Wednesday, 26 August 2009

The Economist on predatory pricing (updated)

Most industrial organisation economists will agree that so-called "predatory pricing" is a rare phenomenon. This doesn't stop the courts from finding predatory pricing almost everywhere as the recent EU Intel case shows. The Economist magazine has a article in which it discusses predatory pricing in light of the Intel judgement. It says
Allegations of predatory pricing have a long history. The Sherman Antitrust Act of 1890, the foundation of America’s competition policy, was partly a response to complaints by small firms that larger rivals wanted to drive them out of business. Trustbusters need to be wary of such claims. Low prices are one of the fruits of competition: penalising business giants for price cuts would be perverse.
The Standard Oil case of 1911 is a landmark in the development of anti-trust law. But in his famous paper "Predatory Price Cutting: The Standard Oil (N. J.) Case", John S. McGee showed that the predatory pricing case against Standard Oil didn't make economic sense.

The Economist continues
Establishing that a firm is guilty of predation is difficult. If rivals stumble or fail, that may be down to their own inefficiency or poor products, and not because they were preyed upon. Proving that a firm is pricing below its costs is tricky in practice. Even where a reliable price-cost or profit-sacrifice test is feasible, failing it need not imply sinister intent. There are often pro-competitive reasons to forgo short-term profits. Firms with a new product, or a new version of an existing one, may wish to pick a lossmaking price to defray the cost to consumers of switching, or because they expect their own costs to fall as they perfect the production process (video-game consoles are a classic example). Losses would then be a licit investment in future profits.

Predation is even trickier to uncover when goods are sold together. A firm that enjoys fat profits on one good may “bundle” it with another on which margins are lower. If the discount on the bundle is hefty enough, other firms may struggle to offer as enticing a deal. In 2001 the EU blocked a proposed tie-up between GE and Honeywell for fear that the merged firm might use bundled discounts to squeeze rival suppliers. In 2007 a committee of antitrust experts appointed by the American government proposed a test for whether bundling is predatory. First, assume the discount applies solely to the low-margin good. So if each good sells for $10 separately and $16 as a bundle, allocate the $4 discount to the more “competitive” product. Next, apply a price-cost test: if the product costs over $6 to make, the bundle is predatory.

That check seems neat but sound business practices may still fall foul of it. It may be cheaper for a firm to sell the two goods together, because of cost savings on distribution. Firms also often use bundling as a way of charging high-demand users more. Thin margins on sales of printers, for example, can be made up by bundling in more profitable toners. This kind of “metering” is an efficient way of recovering fixed costs such as research.

Another ambiguous tactic is to offer rebates to customers that reach certain sales targets. Bulk buyers generally pay lower unit prices to reflect suppliers’ economies of scale. Rebates can also help align incentives. Suppliers want retailers to promote their products, offer in-store information and keep plentiful stocks. The trouble is, retailers bear all the costs of such sales efforts but reap only some of the benefits. Rebates provide incentives for retailers to drive sales, as profits are bigger once the target is met.
Louis Phlips suggests that the necessary conditions for predatory pricing are
To sum up, economic theory suggests that predatory pricing is a real possibility only when the following five conditions are simultaneously met:
1 The aggressor is a multimarket firm (possibly a multiproduct firm).
2 The predator attacks after entry has occurred in one of its markets.
3 The attack takes the form of a price cut in one of the predator's markets, which brings this price below a current non-cooperative Nash equilibrium price at which the entry value is positive for the entrant (possibly below a discriminatory current Nash equilibrium price with the same property).
4 The price cut makes the entry value negative (in present value terms) in the market in which predation occurs.
5 Yet the victim is not sure that the price cut is predatory. The price cut could be interpreted by the entrant as implying that its entry value is negative under normal competition. In other words, the victim entertains the possibility that there is no room for it in the market under competitive conditions.
It seems unlikely that such conditions are ever met in the real world and such conditions also mean that it is unlikely that competition agencies will find a robust and simple rule to use to detect predatory pricing. Most just seem to fall back on the old presumption that firms with market power are always suspect. William Landes tells the story about why Ronald Coase gave up antitrust,
“Ronald [Coase] said he had gotten tired of antitrust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion.”

–William Landes, “The Fire of Truth: A Remembrance of Law and Econ at Chicago”, JLE (1981) p. 193.
A rule that says everything is illegal is at least simple.

Update: In the comments to this post John Lott makes the important point that
If predatory pricing is going to occur any place, it seems much more likely to be done by government enterprises.
For more on anticompetitive behaviour by public enterprises see John Lott Jr., "Predation by Public Enterprises", Journal of Public Economics 43 (2) November: 237-51 and "Competing with the Government: Anticompetitive Behavior and Public Enterprises", edited by R. Richard Geddes, Standford: Hoover Institution Press, 2004. For an empirical analysis of predatory pricing see Lott's book "Are Predatory Commitments Credible?: Who Should the Courts Believe?", Chicago: University Of Chicago Press, 1999.

1 comment:

John Lott said...

The conditions for predation are actually much more difficult than Louis Phlips indicates. There must be certain informational assumptions about what the victim firm knows. For example, if the victim firm has better information on when it will enter into the market and trigger the predation, it can short sell the predatory firm's stock before entering.

If predatory pricing is going to occur any place, it seems much more likely to be done by government enterprises.