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"Big Business will Dominate the free market"?

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Matthew posted on Wed, Apr 20 2011 10:32 AM

Okay, I'm having a discussion with a socialist/statist about the free market, monopoly, and anti-trust laws (repeal them!). I'm getting to the point where my austro-libertarian knowledge is incomplete. He says:

It is a major financial commitment for a startup to stock and staff a store. As soon as they do, bang! Down the prices go down the street!
Is it "peaceful" to attack competitors with your superior economic strength?
If you think it is, then you must agree with my contention that free markets will always end up with a very few dominant players is correct, because that is the inevitable result.
Do you think that the best interests of society are served when a dominant business can dictate prices and drive out competitors?

How do I respond to this?

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Matthew:
How do I respond to this?

He's talking about "predatory pricing."  It's true he has no understanding of business, entrepreneurship or economics.  Send him a copy of the rest of this post:

 

People will say things like "once they've got a foothold in a community, what's to stop them from raising their prices, too? Absolutely nothing."

That's why this old and popular myth of economics is known as "predatory pricing." Sounds scary right? You know this one. It's basically the idea that a big firm that can afford to sell products at a loss for a while (i.e. for less than they paid for them) will drop their prices so low that smaller firms will be driven out of business. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while it was engaged in predatory pricing, and earns monopoly profits forever after.

Sounds logical right? The problem with this is, it doesn't work economically...and (therefore as you would expect) there are virtually no examples of this occurring. There has never been a single clear-cut example of a monopoly created by so-called predatory pricing, let alone one in which prices were raised drastically and customers were "gouged." Claims of predatory pricing are typically made by competitors who are either unwilling or unable to cut their own prices. And as I stated, this is not just a situation in which we have no examples...it economically doesn't work...and has been shown for decades to not work.

Here's a short video that tells a really great story of when a big firm tried predatory pricing against a very smart fellow whose name you've probably heard of.

 


For anyone interested in the actual economics of the theory, I've provided several resources below, some of which actually contain references to dozens more. But for the Cliff's Notes kids, I'll just offer some highlights just for those interested (my comments are in italics in the brackets):
 

Quote:
Predatory pricing is the Rodney Dangerfield of economic theory--it gets virtually no respect from economists. But it is still a popular legal and political theory for several reasons. First, huge sums of money are involved in predatory pricing litigation, which guarantees that the antitrust bar will always be fond of the theory of predatory pricing. [...]

Second, because it seems plausible at first, the idea of predatory pricing lends itself to political demagoguery, especially when combined with xenophobia. The specter of a foreign conspiracy to take over American industries one by one is extremely popular in folk myth. Protectionist members of Congress frequently invoke that myth in attempts to protect businesses in their districts from foreign competition.

Third, ideological anti-business pressure groups, such as Citizen Action, a self-styled consumer group, also employ the predatory pricing tale in their efforts to discredit capitalism and promote greater governmental control of industry. Citizen Action perennially attacks the oil industry for either raising or cutting prices. When oil and gas prices go up, Citizen Action holds a press conference to denounce alleged price gouging. When prices go down, it can be relied on to issue a "study" claiming that the price reductions are part of a grand conspiracy to rid the market of all competitors. And when prices remain constant, pricefixing conspiracies are frequently alleged.

Fourth, predatory pricing is a convenient weapon for businesses that do not want to match their competitors' price cutting. Filing an antitrust lawsuit is a common alternative to competing by cutting prices or improving product quality, or both.

Finally, some economists still embrace the theory of predatory pricing. But their support for the notion is based entirely on highly stylized "models," not on actual experience.1

["In other words, predatory pricing theory persists because well-placed
individuals and organizations that benefit from accusing others of engaging
in predatory pricing will use their resources to keep the theory alive."2]

Quote:
The theory of predatory pricing can be likened to that strange gift from Aunt Maude or a unicorn. [...]

There is another problem with predatory pricing, however, that is just as pressing as the “unicorn” problem. Economists generally attempt to explain firm behavior by using standard neoclassical instruments. As this article demonstrates, however, the neoclassical theory of the firm, as expressed by the use of the standard neo-Marshallian tools depicting imperfect competition, does not grant users the intellectual apparatus by which to conclude that firms, given the assumptions of profit-maximizing behavior, would engage in an activity like predatory pricing. [...] [E]ven some of the theory’s supporters uneasily accede to its unicorn-like characteristics, as I point out later.2

[in other words, not only can no one point to a single example of predatory pricing occurring, but the economic models that even supporters of the predatory pricing theory use to try to show it could happen, don't work the way they should...They contradict...and this has led even the supporters to have to admit their theory basically has no economic basis.]

[...]Shughart writes that if one examines the actions and risks firms must undertake in order to engage in illegal predation, it “does not pay” (1990, p. 296). McGee (1958) writes that predatory pricing cannot be thought of as a rational business strategy because the “predatory” firm in the end is likely to suffer greater losses than its rivals.

Other economists, including Stigler (1967) and Telser (1966) have attacked such a strategy because it conflicts with the assumption of rational behavior by firm owners. Isaac and Smith (1985) examined a number of predatory pricing cases and concluded that they were unable to ascertain whether or not the firms accused actually had engaged in such practices.2

Quote:
First, it should not at all be taken for granted that the large, rich firm is even in a position to impose a price reduction below the small firm's costs. At the lower price it asks, there will be an increase in the quantity of the good demanded. The large firm can make the lower price effective only if it is in a position to supply this additional quantity demanded. Whether or not it can do so depends on how elastic the demand for the product is in response to the price reduction[...]and also on how much unused productive capacity the firm has on hand and that is available for the particular market concerned. If its capacity is insufficient to meet the larger quantity demanded, it has no means of compelling its small competitor to sell at the lower price it asks. For in this case, customers who come to it in order to obtain the lower price must be turned away. They will have to deal with the smaller firm.[...]

A further, much greater difficulty arises. If it is the case that as soon as the small competitor is driven out, the large firm can sharply increase its price, while so long as the small competitor remains in business the price is held below the level of his costs, then usually unrecognized but nonetheless extremely powerful interests are created on behalf of the continued existence of the small competitor.

[...]A less obvious interest in the continued existence of the small competitor is that of the industry's suppliers and that of the producers of products that are complementary to the industry's products.3


[in other words, as long as the smaller competitor is around, everyone gets to enjoy the extremely low prices of the predatory firm...so there is a lot of interest in keeping that competitor around...namely, not just by the competitor himself, but by the suppliers and complementary producers of the industry. They would all be very interested in keeping the smaller firm around...not only to enjoy the lower prices of the predatory firm, but to avoid any higher prices the firm might try to charge in the future.]

And he actually goes on and on. Another big one is the concept of brand reputation. If every time a new competitor pops up, you drop your prices to compete, and then the competitor disappears, and you jack up your prices, how long will it take before people just won't shop at your store? There is a lot to be said for reputation and brand loyalty. If the choice is between a new place that is giving good service and reasonable prices that stay reasonable, people will choose that over a quixotic price changer pretty darn quick.

If you're interested in more reasons why it never works, I highly recommend following the links to sources #1 and #3. Reisman goes into great detail, but provides very simple, easy to understand examples.



1 - DiLorenzo, Thomas J. 1992. “The Myth of Predatory Pricing,” Policy Analysis No. 169. Cato Institute; http://mx.nthu.edu.tw/~cshwang/teach...03-06-monopoly and profit/DiLorenzo=THE MYTH OF PREDATORY PRICING.pdf

2 - Anderson, William L. 2003. "Pounding Square Pegs into Round Holes: Another Look at the Neo-Classical Theory of Predatory Pricing." The Quarterly Journal of Austrian Economics, Vol. 6, Spring; http://mises.org/journals/qjae/pdf/qjae6_1_2.pdf

3 - Reisman, George. 1998. Capitalism: A Treatise on Economics. Ottawa, IL: Jameson Books. pp. 399-407; http://www.capitalism.net/Capitalism...M_Internet.pdf

4 - http://mises.org/daily/226

5 - Isaac, R. Mark, and Vernon L. Smith. 1985. “In Search of Predatory Pricing.” Journal of Political Economy 93: 320–45.

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Here's the tl;dr version - the notion of "predatory pricing" is one great big appeal to fear.

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JonnyD replied on Thu, Apr 21 2011 8:41 PM

I'll copy and paste my response to a socialist about predatory pricing aswell if it helps. It's just a concatenation of all the posts I've read on here.


The people who make these arguments imagine a static pool of competitors. If there are 3 grocery stores in a given area, and Company P (Predator), drives out their two competitors, companies A and B... Then begins to charge "predatory pricing", either companies from other areas/countries can move in, or even companies from completely different fields.

If company P lowers prices below cost and can outlast company B and cause company B to go out of business, company P will have to charge super-normal prices to recoup the losses from the "predatory pricing" strategy. But when company B goes out of business the factory and personel with expertise don't simply fade into the dust, they can be purchased and could easily compete with company P if it is charging prices that are too high.

Also the whole story of predatory pricing leaves out potential competitors and only takes into account current competitors. If I knew that company P was going to raise prices after company B went out of business I would open company C and would easily be able to out compete company P, because they will have to charge very high prices because of all the money they lost putting company B out of business. Even the THREAT of an outside competitor entering the market is enough to keep the price lower.

Companies A and B can buy as much inventory as they can from Company P (since they are selling below cost), and then sell it for slightly higher. Each product A and B buys drives Company P more into the red. It is again, unsustainable.

If one company decides to undercut another with predatory pricing, the other company can just wait it out and tell its investors what's happening. The company that does the undercutting is hurting its own profits more than the competitor's, after all, the undercutter is attracting demand to a product its losing money on, while the competition keeps prices at profitable levels. At most, the undercutter can hope for a short-run increase in market share which will disappear as soon as the undercutter raises prices back to normal levels.

There is nothing wrong with predatory pricing anyway. If a compnay is selling its product below production cost, then the consumer gains by getting something for free. If it made its prices real high after destroying the competition, new competitors would enter the market again to get a piece of the profitable market. And the company would have to lower prices again below cost of production.. and again the consumer would benifit. You see, it just does not make business sense to make a loss selling below producton cost just to be able to make profit later.. because the company would always be atacked by new competitors undercutting its high prices, there would always be another company that had to be starved to death.. and in the meantime consumers would be getting stuff for free. Noone ever got rich giving stuff away for free.. and if some company is giving away something for free.. we as consumers should be thankful that this company is so foolish. Unless you use the government to make your competition illegal
$10 drug now $1500 after FDA grants monopoly http://www.boingboing.net/2011/03/14/10-drug-becomes-1500.html
 
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Jack Roberts:
So not necessarily "big business" but just improved production, distribution and logistics, this can cause a reduction in cost without any loss in quality. For the consumer cheaper prices and better products is a good thing, but it does happen in today’s society and people do lose their businesses.

Is there some society you know of where businesses don't go out of business?

 

EmperorNero:
here comes my question, competitors know that once they compete with him there will be a price war and not a lot of profit to be had, won't that act as a barrier to entry?

It sounds like you're saying that once one company starts selling a good or service—"first mover advantage" is not a business term for no reason—and they therefore have a "natural edge" over any competition that might arise, no other firm would wish to compete with them because there would be a "price war."  Do you have any evidence for this?  Because reality would seem to disagree with you.

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Joe replied on Tue, Apr 26 2011 7:36 PM

also, just as there are economies of scale, there are also diseconomies of scale, which put natural limits on firm size. Natural limits which can only be overcome with the help of the state.  Big firms also run into the same knowledge problem that plagues central planners.  If its too vertical, the firm will be too slow to react to changes in the market.

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