Create and answer a case study similar to American Airlines Case (Chapters 5, 7-11, 13) - Cases Available under Assignments tab- that looks at pricing to drive out competitors and then raising prices in the future.
Predatory Pricing is a pricing strategy where prices are deliberately set so low that the existing competitors cannot survive; and as the competition is driven from the market, prices are then raised by the victor much higher than the previous market price in order to increase revenue and profits. Eventually, the existing competitors to the predatory firm exit the market; and in what was once a competitive market, monopoly remains. The newly 'crowned' monopolist is free to raise the price much higher than previously possible and produce for the entire market as opposed to sharing with competitors. In the short run, the monopolist continues operating in an economic loss situation, causing the existing firms to exit; and in the long run, the remaining firm is able to operate free of competition.
While the definition of predatory pricing is easy to understand, identifying predation in the market-place is difficult. What could be considered by some to be predation and unfair business practice is considered by others to be acceptable competition. The line between competitive and predatory is blurry and the ability to distinguish between the two is challenging. As Christine Durrance notes in her article from the Antitrust Bulletin about the standards for identifying predatory pricing situations, "Predatory behavior and competitive behavior often look alike, and as such, require appropriate standards to detect truly anticompetitive conduct." What is to one observer an illegal predatory pricing strategy; is to another observer an example of a firm competing with the lowest prices possible. Low prices could be used as a strategy to lure customers towards other products that aren't priced as favorably (A high-low pricing strategy) or they could be an example of innovation and efficient operating methods that allows the firm to benefit from lower costs and compete with lower prices than rival firms. The rival firm is likely to cry 'predator' but this does not make it so.
First, to understand the nature of how predatory pricing affects the firms competing in the marketplace, consider a hypothetical monopolistic competitive market where several small firms each produce their own branded line of white T-shirts. Each firm produces a fraction of the total white T-shirt market. The quantity produced by the profit maximizing firm is determined when their marginal cost of production equals the marginal revenue of each shirt produced. As this intersection of marginal cost and marginal revenue are related to the downward sloping demand curve for white shirts, price per unit is revealed. When the price for a shirt exceeds the Average Total Cost for a shirt, the profit maximizing firm will create economic profit. In the graph below, the economic profit for a profit maximizing firm is represented by the blue shaded area.
Enter the Predatory firm who's aim is to price their branded white T-shirts so as to eliminate the possibility of profits in the market. Their goal in the short term is not profit maximization; rather they price their white T-shirts below marginal cost. The quantity produced far exceeds the profit maximizing quantity of the competitors and their market price is much lower. Be sure to note, it is not a predatory strategy in and of itself to price below the marginal cost. As described on the website of the Federal Trade Commission, "Pricing below your own costs is also not a violation of the law unless it is part of a strategy to eliminate competitors, and when that strategy has a dangerous probability of creating a monopoly for the discounting firm so that it can raise prices far into the future and recoup its losses." It is not the lower price that labels this firm a predator, but is instead its pricing below its marginal cost for the purpose of driving competing firms from the market. Deliberately pricing at a loss in this market to eliminate all competition is a predatory strategy; an improved process that allows the new firm to sell a more competitive product, or using a high-low pricing strategy to attract customers, is not. As such, in our predatory scenario, the below graph has no shaded area for economic profits since the predator is operating at a loss.
Eventually, the existing firms will exit the market where a profit is impossible. As the last of the competitors leave the market, the once monopolistic competitive market becomes a pure monopoly with a single firm (the predator) selling white T-shirts. The monopolist firm now begins producing at the point where marginal revenue equals marginal cost. The difference between the newly formed monopoly market and the former monopolistic competitive market is that now the monopolist is producing based upon the entire market's demand for white T-shirts, not just the demand for its own branded white T-shirts. The price is higher than the previous market and the monopolist is able to produce more for the entire market than the previous firms who each shared a portion of the market. In the graph below, the blue shaded area represents the profits of the (now) profit maximizing monopolist firms.
The monopoly market is not necessary smooth sailing for the former predator. Once the new monopolist raises their prices and begins earning economic profits, incentive for other firms to enter the market is created. Thus, the benefits of having become a monopoly are potentially negated. Unless the monopolist can instill some sort of legal barrier to entry, their monopoly will be short lived as new firms begin producing white T-shirts in this market. Also, while often difficult to prove, predatory pricing is an illegal pricing strategy in the United States. Firms that are accused of practicing this strategy are likely to find themselves subject to prosecution. Finally, the present value of the capital expended to operate at a loss for a period long enough to drive the existing firms from the market may exceed the present value of the future profits once the firm becomes a monopoly and raises its prices. A predatory firm can win the battle but lose the war.
Moving beyond the white T-shirt example, Wal-Mart stores have been accused in several states and countries of engaging in predatory pricing. The charge has been that Wal-Mart's practice of pricing staple items (such as milk or butter) is far below its own cost with the aim of eliminating local supermarket chains. Wal-Mart does not deny that the firm prices many of its "corner products" below marginal cost (Newrules.org, 2000) but maintains that this is part of an overall strategy the firm uses to attract customers. "Corner Products" are staples that Wal-Mart believes consumers immediately know the price of. Pricing these products below marginal cost allows the firm to maintain their reputation of having the lowest possible prices. Former President and CEO of Wal-Mart Stores David Glass stated during testimony from a 1993 lawsuit brought against the firm for alleged predatory practices, "It would be better if you could make a profit on everything you sell, but in the real world, that isn't possible...That's the principal reason why we do it." (Jones, 1993).
To further muddy the distinction of Wal-Mart as either a low-cost retailer or a price predatory firm bent upon driving competitors from each of the markets it operates in, consider the ability of Wal-Mart stores to operate with a lower cost than other competitors. Not only does Wal-Mart willingly acknowledge that it does price below marginal cost for many items available in their stores, but it is also likely that very often, their marginal cost is lower than their competitors marginal cost for the same merchandise. Wal-Mart enjoys significant economies of scope and scale within its vast distribution network and is known as a fierce negotiator from its suppliers. Wal-Mart is able to take advantage of these economies and charge lower prices than existing competitors; but it has not been conclusively demonstrated that the firm operates as a predator.
To earn the label of being a predatory pricing firm, the desired end-state must be to eliminate competition in order to then raise prices and operate as a monopoly. Simply competing well with a lower price than competitors does not demonstrate predatory practices, even if the price is below competitors’ marginal cost. Predatory pricing is the deliberate strategy of pricing below your own marginal cost with the eventual goal of raising prices above the level possible in the competitive environment. Once the competition is eliminated, the predatory firm is free to operate as a monopoly and earn a higher profit in the long run than was previous possible.
Questions:
1. Under what circumstances would a firm consider predatory pricing as their strategy?
A). When there are numerous sellers of a homogenous good, each with a very small share of the market
B). When trying to compete against a much larger rival
C). When existing competitors have less cash available
D). When the rival firm is known as a tough competitor
E). Both A and C
-- The Answer is C. A firm would consider predatory pricing if they were operating within a market with an existing competitor who it believes has weaker cash reserves and would be unable to operate for a lengthy time period at a loss. The predatory strategy would be most effective in an instance where the predatory firm already has a reputation as a tough competitor. The firm who is considering a predatory pricing strategy must also be able to forecast and believe that their future long term profits will be enhanced if it operates at a loss in the short term in order to charge a higher price in the future than the present market equilibrium price. The profit maximizing firm will ensure that the present value of the future (higher) profits exceed the present value of all future profits if the market were to remain competitive.
2. If they are not engaging in predatory pricing, what other purpose is served for Wal-Mart to offer some of its products below its marginal cost?
A). Charitable giving
B). To attract customers
C). To lower its fixed cost
D). To lower its tax rate
E). To turn its inventory more often
-- The answer is B. Wal-Mart's low price strategy offers staple goods for less than marginal cost to attract customers who will ultimately buy other products that are priced higher. The strategy calls for low prices on the staple items (called 'corner products' in the vernacular of Wal-Mart managers) so that customers perceive that everything inside the store has a low price. The average customer knows what the price should be for a staple item (butter, bread, milk, socks, etc) and generally has the ability to recall the competitors price for these items. Wal-Mart believes that customers will recognize the low prices for these 'corner products' and will chose to do all of their shopping in their stores instead of the competition.
3. How would a firm offer low prices without earning the label of predator?
A). Only offer low prices until the competition exits the market
B). Use low prices as a strategy to lure customers to their business
C). Offer low prices as a positive consequence of lower cost, more efficient operations
D). Only offer bundles of goods and services
E). Both B and C
-- The answer is E. Low prices in-and-of-themselves are not a predatory scheme. Even a firm offering prices that are less than marginal cost is not necessarily engaging in a predatory strategy. Some firms are able to offer prices below their competitors marginal cost because of efficient operations or more favorable distribution agreements with suppliers. The litmus test for a predatory scheme is whether or not the aim of the firm is to drive competitors from the market and then raise the prices. It is entirely possible for a firm to compete with other firms by using low pricing as a strategy without predation as their motivation.
4. How can it be identified that a firm who is engaging in predatory pricing?
A). The firm is selling good below its own marginal cost and then raises the price to the monopoly price after the competition exits the market
B). When the firm changes its price often
C). By not posting the price for consumers to see before the point of purchase
D). By charging different prices for separate groups
E). Anytime the prices are below the market equilibrium, the firm is practicing predatory pricing
-- The answer is A. It is very challenging to identify a predatory pricing firm. First, it must be established that the firm is indeed offering products below marginal cost. Then it must establish that the purpose for pricing below marginal cost is the elimination of the competition. It is not a violation of antitrust laws to sell for less than your competition. It is only a predatory practice when that strategy is employed with anticompetitve motives.
5. What are the risks of using a predatory pricing strategy?
A). Lower present value of long term profits
B). Costs from defending against accusations of Predatory Pricing
C). Fines for violating antitrust laws
D). Dismantling of the firm
E). All of the above
-- The answer is E. Risks to engaging in a predatory pricing strategy include prosecution under antitrust laws at the State and Federal levels as well the risk of the present value of the long term profits being less after achieving monopoly than had the market remained in a monopolistically competitive state. Not only could any increased long term profits be erased by the costs of litigation to defend against allegations of illegal predator pricing, fines imposed by unfavorable adjudication, or the dismantling of the predatory firm; but also the present value of profits from achieving the monopoly state for the firm could be less than the present value of profits had the firm competed in the monopolistically competitive market.
Bibliography
Baye, Michael R. "Chapter 8: Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets” Managerial Economics and Business Strategy. New York: McGraw-Hill Irwin, 2010. Print.
Baye, Michael R. "Advanced Topics in Business Strategy" Managerial Economics and Business Strategy. New York: McGraw-Hill Irwin, 2010. Print.
Durrance, Christine. "Proposed Standards for Identifying Predation: Williamson's Perspective and the Court." Antitrust Bulletin 55.3 (2010): 663-78. Print.
Predatory Pricing is a pricing strategy where prices are deliberately set so low that the existing competitors cannot survive; and as the competition is driven from the market, prices are then raised by the victor much higher than the previous market price in order to increase revenue and profits. Eventually, the existing competitors to the predatory firm exit the market; and in what was once a competitive market, monopoly remains. The newly 'crowned' monopolist is free to raise the price much higher than previously possible and produce for the entire market as opposed to sharing with competitors. In the short run, the monopolist continues operating in an economic loss situation, causing the existing firms to exit; and in the long run, the remaining firm is able to operate free of competition.
While the definition of predatory pricing is easy to understand, identifying predation in the market-place is difficult. What could be considered by some to be predation and unfair business practice is considered by others to be acceptable competition. The line between competitive and predatory is blurry and the ability to distinguish between the two is challenging. As Christine Durrance notes in her article from the Antitrust Bulletin about the standards for identifying predatory pricing situations, "Predatory behavior and competitive behavior often look alike, and as such, require appropriate standards to detect truly anticompetitive conduct." What is to one observer an illegal predatory pricing strategy; is to another observer an example of a firm competing with the lowest prices possible. Low prices could be used as a strategy to lure customers towards other products that aren't priced as favorably (A high-low pricing strategy) or they could be an example of innovation and efficient operating methods that allows the firm to benefit from lower costs and compete with lower prices than rival firms. The rival firm is likely to cry 'predator' but this does not make it so.
First, to understand the nature of how predatory pricing affects the firms competing in the marketplace, consider a hypothetical monopolistic competitive market where several small firms each produce their own branded line of white T-shirts. Each firm produces a fraction of the total white T-shirt market. The quantity produced by the profit maximizing firm is determined when their marginal cost of production equals the marginal revenue of each shirt produced. As this intersection of marginal cost and marginal revenue are related to the downward sloping demand curve for white shirts, price per unit is revealed. When the price for a shirt exceeds the Average Total Cost for a shirt, the profit maximizing firm will create economic profit. In the graph below, the economic profit for a profit maximizing firm is represented by the blue shaded area.
Eventually, the existing firms will exit the market where a profit is impossible. As the last of the competitors leave the market, the once monopolistic competitive market becomes a pure monopoly with a single firm (the predator) selling white T-shirts. The monopolist firm now begins producing at the point where marginal revenue equals marginal cost. The difference between the newly formed monopoly market and the former monopolistic competitive market is that now the monopolist is producing based upon the entire market's demand for white T-shirts, not just the demand for its own branded white T-shirts. The price is higher than the previous market and the monopolist is able to produce more for the entire market than the previous firms who each shared a portion of the market. In the graph below, the blue shaded area represents the profits of the (now) profit maximizing monopolist firms.
The monopoly market is not necessary smooth sailing for the former predator. Once the new monopolist raises their prices and begins earning economic profits, incentive for other firms to enter the market is created. Thus, the benefits of having become a monopoly are potentially negated. Unless the monopolist can instill some sort of legal barrier to entry, their monopoly will be short lived as new firms begin producing white T-shirts in this market. Also, while often difficult to prove, predatory pricing is an illegal pricing strategy in the United States. Firms that are accused of practicing this strategy are likely to find themselves subject to prosecution. Finally, the present value of the capital expended to operate at a loss for a period long enough to drive the existing firms from the market may exceed the present value of the future profits once the firm becomes a monopoly and raises its prices. A predatory firm can win the battle but lose the war.
Moving beyond the white T-shirt example, Wal-Mart stores have been accused in several states and countries of engaging in predatory pricing. The charge has been that Wal-Mart's practice of pricing staple items (such as milk or butter) is far below its own cost with the aim of eliminating local supermarket chains. Wal-Mart does not deny that the firm prices many of its "corner products" below marginal cost (Newrules.org, 2000) but maintains that this is part of an overall strategy the firm uses to attract customers. "Corner Products" are staples that Wal-Mart believes consumers immediately know the price of. Pricing these products below marginal cost allows the firm to maintain their reputation of having the lowest possible prices. Former President and CEO of Wal-Mart Stores David Glass stated during testimony from a 1993 lawsuit brought against the firm for alleged predatory practices, "It would be better if you could make a profit on everything you sell, but in the real world, that isn't possible...That's the principal reason why we do it." (Jones, 1993).
To further muddy the distinction of Wal-Mart as either a low-cost retailer or a price predatory firm bent upon driving competitors from each of the markets it operates in, consider the ability of Wal-Mart stores to operate with a lower cost than other competitors. Not only does Wal-Mart willingly acknowledge that it does price below marginal cost for many items available in their stores, but it is also likely that very often, their marginal cost is lower than their competitors marginal cost for the same merchandise. Wal-Mart enjoys significant economies of scope and scale within its vast distribution network and is known as a fierce negotiator from its suppliers. Wal-Mart is able to take advantage of these economies and charge lower prices than existing competitors; but it has not been conclusively demonstrated that the firm operates as a predator.
To earn the label of being a predatory pricing firm, the desired end-state must be to eliminate competition in order to then raise prices and operate as a monopoly. Simply competing well with a lower price than competitors does not demonstrate predatory practices, even if the price is below competitors’ marginal cost. Predatory pricing is the deliberate strategy of pricing below your own marginal cost with the eventual goal of raising prices above the level possible in the competitive environment. Once the competition is eliminated, the predatory firm is free to operate as a monopoly and earn a higher profit in the long run than was previous possible.
Questions:
1. Under what circumstances would a firm consider predatory pricing as their strategy?
A). When there are numerous sellers of a homogenous good, each with a very small share of the market
B). When trying to compete against a much larger rival
C). When existing competitors have less cash available
D). When the rival firm is known as a tough competitor
E). Both A and C
-- The Answer is C. A firm would consider predatory pricing if they were operating within a market with an existing competitor who it believes has weaker cash reserves and would be unable to operate for a lengthy time period at a loss. The predatory strategy would be most effective in an instance where the predatory firm already has a reputation as a tough competitor. The firm who is considering a predatory pricing strategy must also be able to forecast and believe that their future long term profits will be enhanced if it operates at a loss in the short term in order to charge a higher price in the future than the present market equilibrium price. The profit maximizing firm will ensure that the present value of the future (higher) profits exceed the present value of all future profits if the market were to remain competitive.
2. If they are not engaging in predatory pricing, what other purpose is served for Wal-Mart to offer some of its products below its marginal cost?
A). Charitable giving
B). To attract customers
C). To lower its fixed cost
D). To lower its tax rate
E). To turn its inventory more often
-- The answer is B. Wal-Mart's low price strategy offers staple goods for less than marginal cost to attract customers who will ultimately buy other products that are priced higher. The strategy calls for low prices on the staple items (called 'corner products' in the vernacular of Wal-Mart managers) so that customers perceive that everything inside the store has a low price. The average customer knows what the price should be for a staple item (butter, bread, milk, socks, etc) and generally has the ability to recall the competitors price for these items. Wal-Mart believes that customers will recognize the low prices for these 'corner products' and will chose to do all of their shopping in their stores instead of the competition.
3. How would a firm offer low prices without earning the label of predator?
A). Only offer low prices until the competition exits the market
B). Use low prices as a strategy to lure customers to their business
C). Offer low prices as a positive consequence of lower cost, more efficient operations
D). Only offer bundles of goods and services
E). Both B and C
-- The answer is E. Low prices in-and-of-themselves are not a predatory scheme. Even a firm offering prices that are less than marginal cost is not necessarily engaging in a predatory strategy. Some firms are able to offer prices below their competitors marginal cost because of efficient operations or more favorable distribution agreements with suppliers. The litmus test for a predatory scheme is whether or not the aim of the firm is to drive competitors from the market and then raise the prices. It is entirely possible for a firm to compete with other firms by using low pricing as a strategy without predation as their motivation.
4. How can it be identified that a firm who is engaging in predatory pricing?
A). The firm is selling good below its own marginal cost and then raises the price to the monopoly price after the competition exits the market
B). When the firm changes its price often
C). By not posting the price for consumers to see before the point of purchase
D). By charging different prices for separate groups
E). Anytime the prices are below the market equilibrium, the firm is practicing predatory pricing
-- The answer is A. It is very challenging to identify a predatory pricing firm. First, it must be established that the firm is indeed offering products below marginal cost. Then it must establish that the purpose for pricing below marginal cost is the elimination of the competition. It is not a violation of antitrust laws to sell for less than your competition. It is only a predatory practice when that strategy is employed with anticompetitve motives.
5. What are the risks of using a predatory pricing strategy?
A). Lower present value of long term profits
B). Costs from defending against accusations of Predatory Pricing
C). Fines for violating antitrust laws
D). Dismantling of the firm
E). All of the above
-- The answer is E. Risks to engaging in a predatory pricing strategy include prosecution under antitrust laws at the State and Federal levels as well the risk of the present value of the long term profits being less after achieving monopoly than had the market remained in a monopolistically competitive state. Not only could any increased long term profits be erased by the costs of litigation to defend against allegations of illegal predator pricing, fines imposed by unfavorable adjudication, or the dismantling of the predatory firm; but also the present value of profits from achieving the monopoly state for the firm could be less than the present value of profits had the firm competed in the monopolistically competitive market.
Bibliography
Baye, Michael R. "Chapter 8: Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets” Managerial Economics and Business Strategy. New York: McGraw-Hill Irwin, 2010. Print.
Baye, Michael R. "Advanced Topics in Business Strategy" Managerial Economics and Business Strategy. New York: McGraw-Hill Irwin, 2010. Print.
Durrance, Christine. "Proposed Standards for Identifying Predation: Williamson's Perspective and the Court." Antitrust Bulletin 55.3 (2010): 663-78. Print.
"Federal Trade Commission Bureau of Competition - Resource Guide to Business Competition." Federal Trade Commission. Web. 22 Nov. 2011. <http://www.ftc.gov/bc/antitrust/predatory_pricing.shtm>
"Wal-Mart Charged With Predatory Pricing | The New Rules Project." Designing Rules as If Community Matters | The New Rules Project. 1 Nov. 2000. Web. 26 Nov. 2011. <http://www.newrules.org/retail/news/walmart-charged-predatory-pricing>
Jones, Kathryn. "Wal-Mart on Trial on 'Predatory Pricing' Charges - New York Times." The New York Times - Breaking News, World News & Multimedia. Web. 30 Nov. 2011. <http://www.nytimes.com/1993/08/24/business/wal-mart-on-trial-on-predatory-pricing-charges.html>
Wilbert, Caroline. "HowStuffWorks "How Wal-Mart Works"" HowStuffWorks "Business & Money" Web. 01 Dec. 2011. <http://money.howstuffworks.com/wal-mart.htm>
Walton, Sam. Sam Walton: Made in America. [S.l.]: Doubleday, 2003. Print.