| Competition law |
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| Basic concepts |
| Anti-competitive practices |
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| Enforcement authorities and organizations |
In business and economics, predatory pricing is the practice of selling a product or service 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, and hypothetically could then raise prices above what the market would otherwise bear.
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 suggest 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.
In essence, 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 for new competitors.
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 for using this pricing strategy, which may be deemed anti-competitive. It may not be de facto illegal, but have severe restrictions.
Recent amendments to the Trade Practices Act 1974 in 2007 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[1] 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. It has been criticised as preventing—through legal
Section 50 of the Competition Act has been repealed.[2]
Section 50(1)(c) of the Competition Act prohibits companies from the 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 with the intention or 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.[3] 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.
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 play chicken to remain in the market, assuming they have the means to do so.
Thomas Sowell explains one reason why predatory pricing is unlikely to work:
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. 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 regulations such as anti-trust laws.
In another example of a successful defense against predatory pricing, a price war emerged between the 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.[5]
Sowell argues:
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 in some circumstances. For instance, by increasing production and lowering prices below costs, a firm may convince its competitors that it has achieved a lower cost of production than they— competitors may be led to believe the firm has high volume and low costs and may therefore believe it is not below cost but rather reflects greater business efficiency. It could lead them to conclude that competing would not be profitable. This is known as low-cost signaling. Eventually a small competitor may not have the resources to stay in business if a larger predator continues predatory pricing for long enough. However, this only suggests that 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, for as soon as they did that, other firms would rapidly be able to enter the market and compete.[6] Anyhow most of outsiders are afraid to entering monopolized market. Such entering demands a lot of capital investments, which would not be repaid soon due to sharp decreasing of prices at the market provoked by resumption of competition.[7][8] Another serious barriers to entering at the monopolized market, such as using by monopolies an intellectual property (patent protection), production and technological experience effect (first-mover advantage), high buyer switching costs (for example a lot of PC users are still use Microsoft products that switching to an alternative product would create significant costs for them) and control of key inputs and technologies (for example, power grids by power generating monopolies)[8] usually making monopolised markets very complicated for outsiders in properties of Laissez-faire capitalism.
"The evidence is, in fact, absolutely conclusive that the Standard Oil Company charges altogether excessive prices where it meets no competition, and particularly where there is little likelihood of competitors entering the field, and that, on the other hand, where competition is active, it frequently cuts prices to a point which leaves even the Standard little or no profit, and which more often leaves no profit to the competitor, whose costs are ordinarily somewhat higher."[9]