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A Legal Test for Identifying Predatory Pricing
February 9, 2011 Market Failures

We’ve been studying Harold Demsetz’s terrific paper, “Barriers to Entry,” slowly over the past few weeks. We’ve already analyzed what it might possible mean to say that a firm’s practices are predatory, and we have discussed how difficult it would be to identify using a purely economics approach. Today we’ll discuss a legal test as proposed by Demsetz.This legal test plays to the difference between analytic reasoning (which we have been doing) and social reasoning (which we are about to attempt). Readers may find Demsetz’s discussion richer upon reading Arnold Kling’s piece on Why People Hate Economics.

The legal test requires that we inquire not into the economics of a price cut, but rather to inquire into the motivation for a price cut. In other words, we see a firm like Apple drop the price of its iPad to $199 down from its current $499 (the cheapest model). Then we ask, “was this done with the express purpose of harming its competitors?” This is troublesome for two reasons.

  1. Whether a price cut is due to the malicious intent to harm by Apple or whether it was simply a strategic economic decision to stay competitive does not alter the effects of a price cut. In other words, a price cut is a price cut. Why the motivation matters at all is an incredible mystery, at least for the economic impact of an action. The origins of our motivations is an age old question. You may probably usefully pick it up by reading Mandeville’s Fable of the Bees from the early 18th century. In it he argues that man’s motivations stem from pride and fear. A few decades later, Adam Smith picks up the discussion in his Theory of Moral Sentiments, where he attributes our motivations to a far richer and “human” set of emotions including empathy and fellow feeling. But that is not the purview of this post.
  2. Suppose motives did matter. How on earth would one begin to identify the motive of an action? Take something as simple as the cup of coffee I am sipping now. It is nice and hot. Did I brew the coffee because it is early and I wanted a zing of caffeine to get the day started? Did I brew it because it is cold here in the morning and I wanted to be warmed up? Or are there other motivations such as it’s tasty when I dip a donut into it? You certainly cannot tell from looking at the coffee (in fact, today’s coffee is decaf). Moreover, it is not clear that I can well articulate why I brewed the coffee. I am sure you’ll argue that it is different with Apple and its iPad, but this not a debate that can be settled by any appeal to the scientific method.

Demsetz provides us with a reason why motive is important. It is because our common law traditions have evolved to use this in making legal decisions. However, the “intentional” predatory pricing motives differ in important ways than the “malice” to which the common law evolved to deal with.

The 1909 Minnesota court case of Tuttle v. Buck is illustrative. A barber sought relief from the efforts of a local banker whom he claimed was ruining his business by providing subsidies for a new competitor barber shop. Tuttle asserted that Buck did this not for competitive reasons, but for the malicious gratification of ruining the plaintiff’s life. The question here is whether the banker, through the pursuit of an otherwise unobjectionable act, should be allowed to get pleasure if his actions “harm” someone. If I, for example, discover oil on my property and proceed to give it away to each of my neighbors for free, you might think this to be a good thing. But if in addition I get some mental satisfaction from knowing I am hurting the business of the home heating company, then my actions become objectionable?

Is there any case for objecting to the activities of the defendent? Yes says Demsetz. If the ONLY effect of his actions was to harm the original barber, then we may have reason to take the claims seriously. Let’s not delve into that (I have some issues with Demsetz’s argument here). But the question is one of how an individual may spend his wealth in consumption activities. Demsetz allows that “we” may disallow activities where I derive happiness from the misfortune of others, but he argues that it is really hard to determine justly whether that is the real source of my pleasure.

It is hard enough to determine if my playing of the radio loudly outside is due to my enjoyment of loud music versus my enjoyment of annoying my neighbor. He argues that in these cases relative wealth positions of the music player and neighbors matter (again, let’s skip this argument). But the situation is different when it comes to Apple lowering its iPad price.

Obviously, the people (like me) who stand to purchase the now cheaper iPad must be counted as a gain if we are going to legitimately call the rival’s misfortune as a loss. If there are large numbers of customers enjoying these gains, and if these low prices prevail for a long time, then the stronger the case is for legalizing these lower prices (his analog is that loud music is OK when it is coming from a carnival servicing a large number of people, even if it harms a neighbor or two).

Second, “predatory pricing” is not a consumption activity – it is a business practice. Thus, the motivation must be in the pursuit of profits, and so the typical tort arguments in non-corporate settings do not apply. The only way I can afford to “lend myself capital” (i.e. take losses while in a price war) or the only way outsiders will lend me capital to finance a price war is if the long term prospects of this activity produce profits. In this sense, both Apple and its competitors stand on equal ground if they pose the same risk to the capital markets. And if you wish to argue that Apple is a “better investment” then we are back to our earlier discussion (from several posts ago) of Apple having cost advantages that are not possessed by its competitors. In other words, trying to corner the marketĀ  by predatory pricing is again impossible to distinguish from the real cost advantages that lead to “non-nefarious” competitive price reductions.

But let’s return to the original fear. The objection to predatory pricing (when it is not the throes of inefficient competitors) is that once a price war is “won” the monopolizing firm will “jack up” prices that harm consumers – so the initial benefits of the low prices are washed away. But this leaves us with two questions:

  1. Has this ever actually happened?
  2. From a legal standpoint, what is the best “anti-trust” policy?

In regard to the first, we know of know evidence that this has ever happened. In regard to two, the question as Demsetz poses it is this, “is it best to attack the practice which might after all be merely competitive or futile, or attack the monopoly should the practice succeed?” Here is why this question is easily answered by aiming to do the latter:

  • If you try to snuff out monopolies before they arise, then you will certainly be snuffing out a large number of beneficial competitive practices as well. This is the proverbial “throwing the baby out with the bathwater approach.”
  • If you wait to snuff out monopolies after you seem them arise, this immediately sends a signal that the expected profits from becoming a monopolist are lower, thereby reducing the attractiveness of monopolizing today.

To summarize, we know that present price cuts help present consumers and may or may not harm them in the future. Not allowing price cuts will certainly harm present consumers, and may or may not benefit them in the future. And in order to bring this discussion into the policy realm, one would have to make serious attempts to measure the benefits and costs of the relevant trade-offs involved, but such efforts have either been largely ignored, or very difficult to implement.

"2" Comments
  1. “Why this motivation matters at all is an incredible mystery.”

    You make dry stuff fun, Wintercow.

  2. Pingback: The Unbroken Window » Blog Archive » Why Do We Love to Kiss Pretty Girls?

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