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Predatory Pricing: Strategic Theory and Legal Policy, Princeton University Discussion Paper (1999)

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Predatory Pricing: Strategic Theory and Legal Policy, Princeton University Discussion Paper (1999) PREDATORY PRICING: STRATEGIC THEORY AND LEGAL POLICY Patrick Bolton,* Joseph F. Brodley** and Michael H. Riordan*** * John H. Scully ’66 Professor of Finance and Economics, Princeton University ** Professor and Kenison Distinguished Scholar of Law, Boston University *** Professor of Economics, Columbia University We have received valuable comments from legal workshop participants at Boston University Law School, Harvard Law School, Yale Law School; and from economic workshop participants at the Antitrust Division, U.S. Dept. of Justice, European Centre for Advanced Research in Economics (ECARE), European Summer Symposium in Economic Theory at Gerzensee, N.Y.U. School of Management, New Zealand Institute for Antitrust Law and Economics, Princeton University, and Tilburg University Centre for Economic Research. We have also received insightful comments from many individuals, including Lucien Bebchuk,, Mathias Dewatripont, Einer Elhauge, Vic Khanna, Louis Kaplow, Alvin Klevorick, Barry Nalebuff, Jim Meeks, Patrick Rey, Alan Schwartz, Marius Schwartz, Dan Vincent, and Bobby Willig. We thank LeeAnne Baker, Jeremy Bartell, Gretchen Elizabeth Joyce and Chad Porter for dedicated and resourceful research assistance. CONTENTS I. The Tension Between Current Legal Views and Modern Economic Theory ..........2 II. Current Legal Policy ....................................................13 A. Before Brooke: The Areeda-Turner Rule ...............................14 B. The Brooke Decision ..............................................20 C. Post-Brooke Decisions .............................................25 III. Proposed Approach .....................................................30 A. Legal Elements—Prima Facie Case ...................................32 1. Facilitating Market Structure ..................................32 2. Scheme of Predation and Supporting Evidence ....................34 3. Probable Recoupment .......................................36 4. Price Below Cost ...........................................40 B. Legal Elements—Efficiencies Justification .............................45 1. Defensive Business Justifications ..............................46 2. Market Expanding Efficiencies Defenses ........................48 IV. Financial Market Predation ...............................................56 A. Economic Theory .................................................56 B. Proof of Financial Predation ........................................63 C. Illustration: Cable TV .............................................65 V. Signaling Strategies: Reputation Effect ......................................76 A. Signaling Strategies ...............................................76 B. Reputation Effect Predation .........................................78 1. Economic Theory ...........................................79 2. Reputation and Financial Predation .............................79 3. Proof of Reputation Effect Strategy .............................82 4. Illustration: Entry into Local Telephone Market ...................84 VI. Cost Signaling, Demand Signaling and Other Predatory Strategies ................93 A. Demand Signaling: Test-Market and Signal Jamming ....................94 1. Economic Theory ...........................................94 2. Proof of Test Market Strategy .................................97 3. Proof of Signal Jamming Predation .............................98 4. Illustration: Entry into Eastern Coffee Market .....................99 B. Cost Signaling ..................................................104 1. Economic Theory ..........................................104 2. Proof of Cost Signaling Strategy ..............................107 VI. Possible Objections and Counter Strategies .................................110 A. Possible Counter Strategies ........................................110 B. Acquisition of Prey’s Assets by Successor Firm ........................115 C. Managerial Incentive to Predate .....................................119 VII. Appendix ............................................................123 1. Cost Signaling: Theory ...........................................123 2. Illustration: Bogus Competition in the Tobacco Industry .................127 3. Cost Signaling Combined with Reputation Effect: Theory ................134 2 INTRODUCTION Predatory pricing poses a dilemma that has perplexed and intrigued the antitrust community for many years. On the one hand, history and economic theory teach that predatory pricing can be an instrument of abuse, but on the other side, price reductions are the hallmark of competition, and the tangible benefit that consumers perhaps most desire from the economic system. The dilemma is intensified by recent legal and economic developments. Judicial enforcement is at a low level, following the Supreme Court’s recent Brooke decision, the first major predatory pricing decision in modern times.1 Indeed, since Brooke was decided in 1993, no predatory pricing plaintiff has prevailed on the merits in the federal courts. At the same time modern economic analysis has developed coherent theories of predation, contravening earlier economic writing claiming that predatory pricing conduct is irrational. More than that, it is now the consensus view in modern economics that predatory pricing can be a successful and fully rational business strategy; and we know of no major economic article in the last 30 years that has claimed otherwise. In addition, several sophisticated empirical case studies have confirmed the use of predatory pricing strategies. But the courts have failed to incorporate the modern writing into judicial decisions, relying instead on earlier theory no longer generally accepted. Growing market concentration, fueled by the current merger wave, has further increased the tension between judicial policy and modern economic theory. Notwithstanding the low level of judicial 1 Brooke Group v. Brown & Williamson Tobacco, 509 U.S. 209 (1993) [hereafter Brooke]. 1 support—or perhaps because of the legal vacuum this has created—government enforcement concern with predatory pricing is at the highest level in many years. The Department of Transportation has recently issued proposed predatory pricing guidelines, antitrust enforcement agencies have ongoing investigations, and private antitrust actions have not slackened despite their apparently dim prospects. Moreover, the growing importance of intellectual property, challenges predatory pricing rules designed for tangible goods markets, as illustrated by the Microsoft case where the alleged predatory pricing involves intellectual property. It is the thesis of this paper that the dilemma and tensions confronting predatory pricing enforcement can be resolved and a coherent approach developed by basing legal policy, at least in part, on modern strategic theory. We begin in Part I by describing the uncertain foundations of present policy based on the judicial belief that predatory pricing is extremely rare or even economically irrational conduct and the tension this creates with modern economic analysis. Part II discusses current enforcement policy, its evolution and culmination in the Supreme Court’s Brooke decision and, most recently, in proposed government Guidelines for airline predation. Part III outlines our proposed strategic approach, setting forth elements to guide analysis in predatory pricing cases, including rules for prima facie liability and an expanded efficiencies defense. Parts IV through VI develop criteria for identifying predatory strategies, which we then apply to financial market predation in Part IV, to reputation effect predation in Part V, and to cost and demand signaling in Part VI. In Part VII we evaluate possible objections and counterstrategies. I. THE TENSION BETWEEN CURRENT LEGAL VIEWS AND MODERN ECONOMIC 2 THEORY A powerful tension has arisen between the foundations of current legal policy and modern economic theory. The courts adhere to a static, non-strategic view of predatory pricing, believing it to be an economic consensus. But this is a consensus most economists no longer accept. The tension is reflected, however, not so much in the legal rule, which at least in theory would allow arguments based on modern strategic analysis. Rather the tension appears in an extreme judicial skepticism against predatory pricing cases that has led to the dismissal of almost all cases since the Brooke decision by summary motion. In order to understand this judicial skepticism and the tension it creates with modern economics, we must examine its source, evaluate its merit and appreciate the challenge posed by modern analysis.2 This requires that we first state what we mean by predatory pricing. In most general terms predatory pricing is defined in economic terms as a price reduction that is profitable only because of the added market power the predator gains from eliminating, disciplining or otherwise inhibiting the competitive conduct of a rival or potential rival. Stated more precisely, a predatory price is a price that is profit maximizing only because of its exclusionary or other anticompetitive effects.3 The anticompetitive effects of predatory pricing are higher prices and reduced 2 One of the first economists to call for judicial evaluation of predatory pricing in light of modern strategic theory was Alvin Klevorick. See Alvin K. Klevorick, The Current State of the Law and Economics of Predatory Pricing, 83 AM ECON. REV. 162 (Papers & Proceedings, 1993). 3 See William Inglis, Etc v. ITT Continental
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