Predatory Pricing as an Outcome of Competition





.....In a message to the list of subscribers to the Austrian Economics discussion group, Professor Randall Holcombe (Randy), wrote the following story about predatory pricing:


.....Most on this list are suspicious of accusations of predatory pricing, and for good reason. However, whenever the topic comes up, I think of the following episode from the early 1960s, when I was a junior high school student in Daytona Beach (which, by the way, was a great place to spend junior high and high school years). A farm cooperative called United Dairy Farmers started selling milk directly to the local grocery stores, and it was priced so much less than other milk that the brand name suppliers sold almost no milk. United Dairy Farmers sold only milk, but no other dairy products, and the brand name suppliers told the grocery stores that if they continued to carry United Dairy Farmers milk, the brand name suppliers would no longer supply them with cheese, ice cream, or any other dairy products. The grocery stores then stopped selling United Dairy Farmers milk.


.....United Dairy Farmers then opened up small drive-through stores selling milk. I recall my mother buying groceries, and then on the way home driving through United Dairy Farmers to buy her milk because of the cost saving, so the brand name suppliers still found their business depressed. They then lowered their milk prices to match United Dairy Farmers, and my mother and others started buying their milk at the grocery stores again. I can recall my mother saying that she realized that if everyone did what she did, United Dairy Farmers would go out of business, and milk prices would go up, but that for the same price, she was not willing to go through the inconvenience of making a separate stop for milk. Furthermore, United Dairy Farmers advertized, telling consumers they needed to continue buying at United Dairy Farmers if they wanted lower milk prices.


.....That move by the brand name suppliers was successful, and United Dairy Farmers was driven out of business. Milk prices rose to the pre-United Dairy Farmers level. That's how I (a junior high school student at the time) remember it. Is the story implausible? Would it constitute predatory pricing?


This brief essay provides a subjectivist analysis of the situation described by Professor Holcombe.


.....Predatory pricing means pricing aimed at driving a competitor out of business in order to be able to charge a higher price than otherwise. There is no reason to think that it would not occur under the conditions of the pure market economy. The question is whether there is a remedy at law for which we have reason to believe that the benefits are greater than the costs. In a strictly economic analysis of the situation we disregard the public choice implications. In a democracy, any remedy would require giving elected representatives, including judges, the right to decide whether a remedy should exist and whether it should be applied in any particular case. A purely economic analysis is not interested in this fact. We also disregard the costs and other problems associated with enforcing a proposed legal remedy. We focus entirely on the question of whether there exists a theoretically zero-cost remedy, set costlessly in accordance with considerations of what is in the best interest of the typical pure market economy participant.


.....I begin by noting an implicit assumption in Randy's story. The brand name suppliers (BRS), prior to the predatory pricing, had been able to achieve a position in which they could charge a monopoly price in the milk market. Otherwise it would have been unprofitable for them to engage in predatory pricing. Given this fact, our first step is to ask how they attained this monopoly. I shall consider four possibilities: market intervention, luck, innovation, and conspiracy. My main focus will be on innovation. I conclude with discussions of (a) the monopoly price and (b) the usefulness of conceiving of short and long run effects in an analysis of pure market economy competition.


Market Intervention


.....The first possible way that BRS could have achieved a position where predatory pricing was possible is through market intervention. Since we want to deal with the emergence of predatory pricing in a pure market economy, we can rule this out by assumption. We can be sure that if the BRS had achieved their position through market intervention, Randy would not have regarded the facts he describes as so interesting.


Luck


.....The second possibility is luck. The BRS may have achieved their positions as a byproduct of some other profit-seeking actions. The superior skill of Michael Jordan must be at least partly due to his natural ability -- the luck of his birth. I do not think that Randy was assuming that BRS position was due to luck. However, if it had been, then the problem is not predatory pricing but the monopoly price. If it was somehow possible for economists or government agents to distinguish those situations in which the monopoly price situation was achieved by luck from those in which it was achieved through market competition, a policy aimed at controlling the lucky monopoly might be supported on purely economic grounds. This would still leave the public choice problem and the enforcement problems, of course. In any case, it seems unreasonable to expect that government agents could distinguish in fact between positions achieved by luck and those achieved in other ways.


.....One further point. One person's luck may be the result of another person's choice. If I unexpectedly bequeath my previously unknown fortune to my fourth wife's granddaughter, she is lucky. But her position could have been the result of my hard work or inventiveness. If I had not believed that I could bequeath my fortune, I would have had less incentive to perform the hard work or carry out the innovation necessary to accumulate it. So I do not think that there is much to be gained by assuming that the BRS's monopoly price position was attained through luck.


Innovation


.....Third, a monopoly price position can be due to previous profit-seeking choices. Perhaps the BRS, discovering the profitability of establishing new brand names and distribution systems, were able to gain an advantage over their competitors. In this event, before the entry of the United Dairy Farmers (UDF), the monopoly price was a means of earning a reward for successful earlier competition -- competition in the form of innovation.


.....Although Randy's mom had to pay higher price for milk than she would have had to pay if the UDF had not been predatorily priced out of the market, she and others in the community were benefitting from the earlier innovation by the BRS. The only legal remedies that I can conceive of, when extended into a general rule for intervention, would also send a message to entrepreneurs that otherwise profitable and socially cooperative (in the Misesian sense) innovation would no longer be profitable. Such a remedy would have allowed Randy's mom to buy cheaper milk at the time but only at the expense of future opportunities to buy a variety of goods either at prices that would have been lower than otherwise or with characteristics that would have not otherwise been available.


Conspiracy


.....Fourth, a monopoly position may be the result of conspiracy by otherwise competing entrepreneurs. The current suppliers of some good or range of goods may first agree to divide the consumers into groups, as if deciding on a property allocation. Then they agree to respect each other's right to sell exclusively to the buyers in his/her assigned group. Or, the suppliers may agree to a common price which is higher than the prices they would otherwise charge.


.....In dealing with conspiracy, it is essential to realize that in order to attain a position to form a conspiracy, the otherwise competing suppliers must already possess a specialized ability or resource that is not available to entrepreneurs who are outside the group. Otherwise, their method of supply could be easily copied by entrepreneurs who would reduce price. Thus, the question arises as to how the conspirators could have attained the specialized abilities that enabled them to succeed in their conspiracy. We have considered three possibilities: government intervention, luck, and innovation. We can apply the same analysis here. If the ability to conspire was the result of innovation, the only remedies for conspiracy that I can conceive would reduce the incentive to innovate. Conspiracy does not substantively change the analysis.


The Monopoly Price


.....It is well known that if a monopolist cannot discriminate in price, he/she charges a price that is higher than the marginal cost of supply. Is it not sensible to search for a remedy to this situation? As before, the question we must ask is how an individual achieved the position of the monopolist. Assuming that it was due to innovation, the only remedies of which I can conceive would reduce the future incentive to innovate. It is true that if consumers as a group could join together at zero cost and make a zero-cost collective decision, they would be willing to pay a monopolist sufficient funds to reduce his/her price. But this is no more important that the fact that if there were zero costs of making exchanges, the gain from production and exchange would be greater than it is. Transactions costs, in the Coasean sense, are never zero.


.....The problem of the monopoly price is precisely the problem that the costs of making transactions are not zero. If the monopolist could reduce his/her price to one buyer without reducing to another, he/she would do so because it would raise his/her profit. Profit would be higher and the incentive to innovate would be even greater. But this is not possible. The fact that we can imagine a situation in which the gains from trade are higher than they otherwise would be does not imply that such a situation is attainable by means of a legal remedy.


.....It is possible that price discrimination would occur but that there is a law that deters this. In this case, the law should be repealed. On the one hand, it prevents the monopolist from offering his product at a price that some consumers are willing to pay. On the other hand, it reduces the incentive to produce the new technique, new product, or specialized ability that enables the individual to achieve a position to charge a monopoly price.


Short and Long Run Effects


.....It has become common in such cases for some economists to distinguish between short run and long run effects. They assert that in the long run (in the absence of any further changes in the data), competition would bid such profits down to zero. This is not only unnecessary but distracting. As soon as the monopoly pricing position is achieved, the so-called anticipated long-term monopoly profit is capitalized in the mind of the entrepreneur. It is not really profit in the sense of being a motivation for action. It is a reward for past action. Even if we assume that the monopoly pricing position would exist for the foreseeable future (say, because we have no reason to think that anyone would recognize the opportunity for profit through competition), the income associated with it would be a reward for previous action.


.....In a proper image of the pure market economy, there is no tendency toward equilibrium in the long run. (On equilibrium ) There is only competition -- copying and innovating. The usual distinction between short run and long run effects disregards innovating in order to focus on copying. Although this is a useful pedagogic tool, it should not be applied in isolation. Innovation is always a characteristic of real entrepreneurial competition.


Answer


.....The answer to Professor Holcombe's question is this: Of course, the story is plausible and it appears to be an example of predatory pricing. Since predatory pricing can only be achieved by an entrepreneur who has attained a position to charge a monopoly price, the profit gained as a result of predatory pricing is part of the reward for an earlier innovation. Accordingly, there are no grounds in the story for market intervention.





Copyright (c) 2000 by James Patrick Gunning



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