Stopping above-cost predatory pricing.

Author:Edlin, Aaron S.

    Since 1993, when the Supreme Court decided Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., (1) no predatory pricing plaintiff has prevailed in a final determination in the federal courts. (2) This case was a great victory for the Chicago School of antitrust. One leader of that school, then-Professor Frank Easterbrook, once asked whether there are so many theories of predation because it "is a common but variegated phenomenon" or rather "for the same reason that 600 years ago there were a thousand positions on what dragons looked like." (3) He concluded that predation was much like dragons and that "there is no sufficient reason for antitrust law or the courts to take [predation] seriously." (4)

    This Essay argues that the decision in Brooke Group was no great day for consumers, for well-functioning markets, or for antitrust law. The Court's reading of the law is unduly narrow and should be revisited. In particular, there is no compelling reason to restrict predation cases to below-cost pricing, (5) as above-cost pricing can also hurt consumers by limiting competition. (6) In cases of monopolization or attempted monopolization, such "above-cost predation" may be more plausible and prevalent than below-cost predation. As a result, this Essay argues that the courts should limit the Brooke Group holding to oligopoly cases like that in which it arose. (7)

    The Department of Justice (DOJ) recently sued American Airlines for predatory pricing and predatory expansion of flights on routes to and from its hub at the Dallas-Fort Worth airport. (8) The DOJ made a plausible case that American Airlines had a monopoly over passenger travel into and out of the Dallas-Fort Worth airport, or that it had or was attempting to acquire monopoly power on particular routes. (9) The DOJ showed that when Vanguard Airlines began flying from Kansas City to Dallas at low fares, American quickly matched fares, lowered prices by over twenty-five percent, and increased the frequency of its flights substantially. Customers saw little reason to fly with Vanguard, given American's response. After Vanguard gave up, however, American raised its fares and reduced its flight frequency, (10) The DOJ made similar allegations with respect to attempts by Sun Jet International and Western Pacific to enter the Dallas-Fort Worth market. These facts alone, however, do not constitute a case of predatory pricing under Brooke Group.

    A successful predatory pricing case under Brooke Group requires showing that American priced below its cost, and also that American stood a reasonable chance of recovering the resulting losses. (11) American won on summary judgment because the trial court found it was pricing above its variable cost. This Essay argues that the two predatory elements isolated in Brooke Group--below-cost pricing and the possibility of recoupment--may be sufficient to make out a predatory pricing case, but they should not be necessary.

    American Airlines apparently had sufficient advantages to force Vanguard to cancel all its nonstop flights between Dallas-Fort Worth and Kansas City by the end of 1995 without pricing below its cost. (12) But does this mean that customers were better off without Vanguard?

    An incumbent monopoly with a significant cost or noncost advantage over entrants--a situation this Essay argues is common for monopolies--can use these advantages to drive entrants from the market by pricing below their cost, but above its own. (13) As Part III makes clear, this strategy is quite credible and effective. If the strategy is legal, higher-cost rivals will not even attempt entry, and consumers may never enjoy low prices. If entrants who would price below the monopoly are excluded from the market, consumers are worse off than if the low-cost monopoly did not exist. (14) This Essay calls such strategies above-cost predation and argues they should violate section 2 of the Sherman Act.

    The standard view of predatory pricing is stated clearly by Judge Easterbrook:

    Predatory prices are an investment in a future monopoly, a sacrifice of today's profits for tomorrow's. The investment must be recouped. If a monopoly price later is impossible, then the sequence is unprofitable and we may infer that the low price now is not predatory. More importantly, if there can be no "later" in which recoupment could occur, then the consumer is an unambiguous beneficiary even if the current price is less than the cost of production. (15) The Supreme Court endorsed a more extreme version of this view in Brooke Group in which today's profit sacrifice must entail actually suffering losses, rather than simply failing to maximize profits.

    This Essay presents a simple model in which there is no "later." The incumbent monopoly is therefore unwilling to make any sacrifices, so it maximizes short-run profits, but it does so with prices low enough to drive out an entrant. (16) If the law fails to recognize these low prices as predatory because they are above cost, consumers are the unambiguous losers, not the unambiguous beneficiaries that Easterbrook and the Supreme Court expect. Existing predation law means the potential entrant will, in fact, not enter, and consumers will always pay high prices to the incumbent. The predatory problem occurs not "later," after exit, but "sooner," before entry. The key problem is ex ante. This shift in temporal focus is a critical part of this Essay's argument.

    Then-Judge Breyer cautioned against this approach and justified the exclusion of above-cost pricing from predatory pricing prohibitions on the ground that otherwise we cast away "birds in hand" in favor of more speculative "birds in the bush." (17) One problem with this reasoning is that the benefits of low pricing (the supposed "birds in hand") may only be temporary if entrants like Vanguard or Barry Wright are driven from the market. Of still more concern, if firms anticipate being driven from the market shortly after entry, they will typically not enter at all. If this occurs, even the transitory gains that Judge Breyer expected will not appear. Judge Breyer may never get his "birds in hand."

    In the spirit of Williamson and Baumol, this Essay proposes a "dynamic" standard for adjudicating predation: In markets where an incumbent monopoly enjoys significant advantages over potential entrants, but another firm enters and provides buyers with a substantial discount, the monopoly should be prevented from responding with substantial price cuts or significant product enhancements until the entrant has had a reasonable time to recover its entry costs and become viable, or until the entrant's share grows enough so that the monopoly loses its dominance. (18) For the sake of concreteness in application, this Essay usually assumes that if an entrant prices twenty percent below an incumbent monopoly, the incumbent's prices will be frozen for twelve to eighteen months. (19) If the incumbent does not observe these strictures, as American Airlines did not, then the entrant under this proposal can sue successfully for predatory pricing without the need to demonstrate below-cost pricing or the opportunity for recoupment.

    This Essay argues that this rule is a sensible interpretation of section 2 of the Sherman Act and that it is consistent with the basic thrust of monopolization doctrine. This predatory pricing rule encourages the incumbent to charge low prices from the start in order to discourage entry. (20) Under this rule, if American Airlines, for example, had wanted to discourage Vanguard from entering, it would have had to charge the low prices that it ultimately used to drive Vanguard out of the market even before Vanguard entered. Since it is never clear when an entrant will turn up, American would have to charge low prices all the time. Baumol's alternative predatory pricing rule, by contrast, which required price reductions to be quasi-permanent, aimed to eliminate the high-price period of recoupment. Baumol's rule would not provide any incentive to price low before entry because it creates no link between post-entry and pre-entry prices. (21)

    This Essay's predation rule means that matching competitors' prices after entry (if there is entry) is no longer a cheap substitute for actually charging low prices in the first place. (22) If the incumbent's prices are still high enough to invite entry, under this rule, firms will enter if they can profitably survive while charging prices twenty percent below the monopoly's current prices. The entrant would not have to survive pricing lower than the monopoly could price in reaction to entry. Under this rule, then, firms that would otherwise fear being driven from the market with above-cost predation can enter profitably.

    Consumers get dual benefits under the proposed predatory pricing rule: (1) Incumbents charge lower prices in order to limit entry, and (2) there is more entry at whatever price incumbents choose than there would be at the same price under Brooke Group. Not everyone benefits from such a rule, of course. The incumbent monopoly suffers lower profits while it charges low limit prices, and if entry does occur, the incumbent may be unable to respond in a profit-maximizing way. The consumer surplus gains from low limit pricing will generally exceed the losses to the incumbent before entry. (23) Overall, however, the social welfare consequences remain ambiguous because if the incumbent's lower limit prices do not discourage all entry, firms protected by the price freeze will sometimes enter despite having higher costs than the incumbent. Consumers would receive a second boon from the entry of these firms--since prices would be lowered--but in some cases profit losses could exceed consumers' gains.

    The proposal advances consumer welfare, which has historically been the core goal of antitrust case law. (24) It stands a good chance of improving overall welfare as well, a goal many commentators advance...

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