Predation’s Problems (Continued)
The case against predatory pricing is much stronger than argued by Donald Boudreaux in "The Problem with Predation" (CEI UpDate, September 1998). Boudreaux relies primarily on the argument that an efficient prey can always ride out a predatory attempt by borrowing, and therefore predatory pricing will seldom be tried because it will seldom be successful. Without disagreeing with his argument, I believe predatory pricing would seldom be successful even if the prey had no access to capital markets.
For predatory pricing to be tried, it must be economically rational, i.e. profitable. It will be profitable only if the present value of future gains exceeds early losses. For openers then, a potential predator is always trading up-front losses for discounted future revenues. The present value of a dollar of revenues, say, five years in the future is worth only about half a dollar of cost today (at a 15 percent discount rate). So, for every dollar of early losses, the predator will have to recoup more than two dollars five years in the future. That alone makes predatory pricing risky business.
There are other important reasons, irrespective of the prey’s access to capital, that make the predator’s net present value of losses and gains almost certainly negative.
1) In order to recoup early losses, the predator must price above cost and earn future supra-normal profits. To do this, there must be artificial barriers to the inevitable investment that will be attracted by these future supra-normal profits. The biggest barriers to entry in most industries are differential regulatory burdens on new entrants because incumbent firms have promoted regulations favorable to their incumbent status. Thus, absent artificial barriers erected by government, unrestricted entry automatically makes predatory pricing highly unlikely.
2) Consider the short run predatory pricing strategy analyzed by Boudreaux, in which the predator attempts to drive out the competitor’s capacity by pricing so low that the prey’s cash flow becomes negative. Here, operating costs exceed revenues, assuming that the prey’s capacity can’t be used to produce anything else. Boudreaux says this is irrational for the predator because the prey can simply borrow to make up operating losses. But rather than borrowing and remaining in operation, the prey can simply shut down and/or go bankrupt. The present value of the prey’s capacity will not become negative because it is not worn out, and whoever owns it knows the predator will raise prices again in order to recoup losses. The shutdown capacity will lay in wait. This means re-entry will be swift, reducing the predator’s expected present value of recouped revenues. Unless early losses are less than the discounted later gains, the predator cannot gain because of the difference in present value between early losses and later recoupment.
3) If the predator chooses a longer run predatory pricing strategy of imposing short run financial losses on the prey but leaving the prey with positive operating revenues, again the prey may go bankrupt. But surely the assets of the bankrupt firm will be operated by someone since the present value of operating revenues is positive. There is no need for borrowing. Thus, it may take a very long time for capacity to wear out and exit the market, pushing the predator’s recoupment far into the future, where present value is very small. Further, as E. A. G. Robinson noted long ago, it almost always takes much longer in calendar time to drive capacity out than it takes for capacity to enter, which further shortens the recoupment window. Again, the net present value of predatory pricing is almost certainly negative.
4) If industry capacity is such that fixed capital can easily move to another industry, as with retail capacity, the the easy exit by the prey that makes the predator’s early losses small also means future easy entry will make recoupment difficult. Again the prospective predator is most certainly in a position where recoupment is at best equal to the early losses, which in present value terms is negative.
Thus, with or without access to capital markets, predatory pricing is almost certainly unprofitable for any predator, which explains why it is seldom tried. I believe it is only tried when the owners of a closely held company have a personal vendetta against a competitor and are willing to sacrifice their own wealth to punish the rival. Other than that, as a wag at the Federal Trade Commission once remarked, public policy is more profitably directed at searching for unicorns.
John T. Wenders is Professor of Economics at the University of Idaho.