Predatory Pricing: Strategic Theory And Legal Policy
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
- The Tension Between Current Legal Views and Modern Economic Theory
- Current Legal Policy
- Proposed Approach
- Financial Market Predation
- Signaling Strategies: Reputation Effect
- Cost Signaling, Demand Signaling and Other Predatory Strategies
- Possible Objections and Counter Strategies
- Appendix
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 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 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 output (including reduced innovation), achieved through the exclusion of a rival or potential rival. But such a definition does not state an operational legal rule.5 It is therefore necessary to base the legal rule on tractable measures such as cost, market structure, and recoupment.
A key premise in developing an enforcement policy for predatory pricing is the expected frequency and severity of its occurrence. That determination necessarily rests on the twin guides of empirical evidence and economic theory. In Matsushita and Brooke the Supreme Court found that predatory pricing was speculative and “inherently uncertain,”5 and noted its “general implausibility.”6 Moreover, in Matsushita the Court embraced the view that a “consensus” of commentators finds that predatory pricing is “rarely tried, and even more rarely successful,”7 and other courts have embraced this view,8 including a later Supreme Court in the Brooke decision.9 The consensus to which the Court referred rested essentially on empirical studies by John McGee and Roland Koller, published in 1958 and 1969;10 and the Court cited each work explicitly.11
In his 1958 article McGee analysed the trial record of the 1911 Standard Oil decision,12 a case long held up as the classic example of predation. The Rockefeller-dominated Standard Oil Company was thought to have cut prices below cost to drive out its smaller rivals intending later to raise prices and exploit consumers. McGee found little indication in the trial record that this had occurred. More than that, McGee found that a predatory strategy by a large firm such as Standard Oil against a much smaller rival would have been economically irrational in view of the much larger market share over which the predator must cut price. Recognizing that the predator cannot sustain such losses indefinitely, the prey will not be induced to leave the market. Nor will lack of funds exclude even the smallest prey since capital markets will step in to supply funds to an efficient producer. But even if the predator could drive the prey from the market, the predator would gain little because when it later attempted to raise price, either the prey or a subsequent purchaser could reopen the failed plant.
For a long time McGee's analysis provided the only coherent economic theory of predatory pricing. While some resisted McGee's conclusion that predatory pricing was irrational,13 no rival theory emerged. However, examples of actual predation clearly existed. Among the most notable was the use of “fighting ships” to exclude shipping rivals, as for example in the famous Mogul Steamship Co. case, as described by B.S. Yamey14 and more recently by Fiona Scott Morton.15 To drive out an intruding rival from the China trade the defendant shipping conference quoted rates, which according to Lord Esher in the Mogul case were “so low that if continued...they themselves could not carry on the trade.”16 Conference ships were even sent empty to Hankow in order to underbid the upstart shipping line.
Other striking instances of predation included the use of fighting brands in the match industry in both Canada and the United Kingdom whereby the monopolist would introduce a special brand, locally marketed, to foil new entry, confining sales of the brand to the entrant's local territory and withdrawing the brand as soon as the entrant left the market or sold out to the monopolist;17 the use of “punitive base points” in the U.S. cement industry, where the industry punished a “recalcitrant” firm that failed to follow the industry's cartel pricing system by making its production centre an involuntary base point with a drastically reduced base price, adhered to by other sellers;18 the setting up of bogus independents, secretly controlled by the American Tobacco Company to sell at low prices in the prey's territory to force rivals to sell out at depressed prices and thereby maintain monopoly;19 sustained below cost pricing by Southern Bell Telephone in the early 1900's when entry was threatened by independent telephone companies and further price reduction when entry occurred, combined with other predatory strategies, preceded Bell's growth to market dominance;20 below cost pricing by the Sugar Trust between 1887 and 1914 to drive out recent entrants,21 locational predation by a leading Canadian supermarket chain which built new stores close to entrant's plant, with the apparent single purpose of forcing losses on entrant as well as its own plant, sustaining the reputation effect hypothesis;22 and an experimental study showing the incentive in markets with incomplete information to engage in predation to deter entry.23 Finally, a recent reexamination of the Standard Oil case—the case on which McGee had primarily relied in rejecting the logic of predation—found that Standard had in fact used predatory tactics, although not necessarily predatory pricing, against its rivals, but in a far more subtle way than McGee had imagined24.
Nevertheless, the force of these examples had to confront the absence of supporting economic theory. In addition, Roland Koller’s 1969 Ph.D. dissertation, which he boldly titled, “The Myth of Predatory Pricing,”25 and which has been relied on by the Supreme Court and leading commentators such as Areeda & Turner and Robert Bork,26 also seemed to provide convincing countervailing evidence.
However, the mythology claim is overdrawn. Koller found that out of 23 cases where he judged the legal record to be sufficiently informative, actual predation was attempted in seven cases (30 percent) and succeeded in only four (17 percent).27 But a more recent study by Zerbe and Cooper examining the same cases beginning in 1940 and updated to 1982 concluded that predatory pricing was present in 27 out of 40 litigated cases.28 Moreover, both studies were likely to have under-reported predatory pricing, as they limited their investigation to litigated cases with revealing trial records. The studies therefore excluded: (1) settlements (including consent settlements with the government) which are likely to be a frequent outcome in strong cases,29 (2) predatory disciplining where no suit is filed because the prey agrees to comply with the predatory demand, (3) forced buy-outs where the prey may typically release antitrust claims, and (4) cases that were not brought because supporting economic theory was as yet undiscovered or unknown. By contrast, recent case studies which have found striking episodes of predatory pricing, such as the Burns study of American Tobacco,30 have used powerful econometric techniques not employed in earlier, more impressionistic surveys and some have probed deeply into historical archives, such as Fiona Scott Morton and Genesove and Mullin.31
Finally, even if the Koller study had correctly concluded that predatory pricing was rare in litigated cases this would scarcely be surprising given the populist legal standard that prevailed in the pre-1969 period he surveyed, following passage of the Robinson-Patman Act in 1936. Strikingly, only six of the 23 cases in the Koller sample occurred before 1936 and these includes two of the four cases in which Koller identified actual predation.32 During the era of expansive Robinson-Patman Act enforcement, discriminatory price-cutting by a large interstate firm injuring a small local rival, accompanied by evidence of animus or simply sustained price-cutting, was virtually per se unlawful. Certainly this was what lawyers were advising their clients,33 and it seems more than likely that such an over inclusive legal rule would have deterred most predatory pricing. That would of course provide no indication that predation would be rare under a less inclusive legal rule.34
The older economic analysis is challenged in an even more fundamental way by developments in economic theory over the last 20 years. Stimulated by the growing number of observed instances of predatory pricing and the emergence of modern game theory which provided the tools to analyze complex strategic situations, economists developed new economic theories beginning in the early 1980's. This new body of research challenges the static framework of perfect information on which McGee had relied. The new analysis explains predatory pricing in a dynamic world of imperfect and asymmetric information in which strategic conduct can be profitable. Under this analysis the predator seeks to influence the expectations of an existing rival, a potential rival, or perhaps most striking of all, the prey’s creditors, to convince the rival that continued competition or future entry into the market will be unprofitable. As summarized by Paul Milgrom—
As this passage suggests, predatory pricing may pose a special threat in rapidly growing, high technology industries, which often involve intellectual property and continuing innovation.36
Developing the strategic approach to predatory pricing, economists have formulated several coherent theories. In these theories, which include financial market predation and various signaling strategies, predatory pricing is a rational, profit maximizing strategy.37 While the formal economic proof of the theories is complex, their intuitions can be simply described. The theory of financial market predation challenges McGee’s assumption that the prey can readily obtain capital under predatory conditions, observing that the providers of capital use the threat of termination when profits are low as an incentive scheme to induce the firm to repay its debts. If predation causes the prey's profits to fall, the banks observe the decline, but cannot tell whether it is caused by predation or inefficient performance; and even if a bank could identify predation, it would be unable to write an enforceable lending contract contingent on its occurrence. Under these circumstances, lending to the prey becomes more risky, and banks or other investors reduce or withdraw their financial support.38
Similarly, in signaling theories of predation a better informed predator sells at low price to mislead its rival into believing that market conditions are unfavorable. Signaling theories include reputation effect, test market and signal jamming and cost signaling. In reputation effect predation a predator reduces price in one market to induce the prey to believe that the predator will cut price in its other markets or in the predatory market itself at a later time. In test market and “signal jamming” the prey is attempting to ascertain consumer response to a new product or to its entry into a new geographic market. The predator frustrates the prey’s market probe by either offering secret discounts and thus inducing the entrant to believe that demand for its product is low, or openly cutting price in the test market to keep the prey ignorant about normal market conditions. In cost signaling a predator drastically reduces price to induce the prey to believe that the predator has lower costs, when in fact the predator has no cost advantage.
To summarize, the present judicial skepticism of predatory pricing assumes that predation is extremely rare, but soundly-based empirical and experimental studies and modern economic theory do not justify this assumption. The judicial skepticism, influenced by economic assumptions based on a world of perfect information, has failed to make use of sophisticated modern theories, founded on a more realistic assumption of imperfect and asymmetric information, where much is not known and where one party may have more knowledge than the other. In addition, the present legal rule does not contain a fully specified efficiencies defense that reaches dynamically efficient pricing strategies, so that predatory pricing enforcement may lead to both under- and over deterrence.
While critics of strategic analysis have suggested a variety of counterstrategies that might foil predation, the counter strategies are not considered in an exhaustive (or equilibrium) analysis that works out all possible moves and countermoves of the parties. Moreover, the counter strategies implicitly assume that market participants have full or symmetric information. As we develop in Part VII, the counterstrategies rarely go through in a world of imperfect information. In another recent critique (which does not rest on an assumption of perfect information) John Lott argues that managers lack incentive to engage in predatory pricing because their compensation depends on short run profits, which can only be reduced by predatory pricing.39 However, this is an incorrect view of current managerial compensation policies and Lott's statistical study provides no basis for a different conclusion, as we also discuss in Part VII.
We propose to remedy these deficiencies by taking an approach explicitly based on modern strategic theory. Modern theory is critically needed because proof of predatory pricing under recent Supreme Court decisions requires a showing that the alleged predation is economically rational, and that is precisely what modern economic theory demonstrates. Thus, our proposal would augment existing approaches by allowing predation to be shown by proof that a predatory strategy exists and that the predator has acted pursuant to that strategy. This would involve identification of a predatory strategy recognized in the economic literature (e.g. financial predation) or in some instances even a new coherent strategy not covered by current economic writing if sufficiently persuasive and factually supported. We emphasize that our proposal is not intended to burden plaintiffs with new requirements of proof, but to augment and enlarge enforcement options to reflect the teachings of modern economics. Plaintiffs would remain free to maintain a predatory pricing case without reliance on modern theory.
Consistent with existing law, our proposed rule would require that price be below some measure of cost, which we think is best viewed in terms of incremental cost. We would also allow an efficiencies defense, but would expand the defense to include dynamic and output-enhancing gains that outweigh competitive losses. We believe that our proposed approach is basically consistent with the legal doctrine of Brooke, and would enrich and inform its application by a better understanding of both predatory strategies and efficiencies justifications. In briefest compass, one might describe our approach as a structured rule of reason informed by modern economic theory. Before presenting our proposal in more detail, we first describe current legal policy, its evolution and the present diminished level of enforcement.
U.S. antitrust law entered a new era in 1993, when the Supreme Court decided the Brooke case, the Court’s most important predatory pricing decision in modern times. As interpreted by the lower courts, the decision had an effect on enforcement comparable only to the impact of the Areeda- Turner article in 1975, which launched the cost-based approach to predatory pricing.40 Indeed, in the five years following Brooke, plaintiffs have not prevailed to final judgment in a single reported case. To appreciate the significance of Brooke we must know something of its historical background, its proper Phillip Areeda & Donald F. Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 HARV. L. REV. 697 (1975). 13 interpretation and subsequent lower court applications.
Predatory pricing enforcement extends over almost the full history of the Sherman Act. Cases were infrequent until after passage of the Robinson-Patman Act in 1936,41 and the inauguration of a strong enforcement effort by the FTC beginning in the 1940's.42 In the early years of the Robinson-Patman Act, enforcement essentially protected small local firms from price cutting by large sellers. Discriminatory price cutting by a large interstate seller which injured a local rival, accompanied by predatory intent was virtually per se unlawful.43 Largely missing was any consideration of the consumer interest in lower prices and vigorous competition.44 Plaintiffs won most litigated cases, including cases they probably should have lost.45 It seems no exaggeration to call this the populist era of predatory pricing enforcement.
Areeda-Turner Rule. The enforcement climate changed radically in 1975 with publication of the Areeda-Turner article.46 The article proposed a single per se standard based on average variable cost—the average unit costs of producing the product excluding fixed costs — which replaced the vague conjunction of factors previously used. The Areeda-Turner rule made an immediate impact on the courts, indeed so much so that plaintiffs’ success rate fell drastically in the years immediately following publication of the article.47
Economic Critique. However, a sharp economic critique quickly challenged the Areeda- Turner rule, asserting in general terms the need for a strategic approach, although economists had not yet rigorously proved that predatory pricing could be profitable. The critics charged that the short run AVC rule missed the essential nature of predation—strategic behavior over time. Price cuts by dominant firms must be viewed as strategic communication involving threats and sanctions. Effective policy, therefore, required a predatory pricing rule which considered strategic factors and long run welfare effects.48 Moreover, the critics did not simply fault the Areeda-Turner Rule. They offered a series of alternative rules, which sought to capture the strategic and intertemporal essence of predatory pricing. The proposals were of two types. The first sought to mirror the seeming simplicity of the Areeda-Turner rule by focusing on a single non-cost parameter that would identify predation. The second attempted to assess strategic conduct directly, relying on multiple criteria, including but not limited to cost.
Falling within the first category were the Williamson output increase rule49 and the Baumol price reversal rule.50 Williamson would find pricing conduct by a dominant firm predatory when the predator significantly increased output within 12 to 18 months following new entry into the market. The Baumol price reversal rule (Baumol I) would deem a price predatory if it forced a rival to leave the market and the predator thereafter reversed the price cut within the next several years. Neither of these rules attempted to identify the firm’s predatory strategy, but relied essentially on the designated objective indicator. While the two tests can be helpful in identifying predation,51 neither is sufficient by itself. Predation is too multifaceted a phenomenon to be identified by any single factor, and the attempt to do so may lead both to errors of over—and under—inclusion.
The second category of post Areeda-Turner proposals attempted to assess strategic conduct directly, combining one or more economic indicators, usually including cost and market structure, often combined with an appraisal of corporate purpose or intent. For example, in the most comprehensive of the proposals, Joskow-Klevorick would identify suspect pricing through evidence of monopolistic market structure, below cost pricing, reversal of the price cut, and documented corporate purpose to increase prices after competition is eliminated.52 Other leading proposals were offered by Posner, Joskow-Klevorick, Scherer, Baumol (Baumol II), and Ordover-Willig.53 These rules are closer in spirit to our approach, but none of them adequately confronts the fact that predation is not a unitary phenomenon, but involves a variety of predatory strategies that require distinct legal approaches. Thus, the critics did not attempt to describe and classify the various predatory strategies and to craft an approach keyed to an identified predatory strategy, as we propose in this article.54
Augmented Areeda-Turner Rule. Following the 1975 Areeda-Turner article, the lower courts at first embraced the average variable cost pricing rule in its per se form, but soon retreated after confronting criticism and litigation problems.55 To begin with, the AVC rule proved difficult to litigate. Cost determination—however cost is defined—is inevitably complicated and uncertain in a courtroom, particularly when made by juries. Second, all of the economic critics rejected a per se short term cost test. Finally, it appeared to many that a per se rule based on average variable costs strongly favored defendants. Indeed, in the five years immediately following the Areeda-Turner article, no predatory pricing plaintiff prevailed, and the rule was aptly called “a defendant's paradise.”56
In the face of these difficulties most courts declined to adopt a per se rule, and instead augmented the Areeda-Turner formulation with other factors, which included cost-based presumptions, intent and market structure. While there were variations between judicial circuits, most commonly courts held that a price below average variable cost was presumptively unlawful, while a price above average total cost was conclusively lawful. A price falling between these two cost benchmarks was presumptively lawful, but the presumption could be rebutted by evidence of intent and market structure.57 In the absence of a controlling Supreme Court precedent, the lower courts weighed the non-cost factors differently, but courts in most circuits relied on evidence of intent and increasingly market structure.58 Some courts followed a "sliding scale" approach, requiring more or less proof of predatory intent (and other non-price factors) depending on how far price fell below average total cost.59 In examining intent, courts began to distinguish between a mere intent to defeat a rival in competition, however vividly expressed, and a plan to eliminate rivals and then raise prices.60 On the other hand, a few courts found intent unhelpful, and simply inferred the specific intent required by the statute from the relation of price to cost.61 In all circuits cost determination remained a source of continuing difficulty, however.62
Litigation Outcomes. The decisive impact of the Areeda-Turner rule was reflected in litigation outcomes. In the seven years immediately following the article’s publication plaintiffs’ success rate measured by favorable judgments fell to only eight percent of cases reported (as compared with 77 percent in the populist era).63 However, in the succeeding 10 years up until the Brooke decision, which roughly coincided with the augmented AVC rule, plaintiffs’ success rate rose to 17 percent.64 Moreover, there is reason to think that if settlements are taken into account plaintiffs’ success rate may have been considerably higher.65 Interestingly, the number of reported cases declined in the latter period, perhaps indicating greater selectivity by counsel in cases tried.66
Indeed, it is possible to believe that predatory pricing enforcement had achieved a more or less satisfactory equilibrium in the years immediately preceding Brooke. While a predatory pricing case remained difficult for a plaintiff to win, flagrant predation based on prices below either average variable or even average total cost remained actionable in most jurisdictions. Juries were something of a wild card, occasionally handing down enormous and perhaps excessive verdicts, but courts moderated these tendencies by granting summary judgement or judgement NOV, following jury verdict. Nevertheless, the continued filing of predatory pricing cases, accompanied by large jury awards when plaintiffs did succeed, probably worked to maintain a steady deterrent on real predation.67 This gradually evolved equilibrium is now threatened—not by the Brooke decision as we read it—but by its application in the lower courts.
The Brooke decision established a new framework for predatory pricing analysis. While elements of the new analysis were anticipated in two earlier Supreme Court decisions,68 Brooke melded them into a more fully articulated judicial policy. First, predatory pricing required proof of below cost pricing, but the Court did not embrace a particular cost test, such as AVC. Clearly, however, a price could not be predatory unless it was below some measure of cost or even “some measure of incremental cost.”.69 Second, and most strikingly, predatory pricing required proof of recoupment—a dangerous probability, or under the Robinson-Patman Act a reasonable prospect, that the predator can later raise price sufficient to recoup its investment in below cost pricing.70
Recoupment is the new factor in Brooke and the elaboration of its requirements provides the added element of proof that Brooke mandates. Proof of recoupment requires not only that the belowÂcost price exclude or discipline the predatory victim, which was required under previous law, but also proof that the predator will be able to raise price above the competitive level (recoupment capability) sufficient to compensate the predator for its predatory investment (recoupment sufficiency). The recoupment requirement sharply differentiates predatory pricing from other predatory or exclusionary conduct, where the inference of injury to competition is drawn from the exclusionary conduct and market structure.71 Recoupment requires the added showing that the predatory conduct will be profitable.72 More specifically, the plaintiff must demonstrate either (1) actual recoupment of its predatory investment through supracompetitive pricing, or (2) that increased pricing power or other economic conditions make recoupment likely. As a necessary precondition, the Court emphasized that the recoupment requirement could be satisfied only if the market structure facilitated predation, which would require proof of market concentration, entry barriers and capacity to absorb the prey’s market share. When these threshold conditions are lacking, summary disposition is appropriate.
In Brooke the Supreme Court upheld lower court dismissal because plaintiff had failed to show that price could be raised above the competitive level. Thus, the Court never reached the issue of recoupment sufficiency.73 Nevertheless, the language of Brooke directs plaintiff to demonstrate that the likely predatory price increase would be “sufficient to compensate for the amounts expended on the predation, including the time value of the money invested in it.”74 Overly literal interpretation of this language could vastly complicate predatory pricing cases.75 However, in examining the facts, the Court makes clear that the recoupment element can be satisfied by showing either that the predatory scheme in fact produced sustained supracompetitive prices, or that it was likely to have caused that result, even if it did not actually do so. Thus, evidence of increased prices likely to persist (partial recoupment) or simply an intensified anticompetitive market structure or other market conditions (recoupment capability) would suffice.76 The subsequent lower court decisions appear consistent with this interpretation.
Clearly, however, the Court applied an exacting standard of proof to the specific evidence offered in the case. The facts in Brooke were unusual in that the alleged predator was not a single dominant firm, but a relatively small cigarette manufacturer holding only 12 percent of the total market, although the market itself was highly concentrated. Predation could occur only through the joint action of the leading firms engaged in oligopolistic price coordination. As no explicit agreement was alleged, the joint action necessarily rested on tacit coordination—a predatory theory the Court thought highly problematic, especially in the factual context of the case.77
The alleged predation occurred in response to the plaintiff’s introduction of non branded, low cost cigarettes, which were known as “blacks and whites,” to reflect their stark packaging on which was printed only simple black letters describing the cigarette content. In response to this bold initiative, which proved popular with consumers, the defendant Brown & Williamson put out its own similar non branded black and white cigarette. In a series of ever steeper price cuts the defendant undersold its rival, reducing its price below average variable costs. For 18 months Brown & Williamson held prices below AVC, sustaining losses of millions of dollars. At the end of the 18 month period the plaintiff, one of the smallest cigarette manufacturers, capitulated and raised price. The defendant and the other cigarette companies generally followed. The list price of non branded black and whites rose by 71 percent, while the price of branded cigarettes increased by 39 percent.78
On these facts the Supreme Court held that no reasonable jury could find that oligopolistic price coordination had produced supracompetitive pricing or that there was even a likelihood that this would occur. The Court noted that supracompetitive pricing through tacit coordination is both improbable in general and particularly unlikely under the facts of the case due to pricing uncertainty caused by multiple product varieties and the practice of giving rebates on list prices, demand uncertainty created by the introduction of unbranded cigarettes, divergent incentives among competing manufacturers, the absence of evidence showing that pricing signals between manufacturers were understood, and the not surprising denial by the plaintiff’s officers that they had tacitly colluded with their competitors, either voluntarily or by compulsion.79
The Court’s exacting requirements of proof appear to be driven partly by the assumption that predatory pricing rarely occurs and partly by its skepticism toward predation by tacit coordination among rival firms. As discussed earlier, the view that predation is rare and implausible conduct is based on outdated economic theory, but in fairness the old theory was the only economic view presented to the Court. Beyond that, and more immediate to the case, the Court’s view of the predatory pricing claim was colored by its doubts that predation by tacit coordination could realistically occur. Indeed, the Court of Appeals held plaintiff’s predatory theory to be so weak that it dismissed the case as economically senseless.80 While not willing to go that far, the Supreme Court itself expressed grave misgivings, emphasizing the difficult coordination problem of maintaining predation by tacit coordination without explicit communication, particularly in view of the defendant’s small market share.81 In cases resting on other, generally accepted predatory theories both the Supreme Court and the lower courts are free to take a less skeptical view of predatory strategies. Thus, Brooke does not foreclose reliance on the soundly based predatory theories discussed in this paper.
A strategic view of recoupment would close the gap in predatory pricing enforcement caused by the neglect of modern analysis. In Brooke the Court omitted from its analysis any consideration of strategic factors such as possible gains from deterring aggressive pricing in future time periods or in other cigarette markets, for example, branded cigarettes. Nor did the Court consider the counterfactual event of what might have happened in the absence of the price war—the diminished profits the predator would have earned had it not forced the prey to stop cutting prices. By contrast under a strategic approach counsel might have attempted to show that a reputation effect or other predatory theory, such as financial market predation, enabled probable recoupment. Whatever might have been the ultimate outcome, that is the issue that should have been submitted to the courts.
As interpreted by the lower courts, the Brooke decision had a powerful effect on case outcomes. In the six years following Brooke plaintiffs have not prevailed in a single case. Of 37 reported decisions, defendants have won 34 cases, and the remaining three cases were settled after plaintiffs survived motions for summary judgment or dismissal. Strikingly of the 34 cases won by defendants all but one were decided by summary judgment, judgment N.O.V., or dismissed on the pleadings.82
Plaintiffs’ dismal success rate since Brooke (after eliminating clearly misconceived cases) appears to be caused at least in part by (1) exacting proof and pleading requirements, spurred by the Supreme Court’s open invitation to dismiss predatory pricing cases by summary means, (2) skepticism that predation can ever be a plausible business strategy, also influenced by the Supreme Court’s opinion, and perhaps not unrelated (3) judicial neglect of modern strategic theories of predatory pricing.
Review of the post-Brooke decisions shows that the lower courts clearly took full advantage of the Supreme Court’s invitation to dispose of non-meritorious cases by summary means. Indeed, there have been only four reported trials since Brooke and in the two cases where plaintiffs initially prevailed, the district courts reversed the jury verdicts by judgment N.O.V. To be sure, many of these cases appear to have been appropriate for summary disposition; for example, in 12 cases the defendant’s market share was below 40 percent or other structural factors showed that post-predation market power was lacking.83 But it is also true that the courts dismissed seven cases on the pleadings, sometimes neglecting the need in antitrust cases to conduct discovery to develop necessary evidence;84 and in other cases imposed severe requirements of proof at the summary judgment level.85 Despite the fact that plaintiffs defeated motions for summary disposition in three cases (all of which were then settled)86, the prospects of a predatory pricing claim in the lower courts remain far from encouraging87
However, there appears to be a brightening prospect that the courts will begin to analyze predatory pricing in the light of modern economics. In Advo, Inc. v. Philadelphia Newspapers, Inc.88 the Third Circuit accepted reputation effect as a possible theory of predatory pricing. The court indicated that price cutting by a chain store in selected local markets could be predatory when the price cutter’s demonstrated predatory conduct inhibits competition in other markets as well as the predatory market, causing prices to rise. Finding that a reputation effect theory “makes economic sense,” the court rejected its specific application in the case as factually unsupported.89 Similarly, in Traffic Scan Network, Inc. v. Winston,90 the district court rejected a reputation effect argument not because it was implausible, but because market conditions would have prevented such an effect. In addition, the Department of Justice has recently filed a civil complaint against American Airlines, based in part on anticompetitive reputation effects from alleged predatory pricing.91
Proposed DOT Guidelines. Perhaps the most striking development since the Brooke case has been the recently proposed Department of Transportation (DOT) Guidelines, which explicitly recognize predatory pricing as a strategic problem and would allow proof of recoupment based on reputation effects.92 The Guidelines focus on the ability of a major air carrier dominating a city hub, such as Chicago or Atlanta, to exclude competition and potential competition between the hub and directly connecting non-hub cities.93 The observed strategic mechanism is a drastic expansion of capacity and lowering of fares by a locally dominant airline in response to new entry of an independent airline. Using the economic definition of predatory pricing, the Guidelines would identify as predatory any response to new entry by a hub-dominant major airline that makes economic sense only because the major airline can exclude the entrant from the market and thereafter charge high fares.
From a strategic viewpoint the most notable thing about the new Guidelines is their reliance on reputation effects to prove recoupment—the expected gains to the predator from deterring future entry by other airlines.94 Thus, if the predator suffers sustained losses in a contested local market such that recoupment in the local market appears doubtful, evidence that the predation deterred future entry into either the local market or the predator’s other monopoly markets could presumably establish recoupment.
In contrast to Brooke the Guidelines do not require proof of below-cost sales. Instead, the Guidelines rely on a gross revenue measure to identify predation. Thus, a predatory response to new entry is a capacity increase in a local hub market that causes the hub-dominant airline to forgo more revenue than all of the new entrant’s capacity could otherwise have diverted from it (or simply yields lower revenue than would a “reasonable alternative strategy” for competing with the entrant).95 The substitution of a gross revenue or output measure for the traditional cost test may be justified because the special characteristics of airline markets makes output expansion a particularly effective predatory strategy. Airlines are able to discriminate between customers with great precision and can respond swiftly to competitor moves, based on “real time” information about rivals. Mobility of assets, including the ability to lease aircraft, permits rapid expansion of capacity in contested local markets.96
The main objection to the use of a non-cost standard to measure predatory pricing is loss of certainty in business planning. Since future demand, particularly in airline markets, may be difficult to predict, under an output rule a major airline may face difficulty in determining whether it can lawfully expand its capacity to serve a local market following new entry.97 On the other hand cost determination in airline markets also presents difficulties due to secondary effects in other markets caused by flights on a specific city pair route.98 Despite the difficulties it poses in airline markets, a cost standard may provide a more secure basis for business planning.99
The DOT Guidelines conceive the problem of airline predation in strategic terms. They do not attempt to define predatory pricing under a single legal formulation, but rather identify the particular predatory strategy involved in local airline markets. This approach is consistent with modern economics, and it is the viewpoint taken in this paper. While we would generally adhere to a cost- based approach, relevant costs would include long run incremental costs, as well as short run costs.
While the use of modern economics in proving predatory pricing is novel compared to recent practice in most of the lower courts, such an advance is implicit in the recoupment standard adopted by the Supreme Court. The recoupment requirement was designed to screen out cases where predation appeared unprofitable and hence irrational. The Court’s skepticism about the rationality of predatory pricing was justified by the now dated economic authorities on which the Court relied.100 However, modern economics has developed new, more sophisticated theories of how recoupment may be achieved consistent with rational behavior, and thus identifies economic conditions under which a predatory pricing strategy is plausible.
Accordingly, our approach would permit the plaintiff to amplify its proof of predation by showing that under the specific facts of the case, one or more strategic theories are economically plausible and that surrounding economic conditions make recoupment likely in the light of such theory. We emphasize that we are not adding a new element of proof. Proof of predatory pricing under modern theory would augment and complement existing approaches. Plaintiff could still bring a case without advancing modern strategic theory. However, under our proposal a plaintiff could also base proof on well-founded strategic analysis whenever the facts warrant.
Our proposed approach is consistent with Brooke. That decision permits proof of predatory pricing and recoupment based on a scheme of predation that excludes rivals and enables the predator to recoup predatory losses. Proof of recoupment may be based on an actual price increase in the predatory market, increased concentration and entry barriers in the post-predation market, or on other relevant market conditions, including market structure and conduct, that make recoupment likely in the future.101 Thus, proof that market conditions make recoupment probable under an identified and recognized strategic theory should satisfy this test. Perhaps because modern strategic theory was not presented to the Supreme Court in Brooke, a gap exists in predatory pricing coverage. Interpretation of the recoupment requirement to encompass modern analysis would close that gap.
A strategic analysis also has implications for the efficiencies justification, which would assume a larger role. The justification would encompass not only defensive responses to price cutting by rivals (e.g. meeting competition) or temporary market conditions (e.g. excess inventory), but also market expanding dynamic efficiencies, such as learning-by-doing and network economies. Strikingly, these efficiencies, particularly dynamic efficiencies, also involve recoupment, but in this case the post-predation gain is procompetitive because recoupment comes not from output contracting monopoly pricing, but from output expanding efficiencies.
Consistent with existing law, the proposed rule would require proof of the following elements: (1) a facilitating market structure, (2) a scheme of predation and supporting evidence, (3) probable recoupment, (4) price below cost, and (5) absence of an efficiencies or business justification defense.102 We discuss the four elements necessary to make out a prima facie case of predatory pricing in this section, and the efficiencies defense in a separate section. The plaintiff would generally have the burden of proof on the first four elements, while the defendant would have the burden on the last element.
The market structure must make predation a feasible strategy. This requires what Joskow and Klevorick call “short run pricing power”—the ability to raise prices (or otherwise exploit consumers) over some significant but not necessarily unlimited period of time. A predatory market structure exists when a dominant firm or small group of jointly acting firms has high market share, and when there are both entry and reentry barriers.103 When these conditions exist, predation may injure competition. When they do not, the court should be able to dismiss the case if the structural facts are sufficiently clear. Thus, predatory market structure would operate as a threshold screen, as the Supreme Court held in the Brooke case.
Entry barriers exist when a new market entrant faces costs that the incumbent predator need not bear, or no longer faces. The most frequent example is sunk costs—fixed cost investment that cannot be withdrawn from the market except at large sacrifice, such as the trackage of a railroad. While the predator has borne these costs in the past, they are now irretrievable. Thus, if challenged by new entry, the incumbent will rationally disregard such costs in its pricing decisions rather than lose the business. The entrant on the other hand must now incur such costs, and hence faces risk of underpricing by an incumbent with sunk costs. Thus, sunk costs may act as an entry barrier, giving the incumbent power to raise price above the competitive level.
Reentry barriers exist when a firm that has left a market bears significant costs in seeking to reopen its business. As an example, a small airline forced to cease operations in a local market just as it is beginning to establish its brand name, may have damaged its reputation as a reliable alternative to the established carrier. To reenter it will have to slowly rebuild its reputation, and this is costly. Reentry barriers combined with entry barriers give a successful predator the power to raise prices. The Supreme Court has emphasized that proof of predatory pricing requires proof that entry and reentry barriers continue to exist during the recoupment period.104
However, the courts have failed to see that successful past predation can itself operate as an entry and reentry barrier particularly where reputation effects are present. In such cases the would-be entrant anticipates that any attempt to enter the market will evoke a predatory response from the incumbent. Anticipating that consequence, the firm declines to enter. That is to say, the incumbent’s past reputation as a predator deters future entry or reentry.105 The problem of proving entry barriers, particularly those based on reputation effect, can be eased by presuming their existence if the incumbent significantly raises price after the prey’s exit without inducing new entry or reentry. Such a presumption is similar to the inference made under the rule of reason that proof of anticompetitive effects may serve as proof of market power.106 The presumption is of course rebuttable since other economic factors, such as excess capacity may explain the absence of entry.
Under Brooke and Matsushita proof of a predatory scheme, under which the predator can expect to recoup its predatory losses, is an essential element in a predatory pricing case. Moreover, the degree of plausibility of the predatory scheme vitally affects the standard of evidentiary proof for recoupment. If the alleged predatory scheme is only weakly plausible, as the Court found to be the case in Brooke and Matsushita, more persuasive evidence of recoupment is required.107 Illuminating the stringency of this requirement, the Court in Brooke subjected the evidence to a demanding analysis such as to make it doubtful that any claim of multi-firm predation could have survived the Court’s scrutiny. However, where the predatory theory is less problematic, proof of market conditions enabling probable recoupment, while still required, more readily leads to the conclusion of probable recoupment. In any event, taken together the alleged scheme of predation and post-predation market conditions must add up to a compelling theory of predation.
The Court found the alleged predatory scheme in Brooke implausible because the scheme appeared to require sustained tacit coordination between multiple firms without explicit communication or agreement on a predatory strategy and a mechanism for recoupment. In the absence of a focal point for coordinated action, it was unclear how the alleged predators could overcome cheating and free-riding problems in executing a predation and recoupment strategy. The Court also thought the predatory scheme to be implausible in Matsushita, even though it involved alleged agreement between the alleged predators, because of the inherent difficulties of orchestrating a coordinated predatory pricing and recoupment strategy among competing firms.108
The predation theories we discuss stand on a stronger foundation of economic theory. Rigorous economic analysis, developed over the last 30 years and using the tools of applied game theory, identify the economic conditions under which predatory pricing is rational, profit-seeking conduct by a dominant firm. Expected or anticipated recoupment is intrinsic to these theories, because without such an expectation predatory pricing is not sensible economic behavior. Thus, modern theories when factually supported may sustain the plausibility of a predatory scheme. Finally, when modern theory has been properly briefed to the Supreme Court in other types of antitrust cases and when the predatory or exclusionary theory is supported by convincing factual evidence, the Court has been willing to follow modern theory.109
Exclusionary Effect on Rivals. The means by which predatory pricing works its ultimate injury to consumers is through its exclusionary effect on rivals or potential rivals. Exclusionary effects involve either the exclusion of a rival or potential rival from the market, or the disciplining of the rival's competitive conduct. At a minimum this requires proof that the below-cost pricing was capable of achieving its intended exclusionary effect on rivals, as the Supreme Court noted in Brooke.110 While such pricing must have been a substantial factor in producing this result, the defendant’s low prices need not have been the exclusive cause of the victim’s market exclusion or threatened exclusion; and indeed other factors may have contributed, such as increased raw material costs or reduced demand. It suffices to show that the alleged unlawful conduct was a “material cause,” “a substantially contributing factor,” or “among the more important causes.”111 On the other hand, predation that was only “a minor contributing factor” to the victim’s forced exclusion or threatened exclusion would be insufficient to establish an exclusionary effect.112
A second type of exclusionary effect is the disciplining of rivals. In this case the rivals are not excluded from the market, but their competitive conduct is inhibited. While some writers define predatory pricing solely in terms of rival exclusion,113 disciplining of rivals is a well accepted anticompetitive effect, particularly by legal authorities.114 In fact, the disciplining of rivals is itself exclusionary since its object is to exclude the growth and expansion of the prey or the prey’s entry into new markets. Proof of a disciplining effect requires the plaintiff to show (1) the victim is a rival firm whose competition threatens or potentially threatens the profits of the predator, (2) following the period of below cost pricing the victim raised its prices, became less aggressive or otherwise restrained its competitive conduct, or that the below-cost pricing was capable of producing this result, and (3) the below-cost pricing was a substantial factor in causing these exclusionary effects.115
The Brooke case provides an illustration of price disciplining (although the plaintiff’s case ultimately failed on the issue of recoupment). The victim Liggett had introduced low cost, unbranded cigarettes which threatened the profits of the larger manufacturers including the defendant Brown and Williamson. After 18 months of sustained below cost pricing by defendant, Liggett raised its prices and essentially became a price follower. Below cost pricing clearly appeared to have been a substantial factor in causing Liggett to raise its prices and to become less aggressive since it was only after five successive price cuts by defendant that Liggett ultimately succumbed.
Injury to Competition and Consumers. Under Brooke and Matsushita proof of an injury to competition, actual or probable, is an essential element of a predatory pricing case. This requires evidence either that (1) the alleged predatory scheme caused prices to rise above the competitive level in the predatory market or in another strategically-linked market in which the predator has market power, or (2) market conditions and the predator's conduct makes future recoupment likely under the alleged scheme. Proof of actual recoupment is not a necessary ingredient of predation since Brooke requires only a showing of probable recoupment. Indeed, if actual recoupment were required, a predator might be able to avoid liability by delaying recoupment until risk of suit has passed, perhaps because the passage of time has made it difficult to rebut the claim that other economic conditions caused the price increase.
Consistent with Brooke, a sufficiently strong showing of an increased ability to raise and maintain high prices as a result of successful predation could meet the recoupment requirement even in absence of a well-articulated strategic theory. In such a case the evidence will have shown that the alleged predator has excluded a rival from a market with a below cost price, has at least partly recouped its predatory losses subsequently by raising price, and likely will be able to maintain above-cost prices sufficiently long to fully recoup its predatory losses. With such evidence of actual recoupment already in progress, it seems reasonable to infer a coherent predatory strategy without requiring the plaintiff to completely spell out and prove the logic of the strategy. The risks of over deterrence in such a case seem minimal since the Supreme Court has made clear that the standard of proof in predatory pricing cases is exacting, and the post-Brooke cases show that it is exceedingly difficult to satisfy that standard, absent a persuasive theory of predation.
In contrast, we propose that the evidentiary standard for probable recoupment should be less demanding when proof of the predatory scheme rests on a coherent strategic theory supported by evidence of market structure and conduct. As suggested above, Brooke permits such an interpretation because the conclusion of probable recoupment is drawn jointly from the plausibility of the predatory theory and the post-predation market conditions. When, as in Brooke, the theory is weak, the post-predation evidence must be stronger.
Where, however, the predatory theory is robust, the post-predation evidence standard should be less exacting, though of course still required. Suppose, for example, that the plaintiff articulates a coherent theory of strategic predatory pricing based on modern economic analysis, that the evidence shows that post-predation market structure and conditions are consistent with the required assumptions of the theory, that the actions of the defendant and other market participants have also been congruent with the theory, and that the plaintiff has been excluded from one or more markets as result of below- cost pricing. With this evidence of post-predation market structure and conduct in hand, it seems reasonable to infer probable recoupment. In this way our proposal extends the existing interpretations of Brooke to enable a plaintiff to prove recoupment based on modern strategic theory without having to show actual recoupment.
The final element in establishing a prima facie case of predatory pricing is proof of sales below cost. A cost standard can be faulted as difficult and expensive to prove, and also under-inclusive because prices above cost can be both predatory and injurious to competition.116 Despite these problems, a cost benchmark is generally necessary for effective business planning for an activity as ubiquitous as pricing. Moreover, since at least 1975, U.S. courts have uniformly followed a cost standard in evaluating predatory pricing.
The cost standards that the courts have most often used are average total cost (ATC) and average variable cost (AVC). Under current U.S. law, a price above ATC is conclusively lawful, while at the other extreme, in most jurisdictions a price below AVC is presumptively unlawful (assuming the other preconditions of Brooke are satisfied).117 A price between AVC and ATC is either presumptively or conclusively lawful, depending on the Circuit.118 In Circuits where the price is presumptively lawful, the presumption can be rebutted by other evidence of predation, particularly intent and market structure.119 However, we shall urge that an incremental cost standard provides a superior measure for assessing predation. Thus, we would substitute average avoidable cost for AVC, and long run average incremental cost for ATC.
This proposal follows in substantial part the recent proposal of William Baumol, who similarly urges substitution of average avoidable cost for AVC.120 We agree that this should be the lower bound cost test. However, we would add an upper bound cost measure of long run average incremental cost as a substitute for ATC, a proposal originally made by Joskow and Klevorick.121 Thus, we adhere to the dual cost approach that many courts presently follow, but we reformulate the cost test to more closely approximate the theoretically correct marginal cost standard.
Average avoidable cost (AAC) is the average per unit cost that predator would have avoided during the period of below cost pricing had it not produced the predatory increment of sales. Thus, if the period of alleged predation is 10 months, AAC is the sum of the costs incurred in producing the predatory increment over the 10 month period divided by the quantity produced. It is immediately apparent that AAC is a short run measure because, like AVC, it does not include any sunk costs incurred before the period of predation (since these are not escapable). However, unlike AVC, AAC does not require an often controversial allocation between fixed and variable costs, and also more closely approximates marginal cost since AAC includes all costs that could have been avoided had the defendant not made the predatory sales, whether fixed or variable. Thus, AAC is both easier to calculate and more theoretically correct than AVC.
Long run average incremental cost (LAIC) is the per unit cost of producing the predatory increment of output whenever such costs were incurred. More precisely, the LAIC of a new product is the firm’s total production cost (including the new product) less what the firm’s total cost would have been had it not produced the new product, divided by the quantity of the product produced.122 LAIC thus includes all product-specific costs incurred in the research, development and marketing of the predatory product or increment of sales even if those costs were sunk before the period of predatory pricing.123 In addition, LAIC logically includes any costs incurred to effectuate the predatory scheme, following formation of the predatory strategy. LAIC is a superior cost measure over ATC for a multi product firm because it does not require courts to allocate joint and common costs, an undertaking which lacks a precise methodology and is particularly unsuited for jury resolution.124 Moreover, LAIC measures the present worth of the productive assets by replacement cost, and not by historic costs which may give little indication of their current value.125
Long run average incremental cost is a necessary benchmark in addition to short run cost because sales below LAIC may reflect a strategy of sacrificing current profit in order to exclude or discipline a rival and thereafter hold price at the monopoly level. Such conduct, if not otherwise explainable, is predatory and a predatory pricing rule that excluded it would be seriously under inclusive.
The risk of under inclusion is particularly acute for intellectual property. A short run cost test provides little protection against predatory pricing involving intellectual property since after the product is developed and launched, AAC or AVC may approach or equal zero. In computer software, for example, the short run incremental cost of a program downloaded from the Internet, is nil. As a result there can be no sale below AAC. An AVC standard does little better since the average variable costs of computer software continuously decline and may approach insignificance as sales volume becomes sufficiently high. Thus, the only tenable cost standard for intellectual property must be a long run cost measure. LAIC is superior to ATC as a measure for intellectual property because LAIC emphasizes that the relevant costs relate to research, development, marketing and production of the predatory product or service, rather than to some larger category of sales.126
Cost Presumptions and Burdens of Proof. Applying these cost concepts, we would treat a price above ATC as conclusively lawful (following Supreme Court precedent), but otherwise we would substitute for ATC, the similar but economically more accurate measure of LAIC. A price below AAC would be presumptively unlawful (assuming the other elements of proof of liability are satisfied). When price is below this level, the defendant would then have the full burden of persuasion to show that the low price was necessary to achieve competition-enhancing efficiencies. Consistent with the standard for proof of liability,127 the efficiencies defense would be applied from an ex ante perspective: Would a representative firm in the industry have anticipated the conduct to be profit maximizing in the absence of exclusionary effects?
If the predator has priced below LAIC (but above AAC), the burden of proof would be divided between plaintiff and defendants. First, the defendant would have an initial burden of production—of coming forward with some tangible evidence of efficiency or legitimate business purpose. Second, once defendant has offered such an explanation, the burden of persuasion would then shift to the plaintiff to persuade the court that the pricing conduct was predatory.
Placing an initial burden of production on the defendant when price is below LAIC is justified because the first four elements will have established not only that price is below some measure of cost, but also that industry structure makes predatory pricing feasible, specific market conditions facilitate and enable the alleged predatory strategy, the prey has been excluded or disciplined, and as a result the price has increased or is likely to increase. Such a record properly puts some burden of explanation on the defendant. At the same time the presence of the specified preconditions mandated by Brooke assures that defendants will not be required to justify all challenged price cutting since the preconditions confine possibly suspect price cutting to a narrow range of cases. Moreover, the defendant is well placed to provide such an explanation since it surely has the best knowledge of the efficiencies and business reasons for its actions.
The efficiencies or business justification defense serves as a means of eliminating cases where below cost pricing by a firm with market power is efficiency-enhancing, rather than predatory. In these cases the sacrifice of present profits through low pricing is justified for reasons other than exclusion or disciplining of rivals. The defense thus serves as a necessary shield against an overly inclusive legal rule. The predatory pricing cases have recognized a business justification defense in a variety of factual settings, but have created no clear standards to guide application of the defense.128
The burden of proving an efficiencies defense is generally placed on defendants in antitrust cases on the theory that they have superior access to the information, which is under their control.129 As noted above,130 in applying our approach, we would place the full burden of proof on the defendant when price is below short run cost. When the price is above short run cost (but below long run incremental cost), defendant would have an initial burden of producing evidence of efficiencies, after which the burden of persuasion would shift to the plaintiff. Business justifications for below cost pricing may be either defensive and competition-compelled or market expanding.
In defensive price cutting a firm prices below its cost in response to price reductions by its rivals or to market events outside the firm’s control, seeking to maintain its competitive position in the market. Examples of defensive price cutting include price reductions that (1) meet the lower price of a rival who initiated the price cutting, (2) minimize losses stemming from unexpected market developments, such as excess capacity, product obsolescence, or shrinking demand, or (3) serve to maintain marketing channels or an ongoing organization, so as to preserve existing options for resumption or expansion of production when market conditions improve.131
Unilateral best response. In addition, we would recognize as an additional justification for defensive price cutting a price reduction below LAIC (but not below short run cost) that is a unilateral best response to a competitive price offered by a rival. By a unilateral best response we mean a price that maximizes the incumbent’s immediate or short run profit even though its rival remains in the market. Such a price will thus always be above incumbent’s short run cost but may well fall below LAIC. Under these conditions the reduced price is simply an independently justified, profit maximizing response to the prevailing market price.132 Note that the incumbent’s price may be profit maximizing even if it undercuts the rival’s price so long as it remains above incumbent’s short run costs.133 Typically, this is likely to occur when the incumbent has high sunk costs and excess capacity such that its short run costs are very low.134
The courts have generally upheld most types of defensive below cost pricing, as compelled by competition. Such pricing benefits consumers in the short run through lower pricing and may promote long run consumer and social welfare in cases where it preserves the price cutter as a competitor or potential competitor in the challenged market. Indeed, the freedom to respond to aggressive price cuts by rivals or to sudden changes in economic conditions may be necessary to give firms the incentive to create and develop markets in the first place.135
The defendant would have the burden of proving the first and third elements— efficiencies gain and efficiency-enhancing recoupment. However, the burden to establish the second element—no less restrictive alternative—should be allocated between the parties. In proving the second element the plaintiff would have the burden of identifying one or more plausible less restrictive alternatives, after which the burden would shift to the defendant to show that such alternatives are either not feasible or not less restrictive.136
We sketch three types of market expanding efficiency defenses: promotional pricing, learning- by-doing, and network externalities. These are all dynamic efficiencies that explain how the higher sales resulting from lower prices might increase future profits even with no exclusionary or disciplining effect. Typically they involve new products or new markets. Evaluation of market expanding efficiencies may raise difficult issues of characterization. On the one hand, market expansion provides procompetitive explanations for recoupment of losses from below cost sales. On the other side, the mere presence of these efficiencies does not preclude a coexisting predatory strategy to exclude or discipline rivals. Thus, it is important to show whether dynamic efficiencies alone make recoupment sufficiently probable to justify the losses from below cost prices. Only when this condition holds should we accept an efficiencies defense involving dynamic economies.
a. Promotional pricing
A profit-maximizing firm with no exclusionary purpose might temporarily price below its cost in order to induce consumers to try a new product.137 The firm’s expectation is that a favorable consumption experience induced by prices below cost will increase future consumer demand at prices above cost. This might be the case if consumers make frequent repeat purchases or communicate their views of product quality to other consumers by word-of-mouth.138 The promotional pricing defense is best understood through a hypothetical case.
Illustrative Example: Tasty-Frozen Pizzas. Tasty-Frozen, a leading manufacturer of frozen pizzas, develops a new kind of cheese that retains its flavor and texture much better than other frozen pizzas. The new ingredient is much more expensive than existing cheeses, but test market research shows that consumers prefer the enhanced pizza and would be willing to pay for it. However, test market research also indicates that consumers, distrustful of “new and improved” product claims, are unwilling to try the new pizza if they must pay a higher price. To convince consumers that the new pizza tastes better, Tasty-Frozen considers in-store sampling but this is a costly and likely ineffective marketing device since in-store congestion limits ability to reach consumers. Instead, Tasty-Frozen introduces its new product at the price charged for other frozen pizzas, supported by an intensive three- month advertising campaign. As a result, the price of the new pizza falls below Tasty-Frozen’s short run costs (e.g. AIC or AVC).
At the end of the three months promotion, Tasty Frozen raises its price. Consumers remain loyal, having come to appreciate the new pizza’s improved taste. While the manufacturer sustains large losses during the three months promotional period, from that time on the firm earns substantial profits from its higher prices and scale economies. Projected sales indicate that Tasty-Frozen will become profitable within a year. Moreover, the company has no incentive to later degrade the quality of its product, e.g. by mixing the new cheese with less expensive standard cheese, because consumers would note the change and no longer be willing to pay a premium. The higher quality of the new pizza has caused many customers to switch from the lower priced brands, and the switch persists even after Tasty-Frozen had raised prices. Indeed, so successful is the new pizza that several of Tasty-Frozen’s low price rivals suffer losses and leave the market.
Assume that Tasty-Frozen dominates the frozen pizza market, that brand recognition creates entry and reentry barriers, pricing is below cost, a predatory strategy is plausible (e.g. financial market predation), rivals are excluded, and following the price cutting, Tasty-Frozen raises price, enabling recoupment of its investment in below cost sales. In the absence of an efficiencies defense Tasty-Frozen’s pricing conduct appears to raise antitrust problems.
Proof of Efficiencies Defense. The above facts would satisfy each of the elements necessary to sustain an efficiencies defense.
(i) Plausible Efficiencies Gain. The below cost pricing has caused consumers to try the new product (and could reasonably have been expected to have this effect). Introduction of the new pizza has improved both product quality and variety, as shown by consumer willingness to pay higher prices after the promotion period; and the fact that cheaper brands of pizza continue to be offered. Thus, successful launching of the new pizza plausibly increases efficiency.
(ii) No Less Restrictive Alternative. Success of the new pizza depends on informing consumers of its superior qualities. Sales below cost have induced consumers to try the new product and persuaded them that its improved taste justifies a higher price. Other means to induce consumers to experience the product, such as in-store sampling, are costly and ineffective. The planned three month period of below cost promotional pricing is no longer than appears reasonably necessary to inform consumers about product attributes. Thus, no less restrictive alternative appears reasonably available to successfully launch the new product.
(iii) Efficiency-enhancing Recoupment. Tasty-Frozen raised its price after three months and became profitable after only a year, thereby recouping, at least in part, its investment in below cost pricing. Tasty-Frozen’s profit stems from the improved quality of its pizza and not elimination or disciplining of rivals, since competition from existing, lower cost frozen pizzas remains vigorous.139 Moreover, the manufacturer has a continuing incentive to maintain product quality since quality alone enables it to charge a premium price in the face of continuing competition from lower priced frozen pizzas. Thus, recoupment stems from the efficiency-enhancing improvement in the quality of Tasty- Frozen’s pizza.
b. Learning-by-doing
The learning curve is an empirical relation showing that unit costs decline with cumulative production experience. The learning curve reflects the idea that learning-by-doing can be an important source of process innovation. In the presence of a learning curve, a profit-maximizing firm might reduce its price below its current cost to increase its production volume without having any predatory purpose. By this means the firm may accelerate its discovery of cost-reducing production methods, recouping its investment in below cost pricing from increased profit available at a later time.140
Proof of Efficiencies Defense. Learning-by-doing induced by below-cost sales may achieve efficiencies gains through earlier discovery of cost-reducing production methods, but it may also have exclusionary effects, which at the limit may create a dominant or monopoly firm. Thus, absence of a less restrictive alternative becomes a key factor in assessing availability of an efficiencies defense. This requires proof that other means of achieving learning curve economies are more costly, for example mentoring by other workers, class room training, process R&D, or producing to inventory. In addition, the period of below-cost pricing must be no longer than reasonably necessary to achieve the learning economies.
Finally, to prove efficiency-enhancing recoupment the firm must show that accelerated production enabled it to achieve important cost savings, and that its rivals, producing at lower volume did not achieve similar cost savings during the same time period. Proof of such facts would tend to establish that below-cost pricing was necessary to induce the savings in production cost.141
c. Network Externalities.
A network externality occurs when a consumer’s valuation of a product increases with the number of other consumers using the product. An example is a telephone network, where the value of the network to a user increases with the number of connected telephone users. The procompetitive rationale for below-cost pricing in cases involving network externalities bears similarities to both promotional pricing and learning-by-doing. The rationale is similar to that for promotional pricing because future demand increases with added current sales. The rationale is similar to learning-by-doing because demand depends on cumulative sales.
When network externalities are present a profit maximizing firm might initially price a product below cost in order to establish a large installed base of users, and thereby increase demand for its product. Moreover, the firm might do this for procompetitive reasons and without any exclusionary purpose. Such a procompetitive effect might occur, for example, if (1) the firm had reason to expect that an installed base would significantly increase the demand for its product, (2) a large installed base would increase availability of complementary products and services, augmenting the value of the basic product, (3) as a result, consumers would value the product more highly, enabling the firm to recoup its investment in below cost pricing, and (4) the period of below-cost pricing extends no longer than reasonably necessary to achieve the installed-base network economies. As in the case of learning curve economies, the presence of a less restrictive alternative is likely to be a key issue.
An example of network externalities would be a new battery for electric cars that requires a network of service stations with specialized equipment and service personnel. Assume a new technology is developed by two firms such that each requires its own specially equipped servicing network, as well as specially designed auto engines. Firm A develops its battery a few months earlier than Firm B and obtains initial contracts with auto manufacturers developing a pioneer electric car to test market in a few cities. Firm A also induces a small number of service stations to buy the necessary equipment and train personnel. When Firm B enters the market, Firm A bids aggressively in each competitive encounter, often bidding below cost. As a result Firm A obtains most of the initial contracts. Since far more cars now have A-type batteries, few service stations are willing to invest in the specialized equipment and training costs for Firm B’s batteries. As a result, the market for Firm B’s batteries dries up and Firm B leaves the market. Thereafter, Firm A raises prices steeply
This example clearly involves a network efficiency since a large installed base for a particular battery makes servicing available and convenient for consumers. A less restrictive alternative would, of course, have been for Firm A to price above cost. In that event consumers would have had a choice between two battery types and probably lower prices. In retrospect that alternative appears clearly viable in view of the rapid growth of the electric car market. On the other hand at the time of the below cost pricing the potential size of the market was unknown, and Firm A might reasonably have anticipated that the market would support only one type of battery. In that event below cost pricing might have been justified as the quickest path to a viable battery network.
Firm A clearly recouped its investment in below cost pricing, but the recoupment may or may not have been efficiency enhancing. If a single, quickly developed battery network was essential to the success of the electric car, recoupment was efficiency-enhancing. However, if above cost pricing would have led to marketing success for two batteries, the huge recoupment Firm A obtained would be predatory, not efficiency-enhancing. Since counter-factual determinations are always difficult, convincing proof should be required to sustain the predatory finding where, as here, market expanding efficiencies are plausibly achieved.
IV. FINANCIAL MARKET PREDATION
Financial market predation is not to be confused with traditional deep pocket predation. The deep pocket theory in its original form held that a richly endowed predator would charge low prices to drive out a poorly endowed rival.142 This simple form of the theory is no longer accepted except in certain regulatory applications143 because it ignores the possibility that profit-seeking investors would finance the prey. Thus, in the general case, we must assume that capital markets are open to a profitable prey, and allow that external financing could foil predation.
Accordingly, modern strategic theory focuses on the relation between the prey and its investors.144 The predator seeks to manipulate that relationship and thereby drive the prey out of the market or deter its expansion into new markets. A predatory strategy becomes viable because of capital market imperfections. In supplying capital, investors face agency or moral hazard problems arising because the managers of the firm may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests.
Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, thereby imposing an explicit or implicit threat of termination in case of poor performance.145 If the investors are debt-holders, they threaten to liquidate the firm or deny new credit in the event of default. If they are venture capitalists they refuse to extend additional financing when early performance is poor. And if they are shareholders, they decline to purchase additional equity if expected returns are low due to disappointing initial performance. Predatory pricing in product markets thus becomes possible when a predator exploits these termination threats to dry up the financing of a rival firm.
Admittedly, termination threats are blunt instruments and investors in principle could shield themselves more effectively by making the financing contract dependent on the firm’s realized profits in a more discerning way. But generally, more sophisticated contractual agreements which attempt to discriminate between different causes of poor financial performance fail because the firm’s accounting profit is manipulable and therefore not reliable. The true economic profit of the firm is not perfectly observable by an outsider, and even if it were, it could not be verified by a court sufficient for use as a condition in a financing contract.
Agency problems are particularly acute in the financing of new enterprises. Typically, there is great uncertainty about cash flow in the beginning stages of a new enterprise. Investment in a new or expanding firm may encounter initial losses or lower than expected profit. These losses may be unavoidable start-up costs, never fully foreseeable, or may be due to agency abuse. Lenders can mitigate moral hazard problems by requiring collateral and by agreeing to extend financing (in staged commitments) only when the firms’ initial performance is adequate. In many instances lenders commit explicitly to further financing, contingent on verifiable performance (as in venture capital contracts), but more commonly the agreement to extend additional financing is implicit146. When the promise of new financing is implicit, firms can only obtain new funding if the new investment is perceived to be sufficiently profitable by the lender and if the lender has adequate protection against agency abuse. Thus, to obtain additional financing in a later period, the borrower must be able to put up a significant fraction of its own capital as collateral, as well as meet its existing financial obligations.
Financial contracts that guard against agency abuse may invite predation. A predator may slash price to drain the prey of sufficient funds to meet its loan commitments, thereby forcing default. Less drastically, the predator may be able to lower the prey’s earnings and thus to impair the prey’s debt capacity by limiting the amount of collateral it can put up. In addition, reduced earnings exacerbate future agency problems by forcing the prey to pledge a bigger share of future profits to its’ outside investors and creditors. As a result the firm’s manager would have less incentive to maximize profits. Finally, lower earnings may cause the lenders to wrongly believe that the firms’ profits are likely to be lower or riskier in the future and therefore to stiffen their lending terms.
It might at first appear that a lender could easily counter predation by agreeing to finance the prey irrespective of its ability to meet scheduled loan repayments; and that the predator, anticipating the lender’s counter strategy, would realize that financial predation cannot succeed. However, a lender will not ordinarily make such a commitment because to contribute funds to a debtor in default provides no restraint on agency misconduct147.
Nor can lenders solve the financing problem by excusing default when caused by predatory pricing. The lender may be unable to determine whether the default stems from predatory pricing or from the debtor’s poor performance because the lender lacks both full information and the expertise available to a market insider. Even if the lender could so determine, the courts can verify that determination only through a costly and inherently uncertain legal proceeding that few lenders would wish to confront.148 Thus, the lending agreement cannot feasibly include a commitment based on the future occurrence of predatory pricing. And in the absence of such commitment the lender may not want to extend lending in the event of predation.149
All this places the lender in a dilemma. If the lender provides a continuing supply of funds sufficient to deter predation, it invites agency misconduct. On the other hand, if the lender attempts to impose financial discipline on the firm with repayment obligations and collateral requirements, it may induce predation. There is no fully satisfactory solution to the dilemma. Indeed, the lending contract that minimizes agency problems will maximize the incentive to prey.150 Since lenders can scarcely afford to ignore agency problems in writing financial contracts, predation potentially remains a viable strategy. The inability of creditors to write optimal financing contracts in the presence of predation raises the costs of debt and lowers the return on new enterprise, thereby inhibiting the development of new competition and possibly reducing economic welfare. In a very real sense capital markets have failed since these adverse effects follow even when it is common knowledge that new entry by an efficient firm would be profitable in the absence of predation.
Perhaps the most insistent critique of a predatory pricing strategy is that even if the prey is forced to exit the market, the predator has accomplished nothing because the prey’s assets remain in the market. Indeed, if the prey’s assets are sold at a low price, then the successor may have a lower debt burden and therefore greater access to capital markets and a lower cost of capital than the defeated prey. Thus, it is argued, the predator now faces a stronger and better financed rival than before, thus making recoupment unlikely. This critique is flawed for reasons we discuss in some detail in Part VII below. Foremost amongst the flaws are the likelihood that the acquired assets may be insufficient for the successor to achieve a viable scale, and that attempts by the successor to gain additional financing may be plagued by concerns about continuing agency problems and further predation.
A related critique is that acquisition of the prey by a well endowed creditor would preclude financial market predation. However, creditor acquisition of the prey is generally not feasible because agency costs and measurement ambiguity frequently prevent the creditor from ascertaining the true profit of the prey, and thus determining whether in the absence of predation, the prey is profitable. Even if the creditor can observe the prey’s profitability, it typically lacks the specialized expertise to manage the prey. If the creditor attempts to gain the needed expertise, it may not succeed, and at the very least faces a time lag, during which it will sustain additional losses. It might be objected that the creditor is in no worse position than the predator. But this objection neglects the fact that the predator is an insider, while the creditor is a market outsider. Thus, the possibility of creditor acquisition of the prey will not always bar financial predation.151
A final possible avenue to further financing is bankruptcy reorganization, which involves compromise and subordination of loans to give the bankrupt a chance to work itself out of insolvency, under judicial supervision. But the inability to make additional financing arrangements dependent on profit confronts new creditors with the same contracting limitations that stymied the original creditors.152 Nor can new creditors rely on the bankruptcy court to effectively constrain agency misconduct by the bankrupt debtor. U.S. bankruptcy reorganization procedures do little to protect against debtor or management misconduct. There is no trustee and no SEC supervision. The old management often remains in control both during and after reorganization under the broad permissiveness of the business judgement rule, and the reorganization plan is almost always that of the debtor.153 The court does not supervise the reorganized firm, but acts essentially as an arbiter between conflicting interests.154
4. The predator understands the prey’s dependence on external financing. Perhaps an obvious point, the predator must know that the prey’s viability depends on outside funding, or can be assumed to know, based on easily accessible facts or rational conjecture. Sometimes this may be common knowledge, as in airline markets, where all firms require outside funding to finance aircraft purchases.155 Alternatively, funding dependency may be disclosed in public SEC filings or discoverable through simple investigation. In other cases knowledge may be inferred from the predator’s conduct or its internal documents.
5. The predator can finance predation internally or has substantially better access to external credit than the prey. This is a necessary assumption because unless the predator has superior access to credit or internal funding, it would face agency risks and resulting financing constraints similar to those that confront the prey.156 Indeed, the predator might face greater difficulties in obtaining outside funding if predation proved more costly for the predator than the prey. As in the case of the prey, agency and verifiability problems would impede financing notwithstanding the ultimate profitability of the predator's conduct. It is reasonable to assume, however, that the predator, typically a monopoly, dominant firm or dominant group of firms, will be less highly leveraged than the prey (and thus raise less agency risk for the creditor). As a result, the predator faces little danger of credit cut-off or reduction of supply, while the prey will be more inhibited by the prospect of a price war157.
A recent case study,158 involving entry into the cable TV market in Sacramento, California provides a vivid context in which to illustrate application of the strategic approach to financial predation. We first briefly describe the facts, and then apply our suggested elements of proof.
(i) Factual Summary
The monopoly cable system operator in Sacramento drastically cut price in response to successive entry attempts by two small rivals, both of which subsequently left the cable market, after which no further entry occurred. The second attempt was much better financed and persisted longer, and we confine discussion to this more substantial effort. Entrant began with outside financing amounting to $6 million,159 which enabled it to overbuild a compact area (the Arden district) serving 5000 homes in Sacramento. This was the first step in a larger plan to build out gradually to challenge the incumbent over a 400,000 home market. Entrant sunk its initial investment, completed its underground conduits and cables and began to recruit customers.
Incumbent responded with drastic price cutting (and other predatory tactics). At least partly as a result of the price cutting, entrant was able to sign up only a handful of customers, and abruptly halted its effort to connect additional customers after only eight months. For a time entrant continued to serve the small core of customers it had succeeded in connecting, but eventually shut down its wired cable system, abandoning non-recoverable investment approaching $5 million. Entrant filed suit claiming predatory pricing,160 and the case was settled during trial for $12 million.161 After its wired cable business became dormant, entrant successfully entered the Sacramento market by building a microwave transmitter, but its exclusion from the cable market had a significant impact on competition (as discussed below). We now show how we would apply our suggested elements of proof to these facts.
(ii) Proof of Case
(A) MARKET STRUCTURE FACILITATING PREDATION
The incumbent held a monopoly of cable system service in Sacramento. It was subject to competition from microwave, but this was inferior in quality and severely limited in the number of channels.162 Incumbent’s monopoly power was probably also signalled by the high return on investment relative to replacement cost for cable TV firms.163 Substantial entry barriers existed in the form of high sunk costs, as well as regulatory hurdles. Incumbent’s ability to raise prices in the Arden sub-market after entrant withdrew would indicate reentry barriers (at least following successful predation).
(B) SCHEME OF PREDATION AND SUPPORTING EVIDENCE
The facts of the case provide a vivid illustration of the relevance and explanatory power of modern strategic theory—here financial predation. Proof of recoupment is established by a showing that recoupment is plausible under soundly based economic theory and by evidence of actual effects making recoupment probable in the light of that theory. The evidence clearly shows that each of the preconditions for financial predation was present.
(1) The prey depends on external financing.
Entrant began operations with $6 million in capital. The firm obtained the funds through a loan, personally guaranteed by its owners, who included two wealthy real estate developers. This financing sufficed to build an initial system serving 5000 homes. The costs of expanding to cover any significant part of the Sacramento market, of which this represented barely one percent, would be staggering, and clearly would require additional external financing. While the two principal investors were quite wealthy, they were essentially passive investors and were reluctant to risk additional funds in a business in which they had no prior experience. Instead their business plan was to rely on bank financing to raise the capital necessary to overbuild the Sacramento market.164
(2) The prey's external financing depends on its initial performance.
In addition to their initial $6 million contribution, the two principal investors had obtained a line of credit from a consortium of banks to build into other geographic areas. Credit was easy to obtain due to the great wealth of the principals, but as indicated they were reluctant to risk their personal assets at risk beyond their initial investments and loan guarantees. The investors’ unwillingness to draw further on personal assets meant that expansion relied on other sources of financing, the availability of which depended on the prey’s initial performance. A positive cash flow from entrant’s initial operations was potentially a source of internal financing and collateral for bank financing.
(3) Predation reduces the prey's cash flow sufficiently to threaten the prey's continued financing and viability.
The incumbent's actions limited entrant's initial customer base to 170 homes, far below the 25Â30 percent penetration needed to break even.165 As a result of this “pitifully low penetration” entrant’s cost of capital was “climbing precipitously.”166 The incumbent’s drastic price cutting convinced the principals that additional financing would require use of their personal credit. The investors did not attempt to draw on their line of credit, but instead abandoned efforts to extend the system, despite their sunk investment.167 Entrant became a far riskier investment as a result of its low cash flow, and in the judgement of its principal investors could not obtain outside funding on the strength of its own credit and future potential.
Instead entrant simply maintained a holding operation, continuing to serve its handful of connected customers and eventually shut down its underground cable operation, into which it had sunk $5 million of non-salvageable investment.168 Of course, other factors might explain the entrant’s abandonment of the cable market, such as changes in expected profitability, the superiority of microwave as a vehicle for challenging an established cable TV system, or a general tightening of credit availability. The case study notes only the latter condition—tightening of credit—but makes clear that the incumbent’s predatory campaign severely reduced entrant's cash flow, and hence its continued financing and viability.169
(4) The predator understands the prey's dependence on external financing.
This element is easily satisfied since the facts showed that the incumbent was attempting to raise entrant's cost of capital so as to exclude entrant as a rival and to deter further entry. The whole purpose of the incumbent's price cutting strategy was to raise the entrant's cost of capital and discourage future contributions from its investors.170 Indeed, an internal memorandum from the incumbent's files assesses the entrant's financial resources, focussing on the net worth of its two principals, comparing this with the resources of a previous entrant who had also abandoned the market after severe price cutting by incumbent.171 More striking still, another memorandum from incumbent's files speaks of sending a message to entrant's bankers.172
Moreover, incumbent knew that to overbuild a significant part of the Sacramento market would take huge amounts of capital and that the entrant's main source of external funds was its individual investors. Incumbent could reasonably conjecture that the initial investors, with no experience in cable, would be unwilling, if not unable, to make such a large commitment without additional external financing. Incumbent also could reasonably conjecture that possible bank financing would depend on the cash flow generated by entrant’s initial operations.
Finally, the fact that entrant abandoned its effort to develop its existing cable market after only a few months of losses confirms the unwillingness of the entrant and its principals to commit additional capital even to develop a market area where they had large sunk investment. If entrant and its investors were not prepared to do that, they would surely have been unwilling to make additional sunk cost investment to expand beyond the its initial sub-market.
(5) The predator can finance predation internally or has substantially better access to external credit than the prey.
Incumbent clearly could finance the predation internally. It spent only $1 million on its predatory campaign.173 Such an expenditure by a profitable monopoly serving a market of 400,000 homes, would clearly appear to be within its internal funding capability. This conclusion is not diminished by the fact that it was almost wholly owned by Scripps Howard, a strong and well-financed national newspaper chain.
(C) PROBABLE RECOUPMENT
Proof of recoupment requires ex post evidence that the alleged predatory pricing (1) excludes or disciplines rivals or potential rivals, and (2) thereby injures competition and consumers by enabling the predator to raise prices or lower quality, or dangerously threatens to do so. The two effects are related in that the exclusion or disciplining of rivals is the instrumentality by which competition and consumers are harmed.
While there was no specific evidence showing that the predator fully recouped its predatory losses through higher post-acquisition prices, other evidence overwhelmingly pointed to probable recoupment, taking into account the plausibility of the strategic theory of financial predation, the fact that the pre-entry price was a monopoly price which predation restored, and the future losses predator avoided by preventing competition.
Exclusionary Effect on Rivals. The evidence showed that the incumbent’s drastic price reductions excluded or was capable of excluding the entrant. Incumbent’s below-cost prices had severely limited entrant’s cash flow by limiting its customer base to an insignificant level, raised its costs of capital, blocked its perceived ability to obtain additional capital, and as a result caused entrant to cease expansion beyond its tiny customer base of 170 homes and eventually to shut down altogether. Following incumbent's drastic price cutting, aggressive marketing and enhanced service, entrant first halted all expansion and then withdrew from the cable TV market. Such withdrawal caused it to lose the bulk of its $6 million investment in the Arden sub-market. Most of entrant's investment in that market was non-salvageable. Entrant of course preserved an option to reenter the Arden cable subÂmarket, but it seems reasonable to conclude that entrant lost most, if not all, of its original investment.174 Perceiving its inability to obtain external financing, entrant abandoned its plan to overbuild the Sacramento market175.
While we lack the data to fully reconstruct the facts bearing on exclusion of the prey, it appears that entrant’s losses and its foreclosure from credit markets were substantially caused by incumbent’s price cutting. Since the case was settled during trial, the causation issue cannot be definitively resolved. However, according to the information we have received from counsel and an expert witness the tightening of credit and other possible non-predatory causes had not yet occurred at the time of the violation, but came later.176 Under these assumptions, it appears likely that the incumbent’s predatory strategy substantially deterred additional investment, and thus was a material cause of plaintiff's injury177.
Injury to Competition and Consumers. Injury to competition and consumers requires a showing that the predation raised prices or lowered quality sufficient to enable probable recoupment, or created market conditions that made such effects probable. The evidence shows that incumbent after having successfully withstood two entry attempts, regained its complete monopoly of the Sacramento market, and hence the ability to price without constraint of actual competition. Moreover, following entrant's exit from the Arden sub-market, incumbent promptly withdrew many discounts and special services it had offered during the period of rivalry, and after two years cancelled its entry-induced lower rate in the Arden district.179
Perhaps the most significant evidence of recoupment, however, was the incumbent's avoidance of the losses it would otherwise have faced from competition—an issue neglected in Brooke. By its own estimate incumbent's successful effort to defeat new entry had avoided losses of $16.5 million per year, with a predatory expenditure of only about $1 million.179 Moreover, no further entrants sought to enter the Sacramento market, after the initial two entrants were rebuffed.180
The fact that the predator was able to recapture its total monopoly of the Sacramento market, even standing alone, appears to satisfy Brooke’s criterion of increased concentration and entry barriers making recoupment probable. But even if this factor had not been present, the other evidence of market structure, conduct and effects, illuminated by the soundly based theory of financial predation (as contrasted with the more speculative theory in Brooke of recoupment by parallel action without agreement) might have justified the finding of probable recoupment. No longer threatened with competition from a significant entrant, the predator’s market power was predictably enhanced.181 Incumbent’s predatory attack caused entrant to abandon its plan to overbuild the Sacramento market and instead to enter on a more limited basis with an inferior technology.
In addition, it is possible that incumbent’s action created a reputational barrier to entry discouraging future potential entrants. We discuss reputational barriers in Part V below.
(D) PRICE BELOW COST
The case study does not analyze the issue of below cost pricing, but price appears to have been well below ATC and, at least for some sales, may have been below average variable costs as well. Predatory pricing and related marketing efforts to prevent entrant from gaining a viable customer base, cost the incumbent $15 per subscriber per month, which amounted to half of incumbent's total revenue.182 Operating costs in the cable TV industry comprise 55 percent of total cost; and the overall industry profit margin is only 20 percent on revenues.183 A 50 percent rate reduction plus other valuable allowances could well push price below short run costs. In any event, sales to some customers were below any measure of cost since incumbent reduced its monthly rate in the Arden sub- market to $1 per month for basic service with free installation for customers who were resistant to signing up with incumbent and free color TVs for customers who had signed up with entrant.184 Thus, it appears that prices were below both ATC (and long run incremental costs), and at least some prices were below average variable cost (and average avoidable costs).185
(E) EFFICIENCIES DEFENSE
The case study contains no evidence supporting an efficiencies defense. But incumbent would be permitted to show that it had a legitimate business purpose for cutting prices below cost. Generally, this would require it to establish that the conduct was profit maximizing in absence of an exclusionary or competition-reducing effect.186
V. SIGNALING STRATEGIES: REPUTATION EFFECT
Recent economic writers have developed several signaling theories—all based on the idea that a predator's low prices may influence the prey's and potential entrants’ beliefs about future profitability and thus induce exit or deter entry.187 These theories include reputation effect, cost signaling, test market, and signal jamming.
In reputation effect predation the predator reduces price in one market to induce the prey and potential entrants to believe that predator will cut price in other markets or in the predatory market at a later time. The predator seeks to establish a reputation as a price cutter, based on some perceived special advantage or characteristic. Thus, a predator trying to establish a reputation for financial predation cuts price when it has superior financial resources (and when the other conditions for financial predation are present). Observing this conduct, a rival in another market or a potential entrant rationally believes that there is a greater probability that the predator will engage in financial predation in the other market, or in the same market at a later time if entry occurs. This reputation-induced belief reduces the future entrant’s expected return and may deter entry. We discuss reputation effect below. In Part VI we discuss demand signaling and cost signaling.
When a predator faces future rivals, an additional benefit of predatory conduct against a current rival may be to discourage entry. Indeed, prevention of future entry constitutes the paradigm case of reputation effect predation. By engaging in predatory pricing against current rivals the predator can acquire a reputation of being a “tough” competitor — not irrationally tough, but tough in the sense of projecting a perceived strategic advantage, for example lower costs, into other markets or time periods. Faced with the prospect of dealing with such a “tough” competitor, an existing rival and particularly a recent entrant, may be induced to exit, potential entrants may be deterred from entering, and financiers discouraged from backing either existing or future rivals.188 The incumbent’s predatory reputation can then serve as an exclusionary mechanism protecting monopoly profits. We discuss reputation effect predation in the context of financial predation, but a reputation effect strategy can augment any main predatory strategy.
Reputation effects enhance the profitability of financial predation by making entry or re-entry less likely. Future potential entrants observing the failure of the current entrant, can only be more cautious in contemplating entry, whether or not they recognize the predatory nature of the price cutting. If potential entrants recognize that predatory pricing has caused the current rival’s exit, fear of facing a similar fate may deter their entry. If potential entrants do not recognize that predatory pricing caused the current rival’s exit, they may simply conclude that entry is less profitable than they previously thought.189 Moreover, in either case future entrants will face a harder problem convincing customers to switch since customers are now more likely to believe that the new entrant will experience a similar outcome. Clearly, an entrant will find it more difficult in these circumstances to convince lenders to finance its project.
In addition, a reduced likelihood of entry may also have anticompetitive effects on the predator’s existing rivals. Far from making the current rival’s position more secure, the reduced probability of entry may actually hasten the current rival’s exit, and this may more than offset any gain to current rivals from increased entry barriers. This result may occur because the reduction in the number of potential entrants means there will be fewer prospective buyers for the victim’s assets if it fails to meet its loan commitments. The victim’s financiers may then project a lower liquidation value for their holdings, and this in turn may induce the financiers to impose more severe liquidation terms, other things being equal.190 To break even the financiers must now raise their repayment terms to offset the fall in expected liquidation value. But higher repayment requirements then require a tougher and less flexible liquidation policy because they intensify the moral hazard risks the lender faces.191
Nor does the chain store paradox prevent a reputation effect strategy for financial predation (or other signaling strategy). As long as there is no well defined final period, or the precise business motive behind the incumbent’s aggressive pricing is not perfectly known, the “chain store paradox logic” breaks down.192 Under these conditions entrant cannot exclude the possibility that aggressive pricing by incumbent may be an efficient business practice, as opposed to a predatory move, and hence reputation effects may be present.193
In sum reputation effects may enhance the power of financial predation whenever the predator faces successive entry, whether in a single market or across multiple markets. In such a situation the predatory action has a demonstration effect, which increases the predator’s payoff, and at the same time lowers the existing rival’s payoff from attempting to ride out the price war.194
(4). The potential entrant victim observes the exit or other adverse effect experienced by the predator’s existing rival in the demonstration market; and such knowledge is to be presumed if it is commonly known in the industry. Finally, the potential entrant victim must observe the adverse effects of the predatory conduct in the demonstration market if its future competition is to be inhibited. Note that the potential entrant need not be aware that a predatory strategy has caused these effects. It is sufficient if the potential entrant simply knows that the predator’s existing rival has been forced from the market or has suffered other serious economic harm. Exclusion or other economic injury to the predator’s existing rival is bad news for the potential entrant, even when the cause is not known, since it likely indicates low market profitability.195 Knowledge that the predator’s existing rival has left the market or sustained serious injury can be presumed if it is commonly known in the industry.
Two recent case studies,196 involving entry into local telephone markets during the formative period of the Bell Telephone system, illustrate the strategic approach to reputation predation. While these examples occurred some time ago, they have modern implications because they involved a network industry in which failure of initial competition led to long enduring monopoly (later sustained by regulation). We focus on the efforts of an independent telephone company to enter the local market in Madison, Wisconsin in competition with the established Bell System company.197
(i) Factual Summary
Wisconsin Telephone [hereafter “Bell”] entered the Madison market in 1879. Sixteen years later, after the Bell patents had expired, an independent telephone company, Dane County Telephone (the “entrant”) sought to enter. The market appeared attractive for entry because Bell had obtained only 236 customers, and these customers appeared far from satisfied. Customers had complained of high prices and poor service, but Bell was unresponsive. Founded by local citizens and politically well connected with organizers, who included Robert LaFollette, later Governor, Senator and a Presidential candidate, entrant offered service at only one-half the price previously charged by Bell. After only seven months entrant had signed up 400 customers on three-year contracts, 140 more than Bell had recruited in 15 years. Entrant was well managed, offered good service and from the beginning attempted to integrate the local telephone service into state and regional markets, and eventually the national market.198
Bell responded by cutting price drastically. Indeed, three months before entrant began service Bell reduced price by 25 percent. In the three months following entry Bell reduced its rates to one-quarter of their original level and offered free service to the city government, railroads, many other businesses, and indeed to any existing Bell customer who would agree not to remove its Bell telephone.199
Despite these inducements, entrant continued to thrive. After three years entrant had 850 customers to Bell’s 240. After ten years entrant provided service to 2500 Madison subscribers, while Bell served only 900. Expanding into the 30 mile radius around Madison, entrant served 3500 additional subscribers to Bell’s 250. Thus entrant now served 7000 customers in the greater Madison region to Bell’s 1150, increasing its relative market share. But entrant’s success was not assured. It realized its future depended on construction of a full toll network connecting with regional and national markets. Lack of capital constrained these plans. Entrant had consumed its existing liquid capital in upgrading and expanding its local network and had difficulty in raising additional funds.200
Entrant’s financial problems were substantially caused by Bell’s low pricing policies and other efforts to block entrant’s financing.201 Bell maintained its low rates in Madison (and other competitive markets) at levels almost surely below its long run average incremental cost,202 which is the correct measure of avoidable costs for dynamically expanding high sunk cost industries, such as telephone markets, where short run marginal costs may be close to zero.203 Stymied in its efforts to raise additional funds, entrant was able to pay a dividend of only about one percent a year. After 13 years of operations, entrant sold out to Bell at a price that was substantially below its shareholders’ investment cost.204 The buyout of local competitors on terms that would discourage further entry was a practice followed elsewhere by the Bell System.205
The problems the entrant faced in Madison confronted other independent telephone companies. Bell followed similar pricing practices in other sections of the country, including Ohio, Illinois, Upstate New York and the Southern United States. Such practices tended to deprive entrants in local telephone markets of the cash flow needed to finance expansion.206 Thus, when another independent telephone company obtained a franchise and sought to construct a rival telephone network in Milwaukee, the organizers found they were unable to raise the needed capital.207
(ii) Proof of Case
Reputation effect predation potentially provides a supplemental basis for establishing a predatory scheme and probable recoupment. Therefore, we confine our discussion to proof of these elements.208
(A) SCHEME OF PREDATION AND SUPPORTING EVIDENCE
The evidence showed that each of the preconditions for reputation effect predation was present.
(1). The predator, a dominant multi-market firm, faces localized or product-limited competition or potential competition; or alternatively, operating within a single market, the predator faces successive entry over time.
The predator, Wisconsin Bell, was the dominant multi-market firm in Wisconsin. No other company had Bell’s widespread network and presence in multiple Wisconsin markets. Bell held a monopoly in Wisconsin’s major city, Milwaukee, as it did in most major U.S. cities. At the same time the Bell system faced localized competition in many of its Wisconsin markets, centered in small to moderate sized communities. At one point Bell faced actual competition in 50 percent of its local Wisconsin markets and potential competition in many more. In these communities, as in Madison, Bell had held a monopoly of telephone service prior to independent entry. While there was some coordination of entry by independent telephone companies into individual cities, entry did not occur simultaneously, but over time, dependent on the action of local groups.
(2). The alleged reputation effect reinforces an identified predatory strategy pursued by the predator, such as financial market predation, cost signaling, or test market predation.
Bell’s price cutting practices appeared to reflect a strategy of financial market predation, reinforced by a reputation effect. Entrant was cash constrained and dependent on outside financing for expansion. Bell’s price cutting tactics threatened entrant’s viability since future success depended on expanding its network connections beyond the local area. Bell was surely aware of this financial need, since it faced large capital requirements itself in expanding its network. Clearly Bell could finance predation internally, continuing to pay a healthy dividend throughout the predatory period.209
(3). The predator deliberately pursues a reputation effect strategy.
Several factors support the conclusion that Bell deliberately pursued a reputation effect strategy. First, Bell held its Madison rates below cost for 13 years210 — conduct which appears inexplicable in absence of an anticipated reputation effect. Second, Bell followed a conscious strategy of buying out independents only at low prices that would discourage new entry.211 Third, Bell pursued other exclusionary tactics that would have enhanced its predatory reputation, including a public relations campaign that implied that the independents were not financially solvent, made wasteful investments and were overcapitalized; denial of interconnection with the Bell system even to non-competitive independent companies; attempts to influence local regulatory policies to weaken rivals; and at least in other sections of the country, expansion ahead of demand.212 Thus, it appears that Bell sought to discourage independents from new entry and expansion by establishing a reputation for price cutting and other predatory and exclusionary actions.
(4). The potential entrant victim observes the exit or other adverse effect experienced by the predator’s existing rival in the demonstration market; and such knowledge is to be presumed if it is commonly known in the industry.
Managers of local telephone companies actively exchanged information. Indeed, entrant’s president took the lead in attempting to establish a regional and national network of independent telephone companies. He was in frequent contact with officers of other independent companies in Wisconsin and throughout the Midwest, exchanging information on the relation between the independents and Bell. Moreover, the rate wars and bitter contests between the independents and Bell were widely reported in the press. Thus, the adverse effects of the price cutting on Bell’s existing rivals were widely known within the telephone industry, and the independent rivals easily perceived that Bell’s low pricing policy was a principal cause of their plight.213
(B) PROBABLE RECOUPMENT
Proof of recoupment requires ex post evidence that the alleged predatory pricing (1) excludes or disciplines rivals or potential rivals, and (2) thereby injures competition and consumers by enabling the predator to raise prices or lower quality, or dangerously threatens to do so. As we have seen, the two effects are related in that the exclusion or disciplining of rivals is the instrumentality by which competition and consumers are harmed.
Exclusionary Effect on Rivals. Bell’s below cost pricing excluded its existing rival in Madison and excluded or was capable of excluding future rivals, both in Madison and in other Wisconsin communities. In Madison, sustained below cost pricing, extending over 13 years, prevented Bell’s existing rival from raising the necessary capital to expand service and construct a toll network. As a result the rival ultimately sold out to Bell on unfavorable terms, receiving only a fraction of its original investment.214 The rival’s financing difficulties were substantially caused by the low pricing, which drastically reduced the rival’s return, allowing only a one percent annual dividend, and blocking additional financing. To be sure, other factors impeded the Madison rival, such as the refusal of the Bell system to interconnect, but almost surely the below cost pricing was a significant and material cause of the Madison rival’s exit.
The exclusion of the Madison independent was an intended mechanism to carry out Bell’s reputation effect strategy. The Madison independent was a prime predatory target because its president was a leader among independents, not only in Wisconsin but throughout the Midwest and because Madison was the state capital where legislators could observe the benefits of competition first hand. The sustained below cost pricing served as a “dire warning” to potential entrants in other cities.215 A later attempt by an independent group to enter Milwaukee failed for inability to obtain financing; and similar effects occurred in other markets.216 Thus, Bell’s intended predatory strategy both excluded its existing rival in Madison and excluded or was capable of excluding potential rivals in Madison and elsewhere.
While the low pricing in Madison was a substantial cause of such reputation effect exclusion, there were other causes as well. These included pressures by Bell on banks and investment bankers to block financing of independents,217 Bell’s purchase of telephone equipment manufacturers who supplied independents, and poor accounting practices by the independents themselves. However, whatever the impact of the other effects, economic studies generally agree that the predatory pricing was a significant cause of the widespread exclusion of the independent telephone companies from Bell’s markets.218
Injury to Competition and Consumers. Reputation effect predation injures competition and consumers because it raises entry barriers into the recoupment markets and thereby enables higher prices or reduced quality sufficient to enable probable recoupment, or created market conditions that made such effects probable. A striking feature of reputation effect predation is that recoupment occurs, not in the predatory market, at least not right away, but primarily in other markets or in the predatory market at a later time. The Wisconsin Telephone case provides a vivid example. Bell maintained its low prices in Madison for 13 years before acquiring the entrant’s assets, possibly delaying recoupment to the point where it was doubtful that predation could be profitable in Madison itself.219 Moreover, the advent of state public utility regulation probably limited Bell’s ability to raise prices subsequently.220 Nevertheless, viewed through the lens of a highly plausible theory of reputation effect predation, the evidence strongly points to additional recoupment in other markets, stemming from reputation effects.
The dominating fact is that following the below-cost pricing by Bell in Madison and in other markets, Bell was able to raise prices to a supracompetitive level without inducing significant entry. Evidence that Bell’s prices increased to supracompetitive levels appears from the facts that Bell’s returns in competitive markets were only a fraction of its returns in monopoly markets. and far exceeded its cost of capital. After the collapse of the independent telephone movement, over the period 1913 to 1935, Bell’s cost of capital was between five and six percent, while its average return was 11 percent. In the monopoly markets of Milwaukee, New York and Chicago Bell’s returns were, respectively, 10 percent, 14.6 percent and 16 percent.221 These large discrepancies strongly suggest a monopoly return, especially since following the demise of the independents, the growth rate for new telephones fell from 20.6 percent during the price wars to 5.5 percent, comparable to the growth rate before the independents attempted entry.222 Further evidence that Bell could maintain substantially higher prices in its monopoly markets appears from the independents’ vigorous lobbying effort in Wisconsin to obtain legislation to limit price discrimination by telephone companies, which Bell vigorously opposed.223
Despite the high prices Bell charged in its monopoly markets, there was no waive of new entry into such markets. On the contrary the high growth rate for new telephones during the competitive period when the independents challenged Bell fell back to levels that prevailed before the rise of the independents.224 Bell regained control of the industry as the independents either sold out to Bell or accepted sublicensing agreements they had previously rejected.225 While Bell’s ability to maintain high prices without attracting new entry rested on more than one factor, predatory pricing was, as we have seen, an important contributing cause.
Thus, the below-cost pricing in Madison and elsewhere established a prima facie case of probable recoupment because (1) the alleged scheme of predation was based on a highly plausible reputation effect strategy and the factual preconditions for such a strategy were present, (2) the predatory scheme excluded or was capable of excluding rivals or potential rivals, and (3) the likely effect was to induce a reputation effect that raised entry and reentry barriers in other local markets, enabling Bell to maintain its monopoly and charge high prices, and thereby injured competition and consumers.226
VI. COST SIGNALING, DEMAND SIGNALING AND OTHER STRATEGIES
In test market predation the predator secretly cuts price to reduce the entrant’s sales in the test market, and thereby induce the entrant to believe that demand is too low to justify market entry. The entrant, incorrectly believing that demand for its product is low, or unable to determine how strong the demand is, abandons further entry attempts, or enters the market on a smaller scale. By contrast, in signal jamming the predator openly cuts price in order to distort the test market results. As a result the entrant cannot ascertain market demand under normal conditions, but instead is able to observe demand for its product only under the exceptional circumstance of an ongoing price war. Thus, the entrant’s market test is foiled, and the entrant is unable to determine whether market demand for its product is sufficient to support entry.227
To analyze these strategies systematically, economic theory focuses on the following simplified story. An entrant is trying to decide whether to launch a new product to compete with an established brand. The entrant does not know whether demand is high or low. If demand for the entrant’s new product is high, entry is feasible. However, if demand is low, entrant will lose money. To enter the market at full scale is expensive. Thus, if entrant must make its decision without additional information, it would stay out of the market because possible losses are too high to justify the gamble of new entry over the whole market. However, by test marketing its new product on a limited basis, entrant can gain sufficient information about future sales to determine whether entry will be profitable. The potential gain from successful entry fully justifies the cost of the market test. A simple illustration illuminates the entrant’s dilemma.
Let us suppose the entrant believes that the probability of high demand is only .3, while the probability that demand is low is .7. If demand is high, the present value of the entrant’s expected operating profit is $50,000, while if it is low it is only $10,000. The costs of the new production facility are $30,000, all of which costs are sunk. Thus, in the absence of any information about demand, the entrant’s expected return from entry, factoring in these probabilities and payoffs is $22,000,228 which is less than the cost of entry $30,000. Thus, based on this information entry does not appear attractive.
The entrant may attempt to obtain more information about demand by test-marketing the new product at a cost of only $5,000. If the entrant could determine that demand is strong, it would enter the market so long as its expected profit exceeds the cost of test marketing. If the incumbent responds passively to the test-market campaign, the entrant will be able to ascertain demand for its product and will enter when demand is high. However, new entry will not please the incumbent since following entry, it earns only duopoly profits, which are less than its previous monopoly profit. By pursuing a strategy of either test market or signal jamming predation, the incumbent can block or impede entry either by misleading the entrant into believing that demand is low or distorting the data that the entrant receives from its test market experiment so that entrant cannot determine whether demand is high or low.
Suppose for example that the entrant’s product is of higher quality than the incumbent’s product such that customers would be willing to pay more for the superior product. If incumbent can secretly cut price below its cost, a significant fraction of customers who would have bought the new product will now stay with the old. The entrant, unable to see the discounts, would then be led to believe that demand is low and decides not to enter.
Even if the entrant observes the price cut, the incumbent may be able to garble the information the entrant receives from the test market, and by that means block entry. Entrant seeks to determine whether customers will pay more for its high quality product. As before, incumbent cuts price below cost, but does so openly. As a result, customers prefer the incumbent’s old product. Even if the entrant knows the incumbent’s price is below cost and not sustainable on a market-wide basis, entrant is nevertheless unable to judge what fraction of customers would purchase its higher quality new product under normal market conditions. Entrant’s test market experiment would then be frustrated and entrant may decide not to enter the market.
(3). The predator’s secret price cutting in the test market differs from its pricing conduct in other markets where it faces competition on a sustained basis. The significance of the predator’s secret price cutting in the test market is illuminated by a comparison with the predator’s pricing conduct in other markets.229 It is highly indicative of test market predation if predator engages in secret price cutting only in the test market. On the other hand, if the predator’s generally engages in secret discounting in other markets, the victim should not be misled in any anticompetitive way. However, when the test market alone is subject to secret discounting, the victim may have difficulty in probing market demand precisely, and may therefore decline to enter the market.
(4). The victim could rationally believe that demand for its product may be weak in the test market. Test market predation will not injure competition unless the victim is misled into believing that demand for its product is weak. The victim’s own testimony is not credible since it would have an inducement to misrepresent. Moreover, such evidence may involve subjective or reflective testimony by managers about what they or their predecessors perceived at a past time—a particularly unreliable form of evidence.230 But even past documents from the victim’s files may be biased with a view to future litigation. Instead, we would test the victim’s belief by the rational firm standard: whether the secret price cutting would mislead a representative firm in the industry. Thus, the price cuts must not have been disclosed publicly; the incumbent must have some “price leadership” role in the industry; and the victim could rationally think that incumbent has an informational advantage in assessing demand conditions.
In the 1970's General Foods, the dominant seller of coffee in the eastern United States, sought to defeat or delay entry of a rival brand by severe price cutting in selected markets. While the Federal Trade Commission in a 1984 decision,231 (made before publication of the first economic paper on signal-jamming) ultimately found the low pricing to be lawful, the facts nevertheless provide a useful scenario to illustrate application of our proposed approach to signal jamming predation.
(i) Factual Summary
General Foods, through its well known Maxwell House brand, dominated the eastern coffee markets with a market share of 43 percent in the East as a whole, and market shares in various eastern metropolitan areas of up to 60 percent. In 1971 Procter & Gamble (“P&G”), which had not previously sold coffee in the East, sought to test market its Folger brand through entry into a few, carefully selected eastern metropolitan areas. General Foods responded by cutting the price of Maxwell House below average variable cost in each of the test markets Procter & Gamble was attempting to enter. The price cutting was intense. Maxwell House was sold below average variable cost for a year or longer in various markets, and at times below the cost of the unprocessed green coffee beans.232
Procter & Gamble had a practice of carefully test marketing brands before undertaking large scale entry. Following the drastic price reductions on Maxwell House coffee, P&G made no attempt to enter other eastern markets for several years. However, the FTC majority dismissed the case on a finding that General Foods lacked market power. The Commission held that General Foods did not have market power because the relevant market was not as FTC Complaint Counsel argued—particular metropolitan areas—but the entire nation where General Foods held only a 24 percent market share. In addition, the Commission found that high excess capacity existed in coffee production; entry barriers were low; and accordingly General Foods had no ability to exclude competitors or raise consumer prices.
(2) Proof of Case
(A) FACILITATING MARKET STRUCTURE
As stated, the FTC found absence of a monopolistic or facilitating market structure. The negative finding on market structure was not inevitable. In fact it was highly arguable that the relevant markets were the local metropolitan areas, which P&G was attempting to enter. General Foods set different prices in different metropolitan markets depending on the strength of competition, and Maxwell House coffee commanded a premium price at the wholesale level, catapulting General Foods’s coffee profits into the top 5 percent of profitable firms.233 However, our purpose is not to dispute the FTC’s findings on market definition and market power, but to illustrate application of our approach to signal jamming predation. Thus, we will assume for purposes of discussion that General Foods had market power in eastern metropolitan markets.
(B) SCHEME OF PREDATION AND SUPPORTING EVIDENCE
(1) The predator observes that the victim is attempting to enter a limited product or geographic market with a new product or brand. This element is easily satisfied. The alleged predation is General Food’s response to the test market entry of Folger into four eastern metropolitan markets. General Foods reduced the price of Maxwell House in direct response to Folger’s entry into particular markets, but did not reduce prices in other markets. This of course did not occur by accident, but was based on General Food’s observed entry of Folger into the test markets. Indeed, General Foods’s price reduction was a deliberately chosen corporate strategy.234
(2) The predator offers below cost prices or discounts on its own competing product or brand, either following or in anticipation of the victim’s entry. Following P&G’s entry into the Cleveland, Pittsburgh and Syracuse markets, General Foods priced Maxwell House below its average variable cost (and presumably short run incremental cost) over a sustained period. In Syracuse price was held at this low level for seven out of nine successive quarters.235 Thus, this element is also easily satisfied.
(3) The predator’s price cutting in the test market differs from its pricing conduct in other markets where it faces competition on a sustained basis. General Foods faced long-standing competition in all of its eastern markets since its largest market share in any metropolitan area was percent. Yet it only reduced prices in markets that Folger sought to enter.236 Moreover, it was only within the Syracuse test market that General Foods introduced a “fighting brand” (“Horizon”), which had, according to the Administrative Law Judge “the sole function to blunt Folger’s Syracuse entry by imitating its packaging.”237 Folger of course presented a serious challenge to Maxwell House since Folger was the most popular coffee brand in the West and was backed by a strong company. But that only cements the proof of this element, showing that the price reduction, targeted against the new entrant, differed from its pricing conduct in other competitive markets.
(4) The victim could rationally believe that the price cutting prevents it from effectively ascertaining demand for its product in the test market. General Foods drastic price reductions on Maxwell House appear to have clouded test results and delayed entry, according to the FTC’s economic witnesses.238 P&G was known to be a careful marketer that followed the practice of requiring its test markets to stabilize and show satisfactory returns before it would expand sales—certainly a rational business approach.239 General Foods priced Maxwell House below cost for sustained periods, thereby distorting test market results. Moreover, the introduction by General Foods of a new brand (Horizon) further disrupted test market sales.240 Thus, it appears that P&G could rationally have concluded that the below-cost pricing prevented it from ascertaining market demand in its test markets.
The other elements necessary to sustain a violation, exclusion of rivals, probable recoupment, price below cost and the efficiencies defense, require little discussion in view of the record. The FTC never reached these issues since it disposed of the case on a failure to prove market power. However, assuming the presence of market power, Complaint Counsel presented evidence that would have supported findings on these remaining elements. The below-cost pricing has its intended exclusionary effect on rivals. The FTC economic witnesses in their post-predation article claimed that P&G delayed further entry into the East in part because of these “test-market distortion effects,”241 which led P&G to conclude that further market tests were needed.242 In fact, P&G delayed wider entry, beyond its initial test markets for several years so that it took a full eight years from P&G’s first test market entry to complete its planned expansion into the East.243 Indeed, internal business documents showed that delaying the entry of the Folger brand was General Foods’s explicit goal.244
Probable recoupment was supported by evidence that after the price cutting in the Cleveland and Pittsburgh test markets, General Foods was able to restore higher prices with only modest loss of market share.245 The resulting deferral of P&G’s entry in the East for several years should easily have enabled General Foods to fully recoup its predatory investments in the limited test markets, injuring consumers by increased prices in the broader Eastern markets and denial of a new brand. Below-cost pricing was established by proof that General Foods maintained price below its average variable cost for long periods. Thus, the burden of proof shifted to the defendant to establish an efficiencies justification.
The alleged predator offered an efficiencies defense, asserting that it had reduced price to meet competition from the Folger brand. But since the predator cut price below its own average variable cost, the meeting competition argument would provide no defense under our proposed rule.
The victim must consider the probability that Firm 1 has made a cost breakthrough and its expected returns if it stays or leaves the market.246 This example shows that if the victim has an alternative (but less profitable) investment available if it withdraws its capital, the victim may chose to leave the market even when it thinks it probable that the victim is bluffing.247 The only way that the victim and consumers can attempt to rectify this outcome is by bringing, or persuading the government to bring, a predatory pricing suit.
A limiting factor in applying a cost signaling theory is the possible inconsistency between the low price, predatory bluffing strategy and subsequent recoupment. Under the recoupment requirement of Brooke, as under our proposed approach, it must be probable that the predator can recoup its losses by raising price after the prey leaves. However, an attempt to do so risks revealing the signaling strategy to the prey and other potential entrants, causing them to upgrade their estimates of market profitability. In the absence of substantial entry and reentry barriers, the prey or other entrants would then have an incentive to enter or reenter the market, preventing recoupment. Under these circumstances the threshold structural requirement that predatory markets have high entry and reentry barriers assumes particular importance.
We trace out the analysis of cost signaling in greater detail using a numerical illustration in the appendix. A detailed analysis of how reputation may magnify the effects of cost signaling can also be found there.
(1). Some event has occurred, known by the victim, that could have enabled the predator to significantly reduce its variable costs. Cost-signaling is most plausible when there has been some development in the industry that could have reduced the predator’s variable costs.248 For example, the predator may have made an important innovation, hired a new management team or CEO, engaged in extensive downsizing, obtained exclusive access to a cheap source of foreign supply or other scarce input. Such development would normally be common knowledge in the industry and thus known to the victim. However, if the event is kept secret, the plaintiff would have to prove that it had actual knowledge of the new development. While cost signaling might occur without such a triggering event, we would limit proof of cost signaling to those cases where the strategy is most likely to have been present.
(2) At or about the same time the predator significantly reduces its price. The timing of the price reduction must be sufficiently close to lead an outside firm to strongly suspect that the price reduction stems from the observed cost-reducing event.
(3). As a result of such price reduction the victim could rationally believe that the predator may have lowered its costs, e.g. in the past the predator has reduced price when costs fell significantly. The victim must have believed that the defined event could have caused the price reduction, but the victim’s own testimony at trial is not credible since it would have an incentive to misrepresent, and because, as we have emphasized throughout, proof of predatory pricing should not rest on reflective evidence of subjective belief. Moreover, because of its self-serving nature, even contemporaneous documents prepared by the victim might be biased, designed to influence possible future litigation.
Thus, we suggest that the victim’s belief be tested by the standard of a reasonable firm: Would a representative firm in the industry reasonably believe that the observed event significantly caused the price reduction? Such belief would be reasonable if either (i) the predator has in the past actually reduced its prices when costs fell, or (ii) the price reduction followed an announcement by predator that it had reduced its costs. Such a belief would not be reasonable if it is commonly known in the industry that the predator’s costs have not fallen or if the victim itself knows this fact. Of course, the rational firm need not have reason to believe with certainty that the predator has achieved a cost breakthrough, only that it is significantly probable.
More incriminating evidence may sometimes be available, which would strengthen the victim’s belief that the price reduction is predatory. Such evidence includes (i) false announcements of a cost breakthrough, R&D development, or other event that could significantly reduce predator’s costs, (ii) biased cost reports or similar accounting distortions made available to the public or to the industry, or (iii) proof of a corporate plan to engage in cost signaling.
(iv) The possible cost reduction is of sufficient magnitude to require the victim to exit or to limit its expansion into other markets. The price reduction must have reasonably caused the victim to leave the market or restrain its future growth or expansion. The best objective indicator of whether the price reduction had this effect is the reasonably anticipated size of the price reduction. Would a reasonable firm of comparable size to the prey deem the price reduction to be large enough to induce the prey’s market exit or constrained operations? See the appendix for an illustration of how we apply these criteria to the facts of a specific case.
VII. POSSIBLE OBJECTIONS AND COUNTER STRATEGIES
Critics of strategic analysis suggest a variety of objections and counter strategies by which either the prey or consumers, or market conditions, can foil predation.249 These include (1) coalitions between the predatory victim and its customers bypassing the predator, (2) coalitions among victims coordinating a defensive strategy, (3) counter-threats by the victim to enter the predator’s other markets, (4) the classic “chain store paradox” that assertedly makes predatory strategies non-credible, (5) customer stockpiling, (6) mutual ignorance of the predator and the prey about market conditions, and (7) sale of the victim’s assets to a successor firm if the victim fails.250 In addition, a recent critique asserts that managerial compensation contracts provide no incentive for managers to engage in predation.251
In addition, the counter strategies thesis faces other impediments, including the possibility of effective counter moves by the predator, the limiting constraints that transaction costs place on coordinated group action, the free rider problem that hampers coalition formation by predatory victims and their customers, the fact that in any customer bidding contest the predator can generally outbid the prey since the predator earns monopoly profit if it retains its monopoly, while the prey presumably earns only a competitive return in competition with the predator. Finally, a counter-coalition involving rival firms may in some cases raise antitrust problems and may also be difficult to enforce.252
To illustrate the difficulties, the counter strategy thesis holds that an entrant can foil predation by entering into long term contracts with its customers. Assertedly, customers have an incentive to sign such contracts because the entrant offers them a lower price than the monopoly price they would otherwise pay. Further, entrant can overcome any customer reluctance to sign by making the contracts contingent on the signing of enough other customers to assure entrant’s viability.253 However, this scenario becomes doubtful when information asymmetry and other factors are taken into account. To begin with, information asymmetry may block coalition formation. For example, in the case of cost signalling, if a poorly informed prey is misled by the predator’s low price into believing that the predator has low costs, why wouldn’t customers be similarly deceived, in which case the coalition will not form? If somehow customers are better informed, why can’t the prey discover the same information on its own, for example by asking customers, in which case there is no information asymmetry?
Second, the predator may have anticipated the entrant’s counter strategy by binding its customers to long term contracts before the entrant begins marketing its product, possibly reinforced by penalty provisions for breach.254 Moreover, the predator need not bid against entrant for all future customers, but only for sufficient customers to make entry non-viable. As a recent economic paper shows, as the number of customers increases, the probability that any individual customer is "pivotal" to the blocking of the prey becomes smaller and smaller. As a result the amount the predator must pay to each contested customer shrinks drastically, so that the predator may need to pay customers very little to foil the entry attempt.255 Moreover, as outlined above, the ability of the predator to outbid the prey and especially to capture pivotal customers may allow it to frustrate the entrant’s contingent contract strategy.
Third, persuading large numbers of customers to sign long term contracts may involve substantial transaction costs and encounters a free rider problem. Each customer has an incentive to hold back from signing the contract, preferring to let others take the risk of provoking the predator, who is likely to be the dominant, if not the only supplier. Customers will naturally prefer to let others take such risks, while sharing the benefits of competitive suppliers if entrant becomes viable.256 Free rider problems are lessened, but not removed even if entrant makes its contracts with customers contingent on signing of enough other customers to assure entrant’s viability. Until the entrant has actually established its sustainability in the market, a customer’s risk-preferred strategy is to stay out of the coalition. Moreover, as outlined above, the ability of the predator to outbid the prey and especially to capture pivotal customers increases its ability to frustrate the entrant’s contingent contract strategy.
Similar problems confront other asserted counter strategies. A coalition between the entrant and its rivals, for example other potential entrants, such that each enters one of the predator’s several markets, faces formidable transaction costs that hinder coordination of entry by other entrants into multiple markets, each subject to its own particular local conditions. In addition, coalition formation encounters a free rider problem because each member would prefer that others take the risk of entering the predator’s market, including antitrust risks since the coalition divides the entry markets between competitors, and enforceability is doubtful because an injunction compelling market entry is not feasible and damages appear highly speculative.
A similarly unlikely counter strategy is a threat and binding commitment by the prey to enter the predator’s other markets in response to the predator’s low price in the prey’s home market.257 It is unclear how the entrant is to make such a binding commitment, other than by simultaneously entering both markets, but then it would have doubled its potential loss and also doubled it difficulty in raising capital. Further, as Judge Easterbrook acknowledges, the predator can respond, by itself making an equally binding commitment not to accede to the multiple entry counter strategy. Finally, if the predation is based on reputation effect, for example reputation as a low cost firm, asymmetric information makes the strategy doubly doubtful. If the prey is deceived or uncertain about the predator's costs in its home market, why would it know more about the predator’s costs in other markets or wish to increase investment and expected losses by entering the predator's other markets?
Customer stockpiling of a price-reduced product is an unlikely counter strategy because if customers believe the predator's low price reflects a sustained cost breakthrough, why would they invest in unneeded inventory? Even if customers recognize the price as predatory, they may lack storage facilities or the capital to support stockpiling. Nor will customers know whether the price will fall further or how long the low price will endure. The same limitations apply to wholesale suppliers. Such intermediate suppliers, for whom the product may be but a small part of their operations, are likely to be even less inclined to speculate on whether the low price is based on a cost reduction or is predatory. Finally, services, such as cable TV and telephone service, cannot be stockpiled at all (although long term supply contracts are a possible substitute).
The objection is also made that the “chain store paradox” would cause multi-market predation strategies to unravel.258 The idea here is that it would not be rational for the predator to take losses in the last market the prey enters because at that point the predator has no future reputation to maintain; so the prey would not be deterred from entering the last market. By similar logic, called backward induction, the prey would come to the same conclusion in the next to last market, and indeed in all earlier markets. This logic is now questioned if there is no well defined final period in which interaction takes place259 or the precise motive behind the predator’s aggressive pricing in not perfectly known, and controlled experiments have failed to validate the conclusions of the theory.260 For these reasons the counterstrategies objection is not persuasive.261
First, the objection does not apply to predation that disciplines, rather than excludes, the prey. Predatory pricing properly includes cases where the entrant does not withdraw from the industry, but is discouraged from making additional investment or developing new products, or where other firms are deterred from entering the market.262 In either case, the prey’s assets are not available for purchase.
Second, the prey’s sunk assets may be insufficient to achieve an efficient scale of operations, so that the successor would not be viable without further financing even if the assets were transferred at zero price. An example, might be the Sacramento cable TV case where the entrant’s built out facilities were probably not viable for a stand alone cable competitor, due to pecuniary scale economies in purchasing programming.
Third, as a separate but related point, the objection will often not apply in network industries, where the predator’s product has become predominant or the industry standard. A successor firm seeking to acquire the prey’s assets would have to reverse that developed consumer preference, as well as perhaps assemble its own network of outlets and a specialized work force. This is unlikely to be an attractive investment after the industry has reached the tipping point, favoring the predator’s product as the industry standard.
Fourth, the objection will not apply to fixed cost assets without large sunk cost components, such as aircraft, ships, buses, and other mobile assets where reputation and brand recognition are essential to local market success and are not available for purchase. For example, if a small airline is excluded from a local market, but remains in business elsewhere, it will not wish to sell its brand name and associated reputation. On the other hand, if the small airline is forced out of the industry entirely, what will its reputation and brand name be worth, after it has suspended its flight schedule, frustrated consumers and left ticket holders with subordinated bankruptcy claims in lieu of tickets? In such cases the physical assets of the failing firm may be offered for sale, but they will not be available at a reduced price. Instead the assets will be sold in a wider market, perhaps national or international in scope.
Fifth, successful predation raises a reputational barrier to further entry and potential entry since the predator’s prior predatory conduct exhibits its predatory character to other market entrants. This in itself may deter an acquiring firm from exposing itself to what is now a greater perceived risk than the original entrant faced. The perceived risk is greater because of the predator’s conduct. Sixth, closely related to the last point, the successor entrant may face a customer free rider problem. Customers having once had their supply interrupted, may not wish to suffer the same inconvenience again before a successor is well established. In informational terms customers receive new information from the demonstration of incumbent’s predatory conduct. The resulting uncertainty about the successor’s duration causes the customers to reduce their estimates of the benefits of switching to the entrant. For example, customers of a failed airline who have lost their frequent flyer miles may not wish to take a second chance with a newly established airline. Thus, customers may hold back from dealing with the successor, preferring to let other customers take the risk of interrupted supply. But when everyone acts this way, the successor entrant never assembles the critical mass of customers necessary to support entry.
Finally, the objection does not apply to the firm that has the greatest incentive to acquire the prey’s assets—the predator itself. The prey’s assets will always be worth more to the predator than to any other acquirer because the predator gains market power, while other potential buyers can expect to earn only a competitive return on the acquired assets. Certainly, predation followed by predator acquisition of the prey has happened in the past, as we discuss above in the Wisconsin Telephone illustration.263 But current examples also occur.264
While it might appear that the antitrust laws would bar predator acquisition of the prey, the failing company merger exemption may shield otherwise objectionable acquisitions. The exemption overlooks competitive risks inherent in such acquisitions in the interests of creditors, employees, and other corporate constituents, provided a good faith effort has elicited no alternative offers presenting less anticompetitive risk and certain other conditions are met.265 To be sure, the acquisition would have to be prenotified to the antitrust agencies266 and the agencies would certainly not clear the acquisition if aware of the predatory conduct. But they may not be aware. The proceeding is entirely administrative, and it is unclear who would inform the government that the failing firm’s plight was caused by predation. Surely not the predator, who would have no desire to scuttle the transaction. The prey itself is a consenting party, attempting to salvage what it can from a failed venture, so it would also lack incentive to reveal the predation. Indeed, the acquisition agreement would probably require the prey to release all claims against the predator. Possibly a competitor might complain, but no other competitor may exist, or existing competitors might welcome increased concentration, tacit collusion and anticipated higher prices. Even if the government knows the industry has sustained a price war, in the absence of complaint, it might simply conclude that the market is highly competitive. Finally, acquisition of stock or assets of less than $10 million need not be reported at all.267 Thus, acquisition of the victim by the predator is not an impossible outcome.
In a recently published critique of strategic analysis (which does not rest on an assumed world of perfect information) John Lott questions the credibility of predatory actions by large widely held corporations when their managers do not have any apparent financial incentive to engage in predation.268 Lott is concerned that managers' compensation may be primarily a function of short run profit, in which case they may not be willing to incur predatory losses. In practice, however, managerial compensation packages are designed to align managers’ objectives with those of shareholders. Compensation packages typically contain a fixed salary component, a percentage of short run profits, and a participation in the firm’s stock (through stock option plans)269.
While managerial incentives may be a relevant consideration in assessing the plausibility of a predatory action by widely held firms, it does not follow—as Lott claims—that all modern strategic theories of predation are flawed because they fail to consider managerial incentives.270 At best his evidence casts doubt on existing theories of entry prevention relying on an explicit commitment to reward managers for keeping entrants out (or punishing them should entry occur)271.
Besides the lack of evidence supporting these theories—as revealed in Lott's empirical research—there are also theoretical difficulties relating to the lack of commitment power of such contracts (when shareholders and managers can easily change the contract following entry if it suits them), which cast doubt on their plausibility. This is why we do not discuss these entry prevention theories in our paper.
Apart from these theories of entry prevention, which rely on the existence of explicit managerial contracts to engage in predatory pricing, all the strategic theories discussed in this paper (including reputation effect theories) are immune to the Lott critique. Indeed, these theories only require that managers act in the interest of shareholders, when there is separation of ownership and control. If the managerial incentive package aligns the manager’s interest with those of shareholders, then there is no longer a meaningful distinction to be drawn between managers and shareholders. Predatory strategies can then be considered solely from the viewpoint of the shareholders’ interests. Thus, as long as there is no clear evidence that managers’ financial interests were not in line with those of shareholders and that, contrary to shareholders, managers had no implicit or explicit financial incentive to engage in predation, there is no reason to be concerned that managers may not want to execute a strategy that is in their shareholders’ interest.272
Even over the sample period considered by Lott it is not possible to find any statistically significant evidence that managers’ objectives in firms found to engage in predatory pricing were not in line with those of shareholders. Lott’s main statistically significant finding is simply that compared with a sample of firms that were not found to engage in predatory pricing the sensitivity of managers’ compensation to short run profits in firms that were guilty of predation was slightly higher. That is not the same as saying that managers in those firms had no interest in pursuing a predatory strategy.
CONCLUSION
The challenge for predatory pricing policy is to develop a legal rule that is neither seriously over inclusive nor excessively under inclusive. Present legal policy is deliberately under inclusive, and for understandable reasons. Until recently economics had no rigorous explanation of how predatory pricing could be rational business behavior. Courts, applying an ad hoc approach during an earlier time of expansive antitrust enforcement, sometimes condemned as predatory conduct that was doubtlessly competitive. Following Areeda-Turner, the courts fell back on the economics that was known – static analysis in a world of perfect information, which theory as well as empirical studies appeared to support. Accordingly, courts adopted a short run cost rule that was deliberately underinclusive. These under inclusive tendencies became more acute, following the Supreme Court’s decision in Brooke when the difficulty of proving predatory pricing in the lower courts amounted to a virtual per se rule of non-liability. Yet at the same time Brooke with its emphasis on closely analyzing the scheme of predation and recoupment had identified the key elements needed for a more balanced approach.
Economic development over the last 20 years of a rigorous analysis of predatory pricing provides the tools required to achieve a more effective legal policy. Economics can now explain when predation can be rational, or in Brooke’s terms when it can enable profitable recoupment, casting new light on earlier examples of predatory pricing. The further challenge for legal analysis is to develop workable legal rules to guide enforcement agency policy and judicial decisions. To accomplish this we propose a structured rule of reason, including a fully specified efficiencies defense. Under such an approach enforcement would focus on cases where market structure and conduct makes predation plausible and where anticompetitive effects have occurred, or are dangerously probable. Equally important, the finding of predation would be subject to an efficiencies justification where below-cost pricing is necessary to achieve significant efficiencies, including dynamic efficiencies. Such an approach, not dissimilar in scope to what courts now apply under the Rule of Reason and non-price predation, offers increased promise of achieving a balanced legal policy that more effectively protects competition.
More specifically, suppose that each firm has the same unit costs of $50. Taking advantage of its niche advantage, each firm sells at a price of $60, earning a profit of $10 per unit. Assume that each firm sells 1000 units at that price, and thus each currently earns $10,000 (1000 X $10). The competitive situation is quite stable. If one firm sought to invade the territory of the other, it would have to overcome the home firm's niche advantage and would incur costs which would make such an invasion unprofitable.273
To make the signaling strategy explicit we consider two alternative scenarios, depending on whether Firm 1 makes a cost breakthrough. In the first scenario Firm 1 achieves a cost breakthrough, which its rival observes. In the second scenario, Firm 1, unable to achieve a cost breakthrough, attempts to bluff its rival through cost signaling. In both cases the price reduction may induce the potential victim to leave the market. But in the first case — where there is a cost breakthrough — exit is economically desirable, while in the second — where no cost breakthrough occurs — exit harms consumers and reduces economic welfare. We analyze the two alternatives in turn.
Case 1: Cost Breakthrough Observed by Rival
Firm 1 makes a major technological breakthrough, such that it is able to slash unit costs from $50 to $20. The cost reduction overwhelms the other firm's niche advantage. As a result Firm 1 is able to cut price to a level that enables it to exclude its rival even when charging the profit maximizing monopoly price. Thus, under its new cost structure Firm 1's price falls from $60 to only $40, Firm 1 now captures all of its rival's customers and also attracts new customers, expanding its total sales from 1000 to 3000.274
Case 1 provides an example of socially desirable cost signaling. While Firm 1 has excluded its rival from the market, this outcome is in all respects desirable since now the whole output is produced at a unit cost of $20 and market price has declined from $60 to $40. Even customers of the excluded firm are better off since they receive a price reduction greater than the $5 dislocation or switching costs they bear in shifting to Firm 1. Moreover, innovation is fully rewarded by allowing Firm 1 to capture a monopoly rent legitimately earned. Finally, even if the second firm's exit leads Firm 1 to raise price above the old price of $60, so that consumers are worse off, the cost saving achieved by Firm 1 may still produce an overall increase in total economic welfare or surplus (depending on elasticity of demand).275
Case 2: Bluffing or Signaling Strategy
We now assume that Firm 1 has achieved no cost breakthrough, but still lowers its price to $40 in an effort to mislead its rival and induce it to leave the market. The rival, unable to observe Firm 1's costs, sees only that Firm 1 has reduced its price below the rival's cost. The rival must now decide whether Firm 1 has indeed achieved a cost breakthrough, in which case it should cut its losses and quit the market; or whether Firm 1 is bluffing, in which case the rival should stay in the market.
Firm 1 has every motivation to bluff. If it can induce its rival to leave the market, it can double its earnings by capturing its rival's customers and returning the price to $60 (assuming entry and reentry barriers). To be sure, Firm 1 must bear the costs of the predatory price reduction. But in our example the future monopoly profit will far outweigh the cost of the price war if it is of limited duration.276 Moreover, the victim, if it has other investment options (as we assume), may find it advantageous to decide quickly whether to leave the market.
In order to think about its decision systematically the victim might prepare a simple table of the possible outcomes from its decision to leave the market or stay:
Victim's Payoff | |
---|---|
Leave market | $55,000277 |
Stay in market when predator has achieved cost breakthrough | -5,000278 |
Stay in market when predator is bluffing | 95,000279 |
Examining this table the victim sees that if it leaves the market it can earn $55,000, which is less than its current profit, but it is free of any strategic risk. On the other hand if the victim remains in the market, it can either do much worse (losing $5000) if its rival has lowered its costs or much better (earning $95,000) if its rival is bluffing. The problem is that the victim does not know which event has occurred. The best it can do is to try to estimate the probabilities (however roughly) and calculate its expected payoffs in light of those probabilities. Suppose the victim believes that the two events -Â bluffing or cost breakthrough -- are equally probable. In that event it will leave the market, since the expected payoff from leaving is $55,000, while the expected payoff from staying is only $45,000 (which is the average of the two remaining outcomes if we assume each is equally probable).280 Indeed, even if the probability Firm 1 is bluffing is as high as 60 percent, the victim will leave the market.281
What this analysis shows is that the merely probable belief by the victim that the incumbent has reduced its cost can induce exit or prevent entry despite the substantial likelihood that the incumbent is bluffing.
The American Tobacco Company engaged in many predatory and anticompetitive activities while building the tobacco trust from 1890 to 1911—the date the Supreme Court finally ordered its dissolution.282 One of American’s predatory strategies involved the use of “bogus independents” in the plug tobacco market, which provides an interesting example of a possible cost-signaling strategy, and allows illustration of our proposed approach for cost signaling.
(i) Factual Summary
In 1893, American Tobacco, which already controlled 85 percent of the cigarette market, entered the production of plug tobacco by merging five of the largest plug manufacturers into one corporation, Continental Tobacco. The trust grew by acquiring competitors—allegedly after lengthy and often severe price cutting. For example, when American’s initial attempts to combine the plug tobacco producers failed, American engaged in below-cost pricing which resulted in losses of over $ 4 million.283 As many as thirty acquired competitors were simply closed down. The trust would preserve the name, organization, and products of the acquired company, and when questioned, would persistently deny having control over them.284 Trust members used fictitious names and unusual addresses in correspondence to conceal the relationship among the companies.285 Compounding the intrigue, bogus independents actually gained entry into an association of bona fide independents that had been formed to provide protection from the trust.286
The use of bogus independents probably reduced the costs of acquisition.287 According to Malcolm Burns, “[i]f the trust effectively disguised its misconduct by initiating the price cutting from a secretly controlled subsidiary . . . the ensuing decline in the profits of a targeted competitor probably will be attributed to intensified and enduring competition,”288 lowering earnings projections, diminishing growth opportunities and curbing investment—all of which should reduce the prey’s market value and lower the amount required to acquire the prey.289 As we suggest below, the use of bogus independents may have also served to induce actual independents to believe that the bogus rival had been able to reduce costs.
The original petition filed by the United States includes numerous examples of bogus independents, four of which were allegedly used to launch predatory pricing campaigns. We focus on one such example, Nall & Williams Tobacco Company of Louisville, a producer of plug tobacco. American used Nall & Williams as a so called “commercial wolf” to launch a predatory pricing campaign against the Nashville Tobacco Works of Nashville Tennessee. The scheme was discussed in a letter written from American Tobacco’s vice president sent to the president of Nall & Williams, a secretly owned subsidiary.290 In this letter the American Tobacco executive asks Nall & Williams to introduce a new brand of tobacco to compete with Nashville Tobacco Works. Nall & Williamson is to market the new brand as soon as possible. Sales, not profit is to be the goal. The subsidiary is to “ enter upon a vigorous campaign, to be kept up until the desired end is accomplished.” Regarding profits, the Tobacco executive writes, “.... while I would like you to show as much [profit] as possible, my idea is that you should not make money at expense of trade, providing, of course, that you are getting this business from certain people.”291
Nall & Williams advertised that it had no connection with the trust,292 and it was even a member of the association of independents formed to provide protection from the trust.293 The United States claimed that Nall & Williams’ attack was “ferocious” and that the owners of the Nashville Tobacco Works “became convinced that they must either sell out to [the trust] or be destroyed.”294 In April 1906, under pressure from the predatory attack, the Nashville Tobacco Works secretly sold out to the trust. Nor did the deception stop at this point. Instead, following acquisition, the trust continued to operate Nashville Tobacco as an independent up until the time the United States filed its antitrust suit.295
(ii) Proof of Case
(A) MARKET STRUCTURE FACILITATING PREDATION
From 1900 to 1910, the trust held the following average market shares: plug, 77.2%; smoking, 68.8%; snuff, 90.7%; and fine cut, 73.9%.296 American Tobacco had an average market share in cigarettes of 86.1% from 1891-1910,297 and controlled about 95% of the licorice root market, a key ingredient to plug tobacco.298 Moreover the Supreme Court found that defendants had gradually obtained control over “all the elements essential to the successful manufacture of tobacco products,” and that “placing such control in the hands of seemingly independent corporations serv[ed] as perpetual barriers to the entry of others into the tobacco trade.”299
(B) SCHEME OF PREDATION AND SUPPORTING EVIDENCE
The evidence showed that each of the preconditions for signaling predation was present.
(1) Some event has occurred, known by the victim, that could have enabled the predator to significantly reduce its costs
The “event” in this case study is the introduction by American of a new brand of tobacco into the territory of the Nashville Tobacco Works through its disguised subsidiary, Nall & Williams . The introduction of a new product sold at a low price could have reflected a lower cost process. New products may result from new production techniques or the acquisition of a cheaper source of supplies—both of which would qualify as an event that could have enabled the predator to reduce costs. The new product entered the market at reduced prices and thus the price reduction coincided with the “event.” Of course, there could be other explanations for the price reduction, but the launching of a new product qualifies as an event capable of signaling a cost saving.
(2) At or about the same time the predator significantly reduces its price
Here the event and the price reduction coincide, so this requirement is easily met.
(3) As a result of such price reduction the victim could rationally believe that the predator may have lowered its costs
It is important to note that the Nashville Tobacco Works need only believe that it is significantly probable that Nall & Williams had achieved lower costs for it possibly to be induced to leave the market.300 Applying this element, we would ask whether a reasonable firm would find it significantly probable that Nall & Williams had achieved cost savings? As mentioned, the introduction of a new product at very low prices could be indicative of some cost saving event. The prey might believe that Nall & Williams had achieved a new production technique or perhaps found a new, cheaper source of supply. Because of the great pains American took to conceal its relationship with Nall & Williams, Nashville Tobacco had little reason to suspect that Nall & Williams was an American Tobacco subsidiary, receiving subsidies from the trust to engage in predatory pricing. That left two remaining alternatives: Either Nall & Williams had launched a self-financed promotional or predatory pricing campaign, or it had achieved a significant cost saving.
Focusing on these alternatives, the self-financed promotion or predatory pricing explanation appears unlikely. Self-financed promotion is unlikely if the price cutting was as ruinous as the government claimed. A predatory price explanation is unlikely if, as seems plausible, the victim was ignorant of the deception and believed the predator to be a small independent firm. The victim would likely recognize that a predatory pricing strategy by a small independent could not be sustained. In that event, the intended victim, Nashville Tobacco, could simply ride out the attack, realizing that its adversary had limited assets. So neither of these alternatives would seem a likely explanation for the low pricing. Of course, Nall & Williamson might have obtained the support of a well funded financial backer, but why would the financial backer be interested in investing large resources in excluding another small rival when it would then face future competition from American, which was rapidly expanding its control over the entire tobacco industry?
The remaining possibility was that Nall & Williams had achieved significant cost savings. How else could a small independent producer of tobacco sell its product at such a low price for a sustained period of time? It seems reasonable that Nashville Tobacco would conclude that it was at least significantly likely that Nall & Williams had achieved a cost savings. To be sure this is only a probability, but as the cost signaling strategy shows, a substantial probability of cost reduction can drastically change the expected profit of remaining in the market.
(4) The possible cost reduction is of sufficient magnitude to require the victim to exit or limit its expansion into other markets
As mentioned, in April 1906, the Nashville Tobacco Works sold out to the trust due to the below-cost selling of Nall & Williams. The United States claimed that Nall & Williams’ attack was “ferocious” and that the owners of the Nashville Tobacco Works “became convinced that they must either sell out to [the trust] or be destroyed.”301 Thus, the magnitude of the cost reduction clearly suffices to have substantially caused the victim’s exit.
(C) OTHER ELEMENTS
The other elements necessary to sustain a violation need only brief discussion. The price cutting forced the prey to sell out secretly, thereby achieving the predator’s exclusionary and deceptive purpose. Probable recoupment is supported by several factors. The predator’s price cutting was part of a pattern of price cutting activity that led to its dominance of the tobacco and plug tobacco markets with high market share and what the Supreme Court described as “perpetual entry barriers.”302 The cost of the predation was limited since the buyouts were typically made at low prices and the price cutting was restricted to the local operating area of the prey.303 While ex post evidence of pricing effects is lacking, letters exchanged by trust members indicate that the trust intended to raise prices after the demise of rivals,304 which certainly reinforces a conclusion of probable recoupment. Finally, reputation effects also enabled recoupment (but these effects do not appear to have stemmed from the cost signaling described here).305
Price was below ATC and may also have been below long run incremental cost since the petition charged that Nall & Williamson sold “below the cost of production” and American suffered heavy losses during the predatory campaign.306 While the record allows no conclusion whether price fell below AVC,307 that would not be an essential finding under our proposed approach. A business justification defense was apparently not raised. But had it been asserted, American would have faced a heavy burden in explaining its bogus competitor strategy and the great lengths to which it went in concealing its relation to its acquired subsidiaries. Such deception is consistent with the predatory cost signaling strategy developed above and cannot easily be reconciled with any legitimate business purpose.
A. Reputation effects within a single market: the efficient potential entrant
Now introduce a potential entrant who enjoys a cost advantage over the two incumbent firms. Assume this efficient entrant has a low unit cost of $45 and a fixed entry or set up cost of $10,000. With a unit cost below the incumbent’s $50 cost, the efficient entrant is ready and willing to enter the market, charging a price of $55. At this price neither incumbent has an incentive to stay in the market since, as assumed in our earlier cost signaling discussion, each incumbent has alternative uses for its capital that would enable it to earn more than the reduced profit now available.308 In that event both firms would exit and the efficient entrant earns $10,000 ($10 each from its 2000 customers less its fixed set up cost of $10,000).
Suppose now that one of the incumbents (the predator), having made no cost breakthrough, follows a bluffing or signaling strategy, reducing its price to $40, which is $10 below its cost of $50. Assuming the other incumbent matches the price reduction, predator now loses $10 per customer or a total of $10,000 per year ($10 X 1000).
If the bluffing strategy succeeds, the predator benefits not only from the increased future earnings it gains by inducing its existing rival to exit, but also from the losses it avoids by deterring entry. Since these benefits are continuing, the predator recoups far more than the cost of the price war.309 This simple example illustrates how a predator has an even greater incentive to engage in predatory pricing when its actions have reputation effects on new entrants.
Under these conditions both the existing rival and the entrant, observing the predator’s price reductions, face a difficult choice whether to compete with the predator. Indeed, for the existing rival the prospect of continued competition with the predator is likely to be even less attractive than in the simple cost signaling case. Consider first the existing firm’s decision whether to remain in the market. Irrespective of whether the predator has been able to reduce costs, the existing victim now has even less to gain by remaining in the market. Indeed, even if the victim discovers that the predator is bluffing, it now faces the threat of entry by the efficient entrant, which lowers the existing firm’s expected future profit after the predator withdraws its price cut. Thus, Firm 1's predatory actions are even more likely to induce the victim to exit than before. In fact, in our numerical example the existing firm would want to leave the market under all circumstances.
A less drastic and more plausible outcome arises if the efficient entrant has limited production capacity and, as a result, lower fixed set up costs. In that event both incumbents may be content to remain in the market, accommodating the entrant and exploiting the residual demand curve. Thus, after the efficient entrant has disposed of its full output, the two incumbents, following an accommodating strategy, continue to charge their previous $60 price, serving a reduced base of customers.310
Under this more plausible scenario the existing rival would stay in the market if it is absolutely certain that the predator is bluffing. However, any small doubt concerning a cost breakthrough by the predator would be enough to induce exit. The modest profit the existing victim earns on its reduced volume of sales if the predator is bluffing would then be outweighed by even a small risk of the heavy loss the victim would sustain if the predator has achieved a cost breakthrough. This example illustrates that the presence of a potential entrant increases not only the benefits of predatory action but also the existing victim’s incentive to exit. These are very general effects arising in almost any situation where there is a possibility of future entry.
Moreover, the exit by the predator’s existing rival also affects the likelihood of future entry. If the predator’s price reduction causes the existing rival to leave the market, the immediate effect is to reduce competition, making the market more attractive for entry. However strikingly, there is now an offsetting possibility that the potential entrant will be less likely to enter even though it could now enter at full production capacity. The existing rival’s exit will almost surely raise the entrant’s estimate that the predator has achieved a cost breakthrough. As previously discussed, the existing rival as a market insider, ought to know more about the predator’s costs than a potential future entrant. The observed exit of the victim may therefore increase the entrant’s belief that the predator has a cost advantage, discouraging entry.311
The reputation effect theories emphasize that the longer predatory action is pursued, for example the more often the incumbent firm responds with price cuts when its competitiveness is tested, the more potential entrants are inclined to believe that incumbent actually has low costs and is not bluffing. Thus, over time an incumbent can build a reputation for low costs by engaging in predatory pricing, making future entry less likely.312
B. Reputation Effects in the Presence of Multi-market Contact
Demonstration effects may also arise when there is multi-market contact just as in the situation where there is a potential entrant in the same market. In both cases the introduction of a third party changes the incentives of the participants such as to induce reputation strategies. The only difference is that now the demonstration effect is directed towards the victim’s other markets.
To see how demonstration effects arise when there is multi-market contact consider again the cost signaling situation described above, but now with two identical markets in which the predator and victim operate. Moreover, suppose that when the predator achieves a cost breakthrough, it can only gradually implement the cost reduction across the two markets. Thus, predator lowers its costs in Market 1 to begin with and in Market 2 only in the next period.313 Under these conditions, the predator can reduce its price in Market 1, thus limiting the cost of its predatory action to only one market. Then, if the reduced price causes the victim to conclude that predator has lower costs, the victim will exit not only from Market 1, but eventually from Market 2 as well, so that the predator gets enhanced benefits from its cost signaling predation.314
Multi market reputation effects inhibit potential competition by the same dynamic that we described in a single market. Observing the exit or losses of the predator’s existing rivals, potential entrants in both markets are induced to believe that the predator may have made a cost breakthrough. They are then less likely to attempt entry.
FOOTNOTES
1Brooke Group v. Brown & Williamson Tobacco, 509 U.S. 209 (1993) [hereafter Brooke].
4 Janusz A. Ordover & Robert D. Willig, supra note ____, at 8, 52.
5See Matsushita Elec. Ind. Co. v. Zenith Radio, 475 U.S. 574, 588-89 (1986).
7See Matsushita, 475 U.S. at 590.
11See Matsushita, 475 U.S., at 574.
12 Standard Oil Co. v. U.S., 221 U.S. 1 (1913).
14 B.S. Yamey, Predatory Price Cutting: Notes and Comments, 15 J. LAW & ECON. 129, 140 (1972).
16 B.S. Yamey, supra note ____.
17 B.S. Yamey, supra note ____, at 136-37.
18Id. at 137; see also FTC v. Cement Institute, 333 U.S. 683 (1948).
32 See Koller II, supra note ____, at 114-117.
35 Paul Milgrom, Predatory Pricing, THE NEW PALGRAVE DICTIONARY OF ECONOMICS 937.
39See JOHN R. LOTT, JR., supra note ____ , Ch 2.
42See generally Koller II, supra note ____.
44See Utah Pie Co., 386 U.S. at 706 (Stewart, J., Dissenting).
56See Williamson, supra note ____, at 66-67.
59 CIRCUIT BY CIRCUIT, supra note ____, at 66-67.
61See e.g., Barry Wright Corp. v. ITT Grinnell Corp., 724 F.2d 227 (1st Cir. 1983).
64 Westlaw search, July, 1996.
72See 3 AREEDA & HOVENKAMP, supra note ____, ¶726a.
73See Brooke, 509 U.S. at 243.
75 See 3 AREEDA & HOVENKAMP, supra note ____, ¶726d.4.
76See generally, 3 AREEDA & HOVENKAMP, supra note ____, ¶726d.4 (similar reading).
77See Brooke, 509 U.S. at 228.
78See Brooke, 509 U.S. at 249 (dissenting opinion).
80 Liggett Group, Inc. v. Brown & Williamson Tobacco Corp., 964 F.2d 335, 342 (1992).
81See Brooke, 509 U.S. at 228; Matsushita, 475 U.S at 590.
88 Advo, Inc., v. Philadelphia Newspapers, Inc., 51 F.3d 1191 (3d Cir. 1995).
90See Traffic Scan Network, Inc. v. Winston, 1995 Trade Cas. (CCH) ¶ 71,044 (E.D. La. May 24, 1995).
94See DOT Proposal, supra note ____ at ¶ 49, 228-29; Roger W. Fones, supra note ____.
100See supra text accompanying notes ____.
104See Cargill, Inc. v. Monfort of Colorado, Inc., 479 U.S. 104, 119-121 (1986).
108See Matsushita, 475 U.S. at 590-595.
109See Eastman Kodak Co., 504 U.S. 451, cited with approval in Brooke, 509 U.S. at 229.
110See Brooke, 509 U.S. at 225.
118See CIRCUIT BY CIRCUIT, supra note ____ at ch. III.
120See Baumol II, supra note ______, at 58-59.
121 Joskow & Klevorick, supra note_____, at 252 n. 79 and accompanying text.
124See Joskow & Klevorick, supra note ____ at 252 n. 79.
125 1 A. KAHN, THE ECONOMICS OF REGULATION 77-83 (1970).
128See CIRCUIT BY CIRCUIT, supra note ____ at 71-76.
129See 4A AREEDA, HOVENKAMP & SOLOW, ANTITRUST LAW, ¶976d (Rev. Ed. 1998).
130See supra text accompanying notes ___.
132 We are indebted to Barry Nalebuff for pointing this out.
165Hazlett article, supra note ____, at 619.
Bramson interview, Feb 5, 1999, supra note ____.
170See Hazlett article, supra note ____, at 621.
172Hazlett interview, supra note ____.
173See Hazlett Article, supra note ____ at 642.
178Hazlett article, supra note ____, at 623.
180Bramson interview, Aug. 19, 1997, supra note ____.
182Hazlett article, supra note ____ at 619 (estimated cost projections by incumbent).
183Hazlett interview, supra note ____.
184Hazlett article, supra note ____ at 618, 620.
190See generally Bolton & Scharfstein (1990), supra note _______.
192 For more detailed discussion see infra text accompanying notes ____.
195See supra text accompanying notes ___.
197See Gabel & Rosenbaum, supra note ____ at 587.
205 See Weiman & Levin, supra note ___, at 119.
206See Gabel & Rosenbaum, supra note ____, at 606; Weiman & Levin, supra note ___, at 116.
209See Gabel & Rosenbaum, supra note ____, at 604.
210See Gabel Ph.D. Dissertation, supra note __ at 153-54.
211See Gabel & Rosenbaum, supra note __, at 607.
212See Gabel Ph.D. Dissertation, supra note ____ at 154-55, 157-169.
214See Gabel & Rosenbaum, supra note ____, at 602.
215Gabel Ph.D. Dissertation, supra note ____ at 153-54.
216See Gabel & Rosenbaum, supra note ____, at 604.
221See David Gabel, Competition in a Network Industry, supra note ____, at 567.
223See Gabel & Rosenbaum, supra note___, at 597.
224See David Gabel, Competition in a Network Industry, supra, at 567.
228 In numbers: 0.7 x $10,000 + 0.3 x $50,000 = $22,000.
231See In re General Foods, 103 F.T.C. 204 (1984).
234See In re General Foods, 103 F.T.C. at 240-42 ¶ 155-70.
236See Hilke & Nelson, Strategic Behavior, supra note ____, at 224.
237 In re General Foods, 103 FTC at 297 ¶ 438.
244See In re General Foods, 103 F.T.C. at 250 ¶¶ 209-210.
245See Hilke & Nelson, Strategic Behavior, supra note ____ at 224.
246 (Not included in this document).
251 JOHN C. LOTT, JR. supra note __, at 29-30.
253 Easterbrook, Predatory Strategies, supra note ___ at 271.
257See Easterbrook, Predatory Strategies, supra note ____, at 285. 114
266See Hart-Scott-Rodino Act, 15 U.S.C. §18a.
267See 15 U.S.C. at §18a(2)(A).
268See JOHN C. LOTT, JR. supra note ___, ch. 2.
283See American Tobacco, 221 U.S. at 161.
284See American Tobacco, 221 U.S. at 162.
293See Brief, American Tobacco, supra note ____ at 269.
294See Brief, American Tobacco, supra note ____ at 243.
301See Brief, American Tobacco, supra note ____ at 243.
302American Tobacco, 221 U.S. at 175.
303See Burns, Predatory Pricing, supra note ____ at 271 n.12.
306See Burns, New Evidence, supra note _____ at 327 & n.5 (1989).
307American Tobacco, 221 U.S. at 161.