Notes on cost-based tests and predatory pricing.

Stephen King

June 1998.

“There is a highly competitive market for predatory pricing theories. Scholars

have produced a blizzard of rules defining unlawful predatory practices. Some
of the rules depend on the relationship between price and cost, some on the
relationship between price and time, some on the relationship between quantity
sold and time. … Do we have so many theories because predation is a common
but variegated phenomenon, curable by no single antidote? Or do we have so
many theories for the same reason that 600 year ago there were a thousand
positions on what dragons looked like?”.1

This note considers the variety of tests that have been proposed to evaluate potential
predatory pricing. In each case, I briefly discuss the rule, the logic that underlies the
rule and the potential practical and theoretical problems of using the rule.

Pricing below short run marginal cost. The seminal article by Areeda and Turner
(1975) began from the premise that pricing below short run marginal cost was
inconsistent with normal profit maximising behaviour.2 This follows from a
simple, static view of the firm. A perfectly competitive firm will expand or
contract output (in the short run) until price equals short-run marginal cost. 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. Such a firm is making a loss on the marginal units it produces.
This would only be sensible if the firm believed that it could recoup these losses
by making higher profits in the future. Further, the higher future profits must be
a consequence of setting price below short run marginal cot today. One source
of future higher profits would be if today’s low pricing led to the exit of a rival
and this allowed the firm to set price above short run marginal cost in the future.

The simple dynamic story presented above – that pricing below short run
marginal cost is inconsistent with static profit maximising behaviour but is
consistent with dynamic predatory pricing – is inadequate on two counts. First,
there are other dynamic models of firm behaviour that explain why a firm might
sell output at a price below static short-run marginal cost but without predatory
intent. For example, if production involves ‘learning by doing’ a firm will have

1
Easterbrook (1981, p263-4)
2
In many cases, such as the article by Areeda and Turner, and the article by
Williamson (1997), considerable debate followed the original publication. I only refer
to this debate where relevant and in broad terms below, rather than summarising all
the specific articles.
 high costs in the short term, but these will fall over time in proportion to the
firm’s cumulative output. A firm might sell below short run marginal cost for a
period of time to encourage consumption and increase output in order to move
more quickly down the learning curve. Such a firm is making short term losses
on marginal output, but this is an investment in longer term cost reduction.

Secondly, even if pricing below short run marginal cost reflected an attempt to
predate, other market conditions are necessary for the predation to have any
chance of success. The predator must reasonably expect that the victim firm will
exit the market. It is far from obvious (and has been the subject of considerable
economic research) why a victim will choose to exit just because a rival sets too
low a price. In the face of the aggressive action, the victim can simply reduce its
output. The main cost of the low pricing would be bourn by the predator, not the
victim. The predator must also have a reasonable expectation that it will recoup
any short-term foregone profits in the longer term after the victim exits. This
requires that there are barriers to new entry or other reasons why a new firm will
not simply replace the ‘victim’ after it exits. In particular, a new firm will be
unable to buy the victim’s plant at a cheap price and then re-enter the market.
The predator must also have market power so that it can reasonably expect to be
able to raise prices in the longer term.

Pricing below average variable cost. Areeda and Turner (1975) note that a rule
based on the short run marginal cost of production may be difficult to
implement. Courts and regulators will often lack the necessary information to
determine short run marginal cost. Instead, a test based on pricing below
average variable cost could be used. For a firm with standard ‘U-shaped’
average costs, short run marginal cost will lie above average variable cost when
the firm produces beyond efficient scale. In this case the average variable cost
rule may be viewed as a weaker test of predation than the short run marginal
cost rule. Of course, if a firm is producing below minimum efficient scale, then
the short run marginal cost is below the average variable cost test rule. For
example, if a firm has economies of scale up to a fixed capacity, then short run
marginal cost will be below average variable cost if production is below full
capacity.

From a static perspective, the average variable cost test also has merits in its
own right. For a perfectly competitive firm, it is optimal to cease production if
the price falls below average variable cost. Continued production fails to cover
even variable costs. Again, if the analysis is extended to a dynamic context then
even a perfectly competitive firm may continue in operation when price is
below average variable cost. For example, Dixit and Pindyck have shown how a
firm facing stochastic demand which follows a random walk, will continue to
produce even if price is slightly below average variable cost, when a closure
decision is irreversible (or costly to reverse).3

Pricing below average total cost. Greer (1979) proposed an alternative to the Areeda
-Turner rule based on average total cost. Greer (1992 p473) states that the
average variable cost test would be “a defendant’s paradise, a monopolist’s
3
See for example, Dixit 1992
 heaven”. Rather, pricing below average total cost should be viewed as predatory
provided it is accompanied by “substantial evidence of predatory intent” (Greer
1992, p474). Posner (1976) has also supported a predation test based on average
total cost.

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. It is also
clear that there are many reasons why a firm may price below average total cost
(but above average variable cost) even in a static situation. A firm makes a loss
if price is below average total cost but the firm is still profit maximising by
continuing production so long as price does not fall below average variable cost.
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”.

Comments on cost-based tests. The cost based tests for predatory pricing are
ambiguous and imprecise. They are imprecise because, in each case, sensible
profit maximising reasons that are not inimical to competition can be put
forward to explain the pricing behaviour. These reasons are unrelated to forcing
the exit of a competitor. The tests are ambiguous because, even when the
pricing behaviour that violates the test is accompanied by the exit of a
competitor, it cannot be inferred that the pricing behaviour was predatory. For
example, none of the tests, by themselves, can distinguish between predatory
pricing and an industry ‘shake-out’. Suppose an industry has an unsustainable
configuration of firms so that at least one firm will be forced to exit in the
medium to long term. If each firm does not know other firms’ costs perfectly,
then a game of brinkmanship can occur where firms make significant short-term
losses before one firm exits. The short-term losses are then ‘recouped’ by the
surviving firms.4 This behaviour, which may violate some or all of the cost
based tests summarised above, does not reflect predation. Rather, low pricing is
a consequence of impending and inevitable exit in the industry.5

The cost based tests also fail to detect all predation. It is well recognised that a
firm may be able to exclude an ‘equally efficient’ competitor even if its price,
say, does not fall below its own average variable cost. Theoretical arguments
that show predation without reference to below cost pricing rely on some
difference between the firms – for example in terms of access to credit (eg.
Snyder 1996) or consumer recognition (eg. Rosenbaum 1987). Care must be
taken when considering these arguments. For example, if an incumbent can
price lower today because it has accumulated learning which has lowered its
costs, then an equally efficient entrant will be able to reap these same
4
See Fudenberg and Tirole 1986
5
King (1998) also shows how impending failure by one firm can lead other firms to
raise output, potentially speeding up the failing firm’s demise. Again, exit in this
model is inevitable, and surviving firms are reacting to the inevitable exit rather than
trying to cause this exit.
 economies over time. An efficient entrant may make a loss in the short term but
this is an investment in lower future prices. It is dubious whether an incumbent
should be forced to raise its prices to make the entrant’s investment less
expensive.

Timing and cost tests. An important issue when considering which cost based test to
use involves the timing of the behaviour. Baumol (1996, p62) states that “the
time period pertinent for calculation … is the time period over which the price
in question prevailed or could reasonably have been expected to prevail”. For
example, if the supposed predatory behaviour were only relatively short lived
then a test based on long run average total costs would appear to be overly
harsh. Such a test is likely to catch a wide variety of harmless, profit
maximising behaviour. Alternatively, if the pricing behaviour extends over a
number of years, then a test based on short-term average variable costs is likely
to be too soft. Benign explanations for making long-term losses are hard to
sustain.

Multi-product firms. If firms produce multiple products then the above cost-based
tests do not apply, particularly if the firm is suspected of predating in only one
or a few of its multiple products. There is no unambiguous definition of
‘average’ cost for one of a number of jointly produced products. The following
two rules address this issue.

Pricing below average incremental cost. This rule was used in the U.S. case of MCI
Communications Corp. v AT&T, (708 F.2d 1081, 486 U.S. 891 [1983]). The
incremental cost of a particular product is the addition to a firm’s costs when it
produces that product in addition to the other products produced by the firm.
The average incremental cost is then the incremental cost divided by the
quantity of the relevant product. If a firm was deciding whether or not to
commence producing the specific product, it would only choose to do so if price
for the product exceeds the average incremental cost.

The average incremental cost test is the multiproduct equivalent of the average
total cost test. However, when analysing predation, as Carlton and Perloff
(1994, p390, note 8) remark, ‘[t]o apply such a standard one must make
assumptions about the level of the output of all the other products that are
jointly produced with the product under discussion”.

Pricing below average avoidable cost. Baumol (1996) supports a predation rule
based on average avoidable cost. This differs from the average incremental cost
test and is analogous to a test based on average variable cost. Incremental cost is
the cost that a firm incurs when producing a particular product in addition to its
current products. Baumol defines avoidable cost as the costs that a firm can
avoid by ceasing production of a particular product given its other production.
Like average variable and average total cost, incremental and avoidable cost
will differ in the short run. Some costs cannot be avoided in the short term but
can be avoided in the longer term. Also, incremental and avoidable costs will
differ if there is any product specific sunk costs. The idea behind the avoidable
cost test is like that behind an average variable cost test. As stated by Baumol
(p58) firm A “will not be able to drive [efficient] firm B from the production of
[good] X (or some proportion of the production of X) if it exceeds … firm B’s
 average avoidable cost incurred in producing the pertinent increase of X (p58).
Note that while Baumol talks about pricing below the other firm’s avoidable
cost, this is based on the assumption that the other firm is equally efficient. This
means that the test involves checking whether a firm is pricing below its own
avoidable cost. Of course, a firm could price below a competitor’s average
avoidable cost but not be predating if the competitor was inefficient. Baumol
notes that this test is weaker than one based on incremental cost, just as an
average variable cost test is weaker than one based on average total cost.

Baumol expands the avoidable cost test to encompass groups of products. A

firm may engage in predatory pricing if any combination 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 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.

Two-stage predation tests. Because of the inadequacy of the above costs tests, a
number of authors have suggested multi-stage tests for predatory conduct. For
example, Joskow and Klevorick (1979) suggest a two-stage approach to
predation. The first stage involves an analysis of market power. Does the
supposed predator have sufficient market power to make predation a feasible
strategy? If conditions suitable for predatory pricing are found, then the test
moves to the second stage. Predation is inferred if
(a) prices were cut below average variable cost; or
(b) prices were set below average total cost but above average variable cost,
were the inference could be rebutted by the supposed predator if the firm
could show that its behaviour maximised short-run profits; or
(c) prices were cut, but not below average total cost, and then were raised
significantly within two years without a corresponding increase in
production costs or market demand.6

A two-stage process to test for predatory behaviour is used by the Canadian

competition authorities.7 The Bureau of Competition Policy’s 1992 Predatory
Pricing Enforcement Guidelines describes a two-stage approach to testing for
predatory behaviour under s.50(1)(c) the Canadian Competition Act. The first
stage analyses market power. If a firm is found to have the relevant degree of
market power, so that predation is a potentially viable strategy, prices are
compared with average variable cost. If prices are above average variable cost
then the presumption is against predatory behaviour. If prices are below average
variable cost then the presumption is that the prices are predatory so long as
there is no other clear business justification. Prices between average variable
cost and average total cost are in a ‘grey’ area and require further investigation.

6
See also Scherer and Ross (1990), p.478.
7
See McMillan Binch (1992) for a summary of the Canadian approach.
Rules based on behaviour other than costs. The inadequacy of cost based rules has
led some economists to suggest alternative tests for predatory behaviour. An
element of a non-cost based test was incorporated into the third part of the
Joskow and Klevorick two-stage test presented above.

The output restriction rule. This rule, proposed by Williamson (1977), states that an
incumbent firm with market power, facing a new entrant, may not produce a
quantity greater than that it produced prior to entry. “When dominant firms
reduce their (demand adjusted) output unchanged in the face of new entry they
shall be deemed to be behaving in a non-predatory way providing that the
resulting market price is not less than average variable cost” (p333). Demand
adjustment simply means that adjustments may need to be made when demand
fluctuates. Williamson views the output restriction rule as a short-term rule. In
the longer term, so long as prices cover average total cost, the firm will not be
behaving in a predatory fashion.

The logic behind the output restriction rule is simple and provides a useful
insight. In almost any standard model of firm behaviour that does not involve
predation, the entry of a new competitor will lead to a rise in total output but a
fall in the output of any incumbent. In particular, it is unlikely, absent a
predatory intent, that new entry will lead an incumbent to expand its output
ceteris paribus. This said, the rule itself is imperfect. In particular, if an output
restriction rule was used to check for predation then this would alter the
behaviour of an incumbent firm prior to any entry. Further, it will often be
possible to sustain prices at levels that are below cost after entry without
actually increasing output. Simple maintaining output at the pre-entry level may
be sufficient to push prices to unprofitable levels when an entrant is also
producing.

Quasi-permanence of price reductions. This rule, proposed by Baumol (1979, p4)

states that, “following entry, the established firm can be left free to cut prices in
order to protect its interests, without being permitted to reraise those prices if
the entrant leaves the market”. Baumol argues that this rule allows the
incumbent to respond to entry and so does not create a ‘price umbrella’ like a
cost-based test, while preventing the incumbent firm from predating with a view
to quick recoupment. At the same time, this rule does not distinguish between
predatory behaviour and an industry shake-out. If the industry structure is
currently unviable, say due to new entry, and the new entrant fails following a
price war, it seems problematic that surviving firms are unable to raise prices
back to profitable levels.

Conclusion. This note has surveyed a large range of ‘economic’ tests for predatory
behaviour. It is not the aim of this brief survey to suggest that any rule is always
‘better’ or ‘worse’ than any other rule. In fact, all of the rules have their
problems and deficiencies. The strong adoption and enforcement of any specific
predatory pricing rule may be undesirable. All of the rules noted have
exceptions – situations where it is economically rationale to violate the rule
without predatory intent. Further, as Scherer and Ross (1990, p472) note “the
rules specified for distinguishing predatory from legal behaviour affect the
decisions taken by powerful firms with respect to capacity and other strategic
 variables. Setting the wrong rule could elicit strategic reactions that make
matters worse, not better”.

The rules summarised in this note are clearly ad hoc. The courts in the U.S.
have applied some of these rules, particularly the Areeda-Turner approach. At
the same time, the U.S. courts have been slow to recognise the developments on
predatory pricing from economics.8 Recent economic theory has shown that
predation may reflect a range of pricing phenomena, usually related to
asymmetric information between market players. At the same time, the various
rules all capture some element of behaviour that we would view as predatory.
By themselves, each individual rule is inadequate. Treated as a portfolio,
however, the rules provide guidelines to analyse firm behaviour and to
informally test the likelihood of predation.

To see this, consider how the tests could be used as part of a predation
investigation. First, we would expect to see some prices violate all of the
relevant cost tests, even if only for a short period. While predatory behaviour
can occur, say, with prices always above average variable cost, given the
uncertainties and fluctuations of the market place, any firm attempting predatory
behaviour is likely to have violated all the cost tests at some time. In particular,
it may be difficult to convince a court that pricing is predatory if prices have not
been below the minimum of short run marginal cost or average variable cost for
at least some sales. Obviously for a multiproduct firm the multiproduct
analogues of variable and total costs are relevant.

In addition, we would expect to see pricing consistently below average total cost
over a longer period of time if behaviour is truly predatory. While an
information asymmetry does not make such pricing a precondition for
predation, it is difficult to explain such prices as anything other than predation
over a longer term. Trying to prove predation where prices have consistently
exceeded average total cost is probably pointless and runs too high a risk of
catching legitimate behaviour.

Even if prices violate all the cost tests some of the time, and some of the cost
tests for a substantial length of time, other behaviour should be examined. The
cost tests do not separate between predatory behaviour and an industry shake-
out. However, the Williamson output restriction rule is useful here. If an
industry is undergoing a shakeout, it is unlikely that an incumbent firm would
increase capacity and/or output. Such behaviour would reflect a predatory
intent. The Baumol rule, which considers later output changes, or more
generally the possibility of recoupment, also needs to be considered. How
would a successful predator prevent new entry? If the victim has plant and
equipment that will remain even if it fails, how can the predator either seize this
equipment or guarantee that it is dispersed so that future competitive entry is
made more difficult? A predator is likely to need to gain the victim’s plant and
equipment either before or after failure. A potential predator is likely to try and
take-over its victim even before the victim voluntarily exits the market. A take-

8
See Klevorick (1993)
 over reduces the cost of the successful predation and locks up the victim’s plant
and equipment.

Internal company documents that show predatory intent can be useful but
should be treated with extreme care. The aim to ‘destroy the competition’ is of
course at the very heart of competitive behaviour. If internal company
documents did not show a ruthless attitude to competitors, then there would be
cause for considerable concern. Wishing the competition harm is not the same
as predation.

At the same time, theoretical insights into predatory behaviour suggest that
some types of company statements are more likely to be useful to back up the
case for predation. Predatory pricing is more likely if an entrant has some
difficulty gaining funds. If there is an information asymmetry between an
entrant and its creditors, an incumbent can try and exploit this asymmetry. For
example, an incumbent can behave aggressively to try and convince creditors
that either the market cannot sustain the new entrant, or that the entrant is poorly
managed and continued funding should not be provided. Statements by the
potential predator dealing with the finances of the entrant can help formulate a
predation case.

In conclusion, no rule is adequate by itself. Further, the costs test as a whole are
inadequate to show predation. Rather, to check for predatory behaviour, the
investigator needs to consider elements of all of the tests and use relevant
information to try and separate predatory behaviour from legitimate firm
behaviour.

References

Areeda, P. and Turner, D. (1975) “Predatory pricing and related practices under
Section 2 of the Sherman Act”, Harvard Law Review, 88, 697-733.

Baumol, W. (1996) “Predation and the logic of the average variable cost test”,
Journal of Law and Economics, 39, 49-72.

Carlton , D. and Perloff, J. (1994) Modern Industrial Organization (2nd. ed.) Harper
Collins, New York.

Dixit, A. (1992) “Investment and Hysteresis”, Journal of Economic Perspectives, 6,

107-32.

Easterbrook, F. (1981) “Predatory strategies and counterstrategies”, University of

Chicago Law Review, 48, 263-337.

Fudenburg, D. and Tirole, J. (1986) “A Theory of Exit in Duopoly”, Econometrica,

54, 943-60.

Greer, D. (1979) “A critique of Areeda and Turner’s standard for predatory

practices”, Antitrust Bulletin, 233-261.
Greer, D. (1992) Industrial Organization and Public Policy (3rd. ed.), Maxwell
Macmillan International, New York.

Joskow, P. and Klevorick, A. (1979) “A framework for analyzing predatory pricing

policy, Yale Law Journal, 89, 213-270.

King, S. (1998) “The behavior of declining industries”, Economic record,

forthcoming.

Klevorick, A. (1993) “The current state of the law and economics of predatory
pricing”, American Economic Review (papers and proceedings), 83, 162-167.

McMillan Binch (1992) “Predatory pricing guidelines” at

http://www.mcbinch.com/antitrust/price.2.htm

Posner, R. (1976) Antitrust law: an economic perspective, University of Chicago

Press, Chicago.

Rosenbaum, D. (1987) “Predatory pricing and the reconstituted lemon juice industry”,
Journal of Economic Issues, 21, 237-258.

Scherer, F. and Ross, D. (1990) Industrial market structure and economic

performance (3rd. ed.), Houghton Mifflin, Boston.

Snyder, C. (1996) “Negotiation and Renegotiation of Optimal Financial Contracts

under the Threat of Predation”, Journal of Industrial Economics, 44, 325-43.

Williamson, O. (1977) “Predatory pricing: a strategic and welfare analysis”, Yale Law
Journal, 87, 284-340.