Predatory pricing (also undercutting) is a pricing strategy where a product or service is set at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. 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 predatory merchant then has fewer competitors or is even a de facto monopoly.
In many countries predatory pricing is considered anti-competitive and is illegal under competition laws. It is usually 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.
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In the short term, predatory pricing through sharp discounting reduces profit margins, as would a price war, and will cause profits to fall. 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.
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 50 of the Competition Act, which criminalized predatory pricing, has been repealed and replaced by sections 78 and 79, which deal with the matters civilly.
Section 78(1)(i) of the Competition Act is 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.
Predatory pricing is illegal in the EU. It is prohibited under EU Competition Law to sell goods at a loss with the purpose of forcing other firms out of business.
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 them 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.
- Price discrimination
- Robinson–Patman Act (US Federal law passed in 1936)
- Contestable market
- Limit price
- Predatory pricing laws shock big operators\, ABC Australia, 2007-10-04, retrieved 2009-03-16
- Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 113 S. Ct. 2578, 2589 209, 1993
- Thomas DiLorenzo, "The Myth of Predatory Pricing," http://www.cato.org/pubs/pas/pa-169es.html
- Predatory prosecution - Forbes.com
- J. Gregory Sidak, Debunking Predatory Innovation, 83 COLUM. L. REV. 1121, 1121 (1983).
- Maury Klein. The Life and Legend of Jay Gould.
- Harold Demsetz, "The Economics of the Business Firm: Seven Critical Commentaries" p 147 http://books.google.com/books?id=vWZDJbZq4SUC&lpg=PA14
- R. Perman, "MBM Business economic notes." Chapter 7. Monopoly and barriers to entry. http://personal.strath.ac.uk/r.perman/tmba6.doc[dead link]
- "Wanadoo fined €10.35m for stifling competition". ComputerWeekly.com. Retrieved 2008-06-29.
- Target matches WalMart's drug cuts; state law limits discounts, Associated Press, September 29, 2007, retrieved 2009-03-16
- Germany Says Wal-Mart Must Raise Prices, New York Times, September 9, 2000, retrieved 2009-03-16
- Amazon.com is challenging French competition law, International Herald Tribune, January 14, 2008, retrieved 2009-03-16
- Areeda, Phillip E and Hovenkamp, Herbert (2002), Antitrust Law (2nd ed.), pp. 723–745
- Cabral, Luis M. B. (2000), Introduction to Industrial Organisation, MIT Press, p. 269
- Jones, Alison & Sufrin, Brenda (2007), EC Competition Law (3rd ed.), OUP, pp. 443–473
- McGee, John (April 1958), Predatory Price Cutting: The Standard Oil (N.J.) Case 1, Journal of Law and Economics
- Predatory Legislature, by William L. Anderson, Ph.D. Professor of Economics
- Predatory Pricing Laws: Hazardous to Consumers Health, by Donald J. Boudreaux, Ph.D. Economics
- Predatory Pricing: Strategic Theory and Legal Policy, Patrick Bolton, Ph.D. Professor of Finance and Economics
- Predatory Prosecution, by Thomas Sowell, Ph.D. Professor Emeritus of Economics
- The Myth of Predatory Pricing, by Thomas J. DiLorenzo, Ph.D. Professor of Economics
- 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