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The Myth of Predatory Pricing

Wednesday, July 11, 2018 15:26
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Economic reality is enormous and complex. Each and every moment brings countless actions, reactions, course corrections, and unexpected discoveries. To make sense of it all requires sound theory and a healthy knowledge of history.

Among the important tasks that sound theory and knowledge of history enable us to perform is to distinguish what’s merely possible from what’s probable. The range of all that is possible is vast. It includes, for example, your discovering next month a vaccine for cancer while modifying a recipe for turtle soup.

It is indeed possible that cancer will be prevented in this way. Yet no one in his or her right mind would leap from a recognition of this remote possibility to the conclusion that all medical research into cancer should end.

Nearly everything that is possible will never happen. Never.

The Theory

This truth is important when discussing so-called predatory pricing. Prices are said to be predatory when they are both below cost and used as a means of monopolizing a market. Superficially, fears of predatory pricing make sense. After all, if a firm today charges prices below cost, not only does it forgo profits today, its low prices also threaten the existence of its rivals. Once the predatory firm’s rivals all go out of business—voila!—the predator has a monopoly and then jacks up prices to monopoly levels. Consumers suffer unwarranted harm.

It’s possible. But this outcome is no more probable than your stumbling upon a cancer vaccine while cooking turtle soup. The reasons are many. Here are just some.

The Reality

For a firm to drive its rivals out of business by charging “excessively” low prices, it must not only cut its prices but also expand its sales. Remember, the objective is to take so many sales away from rival firms that they all go bankrupt. But when a firm increases its sales at below-cost prices, that firm necessarily incurs huge losses. The predator’s rivals, while they might all be obliged to also sell at prices below cost, have an advantage that the predator doesn’t: they can reduce their sales during the price war in order to keep their losses to a minimum.

Basic economic theory makes clear that a firm that tries to monopolize a market by charging prices below cost inflicts on itself losses larger than those it inflicts on any of the firms it’s trying to bankrupt.

Basic economic theory makes clear that a firm that tries to monopolize a market by charging prices below cost inflicts on itself losses larger than those it inflicts on any of the firms it’s trying to bankrupt. And the greater the number of rival firms that must be pushed into bankruptcy, the greater the number of sales that the predator must make at below-cost prices and, thus, the heavier the predator’s self-inflicted losses. This reality prompted Robert Bork to snarkily advise that “the best method of predation is to convince your rival that you are a likely victim and lure him into a ruthless price-cutting attack.”

Those who are desperate to portray predatory pricing as being probable respond by insisting that predatory firms have deeper pockets than do their rivals. These deeper pockets allegedly enable predatory firms to endure heavy losses while their rivals, being so very short on cash, shut down because they cannot afford even light losses.

Capital Changes Everything

This response overlooks the existence of capital markets. A core function of capital markets and their institutions (such as banks, venture capitalists, and angel investors) is to channel needed liquidity to potentially profitable firms. Firms with good track records, promising business plans, and reputable management teams have ready access to global capital markets, which are huge. (The value of outstanding commercial and industrial loans made by U.S. banks alone is now about $2.2 trillion.)

Because firms that can operate profitably over the long run routinely tap into capital markets for liquidity, each firm’s pockets are as deep as its skills are impressive, as its ideas are promising, and as its integrity is high.

Because firms that can operate profitably over the long run routinely tap into capital markets for liquidity, each firm’s pockets are as deep as its skills are impressive, as its ideas are promising, and as its integrity is high. Thus, the pockets of even the richest predatory pricer are no deeper than are those of any of its capable rivals.

Of course, it’s possible that all rivals of a predator will be unable to convince banks or other investors to supply them with needed liquidity. Possible—in the sense that this outcome can be imagined. But it is extremely improbable.

Nevertheless, assume that the extremely improbable occurs and the rich predator manages to bankrupt all of its rivals. Being now the lone supplier in that market, the predator finally has the monopoly power for which it paid so dearly.

Yet this monopoly power is worthless to the predator unless the predator now raises prices above costs in order to reap monopoly profits. So the predator does so. But prices above costs lure new entrants into competition with the predator. So bankrupting all existing rivals isn’t sufficient for the predator to secure monopoly power; the predator must also somehow prevent new rivals from competing with it after it bankrupts its previous rivals. Another round of predatory price cutting ensues, with the predator once more suffering larger losses than are suffered by any of its new rivals.

Again, it’s possible to imagine that all of the new entrants will fail—just as all of the predator’s initial rivals failed—to get sufficient liquidity and will thus be bankrupted by the predator’s low prices. But the very need to string together so many bizarre possibilities makes clear that cutting prices below costs is a fantastically unlikely means of monopolizing markets. This possibility is so remote that it should never be taken seriously.

Nevertheless, many people, including antitrust authorities and trade officials, continue to treat predatory pricing as a plausible means of monopolizing markets. Ironically, this refusal to dismiss predatory pricing as an utterly unrealistic means of securing monopoly power has a strong likelihood of itself creating monopoly power.

Government Action

Precisely because a key feature of healthy market competition is the downward pressure it puts on prices, if governments are open to acting on complaints of predatory pricing, firms that are unable or unwilling to compete fairly will seek shelter from competition by accusing their more entrepreneurial rivals of such predation. Further, fearful of being prosecuted for predatory pricing, entrepreneurial firms—even without actual complaints being leveled against them—will be more reluctant to cut their prices if governments actively police against price cutting. Economic competition is thus stymied rather than stimulated.

In this historical record, you’ll find not a single clear-cut instance of a firm securing genuine monopoly power through so-called predatory pricing.

Comb the historical record as carefully as you can. This record confirms the conclusion of sound economic theory. In this historical record, you’ll find not a single clear-cut instance of a firm securing genuine monopoly power through so-called predatory pricing.

All governments and all courts everywhere would, if they were sincerely committed to keeping markets as competitive as possible, announce loudly and unconditionally that never again will they take accusations of predatory pricing seriously.

Reprinted from the American Institute for Economic Research.



Source: http://freedombunker.com/2018/07/11/the-myth-of-predatory-pricing/

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