predatory pricing

Predatory Pricing – Cambridge 9708 Topic 7.8

1. Definition

Predatory pricing is a deliberate, loss‑making strategy in which a firm sets its price below its short‑run average variable cost (AVC) with the explicit aim of driving rivals out of the market. After competitors have exited, the predator raises price above marginal cost and recovers the short‑run losses as a monopoly.

Key cost concepts (quick reminder)

• AVC (Average Variable Cost) – variable cost per unit; the lowest price a firm can charge in the short run without shutting down.
• ATC (Average Total Cost) – AVC plus average fixed cost; the total cost per unit when all costs are spread over output.
• MC (Marginal Cost) – the cost of producing one extra unit; the short‑run supply curve of a competitive firm is the portion of MC that lies above AVC.
• Fixed Cost (F) – costs that do not vary with output (e.g., rent, plant).

2. Rationale / Objectives (linked to the “margin‑decision‑making” concept)

• Acquisition of market power – eliminating rivals creates a dominant position, allowing the firm to set a price above MC (allocative inefficiency).
• Long‑run profit maximisation – the firm accepts short‑run losses (negative margin) in expectation of higher monopoly profits later (dead‑weight loss).
• Barrier creation – a very low price deters new entrants, reducing dynamic efficiency (less innovation and investment).

3. Conditions for a Successful Predatory Attack

1. Financial resources – the predator must have sufficient cash, cross‑subsidisation, or cheap finance to sustain losses until rivals exit.
2. Recoupment possibility – the market must be large enough to support a higher monopoly price after competitors leave.
3. High barriers to entry – sunk costs, strong brand loyalty, regulatory licences, or control of essential facilities must prevent new firms from filling the gap.
4. Pricing relative to costs – the predator must price below rivals’ ATC **and** at or **above its own AVC**. This ensures the predator can stay in business while rivals, whose ATC is higher, incur losses and exit.

4. Relationship to Other Pricing Policies (7.8.1‑7.8.5)

Policy	Purpose	Typical price relative to cost	Key welfare impact
Predatory pricing	Drive rivals out, later raise price	Below own AVC; below rivals’ ATC	Short‑run consumer gain, long‑run allocative & dynamic loss
Limit pricing	Set price low enough to discourage entry, but not low enough to incur losses	At or just above AVC, below monopoly price	May preserve competition; potential efficiency gain if entry is socially desirable
Price discrimination (first‑, second‑, third‑degree)	Charge different prices to different groups to capture more consumer surplus	Price > MC for each segment, but varies across segments	Can increase total surplus (if marginal cost is constant) but may reduce equity
Price leadership	One dominant firm sets the market price; others follow	Usually at or near marginal cost in competitive markets; above MC in oligopoly	May reduce price competition; welfare impact depends on market structure
Elasticity‑based pricing	Use price elasticity of demand to decide whether a price rise will increase total revenue	Higher price when demand is inelastic, lower price when elastic	Efficient from a revenue‑maximising viewpoint; can cause allocative inefficiency if price > MC

Why predatory pricing can be profit‑maximising

• The firm foresees a “margin‑decision” shift: a negative short‑run margin (price < AVC) is accepted to achieve a large positive long‑run margin (price > MC) once market power is secured.
• The expected present value of future monopoly profits must exceed the present value of short‑run losses.

5. Economic Model and Diagrammatic Representation

Short‑run profit:

\[ \pi = (P - AVC)Q - F \]

During a predatory attack the firm chooses a price such that P < AVC, giving \(\pi < 0\). After rivals exit, the firm raises price to P > MC, generating \(\pi > 0\) in the long run.

Three‑stage diagram (exam‑style)

1. Stage 1 – Predatory price: Price set below the predator’s AVC (loss‑making point on the MC curve). The predator’s short‑run supply curve is the MC segment above AVC, but it deliberately supplies at a loss.
2. Stage 2 – Rival exit: Rivals, whose ATC lies above the predator’s price, incur losses and withdraw from the market.
3. Stage 3 – Monopoly price: With competition removed, the predator raises price above MC (often near the monopoly price) and earns a positive profit.

When drawing, label: AVC, ATC (rival), MC, price in each stage, and the corresponding profit/loss areas.

6. Detection, Evidence and Evaluation of Indicators

Regulators (e.g., the UK Competition and Markets Authority, EU Commission) look for a combination of the following:

• Prices persistently below the predator’s AVC for a sustained period.
• Rapid, significant gain in market share by the low‑price firm.
• Evidence of strong financial capacity (large cash reserves, cross‑subsidisation, parent‑company support).
• High barriers to entry that make it unlikely new firms will replace the exiting rivals.

Evaluation of the indicators

• Below‑AVC pricing is a strong signal, but temporary promotional sales or cost reductions can also produce short‑run losses. Intent must be demonstrated (e.g., internal documents).
• Market‑share growth may result from genuine efficiency, product superiority or branding, not necessarily predation.
• Financial capacity shows feasibility, yet a well‑funded firm could simply be engaging in aggressive competition.
• Barriers to entry are crucial for the “recoupment” test; without them, new entrants would restore competition, weakening the case for predation.
• Regulators therefore require a **holistic assessment** – all four indicators together, plus a quantitative analysis of the likelihood of recouping losses.

7. Welfare Implications (Efficiency & Inefficiency)

• Consumer surplus – rises in the short run (lower price) but falls in the long run when monopoly pricing is reinstated.
• Allocative efficiency – lost because price > MC after rivals exit, creating a dead‑weight loss.
• Productive efficiency – may be reduced if resources are diverted to sustain losses rather than to improve production techniques.
• Dynamic efficiency – reduced because high entry barriers discourage innovation and the entry of potentially more efficient firms.
• Overall resource allocation – the economy bears a net loss: short‑run consumer gain is outweighed by long‑run higher prices, reduced competition, and wasted resources.

8. Comparison with Competitive (Normal) Pricing

Aspect	Predatory Pricing	Competitive (Normal) Pricing
Price relative to AVC	Below AVC (loss‑making)	At or above AVC (break‑even or profit)
Short‑run profit	Negative (deliberate loss)	Zero or positive
Long‑run objective	Secure market dominance → later monopoly profit	Maximise profit each period without seeking monopoly power
Effect on rivals	Intended to force exit	Compete on price, quality, innovation
Regulatory view	Potential abuse of dominance; may be prohibited under competition law	Generally acceptable as normal competition

9. Illustrative Case Study (UK – Supermarket Cereal)

Background: In 2003 a major UK supermarket reduced the price of a popular cereal brand to £0.75 per box. Independent retailers estimated the cereal’s AVC at £0.85 and ATC at £1.00.

Outcome:

• Independent retailers could not match the price and many withdrew the product from their shelves.
• After the smaller retailers exited, the supermarket raised the price to £1.20 per box – above the original market price.
• The Competition and Markets Authority (CMA) opened an investigation. It concluded that the initial pricing was predatory because:
  • the supermarket had sufficient cash reserves and cross‑subsidies from other product lines;
  • the cereal market had high entry barriers (brand loyalty, shelf‑space contracts); and
  • there was a realistic prospect of recouping losses through higher later prices.

Diagram suggestion: A three‑stage graph showing (1) price below AVC, (2) exit of rivals, (3) post‑predation price above MC, with profit/loss areas shaded.

10. Policy Evaluation (7.8.5)

• Competition law – prohibitions on predatory pricing aim to protect long‑run consumer welfare. Effectiveness depends on the ability of regulators to prove intent and recoupment.
• Merger control & market monitoring – early detection of potential predatory attacks can reduce the need for costly investigations.
• Potential government failure – overly aggressive enforcement may deter legitimate price competition (e.g., limit pricing that enhances consumer surplus). A balanced approach is required.

11. Exam‑Style Questions (Cambridge 9708)

1. Define predatory pricing and explain why a firm might adopt this strategy.
2. Using the profit equation \(\pi = (P - AVC)Q - F\), illustrate how a firm can incur short‑run losses but expect long‑run gains.
3. Discuss the four conditions that must be satisfied for a predatory attack to be successful.
4. Evaluate the welfare effects of predatory pricing for consumers and for the overall economy.
5. Explain how regulators can detect predatory pricing and assess the reliability of the indicators they use.
6. Compare predatory pricing with limit pricing and price discrimination, commenting on the circumstances in which each is profit‑maximising.
7. Assess the effectiveness of competition‑law policy in preventing predatory pricing, mentioning possible government failure.

12. Summary

Predatory pricing is a strategic, loss‑making approach used to acquire market power. It requires (i) sufficient financial resources, (ii) a realistic prospect of recoupment, (iii) high barriers to entry, and (iv) pricing below rivals’ ATC while staying at or above the predator’s AVC. Although consumers may enjoy lower prices temporarily, the long‑run effects are higher prices, reduced competition, and multiple efficiency losses (allocative, productive, dynamic). Understanding the economic rationale, the required conditions, the diagrammatic analysis, the broader set of pricing policies, and the regulatory response is essential for both students and policymakers.