In 1991, three retail pharmacies in Faulkner County, Arkansas, sued Wal-Mart for selling pharmaceutical items at predatorily low prices. The plaintiffs claimed that Wal-Mart's below-cost pricing of some pharmaceuticals threatened to create for Wal-Mart a monopoly in pharmaceutical retailing in Faulkner County.
The plaintiffs' story is a familiar one to students of antitrust law: by pricing below cost, a "predator" (in this case Wal-Mart) forces the prices charged by its rivals down below costs. The losses thereby inflicted on rivals drive them into bankruptcy, leaving the predator as the market's sole supplier. With rivals gone, the predator will raise prices to monopolistically high levels. To avoid this undesirable outcome in the future, the law must command the predator to stop charging dangerously low prices today. Only through the diligent policing of courts and antitrust agencies against such predatory tactics can consumers be saved from the extortions of monopolists.
Is this concern about "predatory pricing" warranted? No. Put simply, "Predation doesn't pay." Even if a predator manages to run existing rivals out of business, new entrants will emerge once the predator starts trying to recoup its price-war losses by charging monopoly prices. This new competition keeps the predator from recouping the losses it necessarily incurred by pricing below cost during the predation period; hence, the threat of new entry is generally sufficient to keep firms from predatorily pricing in the first place. Empirical and theoretical work confirm this conclusion. Moreover, even if rivals are unable to squelch predatory-pricing schemes, suppliers or customers of predators will often take effective steps to prevent predation from succeeding.
But no predator is likely to get even this far. In fact, predatory pricing is an exceedingly poor way to run rivals out of business. Not only does a predatory-pricing firm incur large losses today as a result of below-cost sales, but its losses are necessarily larger than those of its rivals. Rivals, after all, can reduce the amounts they sell below cost while the predator must — to hurt rivals by taking away their customers — expand output during the price war. Predatory pricing hurts the predator more than the prey. This indisputable fact led Robert Bork to advise that "the best method of predation is to convince your rival that you are a likely victim and lure him into a ruthless price-cutting attack."
The Wal-Mart example demonstrates how the market can self-police against monopolization. We begin this example by initially making the extreme assumption that Wal-Mart has already monopolized retail pharmacy sales. Consumers, obviously, would suffer. But so, too, would pharmaceutical suppliers. Because monopolist Wal-Mart would raise retail prices to monopoly levels, fewer pharmaceuticals would be sold at retail than would be sold if retailing were competitive. Consequently, wholesale demand for pharmaceuticals would be lower than otherwise. This reduced demand snatches money directly out of the pockets of pharmaceutical suppliers. Surely these suppliers will not sit by idly as Wal-Mart's monopoly eats into their profits.
How might Wal-Mart's suppliers undermine Wal-Mart's monopoly? Several strategies are available. Pharmaceutical suppliers can enter the retail pharmacy trade and compete head to head with Wal-Mart, either by opening their own new retail establishments, by purchasing existing retailers, or by retailing pharmaceutical items directly to consumers through catalogues or the internet. Similarly, these suppliers can finance the entry of other retail pharmacies into Wal-Mart's territory. Either way, in the face of new entry, Wal-Mart would have no choice but to lower its retail prices to competitive levels.
Some suppliers — those who enjoy some monopoly power (say, because of a patent or because of well-developed brand-name recognition) — also can force Wal-Mart to behave competitively by imposing sales quotas on Wal-Mart. If a supplier is the exclusive producer of a pharmaceutical item crucial to Wal-Mart's retail pharmacy business — for instance, a patented drug that all self-respecting, full-service pharmacies carry — this supplier may be able to contractually insist that Wal-Mart sell some minimum number of units of the item every month. The supplier can set this minimum number at the competitive level. To sell this competitive quantity, Wal-Mart will have to lower the price it charges for this item down to what the price would be if Wal-Mart confronted competitors. Failure of Wal-Mart to meet its sales quota allows the supplier to stop supplying Wal-Mart. If the supplier's product is critical enough to Wal-Mart's retail success, and if this product is unavailable from other suppliers, Wal-Mart has incentive to meet the sales.
To ask how suppliers might undermine an existing monopoly, however, is to overlook the most important avenues open to suppliers to keep the retail pharmacy market competitive. Wal-Mart's suppliers have an interest in stopping the monopoly before it materializes.
Suppose, for example, that the Merck pharmaceutical company suspects that Wal-Mart's low retail prices will eventually generate a Wal-Mart monopoly in the retail pharmacy market. Merck can refuse to deal with Wal-Mart as long as Wal-Mart charges prices that Merck feels are too low. Because Wal-Mart does not yet have a monopoly, Merck suffers no significant loss of sales by refusing to distribute through Wal-Mart: Merck will increase the amount of pharmaceuticals it distributes through Wal-Mart's rival pharmacies. Wal-Mart's rivals are helped — they now have more business — while Wal-Mart suffers from the loss of Merck supplies. Wal-Mart's ability to predatorily price rivals out of business is curtailed.
Merck can avoid retail monopolization also by helping to finance the efforts of Wal-Mart's rivals to survive a predatory-price war. By lending monies or guaranteeing bank loans to beleaguered retail pharmacies, Merck diminishes Wal-Mart's prospects for successful monopolization. As Robert Bork points out, the prey "would merely have to show the predator his new line of credit to dissuade the predator from attacking." A retail pharmacy that shows Wal-Mart a contract pledging monies from Merck (or from some other sound lender) will deflate Wal-Mart's enthusiasm for continuing a predatory price war. After all, if even one of Wal-Mart's rivals has the financial wherewithal to successfully fight a predatory-price war with Wal-Mart, Wal-Mart will never monopolize its market.
At the very least, if Wal-Mart were really a threat to monopolize pharmaceutical retailing, Merck and other Wal-Mart suppliers have incentives under existing antitrust laws to assist in legal actions against Wal-Mart. Merck could support a predatory-pricing suit filed by another private party or by the government by offering to testify about the monopolizing dangers of Wal-Mart's pricing policy, and, perhaps, by giving evidence that prices charged by Wal-Mart are below the wholesale prices Merck charges Wal-Mart.
But in the actual suit against Wal-Mart, the trial record contains no indication that any pharmaceutical supplier uttered a word of complaint against Wal-Mart's pricing practices. No pharmaceutical supplier even bothered to submit an amicus brief supporting the plaintiffs' case against Wal-Mart. Dogs that should have barked, if Wal-Mart's actions presaged monopoly, remained tellingly silent.
Although it is impossible to say for certain why no supplier of Wal-Mart assisted in the preparation and prosecution of the plaintiffs' case, the silence of suppliers at least suggests that suppliers did not believe that Wal-Mart's pricing practices threatened monopolization.
The general lesson is that markets themselves contain incentives and opportunities for firms to police against monopolization. Indeed, such opportunities would be greater were it not for existing antitrust laws. Consumers can rely much more confidently upon policing by market participants than upon policing by courts and administrative agencies. Firms have every incentive to accurately assess the likely future consequences of actions taken by their buyers and suppliers.
On the other hand, courts and enforcement bureaucracies have no such incentives and no special skills that allow them to determine when price cuts will and will not likely lead to monopolies. Although rivals of price-cutting firms have incentives to accurately assess the consequences of price cuts, rivals also have every incentive to misrepresent those consequences. Eliminating the ability of rivals to use antitrust law as a means of stifling competition will force them to compete in ways that promote consumer well-being: cutting prices, improving efficiency, and enhancing product quality.
A final note, the Arkansas Supreme Court overturned a trial-court ruling in which Wal-Mart was found to have priced predatorily. In reversing the trial court, Arkansas's high court found that Wal-Mart's admittedly low pharmaceutical prices were competitive rather than predatory. Nevertheless, Wal-Mart's victory was narrow: The high court ruled in Wal-Mart's favor by 4 to 3.
Donald Boudreaux is Associate Professor of Law and Economics at Clemson University and Research Scholar at the Competitive Enterprise Institute. Andrew N. Kleit is Associate Professor of Economics at Louisiana State University. This article is adapted from their CEI paper "How the Market Self-Polices Against Predatory Pricing".