What happened to all the small electronics stores that used to flourish in just about every geographic market? Their disappearance is tied, in part, to the emergence of big-box retailers, known for their irresistible prices on popular items like household goods and stereo systems.
These huge retailers used economies of scale in purchasing, logistics, marketing, and more to offer lower prices than small, less efficient merchants in the local market. Few of the small stores could keep up, and most succumbed, relinquishing the market to the big-box stores.
Stores that gain market share in this manner may also use predatory pricing—a strategic theory of initially offering unsustainably low prices to gain a quick foothold in a new market and force other market participants out of business. Here’s a rundown of predatory pricing and the long-term effects of eliminating competition.
What is predatory pricing?
Predatory pricing is a business strategy in which a company sets its prices at an unsustainably low level—often below its production costs—to drive competitors out of the market or deter new entrants. In many cases, these businesses stick with a predatory pricing strategy until they have established a dominant market position, only to raise prices and recoup their earlier losses.
In some situations, predatory pricing practices lead to a highly concentrated market and higher prices for consumers over the long term. In the absence of competitors, companies lack the market incentive to maintain low prices. If one company holds the dominant position, its customers have no viable recourse against a price increase.
Although predatory pricing is illegal in the United States and many other countries, proving guilt is almost impossible.
How predatory pricing works
- Undercutting rival companies
- Employing a loss leader strategy
- Driving out existing competitors
- Achieving a monopoly without market competition
Some businesses use predatory pricing strategies to undercut competitors by temporarily lowering prices to grab market share. Here’s how predatory pricing typically works:
1. Undercutting rival companies
A predatory business lowers prices significantly below prevailing market prices, even selling goods below cost. The business offers these very low prices in order to eliminate competitors. Such low prices attract consumers and draw sales away from the competition.
2. Employing a loss leader strategy
A predatory business may focus on a few specific products that are underpriced to attract customers. The retailer may even sell these products at a loss, using a pricing strategy that relies on what the industry calls loss leaders.
Large retailers can offer below-cost pricing by leveraging profits from other business segments to offset potential losses. Smaller competitors with fewer resources can’t respond with equivalent predatory pricing tactics.
3. Driving out existing competitors
As smaller competitors struggle to match predatory prices, some may be forced to exit the market or close, clearing the way for dominant firms to prevail in the price war.
4. Achieving a monopoly without market competition
With competitors weakened or eliminated, the predatory business can raise prices to more profitable levels, enjoying a dominant or monopoly position in the market, leaving no viable alternatives for consumers.
An example of predatory pricing
Despite global antitrust laws, there are plenty of predatory pricing examples. Here’s an example of predatory pricing practices involving two hypothetical ecommerce furniture sellers:
Beachwood Furniture Warehouse is a well-established online furniture retailer with a substantial market. Southeast Sofas, a new entrant, is looking to gain a foothold. To undercut Southeast Sofas, Beachwood offers steep price reductions on its furniture products, even selling some at a loss. This predatory strategy creates financial strain for Southeast Sofas as it finds it necessary to match prices to establish itself in the market.
Eventually, Southeast, unable to sustain losses as a newcomer, withdraws from the market. With no direct competition, Beachwood gradually restores its prices to profitable levels and solidifies its position as the dominant ecommerce furniture retailer.
Is predatory pricing illegal?
Predatory pricing is illegal in many countries, including the US. It’s widely considered anti-competitive behavior that harms not only rivals but consumers by reducing competition and leading to higher prices in the long term.
Laws and regulations regarding predatory pricing vary by jurisdiction, but typically fall under antitrust law or competition law (for instance, the landmark 1911 US Supreme Court case Standard Oil Co. of New Jersey v. United States). Some governments may not explicitly define predatory pricing, but it generally involves proving a company engaged in below-cost pricing with the intent of eliminating competition or establishing a monopoly.
Enforcing predatory pricing rules can be challenging for several reasons, including:
- Proving intent: When prosecuting alleged predatory pricing, prosecutors must prove an intent to eliminate competition. Defendant companies can claim legitimate reasons for price reductions, such as seasonal promotions, inventory clearance, or temporary penetration pricing in a new market.
- Establishing a seller’s cost: Authorities often need to demonstrate that prices were set below the company's actual production and acquisition costs, which can be complicated, as these can vary and include fixed and variable elements.
- Long legal processes: Legal proceedings related to predatory pricing can be lengthy and expensive, especially if the accused has money to spend, thanks to its market power. This can deter enforcement, especially if regulators have limited resources.
- Competitive pricing can be positive: It’s not illegal to offer the lowest price in a market, and not all competitive pricing strategies are predatory or harmful to consumers. Sometimes, one company may lower prices to pass on cost savings, improve efficiency, leverage excess capacity, or gain market share without necessarily trying to eliminate competition.
Effects of predatory pricing
Predatory pricing involves setting prices below cost to eliminate or weaken competitors. This can have short-term and long-term effects on businesses, consumers, and competition. Here are some of those effects.
- Price wars: Predatory pricing can lead to price wars, where multiple companies compete to offer the lowest price. While this can benefit consumers, it can harm competitors by eroding profitability.
- A less competitive market: If competitors can’t endure prolonged losses, they may exit the market, granting the predatory business significant pricing power.
- Temporary consumer savings: Consumers may enjoy lower prices thanks to predatory pricing. The effect may be temporary; there’s a substantial probability that sellers raise prices in the absence of competition.
- Monopolies and oligopolies: Monopolies or oligopolies, where a single company or a few companies dominate the market, sometimes result from predatory pricing. This market concentration can lead to reduced consumer choices and the potential for higher prices.
- Less innovation: When a dominant company faces limited competition, it has little incentive to develop new products or services or to invest in research and development (R&D).
- High prices: Although predatory pricing may offer short-term savings to consumers, over the long term, it can lead to reduced quality and less choice as competitors exit or limit their offerings. Consumers may ultimately pay higher prices when competition is weak.
- Barriers to entry: Predatory pricing can create significant barriers to entry for new newcomers who don't try to sell at a loss to gain market share or lack the scale to buy in bulk and pass on cost savings to customers.
Predatory pricing FAQ
What is the difference between predatory pricing and competitive pricing?
Predatory pricing is a deliberate strategy in which a company temporarily sets prices below cost to oust rivals. Competitive pricing is a market-driven strategy where businesses set prices based on supply and demand dynamics.
How does predatory pricing hurt competition?
In the long run, predatory pricing harms competition by driving rivals out of the market, leading to reduced choice, potential monopolistic control, and leading to higher prices for consumers.
Is dumping a form of predatory pricing?
Yes, dumping is a form of predatory pricing in which products are sold in foreign markets at prices lower than their production costs, with the intent to gain market share and eliminate local competition.
Are there any benefits of predatory pricing?
Predatory pricing can lead to short-term price drops for consumers. But those are often outweighed by the long-term adverse effects, including reduced competition, potential monopolies, less innovation, higher prices, and limited choices.