Baker decided not to pursue limit pricing as described in the previous problem.

Question

Baker decided not to pursue limit pricing as described in the previous problem. Now they find themselves with a competitor, which limits their profit to $4 million per year. However, if Baker drops its price to $68 per chip and holds it there for one year, it will be able to drive the other firm out of the market and regain its market power (earnings $10 million per year in profit as described in the previous problem). Over the year in which it engages in predatory pricing, however, Baker will lose $60 million.

a. Ignoring legal considerations, is predatory pricing a profitable strategy? Assume the interest rate is 10 percent and, for simplicity, that any current period profits or loses occur immediately (at the beginning of the year).

b. What if the interest rate were 5 percent instead of 10?

Explanation / Answer

a. Predatory Pricing is a profitable strategy only when the expected future benefits of the lower pricing is more than the loss occured due to the decrease in price. If the Interest Rate is 10% than the cost of total loss occured in the year Baker engaged in predatory pricing is $6 million per annum. ($60 million x 10%). Which is just equal to the loss of revenue due to Competition (10 million - 4 million).

So, if the interest rate is 10% than the strategy of Predatory pricing is not Profitable.

b. If the interest rate is 5% than the total loss of interest due to predatory pricing is $3 million (60 million x 5%). This loss of interest is less than the expected gain of $6 million which will company can gain if the competitor has gone out of market.

So, in this case Predatory Pricing is a Profitable Strategy.

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