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. A predatory price is considered to be one that is lower than the incremental marginal cost of manufacturing a product.
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.
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.
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
The following are advantages of using the predatory pricing method:
- Entry barrier. If a company communicates its willingness to use predatory pricing again, possible new entrants to the market will be deterred from competing.
- Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.
- Market dominance. 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
The following are disadvantages of using the predatory pricing method:
- Illegal. It may be illegal, depending upon the government jurisdiction.
- Questionable actual value. The concept can certainly work in the short term, but may not be viable in the long term, since new competitors may enter the market place.
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.