In 1911 the U.S. Supreme Court broke up John D. Rockefeller’s Standard Oil Company in America’s most famous antitrust case. One legacy of the case involves predatory pricing, or selling below cost to bankrupt rivals, which Standard Oil allegedly used to attain its dominant position in refining. The record, however, shows otherwise. Predatory pricing is essentially an economics urban legend.
Before turning to the history, note that predatory pricing necessarily involves selling below cost. If lower costs let Standard Oil sell profitably at a price where competitors lost money, this would not be predatory pricing. The tactic involves losing money now to drive smaller rivals out of business and earn larger future profits as a monopoly.
Fear of predatory pricing affects public policy and popular opinion today, making the history relevant. The antitrust cases against Microsoft in the 1990s included charges of predatory actions with its Internet Explorer web browser. In addition to Federal antitrust law, more than twenty states prohibit sales below cost generally, with several more, including Alabama, doing so just for gasoline. States generally have a lower standard of evidence, and so state courts hear most predatory pricing claims today.
Fear of predatory behavior, I think, lies behind many concerns about unfair international competition. Suppose China subsidizes exports to the U.S.; Chinese firms might sell us something that cost $10 to produce for $6. I would say we receive a $4 gift with each purchase, and should remember to send a thank you note. But what happens after this “generosity” drives American companies out of business? Won’t the Chinese then sell us this same item for $20? Perhaps, especially if you view the initial low price as predatory.
We fear predatory pricing because it allegedly built Standard Oil and the Rockefeller fortune. According to the popular narrative, Standard used predatory pricing and “struck down its competitors, in one market at a time, until it enjoyed a monopoly position everywhere.” Only the story doesn’t square with the facts. In a classic 1958 paper, economist John McGee reviewed the evidence in the government’s antitrust case against Standard Oil, over 13,000 pages of transcripts, briefs, and exhibits. Standard bought out over 100 refineries, and by 1890 was refining almost 90 percent of America’s oil.
But Professor McGee found no evidence of predatory price cutting by Standard. Furthermore, rivals received good prices for their refineries and the owners often then worked for Standard. Several even started new refineries, which would be like running back into a burning building if they felt that they had been ruined by predatory competition. The record shows that Standard Oil dominated refining by lowering costs. And Americans benefitted: the price of refined petroleum fell from 30 cents a gallon in 1869 to 6 cents in 1897.
The Standard Oil case does not surprise economists able to see the two major logical flaws of predatory pricing. First, selling below cost penalizes large firms more than their smaller rivals. Taking a $1 per unit loss is more costly when you sell 60% of the market than 6%. Second, new firms can typically jump in when a monopolist tries raising the price to recoup their losses. Rivals bought out once can even reenter the competition, as happened to Rockefeller. And the knowledge of how to build refineries (or make other products) still exists, allowing other new entrants. Unless some factor made starting new businesses particularly hard, what economists call barriers to entry, new competitors will quickly undercut a high price. The huge profits to make up for the losses from selling below cost will remain out of reach, like a mirage.
Predatory pricing is a mythical beast. But this boogeyman continues to justify Federal and state laws allowing businesses to sue firms that cut prices. Lower prices based on lower costs benefit consumers and the economy and should be incentivized, not penalized. Businesses unable to keep up on the field of market competition should not be able to harass more efficient rivals in the courtroom.
Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s alone and do not necessarily reflect the views of Troy University.