A firm engages in predatory pricing by temporarily pricing below cost in order to force its competitors out of the market.
Predatory pricing is notoriously difficult to prove. It can be difficult in practice to distinguish predatory pricing from aggressively competitive below-cost pricing (such as “loss leaders” and promotional activities).
Establishing whether predatory pricing has taken place requires that two tests be met (see Figure 1):
- Is the firm pricing below cost? And
- Whether the firm has an “objectively reasonable expectation” of being able to recover the losses it must incur by pricing at below cost.
Figure 1: Remedies for Predatory Pricing
Is the Firm Pricing Below Cost?
There is no universally accepted test to determine whether a firm is pricing below cost.
Under the Areeda-Turner rule, prices must be below a firm’s short run marginal cost to qualify as predatory pricing. Recognizing that short run marginal cost is very difficult to measure, alternative short run measures of cost may be used (short run average variable cost, SRAVC, or short run incremental cost, SRIC).
Many economists promote the use of long run incremental cost (LRIC) as the appropriate cost threshold for predatory pricing. If two firms are equally efficient, they must have the same long run incremental cost. When one of them sets a price below LRIC, the other firm cannot match that price without incurring a loss.
Regardless of the measure used, calculations of firm-specific costs for individual services can be highly contentious.
Does the Firm Expect to Recover its Losses?
Many practitioners are skeptical about the prospect that a firm could know in advance all of the information needed to implement a predatory pricing strategy. In order to have a reasonable expectation that the strategy will succeed, the firm must know:
- How long it must price below cost before it succeeds in forcing its competitors out of the market,
- The size of the loss that it must withstand while predatory pricing is in effect, and
- The probability that it will recover its losses once it has achieved a monopoly.
Remedies
Ex post antitrust remedies, such as fines or compensation, may be available for proven instances of predatory pricing. However, predatory pricing is difficult to prove with sufficient certainty to justify punitive measures.
A more useful remedy for predatory pricing is an appropriate price floor for the affected product or service. This is a preventive remedy, requiring ex ante regulation.
RELATED INFORMATION
Exclusionary or Predatory Pricing