Categories:
Business Economics
Competition
A widely held belief is that large firms with some market power can use their profits generated in particular markets to cut prices below costs in another market and drive out their competitors. Then, according to this belief, once the competitors are driven out, the large firms can raise their prices in that market and collect higher-than-competitive prices.
There are two problems with this view. First, it is logically deficient. Second, there is little evidence to support it.
These are the opening two paragraphs of “Why Predatory Pricing is Highly Unlikely,” Econlib Feature Article, May 1, 2017. This one is by me.
I thank Donald J. Boudreaux for helpful comments.
READER COMMENTS
zeke5123
May 1 2017 at 11:42am
Prof. Henderson,
Nice piece. I generally agree with it, but I do think you oversell two-points: (I) firms may not be able to turn on/off their production capabilities that smoothly (e.g., it might be hard to fire/re-hire workers quickly) and (II) certain production may require substantial capital investment / employee expertise(e.g., airplane production). Perhaps a company could engage in predatory pricing and then buy up the machines used by the old competitors. Now, there is a real high cost to entry (i.e., high capital cost and high cost to recruit expertise) that might deter someone from entering the field, allowing monopolistic rents.
With all of that said, in most fields where barriers to entry aren’t very high, I think your piece holds well. Instead, I would think there are certain fields where predatory pricing could occur.
Would love to hear your thoughts and see if I am making a mistake.
Jon Murphy
May 1 2017 at 11:55am
Excellent article. I’m glad you mention the McGee piece. The first third of it (where he details the logic of predatory pricing) is a highly accessible read for anyone. It’s worth a look, i think.
Jerry Brown
May 1 2017 at 12:27pm
Could it happen that Firm A’s predatory pricing allows it to not only become the primary retailer of its products to the consumer market but also the primary buyer from the suppliers of the products it sells? And maybe that would allow Firm A to exert extra influence to reduce it’s input costs? Such that any new competition would be unable to compete in either market because they would find that suppliers would not be willing to supply the intermediate goods at the same price unless the volumes purchased were similar?
AlanG
May 1 2017 at 1:17pm
So a small biotech company gets approval for a new treatment for a rare genetic defect (and it’s the only treatment that works for these individuals) and prices it at $720,000/year. Is this predatory pricing? Clearly, there are lots of examples in the pharma area of pricing beyond what might be deemed normal and even when there is competitions, it’s only around the margins until patents expire.
On the generic drug side we have seen companies such as Valeant and Turing purchase off patent drugs and immediately raise prices 10 fold or more. Is this not predatory pricing? If not, is there another definition that I’m unaware of (other than “price gouging”).
Jon Murphy
May 1 2017 at 1:27pm
@AlanG:
No, those are not cases of predatory pricing. Predatory pricing refers to the deliberate under-pricing of goods in order to drive out competitors. In your examples, there are no competitors (or the companies are protected from competitors). You’re describing monopolistic pricing (or “price gouging” if we want to use the term used by the DOJ)
David Seltzer
May 1 2017 at 6:21pm
In 1971, I was a graduate student at the University of Chicago GSB. During that year, I was Yale Brozen’s research assistant working on the industry concentration doctrine. Brozen found evidence intra-industry returns, profit rates, were non-monopolistic. The largest firms in concentrated industries, produced more efficiently than smaller firms and prices to the public were lower. I use the term “efficiency” to mean economic or Pareto efficiency.
Mark S Barbieri
May 1 2017 at 7:02pm
There is one area where accusations of predatory pricing are still frequently made and backed up by legal action from the US government. It is when foreign competitors are accused of “dumping”.
I’m still struggling to understand why I should be bothered by foreign companies selling to me below cost.
Don
May 2 2017 at 8:40am
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Ally
May 3 2017 at 5:58am
Professor Henderson,
Echoing zeke5123’s comment, I generally agree with your article. I am, however, interested to hear your thoughts on how this argument changes in the presence of high barriers to entry?
Charlie
May 3 2017 at 9:50am
“Lott studied 28 firms…”
Finding a null result with a low powered test isn’t very informative evidence. Certainly not “strong” evidence as described.
Ed
May 3 2017 at 10:53pm
In Peter Navarro (who is a top economic adviser to Trump) and Greg Autry’s book “Death by China,” they argue that China has used predatory pricing against the U.S. and other markets. The primary example they give is the rare earth cartel China has gained by using this dumping technique.
Does anyone have any further information on this?
Peter Gerdes
May 4 2017 at 1:20am
Your argument assumes that each purchasing decision is made independently of what other people own. Also, for certain kinds of goods it may not be possible to buy the competitors goods and resell them.
For instance, consider the computer market. People prefer to buy computers that are compatible with their existing systems (so they can run the same software) and strongly prefer to buy computers that have lots of software and people only write software for systems that have large user bases.
In a market where there are currently two popular computer systems both have substantial software built for them and both can continue to sell. However, if one company uses predatory pricing to exclude the other for a couple years they can then raise their prices substantially as any potential competitor would have to undercut them so far as to overcome the preference to buy the same system already owned (or that people are familiar with) as well as underwrite enough software for their system to make it competitive. Also in such a situation buying the competitors product and reselling it is actually counterproductive.
—
A more extreme case occurs with software where the marginal cost is essentially 0 but there is a yearly fixed cost to continue to update your software/pay programmers. A company (as Microsoft has actually done) can make their software so cheap that their competitor can’t support their yearly fixed costs merely by covering the yearly fixed cost. Then they can rely on the desire for compatibility to give them protection from new entrants to earn back those losses.
Thomas Sewell
May 4 2017 at 4:45am
@Peter Gerdes,
Being somewhat familiar with the computer market, I’m not sure your examples are very good ones.
Computer hardware is about the most extreme commodity market which exists. There are dozens, if not hundreds or more manufacturers for almost every computer sub-component. They’re generally compatible with each other and with all major software. There is no technical reason the same computer can’t run Linux, FreeBSD Unix, plus every recent version of MacOS and MS Windows, to name a few. So the computer itself has a very high compatibility.
From the OS perspective, MS Windows dominates desktop/laptops, but other OSes still have a significant percentage (about 10%) of that market.
That’s not the market for OSes, though, for two reasons. 1. You can run almost all Windows-compatible software on other operating systems. 2. There are tablets, eReaders, smart phones, servers, embedded systems, etc… within the larger OS market.
In the overall OS market, MS Windows is a significant player, but likely runs about 3rd or 4th in terms of total installations.
In terms of profit, Apple makes much more money per OS installation. They bundle with hardware (and refuse to sell their software on non-Apple hardware). How is that possible if MS is able to monopolize the market? Recently, MS has had to exit completely some smaller OS markets because they just couldn’t compete with various Linux (Mostly android) software.
So your theory just doesn’t fit the facts of what’s actually happened in computers.
Comments are closed.