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While some may feel that this is a bit of a gutless approach it is the only way we can ensure free and open discussion without jeopardising our paycheques.

Wednesday, July 15, 2009

The predator Vs the regulator (Roy Rodgers)

When I was a postgrad I was lucky enough to take a subject called industrial organisation. Our lecturer was Nisvan Erkal. I’ll never forget the subject, it was the first time in three years of propositional calculus that I was able to sit in a theatre and think my god this stuff does bears some resemblance to the real world.

Nisvan was a fairly good lecturer and one of the best moments during the semester was when she spent a couple of hours going over classic economic fallacies. One fallacy that we spent a bit of time on was that of predatory pricing.

This lecture served as a bit of an awakening. Up until that moment in time it had never occurred to me that predatory pricing was in fact an absolute load of bull. Nisvan informed us all quite calmly that the actual conventional position of the vast bulk of economists was that it is absolute crap.

At this point its worth noting that our government appointed protectors the ACCC have yet to come to this conclusion. As embarrassing as it is it is true, the ACCC believes whole heartedly in the theory. Not only that, they have the powers necessary to intervene and protect us from it. The regulation will save us!

While the ACCC does believe in it, it also notes that it is difficult to prove…..apparently

the initial signs of predatory pricing are pro-competitive and there is often no written evidence of anti-competitive purpose with which an allegation could be upheld.

Heads up boys …. Maybe its sooo hard to prove because it’s a load of baloney.

What is predatory pricing? The theory holds that a dominate firm will price goods at below cost (that is below their costs) in order to force other firms/suppliers to lower their prices … effectively engaging them in a price war. The theory holds that for some strange magical reason the dominate firm is able to sit out its subsequent losses whereas its smaller competitors can not and go broke. Once the little guys are broke (or in eco speak exit the market) it is theorised that the dominate firm can increase its prices to a higher level (than pre price war) due to its new found market power. Ultimately these inflated prices should provide our newly monopolised firm with more than enough profit to compensate for the losses incurred during the price war.

Sounds sort of a little bit compelling doesn’t it?

However, the reality is that its loony bin territory and just because the ACCC says its true doesn’t make it so. It belongs to that same school of bizarre bullshit economics that anti dumping regulations comes from (anti dumping is a sort of predatory pricing theory with a bit of xenophobia thrown into the mix). They both belong to the school of protectionism dressed up in strangely illogical and yet somehow bizarrely enforceable pro‑competition drag.

The theory also appears to pander to the insecurities of anti capitalists and big business haters whose formal economics training usually amounts to nothing more than a couple of lectures they gatecrashed halfway though their arts degree.

At this point its worth noting that not once in the last 100 years of research has an economist been able to produce a single example that serves to validate the theory.

In reality there is nothing pro competitive about predatory pricing regulation. It is purely and simply a vehicle for small inefficient firms to shelter themselves from aggressive price competition. The theory of predatory pricing is in fact a tool for anti competitive behaviour. Let me reiterate … this is not some libertarian anti government ranting it is in fact the main stream economic opinion.

If you believe in predatory pricing you probably did your economics degree sometime around 1950.

There are three main reasons the theory doesn’t stack up (note that I am relying on my somewhat hazy memory of a single lecture that occurred a number of years ago … so apologies if I’ve left something out):

1. In order to engage in predatory pricing the dominant firm needs to supply goods at below cost prices , that is prices below not only the prey’s costs but also the predator’s costs. This is a very important point. If the dominant firm is pricing below competitors costs but above or at its own average cost it is not engaging in predatory pricing it is simply engaging in old fashioned competition.

The problem with the theory is that the predatory firm by virtue of its own pre-existing dominance has a lot more to lose from underpricing than its smaller competitors.

The following highly exaggerated example should shed some light … If the dominant firm produces 1 billion units and sells them at $10 below cost it has lost $10 billion. On the other hand the small competitor that produces 1 thousand units is only out of pocket by $10 thousand, Who do you think has the better deal?

2. The second issue is temporal, just how long does the alleged predator have to endure these losses before the competition does the honourable thing and bugger off. Bit of a risk, the smaller competitors by definition are incurring much less loss and may be able to weather the storm much better than the actual predator. It may be even worse than that …. what if the competitors decide to run a skeletal production schedule or alternatively temporarily cease production until the price war is over. After all forgone revenue may be a cheaper option for the smaller firm given that they potentially lose $10 per unit if they continue producing.

3. The third and final issue is that the whole thing is doomed to fail even if the predator actually triumphs over his prey. For predatory pricing to stand the predator has to engage in monopoly pricing once the prey have gone. The problem is that this implies they will earn abnormal profits and abnormal profits tend to attract new entrants.

And guess what if you’re a new entrant you have access to some bargain basement priced capital. When the prey exited the market they would by definition sell off their capacity/capital goods (its usually not sound commercial practice to abandon assets). These capital goods are priced to reflect the lowered expectations of future benefits that results from the price war. So at the end of the day not only does the predator find himself competing with new and keen entrants, these entrants have lower costs curves that reflect the price war and thus are able to compete aggressively with the predator, and if I was an entrant this is exactly what I would do because I know the predator is carrying massive liabilities resulting from his stupid pricing policies.

To the best of my recall this is what Nisvan taught us all those summers ago, and I have to thank her for one of the most memorable economics lectures Ive sat through.


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