David R. Henderson, Why Predatory Pricing Is Highly Unlikely | Library of Economics and Liberty

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.

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David R. Henderson, Why Predatory Pricing Is Highly Unlikely | Library of Economics and Liberty.