underpants-gnomes

There’s a generalized worry that Big Bad Corporations indulge in something called predatory pricing. They cut prices so low that all their competitors go out of business and then they can enjoy a monopoly in the market. Then they jack up prices to consumers again and wax fat off their ill gotten gains. However, to economists of a certain type this always sounds a bit like the Underpants Gnomes. Sure, step 3 is profit but there’s an uncertainty about the step 2 that leads to it.

Various tech companies have been accused of this sort of behavior. It’s certainly alleged that Amazon is trying to destroy the rest of the retail industry to one day feast on the corpses of everyone else’s market share. WalMart has been accused of similar actions in physical retail, Microsoft in operating systems, Google in search, and so on. Historically, this was the charge levied at Rockefeller’s Standard Oil.

In all of these cases, it is that stage two that economists puzzle over. Okay, we get the idea of reducing prices to eliminate the competition. We also get the idea that being a monopolist is a truly profitable and lovely thing to be. The bit we can’t see is, well, once you’ve destroyed the competition then raised prices to rook the customers, what’s to stop someone coming back into the market and competing with you?

In more technical terms, is a monopoly contestable or not. If you have an uncontestable monopoly, yes, sure, you can rook consumers to your heart’s content. There are indeed such monopolies out there: the electricity grid (no, not the power stations; the grid itself) or the water and sewage pipes in an area. There’s a good reason to regulate the charges made by such natural monopolies. But when a monopoly is contestable the situation changes. To keep a contestable monopoly you’ve got to continue to act as if it is being contested. That is, act as if you’re not in fact a monopoly rooking the customer base.

As an example, imagine a Bezosian fantasy in which Amazon did in fact manage to close down every bookshop around the world and drive out of business every competing online retailer. Jeff Bezos honks with glee as his plans come to fruition and starts to demand vast margins from the publishers simply because he can. Is there any shortage of capital for someone to try and enter that business? No method by which someone could lash together a website and hire UPS to do the deliveries? Imagine that Amazon starts trying to charge 70 percent margins on books: Seriously, how long do you think it would be before there are a half a dozen people clutching VC checks with the aim of gnawing on some of that monopoly profit?

Because people can still enter the business, Bezos cannot exploit that monopoly that he’s created. He’s got to continue to act as if there will be competition to ensure there isn’t any. That is, you can’t exploit a contestable monopoly.

What brings all this on is an excellent observation by Bryan Caplan. Can we think of an industry where there really has been predatory pricing over a longish period of time? One in which it has both failed to entirely wipe out the competition and one also in which we could imagine, if that predatory pricing were to cease, there would immediately spring up a host of competitors?

Caplan has, cleverly, found just that example:

Public schools provide education free of charge. The result, unsurprisingly, is overwhelming market dominance. Almost 90 percent of school-age kids attend public school. Most people think this is a great thing. Maybe they’re right, maybe they’re wrong. Either way, though, public schooling can teach us quite a bit about predatory pricing.

Predatory pricing is one of the simplest business practices to explain: Sell at a loss until you bankrupt your competitors. When you think about it, public schools apply this predatory strategy to an extreme degree. They don’t just sell education at a loss. They ‘sell’ education for free!

What can we learn from this epiphany? First and foremost, predation is a lot less effective than you’d think. After practicing predation to the utmost degree, public schools have only captured 90 percent of the market.

He goes on to discuss what would likely happen if that predatory pricing were to stop. And I think he’s entirely correct in pointing out that it really wouldn’t take long at all for new providers of education to spring up. Heck, if 10 percent of the population can already be convinced to spend tens of thousands of dollars a year for something given away free, we know there’s a certain hunger for the product. We also know people are willing to supply that service for a fee.

It’s an excellent real world example of that bit that economists have trouble with over this predatory pricing idea. For here we’ve that example of distinctly predatory pricing both failing to actually wipe out the competition and also to wipe out the probability of market entrants if that predation were stopped.

Thus, we probably don’t have to worry about companies building monopolies by bankrupting all of their competition. For as long as it is possible for people to enter the market and that monopoly is contestable, then monopoly profits cannot be enjoyed without calling into being the competition that destroys the monopoly.

Of course, none of this is really new. When Rockefeller’s Standard Oil was arguably a monopolist it didn’t, in fact, jack up prices to make those gloriously high profit margins. Quite the opposite: it continued to invest in efficiency so it could cut prices again and again to ensure no possible competition arose. Rockefeller himself got the point: the invisible competition that might arise if you try to charge monopoly profits regulates a contestable monopoly just as well as actual real world competition does.