In a previous post, we examined whether it was even possible in principle to determine if a company was engaging in “socially harmful” predatory pricing. Today we’ll address whether there is even a theoretical possibility for making such a determination. And in another future post, we’ll return to the more fundamental question of whether price cutting can be socially harmful and to what extent we should be concerned about it. All we are doing is summarizing the masterful work of Harold Demsetz in his 1981 paper, “Barriers to Entry.”
If you were to open up an old textbook you might find a result that suggests that in a “working” market, the market price of a product should be competed down to the marginal cost of producing the last unit of the good. And from this you might infer then that if a firm sells a good for a price lower than what it cost to make that last unit, then we have a case of predatory pricing, whereas if the firm sells above marginal cost it is not predatory (in fact, the text probably has another chapter on market power and monopoly to explain why this is “awful” too).
Never mind that it is virtually impossible for even firms themselves to know marginal costs before they actually produce a product. I’d assert that they probably don’t even know it ex post. So how could a third party even begin to speculate on what it cost, say, Apple, to make the very last iPad it shipped out. The major problem with identifying whether a good is sold at a price below marginal cost is that it is not clear what the good is, or what the purpose of the pricing policy is.
Consider two situations: loss-leaders and product give-aways. The video-game console, X-Box, is reportedly sold at a loss by Microsoft. In other words, the price of an X-Box as sold to customers in a store is most likely less than the value of the resources used to make that X-Box. However, Microsoft does this to encourage people to become gamers in the first place, and therefore expects to sell fancy controllers and all kinds of games after having people get their hands on the X-Box. What is the good here? And is the pricing predatory? The good being sold is certainly not the X-Box console, but the entire gaming experience. But consider a case where the games are included with the X-Box console, and Microsoft sells it for a time period “below cost” with the hopes that future consumers will like it so much that they will come back in the future and pay the higher costs for it (by the way, do we see this? My experience with technology goods is actually quite the opposite). If you observe the price received for the X-Box unit at the time of sale as a cost below price this would be incorrect. In fact, the correct “price” would have to be the discounted value of the future higher price that Microsoft would receive for their gaming system. There is simply no way Microsoft would continue to take losses on the X-Box if they did not expect future revenue increases to justify the “loss-leading.”
Or consider a slightly different situation. How many times have you strolled down a village street during a festival, or strolled into a shopping mall and have been greeted with a vendor giving away a “free” sample? I’ve had free sips of smoothies, free samples of sugar peanuts, free samples of coffee and more. In these cases, the zero price is absolutely below the cost to make that unit of the good. But would you call this predatory pricing? Is it harmful to consumers? Other competitors? If you do not consider this a violation of the predatory pricing rule, then how are we to think about the harder cases?
So does selling below cost hurt competitors? It would seem so, but as you can see in both of these cases, the actual price received by the firms exceeds the true marginal costs of selling the goods. In cases of actual “predatory pricing” what would have to be true is that firms reduce prices below cost today for the possibility of raising them above costs in the future. How would one, therefore, look at a case of a price below cost today and ascertain whether it is a promotional effort, a “loss-leader” or a “vicious” effort to undercut competitors? One simply cannot.
We’ll continue to work through Demsetz’s paper in the coming weeks, including taking a look at the empirical evidence on “predatory pricing.”