The Problem With Predation

The Problem With Predation

September 01, 1998

This article is based on remarks by Dr. Boudreaux at a July 7, CEI conference on the Department of Transportation’s proposal to limit price cutting in the airline industry.

"Predatory pricing" — the practice of cutting your prices so low as to drive your competition out of business — seems to be the fear-of-the-month in antitrust circles. Suspects include everyone from Microsoft to major U.S. airlines. As a monopolizing tactic, such pricing appears at first glance to be effective. But this first glance reveals a mirage. Predatory pricing is such a ridiculously unlikely means of gaining or enhancing monopoly power that no sane firm will try it.

The predatory-pricing tale is familiar: The "dominant" firm lowers its prices below its costs only to drive its competitors from the field. The hapless rivals of the predator — labeled "the prey" — have no choice but to meet these lower prices and suffer losses. Even though the prey are each as efficient as is the predator, they are assumed to be unable to withstand the losses inflicted during price wars. The prey leave the industry. The predator survives to enjoy a monopoly.

This tale is sheer fantasy. There is no good reason why efficient rivals of would-be predators cannot withstand whatever price-war losses predators choose to inflict.

A key to understanding the economics of predatory pricing is to realize that the predator must lose more money than do any of its prey. The reason is that the predator can force the preys’ prices down only by taking away their customers. And to take away the preys’ customers requires that the predator expand its sales during the price war. In contrast, the prey are free to reduce their sales to levels that minimize (if not eliminate) their losses.

How, then, can predation be a lucrative strategy? The answer must be that the predator is better able than the prey to absorb price-war losses. Fortunately for consumers, predators are not better able to absorb such losses. In fact, any prey that is as efficient as the predator has just as much access to funding for the price war as does the predator.

"How can this be?" asks the skeptic. The answer is straightforward — capital markets. If the prey are as efficient as the predator, the prey will likely be able to borrow enough money to wage the price war successfully.

If the prey can borrow enough money to defend themselves against predatory pricing, then it is obvious that predatory pricing is suicidal. The reason is that the predator loses more money during the price war than do the prey, without the hope of driving its adequately funded prey to extinction.

I know that lots of people snicker at the claim that the prey can borrow sufficient funds to defend themselves in a price war. But what seems initially implausible is, in fact, overwhelmingly likely.

The world is chock-full of investors, all seeking to invest their money profitably. If every entrepreneur with a profitable idea also personally had sufficient funding to launch, it firms would never seek to borrow money. The very existence of credit markets, investors, banks, venture capital, and other such institutions testifies to the fact that people with money are quite willing and able to lend it to strangers who promise to put it to profitable use.

Businesses regularly borrow money to cover the excess of today’s costs over today’s revenues in the hope of surviving until tomorrow when revenues will exceed costs. And that’s just the situation in which a potential victim of a predator finds itself — seeking funding to cover costs today in order to survive to enjoy a profitable tomorrow.

Robert Bork was surely correct when he wrote that:

If the potential victim would find resistance to predation a profitable use for his liquid assets, a lender should find it equally profitable to lend the required capital. In fact, in any case in which the predator must use a technique that inflicts proportionately equal or greater losses upon himself, the victim would merely have to show the predator his new line of credit to dissuade the predator from attacking.

Of course, as economists say, capital markets are imperfect, and lenders sometimes make mistakes. But this fact does not justify government or court policing against price cutting. This is because the very same human limitations that prevent private lenders from always making correct decisions also prevent government officials from making correct decisions.

The kind of knowledge required of government officials who are asked to prevent price cutting is identical to the knowledge required of private lenders who are asked to lend money to firms that claim to be under predatory attack. Remember, healthy price cutting is practically indistinguishable from predatory price cutting.

The debate comes down to this question: Are government officials likely to assess more accurately what’s really going on in an industry than are private investors? I believe not.

There are at least two good reasons for trusting the judgments of private investors rather than those of government officials.

First, private investors stand to gain and lose personally by making good or bad decisions. Not so with bureaucrats.

Second, the consequences of government mistakes are more harmful than are the consequences of mistakes made by private investors.

There are two kinds of mistakes that both investors and the government can make: They can either fail to identify predation when it really is occurring, or they can falsely find predation when it really isn’t occurring.

Suppose predation really is going on. The consequences of a capital-market mistake are identical to those of a government mistake. Both errors clear the way for the predator eventually to destroy the prey and gain at least temporary monopoly power.

But suppose that the observed low prices really aren’t predatory; suppose, instead, that these prices reflect the price-cutter’s superior efficiency. In this case, a mistaken belief by private investors that these low prices are predatory does no social harm. Investors lend money to a firm that doesn’t deserve the funds, while the genuinely more efficient firm keeps its prices low. Consumers never suffer. And eventually the mistake is revealed because the less-efficient firm cannot compete over the long haul with the more-efficient price cutter.

But when government mistakenly judges low prices to be predatory and orders the price cutter to raise its prices, the heart of market competition is ripped with a dagger.

The government’s mistake is never revealed, for the very mechanism of revealing the mistake — the price system — is short-circuited by government’s demand that prices be raised. When a more-efficient firm is obliged by government to raise prices, it loses the ability to prove that it is really more efficient than its complaining rivals. Consumers lose big, both today and tomorrow.

Government should permanently and uncompromisingly resist all temptation to stop firms from cutting prices.