Predatory pricing under uncertainty: revisiting the deep pocket argument

In this paper we develop a stochastic dynamic model of predatory pricing. When profits evolve stochastically, a negative demand shock can lead to bankruptcy for firms, which cannot immediately raise external capital. An assumption that firms are able to hoard liquidity creates incentives for market incumbents to use the predatory pricing strategies in order to keep the new players out of the industry. Applying game theoretic and dynamic programming techniques, we show that an incumbent firm may use a large cash reserve as a war chest to initiate a price war that could drive the entrant out of the market. Because of uncertainty the entrant may wish to take a chance and enter based on the probability of success. Therefore, realised market structure may be different for different sample paths of the stochastic process.