Is predatory pricing rational

Posted on January 10, 2011 | View 1360 | Comment : 6

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The MCX-SX has accused the NSE of predatory pricing in the currency derivative segment,and the case is under review by the Competition Commission of India (CCI).

Predatory pricing refers to a situation where a firm charges a price below its cost of production,with the intent of forcing its competition to either immediately exit the market,or to exit the market after facing losses for a while.Once the competition exits the market,the predatory firm raises prices.

There are three main reasons why it is difficult to prove that a firm is engaged in predatory pricing.

The first is determining whether a firm is charging prices that are below average variable costs.Economic logic states that if a firm is not even covering its average variable costs,the firm will minimise losses by instantly exiting the market.If a firm is covering its average variable costs,but is unable to cover its average total costs,the firm will minimise losses by staying in business in the short run,and exiting in the long run.
Hence,a rational firm will not stay in business when the price for its product is below its average variable cost,unless it has some intent other than current loss minimisation.

The Areeda-Turner test,which the US courts use in several antitrust cases,maintains that a price below the shortrun marginal cost should be unlawful,and uses the average variable cost as a proxy for short-run marginal costs.
Entities outside a firm find it difficult to obtain accurate information on a firms actual costs,especially if the firm is a multiproduct firm.Lawyers representing each entity in a predatory pricing case often disagree on whether a particular expense is to be included in fixed costs or in variable costs,such as in the case of Liggett versus Brown & Williamson,1993.

The second is proving intent.Firms can reduce prices because costs have fallen;hence,it is difficult to prove that a firm reduced prices with predatory intent.
Regulators,therefore,request information on a firms internal communications.In the case of the MCX-SX versus the NSE,the regulators can also look at the timing of the price reduction by the NSE.

The third is the rationale for predatory pricing.The rationale is that the predatory firm manages to force competitors out from the market,and after their exits,raises prices above the competitive level.Short-term losses incurred during the price-cutting stage are lower than the profits that can be earned after competitors are driven away from the market.
This strategy only makes sense if there are barriers to entry.If there are no barriers to entry,once a predatory firm raises prices above the competitive level,other firms will enter the market and force prices down.

Thus,if there are no barriers to entry,predatory pricing is not a rational strategy.An exception to this is when the predatory firm aims to build a reputation for predatory behaviour each time a new firm enters the market.Such a strategy is only possible for a firm with deep pockets,and it is difficult to prove that a firm is adopting such a strategy.

In the case of the MCX-SX versus the NSE,one other factor has to be considered.Stock markets have falling average costs over the relevant range of output.As the number of trades increases,costs per trade fall.There are two points to be considered here.First,the NSE could simply be reducing prices because costs have fallen as their business has increased.

Second,even though average and marginal costs may be driven very low in the case of economies of scale,no matter how low costs fall,a price of zero leads to zero revenues.Given that average costs can never be driven to zero (though they may come very close to zero),a price of zero will lead to losses.

The case before the CCI presents several points of interest.

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