The economics of predation: What drives pricing when there is learning-by-doing?

Predatory pricing—a deliberate strategy of pricing aggressively in order to eliminate competitors—is one of the more contentious areas of antitrust policy and its existence and efficacy are widely debated. The purpose of this paper is to formally characterizes predatory pricing in a modern industry dynamics framework. We endogenize competitive advantage and industry structure through learning-by-doing. We show that we can isolate and measure a firm’s predatory incentives by decomposing the equilibrium pricing condition. Our decomposition maps into existing economic definitions of predation and provides us with a coherent and flexible way to develop alternative characterizations of a firm’s predatory incentives. We ask three interrelated questions. First, when does predation-like behavior arise? Second, what drives pricing and, in particular, how can we separate predatory incentives for pricing aggressively from efficiency-enhancing incentives for pricing aggressively in order to move further down the learning curve? Third, what is the impact of predatory incentives on industry structure, conduct, and performance? In answer to the first question, we find widespread existence of Markov perfect equilibria involving behavior that resembles conventional notions of predatory pricing in the sense that possibility of rival’s exit is associated with aggressive pricing. We answer the second question by presenting an analytical decomposition of the Markov equilibrium pricing condition that allows us to isolate predatory incentives in a vareity of plausible ways. To answer the third question, we show how conduct restrictions corresponding to a variety of different definitions of predatory incentives affects equilibrium behavior. Based on our numerical analysis, conduct restrictions based on definitions of predatory incentives that isolate advantage-denying motives in pricing — i.e., the marginal benefit to a firm from denying a rival the opportunity to develop a competitive advantage or overcome a competitive disadvantage—appear to provide the best balance of short-run and long-run welfare improvements. ∗We thank Lanier Benkard, Chiara Fumagalli, Mike Riordan, Mark Satterthwaite, and Connan Snider for helpful discussions and comments. We also thank participants at the 2010 Searle Center Conference on Antitrust Economics and Competition Policy and the Ninth Annual International Industrial Organization Conference for their useful questions and comments. Besanko and Doraszelski gratefully acknowledge financial support from the National Science Foundation under Grant 0615615. †Kellogg School of Management, Northwestern University, Evanston, IL 60208, [email protected]. ‡Wharton School, University of Pennsylvania, Philadelphia, PA 19104, [email protected]. §Tepper School of Business, Carnegie Mellon University, Pittsburgh, PA 15213, [email protected].