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Microsoft certainly does not price its products on the costs to develop and deliver them. Bill Gates
long ago understood the value of having the industry-standard PC operating system and has priced
Microsoft‟s offerings accordingly. The key here, of course, is that the additional value must exceed the
costs to create it. CVP analysis in this situation is basically no different than in the Company X
example. Only here, one starts with estimates of the value-based price and then calculates the
profitability given probable unit demand and the current cost structure. If the forecast profit is not
sufficient to satisfy investors, one must then focus on reducing costs or increasing the willingness of
consumers to pay more, not simply on raising prices.
Predatory Pricing
In recent years a legal battle raged between two of the nation‟s largest tobacco companies. 8 The
Brooke Group Inc. (previously known as Liggett Group Inc.) accused Brown & Williamson Tobacco
Corporation of predatory pricing in the wholesale cigarette market. At trial in federal court, the jury
decided that Brown & Williamson had indeed engaged in predatory pricing against Brooke. 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 competitors to follow suit. The purpose is to wage a price war and inflict
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 therefore predatory pricing has been
made unlawful.
In order 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 underlying 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. Now, 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 variable 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 reflection 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).