Freeman

ARTICLE

Predatory Pricing Laws: Hazardous to Consumers Health

DECEMBER 01, 1994 by DONALD BOUDREAUX

The local Wal-Mart in Conway, Arkansas, began selling pharmaceuticals in 1987. As with all of its other products, Wal-Mart sold high-quality medicines and health and beauty aids at rock-bottom prices. Not surprisingly, Wal-Mart’s pharmacy business boomed. But rather than receive applause for its enterprising efforts, Wal-Mart was sued for violating antitrust law. In October 1993, an Arkansas trial court ordered Wal-Mart to raise its pharmaceutical prices and to pay treble damages to three local competitors who complained about Wal-Mart’s low prices.

Unfortunately, harassment of firms that charge low prices is not unusual in the Alice-in-Wonderland world of American antitrust law. Although antitrust statutes are trumpeted as protectors of competitive markets and consumers, these laws in fact stifle competition and injure consumers. The pernicious nature of antitrust laws is nowhere more blatant than in so-called "predatory pricing" regulations, such as that used against Wal-Mart in Arkansas.

The "Logic" of "Predatory-Pricing" Prohibitions

"Predatory pricing" is said to occur when a firm seeking to monopolize a market sells its wares at prices below the firm’s costs of production. Such below-cost pricing, it is said, unjustifiably inflicts losses on equally efficient rivals ("prey"). These losses force the prey eventually into bankruptcy, leaving the predator as the only seller in the market. The predator becomes a monopolist tomorrow by charging "excessively" low prices today. Thus, the benefit consumers get from today’s low prices is more than offset (it is assumed) by the harm they suffer from tomorrow’s monopoly prices.

If successful "predatory pricing" as described in the preceding paragraph occurred with some frequency, the case for legal sanctions against it would have a plausible basis. There is no good reason, however, to suppose that "predatory pricing" occurs. A vast amount of theory and evidence suggests that firms attempting to monopolize markets via below-cost pricing are almost sure to fail.1 And profit-seeking firms are not prone to pursue strategies that consistently misfire. It follows that legal prohibitions against "predatory pricing" are, at best, unnecessary.

Why "Predatory Pricing" Is Not a Problem

While no one doubts that each firm wants to be a monopolist, economics shows that below-cost pricing is an especially futile method of achieving monopoly power. "Predatory pricing" will not work because a predator’s prey have available several practical counterstrategies to ensure that they are not run out of business by "predatory pricing."

Suppose Predator, Inc., seeks monopoly power by charging a price below cost. Predator, Inc., must be willing to expand its output and sales at the below-cost price, for only then will it take customers away from its prey and, thereby, force its prey likewise to charge prices below cost. So, the predator inevitably suffers losses during the predatory period. Although the prey may also suffer losses from having to meet Predator, Inc.’s below-cost price, each prey suffers fewer losses than does the predator: Predator, Inc., must expand its sales at the below-cost price while each of the prey reduces its sales volume to loss-minimizing levels.2

The fact that predators would necessarily incur greater losses than their prey should be sufficient, standing alone, to demolish arguments in support of government prohibitions of "predatory pricing." Government serves no good purpose by policing against actions that no one has incentives to pursue. However, advocates of laws against "predatory pricing" reply that predators typically have "longer purses" than do prey–i.e., access to greater wealth to fund price wars. Accordingly, even though predators incur greater losses than do prey, predators are thought to have greater ability to withstand such losses.

This argument is unfounded. "Longer purses" are unlikely in economies with functioning capital markets. In predatory-price wars, efficient prey with no spare funds of their own would be able to borrow the funds necessary to wage counterattacks against predators. After all, predatory pricers (by assumption) attempt to bankrupt firms that promise to be profitable once they’ve withstood the predation. Investors make their living by successfully identifying firms that can use money today to turn profits tomorrow.

But even if predators do have access to "longer purses" than do prey, it is doubtful that firms with funds on hand will invest in attempts to drive efficient rivals from business via below-cost pricing strategies. A much more profitable use of these funds would be to improve production efficiency or to enhance product quality. Not only does improved efficiency or product quality directly add to profits, but rivals cannot match such improvements as easily as they can match price cuts. Firms seeking enduring competitive edges over rivals will invest in ways that rivals find difficult to mimic. Moreover, unlike a predatory pricer, a firm that improves its efficiency or product quality typically suffers no greater expenses than its copycat rivals.

There are yet other reasons to doubt the reality of below-cost pricing as a monopolization scheme. Suppose Predator, Inc., somehow manages to run all of its rivals from the industry. What now? Predator, Inc., must jack its prices up to monopolistic levels in hopes of earning enough monopoly profits to more than offset the losses it incurred when it priced below cost. But nothing cures monopoly like excess profits. Predator, Inc.’s price hikes will attract rivals into the industry, squelching its ability to recoup its predatory losses. Predator, Inc., will find that it spent money in a failed effort to achieve a monopoly.

Of course, entry of new firms doesn’t happen instantaneously–but neither does the exit of preyed-upon rivals. Predator, Inc., wants its prey to exit the industry quickly (so that its up-front losses are small) and new rivals to enter, if at all, only slowly (so it has sufficient time to recoup its predatory losses via monopoly pricing). Unfortunately for Predator, Inc., however, industries in which exit is quick are industries in which new entry is quick; industries in which new entry is slow are industries in which exit is slow.

The symmetry between rivals’ exit-time and entry-time discourages reasonable firms from pursuing "predatory-pricing" strategies. This symmetry exists for a straightforward reason. Ignoring government-erected barriers, entry by firms into an industry will be slow only insofar as investments of capital goods in that industry are "industry specific"–that is, only if equipment for use in that industry has no good alternative uses. Investors are naturally reluctant to commit to projects requiring capital goods whose only other use is as scrap. They realize that once they commit their funds to industry-specific machines, tools, and buildings, they cannot easily go elsewhere for a profit if the industry proves to be unremunerative. (For example, once money has been used to build railroad tracks, the next- best use for railroad tracks is as scrap. Therefore, a railroad will not quickly be run out of business by a rival who charges unusually low rates. A predatory railroad would have massive up-front predation costs.) Thus, the only industries in which the entry of rivals will be slow are industries in which running existing firms out of business takes a long time. The huge up-front predation costs in such industries render "predatory pricing" foolish.

Conversely, industries in which the prey quickly exit are industries that use large proportions of capital having good alternative uses. In these industries, although exit of the prey may be quick, entry will likewise be rapid. The predator will have insufficient time to recoup its losses. In this case, recoupment of predatory expenses would be impossible in the face of rapid entry.

Conclusion: Policies Against "Predatory Pricing" Are a Problem

Economics suggests a number of other reasons why "predatory pricing" is unlikely to succeed (and, hence, unlikely to occur). Space does not permit a review of these additional reasons here. It is important to indicate, however, why laws aimed at stopping "predatory pricing" are themselves quite dangerous.

One way to see the folly of laws against "predatory pricing" is to ask: What would be the value of telling the police to protect citizens against, say, invasions of fire-breathing dragons? If dragons were real, and if these creatures posed a genuine threat to human safety, then such police actions might be appropriate. But, of course, fire-breathing dragons don’t exist (although lots of folks have written about them). Whatever monies public agencies spend guarding against dragon invasions are wasted — diverted from real and more pressing needs. So it is with laws against "predatory pricing." "Predatory pricing" is a mythical beast. Funds spent to hunt down and subdue the beast are wasted.

Unfortunately, there is another, more severe problem with laws proscribing "predatory pricing." "Predatory-pricing" prohibitions dampen vigorous competition. In the words of the U.S. Supreme Court, "cutting prices in order to increase business often is the very essence of competition." Consequently, mistaken inferences of predation–and, the Court might have added, the very ability to sue rivals for predation– "chill" healthy competitive rivalry.3

For example, Wal-Mart was sued by rival pharmacists, not by consumers fearful of future monopoly prices. These pharmacists sought shelter from competitive forces. Rather than suffer lower profits or the necessity of matching the new higher standard of responsiveness to customer demands set by Wal-Mart, the plaintiffs instead accused Wal-Mart of "predatory pricing." Their wish–granted by the trial court–was to make Wal-Mart less customer-friendly so that they, Wal-Mart’s rivals, might avoid robust competition. At trial, one of the plaintiffs whined that he had to do "a lot of belt tightening" after Wal-Mart opened.4 Another plaintiff declared that he sued to make Wal-Mart raise its prices: "I want them to raise their prices. . . . I cannot compete with Wal-Mart."5

Fact is, Wal-Mart behaved just as firms in competitive market economies are supposed to behave. Wal-Mart charged lower prices because it pioneered more efficient retail-distribution methods. These efforts redounded to the benefit of both Wal-Mart (higher profits) and customers (lower prices). But the trial court effectively kicked consumers in the teeth by ruling for the plaintiffs. Firms everywhere now will more readily resort to the courts for protection against spirited competition. Consumers are the unambiguous losers under a legal regime recognizing the legal right of firms to sue rivals for so-called "predatory pricing." Sadly, there is much truth in columnist Llewellyn Rockwell’s claim that "the long, sorry history of anti-trust shows that the policy is really about using government to create cartels, not enforce competition."6

  1. 1. See, e.g., Kenneth G. Elzinga and David E. Mills, "Testing for Predation: Is Recoupment Feasible?" Antitrust Bulletin, Vol. 34 (Winter) 1989, pp. 869-893.
  2. 2. Robert Bork summed up the case against "predatory-pricing" laws: "It looks like 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." Robert H. Bork, The Antitrust Paradox (New York: Basic Books, 1978), p. 152.
  3. 3. Matsushita Electrical Industrial Co. v. Zenith Radio Corp., 475 U.S. 574 (1986), p. 589.
  4. 4. Testimony of plaintiff James Hendrickson, Wal-Mart Stores, Inc. v. American Drugs, Inc., et al., p. 1634 of the trial record. This same plaintiff also admitted that the pharmaceuticals market became more competitive after Wal-Mart entered. See trial transcript at p. 1649.
  5. 5. Trial testimony of Dwayne Goode, id., p. 1615.
  6. 6. Llewellyn H. Rockwell, Jr., "Mashing Microsoft," The Washington Times,, Friday, July 22, 1994.

ASSOCIATED ISSUE

December 1994

ABOUT

DONALD BOUDREAUX

Donald Boudreaux is a professor of economics at George Mason University, a former FEE president, and the author of Hypocrites and Half-Wits.

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