Predatory Pricing and Strategic Entry Barriers Research Paper

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The classic definition of predatory pricing is pricing below cost with the intention of running a competitor out of business. In more general terms, predatory pricing is a price reduction that is only profitable because of added market power the predator gains from eliminating, disciplining, or otherwise inhibiting the competitive conduct of a rival or potential rival (Bolton, Brodley, & Riordan, 2000). Claims of large companies preying on their smaller competitors are commonplace, starting during the formation of trusts during the late nineteenth century up through charges against Wal-Mart today. Yet in the two most recent, precedent-setting predatory pricing cases, the Supreme Court observed that “there is a consensus among commentators that predatory pricing schemes are rarely tried, and even more rarely successful” (Matsushita Electric Industrial Co. v. Zenith Radio Corp., 1986), and “predatory pricing schemes are implausible … and even more implausible when they require coordinated effort among several firms” (Brooke Group Ltd. v. Brown and Williamson Tobacco Corp., 1993). The goal of this research paper is to present a brief history of predatory pricing, beginning with the era of trusts. The debate as to the rationality of predatory pricing will be examined, followed by a discussion of what is currently recognized by the courts as an act of predation. A look at research since Brooke Group ensues. As the recoupment of lost profits during the period of predation is now a necessary condition to be guilty of predatory pricing, strategic entry barriers will be examined. Possible explanations of the prevalence of predatory pricing cases are offered, with a discussion of claims against Wal-Mart to follow. Some short remarks conclude.

Predation and Trusts

During the era of trust building, predatory pricing was believed to be a commonly employed business practice. This was predation of the price discrimination variety— firms would cut prices in some markets to influence rivals while leaving prices higher in other markets. Many cases have been examined by antitrust scholars, including trusts in gunpowder (Elzinga, 1970), sugar (Zerbe, 1969), cornstarch/syrup (United States v. Corn Products Refining Co., 1916), tobacco (Burns, 1986), and matches in Canada and the British “fighting ships” (Yamey, 1972). Perhaps the best-known accusation was put forth by Ida Tarbell in her 1904 book The History of Standard Oil Company. Coupled with testimony during the antitrust case against Standard (Standard Oil Co. of New Jersey v. United States, 1911), it was widely believed that Standard did employ predatory pricing along with other anticompetitive practices. Even today, the Standard Oil case is often the first antitrust case presented in introductory economics texts.

Standard was accused of using its monopoly power to price discriminate, undercutting rivals in some locations, while subsidizing losses with profits from other locations. Similarly, it maintained its monopoly position by selectively cutting prices in markets where competitors dared to enter. It was widely agreed that predatory pricing played an important role in Standard’s monopolization of oil refining. So concerned were regulators about the effectiveness of predatory pricing in securing monopoly power that predatory pricing was included in the list of business practices specifically outlawed by the Clayton Act of 1914 and again in the Robinson-Patman Act of 1936.

The Standard Oil case also led to the first major questioning of predatory pricing as a viable business practice. In his groundbreaking paper, John McGee (1958) scoured the court records, closely examining each of Standard’s 123 known refinery purchases. He found numerous contradictions to what would be considered classic predation. First, predatory pricing assumes that a large firm locally cuts prices while subsidizing the losses from profits elsewhere (i.e., the deep-pockets argument), yet Standard had less than 10% of the refining market as late as 1870. Predatory pricing strategies cannot explain how Standard obtained the necessary monopoly power to prey. McGee was the first to point out that when engaged in a price war, the larger supplier suffers the larger loss. In many regions, Standard had 75% or more of the local market, meaning that in a below-cost price war, Standard’s losses would be at least three times those of the other competitors combined. In addition, a refinery does not just disappear when production stops. There is no reason why a competitor cannot shut down during the price war, then commence production once Standard raises price to recover the losses. McGee posited that obtaining competitors through mergers would be less costly, because the combined firm could earn monopoly profits right away, rather than suffer losses during a price war of unknown length. In addition, there should be some agreeable price, between the rents earned in a competitive market and those earned in a monopoly. McGee found that Standard obtained its monopoly through mergers rather than predation. Most of these mergers were of the friendly type, where owners and managers of the purchased refineries kept their positions. In other cases, owners who had sold to Standard opened new refineries in markets where Standard had a presence. Neither of these should occur if Standard used predation, because such an adversarial relationship would not lead to a cordial working agreement. McGee also refuted the argument that Standard used predation to lower the purchase price. To quote McGee: “I can not find a single instance in which Standard used predatory price cutting to force a rival refiner to sell out, to reduce asset values for purchase, or to drive a competitor out of business” (p. 157).

Chicago and Post-Chicago Schools

Located at the University of Chicago during his Standard Oil study, McGee is a leading member of the Chicago school of antitrust scholars. The terms Chicago and post-Chicago arise frequently in the antitrust literature. Most Chicago scholars have some relation to the University of Chicago, but scholars who are skeptical about predatory pricing, regardless of affiliation, are classified as “Chicago school.” Post-Chicago refers to scholars active primarily in theoretical industrial organization who examine the possibility of predation as an equilibrium strategy. There is no general consensus among post-Chicago scholars as to the viability and frequency of predatory pricing.

The general view of predation held by the Chicago school is that it is not a rational, long-run profit-maximizing strategy. The costs of predation must be offset by future monopoly profits, which are highly uncertain. Without postpredation barriers to entry, the monopoly price cannot be sustained, and no harm comes to consumers. Under this scenario, no action should be taken against aggressive pricing campaigns, even if competitors are injured. The benefits to consumers of vigorous price competition dominate any costs to the firms. Other classic presentations of the Chicago perspective on predatory pricing include Robert H. Bork (1978), Frank H. Easterbrook (1981), and John Lott, Jr. (1999). The current requirement of recoupment crystallized in Brooke Group (to be discussed in detail below) was first explicitly defined in a lower court case heard by Easterbrook (A. A. Poultry Farms, Inc. v. Rose Acre Farms, Inc., 1989).

One perceived weakness of McGee’s (1958) argument was its somewhat static approach. The effect of predation in one market on rivals or potential rivals in other future markets was never explicitly examined. Game theory allowed economists to explicitly model such strategic behavior. The seminal paper in this area, Selten’s (1978) chain store paradox, showed that preying could not be an equilibrium strategy, even when considering its effect on future rivals. A series of papers followed, each relaxing one or more of Selten’s assumptions. The authors working in this area form the “post-Chicago school.”

The post-Chicago school examines the possibility of successful predation in a formal, equilibrium setting. These game-theoretic models include predation as a possible strategy and find that under certain assumptions, predatory pricing can be a rational, equilibrium strategy. These models expand the finite, full-information models of McGee and Selten into a more complex, dynamic world of imperfect and asymmetric information. The post-Chicago literature analyzes two major sets of models: those based on asymmetric financial constraints and those based on signaling. Ordover and Saloner (1989) present a thorough discussion of the post-Chicago literature.

Models involving asymmetric financial constraints trace their origin to Telser’s (1966) “deep-pockets” argument. The predator has greater resources and can outlast the prey during a below-cost price war. In Telser’s model, predatory pricing was not part of an equilibrium because under common knowledge, the potential prey would leave at the first opportunity rather than fight a price war it knew it was destined to lose. Predatory pricing does arise as an equilibrium strategy in works by Fudenberg and Tirole (1985, 1986). In these models, there is an information asymmetry in the credit market. By preying in one period, the predator can lower the expected value of the prey’s assets, leaving the prey unable to obtain financing in future periods.

Predatory pricing can be used as a signal to influence expectations of future profitability held by rivals, potential entrants, or even the creditors of the prey. Early papers by Milgrom and Roberts (1982) and Kreps and Wilson (1982) added an information asymmetry to the chain store model. Both showed that if the predator knew more than the potential entrants, predation could be an equilibrium strategy, although not necessarily the only equilibrium. A predatory price might be used to signal low costs (Milgrom & Roberts, 1982) or that the predator is aggressive and prefers preying to accommodating (Kreps & Wilson, 1982). A predatory price might be part of an equilibrium where the exit of a rival does not occur. Predation is used to change the prey’s behavior, possibly to obtain better merger terms (Saloner, 1987). Critical to all of the post-Chicago school models is the assumption of an information asymmetry. Predation is successful only when the predator knows something that the prey or financial market does not and can use pricing strategies to influence beliefs about the unknown. When the uncertainty is in both directions (i.e., when the predator does not know everything about the prey as well), the likelihood of successful predation drops.

What Constitutes Predation

Under the Sherman and Clayton Acts, a firm could be found guilty of predatory pricing if it priced sufficiently lower in markets where it faced competition than in markets where it did not. Predatory pricing cases were infrequent until passage of the Robinson-Patman Act in 1936. Undercutting the price of a local firm by a large, multimarket firm was prima facie outlawed. In the 1940s, the Federal Trade Commission (FTC) stepped up its enforcement of the Robinson-Patman Act, with plaintiffs winning most litigated cases, including at least some cases where there was not clear predation (Koller, 1971). Antitrust scholars refer to this as the “populist era” of predatory pricing enforcement (Bolton et al., 2000).

The Robinson-Patman Act protected businesses from larger rivals. However, little notice was given to the benefits to consumers arising from lower prices and more vigorous competition. A large firm might undercut a local firm’s price not because it is a predator but perhaps to capture some of the local firm’s rents. The way that predatory pricing was viewed under Robinson-Patman varied considerably. In the precedent-setting 1967 Utah Pie ruling, evidence of predatory intent and an unreasonably low price were sufficient for a verdict of predation. However, the Utah Pie ruling neglected to specifically define what was meant by an “unreasonable” price. In their 1975 paper, Areeda and Turner tied the definition of a predatory price directly to the costs of the predator. A price was found to be predatory if it was below the predator’s average variable cost (used as a proxy for marginal cost). The “Areeda-Turner rule,” or some slight variation, was quickly and widely adopted by the courts. Predation suddenly became more difficult to prove: In the 7 years following the article’s publication, plaintiffs’ success rate dropped to only 8%, as compared to 77% during the populist era (Bolton et al., 2000). To date, the Areeda-Turner rule remains an important factor in determining predatory pricing violations. However, pricing below average variable cost is no longer sufficient to be guilty of predatory pricing.

In the Matsushita case, the Supreme Court, for the first time, looked beyond short-run losses and weighed the possibility of recoupment in its decision. The Court held, “The success of any predatory scheme depends upon maintaining monopoly power for long enough to both recoup the predator’s losses and to harvest some additional gain” (Matsushita Electric Industrial Co. v. Zenith Radio Corp., 1986). As the plaintiffs failed to offer convincing evidence of possible recoupment, the Court found it unnecessary to conduct a detailed inquiry into whether the defendant’s prices were below costs. In the most important precedent-setting case of late, Brooke Group Ltd. v. Brown and Williamson Tobacco Corp. (1993), the prospect of recoupment was the primary determinant of whether damage to competition had occurred. At the appellate level, the Fourth Circuit Court of Appeals acknowledged that prices below some measure of costs are necessary to prove predation. However, the court ruled that predation also required “the rational expectation of later realizing monopoly profits. The failure to show this additional aspect is fatal” (Liggett Group, Inc. v. Brown and Williamson Tobacco Corp., 1992). The Supreme Court declined to enter the conflict over measures of costs but concentrated instead on the plausibility of recoupment. The Court ruled that when assessing the plausibility of recoupment, the analysis must first “demonstrate that there is a likelihood that the predatory scheme alleged would cause a rise in prices above the competitive level” and these prices during the recoupment stage must “be sufficient to compensate for the amounts expended on the predation, including the time value of the money invested in it” (Brooke Group Ltd. v. Brown and Williamson Tobacco Corp., 1993, p. 2589). The Court offered examples of where predation would be unlikely to lead to recoupment: where barriers to entry are low or where the market structure is diffuse and competitive. In the final ruling on Brooke Group, the Court found that recoupment, and therefore predatory pricing, was implausible given the oligopolistic nature of the market. For a thorough examination of recoupment standard put forth in Brooke Group, see Elzinga and Mills (1994).

To be found guilty of predatory pricing today, evidence must be presented that the defendant priced below some measure of cost and that recoupment of losses suffered during the period of predation (recoupment of losses is the subject, not pricing below cost and recoupment) is probable. The recoupment standard is critical and difficult for the plaintiff to prove. Zerbe and Mumford (1996) provide a detailed examination of the first 14 post-Brooke Group cases. In fact, since Brooke Group, the FTC has not successfully prosecuted a single firm.

Current Research in Predatory Pricing and Strategic Entry Barriers

While the courts of late remain skeptical about the prevalence of and damages caused by predatory pricing, it continues to be an area of active research. The requirement that price lies below some measure of cost raises some concerns. Edlin (2002) examines the possibility of predation when prices stay above costs. In addition, cost-based rules would miss an important method of predation—the raising of competitor’s costs. Granitz and Klein (1996) applied econometric techniques not available to McGee and presented evidence that Standard Oil did in fact use this method of predation.

Theorists working in the field of predatory pricing express concern that the courts have rarely cited the strategic (i.e., post-Chicago) literature, even though this literature offers an array of models where predation is a rational, profit-maximizing strategy. It is important to note that in every strategic model, predation occurs in equilibrium only if recoupment is possible. Of course, recoupment is only possible if there is some barrier to entry, so this line of research could be thought of as the study of strategic entry barriers. The arguments put forth in the strategic entry barrier literature are not in conflict with the crux of the Brooke Group ruling. Rather, some economists worry that the courts are inadequately assessing the probability of recoupment. Courts that fail to recognize market imperfections might miss possible ways these imperfections can be exploited to keep rivals out.

Critical in McGee’s (1958) critique of the Standard Oil case was the assumption that costs were similar across firms. When markets work well and technology is easily transferable, such as in oil refining, this assumption is reasonable. But some markets fail to meet these conditions. One example is when production exhibits a learning curve, where costs fall as a producer obtains more experience in production. Cabral and Riordan (1994, 1997) show that a learning curve can be manipulated to create a barrier to entry. In such models, a firm preys early to increase output, thereby moving farther down the learning curve and eventually gaining an entry-deterring cost advantage. This behavior clearly meets the predatory pricing standards put forth in Brooke Group. However, the welfare effects of such predation are indeterminate. As stated in the conclusion of the 1997 paper, “The information requirements of fashioning an effective legal rule against harmful predation are formidable” (p. 168). A similar stance was taken by Chiaravutthi (2007), who studied the possibility of successful predation in a market with network externalities. A network externality occurs when the benefit of joining a network increases with the number of members. Chiaravutthi found that in a laboratory setting, predatory pricing is often a successful strategy. Predation increases membership early, raising the value to potential members above that of other networks and creating an entry barrier. The welfare effects of successful predation were again ambiguous, and the author concluded that “all in all, it seems extremely difficult to frame a legal rule that would make the correct diagnosis in all cases” (p. 169). Note that it was the market failure, not the laboratory setting, that resulted in successful equilibrium predation in Chiaravutthi’s model. Earlier lab testing of predatory pricing in well-behaved markets was not quite as successful (see Gomez, Goeree, & Holt, 1999, for a survey of laboratory-based predatory pricing research).

Since Chamberlain (1933), it has been widely accepted in the industrial organization literature that product differentiation is a potential source of market failure. Schmalensee (1978) showed that product differentiation can be an effective barrier to entry. Lindsey and West (2003) examined the effects of predatory pricing in a market with differentiated products. They found (via simulation) that with product differentiation, predatory pricing is a possible equilibrium strategy. However, the authors did not explicitly address recoupment or welfare effects.

During the 1980s, much research was undertaken in finance on the imperfections inherent is capital markets. Bolton and Scharfstein (1990) showed that these imperfections can lead to an entry barrier necessary for successful predation. Entrants into an industry typically have implicit agreements with their backers for additional postentry financing. This financing is often conditional on early post-entry performance. By preying, an incumbent firm can reduce the entrant’s profits, increasing the chance that additional funding will be denied. Additional work in the field of financial market predation includes Bulow and Rogoff (1989) and Diamond (1989). All of the authors stress the relevance of their models in rapidly evolving industries where firms rely heavily on venture capital for financing.

The discussion on recoupment standards continues. Iacobucci (2006) examines Canada’s wavering on recoupment post Brooke Group. He presents a strong argument that recoupment tests reduce the chance of improperly characterizing lawful price reductions as predatory. A debate between some of the brightest scholars working in the field was published in the Georgetown Law Journal in 2001 (Bolton, Brodley, & Riordan, 2000, 2001; Elzinga & Mills, 2001). Bolton et al. (2000, 2001) take the view that

the courts need to pay more heed to strategic models. They present a series of tests that would better enable the courts to discover possible strategic entry barriers that currently go unnoticed. Elzinga and Mills (2001) point out the strong assumptions in the strategic models and worry that applying theoretical models to actual firm behavior would be extremely difficult. Perhaps their position is put forth best in the following quote: “If you are hunting for a predator and mistakenly shoot a competitor, you injure consumers”

The Prevalence of Predatory Pricing Cases

If predatory pricing is not a viable business practice, why do we still see lawsuits claiming predation? The first reason was discussed above: Strategic predatory pricing is taking place, but the courts are not sophisticated enough to recognize it. Perhaps a plaintiff knows competition has been harmed by predation and that recoupment will be possible. Given that antitrust awards are automatically trebled, it is worth taking the chance to conceivably become the new precedent-setting case.

Baumol and Ordover (1985) provide another explanation of predatory pricing cases: use of the antitrust laws to facilitate tacit collusion. Collusion between competitors to restrict output (i.e., raise price) is against U.S. law. However, it is widely held that there is extensive tacit or informal collusion throughout the economy. Baumol and Ordover present a scenario where industry rivals threaten predatory pricing suits against competitors that make a competitive price cut. Given the expense of fighting a predatory pricing lawsuit (e.g., American Airlines spent $20-$30 million to fight the suit brought by Continental; Clouatre, 1995), such threats can be effective deterrents to competition. Harrington (2004) formally examined the effects of antitrust laws on the stability of cartels. He found that it is possible that such laws, which were enacted to fight cartels, might actually increase the viability of a cartel.

A simpler, nonstrategic explanation is that the plaintiff does not know its rival’s costs. What seems to be a predatory price (i.e., a price significantly below the plaintiff’s costs) might not actually be below the defendant’s costs. Kamp and Thomas (1997) modeled such a situation, where a rival firm’s quality (and therefore costs) was uncertain. Due to a secret quality cut, what appeared to be a predatory, below-cost price was actually a price that was still above cost. The necessary condition of a below-cost price is not met, and the courts would find in favor of the defendant. A final possibility is that a below-cost price is set to capture a larger market share, without regard to possible recoupment. Thomas and Kamp (2006) present several plausible reasons why at least some managers, and perhaps even many managers, sometimes choose to pursue higher market share by cutting prices, even when the price cuts and higher market share reduce profitability. Under either of these types of predation, current predatory pricing policy yields desirable antitrust enforcement outcomes.

Wal-Mart

Since 1990, no firm in the United States has generated more claims of predatory pricing than Wal-Mart. The Bentonville, Arkansas-based retailer obtained its position as the largest retailer in the United States primarily by offering “everyday low prices.” Sometimes its competitors believe that these low prices are too low, even below costs.

Perhaps the most important predatory pricing suit against Wal-Mart was filed in the Faulkner (Arkansas) County Chancery Court by three local pharmacies in 1991 (American Drugs, Inc. v. Wal-Mart Stores, Inc., 1993). The plaintiffs claimed that Wal-Mart violated the 1937 Arkansas Unfair Trade Practices Act by routinely selling pharmaceutical products below cost. Strong evidence was provided that Wal-Mart priced certain items below its wholesale cost. One of the plaintiffs testified that he stocked his own store from Wal-Mart, as the retail price was below the lowest wholesale price he could find (Kurtz, Keller, Landry, & Lynch, 1995). This strategy is not unique to the Wal-Mart case: During an early twentieth-century attempt at predatory pricing, Dow purchased bromine offered on the U.S. market at below costs by its German competitor and resold it for a profit in Europe (Levenstein, 1997). In 1993, the Faulkner Court found Wal-Mart guilty of predatory pricing. Wal-Mart was ordered to stop charging below-invoice prices for its pharmaceuticals and to pay the three plaintiffs $289,407 (Boudreaux, 1996). Wal-Mart appealed to the Arkansas Supreme Court (Wal-Mart Stores, Inc. v. American Drugs, Inc., 1995), and in January 1995, the Court ruled by a 4-3 decision to overturn the lower court verdict and dismiss the case.

More recently, in 2001, Wal-Mart and the Wisconsin Department of Agriculture reached a settlement over claims that Wal-Mart sold butter, milk, laundry detergent, and other staples below costs in five Wisconsin cities. In the settlement, Wal-Mart admitted no wrongdoing and was not required to pay a fine. However, it agreed to pay double or triple fines for any future violations. In 2007, Wal-Mart was forced to eliminate its low-priced generic prescription plan for certain drugs in nine states, as their price was below their true costs. While questions remain as to whether Wal-Mart’s aggressive pricing harms competition, there is no debate as to the benefits of low prices to its customers.

Conclusion

The debate about the existence and feasibility of predatory pricing shows no sign of stopping. Currently, the courts take a somewhat skeptical view of the viability of predatory pricing. Showing that price was below cost is not enough: It is now the plaintiff’s responsibility to show that the predator will be able to recover its losses suffered while preying. Much to the chagrin of theorists working in industrial organization, the courts of late have been unwilling to refer to the strategic literature when ruling. The makeup of courts changes, however, and there is no guarantee that we have reached a steady state regarding predatory pricing.

As long as rival firms engage in intense price competition, there will continue to be claims of predation. And as long as firms price below costs, economists will attempt to model predatory pricing as an equilibrium, profit-maximizing strategy.

See also:

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