Predatory Pricing

Definition

Predatory pricing is a strategy where a company sets prices extremely low, often below cost, with the intention of driving competitors out of the market. This practice can lead to reduced competition and potentially allow the predator to raise prices later when competitors have exited the market. The tactic is risky and can attract legal scrutiny, but it can be effective in deterring new entrants and influencing capacity decisions.

5 Must Know Facts For Your Next Test

1. Predatory pricing can be used as an entry deterrence strategy by making the market appear less attractive to potential competitors.
2. If successful, predatory pricing may lead to monopolistic behavior, where the predator controls a significant market share after eliminating competition.
3. The legality of predatory pricing varies by jurisdiction; some regions have strict antitrust laws that can penalize firms engaging in this practice.
4. Long-term profitability for a firm using predatory pricing relies on its ability to sustain losses until competition is eliminated.
5. Predatory pricing can trigger price wars, as competitors may also lower their prices in response, leading to further market instability.

Review Questions

• How does predatory pricing serve as an entry deterrence strategy in competitive markets?
  • Predatory pricing acts as an entry deterrence strategy by setting prices so low that they create an unwelcoming environment for potential new entrants. By temporarily sacrificing profits to reduce prices below cost, established firms can signal to newcomers that the market is not profitable. This discourages new competitors from entering the market due to fears of unsustainable operations and financial losses, allowing the incumbent firms to maintain their dominance.
• Evaluate the risks and potential consequences of using predatory pricing as a competitive tactic.
  • Using predatory pricing comes with significant risks, including potential legal ramifications under antitrust laws, which can lead to costly lawsuits and fines. Moreover, if the strategy fails to drive competitors out, the firm may face long-term financial damage due to sustained low prices. Additionally, aggressive pricing tactics can lead to retaliatory responses from competitors, resulting in destructive price wars that can erode profit margins across the entire industry.
• Assess how predatory pricing influences capacity decisions within an oligopolistic market structure.
  • In an oligopolistic market, firms must consider how predatory pricing affects their capacity decisions because of the interdependence among competitors. If one firm engages in predatory pricing, it may force others to also lower prices or increase production capacity to compete effectively. This pressure can lead firms to invest in excess capacity or adopt more aggressive production strategies, ultimately affecting their long-term operational efficiency and market stability. Consequently, firms must balance short-term gains from predatory pricing against the risk of overextending their capacities and incurring future losses.

Related terms

Market Penetration Pricing: A strategy where a company sets a low price to enter a competitive market and attract customers quickly.

Barriers to Entry: Obstacles that make it difficult for new competitors to enter a market, often strengthened by established firms' pricing strategies.

Oligopoly: A market structure characterized by a small number of firms that have significant market power and influence over prices.