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September 14, 2008

The Predatory Pricing Myth
by Gerard Jackson

The meddling Rudd has once again revealed his economic illiteracy by accusing supermarkets of predatory pricing. What is being asserted is that these companies will lower their prices until their competitors are driven out of business, at which point the supermarkets will charge monopoly prices for their goods. Yet those who make this charge are never able to provide evidence to support it -- and that includes Rudd. And there's a good reason for that -- there is no evidence.

Everyone knows that when a company lowers the prices of its products demand will increase. If a company engages in predatory pricing then it will have to increase output to meet the additional demand. This means its costs of production will rise. The greater the demand, therefore, the great will be the company's additional costs. And the bigger the firm the greater will be its costs because of its larger investments in capital goods. In addition, as price is just one aspect of competition it would have to lower prices to a point that would overcome other competitive forces, adding even more to its losses. With respect to prices, it has been pointed out that there is no way to distinguish between a 'predatory' price and a competitive one. He went on to state:

...to attack as predation a policy that delivers goods to buyers at a low price may be to attack an honestly competitive price of a promotional sort. A policy to deprives buyers of the opportunity to purchase at lower prices today in the belief that protecting firms from the low prices of rivals today keeps more firms around "tomorrow", and that this assures buyers of lower prices to tomorrow, is wrongheaded. (Harold Demsetz, The Economics of the Business Firm, Cambridge University Press, 1997, p. 165).

Another thing that is always overlooked is that any firm engaging in predatory prices endangers its other markets. It cannot raise prices in those markets to offset its price-cutting strategy because it would lose market share. Moreover, it might very well find that its lower prices will attract customers way from its other branches thereby raising even further the cost of its predatory-pricing strategy. This leads to the conclusion that localised price-cutting strategies are not sustainable.

It's also argued that the "predatory" company uses its monopoly to builds up an arsenal of spare cash to fund its price-cutting war. But if the company is a "monopoly" then why does it need a predatory policy? Assuming that the company is big enough to accumulate large reserves then these reserves could only have come from profits. Meaning that if it is that efficient it has no need to engage in predatory pricing. In any case, this raises several points.

As the company cannot know how long its competitors can hold out it cannot possibly know how long its reserves will last. (This uncertainty forms a serious obstacle to any policy of predatory pricing). As Demsetz explained:

Pricing below cost to deter entry imposes great losses on the incumbent firm than on the would-be entrant, since the former loses much on its large market share while the latter loses practically. (Ibid. P. 165)

Any company considering embarking on a course of price cutting knows that potential competitors need only wait for the company to raise its prices before they enter the market, which they can do at a discount by purchasing the bankrupted rivals' facilities*. This would put a severe damper on any temptation to raise prices above the level at which it had operated before implementing a predatory policy.

Those who make allegations of "predatory" behaviour implicitly assume that once a firm becomes a huge concern its efficiency makes it invulnerable to competition. But if this is so, why does it need to be predatory? Every firm started small, and no firm -- regardless of size -- is immune to market forces. This is a fact that even recent economic history can attest to. One only has to think of IBM or David Jones, for instance, to see the truth of this. As Professor Coase pointed out, companies will continue to expand until the costs of doing so exceeds the benefits. Sabotaging this process will keep living standards lower than they would otherwise be.

Supermarkets provide ample evidence of this fact: they introduced superior management and distribution techniques and technologies which cut costs and prices and offered an unprecedented and ever-growing range of goods and services, generating more employment (indirect as well as direct) and creating external economies from which we have all benefited.

In a free market -- regardless of what critics assert -- it is the consumer who rules.

*For decades Rockefeller's Standard Oil Company stood accused by lawyers and historians of using its market power to destroy its competitors. Writing in the Journal of Law and Economics, (October 1958), Professor John McGee completely debunked the charges against Rockefeller.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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