REPORT
ON
PREDATORY PRICING :
A STRATEGIC ANALYSIS
Under the guidance of
MR. Vijay Kumar Singh
Deputy Director (Law)
Competition Commission of India
SUBMITTED BY:
Charu Rawat (Intern : January
January 2011)
M.A (Economics)
(Economics)
Jawaharlal Nehru University
ACKNOWLEDGE
ACKNOWLEDGEMENT
GEMENT
This paper would not have been possible without the support of my guide
Mr. Vijay Kumar Singh who has given me his precious time, valuable
experience and patience, guiding me throughout my research. It has been a
wonderful opportunity to work under his guidance.
I would also like to thank Mr. Sanjay Kumar Pandey (Joint director , Law)
for providing his valuable ideas for my project report.
Im thankful to Mr G. Sreeniwas, Librarian, Competition Commission of
India, for helping me in collecting the relevant material for my project
report.
To all my friends at CCI, for making my first internship a fun and
memorable experience. To my best friend Amit for giving me his support
and love.
Last but not the least to all the staff at CCI who has extended their help.
I would also like to express my gratitude to my parents who have given me
their unconditional love and for making me who I am today.
1
DISCLAIMER
This project report has been prepared by the author as an intern under the
Internship Program of the Competition Commission of India for academic
purposes only.
The views expressed in the report are personal to the intern and do not
reflect the views of the Commission or any of its staff or personnel and do
not bind the Commission in any manner. This report is the intellectual
property of the Competition Commission of India and the same or any part
thereof may not be used in any manner whatsoever, without express
permission of the Competition Commission of India in writing.
2
TABLE OF CONTENTS
SUMMARY ........................................................................................................................ 4
1. INTRODUCTION .......................................................................................................... 5
2. PREDATORY PRICING UNDER INDIAN COMPETITION LAW ........................... 6
3. ECONOMIC THEORY OF PREDATORY PRICING ................................................ 10
4. PORTER’S FIVE FORCES FRAMEWORK............................................................... 15
5. FACTORS DETERMINING PREDATORY PRICING .............................................. 18
1) DOMINANCE: ......................................................................................................... 18
2) BARRIERS TO ENTRY AND RE-ENTRY: .......................................................... 19
3) EXCESS CAPACITY: ............................................................................................. 19
4) NON-PRICE PREDATION ..................................................................................... 20
5) OTHERS................................................................................................................... 20
6. VARIOUS COST TESTS FOR PREDATORY PRICING .......................................... 21
DEFINITIONS OF VARIOUS COSTS UNDER INDIAN COMPETITION LAW ... 21
THE AREEDA TURNER TEST .................................................................................. 22
PRICING BELOW AVERAGE TOTAL COST .......................................................... 24
SOME LEGITIMATE COMMERCIAL REASONS FOR PRICING BELOW AVC
ARE............................................................................................................................... 24
PRICING BELOW AVERAGE AVOIDABLE COST ................................................ 25
PRICING BELOW LONG RUN AVERAGE INCREMENTAL COST ..................... 26
THE OUTPUT RESTRICTION RULE........................................................................ 26
TWO-STAGE PREDATION TEST ............................................................................. 27
THE RECOUPMENT TEST ........................................................................................ 27
THE PREDATORY INTENT TEST ............................................................................ 28
ABOVE COST PREDATORY PRICING.................................................................... 28
7. COST MEASURES ADOPTED IN INDIAN COMPETITION LAW........................ 29
8. PREDATORY PRICING CASES ................................................................................ 29
AKZO v COMMISSION [1991] ................................................................................. 29
TETRA PAK INTERNATIONAL SA v COMMISSION............................................ 30
DEUTSCH POST AG [2001] ....................................................................................... 30
BROOKE GROUP LTD. v. BROWN & WILLIAMSON TOBACCO CORP ........... 30
MATSUSHITA V. ZENITH RADIO CORP. .............................................................. 31
9. CONCLUSION ............................................................................................................. 31
10. REFERENCES ........................................................................................................... 33
3
SUMMARY
Predatory pricing is an anti – competitive practice by a firm which aims at monopolizing
the market and to drive out the other competitors. It is done by charging prices less than
the costs that a firm incurred in its production process. It restricts competition in the
market and is considered illegal under anti-trust laws of many countries. The predatory
firm after driving other competitors from the market raises their price above the
competitive levels to earn supra-competitive profits and recoup the losses incurred during
the predatory period. This anti-competitive practice undermines the competition in the
market and is not in the interest of the consumers.
Since the main problem of the competition authorities is to differentiate between fair
price competition and predatory pricing, it is very important to develop appropriate
frameworks so that this problem can be detected without any errors. Predatory pricing is
also a very debatable issue because there are many factors to be determined before
judging any pricing strategy to be predatory and its rationality has been questioned many
times. Many economic theories has been proposed to explain this phenomenon and many
cost and non-cost based tests has been applied in various predatory pricing cases by the
authorities. The strategic theory of predatory pricing is able to explain that under what
circumstances predatory pricing might be credible. It is based on the assumptions of
asymmetric information or asymmetric access to financial resources.
The Indian Competition Law has been designed to curb such practices which are aim to
undermine fair competition in the markets. As fair competition is for the welfare of the
consumers any attempts by the firms to exploit their market power is scrutinized by the
competition authorities in India and firms are punished if found guilty of abusing their
market power.
4
1. INTRODUCTION
Predatory pricing refers to the situation where a dominant firm reduces its price to below
cost level for a period of time during which it will be able to eliminate or contain a
competitive force. 1Following that, and once the predatory firm deems it safe enough; it
will raise its price to a level above the competitive price level in order to recoup the
losses made during the reduction period.2 It is the dominant company in such a market
which is likely to have both the inclination and the resources to finance such strategy and
such pricing can be equally ‘unfair’ to competitors.3
Predatory pricing is in practice often difficult to distinguish from normal price
competition. The lowering of prices, the directly visible part of predation, is also an
essential element of competition. By lowering its price or improving the quality of its
product a company competes on the market. This competition that benefits consumers
and that a competition authority wants to defend and protect. Pricing is not predatory
merely because a company is lowering its price.4
The concern about predatory pricing is that firms might strategically cut prices to
unprofitable levels in the short term in order to eliminate or discipline rivals and then
raise long run prices to supra-competitive levels, inflicting a net long-term injury on
1
Maher M. Dabbah; EC and UK Competition Law:-Commentary, Cases and Materials, Cambridge
University Press,pp319.
2
3
Id. at pp 319.
Joanna Goyder and Albertina Albors –Llorens,Goyder’s EC Competition Law, Oxford UniversityPress,
pp319.
4
Doris Hildebrand, The role of economic Analysis in the EC Competition Rules, Kluwer Law
International,pp373-375
5
consumers.5the problem is that such harmful predatory pricing is often hard to distinguish
from desirable competitive price cutting, so that attempts to condemn the former may
mistakenly condemn and deter the latter.6
Rebates and similar practices are an essential component of the competitive process, and
that the law should not deter a dominant firm from passing on its efficiency to customers
in the form of lower prices. The law on predatory pricing has to tread a fine line between
not condemning competitive responses on the part of dominant firms on the one hand and
prohibiting unreasonable exclusionary conduct on the other.7
Pricing is also not predatory just because the lower price means incurring losses or
foregoing profits in the short run. An investment in temporarily lower prices may for
instance be required to enter a market or to make more customers familiar with the
product.8
2. PREDATORY PRICING UNDER INDIAN COMPETITION
LAW
The “predatory pricing” under the Act means “the sale of goods or provision of services,
at a price which is below the cost, as may be determined by regulations, of production of
goods or provision of services, with a view to reduce competition or eliminate the
5
Einer Elhauge and Damien Geradin,Competition Law and economics,, Hart Publishing, pp314
6
Einer Elhauge and Damien Geradin,pp314
7
Doris Hildebrand, The Role of Economic Analysis in the EC Competition Rules, Kluwer International
Volume 39, pp373-373
8
ibid
6
competitors”9. Predation is exploitative behavior and can be indulged in only by
enterprises(s) having dominant position in the concerned relevant market. The major
elements involved in the determination of predatory behavior are:
Establishment of dominant position of the enterprise in the relevant
market Pricing
below cost for the relevant product in the relevant market by the dominant enterprise
[‘Cost’, for this purpose, has been defined in the Competition Commission of India
(Determination of Cost of Production) Regulations, 2009 as notified by the Commission.]
Intention to reduce competition or eliminate competitors. This is traditionally known as
the predatory intent test
Pricing is not predatory just because a lower price means incurring losses or foregoing
profits in the short run. An investment in temporarily lower prices may be required to
enter a market or to make more customers familiar with the product.
Charging lower prices to all or certain customers means the predator is making a sacrifice
by deliberately incurring short run losses with the intention of eliminating or disciplining
rivals or preventing their market entry. The firm will make this sacrifice when there is a
possibility of recouping those losses. Although consumers may benefit from the lower
predatory prices in the short run but in the longer run they will be worse off due to
weakened competition resulting in higher prices, reduced quality and less choice.
2. THEORIES OF PREDATORY PRICING
TRADITIONAL THEORY
The traditional theory of predatory pricing envisions two stages in carrying out the
predation strategy—the predation stage and the post-predation stage.10 In the predation
9
[Explanation (b) of Section 4].
7
stage, the predator prices its product below some measure of economic cost—typically
incremental cost—with the intent of driving other firms from the market. In the post
predation stage, due to the absence of competition from other firms the predatory firm
prices its product at supra-competitive levels, thereby recovering the losses incurred
during the predation stage and earning monopoly profits thereafter.11
For many years there has been the consensus that the traditional predatory pricing is
irrational as firms will reenter the market once the predatory firm raises its prices to
supra-competitive levels. Hence the recoupment of predatory losses is almost impossible
unless there are some barriers to entry. For example traditional predation is particularly
difficult in regulated network industries due to the sunk costs. Also there are productive
capacities which keeps a check on the supra-competitive pricing by firms even if firms
exit the industry.12
MODERN THEORY
Over the past 25 years many modern, strategic theories of predation has emerged which
includes financial market predation, reputation models, cost signaling. These models
requires the condition of asymmetric information i.e. the predatory firm has access to
some information that other firms don’t have which it uses to drive the firms out or to
deter new entrants in the market.
1. FINANCIAL MARKET PREDATION
Under this the predator tries to manipulate the relationship between the prey and the
investors to drive the prey out of the market or to deter entry. Since the capital markets
are prone to imperfections like agency or moral hazard problems due to excessive risk
taking by the managers of the firms, shielding assets from creditors, diluting outside
equity, failing to exert sufficient effort, or otherwise fail to protect investors’ interests.
10
John S. McGee, “Predatory Pricing Revisited,” Journal of Law and Economics, Volume23, October 1980, pp. 296297
11
Dennis L. Weisman, NOTES ON PREDATORY PRICING,pp2-3
12
Dennis L. Weisman, “The Law and Economics of Price Floors in Regulated Industries, “ The Antitrust
Bulletin, Vol. XLVII(1), Spring 2002, p. 112.
8
Suppliers of capital can mitigate these agency problems by extending financing in staged
commitments, thereby imposing an explicit or implicit threat of termination in case of
poor performance.13 If the investors are debt-holders, they threaten to liquidate the firm or
deny new credit in the event of default. If they are venture capitalists they refuse to
extend additional financing when early performance is poor. And if they are shareholders,
they decline to purchase additional equity if expected returns are low due to
disappointing initial performance. Predatory pricing in product markets thus becomes
possible when a predator exploits these termination threats to dry up the financing of a
rival firm.14 The predator can reduce the prices so much that the profitability of the prey
reduces so much that the investors stop providing funds to the prey.
2. REPUTATION PREDATION
Other mechanism by which predatory pricing works is by establishing a reputation for
aggressive pricing. For example, if a competitor is uncertain of a dominant firm’s cost,
it knows, however, that firms with lower cost tend to price lower.15 Hence, if the
dominant firm prices low in response to entry, this may suggest that its cost is low, and
thus one can anticipate similar aggressive behavior in the future.16 Such beliefs are
profitable for the incumbent firm as it would induce exit-as new firm become convinced
that the incumbent firm is a low cost firm and thus it will charge a low price for the
products than the new entrant. Therefore, it will not enter the market.
3. COST SIGNALLING MODEL
Under this signaling strategy the predatory firm signals to its competitors that it is a low
cost firm. Rivals will not enter the market if they believe that the predatory firm is a low
cost firm. To signal that it is a low cost firm it charges a very low price for its products
13
Patrick Bolton,* Joseph F. Brodley** and Michael H. Riordan, PREDATORY PRICING:STRATEGIC THEORY
AND LEGAL POLICY, pp56
14
15
ibid
Malcom R. Burns, Predatory Pricing and the Acquisition Cost of Competitors, Journal of Political
Economy 94(April 1986), pp266-96
16
ibid
9
which is below the short run profit maximizing level. Hence others firms rationally
believes that the firm is a low cost firm and they do not enter the market or the existing
firm will exit the market since the expected returns has been reduced.
4. DEMAND SIGNALLING
Under this signaling strategy the predatory firm signals to its rival firm that the aggregate
demand in the market is too low to support the existence of the two firms. This will
induce the existing firms to exit the market or to deter future entry. But demand signaling
is generally implausible since there is unlikely that one firm only has the information
about the aggregate demand in the market or other firms could not get the information
from price or market share information.
5. TEST MARKET PREDATION
Under test market predation since the incumbent has better information than the potential
entrant about the market and it made the potential entrant believe that the situation is not
favorable for it to enter. Here the new entrant seeks to introduce a new product in a
particular market rather than entering in all the available market to judge the appropriate
response for its product. The predatory firm can charge a lower price for its product and
led the new entrant to believe that the demand is too low to justify entry into the market.
The entrant believes that to be true and exit the market or enters the market on a smaller
scale.17
3. ECONOMIC THEORY OF PREDATORY PRICING
Predatory pricing is defined in economic terms as a price reduction that is profitable only
because of the added market power the predator gains from eliminating, disciplining or
otherwise inhibiting the competitive conduct of a rival or potential rival. Stated more
17
Patrick Bolton,* Joseph F. Brodley** and Michael H. Riordan,pp94-96
10
precisely, a predatory price is a price that is profit maximizing only because of its
exclusionary or other anticompetitive effects.18 The anticompetitive effects of predatory
pricing are higher prices and reduced output (including reduced innovation), achieved
through the exclusion of a rival or potential rival. But such a definition does not state an
operational legal rule.
It is therefore necessary to base the legal rule on tractable
measures such as cost, market structure, and recoupment.19
PRE ENTRY AND POST ENTRY SITUATIONS WITH NORMAL COMPETITION
AND POSSIBLE PREDATORY PRICING20
P
MR’
D (I) (p (I); p (E) =P^ (E)
P (m)
P^ (I)
C (I)
D (p)
MR
Q
(A)
Pre entry situation with normal competition
In the above figure consider a monopolist facing a market demand curve D(p). Initially
the firm is pricing at the profit maximizing level of P(m) where MR is equated with MC
[C(I)]. The entrant prices at P^(I), so the incumbent firm’s demand is now D(I) (p(I) ;
18
ibid
19
ibid
20
W. KIP Viscusi, Joseph E. Harrington Jr. , John Vernon,pp306-307
11
P(E) =P^(E)), which is less than its demand before entry as part of the incumbent firm’s
demand has been taken by the competitor. As the competitor lowers its price more the
more part of incumbent firm’s demand it takes. Therefore, the incumbent’s demand is
dependent on the price charged by the entrant. Now with new demand, the new marginal
revenue cuve is MR’ where the new profit maximizing price is P^(I).
P
Profit
P^(E)
AC (E)
C (E)
D (E) (P (E); P (I) =P^(I))
MR (E)
Q
(B)
Post entry situation with normal competition
The above figure depicts the situation of the entrant after it has entered into the market.
Now with the entrant’s demand curve D(E) (P(E); P(I) = P^(I)) the optimal price level
that it can charge is P^(E). Therefore in equilibrium each firm charges the price which
maximizes its profit given by the rectangle under the price and the AC curve.
12
PRE ENTRY AND POST ENTRY SITUATION UNDER POSSIBLE PREDATION
P
p’(I)
p”(I)
C(I)
D(i)(p(i);p(E)=p”(E)
Q
(A)
P
P”(E)
AC(E)
C(E)
D(E) (p(E);p(I)=p”(I))
Q
(B)
13
The above figure (A) depicts the situation where the incumbent firm is pursuing a more
aggressive pricing policy with intent of reducing the entrant’s profit. The incumbent
prices at P”(I) which is below P^(I). Now the entrant demand curve is shifted to D (E)
(P(E); P(I)=P”(E)) as depicted in figure (B) and the profit maximizing price P”(E) is
lower than P^(E) and the entrant now incurs a loss as the price is below the AC curve.
Also the incumbent’s profit maximizing price P’(I) [ figure (A)] is higher than the price
P”(I) , which maximizes the current profit. Now this situation is a case of possible
predation as the incumbent is charging a price which is below its profit maximizing price
to drive the entrant out of the market and to earn monopoly profits later on.
PROFIT PATTERN UNDER PREDATORY PRICING
P
Predation
Accommodation
Time
0
Time of exit
The above figure shows the profit pattern under the predatory pricing. In response to an
entry an incumbent has two options , either to accommodate or to price aggressively to
14
drive the entrant out of the market. Under accommodation the incumbent can maximize
current profits and under aggressive pricing its current profits are reduced but the future
profits will be higher after the exit. Now predation is preferred over accommodation as
the value of the near term forgone profit is smaller than the value of the long term profit
again.21
4. PORTER’S FIVE FORCES FRAMEWORK
To analyze the industry’s attractiveness a widely used model is the Porter’s Five Forces
of competition framework. According to this model the profitability of an industry is
determined by the five forms of competitive pressures resulting in competitive
advantages for the companies based on their individual resources and capabilities. It is
based on microeconomic concepts of demand and supply, substitute products, the
relationship between volume of production and cost of production, and market structures
like monopoly, oligopoly or perfect competition.22
21
22
W. KIP Viscusi, Joseph E. Harrington Jr. , John Vernon, pp309
Richard Lindberg, The Ambiguity of Predatory Pricing: Strategy as a Clarifier, Research Paper,pp43-45-
15
POTENTIAL
ENTRANTS
THREAT OF NEW
ENTRANTS
BARGAINNG POWER
INDUSTRY
COMPETITORS
SUPPLIERS OF SUPPLIERS
BARGINING POWER
OF BUYERS
BUYERS
RIVALRY AMONG
EXISTING FIRMS
THREAT OF SUBSTITUTE
PRODUCT OR SERVICE
SUBSTITUTES
The five forces of competition are:
Threat of substitutes
Threat of substitution exist when the demand of a product gets affected by the price
change of a substitute product. If there are very close substitutes of the firm’ product it
reduces the ability of a firm to raise prices. The threat of substitutes are determines by
factors like brand loyalty, close customer relationships, switching cost for customers, the
relative price for performance of substitutes and current trends.23
23
Grant R (2002) , Contemporary strategic analysis, Blackwell, pp72-74
16
THREAT OF ENTRY/BARRIERS TO ENTRY
If there is free entry of firms the profits are nominal in the long run. But barriers to entry
hinders this scenario protecting established industries profits and at the same time
deterring entry. The effectiveness of the entry barriers depends on the resources of the
entrants and if they use an innovative strategy to circumvent the existing barriers.24
RIVALRY BETWEEN ESTABLISHED COMPETITORS
Competition intensity is high when there are many firms of similar size, the products are
not differentiated, the firms employ the similar strategies, low market growth rates, high
fixed costs, and low switching costs for consumers, existence of excess capacity and the
barriers to entry are high. To compete the companies now try to establish competitive
advantages over each other by changing prices, product differentiation etc.25
BARGAINING POWERS OF BUYERS
The bargaining power of the buyers determines how much they can put pressure on
margins and volumes. The determinant of the bargaining power of the buyers are ;:
buying in large quantities, supply industry consisting of large number of small operators
,undifferentiated product, easy availability of substitutes, low cost of switching to
alternative product etc.26
BARGAINING POWER OF SUPPLIERS
Suppliers bargaining power is high when the market is dominated by few large suppliers,
there are no substitutes for the inputs, the suppliers customers are fragmented, the
switching cost from one supplier to the other is high. Due to this the suppliers have the
advantage of integrating and charging high prices.
24
Ibid, pp74-76
Ibid, pp77-80
26
Porter ME, Competitive strategy: techniques for analyzing Industries and Competitors, Free Press in
Grant, R (2002), Contemporary Strategy Analysis, pp85
25
17
After analyzing the current and potential future state of the five competitive forces,
companies try to influence these forces to benefit their interest. The objective is to reduce
the power of competitive forces.27 This model has been criticized a few times due to the
following factors: the framework assumes a perfect and static market structure which is
rare, there is lack of empirical evidence regarding the importance of industry
environment for profitability, it also doesn’t focus on strategic alliances between
companies and other forms of collaborations, and it doesn’t focus on the complementing
products. But still Porter’s model has been used widely as it is easy to understand and to
follow relative to other models.
5. FACTORS DETERMINING PREDATORY PRICING
1) DOMINANCE:
Since large capital reserves are needed to sustain the losses during the below cost selling
period, hence only a dominant firm would be able to practice predatory pricing.28 The
dominance of a company can be analyzed with regard to the relevant product and
geographic market by examining the potential demand and substitutability of the products
or services. The economic strength of the predator may derive from its position in other
markets.29
27
28
ibid
W.Kip Viscusi, Joseph E. Harrington,JR John M. Vernoni, Economics of Regulation and Anti-trust, MIT
Press, pp316
29
H. Hovenkamp, Federal Antitrust Policy , Thomson/West, 2005,chap8
18
2) BARRIERS TO ENTRY AND RE-ENTRY:
Successful predatory pricing requires certain level of entry barriers to the market.
Otherwise other potential rivals would immediately re-enter the market once the
predator raises its prices and by adding their output to that of the predator drive
the prices back to competitive level.30 Entry barriers exist when a new market entrant
faces costs that the incumbent firm need not bear or no longer faces, i.e., fixed cost
investments etc. The entrant on the other hand must incur such costs and hence faces the
risk of under-pricing by an incumbent with sunk costs, the latter acting as a barrier to
entry, giving the incumbent the power to raise prices above the competition level.
31
Re-
entry barriers on the other hand exist when a firm that has left a market bears significant
costs in seeking to reopen its business. In the absence of re-entry barriers the firm which
has been forced to exit the market because it was unable to sustain the artificially low
prices dictated by the predator could enter the market again once prices are raised to
monopoly level, thus being able to undermine the predators pricing policy.32
3) EXCESS CAPACITY:
Excess capacity is a pre-requisite for predatory pricing. The predator must be able to
absorb all the new demand created by its price cuts, and in the case of predation against
existing rivals, the predator must be able to absorb the rival’s sales. If it cannot do both
these, demand will exceed predator’s output and prices will have to rise, which will take
the pressure off the rivals and allow them to survive. 33
30
Brodley et al, Predatory Pricing
31
Eugene Buttigieg, EC Competiton Law, Wolters Kluwer Law and Business, pp419
32
ibid
33
W.Kip Viscusi, Joseph E. Harrington,JR John M. Vernoni, Economics of Regulation and Anti-trust, MIT
Press,pp 314
19
4) NON-PRICE PREDATION
Non price predation includes excessive product differentiation, predatory advertisement
and investment, predatory product innovation. The main aim of these non price predatory
pricing is to raise the costs of the rival firms. If cost increase can be imposed on the
rivals, the predatory firm can profit immediately, even if the rivals remain in business,
this is because its margin will increase proportionately with rising price levels. Another
scenario is even if the prices remain constant, the predatory firm gains market share as
rival restricts output.34
5) OTHERS
Examining market share trends during the period of predation is important for
recoupment analysis. If the shares did not change during that period, then recoupment
would have to appear to be implausible.35 Low price elasticity of demand facilitates
recoupment as demand will decline relatively less when the firm raises the market price.
36
If a predator enjoys greater brand royalty, the less costly a predatory pricing shall be
for the firm.37 The more efficient the incumbent is to its rivals, the less expensive it
will be conduct a predatory pricing campaign.
34
35
Richard Lindberg, The Ambiguity of Predatory Pricing: Strategy as a Clarifier, Research Paper,pp37
John R. Lott Jr., Are Predatory Commitments Credible? Who Should the Courts Believe?, Chicago:
University of Chicago Press, 1999.pp105
36
Aaron S. Edlin. "Predatory Pricing" Research Handbook on Economics of Antitrust, . Ed. Einer Elhauge. Edward
Elgar, 2010.
37 Journal article by Greg Le Blanc; Rand Journal of Economics, Signaling Strength: Limit Pricing and Predatory
Pricing, Vol. 23, 1992
20
Predatory pricing is often considered to be feasible only where firms operate in
multimarket. It is argued that if the firm operates in only one market it is more rationale
for it to absorb the new entrant (by merger or takeover) or to accommodate it, rather than
incur greater losses by undercutting it.38 Losses suffered by the firm operating in a multi
market can be recouped by the profits from the other market in which the firm operates.
A firm may be a multimarket in geographical rather than a product sense, so that
reputation for predation in one market may deter entrants elsewhere.39
6. VARIOUS COST TESTS FOR PREDATORY PRICING
Most predatory pricing theory centers on cost levels. The basic concept of predatory
pricing is that a dominant firm prices below cost.40
DEFINITIONS OF VARIOUS COSTS UNDER INDIAN
41
COMPETITION LAW
TOTAL COST-actual cost of production including items , such as cost of material
consumed, direct wages and salaries, direct expenses, work overheads, quality control
cost, research and development cost, packaging cost, finance and administrative
overheads attributable to the product during the referred period
39
Doris Hildebrand, The Role of Economic Analysis in the EC Competition Rules, Kluwer Law
International, pp367
40
Alison Jones and Brenda Sufin, EC Competition Law: Text, Cases and Materials, Oxford University
Press, pp445
41
No. L-3 (5)/Reg-Cost/2009/CCI, clause (a) sub section (2) of section 64
21
TOTAL FIXED COST- those which do not change with output over a given time
period.
TOTAL VARIABLE COST- the total cost referred in clause (i) minus the fixed cost
and share of fixed overheads, if any, during the referred period.
TOTAL AVOIDABLE COST- the total cost that could have been avoided if the
enterprise had not produced the quantity of extra output during the referred period.
AVERAGE AVOIDABLE COST- the total avoidable cost divided by the total output
considered for estimating total avoidable cost.
LONG RUN AVERAGE INCREMENTAL COST- the increment to long run average
cost on account of an additional unit of product, where long run cost includes both capital
and operating costs.
MARKET VALUE- the consideration which the customer pays or agrees to pay for a
product which is sold or provided or can be sold or provided, as the case may be
MARGINAL COST- it is the change in the total cost that arises when the quantity
produces changes by one unit.
STAND ALONE COSTS- the costs that are involved in the production of a product
without taking into account that some of the costs are shared with the production of other
products (i.e. there are common costs).
THE AREEDA TURNER TEST
Areeda and Turner (1975) suggested that pricing below short run marginal cost was
inconsistent with normal profit maximizing behavior. Under this pricing below short run
marginal cost is considered to be economically inefficient (from a short run
22
perspective).42 A firm with ‘market power’ in a purely static setting will always set
output so the market price exceeds short run marginal cost. In these circumstances, if a
firm is observed setting price below short run marginal cost then this may reflect a
predatory intent.43 SRMC is, however almost impossible to calculate in practice and
hence Areeda and Turner suggested the use of AVC as a proxy for SRMC.44Under this
rule pricing below ATC and above AVC is not considered predatory. However predatory
conduct is possible where an undertaking price above its AVC and below its ATC.45 For
example prices can fall below ATC due to sudden fall in demand. While the sales do not
cover the ATC, they still cover all variable costs and a part of the fixed costs. In AKZO,
the European Court held that if prices are above AVC and below ATC, conduct is to be
regarded as predatory where it can be established that the purpose of the conduct was to
eliminate a competitor.46
P
MC
AC
AVC
Q
Region under AC and ATC is not considered
predatory under Areeda and Turner rule
42 Alison Jones and Brenda Sufin, pp319
43 William L. Greene, American Bar , Predatory Pricing (Monograph / American Bar Association, Section of Antitrust
Law), Section of Antitrust Law
43Jean Tirole , The theory of industrial organization, MIT Press,pp373
45 Maher M. Dabbah,PP401
46 Case C-333/94P Tetra Pak v Commission [1996] ECR I-5951 (Tetra Pak II)
23
PRICING BELOW AVERAGE TOTAL COST
Greer (1979) proposed an alternative to the Areeda-Turner rule based on average total
cost. Pricing below average total cost should be viewed as predatory only if it is
accompanied by “substantial evidence of predatory intent47. An average total cost test is
clearly stronger than one based on average variable costs, and is often stronger than one
based on short run marginal costs. A firm makes a loss if price is below average total cost
but the firm is still profit maximizing by continuing production so long as price does not
fall below average variable cost.48
SOME LEGITIMATE COMMERCIAL REASONS FOR PRICING
49
BELOW AVC ARE
Loss leading- it occurs where a retailer cuts the price of a single product in order to
increase sales of other products. It would not be considered illegal unless it was clear that
the intention was to eliminate the competitor
Short run promotions- this involve pricing below AVC for a limited period of time to
introduce a new product in the market. However a series of short term promotions could,
taken together amount to predation
47
(Greer 1992, Business, Government and Society, p166)
48
Indeed, and in contrast to Greer, Carlton and Perloff (1994, p390) note that “[a] strength of the Areeda-
Turner rule is that it explicitly recognizes that pricing below average total cost is not, by itself, proof of
predatory behavior. Indeed price often is below average total cost in competitive industries such as
agriculture due to short-run demand or supply fluctuations”.
49
Maher M. Dabbah, pp400-401
24
Network effects- there are some services where the addition of more customers to the
network adds to the value of the service sold to existing customers50. In these
circumstances, it can be beneficial to sell the part of the service to the customer at below
AVC. This will encourage the expansion of the network and the undertaking can recoup
the losses by charging higher prices for other related services.
Economies of scale and new products- In some cases an undertaking may introduce a
new product to the market at a loss making price in order to build up a large enough
customer base to allow it to achieve the benefit from economies of scale, at which point
the price would become profitable.
Unanticipated shocks- in some markets demand or costs can be volatile and difficult to
anticipate. For e.g. in some cases an undertaking may temporarily fail to cover its AVC
because of unanticipated increase in input costs, or unanticipated reductions in demand
Option value- in some cases in response to an unexpected fall in demand, an undertaking
may wish to maintain a presence in the market in case demand returns to profitable
levels. This would be more likely to occur in a market which, once exited, would involve
substantial sunk costs to re- enter.
PRICING BELOW AVERAGE AVOIDABLE COST
Baumol (1996) supports a predation rule based on average avoidable cost.
51
The idea
behind the avoidable cost test is like that behind an average variable cost test. A firm may
engage in predatory pricing if any combinations of its products generate revenue that fails
to cover the avoidable cost of the combination, even if every product in the combination
is priced above its average avoidable cost. This can occur whenever there are common
50
51
Network effects may also be relevant for goods as well as services
Baumol, W.(1996),“Predation and the logic of the average variable cost test”, Journal of Law and Economics, 39,
49-72
25
costs of producing the group of products. These common costs do not enter any
individual products avoidable costs, but are part of the product group’s avoidable cost.52
Often the AAC benchmark is the same as the AVC benchmark because only variable
costs can be avoided. If the company expand its capacity to predate, the fixed or the sunk
costs incurred in the investments made for this excess capacity is also taken into
account.53
PRICING BELOW LONG RUN AVERAGE INCREMENTAL COST
Pricing below long run average incremental cost is also considered predatory since it is
the cost of firm which it incurs when it produces a product in addition to the other
products it produces. Hence, if a firm is deciding whether to produce a product or not it
will produce it only if its price exceeds its cost. Therefore if a firm prices below its LAIC
it is consider to be anti-competitive. The LAIC benchmark is used for the industries
where there are high fixed costs and very low variable costs, for example network
industries like telecom. Here the use of an AVC or AAC benchmark would not reflect the
specific economic realities of these industries.
THE OUTPUT RESTRICTION RULE
An alternative to cost based rules was put forth by Oliver Williamson.54 The idea is that
since entry shifts in a firm’s demand, a legitimate response should be to reduce quantity.
Thus, an incumbent firm increasing quantity in response to entry is consistent with
predation.55 This rule states that if a firm increases its quantity after the entry occurs i.e.
between 12 to 18 months, then the firm is said to have been predating.
52
Baumol, W.(1996)
53
Einer Elhange & Damien Geradin, pp336
Oliver E. Williamson, Predatory Pricing: A Strategic and Welfare Analysis, Yale Law Journal 87,pp284-
54
334
55
Alison Jones and Brenda Sufin,pp319
26
TWO-STAGE PREDATION TEST
Paul Joskow and Alvin Klevorick suggested using a two stage approach to identifying
predatory pricing.56 The first stage would require an examination of the market structure
to determine if the structure is likely to permit predation to be successful. For example, if
the entry barriers are low, the finding would be that predation is not likely to be a viable
strategy, and the case would not be pursued.57 The second stage would use the cost-based
or pricing behavior tests as described above.58
THE RECOUPMENT TEST
This test assumes that predatory pricing is happening and questions whether it is likely to
succeed in light of the characteristics of the relevant market, the predator firm and its
target(s).59 Specifically this test aims to determine whether a firm’s predatory pricing
campaign would be likely to eliminate and deter competition, and whether it is likely that
the predator firm will then be able to amass at least enough supra-competitive profits to
recover the losses it sustained during the attack.60. However the European Court has held
56
Paul L. Joskow and Alvin K. Klevorick, A Framework for Analyzing Predatory Pricing Policy, Yale Law
Journal 89 , pp213-70
57
Alison Jones and Brenda Sufin,PP319
58
Ibid
59
In the AKZO judgement recoupment of the loss by the dominant firm occupies an important place,
though the ECG did not indicate that it is necessary to show that it was possible for the dominant firm to
recoup the loss to prove the existence of predatory pricing.
60
Some US courts have required proof of recoupment as a key component of the offence of predation;
Joskow and Klevorick ‘ A framework for analysing predatory pricing policy’ (1979) 89 Yale Law Journal
213
27
that, whenever there is a risk that competitors will be eliminated, there is no need to
prove the possibility of recoupment.61
THE PREDATORY INTENT TEST
This test aims to address the more subjective question of whether a firm intended to
engage in predatory pricing. There are direct evidence of intentions such as documentary
evidence used to determine whether an undertaking is intended to predate.62 Or where a
dominant undertaking would not be able to justify deliberately incurring losses on
product by higher profits earned on another product where the latter profits resulted from
eliminating a competitor.63 Indirect evidence includes frequency of the behavior, or
targeting of price cuts against competitor, while price were maintained elsewhere.64
ABOVE COST PREDATORY PRICING
Such a situation arises in the market where there is a dominant incumbent firm who
charges a price well above its costs. Now if a new firm enters the market with a low price
the incumbent firms will charges a lower price to beat the entrant. But as the entrant has
higher costs it cannot compete in the market at the new lower prices and is driven out of
the market. Once the entrant exits the market the incumbent firm again push it prices
back to the previous level. Such kind of above cost pricing is considered to be abusive as
such behavior not only induce the exit of the new firms but also deter similar entry in the
future allowing the more efficient incumbent firm to charge a higher monopoly price.
61
Tetra Pak II, endorsed by the CAT in Aberdeen Journals (NO 2) at paragraphs 441 to 446
62
Maher M. Dabbah,pp402
63
ibid
64
ibid
28
7. COST MEASURES ADOPTED IN INDIAN
COMPETITION LAW
The Indian competition law has adopted AVC as the appropriate measure of cost, which
is by and large the measure of cost adopted in all jurisdictions. There is a presumption in
most cases that where the enterprise sets its sale price below its AVC, it has engaged in a
predatory pricing practice. However, prices falling between the ATC and AVC are also
subject to inquiry, but in such case specific intent would have to be shown. Prices set
above the ATC are unlikely to be challenged.
The CCI also has proposed certain
regulations with respect to determining cost in cases of multi-product enterprises (Reg.
5), Joint products and By-products (Reg. 6), transfer pricing (Reg. 7), and captive
consumption (Reg. 8). Once a predatory price allegation is established, the enterprise
would be said to have abused its dominant position. Where after inquiry, the CCI finds
that an enterprise in a dominant position is in contravention of the provisions of Section
4, it may pass any of the orders specified under Section 27 of the Act and may further
under Section 28 of the Act direct the division of an enterprise enjoying a dominant
position to ensure that such an enterprise does not abuse its dominant position.
8. PREDATORY PRICING CASES
AKZO v COMMISSION [1991] 65
In AKZO case the commission did not prescribe any specific price rules linked to costs
rather it concentrated on the objectives of a dominant company obtained from the
evidence obtained by the commission.66 The commission decision finding predation
focused on AKZO’s threats and its eliminatory intent. It stated in its judgment that, in
applying the Hoffmann-La-Roche principles to AKZO pricing , it was to be presumed
65
66
Case C-62/86 ECR I-3359,[1993] 5 CMLR215.
Joanna Goyder and Albertina Albors –Llorens,Goyder’s,pp320
29
that prices charged that were lower than AVC alone were intended to eliminate
competitors since they would be necessarily loss making.67 Also even prices above AVC
but below ATC are considered to be predatory if it was a plan to deliberately eliminate a
competitor.68
TETRA PAK INTERNATIONAL SA v COMMISSION69,
This is a case where the dominance and abuse are on different markets. In this case the
commission held that Tetra Pak had abused its dominant position on the aseptic market
by its conduct on the non-aseptic market which was designed to obtain a competitive
advantage on the non-aseptic market.70
DEUTSCH POST AG [2001]71
In Deutsch Post the commission applied an incremental cost standard, instead of the
AKZO AVC threshold, when it dealt with a statutory monopolist which was also active
on a competitive market. The Deutsch post hinders competition by cross subsidizing
commercial parcel services through the reserved letter post services.72
BROOKE GROUP LTD. v. BROWN & WILLIAMSON TOBACCO
CORP73
In this case the US Supreme Court held that below –cost prices can be predatory in nature
only if the dominant undertaking had a reasonable prospect of subsequently recouping its
deliberately incurred losses.74 If it did not, the market itself would punish the price
67
Richard Whish, Competition Law, Oxford Publication,pp731-732
68
ibid
69
Case 333/94 [1996] ECR I-5941.
Alison Jones and Brenda Sufin, pp454
71
OJ L125/27,[2001] 5 CMLR 99.
72
Alison Jones and Brenda Sufin,pp456-457
70
73
74
509 U.S. 209
Eugene Buttigieg,pp178-179
30
cutters; there would be no need for any intervention.75It laid out a clear two-tier policy for
judging predatory pricing76
MATSUSHITA V. ZENITH RADIO CORP.,77
Under this case the Supreme Court has rejected the claims made by Zenith Radio Corp.
the Court held that the firms charged with predation does not possess a lot of market
power and there is no possibility of recoupment of loss.
9. CONCLUSION
Predatory pricing is a very perplexing and puzzling topic for the anti-trust communities
of many countries. Critics of predatory pricing argue that it is not a rational strategy to be
pursued by the firms. The problem is that it is very hard to distinguish predatory pricing
from other desirable competitive price cutting. The antitrust laws should adequately curb
the predatory pricing without overly deterring competitive price cutting.
SUGGESTIONS
•
Antitrust courts should make use of the economic evidences in detecting
predatory pricing. Also economic evidences are now able to show the rationality
of predatory pricing like the possibility of recoupment which is an essential
element in determining the rationality of predatory strategy of a firm.
75
In holding that recoupment is an essential element of the test for predatory pricing the Supreme Court (at
226) observed that ‘cuting prices in order to increase business often is the very essence of competition’
76
77
W.Kip Viscusi, Joseph E. Harrington,JR John M. Vernoni,pp304
475 U. S. 574 (1986)
31
•
It is also necessary for the anti-trust authorities to make sure that the market
structure supports the prospects of predatory pricing. This requires a complex
analysis of the markets where anticompetitive effects have occurred or are
probable. This includes defining the dominance of the predatory firm, the barriers
to entry, and the market power of the competitors.
•
As in the AKZO test the intention of the firm becomes the crucial factor when the
prices are between AVC and ATC. Since such pricing is considered to be nonpredatory as the firm is covering its variable costs and some parts of its fixed cost.
However the anti-trust authorities should make a difference between intention of
eliminating the competitors on the basis of performance which is the case under
normal competition and elimination of competitors by anti-competitive practices
such as predatory pricing. The courts should also consider direct and indirect
evidences in proving the act of predation. Direct evidences include documents
from the company such as a detailed plan demonstrating the use of predatory
prices to exclude a rival, to prevent entry or evidence of concrete threats. Indirect
evidences include the scale, duration and continuity of the low pricing, the
possibility of recoupment etc.
32
10. REFERENCES
1. Maher M. Dabbah; EC and UK Competition Law:-Commentary, Cases and
Materials, Cambridge University Press
2. Joanna Goyder and Albertina Albors –Llorens ,Goyder’s EC Competition
Law, Oxford UniversityPress
3. Doris Hildebrand, The Role of Economic Analysis in the EC Competition
Rules, Kluwer International Volume 39
4. Einer Elhauge and Damien Geradin,Competition Law and economics,, Hart
Publishing
5. Eugene Buttigieg, EC Competition Law, Wolters Kluwer Law and Business
6. Paul L. Joskow and Alvin K. Klevorick, A Framework for Analyzing
Predatory Pricing Policy, Yale Law Journal 89
7. Oliver E. Williamson, Predatory Pricing: A Strategic and Welfare Analysis,
Yale Law Journal 87
8. Greer 1992, Business, Government and Society
9. Richard Whish, Competition Law, Oxford Publication
10. Alison Jones and Brenda Sufin, EC Competition Law: Text, Cases and
Materials, Oxford University Press
11. Pindyck and Rubinfeld, Microeconomics, Prentice Hall International, Inc
12. Richard Lindberg, The Ambiguity of Predatory Pricing: Strategy as a
Clarifier, Research Paper
13. Jean Tirole , The theory of industrial organization, MIT Press
14. Malcom R. Burns, Predatory Pricing and the Acquisition Cost of Competitors,
Journal of Political Economy 94(April 1986)
15. W.Kip Viscusi, Joseph E. Harrington,JR John M. Vernoni, Economics of
Regulation and Anti-trust, MIT Press
16. H. Hovenkamp,Federal Antitrust Policy , Thomson/West, 2005
33
17. Louis Philips, Competition Policy: A Game Theoretical perspective,
Cambridge University Press
18. www2.owen.vanderbilt.edu/mike.shor/.../GTheory/.../lecture4.ppt
19. Porter ME, Competitive strategy: techniques for analyzing Industries and
Competitors, Free Press in Grant, R (2002), Contemporary Strategy Analysis
20. Patrick Bolton,* Joseph F. Brodley** and Michael H. Riordan, PREDATORY
PRICING:STRATEGIC THEORY AND LEGAL POLICY
34