Why above-cost price cuts to drive out entrants are not predatory, and the implications for defining costs and market power.

• Author: Elhauge, Einer

CONTENTS I. THE CURRENT STATE OF LEGAL FLUX AND SCHOLARLY DEBATE A. Legal Developments and Ambiguities B. The Inadequacy of Traditional Responses in Either Direction II. DEFINING THE CORRECT COST MEASURE A. The Murky and Divided Nature of the Current Debate over Cost Definitions B. Use Whatever Costs Are Variable During the Period of Predatory Pricing C. Use Variable Costs of the Alleged Predatory Increase in Output That Displaces the Rival Not of Producing the Predator's Entire Output D. If Short-Term Pricing Can Deter Long-Term Investments, Then Use Magnitude of Predator Costs for the Sorts of Costs Variable to the Victim, but Look to the Future To Measure Cost Magnitudes E. If (as Likely) Short-Term Pricing Cannot Deter Long-Term Investments, Then Just Use Those Predator Costs Varied by Its Alleged Predatory Increase in Output F. Conclusion on the Proper Cost Measure III. REACTIVE PRICE CUTS TO DRIVE OUT ENTRANTS NEED NOT INDICATE INCUMBENT MARKET POWER--AND THE IMPLICATIONS FOR DEFINING COSTS WHERE COMMON COSTS EXIST A. Individual Routes in Hub-and-Spoke Systems Cannot Be Assumed To Be Separate Markets B. Why Competitive Markets May Induce Price Discrimination That Maximizes Output C. Why Competitive Price Discrimination Will Often Require Reactive Above-Cost Price Cuts IV. RESTRICTING ABOVE-COST PRICE CUTS HAS ADVERSE EFFECTS EVEN WHEN THE INCUMBENT DOES HAVE MARKET POWER AND IMPLEMENTATION DIFFICULTIES ARE IGNORED A. Effects on Likelihood and Consequences of Less Efficient Entry 1. Consequences for Less Efficient Entrants Who Would Have Entered Without Any Restriction a. Why Less Efficient Entrants Often Enter Without Any Restriction on Reactive Above-Cost Price Cuts b. The Undesirable Consequences 2. Effects for Less Efficient Entrants Whom the Restrictions Encourage To Enter a. Why Restrictions on Reactive Above-Cost Price Cuts Can Provide Weak Encouragement to Entry by Less Efficient Firms b. The Effects of (Weakly) Encouraging This Additional Less Efficient Entry B. Effects on Likelihood and Consequences of Efficient Entry 1. Post-Entry Effects 2. Ex Ante Effects on Creation of More Efficient Entrants 3. The Restrictions Cannot Reasonably Be Construed or Modified To Eliminate Their Adverse Effects on Efficient Entrants C. Effects for Entrants Who Can Overcome Their Initial Efficiency Disadvantage 1. When Overcoming Incumbent Efficiency Advantage Necessitates Some Deterioration in Incumbent Efficiency 2. When Increased Entrant Efficiency Suffices To Overcome Incumbent Efficiency Advantage a. Why Such Entrants Would Generally Enter Without Any Restriction on Reactive Above-Cost Price Cuts b. The Undesirable Consequences 3. Entrants That Share the Incumbent's Declining Cost Curve D. Ex Ante Effects on Incumbent Incentives 1. The Likelihood and Legality of Encouraging Limit Pricing 2. Reduced Incentives To Create Efficient Incumbents E. Summary of Effects and Assessment of Possible Trade-Offs F. The Restrictions Cannot Reasonably Be Construed or Modified To Eliminate or Suspend the Market-Power Requirement V. UNAVOIDABLE IMPLEMENTATION DIFFICULTIES WORSEN THE ABOVE EFFECTS A. When Is the Moment of Entry? B. Post-Entry Quality Changes C. Difficulties in Defining the Incumbent Price Floor or Output Ceiling D. Conclusion on Implementation Difficulties VI. THE BAUMOL BAN ON IMPERMANENT REACTIVE PRICE CUTS A. Post-Entry Effects B. Implementation and Incentive Problems C. Ex Ante Effects VII. CONCLUSION In the early 1990s, antitrust law on both sides of the Atlantic appeared to have reached a consensus that predatory pricing required proof of below-cost prices. (1) But the last few years have witnessed a surprising movement toward prohibiting firms from responding to entry with above-cost price cuts. The European courts got things rolling with a 1996 decision holding it illegal for monopolists to adopt selective above-cost price cuts that sacrificed revenue in order to eliminate entrants. (2) Then, in 1998, the United States Department of Transportation proposed a regulation banning major incumbent airlines from reacting to entry with above-cost price cuts or capacity increases that resulted in "substantially" lower short-term profits than alternative pricing would have. (3) In May 1999, the United States Department of Justice brought the American Airlines litigation based on the similar theory that it was predatory to respond to entry with business practices that (even if above cost) "clearly" sacrificed profits. (4) This government theory was supported by several expert economists, including the Nobel Prize-winning professor Joseph Stiglitz. (5) And now, an important new article by Professor Aaron Edlin proposes the even broader rule that, when an entrant charges at least twenty percent below the prevailing price, a monopolist cannot respond with any price cut at all for twelve to eighteen months or until it loses its monopoly. (6) All of these positions restrict reactive above-cost price cuts (or output increases) even if they result in prices that meet (rather than undercut) the entrant's price, on the notion that buyers would likely stick with the incumbent unless the entrant can offer a lower price.

The basic concept underlying these new legal developments and proposals is hardly new. Some courts and scholars have long thought reactive above-cost price cuts designed to drive out entrants were predatory, (7) and the idea was a standard staple of Socratic dialogue in antitrust classes. (8) The Edlin proposal is the same as Professor Oliver E. Williamson's famous 1977 proposal, except that it substitutes a ban on incumbents lowering their price for Williamson's ban on incumbents increasing their output for twelve to eighteen months after entry. (9) Edlin's proposal also has much in common, as he acknowledges, with Professor William J. Baumol's ingenious 1978 idea of permitting reactive price cuts only if they are quasi-permanent. (10) These are legendary economists. The approach of the European Union (EU) and the U.S. Departments, in turn, has roots in various cases and scholarship that defined a predatory price as one that would not maximize profits unless it could destroy or discipline competitors. (11) The scholars supporting this approach in writings between 1977 and 1981 included such heavy hitters as Professors Lawrence Sullivan, Paul Joskow, Alvin Klevorick, Janusz Ordover, and Robert Willig. (12)

By the early 1990s, however, this earlier wave of theories seemed safely buried, in an apparent triumph for the Areeda-Turner position that predatory pricing must be below cost. But now they have resurfaced in these modern legal developments, partly because cases and scholars defending the cost-based rule rested on conclusory definitions and contestable claims that above-cost restrictions were less administrable and imposed certain short-term losses in post-entry price competition in return for an uncertain long-term gain if the entrant remained in the market. (13) This never provided a satisfactory theoretical response to the critics nor addressed practical objections to actual industry behavior under such a rule. Critics were particularly provoked by an apparently serious problem confronting the airline industry. (14) On many routes there is an incumbent airline that dominates business on that route and sells at a price well above its costs for that route. Periodically, another airline enters the market at a lower price. The incumbent firm then lowers its price to beat (or match) the entrant. The incumbent never prices below its own costs. But because the entrant has higher costs (or lower quality), it cannot compete at the new price and is driven out of the market. Once the less efficient entrant is safely gone, the incumbent reestablishes the old price.

The concern is that such reactive temporary price cuts not only drive out entrants, but deter similar entry in the future, and thus allow the more efficient incumbent to perpetuate monopoly prices that exceed the price the next most efficient firm would charge. If so, the supposedly certain gains from short-run post-entry price competition never arrive because the entry never occurs, and the long-term loss is experienced with certainty every day. Moreover, although airlines present the concern in particularly stark form, this concern can exist in any industry where incumbent firms are more efficient than potential entrants and exploit their market power (when entrants are not present) to charge prices well above incumbent costs. Indeed, if valid, this concern would overturn a general current skepticism based on the presumption that predatory pricing is rare because it requires the incumbent to sustain losses on a large number of sales. (15) If harmful predation involved profitable above-cost pricing, it would be far more plausible and prevalent.

This is a serious concern that can no longer be suppressed with conclusory labels or contestable claims that ignore the effect on incentives to enter. Unless more seriously addressed, these unanswered concerns about above-cost reactive price cuts will likely continue to influence and expand the development of legal doctrines to deal with those concerns in the United States and Europe, both for antitrust law and regulatory agencies. And such unaddressed concerns will bias conclusions about what counts as a cost whenever a cost-based test is still used. It is thus time to take the idea of restricting above-cost reactive price cuts more seriously. But it is not time to adopt that idea. To the contrary, this Article shows that seriously confronting the idea reveals several heretofore unappreciated flaws in such restrictions.

First, such restrictions will often penalize efficient pricing behavior when incumbents do not even have the market power to restrict output. This is because, in many competitive markets, incumbent firms maximize their ability to incur common costs (and thus create output) by...