), or driving competitors out of the market or to create barriers to entry for potential new competitors.
Theoretically, if competitors or potential competitors cannot sustain equal or lower prices without losing money, they go out of business or choose not to enter the business. The so-called predatory merchant then theoretically has fewer competitors or even is a de facto monopoly.
Predatory pricing is considered anti-competitive in many jurisdictions and is illegal under some competition laws. However, it can be difficult to prove that prices dropped because of deliberate predatory pricing, rather than legitimate price competition. In any case, competitors may be driven out of the market before the case is ever heard.
- 1 Concept
- 2 Legal features
- 3 Implementation conditions
- 4 Theories for controlling predatory pricing
- 5 Legal aspects
- 6 Criticism
- 7 Support
- 8 Examples of alleged predatory pricing
- 9 See also
- 10 References
- 11 External links
In the short term, predatory pricing through sharp discounting reduces profit margins, as would a price war, and will cause profits to fall. These two steps of are also called predation stage (offering goods/services below its costs in order of pricing its competitors out of the market); the second step is called recoupment stage ( this stage only arises in case the dominant firm succeeded with squeezing the competitors out of the market- within this stage the dominant firm charges monopoly prices in the effort to cover their losses). There are various tests to assess whether the pricing is predatory: Areeda-Turner suggests it is below Short Run Marginal Costs, the AKZO case suggests it is costing below Average Variable Costs, and the case of United Brands suggests it is simply when the difference in cost between the cost of manufacturing and the price charged to consumers is excessive. Yet businesses may engage in predatory pricing as a longer term strategy. Competitors who are not as financially stable or strong may suffer even greater loss of revenue or reduced profits. After the weaker competitors are driven out, the surviving business can raise prices above competitive levels (to supra competitive pricing). The predator hopes to generate revenues and profits in the future that will more than offset the losses it incurred during the predatory pricing period. This is known as recoupment, but two recent decisions by the courts, Tetra Pak II and Wanadoo stated that this is not necessary for a finding of predatory pricing.
This is a short-term strategy—the predator undergoes short-term pain for long-term gain. Therefore, for the predator to succeed, it must have sufficient strength (financial reserves, guaranteed backing or other sources of offsetting revenue) to endure the initial lean period. There must be substantial barriers to entry that prevent the re-appearance of competitors when the predator raises prices.
But the strategy may fail if competitors are stronger than expected, or are driven out but replaced by others. In either case, this forces the predator to prolong or abandon the price reductions. The strategy may thus fail if the predator cannot endure the short-term losses, either because of it requiring longer than expected or simply because it did not estimate the loss well.
So the predator should hope this strategy to succeed only when it is substantially stronger than its competitors and when barriers to entry are high. The barriers prevent new entrants to the market replacing others driven out, thereby allowing supra competitive pricing to prevail long enough to dwarf the initial loss.
The use of predatory pricing to capture a market in one territory while maintaining high prices in the suppliers' home market (also known as "dumping") creates a risk that the loss-making product will find its way back to the home market and drive down prices there. For example, when Dow Chemical exported competitively-priced bromine to Europe, the established German bromine cartel attempted to punish them by selling bromine in the US at half price (below manufacturing cost), which would prevent Dow from making any profit in the US. But Dow's founder Herbert Dow simply purchased the cheap German product and sold it back to Europe at a profit. Eventually the cartel worked out what was happening and ceased dumping their product, but by then Dow's company had acquired a base of customers in Europe and his US competitors had been forced out of business.
1. The principal part of predatory pricing is the operator in the seller's market, and the operator has certain economic or technical strength. This feature distinguishes it from price discrimination, which includes not only competition between sellers but also competition among buyers.
2. The geographical market of predatory pricing is the country's domestic market. This feature distinguishes it from "dumping". "Dumping" refers to the act of selling commodities in overseas markets at a lower price than the domestic market. It can be seen that these two have similarities in terms of "low-cost sales" and "exhaustion of competitors", but their differences are obvious.
(1) The scopes of application of the two are different. "Predatory pricing" applies to domestic trade, and "dumping" applies to international trade. ( 2) The standards for the identification of the two are different. "Predatory pricing" is based on cost, while "dumping" is based on the price applicable to the normal trading of domestic similar products.
(3) The laws applicable to both are different. "Predatory pricing" mainly applies to domestic laws, while "dumping" mainly applies to international treaties or the laws of other countries.
(4) The consequences of the two are different. Legal sanctions on “predatory pricing” are compensating damages or administrative penalties, while “dumping” is levying anti-dumping duties.
3. The objective performance of predatory pricing is to temporarily sell its goods or provide services in the market at a price lower than the cost. Its essence is that it would rather temporarily lose money, but also wants to squeeze its competitors out of a certain market to form an exclusive situation, and then sells goods and services at monopoly prices. This will not only make up for the losses caused by its low price sales, but also can seek high monopoly profits.
4. Predatory pricing actors' subjective intent is to try to squeeze out competitors in order to seek monopoly status. In practice, however, "predatory pricing" does not eliminate competitors as its direct purpose, but is likely to lure, persuade or threaten competitors to cooperate fully with them or cooperate with them in some monopolistic programs.
1.Sacrificing short-term profits
The economic theory of predatory pricing simply states that companies choose to make less profitable pricing in the short term, but it does not explicitly state that profits must be negative. In anti-monopoly law enforcement, how to determine what level of pricing is predatory pricing becomes a problem in operation. In the anti-monopoly law enforcement, a clear standard is: During the period of predatory prices, the predator's profit is negative, or the price is lower than the cost. But the question here is what kind of cost can be used as a reference. The use of a price that is lower than the cost may make certain predatory pricing practices not legally binding. According to the theory of industrial organization, some predatory pricing practices may not lose money in the short term. However, in this particular case, the company's ability to make low-cost profits can only indicate that the company is a high-efficiency company compared to its competitors. Non-entry of entrants does not necessarily reduce benefits, and entry of entrants does not necessarily improve welfare. Anti-monopoly law ignores this and does not result in major welfare losses. In summary, although below-cost pricing does not summarize all predatory pricing practices, the cost of law enforcement mistakes it brings along may be very small.
2.The ability of incumbent company to raise prices
An important condition for predatory pricing is that incumbent companies have the ability to raise prices after repelling competitors and compensate for short-term losses in predatory pricing. Obviously, to achieve this, it is required that incumbents have market power. Because in the free market, after the incumbent has driven the competitor out of the market, raising the price to monopoly price level is fundamentally unsustainable. The rapid entry of other companies will force the price down so that the predators will not be able to Withdrawing short-term losses from predatory pricing, predatory pricing is unlikely to occur. Thus, the market structure is an important factor in determining whether an enterprise can implement predatory pricing. In anti-monopoly law enforcement, the adoption of market dominance standards for predatory pricing behavior can reduce the mistakes of enforcement of anti-predatory pricing. In many cases, the establishment of low prices by non-dominant manufacturers is often a normal competitive behavior, and the dominant manufacturers with market dominance are often strategically excluded from the needs of competitors. Therefore, the anti-monopoly law should focus on the predatory pricing behavior of the dominant manufacturers that have a dominant market position. On the one hand, it will not crack down on the competitive price cuts of enterprises in normal competition and improve welfare; on the other hand, it will also reduce the anti-monopoly law enforcement burden and reduce enforcement costs.
Theories for controlling predatory pricing
Especially according to Easterbrook predatory pricing is rare, thus it should not be a central concern. Introducing laws for predation, especially because it is rare, could lead to generating false positive errors, which would interplay with the restriction of the rule. The main point within this argument is that government intervention is dispensable, as predation is unlikely to be successful, which leads itself to a deterrent effect. This effect results by selling the products/services below the costs, which causes losses but without getting more market power. The market power will not increase in this case, because the market share holder will weathers this predatory - strategy. Thus the firm punished itself by taking losses without gaining market power. This will serve as a deterrent for other firms. An additional argument against the implementation of rules is, the inability of courts or competition authorities to differentiate predatory from competitive prices.
Short-run cost-based rules
The short-run cost- based rules were proposed by Phillip Areeda and Donald Turner in 1975, and modified in 1978 as well as in 1982 ( Areeda) and in 1986 (Hovencamp) . The rules focusing the short term pricing conduct among fixed plants and refer those prices not to the purpose of the price-setter, but to the costs. The rules are based on short term focus, even when the predatory-pricing strategy is a long term strategy, because the long run would be inefficient, as it would be too speculative. In 1975 they established their first version, arguing that prices at or above reasonable expected average variable costs should be legal and prices below this level should be illegal. Moreover, Areeda and Turner would exclude the dominant firm from “meeting competition“, if this would lead to bringing its price below average variable cost. In the following years Areeda and Turner modified the rules in significant aspects, especially for prices which are above average variable costs - the previous standard of per se legality was superseded by the presumption of legality. Further pricing below average variable costs would mean a presumption of illegality. The prices above full cost remain unchanged per se legal The only exception they can see is the case where marginal costs substantially exceed average costs because the plant is greatly exceeding its capacity, a situation which would not harm equally efficient rivals and be so rare it could be ignored.
Long- term cost-based rule
1The long – term cost-based rule is established by Posner. He assumes that long-run marginal costs are a more reliable test of predation than short run costs. The reason is that the predator (who prices at short-run marginal cost), could eliminate a competitor, who has lack of ability to suffer losses in the short run. Posner argues too, that because of the hard determination of marginal costs, he would substitute average costs from the firms's balance sheet to establish a test which would relate to the full average costs based on the company's books. The test would include certain prerequisites, an intent element, as well as a defence. As a prerequisite Posner requires the plaintiff to demonstrate that the market was predestined for effective predatory pricing. As indicators Posner lists for instance that the predator operates in various markets, whereas the prey operates in less markets; concentrated market; slow entry; few fringe firms; homogenous products, numerous buyers. Posner would authorize the firm to defend because of changes in supply or demand, so that the respondent firm could price its products at short run marginal cost.
Rules governing price increases after predation
William Baumol proposed a long-term rule, seeking to avoid full reliance on cost-based tests. Baumol's rule would require any price cut made in response to entry to continue for a five-year period after exit (i.e. if an incumbent firm cuts its price to drive out an entrant, the incumbent firm is prevented from increasing price for five years). This rule significantly diminishes the incentive of a firm to engage in predatory pricing, since the predatory firm will be unable to reap the benefits of their anticompetitive behavior (monopoly profits). Baumol's proposed rule is not absolute, however. Baumol offers the predator some freedom to raise its post-exit price if the price increase is justified (e.g. by demonstrable changes in the firm's costs or market demand).
In many countries there are legal restrictions upon using this pricing strategy, which may be deemed anti-competitive. It may not be technically illegal, but have severe restrictions.
In 2007, amendments to the Trade Practices Act 1974 created a new threshold test to prohibit those engaging in predatory pricing. The amendments, labelled the 'Birdsville Amendments' after Senator Barnaby Joyce, penned the idea in s46 to define the practice more liberally than other behaviour by requiring the business first to have a 'substantial share of a market' (rather than substantial market power). This was made in a move to protect smaller businesses from situations where there are larger players, but each has market power.
Section 78(1)(i) of the Competition Act prohibits companies from the selling products at unreasonably low prices designed to facilitate or with the effect of eliminating competition or a competitor. The Competition Bureau has established Predatory Pricing Guidelines defining what is considered to be unreasonably low pricing.
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 affect not only 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. 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.
The US Department of Justice, however, claims that modern economic theory based on strategic analysis supports predatory pricing as a real problem, and claims that the courts are out of date and too skeptical.
Under Article 102 of the Treaty on the Functioning of the European Union, pricing below cost is prohibited where the seller has a dominant market position and the pricing will have an anti-competitive effect.
The Competition Act, 2002 outlaws predatory pricing, treating it as an abuse of dominant position, prohibited under Section 4. Predatory pricing under the Act means the sale of goods or provision of services, at a price which is below the cost, as may be determined by regulations, of production of the goods or provision of services, with a view to reduce competition or eliminate the competitors.
Article 10 of the Federal Law No.135-FZ ‘On the Protection of Competition’ (FLPC) (Russian: ст. 10, Федерального закона от 26.07.2006 N 135-ФЗ "О защите конкуренции") deals with unilateral conduct of economic entities by prohibiting abuse of dominant position. The definition of such abuse, as stated in the article, includes "the setting of an unjustified high or unjustified low price of a financial service by a financial entity".
All the matters connected with the abuse of the market power are handled by the Federal Antimonopoly Service of Russian Federation (FAS). The FAS investigates all alleged violations of the antimonopoly legislation and determines whether a dominant position has been exploited by one of the market participants.
The United Kingdom
Section 18(1) of the Competition Act 1998 prohibits the abuse of a dominant position by 'one or more undertakings ... if it may affect trade within the United Kingdom’. This is commonly known as the ‘Chapter II prohibition’. The section is very similar to article 102 of the Treaty on the Functioning of the European Union governing the anti-monopoly laws within the EU jurisdiction, with the exception of parts regarding the effect on trade within the UK.
Sections 19 and 20 of the Act against Restraints of Competition (ARC) prohibit the abuse of a dominant position. Section 19 lists in more detail the entities with market power addressed by the Act. Article 102 of the Treaty on the Functioning of the European Union also applies, although it has some differences with the ARC.
The European competition law art. 82 EC and § 5 KartG 2005 prohibit a market dominant enterprise, as well as a collective of several dominant enterprises, which intentionally suppressing a competitor or increasing their respective market share by using methods other than those of legal competitive performance. According to the law predatory pricing is in the one hand given if the market-dominat enterprise or enterprises controlling the local market, because it offers their products at prices, below their own average variable costs. In the other hand if the prices are below average total costs (fixed plus variable costs) but above average variable costs. If the market abuse is directed against the competitors, and not against suppliers and clients, the Austrian law provides provisions under § 1UWG (in connection with §5 para. 1 KartG 2005, if there is a competitive relationship)  Furthermore, according to §1UWG predatory pricing can be unconscionable, if it is intended to harm competitors – even without r own losses incurred. Moreover, predatory pricing can be unconscionable according to §1UWG if it the dominant firm expel the competitors from the market, in order to gain increasing marketshare and thus the ability to dictate prices.
According to §6, sec. 1, of the Competition Act (CA) entering into of anti-competitive agreements is prohibited. The CA §6 corresponds to art. 81, sec. 1 of the EC- Treaty and prohibit predatory pricing.
Generally, Art. 1 (1) of the antitrust law (I. 703/1977) prohibits all agreements between undertakings, decisions by associations of undertakings and concerted practices which focuses the prevention, restriction or the distortion of competition within the Greek market. Particularly art. 2(1) of I 703/77 prohibits predatory pricing within Greece.
According to Art. 81 of the EC Treaty and sec. 6 of the Swedish Competition Act (KL) agreements between undertakings, which have as their issue or effect to distort competition is prohibited. Thus agreements regarding prices are prohibited per se.
Compliance with the Act is enforced by the German Federal Cartel Office (FCO) (German: Bundeskartellamt). With the FCO as the higher federal authority, there also exist state cartels in each of the federal states in Germany. The FCO is in the area of responsibility of the Federal Ministry for Economic Affairs and Energy (German: Bundesministerium für Wirtschaft und Energie).
Some economists claim that true predatory pricing is rare because it is an irrational practice and that laws designed to prevent it only inhibit competition. This stance was taken by the US Supreme Court in the 1993 case Brooke Group v. Brown & Williamson Tobacco, and the Federal Trade Commission has not successfully prosecuted any company for predatory pricing since.
In addition, the predator's competitors know that it cannot keep its prices down forever, and thus need only to play chicken to remain in the market if they have the means to do so.
Thomas Sowell explains one reason 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. Both may be available-perhaps at distress prices-to others who can spring up to take the defunct firm's place.
- The Washington Post went bankrupt in 1933, though not because of predatory pricing. But neither its physical plant, its people, or its name disappeared into thin air. Instead, publisher Eugene Meyer acquired all three-at a fraction of what he had bid unsuccessfully for the same newspaper just four years earlier. In the course of time, the Post became the biggest newspaper in Washington.
Critics of laws against predatory pricing may support their case empirically by arguing that there has been no instance where such a practice has actually 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 also defeated a predatory pricing attempt by the 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. However, Dow simply instructed his agents to buy up at the very low price and 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. That is used as evidence that the free market is a better way to stop predatory pricing than regulations such as anti-trust laws.
In another example of a successful defense against predatory pricing, a price war emerged between the New York Central Railroad (NYCR) and the Erie Railroad. At one point, NYCR charged only a dollar per car for the transport of cattle. While the cattle cars quickly filled up, management were dismayed to find that Erie Railroad had also invested in the cattle-haulage business, making Erie a buyer of cattle transport, and was thus profiting from NYCR's losses.
- 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.
An article written by Thomas DiLorenzo and published by the Cato Institute suggests that while a company might be able to successfully price other firms out of the market, there is no evidence to support the theory that the virtual monopoly could then raise prices since other firms would rapidly be able to enter the market and compete. Such entering demands substantial capital investments, which would not be repaid for a long time because of sharp price decreases, provoked by resumption of competition.
Examples of alleged predatory pricing
- France Telecom/Wanadoo—The European Court of Justice judged that Wanadoo (now Orange Internet France) charged less than cost in order to gain a lead in the French broadband market. They have been ordered to pay a fine of €10.35m, which might be contested.
- According to an AP article a law in Minnesota forced Wal-Mart to increase its price for a one-month supply of the prescription birth control pill Tri-Sprintec from $9.00 to $26.88.
- According to a New York Times article the German government ordered Wal-Mart to increase its prices.
- According to an International Herald Tribune article, the French government ordered amazon.com to stop offering free shipping to its customers because it violated French predatory pricing laws. After Amazon refused to obey the order, the government proceeded to fine them €1,000 per day. Amazon continued to pay the fines instead of ending its policy of offering free shipping. After a law was created explicitly banning free shipping, Amazon effectively snubbed it by charging one cent for delivery.
- In the Darlington Bus War, Stagecoach Group offered free bus rides to put the rival Darlington Corporation Transport out of business.
- Herbert Henry Dow
- Price discrimination
- Robinson–Patman Act (US Federal law passed in 1936)
- Contestable market
- Limit price
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- Richard Craswell and Mark Fratrik, Predatory Price Theory Applied: The Case of Supermarkets vs. Warehouse Stores, 36 Case Western Reserve Law Review 1 (1986)
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- Thomas DiLorenzo. "The Myth of Predatory Pricing". Cato Institute. Archived from the original on February 23, 1997.
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- 3M Company FKA Minnesota Mining and Manufacturing Company v. LePage’s Incorporated, et al., U.S. Supreme Court No. 02-1865
- EU court upholds antitrust fine against France Telecom unit
- FTC Staff Concludes that Alabama Motor Fuels Marketing Act Restricts Competition, Re: The Alabama Motor Fuels Marketing Act
- Predatory Pricing Report