Predatory Pricing in Antitrust Law and Economics

A Historical Perspective

Nicola Giocoli

• Publisher: Routledge
• Year: 2014
• Print ISBN: 9780415822527
• eBook ISBN: 9781317859635
• Edition: 1
• Topic: Business
• Subtopic: Business Law
• Index: Business

Can a price ever be too low? Can competition ever be ruinous? Questions like these have always accompanied American antitrust law. They testify to the difficulty of antitrust enforcement, of protecting competition without protecting competitors.

As the business practice that most directly raises these kinds of questions, predatory pricing is at the core of antitrust debates. The history of its law and economics offers a privileged standpoint for assessing the broader development of antitrust, its past, present and future. In contrast to existing literature, this book adopts the perspective of the history of economic thought to tell this history, covering a period from the late 1880s to present times.

The image of a big firm, such as Rockefeller's Standard Oil or Duke's American Tobacco, crushing its small rivals by underselling them is iconic in American antitrust culture. It is no surprise that the most brilliant legal and economic minds of the last 130 years have been engaged in solving the predatory pricing puzzle. The book shows economic theories that build rigorous stories explaining when predatory pricing may be rational, what welfare harm it may cause and how the law may fight it. Among these narratives, a special place belongs to the Chicago story, according to which predatory pricing is never profitable and every low price is always a good price.

1 The economics of predatory pricing

1 Classic and modern definitions of predatory pricing

The second section of the Sherman Act reads:

Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished.

Legally speaking, the offense of monopolization – or §2 offense, as it is often called – requires proof of a dominant firm with substantial market power and at least one qualifying exclusionary practice. The latter may be defined as an act that

1. is reasonably capable of creating, enlarging, or prolonging monopoly power by limiting the opportunities of rivals; and 2. either does not benefit consumers at all, or is unnecessary for the particular consumer benefits produced, or produces harms seriously disproportionate to the resulting benefits.

(Hovenkamp 2005, 152)

Predatory behavior is one such practice. It is therefore a §2 offense, explicitly forbidden by antitrust law. While the legitimate aim of any competitive act is to increase one’s own profit and while this may often legitimately happen only at the expense of one’s own competitors, what characterizes predation as an unlawful exclusionary practice is the circumstance that the predatory act would not be profitable absent its exclusionary effect. This feature is emphasized in the following classic definitions:

Predation may be defined, provisionally, as a firm’s deliberate aggression against one or more rivals through the employment of business practices that would not be considered profit maximizing except for the expectation either that (1) rivals will be driven from the market, leaving the predator with a market share sufficient to command monopoly profits, or (2) rivals will be chastened sufficiently to abandon competitive behavior the predator finds inconvenient or threatening.

(Bork 1978, 144)

Predatory behavior is a response to a rival that sacrifices part of the profit that could be earned under competitive circumstances, were the rival to remain viable, in order to induce exit and gain consequent additional monopoly profit.

(Ordover and Willig 1981, 9–10)

Several business practices may fall within such broad definitions. This book will focus on the most frequent, and famous, of them, predatory pricing (PP hereafter). The practice is defined in the Oxford English Dictionary as “the setting of uneconomically low prices in order to damage one’s competitors or put smaller rival companies out of business.” US law gives a similar definition. In Title 15, Ch. 1, §13.a of the so-called US Code we read: “It shall be unlawful for any person engaged in commerce, in the course of such commerce […] to sell, or contract to sell, goods at unreasonably low prices for the purpose of destroying competition or eliminating a competitor.”¹

This prohibition did not feature in the Sherman Act, nor in the original formulation of the Clayton Act, to which it has been added only in 1936, as §3 of the Robinson–Patman Act. PP may therefore violate two different laws: the Clayton Act, as amended by the Robinson–Patman Act, and, as an instance of exclusionary practices, §2 of the Sherman Act. The two violations are treated in the same way in modern case law. As the US Supreme Court clarified in a landmark decision:

Competitive injury under the Robinson–Patman Act is of the same general character as the injury inflicted by predatory pricing schemes actionable under §2 of the Sherman Act. […] The essence of the claim under either statute is the same: A business rival has priced its products in an unfair manner with an object to eliminate or retard competition and thereby gain and exercise control over prices in the relevant market.

(Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 [1993], at 221–2)

The notion of “unreasonably low price,” mentioned by US law, or that of “unfair pricing,” used by the Supreme Court, are given concrete meaning by comparing price to production costs. For example, in the OECD glossary of industrial economics we read that PP is:

A deliberate strategy, usually by a dominant firm, of driving competitors out of the market by setting very low prices or selling below the firm’s incremental costs of producing the output (often equated for practical purposes with average variable costs). Once the predator has successfully driven out existing competitors and deterred entry of new firms, it can raise prices and earn higher profits.

(OECD 1993, 67)

This definition calls into play a list of elements – a dominant firm, a price below the rival’s costs, two phases, two possible goals (forcing exit or deterring entry) – which feature in all PP definitions given by modern industrial economists. A few examples will suffice.

One of the most popular Industrial Organization (IO hereafter) handbooks defines PP as:

a strategy in which a dominant firm cuts price below rivals’ average cost, even if this means accepting short-run losses, to drive rivals from the market. Once rivals leave the market, the incumbent raises price and collects sufficient economic profit to make the present-discounted return from predatory pricing positive. A variation is that a dominant firm cuts price as a way of encouraging rivals to compete less vigorously, without necessarily driving them from the market.

(Martin 2002, 246)

Another recent textbook on competition policy explains that predatory pricing

occurs when a firm sets prices at a level that implies the sacrifice of profits in the short-run in order to eliminate competition and get higher profits in the long-run. This definition […] contains the two main elements for the identification of predatory behaviour in practice: first, the existence of a short-term loss; second, the existence of enough market power by the predator so that it can reasonably expect to be able to raise prices so as to increase profits in the long-run once a rival (or more rivals) has been driven out the market.

(Motta 2004, 412)

The conditions making PP profitable are stated in another popular volume: when incumbents lower their prices,

this is defined to be predatory pricing only when the intent is exclusionary; that is, profitable only because it will result in a higher future price in this or some other markets by virtue of inducing exit or deterring entry in those other markets.

(Viscusi et al. 2005, 307–8, original emphasis)

In light of the aim of the present book, two further definitions may help. What makes these additional definitions especially attractive is that they present the alternative views of PP – the classic and the game-theoretic one – which, as the next sections show, have animated the debate about the economics of predatory behavior. In his influential 1970 exposition of IO, Mike Scherer gave a lengthy explanation of PP in the following terms:

One of the purported traits of large, financially powerful conglomerate firms is their greater ability and willingness to engage in sustained price-cutting with the intent of disciplining smaller competitors or even driving them out of the market. […] The most extreme form of predatory pricing takes place when a seller holds price below the level of its rivals’ costs (and perhaps also its own) for protracted periods, until the rivals either close down operation altogether or sell out on favorable terms. The predator’s motivation is to secure a monopoly position once rivals have been driven from the arena, enjoying long-run profits higher than they would be if the rivals were permitted to survive. Even if it must itself sustain losses during the price war, the predator can afford to do so because it can draw upon profits earned selling the same product in other geographic territories, or from selling different products. In other words, it subsidizes its predatory operations with profits from other markets until the predation creates conditions which will repay the original subsidy.

(Scherer 1970, 273)

It is convenient to juxtapose this long passage with the definition provided by Patrick Bolton, Joseph Brodley and Michael Riordan (BBR) in their oft-quoted paper sponsoring the adoption by US courts of the game-theoretic approach:

Predatory pricing is defined in economic terms as a price reduction that is profitable only because of the added market power the predator gains from eliminating, disciplining, or otherwise inhibiting the competitive conduct of a rival or potential rival. Stated more precisely, a predatory price is a price that is profit-maximizing only because of its exclusionary or other anticompetitive effects. The anticompetitive effects of predatory pricing are higher prices and reduced output – including reduced innovation – achieved through the exclusion of a rival or potential rival.

(Bolton et al. 2000, 2242–3)

These two long quotes have several common elements, but also exhibit significant differences. Both definitions consider market power as a precondition for PP, view the increase in such power as the source of the extra profits repaying the losses of predation, and extend the goal of predation from the sheer elimination of rivals to the disciplining of their competitive behavior. In short, both definitions characterize PP as “an investment in the creation of market power.” Like any other investment, a predatory strategy partakes of the “suffer a cost now to get a bigger gain tomorrow” nature – i.e., it is an inherently intertemporal practice.

However, the differences between the two definitions are even more significant than their commonalities. First of all, Scherer’s definition only applies to a big firm trying to achieve monopoly starting from an already dominant position. Bigness is deemed necessary for sustaining the predatory investment, because size (to be understood as “presence in other markets”) warrants the availability of the financial resources enabling the predator to survive the losses. As industrial economist Corwin Edwards reportedly said: “The large company is in a position to hurt without being hurt” (quoted by Scherer 1970, 273). Thus, a precondition of PP is that the predator be endowed with economic – as distinguished from mere market – power. While market power is a strictly theoretical notion – to be measured via analytical tools, such as market shares or the Amoroso-Lerner index – economic power is a broader, non-measurable notion, which encompasses all the powers – financial, political, social – bestowed upon a firm by its sheer size and the assessment of which goes beyond the limits of economic analysis.² Second, Scherer identifies PP as selling below cost – by which he surely means below rivals’ costs, and possibly also below one’s own. Third, his definition explicitly mentions the requirement of intent: the big firm’s price cut must be deliberately aimed at harming its competitors. Finally, Scherer’s definition views PP as a strategy only directed against existing rivals.

The alternative definition by BBR is more general under all these respects. First, their definition only requires that the predator be endowed with some market power, to which the predatory strategy is said to add. Nowhere, not even implicitly, is the predator required to be either a big or a dominant firm, nor to be active in multiple markets, nor to aim at full monopoly. Economic power falls outside of their discourse, which remains entirely within the boundaries of economic analysis. Second, there is no necessary relation between price and costs: all that is required is that the price charged by the predator be a seemingly irrational one, were it not for its power-augmenting effect. Even the notion of the predator’s losses is generalized from actual losses (negative profits) to the broader idea of foregone profits. Third, this definition intentionally eschews any reference to the predator’s intent, let alone some specific intent to monopolize. As the next chapters show, the intent requirement has always caused trouble to the enforcement of PP legislation. It is not surprising that a modern definition eschews it. Finally, BBR explicitly refer to the possibility that PP may be directed at curbing potential competition by deterring entry. This is consistent with the notion of anticompetitive effects (in terms of higher prices and reduced output) which features as another key novelty of their definition. While Scherer’s definition may also encompass a characterization of antitrust law as directed at protecting a big firm’s competitors, especially small ones, BBR unambiguously depict the law’s goal as the protection of competition, rather than competitors, to be achieved by preventing the competitive harm caused by PP.

Historically speaking, Scherer’s narrower version corresponds to what we may call the classic definition of PP, while that of BBR is the modern one. The word “classic” here denotes that this has been the definition which, more or less explicitly and more or less exactly, several generations of industrial economists have made their own, commencing in the last two decades of the nineteenth century, proceeding with full force after WWII and ending only with the rise of the game-theoretic approach to IO in the early 1980s. The latter approach would provide a broader characterization of PP, properly represented by BBR’s “modern” definition.

However, even the classic definition of PP never fully overlapped with the narrative that US courts had in mind when asked to apply antitrust law to allegedly predatory episodes. In what we may dub the classic legal standard of PP, the specific theoretical elements of Scherer’s definition – market dominance, monopoly position, below-cost pricing, loss subsidizing, etc. – were dissolved into a vague narrative that emphasized its non-analytical components, like the “unfair use” of pricing policy against smaller rivals or the multi-faceted risks (economic, political, social) implicit in any concentrated market structure. In that story, PP just meant that a big firm had unfairly exploited its power to undercut its smaller rivals, with the intention of further increasing that power by causing them to exit the market. For more than 60 years, from 1911 to 1975, US courts have been enforcing the anti-PP prohibition guided by a legal standard that hinged on that story, rather than on economic analysis. Accordingly, the goals to be pursued were the protection of small firms from unfair price cuts made by bigger rivals and the preservation of a competitive market structure, understood as absence of excessive agglomerations of economic power. In short, protecting competitors and diffusing economic power were the real drivers of anti-PP enforcement. Economic efficiency was never specifically articulated as a distinct goal.³

Following the classic legal standard, courts looked for the two essential elements of its underlying narrative: a considerable economic power and the intention to prey upon smaller rivals, i.e., to unfairly exploit that power. Power and intent thus constituted the two necessary ingredients of any accusation of predatory behavior. Curiously, both the standard and the underlying story were closer under a crucial respect to BBR’s definition of PP than to Scherer’s: US courts could apply the standard without, strictly speaking, any comparison between the predator’s price and its or its rival’s costs. Though in practice such a comparison did represent the core issue of most PP cases, it was possible for a big firm to be found guilty of predatory behavior despite pricing above cost. What really mattered was, first, that it was a big firm, and, second, that the court was convinced that it had unlawfully intended to prey upon it...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Acknowledgments
• Introduction
• 1. The economics of predatory pricing
• 2. The two freedoms and British common law
• 3. American economists and destructive competition
• 4. Predatory pricing in the formative era of antitrust law
• 5. Predatory pricing in the structuralist era
• 6. The Chicago School and the irrelevance of predation
• 7. Harvard rules: Areeda and Turner’s solution
• 8. The demise of predatory pricing as an antitrust violation
• Conclusion
• List of cases
• References
• Index