Predatory pricing schemes are used by large sellers of goods or services to squeeze out competition, with the ultimate goal of increasing the large firm's market power. With the increased market power, the large firm would then be able to increase prices to a level higher than would have been possible with competitors and, therefore, make larger profits.
Predatory pricing can be hard to identify because it requires an ongoing and purposeful pricing of goods below production cost. It also requires a clear understanding of the costs incurred by the maker of the goods, not merely the assumed cost of production. For example, a manufacturer who devises a method for production that is much more efficient can lower prices and still be above costs. This would not be predatory pricing. Identification requires data that shows that the total costs of production cannot be recovered at the prices being charged.
In the United States, predatory pricing is regulated chiefly by the Federal Trade Commission and the Justice Department. The Justice Department primarily polices antitrust matters, which are often linked to predatory pricing.
Traits of a Business Capable of Predatory Pricing
To utilize a predatory pricing strategy, a company must be large enough relative to its competition that it will be able to maintain below-market prices long enough to squeeze out the smaller competition.
Likewise, for the strategy to have any benefit to the company, it must be difficult for new businesses to enter the market. Otherwise, the old competitors will simply be replaced with new ones when prices rise above the below-cost levels.
Criticisms of Regulations
Some critics contend that free markets are the best long-term solution to predatory pricing strategies. These theorists contend that the costs of pricing goods below cost are too great even for large companies to justify and that predatory pricing may squeeze smaller firms out of the industry only temporarily--they will return to operation when prices are again at or above costs. Consequently, under this argument, there is no incentive to use predatory pricing.
Example of Predatory Pricing
One of the most famous examples of predatory pricing in recent history involved OPEC's purposeful pricing of oil below cost. Saudi Arabia led a flood of oil into the market to push prices downward in 1985 and 1986. This squeezed smaller oil producers out of the market and expanded OPEC's own market share. It also helped limit future production, which ultimately helped support higher prices.