Predatory pricing

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Predatory pricing (also known as destroyer pricing) is the practice of a firm selling a product at very low price with the intent of driving competitors out of the market, or create a barrier to entry into the market for potential new competitors. If the other firms cannot sustain equal or lower prices without losing money, they go out of business. 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 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 difficult to prove due to high legal hurdles designed to protect legitimate price competition.

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[edit] Concept

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. Therefore, for the predator to succeed, either it must have sufficient strength (financial reserves or other sources of offsetting revenue) to endure the initial lean period, or there must be substantial barriers to entry of other competitors.

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. The strategy may also fail if the predator is not able to endure the short-term losses for as long as it expected.

Therefore, this strategy could hope to succeed only 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.

[edit] Legal aspects

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 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.[1] 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 to facilitate, 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 area 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.

In Australia, recent amendments to the Trade Practices Act 1974 in 2007 have created a new threshold test to prohibit those engaging in predatory pricing. The new amendments (labelled the 'Birdsville Amendments' after the pub Senator Barnaby Joyce penned the idea: Predatory pricing laws shock big operators) to s46 define the practice more liberally than other behaviour by requiring the business first 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. It has been criticised as preventing (through legal bureaucracy) large businesses removing old stock, offering discounts (such as fuel discounts and 'shopper dockets').

[edit] Criticism

Some economists claim that true predatory pricing is rare because it is an irrational practice and that 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 Federal Trade Commission has not successfully prosecuted any company for predatory pricing since.

Proponents of the theory that predatory pricing is irrational[citation needed] argue 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.

Opponents of the theory argue that this 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.[2]

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 need 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. 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. [3]

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 also 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, though it should be noted that in this example the item—bromine—is a commodity as opposed to a value-added product, and that neither branded items such as athletic shoes or automobiles nor services such as dentistry or health care could be purchased and resold in the same way.

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 shipment of cattle. While the cattle cars quickly filled up, management was dismayed to find that Erie Railroad had also invested in the cattle-shipping business.[4]

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.[5]

[edit] Support

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 price below costs, a firm may convince its competitors that it has achieved a lower cost of production than them—the competitors will see the firm's high volume and low price and may believe that the firm's price is not below its costs but rather the firm's costs are low because of its high volume—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 signaling. Also, by pricing aggressively the incumbent firm will acquire a reputation for being "tough", this may deter potential entrants in the future.[citation needed]

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. Moreover, the criticism of predatory pricing theory suggests that competition will come flooding back in to profit from the irrational market pricing. This view is based on conventional market economics, but it overlooks that there may barriers to entry or other significant transaction costs that cannot be borne by smaller competitors in the short run or in some cases even in the long run.[citation needed]

Moreover, most criticism of predatory pricing is based on oversimplified models and demonstrably fallacious assumptions, which disregard the the fact that businesses which engage in predatory pricing (1) are typically able to buy in sufficient volume to negotiate lower costs and/or bypass one or more levels of the distribution chain through which their competitors must operate, (2) are typically diversified retailers, able to subsidize losses in some departments with profits in others, and (3) are typically chain retailers, able to subsidize a temporary overall loss at one location with profits from other locations.[citation needed] Once all competitors for a given product line are driven out of an area, prices on that product line can be raised to a point that is profitable (particularly with reduced costs), yet low enough to serve as a barrier to entry, at least for independent specialty merchants. Also frequently overlooked by critics is the fact that predatory retailers typically locate their stores far enough away from established local merchants to discourage their customers from patronizing the local merchants in the same trip.[citation needed] As local independent merchants are driven out of business, customer traffic in established retail areas (both traditional downtowns and shopping centers of various sizes and types) decreases, leaving the remaining merchants more vulnerable to being driven out.

[edit] Alleged Examples

 This section is missing citations or needs footnotes.
Using inline citations helps guard against copyright violations and factual inaccuracies. (March 2008)
  • Netscape had been selling their web browser for approximately $30 retail. A new competitor called Microsoft entered the market by introducing Internet Explorer at $0 retail, thus selling the software below development cost. This action quickly drove Netscape's browser market share to almost-zero, and the company was forced to liquidate to AOL. It is disputed as to whether this was really a case of predatory pricing, because Microsoft never raised the price of Internet Explorer even after achieving monopolistic status in the web browser market. This action eventually brought the scrutiny of the U.S. Justice Department in an anti-trust case.[citation needed]
  • 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, although this can still be contested.[citation needed]
  • During the late 1980’s and early 1990’s, Irish national airline Aer Lingus attempted to predatorily price out new Irish entrant Ryanair, using up a huge amount of their cash reserves in the process. This severely backfired with Ryanair surviving, becoming highly cost efficient and expanding to become one of the largest airlines in Europe. Aer Lingus have since experienced a number of near bankruptcies in part due to being unable to compete with Ryanair. In 2006 Ryanair launched a takeover attempt of Aer Lingus.[citation needed]
  • According to a September 29, 2007 Associated Press 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. [1]
  • According to a September 9, 2000 article in the New York Times, the government in Germany ordered Wal-Mart to increase its prices. [2]
  • According to a January 14, 2008 article in the International Herald Tribune, the government in France ordered amazon.com to stop offering free shipping to its customers, because it was in violation of France's predatory pricing laws. After Amazon.com refused the government's order, the government proceeded to fine amazon.com €1,000 per day. Amazon continued to pay the daily fine, instead of ending its policy of offering free shipping. [3]
  • According to a March 31, 2004 opinion column by George Mason University economics professor Walter E. Williams, 13 of the 50 states in the United States have minimum gasoline prices. [4]

[edit] References

  1. ^ Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 113 S. Ct. 2578, 2589 (1993)
  2. ^ Areeda, Phillip and Turner, Donald F. (1975). "Predatory Pricing and Related Practices Under Section 2 of the Sherman Act". Harvard Law Review 88: 697. doi:10.2307/1340237. 
  3. ^ Predatory prosecution - Forbes.com
  4. ^ Maury Klein. The Life and Legend of Jay Gould.
  5. ^ Predatory prosecution - Forbes.com
  • 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
  • Jones, Alison and Sufrin, Brenda, "EC Competition Law", 3rd edn., Oxford University Press, 2007, pp. 443-473
  • McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958)

[edit] See also

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