Why Above-Cost Price Cuts to Drive Out Entrants Do Not Signal Predation or Even Market Power - And the Implications for Defining Costs

Abstract:     
Recently, European and U.S. officials have made surprising moves toward restricting firms from using above-cost price cuts to drive out entrants. This Article argues that these legal developments likely reflect the fact that scholarly critiques of cost-based tests of predatory pricing have never been satisfactorily addressed, and offers a better explanation about why restrictions on reactive above-cost price cuts are likely to be undesirable. It begins concluding that "costs" should be defined functionally as whichever cost measure assures that prices above costs cannot deter or drive out equally efficient rivals, and shows how applying that functional benchmark resolves numerous apparent anomalies in current predatory pricing law. It then shows that reactive above-cost price cuts do not necessarily indicate an undesirable protection of market power, but rather can be an efficient response to deviations from the output-maximizing price discrimination schedule in competitive markets, particularly in the airline industry that has been the greatest cause of concern. Even when an incumbent does have market power, restrictions on reactive above-cost price cuts have mainly undesirable effects. They fail to encourage entry but do raise post-entry prices in the bulk of cases, where the entrants are or will predictably become as efficient as the incumbent, or would have entered anyway despite relative inefficiency. They can only weakly encourage less efficient entry since the restrictions cannot protect less efficient entrants in the long run, and even in such cases they have mixed effects on post-entry prices since they give incumbents perverse incentives to raise post-entry prices to speed the day when the restriction expires. In all cases, they impose wasteful transition costs and losses in productive efficiency, and they lessen incentives to create more efficient incumbents and entrants. These adverse effects are worsened by implementation difficulties that cannot be avoided no matter how the rules are defined, including that possible definitions of the moment of entry or exit either make the restrictions ineffectual or make their adverse effects last far longer than any benefits from entry, that they will inefficiently increase or decrease innovation rates, and that any price floor or output ceiling will cause inefficiencies because of either great uncertainty or inflexibility in the fact of changing market conditions.

Note: An earlier version of this abstract was published under the title "A Better Explanation for Why Pricing Above Cost Should Not Be Predatory - and the Implications for How to Define Costs."

JEL Classifications: K00, K21, L00, L10, L12, L40, L41

Accepted Paper Series