Predatory pricing definition
/What is Predatory Pricing?
Predatory pricing is the practice of deliberately setting prices so low that competitors cannot compete, and so are driven from the marketplace. Predatory pricing can act as a strong barrier to entry, since potential competitors will steer clear of any company sending such a strong competitive signal.
The result of predatory pricing should be a situation where the company can then raise prices and reap exceptional profits; however, if raising prices removes the primary barrier to entry, then an excessive price increase could soon lead to the entry of new competitors, who must then be warded off with another round of predatory pricing. In reality, companies engaging in predatory pricing do so in order to increase their production volumes, which allows them to drive down costs and earn a profit at the "predatory" price point.
What is a Predatory Price?
A predatory price exists when the price is lower than the incremental marginal cost of manufacturing a product. In this situation, the seller is guaranteed to incur a loss on every unit sold.
Who Uses Predatory Pricing?
Predatory pricing is only an option for the largest firms, since they may incur a loss on every unit sold until competitors leave the market, which requires substantial financial resources to support. The only other case in which predatory pricing can be used is when a small company with a large amount of startup capital is willing to burn through its cash reserves with a predatory pricing strategy.
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Legality of Predatory Pricing
Predatory pricing is considered illegal in some countries. In these locations, laws keep a business manager from pricing anywhere near the incremental marginal cost of manufacturing a unit, since competitors can engage in lawsuits if there is even an appearance of predatory pricing. Usually, the risk of a lawsuit is higher when a company already has a large market share when the claim of predatory pricing is alleged. If a smaller company were to engage in identical predatory pricing behavior, it might be at less risk of a lawsuit, simply because it probably would not have the financial resources to incur losses for a protracted period of time, and so would have to give up the pricing practice, irrespective of a lawsuit.
Example of Predatory Pricing
ABC International has been competing with DEF Company for years in the critical yellow widget market. ABC decides to drive out DEF for good by pricing its yellow widgets at $2.50 each, which is lower than the $3.00 unit cost of producing them. DEF recently underwent a highly-leveraged management buyout and so has a considerable amount of debt on its books and little cash. As a result, DEF cannot match the lower price point for long, and is forced to exit the market.
Advantages of Predatory Pricing
An essential advantage of predatory pricing is that, by communicating one’s willingness to use predatory pricing, possible new entrants to the market will be deterred from competing. Another advantage is that financially weaker competitors will be driven from the market, or into smaller niches within the market. And finally, it is possible to achieve a dominant market position with this strategy, though predatory pricing may have to be used again in the future to drive away new market entrants.
Disadvantages of Predatory Pricing
Despite the preceding advantages, there are also quite a few disadvantages associated with predatory pricing. They are as follows:
Short-term losses. The company engaging in predatory pricing often incurs significant losses while maintaining unsustainably low prices. This can strain its financial resources, especially if the predatory strategy fails to achieve its goal of eliminating competition.
Possible legal consequences. Predatory pricing is illegal in many jurisdictions as it violates antitrust laws. Companies engaging in this practice risk legal action, fines, and reputational damage.
Market distortion. By artificially lowering prices, predatory pricing distorts the natural functioning of supply and demand. This can harm market stability and make it difficult for new entrants to assess the true market value of goods or services.
Reduced customer choice. If predatory pricing succeeds in driving competitors out of the market, it can lead to reduced competition. Over time, this limits consumer choice as fewer firms remain in the market.
Reputational damage. Predatory pricing can tarnish the reputation of an industry. If consumers or investors perceive the market as being unfair or anti-competitive, it could discourage participation and innovation.
Risk of retaliation. Competitors may respond with aggressive pricing strategies of their own, potentially leading to a price war. This can erode profits across the industry, harming all players, including the predator.
Barriers to innovation. As smaller competitors are forced out, there is less incentive for the dominant firm to innovate. A lack of competition often leads to stagnation in product development and service improvement.
Small business impact. Small businesses, which often operate on thin margins, are disproportionately affected. They may not have the resources to sustain operations during periods of aggressive price undercutting, leading to closures and job losses.
Economic inefficiency. Predatory pricing can lead to resource misallocation, as firms focus on underpricing rather than improving quality or efficiency. This can reduce overall economic productivity.
In summary, while predatory pricing might seem like a way to gain a competitive edge, its negative consequences for both the company involved and the broader market often outweigh its short-term benefits.
Evaluation of Predatory Pricing
This method is illegal within some government jurisdictions. Thus, if used, you should be aware of the legal ramifications. Other than that issue, it is a theoretically viable tool for driving competitors out of the marketplace, but will likely be needed again in the future to drive away additional threats from other potential competitors.