Question

What is predatory pricing? How might it reduce competition, and why might it be difficult to tell when it should be illegal?

Short answer

Predatory pricing is a strategy where a dominant firm sets prices below the cost of production to drive competitors out of the market or discourage new entrants, leading to reduced competition, decreased product variety, and less innovation. However, it is difficult to determine when it should be illegal, as proving intent, establishing costs, detecting the temporary nature of predatory pricing, and distinguishing it from legitimate competitive pricing can be challenging.

Step-by-step solution

Definition of Predatory Pricing

Predatory pricing is a strategy where a dominant company, with strong financial resources, deliberately sets the prices of its products or services below the cost of production. The objective is to drive competitors out of the market or to discourage potential new entrants. By doing so, the dominant firm aims to create barriers to entry or gain higher market shares. Once the competition has been weakened or eliminated, the predatory firm can raise its prices and enjoy greater market power.

Effects of Predatory Pricing on Competition

Predatory pricing can reduce competition in several ways: 1. Bankruptcy: Competing firms, unable to match the predatory prices and sustain losses for an extended period, might go out of business. 2. Discouragement of potential entrants: The predatory pricing strategy can act as a warning to potential market entrants that the dominant firm is willing to engage in aggressive pricing tactics to maintain its market position, deterring new entrants. 3. Reduction in product variety and innovation: As competitors exit the market or avoid entry, there will be less variety in products and services, leading to decreased consumer choice. Moreover, reduced market competition might result in less innovation, as there are fewer firms actively working to develop better products or business models.

Challenges in Identifying Predatory Pricing as Illegal

Determining when predatory pricing should be deemed illegal is often challenging for several reasons: 1. Proving intent: It is difficult to prove that a firm is engaging in predatory pricing with the sole intention of driving competitors out of the market. Firms can argue that they are offering lower prices due to increased efficiencies, overstock, or as a promotional strategy. 2. Price-cost tests: Establishing the cost of production is not always straightforward, and various accounting methods can be employed to manipulate costs for legal purposes. Thus, it might be challenging to determine if prices are genuinely set below the cost of production. 3. Temporary nature of predatory pricing: Since predatory pricing is a temporary strategy, it can be challenging for regulators to detect and prove it until long after its implementation and consequences have become apparent. 4. Distinguishing between legitimate competitive pricing and predatory pricing: Competitors may lower their prices as a response to a reduction in a firm's costs or improve efficiencies. Regulating predatory pricing without deterring firms from engaging in legitimate competition is crucial for market efficiency. In conclusion, predatory pricing is the practice of setting prices below-cost in an attempt to eliminate or weaken competition. While it can lead to reduced competition and decreased innovation, it is challenging to determine when it should be considered illegal due to issues related to proving intent, determining costs, and distinguishing it from legitimate competitive pricing practices.