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The myth of predatory pricing.

Any company attempting to monopolize a market by lowering its prices to such a low level that all competitors are driven out of business would be acting irrationally.

One of the oldest big business conspiracy theories--predatory pricing--was popularized in the late 19th century by journalists such as Ida Tarbell. In History of the Standard Oil Company, she excoriated John D. Rockefeller because its low prices had driven her brother's employer, the Pure Oil Company, from the petroleum-refining business. "Cutting to Kill" was the title of the chapter in which she condemned Standard Oil's allegedly predatory price cutting.

The predatory pricing argument is simple. The predatory firm first lowers its price until it is below the average cost of its competitors, who then must lower their prices below average cost, thereby losing money on each unit sold. If they fail to cut their prices, they will lose virtually all of their market share; if they do, they eventually will go bankrupt. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while engaged in predatory pricing, and earns monopoly profits forever after.

The theory of predatory pricing always has seemed to have a grain of truth to it--at least to non-economists--but research over the past 35 years has shown that, as a strategy for monopolizing an industry, it is irrational; that there never has been a single clear-cut example of a monopoly created by so-called predatory pricing; and that such claims typically are made by competitors who either are unwilling or unable to cut their own prices. Thus, legal restrictions on price cutting, in the name of combating "predation" inevitably are protectionist and anti-consumer.

Predatory pricing gets virtually no respect from economists, but remains a popular legal and political theory for several reasons. First, huge sums of money are involved in litigation, guaranteeing that the anti-trust bar always will be fond of the theory. During the 1970s, AT&T estimated that it spent more than $100,000,000 a year defending itself against claims of predatory pricing. It has been estimated that the average cost to a major corporation of litigating such a case is $30,000,000.

Second, because it seems plausible at first, the idea of predatory pricing lends itself to political demagoguery, especially when combined with xenophobia. The specter of a foreign conspiracy to take over American industries one by one is extremely popular in folk myth. Protectionist members of Congress frequently invoke that myth in attempts to protect businesses in their districts from foreign competition.

Third, ideological anti-business pressure organizations, such as Citizen Action, a self-styled consumer group, also employ the predatory pricing tale in their efforts to discredit capitalism and promote greater governmental control of industry. Citizen Action perennially attacks the oil industry for either raising or cutting prices. When oil and gas prices go up, it holds a press conference to denounce alleged price gouging. When they go down, it can be relied on to claim that the reductions are part of a grand conspiracy to rid the market of competitors. Even when prices remain constant, price-fixing conspiracies frequently are alleged.

Fourth, predatory pricing is a convenient weapon for businesses that do not want to match their competitors' price cutting. Filing an anti-trust lawsuit is a common alternative to competing by slashing prices, improving product quality, or both.

Finally, some economists still embrace the theory of predatory pricing. However, their support for the notion is based entirely on highly stylized "models," not on actual experience.

In 1958, economist John McGree examined the 1911 Standard Oil anti-trust decision that required John D. Rockefeller to divest his company. He concluded that not only would it have been foolish for Standard Oil to have engaged in predatory pricing, it also would be irrational for any business to attempt to monopolize a market in such a manner.

In the first place, such practices are very costly for the large firm, which always is assumed to be the predator. If price is set below average cost, the largest firm will incur the greatest losses by virtue of having the highest volume of sales. Losing a dollar on each of 1,000 widgets sold per month is more costly than losing a dollar on each of 100 widgets.

Second, there is great uncertainty about how long a price war would last. The prospect of incurring losses indefinitely in the hope of someday being able to charge monopolistic prices will give any business person pause.

Third, there is nothing stopping the competition from temporarily shutting down and waiting for the price to return to profitable levels. If that strategy is employed, price competition will render the predatory strategy unprofitable--all loss and no compensatory benefit. Alternatively, even if the preyed-upon firms went bankrupt, others could purchase their facilities and compete with the predator. Such competition virtually is guaranteed if the predator is charging monopolistic prices and earning above-normal profits.

Fourth, there is the danger that the price war will spread to surrounding markets and cause the alleged predator to incur losses in those areas as well.

Finally, the opportunity cost of the funds allegedly used to try to bankrupt rivals must be taken into account. For predatory pricing to seem rational, the rate of return on predation must be higher than the market rate of interest. In fact, it must be higher than the expected rate of return on any other investment the predator might make, including lobbying for protectionism, monopoly franchises, etc. Predation is unlikely, given the great uncertainties about whether it would have any positive return at all.


The theory of predatory pricing always has assumed that a dominant firm is able to manipulate its smaller rivals. Yet, the potential use of predatory counterstrategies by the smaller rivals makes the likelihood of successful predatory pricing extremely remote.

The predator can recoup its losses only if consumers cooperate. The strategy will fail if they are able to stock up during the low-price predation period. If they do so, there never can be a post-predation recoupment period for the predator. If the predator responds by limiting quantity, its rivals can step in and make up the difference by supplying additional quantities at a higher price.

Admittedly, consumer stockpiling is not always possible, and there is another difficulty related to the predator's ability to recoup his losses: the "victims" have strong incentives to ride out the price war because of the lure of monopoly profits when it is over. The capital markets, moreover, should be willing to finance the victims because they, after all, are not incurring as large a loss as is the predator. There is a risk, of course, in providing capital to the victims, but that can be attenuated by charging an appropriate interest rate. There also is the possibility that larger firms, with their own "deep pockets," will acquire the victims if it seems profitable to do so.

Even if the victim goes bankrupt, the predator is by no means guaranteed a monopoly. The bankrupt firm's resources do not simply disappear--they may be acquired by another firm (possibly at fire-sale prices). Because the purchaser has lower fixed costs, it may be able to underprice the predator.

The victim also could approach its customers and arrange for long-term contracts at a price above the predatory one. They would be willing to enter into such contracts if they realized that the current low price was to be followed by a monopolistic price.

Finally, it should be kept in mind 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. If that is the case, such pricing clearly does not pay.

"Dumping" on competition

Nevertheless, special-interest groups wishing to undermine competition have no incentives to pay attention to the theory and reality of predatory pricing. In fact, as economist Gordon Tullock wrote in Welfare for the Well-to-Do, "Special interest groups normally have an interest in diminishing the information of the average voter. If they can sell him some false tale which supports their particular effort to rob the treasury, it pays. They have resources and normally make efforts to produce this kind of misinformation."

Thus, the myth of predatory pricing will continue to be perpetrated in the courts and in the legislature. So-called anti-dumping laws are an example. In the context of international trade, "dumping" occurs when a foreign manufacturer sells a product in the US. at a lower price than is charged in the home market. Such price differentials easily can be explained by competition--new entrants in a foreign market must offer low prices to induce consumers to try their products. Fierce competition in the domestic market also is a reason for price differentials.

Anti-dumping laws ignore the competitive aspects of price cutting and invoke predatory pricing as a rationale for protectionism. For example, in November, 1987, the U.S. Department of Commerce ruled that "Japanese companies violated international trade laws by failing to increase their prices to match the sharp rise in the value of the yen." With the rise in the value of the yen, Japanese goods sold in the US. became relatively more expensive. The Japanese producers responded by cutting their costs, prices, and profit margins to remain competitive, to the great satisfaction of American consumers. According to the Commerce Department, Japanese export prices declined by 23% between 1985 and 1987. Despite significant benefits to US. consumers, the Reagan Administration's Commerce Department attempted to "force" Japanese companies to raise their prices.

Such a policy is absurd not only because it obviously harms American consumers, but also since, under it, the US. government effectively enforces a cartel pricing arrangement that benefits foreign manufacturers. The Japanese companies may have wanted to raise their prices and earn monopolistic profits, but competition prohibited it. Being prosecuted under the anti-dumping laws achieved for them what they were not able to achieve for themselves in the marketplace.

The same anti-consumer policies prevail today. In June, 1991, the Commerce Department launched an investigation of alleged dumping of Japanese minivans in the American market. The Big Three domestic automakers were advocating Japanese price increases, which they hoped would "blunt the Japanese advance" in the minivan market. The Big Three at that time controlled 88% of the minivan market, but complained that their sales were "weakened by unfair pricing." They accused Japanese automakers of charging prices in the US. that were 30% lower than in their home country. There could not be a more specious argument for using the coercive powers of government to thwart competition and harm consumers.

On Dec. 20, 1991, the Commerce Department ruled in favor of the Big Three. It charged Mazda with the "crime" of selling minivans in the US. for 7.19% less than in Japan; Toyota was "guilty" of selling its minivans in America at 0.95% less. Because of that ruling--now under appeal--the US. government will impose tariffs on Japanese products, thus enabling the domestic automakers to charge even high prices. Consumers unequivocally will be harmed.

The government's alleged right to tell citizens how they may use their legally and peacefully acquired property, and at what prices they may sell it, should be questioned. The real question is: What right does government have to interfere with a business person who is peacefully striving to earn a living by cutting, raising, or maintaining prices? Are private property and individual freedom of choice desirable social institutions, or aren't they? To advocate a law regulating or eliminating "predatory" price cutting is to answer that question in the negative.

Any proposal to interfere with voluntary market pricing arrangements is a denial of the legitimacy of private property rights and individual freedom of choice. From a natural rights perspective, laws designed to regulate predatory pricing--or any other kind of pricing--are improper. As Dominick Armentano stated in Antitrust and Monopoly, ". . . individuals have inalienable rights to life, liberty, and property. These rights imply the liberty of any person or persons to enter into any noncoercive trading agreement on any terms mutually acceptable, to produce and trade any factor or good that they own, and to keep any property realized by such free exchange. This perspective would hold that it is right to own and use property; it is right to employ that property in any manner that does not infringe on anyone else's property rights; it is right to trade any or all of that property to anyone else on any terms mutually acceptable; and that it is right to keep and enjoy the fruits of that effort. . . .Consequently, it would be wrong . . . to outlaw or regulate certain types of business contracts, organizational structures, or business cooperation."

That perspective has a long history. In one of the most famous passages of Wealth of Nations, Adam Smith warned of the pervasiveness of business conspiracies: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." In the very next sentence, though, he added: "It is impossible indeed to prevent such meetings by any law which either could be executed, or would be consistent with liberty and justice." Smith clearly recognized the potential for business conspiracies; whether they were likely or not, he believed that any government regulation of them was improper.

Nevertheless, the doctrine of predatory pricing still motivates anti-trust suits and other protectionist pleadings. However, it is legislation and regulation enacted in the name of predatory pricing (not predatory pricing itself) that are truly monopolizing. Government--not the free market--is the source of monopoly.
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Author:DiLorenzo, Thomas J.
Publication:USA Today (Magazine)
Date:Jan 1, 1993
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