Some Economics of Predatory Pricing

by Don Boudreaux on December 5, 2011

in Antitrust, Competition, Complexity & Emergence, Myths and Fallacies, Prices

I’ve gotten a few e-mails over the past day or so encouraging me to post more on predatory pricing.  I’ll do so.  Now, though, I am on the road for a speaking engagement and have too little time today to post more than links to these three papers.

The first is here.  (I’ll do my best later to find and post a link to an ungated version.)

The second is linked here.

I end this post with a link to this important paper from 2001 by Ken Elzinga and David Mills, two of today’s leading scholars on the topic of predatory pricing.

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{ 52 comments }

SmoledMan December 5, 2011 at 3:26 pm

For the left, Microsoft is always the poster boy for “predatory pricing” because of Internet Explorer being bundled with Windows in the mid 90s. What was never explained was how giving away something for free when all the other browsers were also free an example of this practice? I get the sense that leftists hate Microsoft for some reason that I can’t put my finger on it.

sethstorm December 5, 2011 at 11:09 pm

Default availability in the install.

yet another Dave December 6, 2011 at 7:00 pm

point?

Fred December 6, 2011 at 8:09 am

I have yet to meet a Mac fanatic who was not also a raging leftist. To the point where I actually turned down a good paying job because the shop used all Macintosh products, and I knew that I would not be happy trapped in a room all day with a bunch of lefty loons.

brotio December 6, 2011 at 3:44 pm

Rush Limbaugh

Fred December 6, 2011 at 7:48 pm

did not know that brother uncle

brotio December 7, 2011 at 2:15 am

:D

Ken December 5, 2011 at 3:40 pm

Because they succeeded?

SmoledMan December 5, 2011 at 3:53 pm

Yet they are in love with Apple which has succeeded far greater then Microsoft. Apple has way more cash on hand.

Jon Murphy December 5, 2011 at 3:59 pm

Soon enough they’ll hate Apple. Microsoft was once the darling of the hipsters. Then it became mainstream.

SmoledMan December 5, 2011 at 4:12 pm

I don’t recall that. Wasn’t Apple always the hipster company and Microsoft was the nerdy one that made crappy software but it worked well enough?

Jon Murphy December 5, 2011 at 4:17 pm

And what a nerds but just ugly hipsters? :-P

I could be wrong (my memories of the 90′s are a bit hazy because I was a pre-teen), but I thought I remember the culture being “cool” to have a PC and neardy to have a Mac

Sam Grove December 5, 2011 at 4:23 pm

The PC was business oriented while Apple was oriented toward graphic arts. Eventually, the PC was seen as more suitable to gaming than Apple devices because the PC was more accessible to hacking.

kyle8 December 5, 2011 at 7:44 pm

Actually Sam the reason that Microsoft/PC took over the gaming industry and many other apps is simply because they were not propitiatory . Apple did not allow third party additions or third party applications and demanded high fees for software licensing. There hardware was also quite expensive.

If they are not careful they will lose market share in the phone and pad wars for exactly the same reasons.

Sam Grove December 5, 2011 at 8:34 pm

A lot of people seem to forget that Microsoft does not build computers.

anthonyl December 6, 2011 at 11:44 am

That’s the way I always saw it.

andy December 5, 2011 at 5:53 pm

I had a different set of problem with predatory pricing – and that is: when is it predatory pricing and when it is not? What is the definition of predatory pricing?

Suppose perfect competition; suppose there are too many firms in the market. The result – prices are bellow whatever costs the antitrust comission considers. And yes, all participants sell for the lower price with the complete intention of driving out other firms out of the market. Are we to say that we could have predatory pricing on a market with perfect competition? The price-getter vs. price-setter seems to me just a result of the model.

Consider a duopoly model; according to the model, the only solution is either explicit or implicit collusion, or, alternatively – price war. Predatory pricing. This is gets more confounded when we consider large fixed-cost, low variable-cost industries (i.e. airlines) (I think Vernon Smith has some references to studies regarding pricing strategies in these types of industries; they don’t conform to the typical market models).

If you search for predatory pricing “cases”, you will find the following description:
1) incumbent firm
2) competitor entered the market
3) the prices dropped (sometimes in such a way, that it was really “bellow costs”)
4) the competitor leaved the market
5) the price got back to the former level

This is usually what is taken as ‘proof of predatory pricing’. Am I alone who finds this totally unimpressive?

Another classical problem is the problem of “relevant market”. It comes like this: let’s measure, which customers switched sellers, when the ‘predatory’ company lowered prices. Looks logical, right? Never mind, that nobody has ex-ante idea, how it turns out. We had a “bus company” here with very good marketing; they got competition on one line and lowered prices for some customers to a very low level. The competing bus company leaved; at the same time the state train company announced extremely low fares on the same route; unfortunately because of the quality of the trains, they didn’t attract any more customers; ergo, the trains are not a part of the relevant market. Priceless.

My conclusions:
- the pricing/competition on high-fixed-cost, low-variable-costs has a completely different dynamics
- if you happen to be in a duopoly-like situation, shoot yourself in your head
- everybody competes in the market with the intention to drive out his competitors out of the market; the ‘proof’ that somebody is doing predatory pricing is indistinguishable from a stituation of ‘too many firms in the market’

Read V.Smith’s “Constructivist and Ecological Rationality”, he actually devotes quite a lot of space to this type of behaviour.

vidyohs December 5, 2011 at 6:38 pm

“everybody competes in the market with the intention to drive out his competitors out of the market;”

Not everybody, andy. Some do not.

I always tell my clients, “I don’t want all your jobs, just the next one.” I don’t care if there are other videographers in Houston, nor do I care how much or how little they work. As long as I am working as much as will satisfy my needs, I can’t see engaging in a price war with any other videographer.

From my experience, only a rare few businesses take an attitude of scorched Earth pricing policies to drive others out of business.

kyle8 December 5, 2011 at 7:49 pm

To expound on this, there are some businesses that purposely discriminate by the type of customers they seek. Makers of luxury goods and services are an example.

Others begin to purposely slow the growth of their own business as they see quality begin to decline, or expansion costs go up too much.

It isn’t always about size, it’s about profit.

andy December 6, 2011 at 4:27 am

You are just rationalizing the fact, that you (rightfuly) expect that price war would not make sense for you. However, if you win your next customer, you have effectively priced out the competition. If you do it well enough, your competition will leave the market; just wondering what’s so special on the event of going from market share 1% to 0%, as opposed to going from 25% to 1%/

What if a company decides to sell for such a low price, that nobody wants to enter the market? Is it predatory pricing? They are already in the phase were they have driven out competition – now they just need to raise the prices….

vidyohs December 6, 2011 at 6:13 am

Perhaps you’re right on the level at which you’re offering your points; but, as I am a street guy whose entire outlook on business is very much personal, I am offering my opinion on what is more likely to be done down at the base level.

I do not think price in my competition with other videographers, I think quality of product, quality of service, and building and maintaining personal relationships with my clients as my means of winning and keeping clients. I swim in a sea of businesses that deal pretty much the same way.

Would I still think the same way if I had entered the business years ago when I still had the energy and ambition to want to build a nationwide multi-city business where price is more likely to become a factor? Probably I would think more along the lines you’re suggesting.

But, that is the point. A one size fits all attitude towards business may make fine theory, but it sucks when that theory is applied as policy. I believe that is one of the points the Sirs Don and Russ and most of the participants here have been making over and over.

andy December 6, 2011 at 7:30 am


I do not think price in my competition with other videographers, I think quality of product, quality of service, and building and maintaining personal relationships with my clients as my means of winning and keeping clients..

You are trying to price out competitors out of the market by offering higher quality for the same price; you are trying to block competition by maintaining personal relationship with your clients; for your competition it is equivalent as if you offered lower price. They also have the option to compete with you on many terms – including lower price.

The point is that in order to get a deal, you must – somehow – price out the competition out of the deal. If you do it by offering “more” for the same prace or “the same” for lower price seems to me unimportant.

The definition of predatory pricing on the lines of ‘intention to drive competition out of the market’ seems to me too general. Firms getting bankrupt is absolutely normal market phenomena; would you argue that competitors of such firm couldn’t expect that pursuing low-price policy wouldn’t result in bankruptcy of some competitor?

vidyohs December 6, 2011 at 6:38 pm

@andy
You are certainly welcome to interpret predatory pricing in any manner you choose, if my knowing how to be a good businessman and establishing good relationships with my clients falls under your interpretation, God bless you, stay with it, amigo, stay with it. However, I have to think you’re pushing it way too far when you claim that high price is predatory pricing based on the fact that the goods being offered are of superior quality, and are offered by a superior businessman, as well as costing more. That is a tad overboard and a strange claim to make regarding predatory pricing.

It becomes even more strange when you ignore the fact that I told you I don’t care how many other videographers there are in Houston, nor do I price myself at the most expensive and certainly not the cheapest. I have even trained my competition and given them my contact list, and I will never see a penny from what they have earned, or will earn.

And, the people on my contact list still call me first to see if I am available. Predatory? Hardly.

Do you have an agenda that I have somehow derailed?

Ken December 5, 2011 at 9:27 pm

It’s effectively futile to suppose perfect competition. Even with the most commoditized product imaginable, I can differentiate on service, delivery quality, etc.

anthonyl December 6, 2011 at 11:58 am

Thank you for thinking out and writing down in one comment what a high school text won’t do in a whole chapter. Predatory pricing is a phrase made up by people who don’t like to compete in an open market.
When I think about the crap they taught us in public schools and left us to find the truth ourselves without a WWW at the time the more I hate public schools.

andy December 5, 2011 at 6:25 pm

A small addon: predatory pricing allegations seems to me a form of central planning. The proof of logic is usually:
1) we think the airline market with 2 competitiors will produce low prices and still above-normal profits
2) the incumbent firm lowered prices; we can reasonably prove that this will lead to elimination of competitor and higher profits
3) therefore, lowering prices is “uncompetitive”

Generalizing it:
1) the state knows that the optimal-efficient market situation is X
2) you perform action A which will (reasonably) lead to outcome Y
3) therefore, we should have a power to force you to do action B instead, which, we think, will lead to outcome X

Most of the comments/literature focus on point 2. Yet, unlike other forbidden behaviour, the proof fails if we omit point (1). Since when do we accept that?

vidyohs December 5, 2011 at 6:30 pm

“4) the competitor leaved the market
The competing bus company leaved;”

Andy, the correct word is left, not leaved.

the competitor left the market.
The competing bus company left.

andy December 6, 2011 at 4:28 am

Sorry, my english gets pretty bad at 1am… I thought it looked weird…

vidyohs December 6, 2011 at 6:15 am

I wasn’t putting you down. I just thought that maybe English is not your first language and you made a mistake in usage that you would like to know about and correct in future correspondence.

I would hope you’d do the same for me if the situation was reversed.

steve December 5, 2011 at 7:57 pm

“I get the sense that leftists hate Microsoft for some reason that I can’t put my finger on it.”

I thought we hated Microsoft because their products sucked. Linux was and is better. Apple products have been better.

Steve

indianajim December 5, 2011 at 8:50 pm

“The Myth of Predatory Pricing”:

http://www.cato.org/pubs/pas/pa-169.html

Salt Water Economist December 6, 2011 at 7:22 am

Don,

Your arguments about predatory pricing make no sense; but they do reveal you bias.

You say that only a stupid business would engage in predatory pricing and that such conduct is rare. Why are you opposed to laws that deter people from engaging in stupid conduct?

The only explanation would be that many more firms want to engage in such stupid conduct and you are a “front” for them. The desire shows or tends to show they are not so stupid and you don’t know what you are talking about.

Jon Murphy December 6, 2011 at 8:59 am

“You say that only a stupid business would engage in predatory pricing and that such conduct is rare.”

Actually, we say predatory pricing doesn’t exist.

“Why are you opposed to laws that deter people from engaging in stupid conduct?”

Smoking is a stupid decision, but we recognize and respect a persons right to chose how to live his life.

“The only explanation would be that many more firms want to engage in such stupid conduct and you are a “front” for them.”

And there goes your credibility.

Salt Water Economist December 6, 2011 at 6:39 pm

Jon Murphy states:

Smoking is a stupid decision, but we recognize and respect a persons right to chose how to live his life.

Sorry Jon, but your comment shows only that you are disingenuous.

First, you offer no principled way to apply the implicit proposition for which you seem to be arguing for you do not answer the question, How is society to distinguish between laws that make driving down the highway at 100 miles an hour, which you seem to excuse as being stupid conduct, and smoking.

Second, and more important than the first, smoking is a behavior driven by addiction, but deliberately pricing to drive out a competitor is certainly not addictive behavior.

Third, and this is the real nuts of the case, when you go to bat for a position that you claim to stupid, on an issue where there is no evidence showing or tending to show injury to the public at present, the question fairly arises, has your opinion been purchased?

Such lawsuits are less frequent than hens’ teeth.

Cliff December 6, 2011 at 9:22 am

The problem is that the laws against “predatory pricing” in fact outlaw completely normal, utility-maximizing pricing. That should be obvious.

Salt Water Economist December 6, 2011 at 6:41 pm

Cliff,

Here is some breaking news. This problem is like “non-existent.”

I haven’t seen a news story in 25 years of a firm claiming it cannot set prices as it desires to set them.

dave smith December 6, 2011 at 10:08 am

Not to speak for Don, but I’d bet he would give a public choice explaination for opposing preditory pricing. That is, these laws do not exist to fight preditory pricing, real or imagined, but rather exist to make political entrepreneurship profitable.

Jon Murphy December 6, 2011 at 11:55 am

true.

Sam Grove December 6, 2011 at 1:49 pm

Why are you opposed to laws that deter people from engaging in stupid conduct?

The only explanation would be that many more firms want to engage in such stupid conduct and you are a “front” for them.

You expose YOUR bias in supposing that there is only one explanation. Another explanation is that such laws and their application are subject to interpretation (in that no one has demonstrated the ability to read minds) and thus can be used for political purposes, say to attack competitors.

yet another Dave December 6, 2011 at 6:52 pm

What Sam Grove said.

Who decides what “stupid conduct” means? What method does this person or group of people use to make such a decision? What options do those who disagree with the decisionhave? The list of questions could go on, but isn’t it obvious that “laws that deter people from engaging in stupid conduct” are purely subjective and rife with opportunities for all manner of shenanigans?

Jon Murphy December 6, 2011 at 7:33 pm

Save your breath, gentlemen. He is nothing more than another troll attempting to pass bias and opinion as fact and evidence.

Sheath your swords. These small fry are not worth our attention. We’ve bigger fish to fry.

Jon Murphy December 6, 2011 at 9:20 am

Here’s the thing with predatory pricing.

It starts with the assumption that there is an equilibrium price that we can know and measure (an assumption a 1st semester econ student can refute). Then, building on that assumption, it assumes that the aforementioned equilibrium price is static (or, at least devoid of major deviations). So, then the argument is made that a company will come in and supply the good at below the market price in order to drive out competition. Following the elimination of the competition, the firm will then raise their prices to the highest level the market can bare (presumably higher than the market-price before). This is where the story ends.

Incorrect.

What happens next? In a situation like this, a new firm can and will enter the market and can and will supply at a lower price than the monopoly. This will force the monopoly to either A) Begin their predatory pricing action again or B) lower their price to be in line with the new firm. This cycle will repeat over and over again into perpetuity unless the firm continues to operate below cost. If the firm continues to operate below cost (ATC, not AVC), then they will not be making profit. In that case, why enter the market in the first place? So, based upon the assumptions used to claim predatory pricing, one can show it is, at best, illogical.

However, seeing as we start with two assumptions that are useful in econ 101 but not many places elsewhere, it shows there are inherent flaws with the theory. At what point is price dropping, not due to competition, but due to predatory behavior? How do you prove it?

Fred December 6, 2011 at 9:56 am

You are making the mistake of putting the burden of proof on the accuser.

If you switch the burden of proof to the accused, then accept nothing short of raising prices back up to what you would like them to be as proof of innocence, then you win the argument every time.

Jon Murphy December 6, 2011 at 10:01 am

Right you are, Fred! Foolish me! I was thinking one is innocent until proven guilty. I forget it’s the opposite for businesses.

Bizet Bastiat December 6, 2011 at 11:35 am

Le Prix I am a rebellious bird
a creature no one alone can tame,
and if you call for me it’ll be quite in vain
for it’s in my nature to say no.
and nothing helps not a threat nor a prayer
where one talks well the other offers a trade
and it’s the other one that i prefer
doesn’t say a thing but pleases me.
Le Prix! Le Prix! Le Prix! Le Prix!

L’ordre is a gypsy’s child,
it has never, never known what law is,
if you do not want her she wants you
and if she wants you then beware!
if you do not want her,
if you do not want her she wants you!
but if she wants you,
if she wants you then beware!

La Richesse you thought you had caught by surprise
it beats its wings and then flies away…
it nestles afar you can wait for it
and when you don’t expect it anymore there it is!

sdfsdf December 6, 2011 at 5:13 pm

Even if it could possibly, exist, who cares?

So a big company sells products/services at a loss to drive others out of business. Then when they are the only provider they raise prices, tempting others to compete. how is this a problem?

Salt Water Economist December 6, 2011 at 6:43 pm

you make a false assumption–they people forced out of a market can re-enter, disregarding that the world don’t work that way

yet another Dave December 6, 2011 at 6:59 pm

You’re mistaken – no such assumption exists. The word “others” in the second sentence doesn’t refer to the same people as the word “others” in the first sentence.

Fred December 6, 2011 at 7:56 pm

You make a false assumption – that people forced out of the market must reenter for there to be competition.

There is always new competition. In everything.
There’s always some whippersnapper who thinks he’s got a better idea.
Often times the market agrees, regardless of what the political class says, and whippersnapper gets rich (while providing something to the masses cheaper than the other guy. wtf is wrong with that?).

Salt Water Economist December 7, 2011 at 6:27 am

Fred

What is the substitute for gasoline for you car or sugar for your tea

Seriously dude, they are not always substitutes

Fred December 7, 2011 at 9:52 am

Change the subject much?

Jon Murphy December 7, 2011 at 10:01 am

“What is the substitute for gasoline for you car or sugar for your tea

Seriously dude, they are not always substitutes”

You’ve never taken an economics class, have you? The economy is not static, it is dynamic. The mere fact that there are lack of substitutes currently means NOTHING. Whale oil was once THE source of lighting. Steam was once the method of movement. Technology changes all the time. Hell, there are substitutes to gasoline right now: electricity, hydrogen fuel cells, solar energy, etc. I know this is a digression and a strawman argument, but you could have picked a better strawman.

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