*     John H. Scully ’66 Professor of Finance and Economics, Princeton University
**    Professor and Kenison Distinguished Scholar of Law, Boston University
***   Professor of Economics, Columbia University

We have received valuable comments from legal workshop participants at Boston University Law School, Harvard Law School, Yale Law School; and from economic workshop participants at the Antitrust Division, U.S. Dept. of Justice, European Centre for Advanced Research in Economics (ECARE), European Summer Symposium in Economic Theory at Gerzensee, N.Y.U. School of Management, New Zealand Institute for Antitrust Law and Economics, Princeton University, and Tilburg University Centre for Economic Research. We have also received insightful comments from many individuals, including Lucien Bebchuk,, Mathias Dewatripont, Einer Elhauge, Vic Khanna, Louis Kaplow, Alvin Klevorick, Barry Nalebuff, Jim Meeks, Patrick Rey, Alan Schwartz, Marius Schwartz, Dan Vincent, and Bobby Willig. We thank LeeAnne Baker, Jeremy Bartell, Gretchen Elizabeth Joyce and Chad Porter for dedicated and resourceful research assistance.

CONTENTS

1. The Tension Between Current Legal Views and Modern Economic Theory
2. Current Legal Policy
1. Before Brooke: The Areeda-Turner Rule
2. The Brooke Decision
3. Post-Brooke Decisions
3. Proposed Approach
1. Legal Elements—Prima Facie Case
1. Facilitating Market Structure
2. Scheme of Predation and Supporting Evidence
3. Probable Recoupment
4. Price Below Cost
2. Legal Elements—Efficiencies Justification
1. Defensive Business Justifications
2. Market Expanding Efficiencies Defenses
4. Financial Market Predation
1. Economic Theory
2. Proof of Financial Predation
3. Illustration: Cable TV
5. Signaling Strategies: Reputation Effect
1. Signaling Strategies
2. Reputation Effect Predation
1. Economic Theory
2. Reputation and Financial Predation
3. Proof of Reputation Effect Strategy
4. Illustration: Entry into Local Telephone Market
6. Cost Signaling, Demand Signaling and Other Predatory Strategies
1. Demand Signaling: Test-Market and Signal Jamming
1. Economic Theory
2. Proof of Test Market Strategy
3. Proof of Signal Jamming Predation
4. Illustration: Entry into Eastern Coffee Market
2. Cost Signaling
1. Economic Theory
2. Proof of Cost Signaling Strategy

6. Possible Objections and Counter Strategies
1. Possible Counter Strategies
2. Acquisition of Prey’s Assets by Successor Firm
3. Managerial Incentive to Predate
7. Appendix
1. Cost Signaling: Theory
2. Illustration: Bogus Competition in the Tobacco Industry
3. Cost Signaling Combined with Reputation Effect: Theory

INTRODUCTION

Predatory pricing poses a dilemma that has perplexed and intrigued the antitrust community for many years. On the one hand, history and economic theory teach that predatory pricing can be an instrument of abuse, but on the other side, price reductions are the hallmark of competition, and the tangible benefit that consumers perhaps most desire from the economic system.

The dilemma is intensified by recent legal and economic developments. Judicial enforcement is at a low level, following the Supreme Court’s recent Brooke decision, the first major predatory pricing decision in modern times.¹ Indeed, since Brooke was decided in 1993, no predatory pricing plaintiff has prevailed on the merits in the federal courts. At the same time modern economic analysis has developed coherent theories of predation, contravening earlier economic writing claiming that predatory pricing conduct is irrational. More than that, it is now the consensus view in modern economics that predatory pricing can be a successful and fully rational business strategy; and we know of no major economic article in the last 30 years that has claimed otherwise. In addition, several sophisticated empirical case studies have confirmed the use of predatory pricing strategies. But the courts have failed to incorporate the modern writing into judicial decisions, relying instead on earlier theory no longer generally accepted.

Growing market concentration, fueled by the current merger wave, has further increased the tension between judicial policy and modern economic theory. Notwithstanding the low level of judicial support—or perhaps because of the legal vacuum this has created—government enforcement concern with predatory pricing is at the highest level in many years. The Department of Transportation has recently issued proposed predatory pricing guidelines, antitrust enforcement agencies have ongoing investigations, and private antitrust actions have not slackened despite their apparently dim prospects. Moreover, the growing importance of intellectual property, challenges predatory pricing rules designed for tangible goods markets, as illustrated by the Microsoft case where the alleged predatory pricing involves intellectual property. It is the thesis of this paper that the dilemma and tensions confronting predatory pricing enforcement can be resolved and a coherent approach developed by basing legal policy, at least in part, on modern strategic theory.

We begin in Part I by describing the uncertain foundations of present policy based on the judicial belief that predatory pricing is extremely rare or even economically irrational conduct and the tension this creates with modern economic analysis. Part II discusses current enforcement policy, its evolution and culmination in the Supreme Court’s Brooke decision and, most recently, in proposed government Guidelines for airline predation. Part III outlines our proposed strategic approach, setting forth elements to guide analysis in predatory pricing cases, including rules for prima facie liability and an expanded efficiencies defense. Parts IV through VI develop criteria for identifying predatory strategies, which we then apply to financial market predation in Part IV, to reputation effect predation in Part V, and to cost and demand signaling in Part VI. In Part VII we evaluate possible objections and counterstrategies.

I. THE TENSION BETWEEN CURRENT LEGAL VIEWS AND MODERN ECONOMIC THEORY

A powerful tension has arisen between the foundations of current legal policy and modern economic theory. The courts adhere to a static, non-strategic view of predatory pricing, believing it to be an economic consensus. But this is a consensus most economists no longer accept. The tension is reflected, however, not so much in the legal rule, which at least in theory would allow arguments based on modern strategic analysis. Rather the tension appears in an extreme judicial skepticism against predatory pricing cases that has led to the dismissal of almost all cases since the Brooke decision by summary motion. In order to understand this judicial skepticism and the tension it creates with modern economics, we must examine its source, evaluate its merit and appreciate the challenge posed by modern analysis.² This requires that we first state what we mean by predatory pricing.

In most general terms predatory pricing is defined in economic terms as a price reduction that is profitable only because of the added market power the predator gains from eliminating, disciplining or otherwise inhibiting the competitive conduct of a rival or potential rival. Stated more precisely, a predatory price is a price that is profit maximizing only because of its exclusionary or other anticompetitive effects.³ The anticompetitive effects of predatory pricing are higher prices and reduced output (including reduced innovation), achieved through the exclusion of a rival or potential rival. But such a definition does not state an operational legal rule.⁵ It is therefore necessary to base the legal rule on tractable measures such as cost, market structure, and recoupment.

A key premise in developing an enforcement policy for predatory pricing is the expected frequency and severity of its occurrence. That determination necessarily rests on the twin guides of empirical evidence and economic theory. In Matsushita and Brooke the Supreme Court found that predatory pricing was speculative and “inherently uncertain,”⁵ and noted its “general implausibility.”⁶ Moreover, in Matsushita the Court embraced the view that a “consensus” of commentators finds that predatory pricing is “rarely tried, and even more rarely successful,”⁷ and other courts have embraced this view,⁸ including a later Supreme Court in the Brooke decision.⁹ The consensus to which the Court referred rested essentially on empirical studies by John McGee and Roland Koller, published in 1958 and 1969;¹⁰ and the Court cited each work explicitly.¹¹

In his 1958 article McGee analysed the trial record of the 1911 Standard Oil decision,¹² a case long held up as the classic example of predation. The Rockefeller-dominated Standard Oil Company was thought to have cut prices below cost to drive out its smaller rivals intending later to raise prices and exploit consumers. McGee found little indication in the trial record that this had occurred. More than that, McGee found that a predatory strategy by a large firm such as Standard Oil against a much smaller rival would have been economically irrational in view of the much larger market share over which the predator must cut price. Recognizing that the predator cannot sustain such losses indefinitely, the prey will not be induced to leave the market. Nor will lack of funds exclude even the smallest prey since capital markets will step in to supply funds to an efficient producer. But even if the predator could drive the prey from the market, the predator would gain little because when it later attempted to raise price, either the prey or a subsequent purchaser could reopen the failed plant.

For a long time McGee's analysis provided the only coherent economic theory of predatory pricing. While some resisted McGee's conclusion that predatory pricing was irrational,¹³ no rival theory emerged. However, examples of actual predation clearly existed. Among the most notable was the use of “fighting ships” to exclude shipping rivals, as for example in the famous Mogul Steamship Co. case, as described by B.S. Yamey¹⁴ and more recently by Fiona Scott Morton.¹⁵ To drive out an intruding rival from the China trade the defendant shipping conference quoted rates, which according to Lord Esher in the Mogul case were “so low that if continued...they themselves could not carry on the trade.”¹⁶ Conference ships were even sent empty to Hankow in order to underbid the upstart shipping line.

Other striking instances of predation included the use of fighting brands in the match industry in both Canada and the United Kingdom whereby the monopolist would introduce a special brand, locally marketed, to foil new entry, confining sales of the brand to the entrant's local territory and withdrawing the brand as soon as the entrant left the market or sold out to the monopolist;¹⁷ the use of “punitive base points” in the U.S. cement industry, where the industry punished a “recalcitrant” firm that failed to follow the industry's cartel pricing system by making its production centre an involuntary base point with a drastically reduced base price, adhered to by other sellers;¹⁸ the setting up of bogus independents, secretly controlled by the American Tobacco Company to sell at low prices in the prey's territory to force rivals to sell out at depressed prices and thereby maintain monopoly;¹⁹ sustained below cost pricing by Southern Bell Telephone in the early 1900's when entry was threatened by independent telephone companies and further price reduction when entry occurred, combined with other predatory strategies, preceded Bell's growth to market dominance;²⁰ below cost pricing by the Sugar Trust between 1887 and 1914 to drive out recent entrants,²¹ locational predation by a leading Canadian supermarket chain which built new stores close to entrant's plant, with the apparent single purpose of forcing losses on entrant as well as its own plant, sustaining the reputation effect hypothesis;²² and an experimental study showing the incentive in markets with incomplete information to engage in predation to deter entry.²³ Finally, a recent reexamination of the Standard Oil case—the case on which McGee had primarily relied in rejecting the logic of predation—found that Standard had in fact used predatory tactics, although not necessarily predatory pricing, against its rivals, but in a far more subtle way than McGee had imagined²⁴.

Nevertheless, the force of these examples had to confront the absence of supporting economic theory. In addition, Roland Koller’s 1969 Ph.D. dissertation, which he boldly titled, “The Myth of Predatory Pricing,”²⁵ and which has been relied on by the Supreme Court and leading commentators such as Areeda & Turner and Robert Bork,²⁶ also seemed to provide convincing countervailing evidence.

However, the mythology claim is overdrawn. Koller found that out of 23 cases where he judged the legal record to be sufficiently informative, actual predation was attempted in seven cases (30 percent) and succeeded in only four (17 percent).²⁷ But a more recent study by Zerbe and Cooper examining the same cases beginning in 1940 and updated to 1982 concluded that predatory pricing was present in 27 out of 40 litigated cases.²⁸ Moreover, both studies were likely to have under-reported predatory pricing, as they limited their investigation to litigated cases with revealing trial records. The studies therefore excluded: (1) settlements (including consent settlements with the government) which are likely to be a frequent outcome in strong cases,²⁹ (2) predatory disciplining where no suit is filed because the prey agrees to comply with the predatory demand, (3) forced buy-outs where the prey may typically release antitrust claims, and (4) cases that were not brought because supporting economic theory was as yet undiscovered or unknown. By contrast, recent case studies which have found striking episodes of predatory pricing, such as the Burns study of American Tobacco,³⁰ have used powerful econometric techniques not employed in earlier, more impressionistic surveys and some have probed deeply into historical archives, such as Fiona Scott Morton and Genesove and Mullin.³¹

Finally, even if the Koller study had correctly concluded that predatory pricing was rare in litigated cases this would scarcely be surprising given the populist legal standard that prevailed in the pre-1969 period he surveyed, following passage of the Robinson-Patman Act in 1936. Strikingly, only six of the 23 cases in the Koller sample occurred before 1936 and these includes two of the four cases in which Koller identified actual predation.³² During the era of expansive Robinson-Patman Act enforcement, discriminatory price-cutting by a large interstate firm injuring a small local rival, accompanied by evidence of animus or simply sustained price-cutting, was virtually per se unlawful. Certainly this was what lawyers were advising their clients,³³ and it seems more than likely that such an over inclusive legal rule would have deterred most predatory pricing. That would of course provide no indication that predation would be rare under a less inclusive legal rule.³⁴

The older economic analysis is challenged in an even more fundamental way by developments in economic theory over the last 20 years. Stimulated by the growing number of observed instances of predatory pricing and the emergence of modern game theory which provided the tools to analyze complex strategic situations, economists developed new economic theories beginning in the early 1980's. This new body of research challenges the static framework of perfect information on which McGee had relied. The new analysis explains predatory pricing in a dynamic world of imperfect and asymmetric information in which strategic conduct can be profitable. Under this analysis the predator seeks to influence the expectations of an existing rival, a potential rival, or perhaps most striking of all, the prey’s creditors, to convince the rival that continued competition or future entry into the market will be unprofitable. As summarized by Paul Milgrom—

Thus, for example, a firm in an industry with rapid product change might cut prices sharply in answer to new entry in order to discourage the new entrant from continuing an active product development program. Whether the entrant attributes its lack of profitability to its high costs, to weak market demand, to over-capacity in the industry, or to aggressive behavior by its competitor, it will properly reduce its estimate of its future profits. If its capital has other good uses, this might lead it to withdraw from the industry. If not, it may nevertheless be dissuaded from making new investments in and developing new products for the industry. At the same time, other firms may be deterred from entering the industry. If any of these things happen, the predator benefits.³⁵

As this passage suggests, predatory pricing may pose a special threat in rapidly growing, high technology industries, which often involve intellectual property and continuing innovation.³⁶

Developing the strategic approach to predatory pricing, economists have formulated several coherent theories. In these theories, which include financial market predation and various signaling strategies, predatory pricing is a rational, profit maximizing strategy.³⁷ While the formal economic proof of the theories is complex, their intuitions can be simply described. The theory of financial market predation challenges McGee’s assumption that the prey can readily obtain capital under predatory conditions, observing that the providers of capital use the threat of termination when profits are low as an incentive scheme to induce the firm to repay its debts. If predation causes the prey's profits to fall, the banks observe the decline, but cannot tell whether it is caused by predation or inefficient performance; and even if a bank could identify predation, it would be unable to write an enforceable lending contract contingent on its occurrence. Under these circumstances, lending to the prey becomes more risky, and banks or other investors reduce or withdraw their financial support.³⁸

Similarly, in signaling theories of predation a better informed predator sells at low price to mislead its rival into believing that market conditions are unfavorable. Signaling theories include reputation effect, test market and signal jamming and cost signaling. In reputation effect predation a predator reduces price in one market to induce the prey to believe that the predator will cut price in its other markets or in the predatory market itself at a later time. In test market and “signal jamming” the prey is attempting to ascertain consumer response to a new product or to its entry into a new geographic market. The predator frustrates the prey’s market probe by either offering secret discounts and thus inducing the entrant to believe that demand for its product is low, or openly cutting price in the test market to keep the prey ignorant about normal market conditions. In cost signaling a predator drastically reduces price to induce the prey to believe that the predator has lower costs, when in fact the predator has no cost advantage.

To summarize, the present judicial skepticism of predatory pricing assumes that predation is extremely rare, but soundly-based empirical and experimental studies and modern economic theory do not justify this assumption. The judicial skepticism, influenced by economic assumptions based on a world of perfect information, has failed to make use of sophisticated modern theories, founded on a more realistic assumption of imperfect and asymmetric information, where much is not known and where one party may have more knowledge than the other. In addition, the present legal rule does not contain a fully specified efficiencies defense that reaches dynamically efficient pricing strategies, so that predatory pricing enforcement may lead to both under- and over deterrence.

While critics of strategic analysis have suggested a variety of counterstrategies that might foil predation, the counter strategies are not considered in an exhaustive (or equilibrium) analysis that works out all possible moves and countermoves of the parties. Moreover, the counter strategies implicitly assume that market participants have full or symmetric information. As we develop in Part VII, the counterstrategies rarely go through in a world of imperfect information. In another recent critique (which does not rest on an assumption of perfect information) John Lott argues that managers lack incentive to engage in predatory pricing because their compensation depends on short run profits, which can only be reduced by predatory pricing.³⁹ However, this is an incorrect view of current managerial compensation policies and Lott's statistical study provides no basis for a different conclusion, as we also discuss in Part VII.

We propose to remedy these deficiencies by taking an approach explicitly based on modern strategic theory. Modern theory is critically needed because proof of predatory pricing under recent Supreme Court decisions requires a showing that the alleged predation is economically rational, and that is precisely what modern economic theory demonstrates. Thus, our proposal would augment existing approaches by allowing predation to be shown by proof that a predatory strategy exists and that the predator has acted pursuant to that strategy. This would involve identification of a predatory strategy recognized in the economic literature (e.g. financial predation) or in some instances even a new coherent strategy not covered by current economic writing if sufficiently persuasive and factually supported. We emphasize that our proposal is not intended to burden plaintiffs with new requirements of proof, but to augment and enlarge enforcement options to reflect the teachings of modern economics. Plaintiffs would remain free to maintain a predatory pricing case without reliance on modern theory.

Consistent with existing law, our proposed rule would require that price be below some measure of cost, which we think is best viewed in terms of incremental cost. We would also allow an efficiencies defense, but would expand the defense to include dynamic and output-enhancing gains that outweigh competitive losses. We believe that our proposed approach is basically consistent with the legal doctrine of Brooke, and would enrich and inform its application by a better understanding of both predatory strategies and efficiencies justifications. In briefest compass, one might describe our approach as a structured rule of reason informed by modern economic theory. Before presenting our proposal in more detail, we first describe current legal policy, its evolution and the present diminished level of enforcement.

II. CURRENT LEGAL POLICY

U.S. antitrust law entered a new era in 1993, when the Supreme Court decided the Brooke case, the Court’s most important predatory pricing decision in modern times. As interpreted by the lower courts, the decision had an effect on enforcement comparable only to the impact of the Areeda- Turner article in 1975, which launched the cost-based approach to predatory pricing.⁴⁰ Indeed, in the five years following Brooke, plaintiffs have not prevailed to final judgment in a single reported case. To appreciate the significance of Brooke we must know something of its historical background, its proper Phillip Areeda & Donald F. Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 HARV. L. REV. 697 (1975). 13 interpretation and subsequent lower court applications.

1. Before Brooke: The Areeda-Turner Rule

Predatory pricing enforcement extends over almost the full history of the Sherman Act. Cases were infrequent until after passage of the Robinson-Patman Act in 1936,⁴¹ and the inauguration of a strong enforcement effort by the FTC beginning in the 1940's.⁴² In the early years of the Robinson-Patman Act, enforcement essentially protected small local firms from price cutting by large sellers. Discriminatory price cutting by a large interstate seller which injured a local rival, accompanied by predatory intent was virtually per se unlawful.⁴³ Largely missing was any consideration of the consumer interest in lower prices and vigorous competition.⁴⁴ Plaintiffs won most litigated cases, including cases they probably should have lost.⁴⁵ It seems no exaggeration to call this the populist era of predatory pricing enforcement.

Areeda-Turner Rule. The enforcement climate changed radically in 1975 with publication of the Areeda-Turner article.⁴⁶ The article proposed a single per se standard based on average variable cost—the average unit costs of producing the product excluding fixed costs — which replaced the vague conjunction of factors previously used. The Areeda-Turner rule made an immediate impact on the courts, indeed so much so that plaintiffs’ success rate fell drastically in the years immediately following publication of the article.⁴⁷

Economic Critique. However, a sharp economic critique quickly challenged the Areeda- Turner rule, asserting in general terms the need for a strategic approach, although economists had not yet rigorously proved that predatory pricing could be profitable. The critics charged that the short run AVC rule missed the essential nature of predation—strategic behavior over time. Price cuts by dominant firms must be viewed as strategic communication involving threats and sanctions. Effective policy, therefore, required a predatory pricing rule which considered strategic factors and long run welfare effects.⁴⁸ Moreover, the critics did not simply fault the Areeda-Turner Rule. They offered a series of alternative rules, which sought to capture the strategic and intertemporal essence of predatory pricing. The proposals were of two types. The first sought to mirror the seeming simplicity of the Areeda-Turner rule by focusing on a single non-cost parameter that would identify predation. The second attempted to assess strategic conduct directly, relying on multiple criteria, including but not limited to cost.

Falling within the first category were the Williamson output increase rule⁴⁹ and the Baumol price reversal rule.⁵⁰ Williamson would find pricing conduct by a dominant firm predatory when the predator significantly increased output within 12 to 18 months following new entry into the market. The Baumol price reversal rule (Baumol I) would deem a price predatory if it forced a rival to leave the market and the predator thereafter reversed the price cut within the next several years. Neither of these rules attempted to identify the firm’s predatory strategy, but relied essentially on the designated objective indicator. While the two tests can be helpful in identifying predation,⁵¹ neither is sufficient by itself. Predation is too multifaceted a phenomenon to be identified by any single factor, and the attempt to do so may lead both to errors of over—and under—inclusion.

The second category of post Areeda-Turner proposals attempted to assess strategic conduct directly, combining one or more economic indicators, usually including cost and market structure, often combined with an appraisal of corporate purpose or intent. For example, in the most comprehensive of the proposals, Joskow-Klevorick would identify suspect pricing through evidence of monopolistic market structure, below cost pricing, reversal of the price cut, and documented corporate purpose to increase prices after competition is eliminated.⁵² Other leading proposals were offered by Posner, Joskow-Klevorick, Scherer, Baumol (Baumol II), and Ordover-Willig.⁵³ These rules are closer in spirit to our approach, but none of them adequately confronts the fact that predation is not a unitary phenomenon, but involves a variety of predatory strategies that require distinct legal approaches. Thus, the critics did not attempt to describe and classify the various predatory strategies and to craft an approach keyed to an identified predatory strategy, as we propose in this article.⁵⁴

Augmented Areeda-Turner Rule. Following the 1975 Areeda-Turner article, the lower courts at first embraced the average variable cost pricing rule in its per se form, but soon retreated after confronting criticism and litigation problems.⁵⁵ To begin with, the AVC rule proved difficult to litigate. Cost determination—however cost is defined—is inevitably complicated and uncertain in a courtroom, particularly when made by juries. Second, all of the economic critics rejected a per se short term cost test. Finally, it appeared to many that a per se rule based on average variable costs strongly favored defendants. Indeed, in the five years immediately following the Areeda-Turner article, no predatory pricing plaintiff prevailed, and the rule was aptly called “a defendant's paradise.”⁵⁶

In the face of these difficulties most courts declined to adopt a per se rule, and instead augmented the Areeda-Turner formulation with other factors, which included cost-based presumptions, intent and market structure. While there were variations between judicial circuits, most commonly courts held that a price below average variable cost was presumptively unlawful, while a price above average total cost was conclusively lawful. A price falling between these two cost benchmarks was presumptively lawful, but the presumption could be rebutted by evidence of intent and market structure.⁵⁷ In the absence of a controlling Supreme Court precedent, the lower courts weighed the non-cost factors differently, but courts in most circuits relied on evidence of intent and increasingly market structure.⁵⁸ Some courts followed a "sliding scale" approach, requiring more or less proof of predatory intent (and other non-price factors) depending on how far price fell below average total cost.⁵⁹ In examining intent, courts began to distinguish between a mere intent to defeat a rival in competition, however vividly expressed, and a plan to eliminate rivals and then raise prices.⁶⁰ On the other hand, a few courts found intent unhelpful, and simply inferred the specific intent required by the statute from the relation of price to cost.⁶¹ In all circuits cost determination remained a source of continuing difficulty, however.⁶²

Litigation Outcomes. The decisive impact of the Areeda-Turner rule was reflected in litigation outcomes. In the seven years immediately following the article’s publication plaintiffs’ success rate measured by favorable judgments fell to only eight percent of cases reported (as compared with 77 percent in the populist era).⁶³ However, in the succeeding 10 years up until the Brooke decision, which roughly coincided with the augmented AVC rule, plaintiffs’ success rate rose to 17 percent.⁶⁴ Moreover, there is reason to think that if settlements are taken into account plaintiffs’ success rate may have been considerably higher.⁶⁵ Interestingly, the number of reported cases declined in the latter period, perhaps indicating greater selectivity by counsel in cases tried.⁶⁶

Indeed, it is possible to believe that predatory pricing enforcement had achieved a more or less satisfactory equilibrium in the years immediately preceding Brooke. While a predatory pricing case remained difficult for a plaintiff to win, flagrant predation based on prices below either average variable or even average total cost remained actionable in most jurisdictions. Juries were something of a wild card, occasionally handing down enormous and perhaps excessive verdicts, but courts moderated these tendencies by granting summary judgement or judgement NOV, following jury verdict. Nevertheless, the continued filing of predatory pricing cases, accompanied by large jury awards when plaintiffs did succeed, probably worked to maintain a steady deterrent on real predation.⁶⁷ This gradually evolved equilibrium is now threatened—not by the Brooke decision as we read it—but by its application in the lower courts.

2. The Brooke Decision

The Brooke decision established a new framework for predatory pricing analysis. While elements of the new analysis were anticipated in two earlier Supreme Court decisions,⁶⁸ Brooke melded them into a more fully articulated judicial policy. First, predatory pricing required proof of below cost pricing, but the Court did not embrace a particular cost test, such as AVC. Clearly, however, a price could not be predatory unless it was below some measure of cost or even “some measure of incremental cost.”.⁶⁹ Second, and most strikingly, predatory pricing required proof of recoupment—a dangerous probability, or under the Robinson-Patman Act a reasonable prospect, that the predator can later raise price sufficient to recoup its investment in below cost pricing.⁷⁰

Recoupment is the new factor in Brooke and the elaboration of its requirements provides the added element of proof that Brooke mandates. Proof of recoupment requires not only that the below­cost price exclude or discipline the predatory victim, which was required under previous law, but also proof that the predator will be able to raise price above the competitive level (recoupment capability) sufficient to compensate the predator for its predatory investment (recoupment sufficiency). The recoupment requirement sharply differentiates predatory pricing from other predatory or exclusionary conduct, where the inference of injury to competition is drawn from the exclusionary conduct and market structure.⁷¹ Recoupment requires the added showing that the predatory conduct will be profitable.⁷² More specifically, the plaintiff must demonstrate either (1) actual recoupment of its predatory investment through supracompetitive pricing, or (2) that increased pricing power or other economic conditions make recoupment likely. As a necessary precondition, the Court emphasized that the recoupment requirement could be satisfied only if the market structure facilitated predation, which would require proof of market concentration, entry barriers and capacity to absorb the prey’s market share. When these threshold conditions are lacking, summary disposition is appropriate.

In Brooke the Supreme Court upheld lower court dismissal because plaintiff had failed to show that price could be raised above the competitive level. Thus, the Court never reached the issue of recoupment sufficiency.⁷³ Nevertheless, the language of Brooke directs plaintiff to demonstrate that the likely predatory price increase would be “sufficient to compensate for the amounts expended on the predation, including the time value of the money invested in it.”⁷⁴ Overly literal interpretation of this language could vastly complicate predatory pricing cases.⁷⁵ However, in examining the facts, the Court makes clear that the recoupment element can be satisfied by showing either that the predatory scheme in fact produced sustained supracompetitive prices, or that it was likely to have caused that result, even if it did not actually do so. Thus, evidence of increased prices likely to persist (partial recoupment) or simply an intensified anticompetitive market structure or other market conditions (recoupment capability) would suffice.⁷⁶ The subsequent lower court decisions appear consistent with this interpretation.

Clearly, however, the Court applied an exacting standard of proof to the specific evidence offered in the case. The facts in Brooke were unusual in that the alleged predator was not a single dominant firm, but a relatively small cigarette manufacturer holding only 12 percent of the total market, although the market itself was highly concentrated. Predation could occur only through the joint action of the leading firms engaged in oligopolistic price coordination. As no explicit agreement was alleged, the joint action necessarily rested on tacit coordination—a predatory theory the Court thought highly problematic, especially in the factual context of the case.⁷⁷

The alleged predation occurred in response to the plaintiff’s introduction of non branded, low cost cigarettes, which were known as “blacks and whites,” to reflect their stark packaging on which was printed only simple black letters describing the cigarette content. In response to this bold initiative, which proved popular with consumers, the defendant Brown & Williamson put out its own similar non branded black and white cigarette. In a series of ever steeper price cuts the defendant undersold its rival, reducing its price below average variable costs. For 18 months Brown & Williamson held prices below AVC, sustaining losses of millions of dollars. At the end of the 18 month period the plaintiff, one of the smallest cigarette manufacturers, capitulated and raised price. The defendant and the other cigarette companies generally followed. The list price of non branded black and whites rose by 71 percent, while the price of branded cigarettes increased by 39 percent.⁷⁸

On these facts the Supreme Court held that no reasonable jury could find that oligopolistic price coordination had produced supracompetitive pricing or that there was even a likelihood that this would occur. The Court noted that supracompetitive pricing through tacit coordination is both improbable in general and particularly unlikely under the facts of the case due to pricing uncertainty caused by multiple product varieties and the practice of giving rebates on list prices, demand uncertainty created by the introduction of unbranded cigarettes, divergent incentives among competing manufacturers, the absence of evidence showing that pricing signals between manufacturers were understood, and the not surprising denial by the plaintiff’s officers that they had tacitly colluded with their competitors, either voluntarily or by compulsion.⁷⁹

The Court’s exacting requirements of proof appear to be driven partly by the assumption that predatory pricing rarely occurs and partly by its skepticism toward predation by tacit coordination among rival firms. As discussed earlier, the view that predation is rare and implausible conduct is based on outdated economic theory, but in fairness the old theory was the only economic view presented to the Court. Beyond that, and more immediate to the case, the Court’s view of the predatory pricing claim was colored by its doubts that predation by tacit coordination could realistically occur. Indeed, the Court of Appeals held plaintiff’s predatory theory to be so weak that it dismissed the case as economically senseless.⁸⁰ While not willing to go that far, the Supreme Court itself expressed grave misgivings, emphasizing the difficult coordination problem of maintaining predation by tacit coordination without explicit communication, particularly in view of the defendant’s small market share.⁸¹ In cases resting on other, generally accepted predatory theories both the Supreme Court and the lower courts are free to take a less skeptical view of predatory strategies. Thus, Brooke does not foreclose reliance on the soundly based predatory theories discussed in this paper.

A strategic view of recoupment would close the gap in predatory pricing enforcement caused by the neglect of modern analysis. In Brooke the Court omitted from its analysis any consideration of strategic factors such as possible gains from deterring aggressive pricing in future time periods or in other cigarette markets, for example, branded cigarettes. Nor did the Court consider the counterfactual event of what might have happened in the absence of the price war—the diminished profits the predator would have earned had it not forced the prey to stop cutting prices. By contrast under a strategic approach counsel might have attempted to show that a reputation effect or other predatory theory, such as financial market predation, enabled probable recoupment. Whatever might have been the ultimate outcome, that is the issue that should have been submitted to the courts.

3. Post-Brooke Decisions

As interpreted by the lower courts, the Brooke decision had a powerful effect on case outcomes. In the six years following Brooke plaintiffs have not prevailed in a single case. Of 37 reported decisions, defendants have won 34 cases, and the remaining three cases were settled after plaintiffs survived motions for summary judgment or dismissal. Strikingly of the 34 cases won by defendants all but one were decided by summary judgment, judgment N.O.V., or dismissed on the pleadings.⁸²

Plaintiffs’ dismal success rate since Brooke (after eliminating clearly misconceived cases) appears to be caused at least in part by (1) exacting proof and pleading requirements, spurred by the Supreme Court’s open invitation to dismiss predatory pricing cases by summary means, (2) skepticism that predation can ever be a plausible business strategy, also influenced by the Supreme Court’s opinion, and perhaps not unrelated (3) judicial neglect of modern strategic theories of predatory pricing.

Review of the post-Brooke decisions shows that the lower courts clearly took full advantage of the Supreme Court’s invitation to dispose of non-meritorious cases by summary means. Indeed, there have been only four reported trials since Brooke and in the two cases where plaintiffs initially prevailed, the district courts reversed the jury verdicts by judgment N.O.V. To be sure, many of these cases appear to have been appropriate for summary disposition; for example, in 12 cases the defendant’s market share was below 40 percent or other structural factors showed that post-predation market power was lacking.⁸³ But it is also true that the courts dismissed seven cases on the pleadings, sometimes neglecting the need in antitrust cases to conduct discovery to develop necessary evidence;⁸⁴ and in other cases imposed severe requirements of proof at the summary judgment level.⁸⁵ Despite the fact that plaintiffs defeated motions for summary disposition in three cases (all of which were then settled)⁸⁶, the prospects of a predatory pricing claim in the lower courts remain far from encouraging⁸⁷

However, there appears to be a brightening prospect that the courts will begin to analyze predatory pricing in the light of modern economics. In Advo, Inc. v. Philadelphia Newspapers, Inc.⁸⁸ the Third Circuit accepted reputation effect as a possible theory of predatory pricing. The court indicated that price cutting by a chain store in selected local markets could be predatory when the price cutter’s demonstrated predatory conduct inhibits competition in other markets as well as the predatory market, causing prices to rise. Finding that a reputation effect theory “makes economic sense,” the court rejected its specific application in the case as factually unsupported.⁸⁹ Similarly, in Traffic Scan Network, Inc. v. Winston,⁹⁰ the district court rejected a reputation effect argument not because it was implausible, but because market conditions would have prevented such an effect. In addition, the Department of Justice has recently filed a civil complaint against American Airlines, based in part on anticompetitive reputation effects from alleged predatory pricing.⁹¹

Proposed DOT Guidelines. Perhaps the most striking development since the Brooke case has been the recently proposed Department of Transportation (DOT) Guidelines, which explicitly recognize predatory pricing as a strategic problem and would allow proof of recoupment based on reputation effects.⁹² The Guidelines focus on the ability of a major air carrier dominating a city hub, such as Chicago or Atlanta, to exclude competition and potential competition between the hub and directly connecting non-hub cities.⁹³ The observed strategic mechanism is a drastic expansion of capacity and lowering of fares by a locally dominant airline in response to new entry of an independent airline. Using the economic definition of predatory pricing, the Guidelines would identify as predatory any response to new entry by a hub-dominant major airline that makes economic sense only because the major airline can exclude the entrant from the market and thereafter charge high fares.

From a strategic viewpoint the most notable thing about the new Guidelines is their reliance on reputation effects to prove recoupment—the expected gains to the predator from deterring future entry by other airlines.⁹⁴ Thus, if the predator suffers sustained losses in a contested local market such that recoupment in the local market appears doubtful, evidence that the predation deterred future entry into either the local market or the predator’s other monopoly markets could presumably establish recoupment.

In contrast to Brooke the Guidelines do not require proof of below-cost sales. Instead, the Guidelines rely on a gross revenue measure to identify predation. Thus, a predatory response to new entry is a capacity increase in a local hub market that causes the hub-dominant airline to forgo more revenue than all of the new entrant’s capacity could otherwise have diverted from it (or simply yields lower revenue than would a “reasonable alternative strategy” for competing with the entrant).⁹⁵ The substitution of a gross revenue or output measure for the traditional cost test may be justified because the special characteristics of airline markets makes output expansion a particularly effective predatory strategy. Airlines are able to discriminate between customers with great precision and can respond swiftly to competitor moves, based on “real time” information about rivals. Mobility of assets, including the ability to lease aircraft, permits rapid expansion of capacity in contested local markets.⁹⁶

The main objection to the use of a non-cost standard to measure predatory pricing is loss of certainty in business planning. Since future demand, particularly in airline markets, may be difficult to predict, under an output rule a major airline may face difficulty in determining whether it can lawfully expand its capacity to serve a local market following new entry.⁹⁷ On the other hand cost determination in airline markets also presents difficulties due to secondary effects in other markets caused by flights on a specific city pair route.⁹⁸ Despite the difficulties it poses in airline markets, a cost standard may provide a more secure basis for business planning.⁹⁹

The DOT Guidelines conceive the problem of airline predation in strategic terms. They do not attempt to define predatory pricing under a single legal formulation, but rather identify the particular predatory strategy involved in local airline markets. This approach is consistent with modern economics, and it is the viewpoint taken in this paper. While we would generally adhere to a cost- based approach, relevant costs would include long run incremental costs, as well as short run costs.

III. PROPOSED APPROACH

A strategic approach to predatory pricing would augment existing practice in two critical respects. First, it would explicitly permit proof of predation based on modern economics. Second, it would expand the standard efficiencies and business justification defenses to encompass procompetitive dynamic gains. In addition, we suggest use of short and long run incremental cost rather than average cost in proving below cost pricing, and, further, suggest use of a discriminating burden-of-proof for the different legal elements within our framework. Neither of these latter suggestions is essential to our proposed strategic approach, however.

While the use of modern economics in proving predatory pricing is novel compared to recent practice in most of the lower courts, such an advance is implicit in the recoupment standard adopted by the Supreme Court. The recoupment requirement was designed to screen out cases where predation appeared unprofitable and hence irrational. The Court’s skepticism about the rationality of predatory pricing was justified by the now dated economic authorities on which the Court relied.¹⁰⁰ However, modern economics has developed new, more sophisticated theories of how recoupment may be achieved consistent with rational behavior, and thus identifies economic conditions under which a predatory pricing strategy is plausible.

Accordingly, our approach would permit the plaintiff to amplify its proof of predation by showing that under the specific facts of the case, one or more strategic theories are economically plausible and that surrounding economic conditions make recoupment likely in the light of such theory. We emphasize that we are not adding a new element of proof. Proof of predatory pricing under modern theory would augment and complement existing approaches. Plaintiff could still bring a case without advancing modern strategic theory. However, under our proposal a plaintiff could also base proof on well-founded strategic analysis whenever the facts warrant.

Our proposed approach is consistent with Brooke. That decision permits proof of predatory pricing and recoupment based on a scheme of predation that excludes rivals and enables the predator to recoup predatory losses. Proof of recoupment may be based on an actual price increase in the predatory market, increased concentration and entry barriers in the post-predation market, or on other relevant market conditions, including market structure and conduct, that make recoupment likely in the future.¹⁰¹ Thus, proof that market conditions make recoupment probable under an identified and recognized strategic theory should satisfy this test. Perhaps because modern strategic theory was not presented to the Supreme Court in Brooke, a gap exists in predatory pricing coverage. Interpretation of the recoupment requirement to encompass modern analysis would close that gap.

A strategic analysis also has implications for the efficiencies justification, which would assume a larger role. The justification would encompass not only defensive responses to price cutting by rivals (e.g. meeting competition) or temporary market conditions (e.g. excess inventory), but also market expanding dynamic efficiencies, such as learning-by-doing and network economies. Strikingly, these efficiencies, particularly dynamic efficiencies, also involve recoupment, but in this case the post-predation gain is procompetitive because recoupment comes not from output contracting monopoly pricing, but from output expanding efficiencies.

1. Legal Elements—Prima Facie Case

Consistent with existing law, the proposed rule would require proof of the following elements: (1) a facilitating market structure, (2) a scheme of predation and supporting evidence, (3) probable recoupment, (4) price below cost, and (5) absence of an efficiencies or business justification defense.¹⁰² We discuss the four elements necessary to make out a prima facie case of predatory pricing in this section, and the efficiencies defense in a separate section. The plaintiff would generally have the burden of proof on the first four elements, while the defendant would have the burden on the last element.

1. Facilitating Market Structure

The market structure must make predation a feasible strategy. This requires what Joskow and Klevorick call “short run pricing power”—the ability to raise prices (or otherwise exploit consumers) over some significant but not necessarily unlimited period of time. A predatory market structure exists when a dominant firm or small group of jointly acting firms has high market share, and when there are both entry and reentry barriers.¹⁰³ When these conditions exist, predation may injure competition. When they do not, the court should be able to dismiss the case if the structural facts are sufficiently clear. Thus, predatory market structure would operate as a threshold screen, as the Supreme Court held in the Brooke case.

Entry barriers exist when a new market entrant faces costs that the incumbent predator need not bear, or no longer faces. The most frequent example is sunk costs—fixed cost investment that cannot be withdrawn from the market except at large sacrifice, such as the trackage of a railroad. While the predator has borne these costs in the past, they are now irretrievable. Thus, if challenged by new entry, the incumbent will rationally disregard such costs in its pricing decisions rather than lose the business. The entrant on the other hand must now incur such costs, and hence faces risk of underpricing by an incumbent with sunk costs. Thus, sunk costs may act as an entry barrier, giving the incumbent power to raise price above the competitive level.

Reentry barriers exist when a firm that has left a market bears significant costs in seeking to reopen its business. As an example, a small airline forced to cease operations in a local market just as it is beginning to establish its brand name, may have damaged its reputation as a reliable alternative to the established carrier. To reenter it will have to slowly rebuild its reputation, and this is costly. Reentry barriers combined with entry barriers give a successful predator the power to raise prices. The Supreme Court has emphasized that proof of predatory pricing requires proof that entry and reentry barriers continue to exist during the recoupment period.¹⁰⁴

However, the courts have failed to see that successful past predation can itself operate as an entry and reentry barrier particularly where reputation effects are present. In such cases the would-be entrant anticipates that any attempt to enter the market will evoke a predatory response from the incumbent. Anticipating that consequence, the firm declines to enter. That is to say, the incumbent’s past reputation as a predator deters future entry or reentry.¹⁰⁵ The problem of proving entry barriers, particularly those based on reputation effect, can be eased by presuming their existence if the incumbent significantly raises price after the prey’s exit without inducing new entry or reentry. Such a presumption is similar to the inference made under the rule of reason that proof of anticompetitive effects may serve as proof of market power.¹⁰⁶ The presumption is of course rebuttable since other economic factors, such as excess capacity may explain the absence of entry.

2. Scheme of Predation and Supporting Evidence

Proof of predatory pricing and recoupment require a showing that predation is plausible ex ante and probable ex post. Ex ante plausibility is shown by proof of a predatory scheme and supporting evidence. Ex post probability is shown by proof of subsequent exclusion of rivals and post-predation market conditions that make future recoupment likely. We discuss the ex ante condition—proof of a predatory scheme and supporting evidence—in this section and the ex post conditions in the following section.

Under Brooke and Matsushita proof of a predatory scheme, under which the predator can expect to recoup its predatory losses, is an essential element in a predatory pricing case. Moreover, the degree of plausibility of the predatory scheme vitally affects the standard of evidentiary proof for recoupment. If the alleged predatory scheme is only weakly plausible, as the Court found to be the case in Brooke and Matsushita, more persuasive evidence of recoupment is required.¹⁰⁷ Illuminating the stringency of this requirement, the Court in Brooke subjected the evidence to a demanding analysis such as to make it doubtful that any claim of multi-firm predation could have survived the Court’s scrutiny. However, where the predatory theory is less problematic, proof of market conditions enabling probable recoupment, while still required, more readily leads to the conclusion of probable recoupment. In any event, taken together the alleged scheme of predation and post-predation market conditions must add up to a compelling theory of predation.

The Court found the alleged predatory scheme in Brooke implausible because the scheme appeared to require sustained tacit coordination between multiple firms without explicit communication or agreement on a predatory strategy and a mechanism for recoupment. In the absence of a focal point for coordinated action, it was unclear how the alleged predators could overcome cheating and free-riding problems in executing a predation and recoupment strategy. The Court also thought the predatory scheme to be implausible in Matsushita, even though it involved alleged agreement between the alleged predators, because of the inherent difficulties of orchestrating a coordinated predatory pricing and recoupment strategy among competing firms.¹⁰⁸

The predation theories we discuss stand on a stronger foundation of economic theory. Rigorous economic analysis, developed over the last 30 years and using the tools of applied game theory, identify the economic conditions under which predatory pricing is rational, profit-seeking conduct by a dominant firm. Expected or anticipated recoupment is intrinsic to these theories, because without such an expectation predatory pricing is not sensible economic behavior. Thus, modern theories when factually supported may sustain the plausibility of a predatory scheme. Finally, when modern theory has been properly briefed to the Supreme Court in other types of antitrust cases and when the predatory or exclusionary theory is supported by convincing factual evidence, the Court has been willing to follow modern theory.¹⁰⁹

3. Probable Recoupment

Under Brooke and Matsushita a predatory scheme, however plausible and well supported by ex ante evidence, violates the antitrust laws only if the ex post evidence shows that the alleged predatory pricing (1) excludes or disciplines rivals or potential rivals, and (2) thereby injures competition and consumers by enabling the predator to raise prices or lower quality, or dangerously threatens to do so. The exclusion or disciplining of rivals is the intended instrument of the predatory scheme and the future raising of prices is its anticipated effect. Together they establish that the predatory scheme is not only plausible in itself, but had its planned effect on rivals and injures consumers either now or in the foreseeable future. We discuss the two effects separately for clarity of analysis.

Exclusionary Effect on Rivals. The means by which predatory pricing works its ultimate injury to consumers is through its exclusionary effect on rivals or potential rivals. Exclusionary effects involve either the exclusion of a rival or potential rival from the market, or the disciplining of the rival's competitive conduct. At a minimum this requires proof that the below-cost pricing was capable of achieving its intended exclusionary effect on rivals, as the Supreme Court noted in Brooke.¹¹⁰ While such pricing must have been a substantial factor in producing this result, the defendant’s low prices need not have been the exclusive cause of the victim’s market exclusion or threatened exclusion; and indeed other factors may have contributed, such as increased raw material costs or reduced demand. It suffices to show that the alleged unlawful conduct was a “material cause,” “a substantially contributing factor,” or “among the more important causes.”¹¹¹ On the other hand, predation that was only “a minor contributing factor” to the victim’s forced exclusion or threatened exclusion would be insufficient to establish an exclusionary effect.¹¹²

A second type of exclusionary effect is the disciplining of rivals. In this case the rivals are not excluded from the market, but their competitive conduct is inhibited. While some writers define predatory pricing solely in terms of rival exclusion,¹¹³ disciplining of rivals is a well accepted anticompetitive effect, particularly by legal authorities.¹¹⁴ In fact, the disciplining of rivals is itself exclusionary since its object is to exclude the growth and expansion of the prey or the prey’s entry into new markets. Proof of a disciplining effect requires the plaintiff to show (1) the victim is a rival firm whose competition threatens or potentially threatens the profits of the predator, (2) following the period of below cost pricing the victim raised its prices, became less aggressive or otherwise restrained its competitive conduct, or that the below-cost pricing was capable of producing this result, and (3) the below-cost pricing was a substantial factor in causing these exclusionary effects.¹¹⁵

The Brooke case provides an illustration of price disciplining (although the plaintiff’s case ultimately failed on the issue of recoupment). The victim Liggett had introduced low cost, unbranded cigarettes which threatened the profits of the larger manufacturers including the defendant Brown and Williamson. After 18 months of sustained below cost pricing by defendant, Liggett raised its prices and essentially became a price follower. Below cost pricing clearly appeared to have been a substantial factor in causing Liggett to raise its prices and to become less aggressive since it was only after five successive price cuts by defendant that Liggett ultimately succumbed.

Injury to Competition and Consumers. Under Brooke and Matsushita proof of an injury to competition, actual or probable, is an essential element of a predatory pricing case. This requires evidence either that (1) the alleged predatory scheme caused prices to rise above the competitive level in the predatory market or in another strategically-linked market in which the predator has market power, or (2) market conditions and the predator's conduct makes future recoupment likely under the alleged scheme. Proof of actual recoupment is not a necessary ingredient of predation since Brooke requires only a showing of probable recoupment. Indeed, if actual recoupment were required, a predator might be able to avoid liability by delaying recoupment until risk of suit has passed, perhaps because the passage of time has made it difficult to rebut the claim that other economic conditions caused the price increase.

Consistent with Brooke, a sufficiently strong showing of an increased ability to raise and maintain high prices as a result of successful predation could meet the recoupment requirement even in absence of a well-articulated strategic theory. In such a case the evidence will have shown that the alleged predator has excluded a rival from a market with a below cost price, has at least partly recouped its predatory losses subsequently by raising price, and likely will be able to maintain above-cost prices sufficiently long to fully recoup its predatory losses. With such evidence of actual recoupment already in progress, it seems reasonable to infer a coherent predatory strategy without requiring the plaintiff to completely spell out and prove the logic of the strategy. The risks of over deterrence in such a case seem minimal since the Supreme Court has made clear that the standard of proof in predatory pricing cases is exacting, and the post-Brooke cases show that it is exceedingly difficult to satisfy that standard, absent a persuasive theory of predation.

In contrast, we propose that the evidentiary standard for probable recoupment should be less demanding when proof of the predatory scheme rests on a coherent strategic theory supported by evidence of market structure and conduct. As suggested above, Brooke permits such an interpretation because the conclusion of probable recoupment is drawn jointly from the plausibility of the predatory theory and the post-predation market conditions. When, as in Brooke, the theory is weak, the post-predation evidence must be stronger.

Where, however, the predatory theory is robust, the post-predation evidence standard should be less exacting, though of course still required. Suppose, for example, that the plaintiff articulates a coherent theory of strategic predatory pricing based on modern economic analysis, that the evidence shows that post-predation market structure and conditions are consistent with the required assumptions of the theory, that the actions of the defendant and other market participants have also been congruent with the theory, and that the plaintiff has been excluded from one or more markets as result of below- cost pricing. With this evidence of post-predation market structure and conduct in hand, it seems reasonable to infer probable recoupment. In this way our proposal extends the existing interpretations of Brooke to enable a plaintiff to prove recoupment based on modern strategic theory without having to show actual recoupment.

4. Price Below Cost

The final element in establishing a prima facie case of predatory pricing is proof of sales below cost. A cost standard can be faulted as difficult and expensive to prove, and also under-inclusive because prices above cost can be both predatory and injurious to competition.¹¹⁶ Despite these problems, a cost benchmark is generally necessary for effective business planning for an activity as ubiquitous as pricing. Moreover, since at least 1975, U.S. courts have uniformly followed a cost standard in evaluating predatory pricing.

The cost standards that the courts have most often used are average total cost (ATC) and average variable cost (AVC). Under current U.S. law, a price above ATC is conclusively lawful, while at the other extreme, in most jurisdictions a price below AVC is presumptively unlawful (assuming the other preconditions of Brooke are satisfied).¹¹⁷ A price between AVC and ATC is either presumptively or conclusively lawful, depending on the Circuit.¹¹⁸ In Circuits where the price is presumptively lawful, the presumption can be rebutted by other evidence of predation, particularly intent and market structure.¹¹⁹ However, we shall urge that an incremental cost standard provides a superior measure for assessing predation. Thus, we would substitute average avoidable cost for AVC, and long run average incremental cost for ATC.

This proposal follows in substantial part the recent proposal of William Baumol, who similarly urges substitution of average avoidable cost for AVC.¹²⁰ We agree that this should be the lower bound cost test. However, we would add an upper bound cost measure of long run average incremental cost as a substitute for ATC, a proposal originally made by Joskow and Klevorick.¹²¹ Thus, we adhere to the dual cost approach that many courts presently follow, but we reformulate the cost test to more closely approximate the theoretically correct marginal cost standard.

Average avoidable cost (AAC) is the average per unit cost that predator would have avoided during the period of below cost pricing had it not produced the predatory increment of sales. Thus, if the period of alleged predation is 10 months, AAC is the sum of the costs incurred in producing the predatory increment over the 10 month period divided by the quantity produced. It is immediately apparent that AAC is a short run measure because, like AVC, it does not include any sunk costs incurred before the period of predation (since these are not escapable). However, unlike AVC, AAC does not require an often controversial allocation between fixed and variable costs, and also more closely approximates marginal cost since AAC includes all costs that could have been avoided had the defendant not made the predatory sales, whether fixed or variable. Thus, AAC is both easier to calculate and more theoretically correct than AVC.

Long run average incremental cost (LAIC) is the per unit cost of producing the predatory increment of output whenever such costs were incurred. More precisely, the LAIC of a new product is the firm’s total production cost (including the new product) less what the firm’s total cost would have been had it not produced the new product, divided by the quantity of the product produced.¹²² LAIC thus includes all product-specific costs incurred in the research, development and marketing of the predatory product or increment of sales even if those costs were sunk before the period of predatory pricing.¹²³ In addition, LAIC logically includes any costs incurred to effectuate the predatory scheme, following formation of the predatory strategy. LAIC is a superior cost measure over ATC for a multi­ product firm because it does not require courts to allocate joint and common costs, an undertaking which lacks a precise methodology and is particularly unsuited for jury resolution.¹²⁴ Moreover, LAIC measures the present worth of the productive assets by replacement cost, and not by historic costs which may give little indication of their current value.¹²⁵

Long run average incremental cost is a necessary benchmark in addition to short run cost because sales below LAIC may reflect a strategy of sacrificing current profit in order to exclude or discipline a rival and thereafter hold price at the monopoly level. Such conduct, if not otherwise explainable, is predatory and a predatory pricing rule that excluded it would be seriously under inclusive.

The risk of under inclusion is particularly acute for intellectual property. A short run cost test provides little protection against predatory pricing involving intellectual property since after the product is developed and launched, AAC or AVC may approach or equal zero. In computer software, for example, the short run incremental cost of a program downloaded from the Internet, is nil. As a result there can be no sale below AAC. An AVC standard does little better since the average variable costs of computer software continuously decline and may approach insignificance as sales volume becomes sufficiently high. Thus, the only tenable cost standard for intellectual property must be a long run cost measure. LAIC is superior to ATC as a measure for intellectual property because LAIC emphasizes that the relevant costs relate to research, development, marketing and production of the predatory product or service, rather than to some larger category of sales.¹²⁶

Cost Presumptions and Burdens of Proof. Applying these cost concepts, we would treat a price above ATC as conclusively lawful (following Supreme Court precedent), but otherwise we would substitute for ATC, the similar but economically more accurate measure of LAIC. A price below AAC would be presumptively unlawful (assuming the other elements of proof of liability are satisfied). When price is below this level, the defendant would then have the full burden of persuasion to show that the low price was necessary to achieve competition-enhancing efficiencies. Consistent with the standard for proof of liability,¹²⁷ the efficiencies defense would be applied from an ex ante perspective: Would a representative firm in the industry have anticipated the conduct to be profit maximizing in the absence of exclusionary effects?

If the predator has priced below LAIC (but above AAC), the burden of proof would be divided between plaintiff and defendants. First, the defendant would have an initial burden of production—of coming forward with some tangible evidence of efficiency or legitimate business purpose. Second, once defendant has offered such an explanation, the burden of persuasion would then shift to the plaintiff to persuade the court that the pricing conduct was predatory.

Placing an initial burden of production on the defendant when price is below LAIC is justified because the first four elements will have established not only that price is below some measure of cost, but also that industry structure makes predatory pricing feasible, specific market conditions facilitate and enable the alleged predatory strategy, the prey has been excluded or disciplined, and as a result the price has increased or is likely to increase. Such a record properly puts some burden of explanation on the defendant. At the same time the presence of the specified preconditions mandated by Brooke assures that defendants will not be required to justify all challenged price cutting since the preconditions confine possibly suspect price cutting to a narrow range of cases. Moreover, the defendant is well placed to provide such an explanation since it surely has the best knowledge of the efficiencies and business reasons for its actions.

2. Legal Elements—Efficiencies Justification

The efficiencies or business justification defense serves as a means of eliminating cases where below cost pricing by a firm with market power is efficiency-enhancing, rather than predatory. In these cases the sacrifice of present profits through low pricing is justified for reasons other than exclusion or disciplining of rivals. The defense thus serves as a necessary shield against an overly inclusive legal rule. The predatory pricing cases have recognized a business justification defense in a variety of factual settings, but have created no clear standards to guide application of the defense.¹²⁸

The burden of proving an efficiencies defense is generally placed on defendants in antitrust cases on the theory that they have superior access to the information, which is under their control.¹²⁹ As noted above,¹³⁰ in applying our approach, we would place the full burden of proof on the defendant when price is below short run cost. When the price is above short run cost (but below long run incremental cost), defendant would have an initial burden of producing evidence of efficiencies, after which the burden of persuasion would shift to the plaintiff. Business justifications for below cost pricing may be either defensive and competition-compelled or market expanding.

1. Defensive Business Justifications

In defensive price cutting a firm prices below its cost in response to price reductions by its rivals or to market events outside the firm’s control, seeking to maintain its competitive position in the market. Examples of defensive price cutting include price reductions that (1) meet the lower price of a rival who initiated the price cutting, (2) minimize losses stemming from unexpected market developments, such as excess capacity, product obsolescence, or shrinking demand, or (3) serve to maintain marketing channels or an ongoing organization, so as to preserve existing options for resumption or expansion of production when market conditions improve.¹³¹

Unilateral best response. In addition, we would recognize as an additional justification for defensive price cutting a price reduction below LAIC (but not below short run cost) that is a unilateral best response to a competitive price offered by a rival. By a unilateral best response we mean a price that maximizes the incumbent’s immediate or short run profit even though its rival remains in the market. Such a price will thus always be above incumbent’s short run cost but may well fall below LAIC. Under these conditions the reduced price is simply an independently justified, profit maximizing response to the prevailing market price.¹³² Note that the incumbent’s price may be profit maximizing even if it undercuts the rival’s price so long as it remains above incumbent’s short run costs.¹³³ Typically, this is likely to occur when the incumbent has high sunk costs and excess capacity such that its short run costs are very low.¹³⁴

The courts have generally upheld most types of defensive below cost pricing, as compelled by competition. Such pricing benefits consumers in the short run through lower pricing and may promote long run consumer and social welfare in cases where it preserves the price cutter as a competitor or potential competitor in the challenged market. Indeed, the freedom to respond to aggressive price cuts by rivals or to sudden changes in economic conditions may be necessary to give firms the incentive to create and develop markets in the first place.¹³⁵

3. Market Expanding Efficiencies Defenses

In market expanding price cutting the firm prices below its cost to promote a new product or enter a new market, entice consumers to shop at an existing outlet, reduce costs through learning-by­doing, or increase the value of its product through network externalities. Such pricing is essentially dynamic in that the price cutter anticipates that lower costs or increased marketing efficiency in the future will compensate for present losses.

Market expanding price cutting raises more difficult issues than defensive price cutting because it involves an aggressive move that may either be procompetitive and output expanding, or injurious to competition, excluding or disciplining rivals. To sort out these differing effects we suggest that a market expanding business justification defense should have three elements:

(1) Plausible efficiencies gain. The increased sales resulting from the below cost pricing plausibly increases efficiencies, e.g. reduces cost through learning by doing or other increasing returns to scale effects.

(2) No less restrictive alternative. The efficiencies gained cannot reasonably be achieved by a means substantially less restrictive of competition.

(3) Efficiency-enhancing recoupment. Recoupment of the investment in below cost sales stems from efficiency-enhancing factors, e.g. higher product quality or lowered cost, rather than from increased profits through eliminating or disciplining a rival.

The defendant would have the burden of proving the first and third elements— efficiencies gain and efficiency-enhancing recoupment. However, the burden to establish the second element—no less restrictive alternative—should be allocated between the parties. In proving the second element the plaintiff would have the burden of identifying one or more plausible less restrictive alternatives, after which the burden would shift to the defendant to show that such alternatives are either not feasible or not less restrictive.¹³⁶

We sketch three types of market expanding efficiency defenses: promotional pricing, learning- by-doing, and network externalities. These are all dynamic efficiencies that explain how the higher sales resulting from lower prices might increase future profits even with no exclusionary or disciplining effect. Typically they involve new products or new markets. Evaluation of market expanding efficiencies may raise difficult issues of characterization. On the one hand, market expansion provides procompetitive explanations for recoupment of losses from below cost sales. On the other side, the mere presence of these efficiencies does not preclude a coexisting predatory strategy to exclude or discipline rivals. Thus, it is important to show whether dynamic efficiencies alone make recoupment sufficiently probable to justify the losses from below cost prices. Only when this condition holds should we accept an efficiencies defense involving dynamic economies.

a. Promotional pricing

A profit-maximizing firm with no exclusionary purpose might temporarily price below its cost in order to induce consumers to try a new product.¹³⁷ The firm’s expectation is that a favorable consumption experience induced by prices below cost will increase future consumer demand at prices above cost. This might be the case if consumers make frequent repeat purchases or communicate their views of product quality to other consumers by word-of-mouth.¹³⁸ The promotional pricing defense is best understood through a hypothetical case.

Illustrative Example: Tasty-Frozen Pizzas. Tasty-Frozen, a leading manufacturer of frozen pizzas, develops a new kind of cheese that retains its flavor and texture much better than other frozen pizzas. The new ingredient is much more expensive than existing cheeses, but test market research shows that consumers prefer the enhanced pizza and would be willing to pay for it. However, test market research also indicates that consumers, distrustful of “new and improved” product claims, are unwilling to try the new pizza if they must pay a higher price. To convince consumers that the new pizza tastes better, Tasty-Frozen considers in-store sampling but this is a costly and likely ineffective marketing device since in-store congestion limits ability to reach consumers. Instead, Tasty-Frozen introduces its new product at the price charged for other frozen pizzas, supported by an intensive three- month advertising campaign. As a result, the price of the new pizza falls below Tasty-Frozen’s short run costs (e.g. AIC or AVC).

At the end of the three months promotion, Tasty Frozen raises its price. Consumers remain loyal, having come to appreciate the new pizza’s improved taste. While the manufacturer sustains large losses during the three months promotional period, from that time on the firm earns substantial profits from its higher prices and scale economies. Projected sales indicate that Tasty-Frozen will become profitable within a year. Moreover, the company has no incentive to later degrade the quality of its product, e.g. by mixing the new cheese with less expensive standard cheese, because consumers would note the change and no longer be willing to pay a premium. The higher quality of the new pizza has caused many customers to switch from the lower priced brands, and the switch persists even after Tasty-Frozen had raised prices. Indeed, so successful is the new pizza that several of Tasty-Frozen’s low price rivals suffer losses and leave the market.

Assume that Tasty-Frozen dominates the frozen pizza market, that brand recognition creates entry and reentry barriers, pricing is below cost, a predatory strategy is plausible (e.g. financial market predation), rivals are excluded, and following the price cutting, Tasty-Frozen raises price, enabling recoupment of its investment in below cost sales. In the absence of an efficiencies defense Tasty-Frozen’s pricing conduct appears to raise antitrust problems.

Proof of Efficiencies Defense. The above facts would satisfy each of the elements necessary to sustain an efficiencies defense.

(i) Plausible Efficiencies Gain. The below cost pricing has caused consumers to try the new product (and could reasonably have been expected to have this effect). Introduction of the new pizza has improved both product quality and variety, as shown by consumer willingness to pay higher prices after the promotion period; and the fact that cheaper brands of pizza continue to be offered. Thus, successful launching of the new pizza plausibly increases efficiency.

(ii) No Less Restrictive Alternative. Success of the new pizza depends on informing consumers of its superior qualities. Sales below cost have induced consumers to try the new product and persuaded them that its improved taste justifies a higher price. Other means to induce consumers to experience the product, such as in-store sampling, are costly and ineffective. The planned three month period of below cost promotional pricing is no longer than appears reasonably necessary to inform consumers about product attributes. Thus, no less restrictive alternative appears reasonably available to successfully launch the new product.

(iii) Efficiency-enhancing Recoupment. Tasty-Frozen raised its price after three months and became profitable after only a year, thereby recouping, at least in part, its investment in below cost pricing. Tasty-Frozen’s profit stems from the improved quality of its pizza and not elimination or disciplining of rivals, since competition from existing, lower cost frozen pizzas remains vigorous.¹³⁹ Moreover, the manufacturer has a continuing incentive to maintain product quality since quality alone enables it to charge a premium price in the face of continuing competition from lower priced frozen pizzas. Thus, recoupment stems from the efficiency-enhancing improvement in the quality of Tasty- Frozen’s pizza.

b. Learning-by-doing

The learning curve is an empirical relation showing that unit costs decline with cumulative production experience. The learning curve reflects the idea that learning-by-doing can be an important source of process innovation. In the presence of a learning curve, a profit-maximizing firm might reduce its price below its current cost to increase its production volume without having any predatory purpose. By this means the firm may accelerate its discovery of cost-reducing production methods, recouping its investment in below cost pricing from increased profit available at a later time.¹⁴⁰

Proof of Efficiencies Defense. Learning-by-doing induced by below-cost sales may achieve efficiencies gains through earlier discovery of cost-reducing production methods, but it may also have exclusionary effects, which at the limit may create a dominant or monopoly firm. Thus, absence of a less restrictive alternative becomes a key factor in assessing availability of an efficiencies defense. This requires proof that other means of achieving learning curve economies are more costly, for example mentoring by other workers, class room training, process R&D, or producing to inventory. In addition, the period of below-cost pricing must be no longer than reasonably necessary to achieve the learning economies.

Finally, to prove efficiency-enhancing recoupment the firm must show that accelerated production enabled it to achieve important cost savings, and that its rivals, producing at lower volume did not achieve similar cost savings during the same time period. Proof of such facts would tend to establish that below-cost pricing was necessary to induce the savings in production cost.¹⁴¹

c. Network Externalities.

A network externality occurs when a consumer’s valuation of a product increases with the number of other consumers using the product. An example is a telephone network, where the value of the network to a user increases with the number of connected telephone users. The procompetitive rationale for below-cost pricing in cases involving network externalities bears similarities to both promotional pricing and learning-by-doing. The rationale is similar to that for promotional pricing because future demand increases with added current sales. The rationale is similar to learning-by-doing because demand depends on cumulative sales.

When network externalities are present a profit maximizing firm might initially price a product below cost in order to establish a large installed base of users, and thereby increase demand for its product. Moreover, the firm might do this for procompetitive reasons and without any exclusionary purpose. Such a procompetitive effect might occur, for example, if (1) the firm had reason to expect that an installed base would significantly increase the demand for its product, (2) a large installed base would increase availability of complementary products and services, augmenting the value of the basic product, (3) as a result, consumers would value the product more highly, enabling the firm to recoup its investment in below cost pricing, and (4) the period of below-cost pricing extends no longer than reasonably necessary to achieve the installed-base network economies. As in the case of learning curve economies, the presence of a less restrictive alternative is likely to be a key issue.

An example of network externalities would be a new battery for electric cars that requires a network of service stations with specialized equipment and service personnel. Assume a new technology is developed by two firms such that each requires its own specially equipped servicing network, as well as specially designed auto engines. Firm A develops its battery a few months earlier than Firm B and obtains initial contracts with auto manufacturers developing a pioneer electric car to test market in a few cities. Firm A also induces a small number of service stations to buy the necessary equipment and train personnel. When Firm B enters the market, Firm A bids aggressively in each competitive encounter, often bidding below cost. As a result Firm A obtains most of the initial contracts. Since far more cars now have A-type batteries, few service stations are willing to invest in the specialized equipment and training costs for Firm B’s batteries. As a result, the market for Firm B’s batteries dries up and Firm B leaves the market. Thereafter, Firm A raises prices steeply

This example clearly involves a network efficiency since a large installed base for a particular battery makes servicing available and convenient for consumers. A less restrictive alternative would, of course, have been for Firm A to price above cost. In that event consumers would have had a choice between two battery types and probably lower prices. In retrospect that alternative appears clearly viable in view of the rapid growth of the electric car market. On the other hand at the time of the below cost pricing the potential size of the market was unknown, and Firm A might reasonably have anticipated that the market would support only one type of battery. In that event below cost pricing might have been justified as the quickest path to a viable battery network.

Firm A clearly recouped its investment in below cost pricing, but the recoupment may or may not have been efficiency enhancing. If a single, quickly developed battery network was essential to the success of the electric car, recoupment was efficiency-enhancing. However, if above cost pricing would have led to marketing success for two batteries, the huge recoupment Firm A obtained would be predatory, not efficiency-enhancing. Since counter-factual determinations are always difficult, convincing proof should be required to sustain the predatory finding where, as here, market expanding efficiencies are plausibly achieved.

IV. FINANCIAL MARKET PREDATION

1. Economic Theory

Financial market predation is not to be confused with traditional deep pocket predation. The deep pocket theory in its original form held that a richly endowed predator would charge low prices to drive out a poorly endowed rival.¹⁴² This simple form of the theory is no longer accepted except in certain regulatory applications¹⁴³ because it ignores the possibility that profit-seeking investors would finance the prey. Thus, in the general case, we must assume that capital markets are open to a profitable prey, and allow that external financing could foil predation.

Accordingly, modern strategic theory focuses on the relation between the prey and its investors.¹⁴⁴ The predator seeks to manipulate that relationship and thereby drive the prey out of the market or deter its expansion into new markets. A predatory strategy becomes viable because of capital market imperfections. In supplying capital, investors face agency or moral hazard problems arising because the managers of the firm may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests.

Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, thereby imposing an explicit or implicit threat of termination in case of poor performance.¹⁴⁵ If the investors are debt-holders, they threaten to liquidate the firm or deny new credit in the event of default. If they are venture capitalists they refuse to extend additional financing when early performance is poor. And if they are shareholders, they decline to purchase additional equity if expected returns are low due to disappointing initial performance. Predatory pricing in product markets thus becomes possible when a predator exploits these termination threats to dry up the financing of a rival firm.

Admittedly, termination threats are blunt instruments and investors in principle could shield themselves more effectively by making the financing contract dependent on the firm’s realized profits in a more discerning way. But generally, more sophisticated contractual agreements which attempt to discriminate between different causes of poor financial performance fail because the firm’s accounting profit is manipulable and therefore not reliable. The true economic profit of the firm is not perfectly observable by an outsider, and even if it were, it could not be verified by a court sufficient for use as a condition in a financing contract.

Agency problems are particularly acute in the financing of new enterprises. Typically, there is great uncertainty about cash flow in the beginning stages of a new enterprise. Investment in a new or expanding firm may encounter initial losses or lower than expected profit. These losses may be unavoidable start-up costs, never fully foreseeable, or may be due to agency abuse. Lenders can mitigate moral hazard problems by requiring collateral and by agreeing to extend financing (in staged commitments) only when the firms’ initial performance is adequate. In many instances lenders commit explicitly to further financing, contingent on verifiable performance (as in venture capital contracts), but more commonly the agreement to extend additional financing is implicit¹⁴⁶. When the promise of new financing is implicit, firms can only obtain new funding if the new investment is perceived to be sufficiently profitable by the lender and if the lender has adequate protection against agency abuse. Thus, to obtain additional financing in a later period, the borrower must be able to put up a significant fraction of its own capital as collateral, as well as meet its existing financial obligations.

Financial contracts that guard against agency abuse may invite predation. A predator may slash price to drain the prey of sufficient funds to meet its loan commitments, thereby forcing default. Less drastically, the predator may be able to lower the prey’s earnings and thus to impair the prey’s debt capacity by limiting the amount of collateral it can put up. In addition, reduced earnings exacerbate future agency problems by forcing the prey to pledge a bigger share of future profits to its’ outside investors and creditors. As a result the firm’s manager would have less incentive to maximize profits. Finally, lower earnings may cause the lenders to wrongly believe that the firms’ profits are likely to be lower or riskier in the future and therefore to stiffen their lending terms.

It might at first appear that a lender could easily counter predation by agreeing to finance the prey irrespective of its ability to meet scheduled loan repayments; and that the predator, anticipating the lender’s counter strategy, would realize that financial predation cannot succeed. However, a lender will not ordinarily make such a commitment because to contribute funds to a debtor in default provides no restraint on agency misconduct¹⁴⁷.

Nor can lenders solve the financing problem by excusing default when caused by predatory pricing. The lender may be unable to determine whether the default stems from predatory pricing or from the debtor’s poor performance because the lender lacks both full information and the expertise available to a market insider. Even if the lender could so determine, the courts can verify that determination only through a costly and inherently uncertain legal proceeding that few lenders would wish to confront.¹⁴⁸ Thus, the lending agreement cannot feasibly include a commitment based on the future occurrence of predatory pricing. And in the absence of such commitment the lender may not want to extend lending in the event of predation.¹⁴⁹

All this places the lender in a dilemma. If the lender provides a continuing supply of funds sufficient to deter predation, it invites agency misconduct. On the other hand, if the lender attempts to impose financial discipline on the firm with repayment obligations and collateral requirements, it may induce predation. There is no fully satisfactory solution to the dilemma. Indeed, the lending contract that minimizes agency problems will maximize the incentive to prey.¹⁵⁰ Since lenders can scarcely afford to ignore agency problems in writing financial contracts, predation potentially remains a viable strategy. The inability of creditors to write optimal financing contracts in the presence of predation raises the costs of debt and lowers the return on new enterprise, thereby inhibiting the development of new competition and possibly reducing economic welfare. In a very real sense capital markets have failed since these adverse effects follow even when it is common knowledge that new entry by an efficient firm would be profitable in the absence of predation.

Perhaps the most insistent critique of a predatory pricing strategy is that even if the prey is forced to exit the market, the predator has accomplished nothing because the prey’s assets remain in the market. Indeed, if the prey’s assets are sold at a low price, then the successor may have a lower debt burden and therefore greater access to capital markets and a lower cost of capital than the defeated prey. Thus, it is argued, the predator now faces a stronger and better financed rival than before, thus making recoupment unlikely. This critique is flawed for reasons we discuss in some detail in Part VII below. Foremost amongst the flaws are the likelihood that the acquired assets may be insufficient for the successor to achieve a viable scale, and that attempts by the successor to gain additional financing may be plagued by concerns about continuing agency problems and further predation.

A related critique is that acquisition of the prey by a well endowed creditor would preclude financial market predation. However, creditor acquisition of the prey is generally not feasible because agency costs and measurement ambiguity frequently prevent the creditor from ascertaining the true profit of the prey, and thus determining whether in the absence of predation, the prey is profitable. Even if the creditor can observe the prey’s profitability, it typically lacks the specialized expertise to manage the prey. If the creditor attempts to gain the needed expertise, it may not succeed, and at the very least faces a time lag, during which it will sustain additional losses. It might be objected that the creditor is in no worse position than the predator. But this objection neglects the fact that the predator is an insider, while the creditor is a market outsider. Thus, the possibility of creditor acquisition of the prey will not always bar financial predation.¹⁵¹

A final possible avenue to further financing is bankruptcy reorganization, which involves compromise and subordination of loans to give the bankrupt a chance to work itself out of insolvency, under judicial supervision. But the inability to make additional financing arrangements dependent on profit confronts new creditors with the same contracting limitations that stymied the original creditors.¹⁵² Nor can new creditors rely on the bankruptcy court to effectively constrain agency misconduct by the bankrupt debtor. U.S. bankruptcy reorganization procedures do little to protect against debtor or management misconduct. There is no trustee and no SEC supervision. The old management often remains in control both during and after reorganization under the broad permissiveness of the business judgement rule, and the reorganization plan is almost always that of the debtor.¹⁵³ The court does not supervise the reorganized firm, but acts essentially as an arbiter between conflicting interests.¹⁵⁴

2. Proof of Financial Predation Strategy

Proof of a plausible strategy of financial market predation would require a showing of five essential preconditions or enforcement screens. Fulfilment of these preconditions would establish that financial predation could be a viable predatory strategy. Of course proof that financial predation is a viable strategy does not establish an antitrust violation. Proof of violation would require proof of all of the elements set forth in our proposed rule. The preconditions are as follows:

1. The prey depends on external financing. Dependence on outside funding creates agency problems and contractual responses that expose the prey to predation. Such dependency is the typical condition of the new or expanding firm, as vividly seen in venture capital financing.

2. The prey's external financing depends on its initial performance. This is an essential condition because unless the prey’s financing depends on initial performance, the financial relationship between the prey and its investors and creditors would be insensitive to a strategy of price predation. Cash flow is the most obvious performance indicator on which outside investors are likely to focus. Lending contracts requiring repayment or increased capital contributions over staged intervals are a common form of financing that exhibits the requisite dependence on cash flow. Similarly, new investors would be discouraged by lower than expected cash flow. In some cases, external financing might depend on other performance indicators beside cash flow, such as revenues or initial market penetration.

3. Predation reduces the prey’s initial performance sufficiently to threaten the prey’s continued financing and viability. Predatory risk must be of sufficient magnitude and probability to affect the supply of further financing, thereby threatening the prey’s financial viability. These conditions reasonably would be present in many cases, and might be demonstrated by the prey’s business plan.

4. The predator understands the prey’s dependence on external financing. Perhaps an obvious point, the predator must know that the prey’s viability depends on outside funding, or can be assumed to know, based on easily accessible facts or rational conjecture. Sometimes this may be common knowledge, as in airline markets, where all firms require outside funding to finance aircraft purchases.¹⁵⁵ Alternatively, funding dependency may be disclosed in public SEC filings or discoverable through simple investigation. In other cases knowledge may be inferred from the predator’s conduct or its internal documents.

5. The predator can finance predation internally or has substantially better access to external credit than the prey. This is a necessary assumption because unless the predator has superior access to credit or internal funding, it would face agency risks and resulting financing constraints similar to those that confront the prey.¹⁵⁶ Indeed, the predator might face greater difficulties in obtaining outside funding if predation proved more costly for the predator than the prey. As in the case of the prey, agency and verifiability problems would impede financing notwithstanding the ultimate profitability of the predator's conduct. It is reasonable to assume, however, that the predator, typically a monopoly, dominant firm or dominant group of firms, will be less highly leveraged than the prey (and thus raise less agency risk for the creditor). As a result, the predator faces little danger of credit cut-off or reduction of supply, while the prey will be more inhibited by the prospect of a price war¹⁵⁷.

3. Illustration: Cable TV

A recent case study,¹⁵⁸ involving entry into the cable TV market in Sacramento, California provides a vivid context in which to illustrate application of the strategic approach to financial predation. We first briefly describe the facts, and then apply our suggested elements of proof.

(i) Factual Summary

The monopoly cable system operator in Sacramento drastically cut price in response to successive entry attempts by two small rivals, both of which subsequently left the cable market, after which no further entry occurred. The second attempt was much better financed and persisted longer, and we confine discussion to this more substantial effort. Entrant began with outside financing amounting to $6 million,¹⁵⁹ which enabled it to overbuild a compact area (the Arden district) serving 5000 homes in Sacramento. This was the first step in a larger plan to build out gradually to challenge the incumbent over a 400,000 home market. Entrant sunk its initial investment, completed its underground conduits and cables and began to recruit customers.

Incumbent responded with drastic price cutting (and other predatory tactics). At least partly as a result of the price cutting, entrant was able to sign up only a handful of customers, and abruptly halted its effort to connect additional customers after only eight months. For a time entrant continued to serve the small core of customers it had succeeded in connecting, but eventually shut down its wired cable system, abandoning non-recoverable investment approaching $5 million. Entrant filed suit claiming predatory pricing,¹⁶⁰ and the case was settled during trial for $12 million.¹⁶¹ After its wired cable business became dormant, entrant successfully entered the Sacramento market by building a microwave transmitter, but its exclusion from the cable market had a significant impact on competition (as discussed below). We now show how we would apply our suggested elements of proof to these facts.

(ii) Proof of Case

(A) MARKET STRUCTURE FACILITATING PREDATION

The incumbent held a monopoly of cable system service in Sacramento. It was subject to competition from microwave, but this was inferior in quality and severely limited in the number of channels.¹⁶² Incumbent’s monopoly power was probably also signalled by the high return on investment relative to replacement cost for cable TV firms.¹⁶³ Substantial entry barriers existed in the form of high sunk costs, as well as regulatory hurdles. Incumbent’s ability to raise prices in the Arden sub-market after entrant withdrew would indicate reentry barriers (at least following successful predation).

(B) SCHEME OF PREDATION AND SUPPORTING EVIDENCE

The facts of the case provide a vivid illustration of the relevance and explanatory power of modern strategic theory—here financial predation. Proof of recoupment is established by a showing that recoupment is plausible under soundly based economic theory and by evidence of actual effects making recoupment probable in the light of that theory. The evidence clearly shows that each of the preconditions for financial predation was present.

(1) The prey depends on external financing.

Entrant began operations with $6 million in capital. The firm obtained the funds through a loan, personally guaranteed by its owners, who included two wealthy real estate developers. This financing sufficed to build an initial system serving 5000 homes. The costs of expanding to cover any significant part of the Sacramento market, of which this represented barely one percent, would be staggering, and clearly would require additional external financing. While the two principal investors were quite wealthy, they were essentially passive investors and were reluctant to risk additional funds in a business in which they had no prior experience. Instead their business plan was to rely on bank financing to raise the capital necessary to overbuild the Sacramento market.¹⁶⁴

(2) The prey's external financing depends on its initial performance.

In addition to their initial $6 million contribution, the two principal investors had obtained a line of credit from a consortium of banks to build into other geographic areas. Credit was easy to obtain due to the great wealth of the principals, but as indicated they were reluctant to risk their personal assets at risk beyond their initial investments and loan guarantees. The investors’ unwillingness to draw further on personal assets meant that expansion relied on other sources of financing, the availability of which depended on the prey’s initial performance. A positive cash flow from entrant’s initial operations was potentially a source of internal financing and collateral for bank financing.

(3) Predation reduces the prey's cash flow sufficiently to threaten the prey's continued financing and viability.

The incumbent's actions limited entrant's initial customer base to 170 homes, far below the 25­30 percent penetration needed to break even.¹⁶⁵ As a result of this “pitifully low penetration” entrant’s cost of capital was “climbing precipitously.”¹⁶⁶ The incumbent’s drastic price cutting convinced the principals that additional financing would require use of their personal credit. The investors did not attempt to draw on their line of credit, but instead abandoned efforts to extend the system, despite their sunk investment.¹⁶⁷ Entrant became a far riskier investment as a result of its low cash flow, and in the judgement of its principal investors could not obtain outside funding on the strength of its own credit and future potential.

Instead entrant simply maintained a holding operation, continuing to serve its handful of connected customers and eventually shut down its underground cable operation, into which it had sunk $5 million of non-salvageable investment.¹⁶⁸ Of course, other factors might explain the entrant’s abandonment of the cable market, such as changes in expected profitability, the superiority of microwave as a vehicle for challenging an established cable TV system, or a general tightening of credit availability. The case study notes only the latter condition—tightening of credit—but makes clear that the incumbent’s predatory campaign severely reduced entrant's cash flow, and hence its continued financing and viability.¹⁶⁹

(4) The predator understands the prey's dependence on external financing.

This element is easily satisfied since the facts showed that the incumbent was attempting to raise entrant's cost of capital so as to exclude entrant as a rival and to deter further entry. The whole purpose of the incumbent's price cutting strategy was to raise the entrant's cost of capital and discourage future contributions from its investors.¹⁷⁰ Indeed, an internal memorandum from the incumbent's files assesses the entrant's financial resources, focussing on the net worth of its two principals, comparing this with the resources of a previous entrant who had also abandoned the market after severe price cutting by incumbent.¹⁷¹ More striking still, another memorandum from incumbent's files speaks of sending a message to entrant's bankers.¹⁷²

Moreover, incumbent knew that to overbuild a significant part of the Sacramento market would take huge amounts of capital and that the entrant's main source of external funds was its individual investors. Incumbent could reasonably conjecture that the initial investors, with no experience in cable, would be unwilling, if not unable, to make such a large commitment without additional external financing. Incumbent also could reasonably conjecture that possible bank financing would depend on the cash flow generated by entrant’s initial operations.

Finally, the fact that entrant abandoned its effort to develop its existing cable market after only a few months of losses confirms the unwillingness of the entrant and its principals to commit additional capital even to develop a market area where they had large sunk investment. If entrant and its investors were not prepared to do that, they would surely have been unwilling to make additional sunk cost investment to expand beyond the its initial sub-market.

(5) The predator can finance predation internally or has substantially better access to external credit than the prey.

Incumbent clearly could finance the predation internally. It spent only $1 million on its predatory campaign.¹⁷³ Such an expenditure by a profitable monopoly serving a market of 400,000 homes, would clearly appear to be within its internal funding capability. This conclusion is not diminished by the fact that it was almost wholly owned by Scripps Howard, a strong and well-financed national newspaper chain.

(C) PROBABLE RECOUPMENT

Proof of recoupment requires ex post evidence that the alleged predatory pricing (1) excludes or disciplines rivals or potential rivals, and (2) thereby injures competition and consumers by enabling the predator to raise prices or lower quality, or dangerously threatens to do so. The two effects are related in that the exclusion or disciplining of rivals is the instrumentality by which competition and consumers are harmed.

While there was no specific evidence showing that the predator fully recouped its predatory losses through higher post-acquisition prices, other evidence overwhelmingly pointed to probable recoupment, taking into account the plausibility of the strategic theory of financial predation, the fact that the pre-entry price was a monopoly price which predation restored, and the future losses predator avoided by preventing competition.

Exclusionary Effect on Rivals. The evidence showed that the incumbent’s drastic price reductions excluded or was capable of excluding the entrant. Incumbent’s below-cost prices had severely limited entrant’s cash flow by limiting its customer base to an insignificant level, raised its costs of capital, blocked its perceived ability to obtain additional capital, and as a result caused entrant to cease expansion beyond its tiny customer base of 170 homes and eventually to shut down altogether. Following incumbent's drastic price cutting, aggressive marketing and enhanced service, entrant first halted all expansion and then withdrew from the cable TV market. Such withdrawal caused it to lose the bulk of its $6 million investment in the Arden sub-market. Most of entrant's investment in that market was non-salvageable. Entrant of course preserved an option to reenter the Arden cable sub­market, but it seems reasonable to conclude that entrant lost most, if not all, of its original investment.¹⁷⁴ Perceiving its inability to obtain external financing, entrant abandoned its plan to overbuild the Sacramento market¹⁷⁵.

While we lack the data to fully reconstruct the facts bearing on exclusion of the prey, it appears that entrant’s losses and its foreclosure from credit markets were substantially caused by incumbent’s price cutting. Since the case was settled during trial, the causation issue cannot be definitively resolved. However, according to the information we have received from counsel and an expert witness the tightening of credit and other possible non-predatory causes had not yet occurred at the time of the violation, but came later.¹⁷⁶ Under these assumptions, it appears likely that the incumbent’s predatory strategy substantially deterred additional investment, and thus was a material cause of plaintiff's injury¹⁷⁷.

Injury to Competition and Consumers. Injury to competition and consumers requires a showing that the predation raised prices or lowered quality sufficient to enable probable recoupment, or created market conditions that made such effects probable. The evidence shows that incumbent after having successfully withstood two entry attempts, regained its complete monopoly of the Sacramento market, and hence the ability to price without constraint of actual competition. Moreover, following entrant's exit from the Arden sub-market, incumbent promptly withdrew many discounts and special services it had offered during the period of rivalry, and after two years cancelled its entry-induced lower rate in the Arden district.¹⁷⁹

Perhaps the most significant evidence of recoupment, however, was the incumbent's avoidance of the losses it would otherwise have faced from competition—an issue neglected in Brooke. By its own estimate incumbent's successful effort to defeat new entry had avoided losses of $16.5 million per year, with a predatory expenditure of only about $1 million.179 Moreover, no further entrants sought to enter the Sacramento market, after the initial two entrants were rebuffed.¹⁸⁰

The fact that the predator was able to recapture its total monopoly of the Sacramento market, even standing alone, appears to satisfy Brooke’s criterion of increased concentration and entry barriers making recoupment probable. But even if this factor had not been present, the other evidence of market structure, conduct and effects, illuminated by the soundly based theory of financial predation (as contrasted with the more speculative theory in Brooke of recoupment by parallel action without agreement) might have justified the finding of probable recoupment. No longer threatened with competition from a significant entrant, the predator’s market power was predictably enhanced.¹⁸¹ Incumbent’s predatory attack caused entrant to abandon its plan to overbuild the Sacramento market and instead to enter on a more limited basis with an inferior technology.

In addition, it is possible that incumbent’s action created a reputational barrier to entry discouraging future potential entrants. We discuss reputational barriers in Part V below.

(D) PRICE BELOW COST

The case study does not analyze the issue of below cost pricing, but price appears to have been well below ATC and, at least for some sales, may have been below average variable costs as well. Predatory pricing and related marketing efforts to prevent entrant from gaining a viable customer base, cost the incumbent $15 per subscriber per month, which amounted to half of incumbent's total revenue.¹⁸² Operating costs in the cable TV industry comprise 55 percent of total cost; and the overall industry profit margin is only 20 percent on revenues.¹⁸³ A 50 percent rate reduction plus other valuable allowances could well push price below short run costs. In any event, sales to some customers were below any measure of cost since incumbent reduced its monthly rate in the Arden sub- market to $1 per month for basic service with free installation for customers who were resistant to signing up with incumbent and free color TVs for customers who had signed up with entrant.¹⁸⁴ Thus, it appears that prices were below both ATC (and long run incremental costs), and at least some prices were below average variable cost (and average avoidable costs).¹⁸⁵

(E) EFFICIENCIES DEFENSE

The case study contains no evidence supporting an efficiencies defense. But incumbent would be permitted to show that it had a legitimate business purpose for cutting prices below cost. Generally, this would require it to establish that the conduct was profit maximizing in absence of an exclusionary or competition-reducing effect.¹⁸⁶

V. SIGNALING STRATEGIES: REPUTATION EFFECT

1. Signaling Strategies

In reputation effect and other signaling predation, the predator lowers prices in order to mislead the prey and potential entrants into believing that market conditions are unfavorable. These are plausible predatory strategies because a firm's decision to enter or to leave a market is necessarily based on its evaluation of expected future revenues and costs. Most firms contemplating entry or exit from an industry do not have all the relevant information to determine future revenues and costs. To the extent that an incumbent firm is better informed than others about cost or other market conditions, or can manipulate and distort market signals about profitability, it may be able to influence the expectations of its rivals through its pricing decisions or other actions. For example, an incumbent firm may be able to induce exit or prevent entry by setting low prices if its rivals believe that the incumbent’s low prices reflect low costs.

Recent economic writers have developed several signaling theories—all based on the idea that a predator's low prices may influence the prey's and potential entrants’ beliefs about future profitability and thus induce exit or deter entry.