You might have heard about price cutting before. Maybe it was under a different name, but if you’ve lived on this earth for a good amount of time, you know what I’m talking about.
Predatory Price Cutting is a rather logical sounding economic theory. A company can kick out competition by dramatically cutting prices on their goods thereby forcing their competitors to either cut prices or keep their rates. The argument is, that the competitors would either go bankrupt (if they matched prices with the price cutter), or lose a large portion of their business (by refusing to lower prices).
For example: imagine that Nike wants to setup a monopoly in the athletic shoe industry. To kick out their competition, Nike begins to lower their prices dramatically.
Nike is a big company, but their competitors are much smaller, which means Nike can survive such low prices. Their competitors on the other hand cannot (lowering their prices would put them out of business). As a result, consumers flock to Nike for the low prices, putting the competition out of business.
Now that the competition is gone, Nike has the entire athletic shoe industry to itself. A monopoly is effectively created, and Nike can now jack up prices on its products (to make up for lost profits).
At first glance, this makes sense. Of course companies would use this tactic to kick out competition and potentially create a monopoly. Smaller competitors wouldn’t be able to meet the prices of the price cutter without suffering huge losses. The price cutter (i.e. the big company) can get away with it (for a time) because of the “extra funds” they have. They can soak up the losses easier than a small business can.
However, this is not the case. In fact, predatory pricing is so irrational that it’s extremely rare to see companies participate in it (think of unicorns rare). It’s even rarer to see a company use this tactic to push out competition to create a monopoly. Here’s why…
- Such methods are extremely costly for the predator company (usually a large company). If a company is lowering the price of their goods below the average cost, they’re losing profits. The largest company always loses the most profit, compared to small companies. “Losing a dollar on each of 1,000 widgets sold per month is more costly than losing a dollar on each of 100 widgets.”
- Uncertainty on how long the “price war” will last. If a company is using predatory price cutting to drive out competition with the goal of creating a monopoly they have no idea how long the competition will hold out. It could be six months, two years, or a decade (all the while they’re losing profits). This uncertainty makes predatory price cutting extremely dangerous for companies.
- Nothing is stopping the competition from closing down for a limited period to weather the storm. Also, if a competitor goes bankrupt, other companies can buy their facilities and continue the competition. There’s also the fact that competition is guaranteed wherever a company is charging monopolistic prices and abusing their consumers.
- “There is the danger that the price war will spread to surrounding markets and cause the alleged predator to incur losses in those markets as well.”
- Predatory price cutting relies on the predator company having a sufficient amount of funds to weather through their below average prices. Where do these funds come from? If the company isn’t already a monopoly how can it successfully survive its own price cutting?
- The rate of return needs to be higher than expected profits after rivals are removed. Such uncertainty on whether the benefit will be high enough makes it unlikely that companies will take such predatory action. You need to be sure your profits in the future monopoly over compensate for your low profits in the present.
- Smaller companies (the victims of predatory price cutting) can institute predatory counterstrategies, such as allying with the consumer, loans, etc.
- Consumers can take precautionary measures to defend themselves against predatory price cutting. They can stock up on goods (while the price is low), buy from the victim companies (so as to keep the predator from gaining control), and create their own competition if the predator limits supply (or raises prices).
- Even if the predator succeeds in pushing out all the competition it’s still not guaranteed a monopoly. Competition is always present, especially if they try to abuse their monopoly by charging ridiculous prices.
This is why the Standard Oil Company (run by John D. Rockefeller) most likely didn’t use predatory price cutting to squash its competitors out of the market. It was too risky!
Judging from the record, Standard Oil did not use predatory price discrimination to drive out competing refiners, nor did its pricing practice have that effect. Whereas there may be a very few cases in which retail kerosene peddlers or dealers went out of business after or during price cutting, there is no real proof that Standard’s pricing policies were responsible.
…Standard did not systematically, if ever, use local price cutting in retailing, or anywhere else, to reduce competition. To do so would have been foolish; and, whatever else has been said about them, the old Standard organization was seldom criticized for making less money when it could readily have made more. [emphasis added] (source)
Standard Oil did use price cutting, but only to create more profits, not knock out competitors. Like I said before, using price cutting to create a monopoly would be extremely risky.
There’s also the little known fact that during Standard Oil’s apex, prices on oil actually fell. That’s because there was never a competition-free environment with which to jack up prices. Standard Oil never got a total monopoly, nor did they make monopoly-like business decisions like driving up prices or limiting supply.
What’s funny is that this whole myth surrounding Standard Oil’s monopolizing came from a less then innocent source.
Ida Tarbell was one of the first journalists to popularize the myth of predatory price cutting. Why you ask? Well, it just so happened to be that her brother’s employer, Pure Oil Company, was driven out of the market by Standard Oil. Oh, how convenient.
The fact is that competition is continually being driven out of the market. If you can’t provide the most value for the consumer then you deserve to be knocked out of the game. Pure Oil Company obviously couldn’t compete with Standard Oil’s low prices. It’s not unfair, it’s how the market works.
Competition is like your body’s blood production cycle. New blood is continually being made to replace old blood cells. It’s the same with market competition. The old is always leaving, making room for the new.
It’s an always evolving environment.
Predatory price cutting is rarely as negative as it seems. In most cases, it’s beneficial to the consumer. Any company that can’t compete doesn’t deserve a place in the market. Competition drives out the old blood and brings in reinvigorated new blood. Price cutting is a natural facet of that.
So in the end, Rockefeller’s Standard Oil monopoly was barely that. Competition still existed, and in fact, oil prices steadily fell, while quality rose.
It’s amazing the myths you disprove when you actually take the time to evaluate the Free Market. At first thought, monopolies and price cutting might sound bad, but they’re rarely all they’re trumped up to be.