Beyond Brooke Group: Bringing Reality to the Law of Predatory Pricing.

Author:Hemphill, C. Scott
Position:Symposium: Unlocking Antitrust Enforcement
 
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INTRODUCTION

Over the past twenty-five years, antitrust claims alleging a predatory price cut have fallen into disuse. This can largely be attributed to the Supreme Court's 1993 decision in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., (1) which established the current framework for evaluating predatory pricing claims. Under Brooke Group, a plaintiff must show that the alleged predator both set a price below cost and had a sufficient likelihood of recouping its predation-period losses through post-predation gains. The price-cost and recoupment tests are difficult to satisfy and were imposed to serve the Court's stated goal to avoid condemning--and thereby chilling--procompetitive price cuts. Beyond this framework, Brooke Group offered the view, expressed in dicta, that predation is implausible.

In this Feature, we reconsider the application of Brooke Group to modern predation cases and other pricing strategies. As we explain, Brooke Group's two-part framework was adopted by the Court without any contested presentation of its merits, and both parts of the framework are subject to serious criticism. (2) The price-cost test permits the exclusion of higher-cost rivals whose presence would otherwise place downward pressure on prices. The recoupment test exonerates some below-cost pricing whose condemnation would have little chilling effect on procompetitive conduct. Using the tests in tandem can yield inconsistent, even paradoxical, results. Despite these infirmities, however, the Brooke Group framework appears to be well entrenched in the Court's jurisprudence. (3) We therefore take the framework as given and suggest how best to apply it in practice, recognizing that the Court could revisit this precedent in an appropriate case.

Our main contribution is to articulate the elements of a successful predation claim and explain how courts should operate within the strictures of Brooke Group. For example, suppose that an airline has monopoly power on a route between its hub and another major city. In response to new entry by a low-cost carrier (LCC), the incumbent drops its price and increases capacity on the route. The LCC gives up and exits the market, whereupon the incumbent returns to its previous price and quantity. Other entrants are thereby discouraged from challenging the incumbent on this and other routes.

How should a court approach these facts? Using recent airline predation cases to illustrate our argument, we identify three elements of flexibility within the Brooke Group framework that, taken together, enable a court to conduct an empirically grounded evaluation of the predation claim. First, where the evidence shows recoupment by a monopolist, Brooke Group's skepticism does not apply. Brooke Group dealt with alleged recoupment by an oligopoly, with no conspiracy among its members to facilitate the scheme, a market structure that (in the Court's view) made successful predation particularly unlikely. Monopolies are different. Second, a plaintiff is free, even under Brooke Group, to show that the defendant successfully recouped by acquiring a reputation for predation in other markets. The Brooke Group Court had no opportunity to consider reputation or any of the other modern economic theories under which recoupment is a rational strategy. Third, for purposes of the price-cost test, the plaintiff has leeway to select an appropriate measure of cost. Brooke Group itself used average variable cost, but anticipated the use of other measures, such as incremental cost. (4)

The Court's unusually detailed review of particular case facts in Brooke Group provides a further reason to confine Brooke Group's dicta that predation is implausible. As we explain using new historical research, the Court did not initially plan to provide such a detailed review of the case. The Justices initially voted to reverse the court of appeals, but Justice Kennedy switched his vote. His final opinion for the Court, affirming the judgment of the court below, relied on an unusual, fact-bound reassessment of the sufficiency of the evidence. The Court's extensive review afforded numerous opportunities to express skepticism about the particular predatory strategy at issue in the case. Where real-world predation cases differ from the facts and theories that the Court considered in detail, the Court's skeptical dicta from Brooke Group should not apply.

Our secondary contribution is to caution against extending the Brooke Group framework into other areas of antitrust law. Using loyalty discounts as an example, we argue against the extension of Brooke Group to pricing strategies that are more complex than the relatively simple price cutting at issue in predatory pricing cases. Defendants and some commentators have argued that the Brooke Group framework, particularly the price-cost test, should be applied to such strategies. We disagree. In our view, the premises used to justify that test for simple price cutting do not apply to more complex strategies.

This Feature proceeds in three Parts. Part I presents and criticizes the Brooke Group framework, placing the Court's dicta within the context of the unusual, fact-bound case from which it emerged. Using airline predation as an example, Part II identifies points of flexibility when applying the recoupment and price-cost tests. Part III explains why the price-cost test should not be extended to the analysis of loyalty discounts.

  1. THE DOCTRINE AND DICTA OF BROOKE CROUP

    This Part assesses the doctrine and dicta developed in Brooke Group. Section I.A provides a critical review of the two legal tests adopted by the Court. Section I.B describes the Court's skeptical--and highly fact-bound--dicta.

    1. The Brooke Group Framework

      The Court's opinion in Brooke Group set out, for the first time, two essential requirements that a plaintiff must establish for a successful claim of predatory pricing. First, the plaintiff must show that the defendant set a price below its cost. (5) The Court required an "appropriate" measure of cost, but left open which measure should be used. (6) Second, a plaintiff must establish a likelihood of recoupment: a "reasonable prospect" or "dangerous probability" (7) that the defendant will "recoup[] its investment in below-cost prices." (8) Plaintiffs can establish recoupment by showing either an ex ante likelihood of recoupment, or that recoupment was achieved in fact. (9) The price-cost and recoupment tests may be considered in either order.

      1. Price-Cost Test

        Prior to Brooke Group, economists urged an approach to predatory pricing that minimized error costs. (10) The application of any legal rule risks two types of error. In the antitrust context, the condemnation of procompetitive behavior is termed a "false positive." Permitting anticompetitive behavior is called a "false negative." The error costs of a substantive antitrust rule depend upon the harm and frequency of false positives and false negatives, including distortion in the conduct of firms in response to the rule. Determining the error costs of a particular rule is a complex task and requires a good understanding of the relevant inputs. In the case of predatory pricing, such a judgment depends in part on the frequency of procompetitive and anticompetitive price cuts, and the benefits and harms that arise from each. (11)

        The Court's price-cost test reflects the avoidance of one type of error costs: false positives. The Court explained that price cuts are generally desirable--the "mechanism by which a firm stimulates competition" and "the very conduct the antitrust laws are designed to protect." (12) As the Court saw it, a price cut--at least as long as the price remains above cost--is unambiguously desirable because it increases output, thereby raising total and consumer welfare. A false condemnation of an innocent price cut is thus costly because it "chills" desirable price cuts. (13) That is, the major problem is not the erroneous result in the case at hand, but rather the potential for the false condemnation to discourage other price cuts.

        The Court's approach accepts some false negatives--anticompetitive above-cost price cuts--in order to avoid the chilling effect of false positives. (14) Such a lenient rule, however, can be costly. An important source of false negatives is above-cost price cuts that exclude a higher cost rival whose presence otherwise would have constrained the dominant firm's prices. Moreover, some excluded entrants would have become more efficient if enabled to grow, gain scale, and learn by doing. A further cost of a lenient rule is that other firms that might be deterred from entering after they observe aggressive price cuts aimed at excluding earlier entrants. In short, the long-run welfare costs of exclusion from predatory price cutting could be much greater than the short-run benefits of lower prices.

        Brooke Group did not deny that its test is underinclusive, (15) but defended its rule on the ground that a more aggressive test that extended liability to above-cost price cuts was "beyond the practical ability of a judicial tribunal to control without courting intolerable risks of chilling legitimate price-cutting." (16) The Court further asserted in dicta that false negatives would be rare, quoting its statements in earlier cases that "predatory pricing schemes are rarely tried, and even more rarely successful." (17)

        As discussed below, this famous dictum about predatory pricing was offered without adequate empirical support. (18) Indeed, it relied on a selective evaluation of the academic literature, including John McGee's controversial 1958 article concluding that Standard Oil had not engaged in predation. (19) It was also immaterial to the case at hand. In the first place, the Court seems to have meant the term "predatory pricing" to encompass only below-cost pricing; even if that were rare, it would tell us little about whether firms engage in successful schemes to...

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