Predatory Pricing: Myth or Conspiracy?

  “The attempt to reduce or to eliminate predatory pricing is also likely to reduce or eliminate competitive pricing beneficial to consumers”.Harold Demsetz, professor   emeritus of economics at UCLA.

In the article “The Myth of Predatory Pricing” by Thomas J. DiLorenzo, he writes: Predatory pricing is one of the oldest big business conspiracy theories. It was popularized in the late 19th century by journalists such as Ida Tarbell, who in “History of the Standard Oil Company” excoriated John D. Rockefeller because Standard Oil’s 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 Tarbell condemned Standard Oil’s allegedly predatory price cutting.

The predatory pricing argument is very simple. The predatory firm first lowers its price until it is below the average cost of its competitors. The competitors must then 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 their market share; if they do cut their prices, they will eventually 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 it was engaged in predatory pricing, and earns monopoly profits forever after.

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

In DiLorenzo’s article he writes: “Predatory pricing is the Rodney Dangerfield of economic theory; it gets virtually no respect from economists. But it is still a popular legal and political theory for several reasons. First, huge sums of money are involved in predatory pricing litigation, which guarantees that the antitrust bar will always be fond of the theory of predatory pricing. 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.

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 groups and self-styled consumer group, also employ the predatory pricing tale in their efforts to discredit capitalism and promote greater governmental control of industry. The perennial attacks on the oil industry: When oil and gas prices go up there is the alleged price gouging. When prices go down, there is the call for a “study” claiming that the price reductions are part of a grand conspiracy to rid the market of all competitors. And when prices remain constant, price-fixing conspiracies are frequently alleged.

Fourth, predatory pricing is a convenient weapon for businesses that do not want to match their competitors’ price cutting. Filing an antitrust lawsuit is a common alternative to competing by cutting prices or improving product quality, or both. Finally, some economists still embrace the theory of predatory pricing. But their support for the notion is based entirely on highly stylized “models,” not on actual experience.”

The classic article on predatory pricing was written by economist John McGee in 1958. McGee examined the famous 1911 Standard Oil antitrust decision that required John D. Rockefeller to divest his company. Although at that time popular folklore held that Rockefeller had “monopolized” the oil refinery business by predatory pricing, McGee showed that Standard Oil did not engage in predatory pricing; it would have been irrational to have done so.

Judging from the record, Standard Oil did not use predatory price discrimination to drive out competing refiners, nor did its pricing practice have that effect. Whereas there may be a very few cases in which retail kerosene peddlers or dealers went out of business after or during price cutting, there is no real proof that Standard’s pricing policies were responsible. McGee was the first economist to think through the logic of predatory pricing, laying aside the emotional rhetoric that had always surrounded it. He concluded that not only would it have been foolish for Standard Oil to have engaged in predatory pricing; it would also be irrational for any business to attempt to monopolize a market in that way.

By 1970 more than 120 federal (and thousands of private) antitrust cases, in which predatory pricing was alleged had been brought under the 1890 Sherman Act (revised with the Clayton Antitrust Act of 1914 and the Robinson-Patman Act of 1936 amendment to the Clayton Act). Yet in a 1970 study of the so-called gunpowder trust–43 corporations in the explosives industry; Kenneth Elzinga stated, after an extensive literature search, that “to my knowledge no one has ever examined in detail, as McGee did, other alleged incidents of predatory pricing.” Elzinga found no evidence that the gunpowder trust, which had been accused of predatory pricing, actually practiced it.

Shortly after Elzinga’s work appeared, Ronald H. Koller examined the “123 federal antitrust cases since the passage of the Sherman Act in 1890 in which it was alleged that behavior generally resembling predation had played a significant role.” Ninety-five of those cases resulted in convictions, even though in only 26 of the cases was there a trial that “produced a factual record adequate for the kind of analysis employed” by Koller. Apparently, many of the defendants decided it was cheaper to plead guilty than to defend themselves.

Even though no systematic analysis of predatory pricing was performed in any of the 123 cases, Koller established the following criteria for independently determining whether a monopoly was established by predatory pricing: Did the accused predator reduce its price to less than its short-run average total cost? If so, did it appear to have done so with a predatory intent? Did the reduction in price succeed in eliminating a competitor, precipitating a merger, or improving “market discipline”?

Koller’s criteria give predatory pricing theory more credit than it deserves: Below-cost pricing per se is not necessarily a sign of predatory behavior; it is a normal feature of competitive markets. Moreover, determining predatory intent is an exercise that is far beyond the capabilities of any economist and for which mystics might be better suited. And “eliminating a competitor” is the very purpose of all competition.

Employing those criteria for determining predatory behavior, Koller found that below-cost pricing “seems to have been at least attempted” in only seven cases. That, of course, proves nothing about monopolizing behavior, given the fact that below-cost pricing can be just as easily construed as competitive behavior. Koller claims that in four of the 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.

Even in the cases where a competitor seemed to have been eliminated by low prices, “in no case were all of the competitors eliminated.” Thus, there was no monopoly, just lower prices. Three cases seem to have facilitated a merger, but mergers are typically an efficient alternative to bankruptcy, not a route to monopoly. In those cases, as in the others, the mergers did not result in anything remotely resembling a monopolistic industry, as defined by Koller (i.e., one with a single producer).

Despite over 100 federal antitrust cases based on predatory pricing, Koller found absolutely no evidence of any monopoly having been established by predatory pricing between 1890 and 1970. Yet at the time Koller’s study was published (1971), predatory pricing had long been part of the conventional wisdom. The work of McGee, Elzinga, and other analysts had not yet gained wide recognition.

In one of the most famous passages of “Wealth of Nations”, Adam Smith warns 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.”  But in the very next sentence Smith 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; but whether they were likely or not, he believed that any government regulation of them was improper.                                                                     

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Examples of Alleged Predatory Pricing:

Standard Oil Company – In 1909, the US Department of Justice sued Standard under federal anti-trust law, the Sherman Antitrust Act of 1890, for sustaining a monopoly and restraining interstate commerce. The government said that Standard raised prices to its monopolistic customers but lowered them to hurt competitors, often disguising its illegal actions by using bogus supposedly independent companies it controlled. “The evidence is, in fact, absolutely conclusive that the Standard Oil Company charges altogether excessive prices where it meets no competition, and particularly where there is little likelihood of competitors entering the field, and that, on the other hand, where competition is active, it frequently cuts prices to a point which leaves even the Standard little or no profit, and which more often leaves no profit to the competitor, whose costs are ordinarily somewhat higher.”

France Telecom/Wanadoo – The European Court of Justice judged that Wanadoo (Now Orange Internet France) charged less than cost in order to gain a lead in the French broadband market. They have been ordered to pay a fine of €10.35m, although this can still be contested.

Microsoft  – released their web-browser Internet Explorer for free. As a result the market leader and primary competitor, Netscape, was forced to release Netscape Navigator for free in order to stay in the market. Internet Explorer’s free inclusion in Windows led to it quickly becoming the web browser used by most computer users.

According to an AP article  –  Minnesota forced Wal-Mart to increase its price for a one month supply of the prescription birth control pill Tri-Sprintec from $9.00 to $26.88.

According to a New York Times article – German government ordered Wal-Mart to increase its prices.

According to an International Herald Tribune article – French government ordered amazon.com to stop offering free shipping to its customers, because it was in violation of French predatory pricing laws. After Amazon refused to obey the order, the government proceeded to fine them €1,000 per day. Amazon continued to pay the fines instead of ending its policy of offering free shipping.

Low oil prices during the 1990s – while being financially unsustainable, effectively stifled exploration to increase production, delayed innovation of alternative energy sources and eliminated competition from other more expensive yet productive sources of petroleum such as stripper wells.

Darlington Bus War, Stagecoach Group – offered free bus rides in order to put the rival Darlington Corporation Transport out of business.