122 Understanding the Numbers
The jury awarded damages of $150 million to be paid to Brooke by Brown &
Williamson. However, the presiding judge threw out this verdict. Brooke then
filed an appeal, and the case continued.
Predatory pricing cases are not unusual, and damage awards as large as
$150 million are not unheard of. Predatory pricing, as the name implies, is a
tactic where the predator company slashes prices in order to force its competi-
tors to follow suit. The purpose is to wage a price war and inf lict upon the
competition losses of such severity that they will be driven out of business.
After destroying the competition, the predator company will be free to raise
prices so that it can recover the losses it sustained in the price war and also
rake in profits that will greatly exceed normal earnings at the competitive
level. This final result is harmful to competition, and predatory pricing has
therefore been made unlawful.
To determine whether a firm has engaged in predatory pricing, the courts
need a test that will supply the correct answer. One of the usual tests is
whether there is a sustained pattern of pricing below average variable cost. If
the answer is yes, this indicates predatory pricing. Let us examine the logic un-
derlying this widely used test.
First, recall that contribution is the margin between selling price and
variable cost. Contribution goes toward paying fixed costs and providing a
profit. If price is less than variable cost, contribution is negative. In that case,
the firm cannot fully cover its fixed costs, and certainly it will suffer losses.
Therefore, it makes no sense for the firm to charge a price that is below vari-
able cost unless the firm is engaging in predatory pricing in order to destroy
competing firms. That is why pricing below variable cost is considered to be
consistent with predatory pricing.
We should bear in mind that the variable cost used in the test is that of
the alleged predator, not of the alleged victim. The reason is that the alleged
predator may be an efficient low-cost producer, whereas the alleged victim
may be an inefficient high-cost producer. Therefore, a price below the alleged
victim’s variable cost may be above that of the alleged predator, in which case
it could be a legitimate price and simply a ref lection of the superior efficiency
of the alleged predator. The antitrust laws are designed to protect competition,
but not competitors (especially those competitors who are inefficient).
Of course, this is only one indicator of predatory pricing, and all of the
relevant evidence must be considered. There should also be a pattern of sus-
tained pricing below variable cost. Prices that are slashed only sporadically or
occasionally are probably legitimate business tactics, such as loss-leader pricing
to attract customers or clearance sales to get rid of obsolete goods.
Predatory pricing is an important topic and has been the subject of major
lawsuits in a wide variety of industries. Because it is a common test for preda-
tory pricing, variable cost is also a very important topic that all successful busi-
nesspeople will benefit from thoroughly understanding.
Predatory pricing is usually thought of in a regional sense, or perhaps on a
national scale. But it can also occur on an international basis. In that case, it is
known as dumping.