Predatory pricing (also undercutting) is a risky and dubious 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. 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 is even a de facto monopoly.
Nowadays predatory pricing is considered anti-competitive in many jurisdictions and is illegal under 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.
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.
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.
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 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.
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.
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:
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.
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.