What’s it: Destroyer pricing is a low pricing strategy to drive competitors out of the market. After being expelled, the company can act as a monopolist in the market. Other terms for this strategy are undercutting and predatory pricing.
The dominant firm charges below average variable cost, which makes it operate at a loss. It forces competitors to lower prices at the same rate. If they can’t do this, consumers turn, and they suffer a loss.
Losses are increasing as more and more consumers switch. Finally, rather than incur more significant losses, they are forced to exit the market.
Why the company adopts destroyer pricing
Tighter competition squeezed corporate profits. They must be competitive to compete effectively.
The high level of competition is usually synonymous with the number of companies. The more companies there are, the higher the competitive pressure. Companies must share the market’s profit among themselves.
To increase long-term profit, one way is to destroy competitors. That way, the company will have greater market power. One of the strategies the company is implementing is adopting destroyer pricing.
Destroyer pricing driving competitors out of the market by rendering them uncompetitive. Companies charge low prices, even to the point of making a loss, to move customers away from competitors. When competitors can’t match them, they go failure and are forced to leave the market because they don’t want to bear higher losses.
Having succeeded in eliminating competitors, the firm enjoys monopoly power. The company can then increase the price to compensate for the losses during destroyer pricing.
Not only does it force out existing competitors, but low prices also become barriers to entry. New entrants see the market as unfavorable, making them reluctant to enter.
How destroyer pricing works
This strategy makes more sense if the dominant company adopts it. They have better resources and capabilities than other companies, enabling them to have a lower cost structure.
When they adopt prices below average variable cost, competitors cannot match them, unless they have to bear a more significant loss. Say that the dominant firm has an average variable cost of $10 per unit because of the lower cost structure. Meanwhile, competitors have an average variable cost per unit of $15. If the predatory price is set at $9, the dominant firm bears less loss ($1) than its competitors ($6) per unit.
Thus, dominant firms are more likely to hold losses for a more extended period than their smaller competitors.
At the start of destroyer pricing adoption, a price war will emerge on the market. During adopting destroyer pricing, the company’s profit is negative because the price is lower than the cost.
Competitors will compete to lower their costs and lower their selling prices to retain existing customers. But, because of the higher cost structure, such efforts would, of course, only result in more significant losses. Remaining uncompetitive, the sensible option is to exit the market.
After the competitors are expelled, the dominant firm will act as a monopolist. They will then increase the price to recover their losses.
How effective is destroyer pricing
Not all markets are right for aggressive destroyer pricing. It is effective only if: First, demand is elastic. When the price falls, it will trigger a much higher increase in demand. Most of all, consumers switch to cheaper products.
Second, low consumer loyalty. The only reason consumers buy products is the price. Product features or quality have no impact on consumer preference and loyalty towards certain products.
Third, low prices effectively prevent new companies from entering. New entrants may have more significant resources to compete competitively. They have accumulated experience and built internal capabilities and resources in other businesses.
They tend to see market growth and profits in the long term rather than the short term. Despite the profit pressure in the short term, they are still willing to enter the market.
Take the case of Windows Explorer and Google Chrome. Even though Microsoft offers Windows Explorer for free, it doesn’t detract from Google’s interest in introducing its cross-platform web browser. Microsoft, of course, has significant resources, and so does Google. Evidently, now, Google Chrome has managed to overtake Windows Explorer and has a market share of around 68% as of May 2020 worldwide.
Why it’s illegal, but it’s hard to prove
Destroyer pricing is illegal in some jurisdictions. It is anti-competitive and harms consumers in the long run. Such practices make the market vulnerable to monopolistic practices. Monopoly power allows firms to set prices, sales volumes, and quality to their advantage.
However, this kind of practice will be challenging to prove. Low prices are a consequence of increasing competition. So whether the price is low because the company deliberately did it or not is debatable.
Destroyer pricing advantages and disadvantages
Destroyer pricing may benefit consumers in the short term. This strategy will trigger a price war in the market and lead to a decline in selling prices. So, consumers will enjoy lower prices as well as a wider choice.
But, in the long run, such practices will hurt consumers. The winner of the price war will act as a monopolist. They will most likely raise the selling price to cover losses during the price war.
On the other hand, destroyer pricing adopters bear the losses in the short term by setting the selling price lower than the cost. As competitors have been driven out of the market, they can enjoy the benefits in the long run. They can raise prices without any pressure from competition.
But, such a strategy also leaves destroyer pricing adopters vulnerable. Instead of winning the price war, they could lose. Competitors may have extensive support from the parent company, which provides sufficient resources to win the competition. Likewise, large potential entrants may be willing to step in looking at long-term rather than short-term prospects.