Predatory Pricing: A Real-World Example?Restaurant Competition in a Declining Market

The general view among economists is that only rarely would we expected to see real-world examples of predatory pricing, where a firm charges below-cost prices to drive others out of business so it can then raise its own prices after it obtains a monopoly. From Wikipaedia,

In essence, the predator undergoes short-term pain for long-term gain. Therefore, for the predator to succeed, it must have sufficient strength (financial reserves, guaranteed backing or other sources of offsetting revenue) to endure the initial lean period. There must be substantial barriers to entry for new competitors.

But the strategy may fail if competitors are stronger than expected, or are driven out but replaced by others. In either case, this forces the predator to prolong or abandon the price reductions. The strategy may thus fail if the predator cannot endure the short-term losses, either because of it requiring longer than expected or simply because it did not estimate the loss well.

So, understandably, I was surprised to hear of allegations of predatory pricing in the restaurant business in our area.

The story I was told goes as follows: one particular place is offering amazing specials that are clearly below-cost. In the process, it is sucking business away from the other places, some of which will likely not survive. These places feel as if they are being driven out of business by an aggressive outsider.

But is it predatory pricing? Probably not.

One essential element for predatory pricing must be the intent of raising prices after others are driven out of business. But the surviving firms will not be in an industry that has high barriers to entry. Sure, after some firms leave the industry it might take another 6 months or more before new competition can enter. And in this area, with the shutdown of a major manufacturer (Volvo-Champion Road Graders), it might take even longer for new competition to emerge in this upper-end segment of the market where the action is taking place. But if others can, and will, enter this segment of the restaurant market, it will be difficult for any place to maintain high prices for long. Customers will eventually drift away, toward restaurants that offer a better price-value-atmosphere-quality combination.

So why is this person engaging in such aggressive pricing? I can think of four possible explanations.

1. They really are practicing predatory pricing and are looking forward to recouping their losses within a one- to two-year period when there will be reduced competition.
2. With the overall downturn in the economy, this place is just being more aggressive than others in its attempts to retain customers and employees.
3. Their aggressive pricing is really just promotional pricing. They are  pricing some items below their variable costs to attract business, and they expect to more than make up the difference with high profit margins on other items, such as beverages (I was recently charged $13 for a one-ounce shot of scotch at one restaurant in London, ON), desserts, and other extras.
4. The new, aggressive manager is rewarded according to growth in revenue or some other measure of sales volume. The place where this is occurring has gone through several changes of ownership over the past 40 years but has always had a fairly good reputation despite its being a bit out of the way. He told one of his competitors that he has gone in and followed these aggressive tactics 36 times before and been successful in all but two of them.

But what is the measure of success? From an economics standpoint, success should be in terms of contributions to the net present value of the firm. But it looks to me as if his measure of success is more short-term and somewhat truncated. It sounds as if his measure of success is growth of the firm's business (measured by revenue) over a year or less. Once he leaves, then what happens? And why would the parent corporation hire him to pursue these strategies if they do not have longer term success (contribution to the net worth of the firm)?

At any rate, even if his policies have the effect of driving some firms out of business, I doubt if this is a real-world case of predatory pricing. It sounds to me more like a combination of promotional pricing, coupled with a principal-agent problem in designing managerial compensation schemes.

Restaurants of interest:

• Bailey's, on the square in Goderich.
• Ben Miller Inn
• The Little Inn in Bayfield
• The Red Pump, Bayfield
• Thyme on 21, Goderich

Meanwhile, the specials and the competition make sticking to one's diet very difficult.