Contrast the NIO and Chicago School theories of predatory pricing.4. What is Lott’s conclusion…

Case study 9.3: Credible commitments21

John Lott’s book Are Predatory Commitments Credible? Who Should the Courts Believe? (1999) is an attempt to test one of the implied assumptions of game-theoretic models.

The key questions for NIO (new industrial organization) models developed by game theorists are: ‘Are CEOs hawks or doves, and how can an entrant tell the difference?’ Predatory pricing in the NIO arises when a dominant firm can credibly signal that it will price below cost if anyone enters the market. If the signal is credible, the entrant will not enter. The Chicago School had shown that predatory pricing would be costly to the dominant firm and argued that therefore it would be unlikely to be practiced. Proponents of the NIO agree that predatory pricing is costly, but they argue that to keep an entrant out, no firm need actually practice predatory pricing if the threat to do so is credible.

A ‘hawk’ is a firm that will actually cut prices to drive out an entrant. A ‘dove’ is a firm that will acquiesce to entry because it cannot bear the shortterm losses entailed by engagement in predatory pricing. Of course, doves threaten predatory pricing just as hawks do. How can the entrant discover who is a hawk and who a dove?

Lott’s answer is that a hawk-CEO must have high job security. As the entrant enters, the hawk-CEO goes to war against the entrant by driving down prices and thereby greatly reducing profits. If the CEO must answer to stockholders for declines in the price of stock, or if his own pay is tied to the stock price through options or other means, then he will be unwilling to prosecute the war. The signal required to make a predatory commitment credible is a system of corporate governance that allows the CEO more control over the corporation than stockholders would otherwise give him. In short, to signal credibly, the CEO must be a dictator rather than an elected representative. Dictatorship, of course, has its costs, in nations or in firms, so not every firm will want to be a hawk. Lott proposes that this difference in corporate governance presents an opportunity to test the NIO theory of credible commitments. He examines twenty-eight firms accused of predatory pricing between 1963 and 1982. Is the corporate governance of these firms more hawklike than that of other firms? It is not. Lott finds few differences in CEO turnover, incorporation in a state with antitakeover provisions, stock ownership, or CEO pay sensitivity between the firms accused of predatory pricing and a control group. One of the key assumptions of the NIO is therefore wrong. The question remains, ‘Why would firms that had no better commitment strategy than a control group have been accused of predatory pricing?’ Although this question lies beyond the scope of Lott’s book, one can only conjecture that those firms were accused of predatory pricing not because they actually practiced it but because their competitors wanted to stop competition (see Fred S. McChesney and William F. Shughart II, The Causes and Consequences of Antitrust: The Public Choice Perspective, Chicago: University of Chicago Press, 1995).

If firms accused of predatory pricing do not seem to differ systematically from the control group, is any firm capable of following a predatory-pricing strategy? In effect, could any organization commit to not maximizing profits, if only for a limited period of time? Lott’s answer is that one group of firms can make such a commitment: publicly owned firms. The basic idea comes from Niskanen’s model (William Niskanen, Bureaucracy and Representative Government, Chicago: Aldine Atherton, 1971): publicly owned firms maximize size rather than profit. Lott gives several examples, but none hits closer to home than the public university, which must maintain enrollment in order to maintain the size of the faculty and therefore sets prices considerably below costs.

Lott’s second type of evidence that publicly owned firms practice price predation is the fact that dumping cases – the international version of predatory-pricing complaints – have been filed under the General Agreement on Tariffs and Trade more frequently against firms from communist countries than against firms from noncommunist countries. Lott shows, therefore, that the NIO theory of predatory pricing makes sound predictions (hawks practice predatory pricing more than doves), but it has limited application to the private-enterprise system, to which its advocates intended it to apply.

Lott’s third argument supplements the theory of predatory pricing. He extends Jack Hirshleifer’s observation that inventors of public goods can internalize at least some of the value of theirinvention by taking long or short positions in assets whose price will change after the discovery is made public (see Jack Hirshleifer, ‘The private and social value of information and the reward to inventive activity’, American Economic Review, 61 (1971): 561–574). Lott extends this idea by arguing that an entrant facing an incumbent with a reputation for toughness should take a short position in the incumbent’s stock, enter, and reap trading profits. In effect, the incumbent firm with a reputation for toughness finances the entry of its own competitors. The entrant can also make profits by exiting. If the entrant enters and finds that it cannot withstand the attack of the hawk, it can take a long position in the incumbent’s stock, exit, and collect the trading profits. Either way, trading profits increase the incentive to enter because whether or not entry ultimately succeeds, trading profits allow the entrant to make a profit. As Lott puts it, ‘the more successfully a predator deters entry, the greater the return that trading profits create toward producing new entry. Creating a reputation to predate can thus be selfdefeating’ (p. 115).

Lott provides several anecdotes about the use of trading profits, but he admits he can find few recent examples. The problem, of course, is that a firm holding a short position in a competitor’s stock would not want to advertise that fact to the market. Therefore, we would expect such evidence to be thin. The trading-profits idea does suggest that the threat to practice predatory pricing would be more successful when the incumbent firm was closely held, and therefore entrants could not easily buy shares of it. This relationship might make predatory pricing more likely in developing countries that are dominated by family-run firms and that lack welldeveloped equity markets.

One of the basic insights of economics is that wellestablished markets threaten rents. Lott’s simple application of this wisdom ought to change the way economists think about antitrust cases and the way they are litigated both as private and as public cases. The notion that trading profits can mitigate or eliminate the private damage from predatory pricing should certainly give antitrust experts cause to worry about the efficiency of treble damages. I await the day when the defendant in an antitrust case will respond, ‘If my actions were predatory, why didn’t the plaintiff just buy my stock short and use the profits to stay in the market.’

Questions

1. What is meant by a hawk-CEO?

2. Why should hawk-CEOs need high job security?

3. Contrast the NIO and Chicago School theories of predatory pricing.

4. What is Lott’s conclusion relating to empirical evidence for the NIO?

5. Explain Lott’s theory of trading profits and how it relates to predatory pricing; how does the theory support his conclusion that ‘Creating a reputation to predate can thus be self-defeating’?