Predatory pricing is a strategy in which companies set prices very low, far below normal. The aim is to eliminate competition in the market.
In some countries, this practice is illegal, even though it is difficult to prove. Setting low prices is a consequence of increased competition in the market. Thus, differentiating fair competition from predatory pricing is debatable. One indication of this practice is pricing below average variable costs.
Who uses predatory pricing and why
Large companies are more likely to use this strategy. They can offer products and services at prices far below market norms. A substantial market share allows them to have a significant market power to influence the market. Also, they enjoy a low-cost structure due to economies of scale and economies of scope. Hence, such advantages enable them to drop prices.
That contrasts with small companies. They have weak market power. The high-cost structure makes it difficult for them to sell products at a loss.
The main motive of large companies implementing this pricing strategy is to drive competitors out of the market. Predators cut prices to very low levels so that:
- Potential new entrants are reluctant to enter the market
- New entrants enter but must operate at a loss so that it immediately exits the market
- Existing competitors are out of the market due to suffering losses
How predatory pricing works
Predators set prices very low for prolonged periods. By lowering prices far below market norms, they have the potential to grab consumers from competitors.
In the short term, consumers enjoy lower price gains. Competition is becoming increasingly intense, and prices continue to fall. Because buyers might not be loyal to specific brands, they surely will buy from the cheapest brands.
Some companies cannot compete and must operate at a loss. Because competition does not make sense, they prefer to leave the market rather than incur more significant losses.
After eliminating competition, predators enjoy monopoly power. Predators can then raise prices to recover their previous losses.
When demand is inelastic, and switching costs are high, consumers have no other options. They are forced to buy products from predators. So, in the long run, customers suffer from higher prices, and predators benefit from rising prices.
Difference between predatory pricing and limit pricing
In predatory pricing, companies set prices very low, below the level of competition and average variable costs. The company intentionally made losses to force competitors out of the industry. And, of course, deterring new competitors from entering.
Whereas, in limit pricing, the company sets a low price, but is still at a competitive level and is above average variable costs. The aim is to prevent new companies from entering the market.
How to defeat predatory pricing
There are several options for reducing predator pressure. Offering low prices is not always successful if switching costs are low or demand is elastic. Consumers may be reluctant to switch to predatory products for reasons such as quality or reliable customer service.
Companies can adopt a judo strategy by taking a flexible strategy and avoiding direct competition with predators, for example, by choosing narrower market segments (niche markets). Predators are usually not interested in entering niche markets because they are not profitable. They prefer to serve the mass market, which allows it to set low prices.
Next, companies need to find spots to attract consumers. Through a differentiation strategy, they can increase switching costs and make their customers loyal.
Why predatory pricing is illegal
Predatory pricing is illegal because the main motive is to eliminate competition. It defies antitrust law because it makes markets more vulnerable to monopolies.
After successfully driving out competitors, predators reach a dominant position and have enormous monopoly power. Predators can easily control the supply, quality, and prices on the market.
Such market control tends to harm consumers. Predators can act to achieve higher profits by reducing supply, so prices rise. Or, predators can reduce quality to obtain higher profit margins.
What is predatory dumping
Predatory dumping is a variation of predatory practice but involves two markets, domestic and abroad. In this case, predators try to conquer new markets overseas by selling lower prices there. Instead, they sell the same items at a higher price on the domestic market.
For example, the New Zealand potato industry accuses Belgium and the Netherlands of predatory practices by dumping surplus products into New Zealand.
What are its advantages and disadvantages
For predators, setting a low price is the fastest way to reach a dominant market position. When successful, they enjoy monopoly power and are free to act for their own benefit.
Very low prices are a barrier to entry for new players. The competition level will decline because of no entry. And, at the same time, existing companies left the market.
In the short term, consumers enjoy lower prices due to increased competition between predators and other companies.
But, in the long run, this practice could harm consumers. Predators enjoy monopoly power and act for their own benefit by controlling the supply, price, and quality of products. It also reduces consumer choice in bargaining.