|
|
By K. Uong
What is predatory pricing? “Predatory pricing occurs when a firm temporarily reduces its prices below that level justified by competitive conditions in order to force a competitor from the market or to deter a competitor from engaging in rivalrous behavior, and having achieved this purpose, then expects to be able to raise prices above the competitive level (Smith, p 113).” From this definition we see that predatory pricing is distinguished from mere price cutting or “dumping” because predatory pricing involves not only the actual price cutting required to tame or drive out target firm(s) but also the subsequent increase in price above competitive level to achieve monopoly profits. Price cutting is believed to be beneficial for the competitive process and especially beneficial for consumers, but the price cut is just one aspect of predatory pricing. In Australian law predatory pricing is generally dealt with under section 46 of the Trade Practices Act, which handles cases of market power and misuse of market power.
This essay looks at the arguments
for and against the rationality of predatory pricing throughout history, from
McGee’s analysis to more recent game theoretic analysis. The arguments for the
irrationality of predatory pricing are strong, as is the game theory that
suggests that under certain circumstances the practice is rational. Even if
predatory pricing is possible or rational in a theoretic sense, how commonplace
is predatory pricing in the markets is unclear. This essay argues that
predatory pricing legislation can be dangerous if applied too hastily. Given
the high costs of predation legislation, doing away with predatory pricing laws
may be socially beneficial depending on the magnitude of costs relative to
benefits. If benefits for predation legislation outweigh costs, predation
legislation still needs to be applied carefully, conservatively, and consistently.
Observation of cases in both
DiLorenzo from the Cato Institute says that predatory pricing criticisms began when inefficient firms were driven out of the market by more efficient firms, leading to bitterness and resentment of the major firms. DiLorenzo argued that criticisms against predatory pricing are based more on the emotion of envy rather than economic reasoning. He claims that predatory pricing legislation continues to exist today because of legal and political interests, even though economic theory is generally skeptical of predatory pricing. The innate complexity of predatory pricing is illustrated in the many different opinions on the issue. One of the major problems facing courts is the difficulty in separating predatory behavior from normal competitive behavior.
Predatory pricing is notoriously difficult to detect. The first core test for predatory pricing, the Areeda-Turner (AT) cost test focused on short-run marginal costs. The job was made difficult because short-run marginal cost was hard to obtain. Many economists, however, including Areeda and Turner themselves were aware that the AT tests overlooked the behavioral dimensions of predatory pricing, focusing more on structural conditions. Smith suggests that behavioral pre-conditions are as important as structural pre-conditions for predatory pricing.
Edwards (2002, p.170) says that there is “no bright line test available to accurately delineate pro-competitive from anti-competitive conduct.” He goes on to say, “I will be so bold as to say that no such test or rule will ever be found—it is not in the nature of the problem of predatory pricing that it will admit a simple solution (p.171).” Klevorick (p. 163) says, “To date…the Supreme Court [in America] has declined to provide the basic legal definition of predatory pricing or to enunciate a legal rule that would enable lower courts, and in particular the trail courts on the front lines of predatory-pricing battles, to distinguish legal price-cutting behavior from illegal price reductions. This is not to say that the Supreme Court has provided no guidance to the lower courts concerning predatory pricing, but the signals have been less than clear. Hence, the several Circuit Courts of Appeals have struggled more or less on their own to choose among the AT tests, alternative cost-based standards, other approaches put forth by commentators, and traditional notions of intent.” If experts are not able to delineate between predatory pricing and normal competitive behavior, firms may not be able to delineate as well. Inconsistency on what precisely is predatory pricing, as evident in disputes among economists, judges, and other experts, may effect an atmosphere of uncertainty, which may result in a business environment that discourages investment.
Smith (p. 113) says that “[Predatory pricing] tends to look like a competitive response, for example to increased supply associated with entry or possibly to an entrant with better technology or a superior product. Rather than being predatory, competitive responses like these can represent the fierce rivalry which competition policy and law support.” Smith even shows how accusations of predatory behavior motivated by superficial observations of price drops and subsequent price rises, may be inaccurate because of the mistake of believing that the behavior of the incumbent is influencing the market when it is, in fact, the other way around—the market influences the behavior of the incumbent. “New entry is likely to increase the quantity of the product available relative to demand…and so should result in lower prices (p 114).” Smith goes on to say that “should firm(s) exit the market following the price war, prices are likely to rise.” This is because of reduced supply. In a reasonably competitive market, price should return to the level present when the new entrant had not yet entered the market, but this is expected to occur in the long run. In the short run, because the market doesn’t instantaneously clear, prices may temporarily jump up over the original equilibrium because other firms in the industry may have misjudged the extent of the decrease in consumer demand following the exit of the new entrant and the price increase. These market forces may keep prices up and spark allegations of predatory behavior.
Because looking at predatory pricing from an economic perspective results in complex results, some judges drop back on intent as a convenient way to establish guilt. It should be noted that not all judges believe intent is a primary consideration in cases of predatory pricing. “Judge Easterbrook rejects intent as a basis for determining whether a price reduction is predatory; he argues that it is just too unreliable an indicator and can play no useful role in such litigation (Klevorick, p. 164).”
Another issue to consider is whether a “predatory” intent should be punishable. McHugh J says in Boral v. ACCC: “[A firm with a substantial degree of market power] has no general duty to help its competitors, whether by holding a price umbrella over their heads or by otherwise pulling competitive punches (Griggs).” A predatory intent may even be healthy if competitive markets are the gold standard for economic efficiency. DiLorenzo from the Cato Institute says, “Koller [a judge] claims that in [most cases] low prices seemed to have been motivated by the desire to eliminate a rival. One would hope so! The entire purpose of competitive behavior—whether cutting prices or improving product quality—is to eliminate one’s rivals.”
A firm may be able to lower costs due to improved technology. Intellectual property right laws encourage innovation by giving firms property rights for an idea, allowing the firm to extract monopoly profits for their innovation. The monopoly profits will harm consumers, but the belief is that what society gains from positive externalities from the innovation will compensate for the harm to consumers. The same argument we use to legitimize monopoly pricing from an innovative firm can be used to legitimize predatory pricing. A firm that takes the initiative to invest in research and find technology that allows it to cost-cut should be allowed to predatory price so the predatory innovator can reap the monopoly profits afterwards as a reward for its innovation.
A pharmaceuticals corporation can come up with a new medicine and patent its invention. Operational efficiency, however, may be hard to patent. If the pharmaceuticals corporation comes up with a better production process, and if the firm reveals the secret, other firms can copy and detection will be difficult. While new products are usually patented, firms usually hide technology involved in operational efficiency increases. While intellectual property rights reward new products with monopoly profits, what is the reward for increasing operational efficiency? By dropping costs a firm can increase profits but additionally the higher profits from lower costs through increased technology may allow firms to more successfully withstand price wars. Operational efficiency may be rewarded with predatory pricing, and hence if predatory pricing is made illegal, there is less incentive for increasing operational efficiency. There will be under-innovation in operational efficiency if predatory pricing is banned. Some may argue that increases in operational efficiency that a firm keeps secret may not be a positive externality because the benefits only go to the firm and not to society. If the cost reduction that results from increased technology results in lower prices, then the consumers will win and society thus benefits.
The argument against the idea that predatory pricing can be a reward for increased operational efficiency or innovation is that a firm can predatory price without any increase in efficiency or technology. A firm dropping prices to pass on cost-savings to the consumer is different to a predatory firm that decreases prices and suffers short-term losses so that it can gain market power in the long run. Once the predator gets rid of competition, it will be in a position in which there will be less incentive to innovate.
An economic analysis by John McGee is seen as the first major credible argument against the concept of predatory pricing. McGee argued that predatory pricing was an irrational strategy with risks so high that few firms would engage in the practice. This position was adopted by the US Supreme Court in Brooke Group v. Brown & Williamson Tobacco Co. 509 U.S. 209 (1993). Brooke, an incumbent in the generic cigarette market, accused Brown & Williamson Tobacco of entering the market and offering very big volume rebates to wholesalers. Brown & Williamson moved into the generic market after noticing falling sales due to customers substituting for generic brand cigarettes. The respondent was accused of trying to drive out or tame Brookes in the generic cigarette market so that supracompetitive prices could be maintained on their branded cigarettes. It was eventually found that there was no evidence to show that Brown & Williamson had the ability to recoup losses from price cuts. Since this case, the FTC has not successfully prosecuted any company for predatory pricing. One of the reasons for this is the two stage bright line test used by the U.S. Supreme Court in the Brookes Group case. For an allegation of predatory pricing to be accepted it must be shown that (1) the firm must price below cost (no specific cost test is prescribed but generally AVC is studied) and (2) there must be a “dangerous probability” that the firm can recoup losses. The difficulty of bringing predatory pricing cases to court is not only seen in the U.S. but also seen in Australia. Courts tend to have a skeptical attitude towards claims of predation. “Few predatory pricing cases have been brought before the Australian courts, and of these only one has been successful (Smith, p. 115).” This case was Victorian Egg Marketing Board v. Parkwood Eggs Pty Ltd (1978) 33 FLR 294.
In both America and Australia, the main reasons for this skepticism in predatory pricing as a viable strategy is the number of effective counterstrategies the “prey” could use to oppose predation.
New entrants can engage in various strategies to counter the threat of predation from the incumbent. The first is what DiLorenzo calls consumer cooperation. For predation to be successful, consumers must be highly atomistic, which makes it much harder for them to take collective action against the predator. Smith (p. 118) explains this concept well: “Where there is a small number of relatively large customers, they are likely to be more informed and to take a long term view….Small buyers tend to be less well informed and generally take the lowest price offered.”
Another predatory counterstrategy mentioned by DiLorenzo is the possibility that the victim or prey rides out the price war and, to give itself a greater chance of winning the price war, allies itself with capital markets.
For example, if the target of predation chooses to fight the price war, it could go seek funding for the price war by borrowing money from capital markets. Financiers will lend the money necessary for the firm to survive the price war if they are certain that the target will win the price war. DiLorenzo’s argument is that the predator is likely to lose the price war because, as a bigger firm, they face greater losses. DiLorenzo did acknowledge the risks moneylenders would face but probably underestimated the extent of the risk. Especially if the predator has a reputation for being tough and aggressive, moneylenders may be reluctant to lend money to the prey. In fact, moneylenders may even finance the predator. They may be more likely to finance a firm already well established in the market as opposed to a new entrant.
A bluffing predator with a reputation for toughness can scare moneylenders and firms contemplating entry into the industry. This tough reputation acts as a barrier to entry: “…an earlier example of an aggressive response to entry and the threat of similar action in the future may be enough to establish the incumbent firm’s reputation and deter entry. Action may not be necessary. Perhaps most receptive to such signals are those likely to be approached by potential new entrants for finance. As a consequence of the perceived risk associated with the proposed venture, either finance will be unavailable or may be so costly as to make entry non-viable (Smith, p 122).”
Another argument is the shut-down argument. The target of a predatory pricing campaign could temporarily shut down during the price war. If the predator continues with the predation, its losses would drive itself out from the market. Even if the predator raised its prices there is, as the argument goes, still the danger that these high prices and high profits will attract more new entrants who will enter and undercut the incumbent. However, this argument doesn’t take into full consideration barriers to entry. It is the presence of barriers to entry that gives a firm confidence to engage in predatory pricing. Many economists today agree that barriers to entry are a key consideration in competition analysis.
In Boral v. ACCC the High Court stated that the existence of low barriers to entry meant that BBM could not have engaged in predatory behavior lest its attempts to recoup be spoiled by another new entrant exploiting easy entry. “Ability to benefit from…predatory conduct, as well as to recoup losses depends on the market power of the predator, especially on barriers to entry. It would be irrational to attempt to drive a competitor from the market if barriers to entry were low and, in the absence of collusion, where numerous competitors remained (Smith, p. 119).” Barriers to entry being low or high can change over time. Barriers are not only structural but also strategic or behavioral. For example, the incumbent can raise prices of key resources, raising the input price for new entrants.
Predatory pricing can be seen as an investment—the firm is forgoing profits in the present in the hope that it can achieve greater payoffs in the future. Like most investments, there is risk. In the case of predatory pricing, some argue that predatory pricing carries so much risk that most firms would not engage in the practice.
In Matsushita Elec. Industrial Co. v. Zenith Radio, 475 U.S. 574 (1986), the respondent argued that there was a conspiracy by Japanese firms to drive American firms from the market. The court noted the inherent risk and uncertainty in predatory pricing. “Predatory pricing conspiracies are by nature speculative. They require the conspirators to sustain substantial losses in order to recover uncertain gains. The alleged conspiracy is therefore implausible….The short-run loss is definite, but the long-run gain depends on successfully neutralizing the competition." The Court eventually found that much of the evidence given by Zenith was inadmissible.
Another reason predatory pricing is risky is the presence of competitors. In Boral v. ACCC, BBM (parent company was Boral) was accused of pricing below cost to drive away new entrant C&M Brick. Justice Heerey, however, stated that the market in which BBM operated was occupied by two other firms Pioneer and Rocla, which each had approximately the same market share as BBM. Any attempt therefore by BBM to predate would result in short-term losses, weakening BBM and thereby making it potentially vulnerable against other competitors already in the market. Once BBM successfully runs the victim from the market and tries to raise prices back up over competitive levels, there is no guarantee that other competitors may price under BBM’s prices, thereby quickly running out the weakened BBM. This links the issue of predatory pricing with the issue of collusion because, if BBM is able to collude, make agreements, and build trust with other firms in the market, the firms could coordinate collectively and act as one, making the task of running a firm from the market less risky. In fact, the presence of strong competitors was one of the key factors (along with low barriers to entry in the Melbourne concrete masonry market) that vindicated Boral of any wrongdoing once the case was appealed all the way to the High Court.
In considering the risks of predatory pricing it is worthwhile to look at the concept of discounting. Firms planning to engage in predatory behavior are sacrificing short-term profits for the sake of greater long-term profits. The firm may not value those future profits as much as it values short-term profits, especially if shareholders and board members demand immediate gains. Even if the firm makes a greater future profit from its predatory investment, the investment may not be optimal as the firm may have put the money into an alternative investment that may have a higher rate of return. The rate of return on predatory pricing must be greater than the market rate of return. DiLorenzo says that “the anticipated monopoly profits of the predator must be discounted to their present value. The predator firm may realize that possible monopoly profits in the future are not worth lost profits today.” Smith (p. 118) says, “The longer the period for which the predatory action must be sustained, the higher the discount rate applied to future yields and the less likely it is that the conduct would benefit the predator.” Some alternatives to predatory pricing include acquisitions. Instead of driving a rival from the market, the firm could be invited into the cartel or bought out. In international cases involving the threat of foreign competition, a domestic firm, instead of trying to drive foreign firms out using predatory pricing, could invest in much more legitimate looking form of protection, such as lobbying for higher tariffs or import quotas. The opportunity cost of predatory pricing may be so high that the practice is just not worth it.
Some suggest that firms engaging in predatory pricing are not doing so to maximize profits, but may be intent on getting revenge or punishing a firm. Vandals often destroy goods belonging to others because the sight or knowledge of other people experiencing disutility raises one’s own utility, that is, one’s utility is negatively related to the utility of another hated individual. This is the opposite of altruistic behavior. Many individuals are willing to sacrifice effort to gain utility from the disutility of others and firms may be the same, especially smaller firms or not-for-profit firms. It is not rational for a vandal to destroy other people’s property when considering the effort and time resources wasted, but factor in the utility from revenge and the action may be understandable, although not really “rational.”
Predatory pricing may be commonplace in winner-takes-all markets in which high profits depend on having a large base of customers early on. For example, in the information industry, software may have high initial fixed costs of production but subsequent low reproduction costs. In an attempt to increase its customer base early on it may price below cost until it gains enough of a market share to make money from. In the information industry a dominant firm is able to set protocols and standards, giving it the ability to impose significant switching costs if customers choose to use rival products. Since there is such high fixed cost and negligible reproduction costs, information industries are often characterized by economies of scale, meaning that a new entrant into the market will find it difficult to recover its initial sunk costs in developing the product if it had to wage a price war against the incumbent.
Since the early 1980s, economic models based on game theory and the theory of imperfect information have suggested that predatory pricing can be rational and profitable under certain circumstances. Edwards (2002, p. 170) says that, “for a long period, the prevailing view was that predatory conduct is rarely rational and rarely observed. More recently, economic theories of strategic behavior have emerged that suggest predation can be a rational long term strategy.”
This wave of new game theoretic models differed to the neoclassical models in that the neoclassical models too often assumed perfect information and ignored the importance of information asymmetry. In these models that incorporate information asymmetry, predatory pricing is a viable strategy if the dominant incumbent firm has more information than the potential entrants. A lack of information creates uncertainty, which is a form of early deterrence and is analogous to a structural barrier to entry.
An example of this asymmetry of information leading to cases of predatory pricing is when a firm increase output and lowers prices to make competitors think it has a lower cost of production than they really do, making competitors leave the market based on the belief that it would not be profitable for them to compete. This is known as low-cost signaling.
Game theory says that predatory pricing may be possible. But if something can happen (in theory) does it actually happen? Edwards (2002, p. 170) say that “casual observations suggest [predatory pricing] conduct [is] quite often engaged in.” Contrast this against DiLorenzo from the Cato Institute who said that “predatory pricing cannot even be replicated under laboratory conditions by ‘experimental’ economics.”
Game theoretic models may show that predatory pricing is possible but it can be argued that anything is possible theoretically depending on which model we use and which assumptions we set. One way to look at the likelihood of predatory pricing is to perform experiments or conduct some other empirical research. Theoretical research is valid by itself but is more useful with empirical data to complement it, preferably experimental data, but observational data may also suffice. Experiments allow us to control factors that we think may have an impact on dependent variables of interest, whereas observational analysis doesn’t allow this, leading to the potential threat of confounding or lurking variables. On the other hand, observational analysis looks at the real world and is more likely to deliver results of practical importance, whereas it is questionable as to whether conclusions and concepts gained under laboratory conditions can be applied to what happens in the real world markets. In economic experiments, researchers can use human subjects or they can use computers to simulate the behavior of rational agents under constraints specified in the program. Isaac and Smith (as mentioned in Holt, 1993, p. 47) performed laboratory tests on predatory pricing. In the tests, “predatory pricing was not observed in any session, even after introducing several other design variations (e.g., sunk costs) intended to be progressively more favorable to such pricing.”
Even if game theoretic models show that predatory pricing is rational, it may only be so under very many detailed circumstances. Conditions have to be just right for predatory pricing to occur and, in a world in which both the victim and predator are likely to face imperfect information, predatory pricing is very risky. More often than not the circumstances are not right and firms never have the opportunity to engage in predation. Even if some models show that it is rational to engage in predation, cases of predatory pricing may still be rare and, given the complexity of these circumstances, by having the predatory pricing legislation there is still the danger of stifling competition and efficiency with wrongful punishment.
The costs of predatory pricing legislation can be high. There is much waste created when firms are forced to put money into protecting themselves from the threat of litigation. DiLorenzo states that “…huge sums of money are involved in predatory pricing litigation....During the 1970s AT&T estimated that it spent over $100 million a year defending itself against claims of predatory pricing. It has been estimated that the average cost to a major corporation of litigating a predation case is $30 million.”
Because predatory pricing is so risky, it may be self-deterring. The punishment for predatory pricing prescribed by the law may not be necessary if predatory pricing is self-deterring. In fact, it may not just be costly but also, because of self-deterrence, predatory pricing legislation may be redundant.
Alvin K. Klevorick, “The Current State of the Law and Economics of Predatory Pricing,” The American Economic Review, Vol. 83, No. 2, Papers and Proceedings of the Hundred and Fifth Annual Meeting of the American Economic Association. (May, 1993), pp. 162-167.
Calvani, Terry, “Predatory Pricing and State Below-Cost Sales Statutes in the United States: An Analysis,” retrieved from Internet 9 May 2005 from http://strategis.ic.gc.ca/pics/ct/calvani.pdf
DiLorenzo, Thomas J, “The Myth of Predatory Pricing,” The Cato Institute, retrieved from Internet 5 May 2005 from http://www.cato.org/pubs/pas/pa-169es.html
Edwards, Geoff, “The Perennial Problem of Predatory Pricing,” Australian Business Law Review, Volume 30, pp 170 to 201.
Griggs,
Lynden. "Predatory pricing and
Holt, Charles,
"Industrial Organization: A Survey of Laboratory Research," Handbook
of Experimental Economics, Princeton University Press, February 1993,
retrieved from the Internet at
McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics 1 (April 1958): 13769.
Rigby, Sophie,
“Predatory Pricing: Lessons from Boral,” FindLaw
Smith, Rhonda L. and David K. Round (1998), “Oligopoly and Predatory Pricing,” Competition and Consumer Law Journal, Volume 6, No 2, December.
