David R. Henderson

Why Predatory Pricing Is Highly Unlikely

David R. Henderson*
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According to most accounts, the Standard Oil Co. of New Jersey established an oil refining monopoly in the United States, in large part through the systematic use of predatory price discrimination. Standard struck down its competitors, in one market at a time, until it enjoyed a monopoly position everywhere....

The main trouble with this "history" is that it is logically deficient, and I can find little or no evidence to support it.

—John S. McGee, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics, Vol. 1, (October 1958), p. 138.

Introduction
 
A widely held belief is that large firms with some market power can use their profits generated in particular markets to cut prices below costs in another market and drive out their competitors. Then, according to this belief, once the competitors are driven out, the large firms can raise their prices in that market and collect higher-than-competitive prices.

There are two problems with this view. First, it is logically deficient. Second, there is little evidence to support it.

Why does the issue matter? One main reason is that there are strictures against predatory pricing in U.S. antitrust law. But even if predatory pricing occurred, it would be hard in practice to distinguish between predatory pricing and simple healthy competitive price cutting. The more rare predatory pricing is, the more likely it is that successful prosecutions of alleged predatory pricing are unwitting attacks on healthy price competition. This would hurt consumers and some of the most-efficient firms. Fortunately, as we shall see, the Federal Trade Commission, the agency that enforces restrictions against predatory pricing, seems to understand the reasoning I'm about to explain.

The classic alleged case of predatory pricing was that of Standard Oil of New Jersey. Back in the 1950s, Aaron Director, a law professor at the University of Chicago and one of the founders of the discipline of law and economics, using basic economic reasoning, predicted that a look at the record would show that Standard Oil did no such thing. He persuaded economist John S. McGee to examine the trial record. The result was the article quoted above, which has become famous. There was, indeed, no evidence in the trial record that Standard Oil engaged in predatory pricing.

The Economic Problem with Predation

Why is predatory pricing so unlikely? To see why, let's take a plausible numerical example. Imagine that Firm A makes high profits in market X and is the sole seller in that market. Firm A wants to knock out firm B in market Y. Imagine that both Firm A's and Firm B's average costs are $5 per unit and that they are each pricing at $6 per unit. I'm including a competitive cost of capital in average cost. Firm A currently sells 5,000 units monthly in market Y and Firm B sells 1,000 units monthly. Why do I assume Firm A sells more than B? Because the usual predatory pricing story is that the firm with the larger market share uses predatory pricing to knock out the firm with the smaller share.

To engage in predatory pricing, Firm A must cut its price in market Y to below $5 per unit. If it simply cut price to, say, $5.50, Firm B could cut price to $5.50 also and weather the storm indefinitely since it is still more than covering its $5.00 average cost, which, recall, includes the cost of capital.

So imagine that Firm A cuts it price to $4.00. Imagine that Firm B matches the price cut. If the demand were perfectly inelastic, each would continue to sell the number of units it sold before. More realistically, though, at a lower price more would be demanded. Let's assume that the quantity demanded increases by 20 percent, to 7,200. How will that quantity demanded be split between the two firms? There is no reason to think that Firm B, the prey, will simply increase output in response to the higher quantity demanded. Remember that the price is now lower and so when prices fall, firms typically respond by cutting output, not increasing it. Let's be conservative, though, and assume that Firm B does not change its output. So Firm B continues to sell 1,000 units and Firm A sells 6,200 units.

Now both Firm A and Firm B will make losses. Notice something interesting, though. Firm A's losses will exceed Firm B's losses. Firm A will lose $1 each on 6,200 units, for a total loss of $6,200 per month. Firm B will lose $1 each on 1,000 units, for a total loss of $1,000 per month. And remember that we reached this conclusion by assuming, possibly unrealistically, that Firm B does not cut back its output.

So far, it's not looking good for either firm. But, as hypothesized, Firm A's high profits in market X allow it to last longer than Firm B. Assume that the price war lasts one year and then Firm B is knocked out. Firm A then proceeds to raise prices.

How high must Firm A plan to raise prices to make its year of losses worth bearing? That will depend on how long Firm A goes without competition in market X. If Firm A could be assured that there would never be another competitor in market X, then it could do well by pricing a little lower than the previous $6. The reason is that, although, it would make a little less than its old $1 per unit, it would sell more units and, over time, would more than make it up.

 
"The new competitor could buy Firm B's assets at fire-sale prices, thus reducing average cost."

But Firm A now has a tough problem. If it sells for anything more than $5, another competitor might enter. There is no reason to think that another competitor couldn't match the $5 average cost. And there is some reason to think that its cost could be lower than $5. Why? The new competitor could buy Firm B's assets at fire-sale prices, thus reducing average cost.

Moreover, what if Firm B responds to Firm A's price cut, not by matching it, but by closing down temporarily. Why might it do so? One reason would be that its average variable cost (AVC) is less than its average cost. Imagine that its average variable cost is $4.50. Now, while Firm B is shut down, its loss is not $1 per unit ($4 − $5), but 50 cents per unit (its $5 average cost minus its avoided $4.50 AVC.) Firm A's losses, by contrast, are a full $1 per unit, and now, since Firm B is selling nothing, Firm A's loss is on 7,200 units. So Firm A is in even worse shape than if Firm B had matched the $4 price.

 

For more information, see Antitrust, by Fred McChesney, and the biography of Reinhard Selten in The Concise Encyclopedia of Economics. See also the EconTalk podcast episode Boudreaux on Market Failure, Government Failure and the Economics of Antitrust Regulation, Oct. 2007.

I have left out one other way the prey can respond to a potential predator: by buying the predator's product. Business historian Burton Folsom documents a case in which this actually happened. In 1904, a German cartel called the Bromkonvention dominated the world market for bromine. It engaged in predatory pricing to put Dow Chemical Company out of the business. Herbert Dow responded by buying low-priced bromine from the cartel, repackaging it, and reselling it profitably globally; some of Dow's customers were in Germany.1

In my numerical example above, I posited that Firm A and Firm B have the same average costs. But what happens if potential predator A has lower costs than prey B? Can't A then cut price to a level below B's cost but still make money with a price above its own cost? Yes. But that's not predatory pricing. That's simply healthy price competition. It appears to be what Walmart engages in. It's hard to argue that Walmart is unprofitable. Instead, Walmart, using cutting-edge technology and aggressive strategies on the prices it pays suppliers, has lower costs than the competitors that it knocks out of business.

The Game Theory Counterargument

My argument is not slam-dunk. But it's close to slam-dunk. I remember, as a UCLA graduate student, using the above arguments in a conversation with the late UCLA economist Earl Thompson. Thompson, who was more familiar with game theory than I was, didn't deny my arguments. Instead, he argued that a potential predator could "credibly commit" to predatory pricing without necessarily having to engage in it. Since then, other game theorists have made the same argument. The argument is slightly plausible, but unlikely to be important in practice. Even if one potential prey is credibly scared off, others might not be. 2 Moreover, economist John R. Lott, Jr. broke new ground on this issue in 19993 by going beyond game-theory models and testing one of the key assumptions that led game theorists to the idea that credible commitment could work. As Eric A. Helland of Ball State University wrote in his excellent review4 of Lott's book, the key question is: are CEOs of the allegedly predatory firm "hawks" or "doves?" Helland writes:

A "hawk" is a firm that will actually cut prices to drive out an entrant. A "dove" is a firm that will acquiesce to entry because it cannot bear the short-term losses entailed by engagement in predatory pricing. Of course, doves threaten predatory pricing just as hawks do. How can the entrant discover who is a hawk and who a dove?

Lott pointed out that a CEO who is a hawk must have high job security, or else shareholders and boards of directors will get restless when observing the predator's losses. Does he? Lott studied 28 firms accused of predatory pricing to see if they had a more "hawk-like" governance structure than that of other firms. As Helland summarizes, "Lott finds few differences in CEO turnover, incorporation in a state with antitakeover provisions, stock ownership, or CEO pay sensitivity between the firms accused of predatory pricing and a control group." So a key implicit assumption of the "credible commitment" story turns out to be untrue. As Lott put it, "The results seriously challenge the relevance of game-theoretic predatory models by showing that their assumptions are inconsistent with actual firm behavior.5

The case that predatory pricing is highly unlikely remains strong.

The Law

What's the downside, though, of having laws against predatory pricing? After all, predatory pricing could happen. The downside is that many antitrust suits brought against alleged predatory pricers will really be suits against healthy price competition. This would hurt consumer and some of the most-efficient firms.

The bad news legally is that private firms can sue their competitors for predatory pricing. The good news is that the main government entity in charge of going after predatory pricing is the Federal Trade Commission and that the logic detailed above, and, probably most important, the Supreme Court's Matsushita Elec. Indus. Co. v. Zenith Radio Corp. (1986) decision,6 have caused the FTC to set a high bar before suing for predatory pricing. This is one area in which the Law and Economics revolution, which began in the late 1950s, has had a good, and apparently long-lasting, effect. Here's the FTC's opening paragraph on predatory pricing on its web site:

Can prices ever be "too low?" The short answer is yes, but not very often. Generally, low prices benefit consumers. Consumers are harmed only if below-cost pricing allows a dominant competitor to knock its rivals out of the market and then raise prices to above-market levels for a substantial time. A firm's independent decision to reduce prices to a level below its own costs does not necessarily injure competition, and, in fact, may simply reflect particularly vigorous competition. Instances of a large firm using low prices to drive smaller competitors out of the market in hopes of raising prices after they leave are rare. This strategy can only be successful if the short-run losses from pricing below cost will be made up for by much higher prices over a longer period of time after competitors leave the market. Although the FTC examines claims of predatory pricing carefully, courts, including the Supreme Court, have been skeptical of such claims.7

Score one for the FTC's, and especially the U.S. Supreme Court's, good economic sense.


Footnotes
1.

This point is referenced in Donald J. Boudreaux and Burton W. Folsom, "Microsoft and Standard Oil: radical lessons for antitrust reform," The Antitrust Bulletin, Fall 1999, p. 568.

2.

For a more-extensive theoretical critique of the "credible commitment" argument for predation, see pp. 282-297 of Frank H. Easterbrook, "Predatory Strategies and Counterstrategies," 48 University of Chicago Law Review, 263 (1981). Indeed, Easterbrook's lengthy article is an exhaustive examination of the many problems that make predatory pricing unlikely.

3.

John R. Lott, Jr., Are Predatory Commitments Credible? Who Should the Courts Believe? Chicago: University of Chicago Press, 1999.

4.

Eric A. Helland, "Review of Are Predatory Commitments Credible? Who Should the Courts Believe?", Independent Review, Winter 2001, Vol. 5, No. 3.

5.

Lott, Predatory Commitments, p. 59.


*I thank Donald J. Boudreaux for excellent comments on an earlier draft. I am responsible, however, for any remaining errors.

David R. Henderson is a research fellow with Stanford University's Hoover Institution and a professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, California. He blogs at EconLog.

For more articles by David R. Henderson, see the Archive.

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