The attempt to reduce or to eliminate predatory pricing is also likely to reduce or eliminate competitive pricing beneficial to consumers.
— Harold Demsetz
Predatory pricing is one of the oldest big business conspiracy theories. It was popularized in the late 19th century by journalists such as Ida Tarbell, who in History of the Standard Oil Company excoriated John D. Rockefeller because Standard Oil’s low prices had driven her brother’s employer, the Pure Oil Company, from the petroleum-refining business. “Cutting to Kill” was the title of the chapter in which Tarbell condemned Standard Oil’s allegedly predatory price cutting.
The predatory pricing argument is very simple. The predatory firm first lowers its price until it is below the average cost of its competitors. The competitors must then lower their prices below average cost, thereby losing money on each unit sold. If they fail to cut their prices, they will lose virtually all of their market share; if they do cut their prices, they will eventually go bankrupt. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while it was engaged in predatory pricing, and earns monopoly profits forever after.
The theory of predatory pricing has always seemed to have a grain of truth to it—at least to noneconomists—but research over the past 35 years has shown that predatory pricing as a strategy for monopolizing an industry is irrational, that there has never been a single clear-cut example of a monopoly created by so-called predatory pricing, and that claims of predatory pricing are typically made by competitors who are either unwilling or unable to cut their own prices. Thus, legal restrictions on price cutting, in the name of combatting “predation,” are inevitably protectionist and anti-consumer, as Harold Demsetz noted.
Predatory pricing is the Rodney Dangerfield of economic theory—it gets virtually no respect from economists. But it is still a popular legal and political theory for several reasons. First, huge sums of money are involved in predatory pricing litigation, which guarantees that the antitrust bar will always be fond of the theory of predatory pricing. During the 1970s AT&T estimated that it spent over $100 million a year defending itself against claims of predatory pricing. It has been estimated that the average cost to a major corporation of litigating a predation case is $30 million.
Second, because it seems plausible at first, the idea of predatory pricing lends itself to political demagoguery, especially when combined with xenophobia. The specter of a foreign conspiracy to take over American industries one by one is extremely popular in folk myth. Protectionist members of Congress frequently invoke that myth in attempts to protect businesses in their districts from foreign competition.
Third, ideological anti-business pressure groups, such as Citizen Action, a self-styled consumer group, also employ the predatory pricing tale in their efforts to discredit capitalism and promote greater governmental control of industry. Citizen Action perennially attacks the oil industry for either raising or cutting prices. When oil and gas prices go up, Citizen Action holds a press conference to denounce alleged price gouging. When prices go down, it can be relied on to issue a “study” claiming that the price reductions are part of a grand conspiracy to rid the market of all competitors. And when prices remain constant, price-fixing conspiracies are frequently alleged.
Fourth, predatory pricing is a convenient weapon for businesses that do not want to match their competitors’ price cutting. Filing an antitrust lawsuit is a common alternative to competing by cutting prices or improving product quality, or both.
Finally, some economists still embrace the theory of predatory pricing. But their support for the notion is based entirely on highly stylized “models,” not on actual experience.