He’s talking about “predatory pricing.” It’s true he has no understanding of business, entrepreneurship or economics. Send him a copy of the rest of this post:
People will say things like “once they’ve got a foothold in a community, what’s to stop them from raising their prices, too? Absolutely nothing.”
That’s why this old and popular myth of economics is known as “predatory pricing.” Sounds scary right? You know this one. It’s basically the idea that a big firm that can afford to sell products at a loss for a while (i.e. for less than they paid for them) will drop their prices so low that smaller firms will be driven out of business. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while it was engaged in predatory pricing, and earns monopoly profits forever after.
Sounds logical right? The problem with this is, it doesn’t work economically…and (therefore as you would expect) there are virtually no examples of this occurring. There has never been a single clear-cut example of a monopoly created by so-called predatory pricing, let alone one in which prices were raised drastically and customers were “gouged.” Claims of predatory pricing are typically made by competitors who are either unwilling or unable to cut their own prices. And as I stated, this is not just a situation in which we have no examples…it economically doesn’t work…and has been shown for decades to not work.
Here’s a short video that tells a really great story of when a big firm tried predatory pricing against a very smart fellow whose name you’ve probably heard of.
For anyone interested in the actual economics of the theory, I’ve provided several resources below, some of which actually contain references to dozens more. But for the Cliff’s Notes kids, I’ll just offer some highlights just for those interested (my comments are in italics in the brackets):
Quote:
| Predatory pricing is the Rodney Dangerfield of economic theory–it gets virtually no respect from economists. But it is still a popular legal and political theory for several reasons. First, huge sums of money are involved in predatory pricing litigation, which guarantees that the antitrust bar will always be fond of the theory of predatory pricing. […] Second, because it seems plausible at first, the idea of predatory pricing lends itself to political demagoguery, especially when combined with xenophobia. The specter of a foreign conspiracy to take over American industries one by one is extremely popular in folk myth. Protectionist members of Congress frequently invoke that myth in attempts to protect businesses in their districts from foreign competition. Third, ideological anti-business pressure groups, such as Citizen Action, a self-styled consumer group, also employ the predatory pricing tale in their efforts to discredit capitalism and promote greater governmental control of industry. Citizen Action perennially attacks the oil industry for either raising or cutting prices. When oil and gas prices go up, Citizen Action holds a press conference to denounce alleged price gouging. When prices go down, it can be relied on to issue a “study” claiming that the price reductions are part of a grand conspiracy to rid the market of all competitors. And when prices remain constant, pricefixing conspiracies are frequently alleged. Fourth, predatory pricing is a convenient weapon for businesses that do not want to match their competitors’ price cutting. Filing an antitrust lawsuit is a common alternative to competing by cutting prices or improving product quality, or both. Finally, some economists still embrace the theory of predatory pricing. But their support for the notion is based entirely on highly stylized “models,” not on actual experience.1 ["In other words, predatory pricing theory persists because well-placed individuals and organizations that benefit from accusing others of engaging in predatory pricing will use their resources to keep the theory alive."2] |
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Quote:
| The theory of predatory pricing can be likened to that strange gift from Aunt Maude or a unicorn. […] There is another problem with predatory pricing, however, that is just as pressing as the “unicorn” problem. Economists generally attempt to explain firm behavior by using standard neoclassical instruments. As this article demonstrates, however, the neoclassical theory of the firm, as expressed by the use of the standard neo-Marshallian tools depicting imperfect competition, does not grant users the intellectual apparatus by which to conclude that firms, given the assumptions of profit-maximizing behavior, would engage in an activity like predatory pricing. […] [E]ven some of the theory’s supporters uneasily accede to its unicorn-like characteristics, as I point out later.2 [in other words, not only can no one point to a single example of predatory pricing occurring, but the economic models that even supporters of the predatory pricing theory use to try to show it could happen, don’t work the way they should…They contradict…and this has led even the supporters to have to admit their theory basically has no economic basis.] […]Shughart writes that if one examines the actions and risks firms must undertake in order to engage in illegal predation, it “does not pay” (1990, p. 296). McGee (1958) writes that predatory pricing cannot be thought of as a rational business strategy because the “predatory” firm in the end is likely to suffer greater losses than its rivals. Other economists, including Stigler (1967) and Telser (1966) have attacked such a strategy because it conflicts with the assumption of rational behavior by firm owners. Isaac and Smith (1985) examined a number of predatory pricing cases and concluded that they were unable to ascertain whether or not the firms accused actually had engaged in such practices.2 |
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Quote:
| First, it should not at all be taken for granted that the large, rich firm is even in a position to impose a price reduction below the small firm’s costs. At the lower price it asks, there will be an increase in the quantity of the good demanded. The large firm can make the lower price effective only if it is in a position to supply this additional quantity demanded. Whether or not it can do so depends on how elastic the demand for the product is in response to the price reduction[…]and also on how much unused productive capacity the firm has on hand and that is available for the particular market concerned. If its capacity is insufficient to meet the larger quantity demanded, it has no means of compelling its small competitor to sell at the lower price it asks. For in this case, customers who come to it in order to obtain the lower price must be turned away. They will have to deal with the smaller firm.[…] A further, much greater difficulty arises. If it is the case that as soon as the small competitor is driven out, the large firm can sharply increase its price, while so long as the small competitor remains in business the price is held below the level of his costs, then usually unrecognized but nonetheless extremely powerful interests are created on behalf of the continued existence of the small competitor. […]A less obvious interest in the continued existence of the small competitor is that of the industry’s suppliers and that of the producers of products that are complementary to the industry’s products.3 [in other words, as long as the smaller competitor is around, everyone gets to enjoy the extremely low prices of the predatory firm…so there is a lot of interest in keeping that competitor around…namely, not just by the competitor himself, but by the suppliers and complementary producers of the industry. They would all be very interested in keeping the smaller firm around…not only to enjoy the lower prices of the predatory firm, but to avoid any higher prices the firm might try to charge in the future.] |
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And he actually goes on and on. Another big one is the concept of brand reputation. If every time a new competitor pops up, you drop your prices to compete, and then the competitor disappears, and you jack up your prices, how long will it take before people just won’t shop at your store? There is a lot to be said for reputation and brand loyalty. If the choice is between a new place that is giving good service and reasonable prices that stay reasonable, people will choose that over a quixotic price changer pretty darn quick.
If you’re interested in more reasons why it never works, I highly recommend following the links to sources #1 and #3. Reisman goes into great detail, but provides very simple, easy to understand examples.
1 - DiLorenzo, Thomas J. 1992. “The Myth of Predatory Pricing,” Policy Analysis No. 169. Cato Institute; http://mx.nthu.edu.tw/~cshwang/teach…03-06-monopoly and profit/DiLorenzo=THE MYTH OF PREDATORY PRICING.pdf
2 - Anderson, William L. 2003. “Pounding Square Pegs into Round Holes: Another Look at the Neo-Classical Theory of Predatory Pricing.” The Quarterly Journal of Austrian Economics, Vol. 6, Spring; http://mises.org/journals/qjae/pdf/qjae6_1_2.pdf
3 - Reisman, George. 1998. Capitalism: A Treatise on Economics. Ottawa, IL: Jameson Books. pp. 399-407; http://www.capitalism.net/Capitalism…M_Internet.pdf
4 - http://mises.org/daily/226
5 - Isaac, R. Mark, and Vernon L. Smith. 1985. “In Search of Predatory Pricing.” Journal of Political Economy 93: 320–45.