Review ofIndustrial Organization 11: 753-758,1996. @ 1996 Kluwer Academic Publishers. Printed in the Netherlands.

Is Predation Rational? Is It Profitable?

WALTER ADAMS’, JAMES W. BROCK2 and NORMAN P. OBST3 ‘Department of Economics, Ttinity University (Ta; ‘Department of Economics, Miami University, Oxford OH 45056, US.A.; ‘Department of Economics, Michigan State University, U.S.A.

Predation, according to New Learning theorists, is defined “as a firm’s deliberate aggression against one or more rivals through the employment of business practices that would not be considered profit maximizing except for the expectations either that (1) rivals will be driven from the market, leaving the predator with a market share sufficient to command monopoly profits, or (2) rivals will be chastened sufficiently to abandon competitive behavior the predator finds inconvenient or threatening” (Bark, 1978, p. 14). In the case of price predation, they contend, a “firm contemplating predatory price warfare will perceive a series of obstacles that make the prospect of such a campaign exceedingly unattractive. The losses during the war will be proportionally higher for the predator than for the victim; merger law will make it all but impossible for the predator to purchase the victim, so the campaign will have to last until the victim’s organization and assets are dissolved; ease of entry will be symmetrical with ease of exit; and anticipated monopoly revenues, being deferred, must be discounted at the current interest rate”, (Bark, 1978, p. 149). Therefore, the New Learning advocates conclude, predatory pricing “is most unlikely to exist . . . attempts to outlaw it are likely to harm consumers more than would abandoning the effort” (Bark, 1978, p. 155).

This view has found resonance not only among economists,’ but has also pene- trated the antitrust bar and the courts. Its dominance was assured when the Supreme Court, in a series of landmark antitrust decisions, held that predation is so irra- tional and so fraught with uncertainty and perils that a rational profit-maximizing

r See John S, McGee (1958) ‘Predatory price cutting: The Standard Oil (NJ) case, Journal of Law & Economics, October, p. 137; Lester Telser (1977) ‘Cutthroat competition and the long purse’, Journal of Law and Economics, p. 259; Richard A. Posner (1979) ‘The Chicago school of antitrust analysis’, University of pennsylvania Law Review p. 927; Frank H. Easterbrook (1981) ‘Predatory strategies and counterstrategies’, CJniversi@ of Chicago Law Review pp. 268-269; ‘FTC transition report’, reprinted in Congressional Record, 2 1 September 198 1, pp. 2 1,350; Gary S. Becker ( 1987) ‘Antitrust’s only proper quarry: collusion’, Business &ek 12 October, p. 22; W. Kip Viscusi, John M. Vernon, and Joseph B. Harrington (1992) Economics of Regulation and Antitrust. Lexington MA: D.C. Heath, p. 286; Alvin K. Klevorick (1993) ‘The current state of the law and economics of predatory pricing’, American Economic Review, May, p. 162; David L. Kaserman and John W. Mayo (1995) Government and Business: The Economics of Antitrust and Regulation, New York Dryden Press, p. 13 I. For a lucid and usually persuasive articulation of the “recoupment” standard in predation cases, see Elzinga and Mills (1994) ‘Trumping the Areeda-Turner test: the recoupment standard in Brooke Group’, Antitrust Law Journal, p. 559.

754 W. ADAh4.3 ET AL.

firm would rarely, if ever, resort to its use. In Matsushita (1986), for example, the Supreme Court categorically declared that “the success of such schemes is inherently uncertain”, and that “there is a consensus among commentators that predatory pricing schemes are rarely tried, and even more rarely successful” (Mat- sushita, p. 589). In the instant case, therefore, the Court concluded that the predation claim “is one that simply makes no economic sense”. In Cargill (1986), the Court re-asserted that “the obstacles to the successful execution of a strategy of pre- dation are manifold, and that the disincentives to engage in such a strategy are accordingly numerous” (Cargill, p. 121, note 17). Most recently, in Brown and Williamson (1993), the Court re-emphasized its faith in the “general implausibility of predatory pricing”2 (Sup. Ct., p. 2590). While the Court conceded that there was overwhelming evidence of predatory intent, sustained below-cost pricing, reg- ular post-predation price increases, and supra-competitive profits, it nevertheless chose to view that evidence through the “economic implausibility” lens of the New Learning, and therefore ruled in favor of the alleged predator.

But is predatory pricing really so irrational as to render it virtually nonexistent? Is it so unprofitable as to render it a concept of practical irrelevance and a fiction of uninformed fantasy? Should the courts, therefore, categorically dismiss predatory pricing claims brought under the antitrust laws? As the following theoretical model and its application to the facts of a recent landmark case strongly suggest, the answer to these questions is clearly “no”.

I. A Theoretical Model

The validity of the assertion that predation is highly improbable depends on assump- tions regarding the values of key variables within a profit relation. To see this, it is useful to construct a simple, but illuminating, model of predatory behavior. We shall assume the incumbent firm’s horizon extends from time to, at which time the potential prey enters the market (or a submarket), to time 82, the end of the incumbent’s planning horizon. We shall also assume that the incumbent firm pres- elects time ir between tc and i2 to decide on the success or failure of its predatory campaign.

Two separate scenarios are theoretically conceivable. First, if the incumbent firm does not engage in predation to eliminate or discipline a rival, the value of its profits will be @, from ic to tr and Hc from tr to t2 where both profit levels are future values evaluated at time t2 .

’ For an analysis of the impact of these decisions on the judiciary generally, see Susan S. DeSanti and William E. Kovacic (1991) ‘Matsushita: its construction and application by the lower courts’, Antitrust Law Journal, p. 609.

IS PRBDATION RATIONAL? IS IT PROFITABLE? 755

In the second scenario, there are two possibilities. Either the incumbent firm’s predation strategy is successful or not. If, with subjective probability, P, of success at the outset of the campaign, the incumbent is successful, it will earn profit HP, which includes the costs of predatory pricing, from to to ii and profits Ha (greater than H,-) with the success of its predation at time ti, again, both evaluated at future time t2. Alternatively, if the incumbent is unsuccessful, i.e., if it fails to eliminate or discipline the targeted competitor, it will still earn profit level HP from

4 K? I- I- I to t1 t2

to to tl but will only earn Hc from tl to t2 with both again projected to time t2 as are all of the profit levels.

The short-run profit maximizing Grm is assumed to maximize the utility of final wealth at time t2 the end of its planning horizon. In the absence of information regarding the extent of risk aversion, we shall initially examine the behavior of a risk-neutral firm. The extension of our results to a risk-averse firm is, as we shall indicate, quite straight-forward. In order for the risk-neutral firm to reject a predation strategy, as the New Learning asserts, the level of final wealth at time t2

when the firm chooses not to be a predator must be greater than the expected level of final wealth at time t2 when the firm does engage in predation behavior. This condition, in symbols, is:

since the subjective probabilities of predation success and failure are P and (1 - P) respectively. Relation (1) can be simplified to:

I’ < (&, - Hp)/@L -I&). 69

Thus, the New Learning’s claim that a risk-neutral firm will reject predatory pricing is valid only if the perceived probability of success from a predation campaign is sufficiently small. It must be less than the ratio of two numbers: The first is the cost of predatory pricing (relative to the lower profit level as a result of emerging competition); the second is the reward from successful predation (relative to the profit level that would have otherwise prevailed in the face of competition). If the perceived probability of success is less than the ratio of these two values, predation will be viewed as unprofitable and will not be undertaken. The New Learning analysis will be correct if &, - HP, the loss incurred from predatory pricing, is sufficiently large relative to Hs - Hc, the extra supra-competitive profits earned after successful predation, so that the probability of success will not be high enough to justify predation.

The other side of the coin, however, is that the short-run profit maximizing firm may engage in predation if these profit levels do not take on the indicated levels.

756 W. ADAMS ET AL.

If the perceived probability of success is sufficiently high relative to the above payoff ratio, the risk-neutral firm wiZ1 undertake predatory pricing. Furthermore the expected gain may be so large as to compensate the firm as well for any extra perceived risk so that even a risk-averse fum will choose predation as a rational, profit-maximizing strategy.

In order to decide which of the foregoing scenarios is relevant in a concrete situation, we obviously need empirical evidence. We need to know the quantitative dimension of each factor in our equations. Theory alone is not enough.

II. A Test Case

The facts in the recent B&W case - both in the opinion of the District Court (748 F. Supp. 344) and the Supreme Court (113 S. Ct. 2578) -were not in dispute. By 1980, the overall demand for cigarettes in the U.S. was declining and there was no prospect of immediate recovery. Liggett, once a major factor in the industry, with market shares in excess of 20%, found that its market share in 1980 was slightly above 2Oh. With that meager market share, the company was on the verge of going out of business.

At the urging of a distributor, Liggett took an innovative step to revive its prospects: It created an entirely new market segment by introducing a line of unbranded, generic cigarettes packaged in plain black-and-white wrappers. It offered these generics at a list price roughly 30% lower than the list price of full-priced, branded cigarettes. Liggett’s innovation was an unqualified success. By mid-1984, generic sales accounted for 4.1% of the total U.S. cigarette business, with Liggett holding 97% of the generic segment of the market.

It was at this point that B&W announced that it would start selling look-alike black-and-white generics, positioned to compete directly with Liggett’s generics. B&W captured wholesaler loyalty through significant volume rebates which put the price of black-and-white generics to wholesalers well below B&W’s variable cost (District Court, p. 354). Moreover, B&W encouraged the wholesalers to pocket these rebates instead of passing the savings on to consumers, in order to prevent any new demand for black-and-white generics from eroding the demand for its (and its fellow oligopolists’) full-priced branded cigarettes.

That the intent of B&W’s strategy was clearly predatory is evidenced in numer- ous documents written by top B&W executives. The District Court said, “These documents, indicating B&W’s anticompetitive intent, are more voluminous and detailed than any other reported case. This evidence not only indicates B&W want- ed to injure Liggett, it also details an extensive plan to slow the growth of the generic cigarette segment” (District Court, p. 354).

B&W’s strategy succeeded in relatively short order. After a feverish price war, during which B&W and Liggett furiously raised and reraised their rebate offers to distributors, an outmatched Liggett surrendered. It raised its list price on generics, and consequently it suffered a reduction in its share of the generic market from

IS PREDATION RATIONAL? IS IT PROFITABLE? 757

89% in 1983 to 14% in 1985, and from a 6% share of all cigarette sales in 1984 to 2.8% in 1988, and to 1% by 1994.

The Supreme Court was not unmindful of these facts. Indeed, as the majority opinion noted, “By the summer of 1986, a pattern of twice yearly increases [in generic prices] in tandem with the full-priced branded cigarettes was established. The dollar amount of these increases was the same for generic and full-priced cigarettes, which resulted in a greater percentage price increase in the less expensive generic cigarettes and narrowing of the percentage gap between the list price of branded and black and white cigarettes . . . ” (Sup. Ct., p. 2585). From January 1986 to June 1989, the oligopoly raised generic cigarette prices by 7 1% - nearly twice the rate at which it increased its branded cigarette prices over the same period. In fact, by 1990 the oligopoly had succeeded in raising generic prices to a level higher than that at which its full-priced brands had been sold just six years earlier.

When the Supreme Court decided the B&W case, it chose to ignore the sub- stance of the evidentiary record and instead to rest its opinion “upon the general implausibility of predatory pricing”. 3 Yet an application of our model to the evi- dence in the case strongly suggests the opposite to be true. Using relation (2) above and making the appropriate substitutions on the basis of the mcontroverted facts of the case,4 the following results are obtained: The estimated loss fiom predatory pricing is $32 million over the year and one-half time period anticipated to be suf- ficiently long for success (tit is one and one-half years, and undiscounted H,, - HP is $32,000,000). The estimated loss from entry, however, is $400 million over a five year period (i2 is five years, and undiscounted Hs - Hc is $280,000,000 or $80 million per year for three and one-half years). The plarming horizon is five years while the interval of predatory pricing is projected to be one and one-half years. Even accounting for discount factors and a reasonable risk premium, with the above quantities, it would not require a high value of the probability of success for the short-run profit maximizing firm to consider it “rational” and “profitable” to engage in predation. For example, if we assume a 10% interest rate, using rela- tion (2) we obtain the perceived probability of success need only be 15/100 for a risk-neutral B&W to view predation as optimal (future values 46.16 over 3 18.04).

Put differently, under these circumstances, B&W could have afforded to launch seven predation campaigns with the expectation of succeeding in only one out of seven times, and nevertheless coming out ahead. Its cost/reward ratio for predation was so low that, at the end of those seven campaigns, B&W would have ended up with a higher level of accumulated profits than if it had not engaged in predation at all. The New Learning also tells us that because the losses from predatory pricing are up-front while the potential benefits arrive later, predation will be unprofitable when the appropriate discount factor is used. Yet, in B&W, the loss/reward payoff ratio is fairly insensitive to the choice of discount factor. For example, if a 20%

For an articulate defense of this decision, see Elzinga and Mills, pp. 559ff. ’ The following numbers are taken from Brown & Williamson’s own documents. They appear in

the trial record as PX#291 and PX#l2.

758 W ADAMS ET AL.

discount factor is used instead of the 10% illustrated above, the payoff ratio only changes from 15/100 to lS/lOO (future values 64.53 over 360.32), The ratio would still be low enough to make predation an attractive policy option for an incumbent besieged by new competition.

In sum, the New Learning seriously underestimates the rationality, profitabil- ity, and likelihood of predation for at least three important reasons: First, it fails to consider that predatory pricing can be employed to protect dreua’y existing supra-competitive profits. The potential benefit of successful predation is substan- tial, because the incumbent firm can thereby prevent or reduce profit erosion from emerging competition. Second, the New Learning overestimates the losses associ- ated with predatory pricing, because it fails to consider that the predator may be able to damage the prey in the latter’s dominant product market without necessarily incurring losses in all of its own product and/or geographical markets. By narrowly targeting price cuts to specific product lines, as was the case in B&W, the predator can limit its cost without substantially reducing its chances of success. Third, the New Learning exaggerates the importance of the time elapsed between the costs of predation and its rewards. While it is obviously true that the costs of predation precede the anticipated reward, the B&W case illustrates a situation where the returns to predation are so large as to swamp the effect of the discount factor.

References Bork, Robert A. (1978) The Antitrust Purudox, New York Basic Books. Brooke Group v. Brown & Williamson Tobacco Corporation, 748 F. Supp. 344 (M.D.N.C. 1990),

cited in the text as (Dist. Ct.). Brooke Group v. Brown & Williamson Tobacco Corporation, 113 S. Ct. 2577 (1993), cited in text as

(Sup. ct.). Cargill Inc. v. Monfort of Colorado, Inc., 479 U.S. 104 (1986). Elzinga, Kenneth G. and Mills, David E. (1994) ‘Trumping the Areeda-Turner Test: The Recoupment

Standard in Brooke Group’, Antitrust Law Journal 63, W-584. Matsushita Electric Industrial Co. v. Zenith Radio Corp., 475 U.S. 574 (1986).