Freeman

ARTICLE

The Predatory Bogeyman

Predatory Price-Cutting Theory Falls Apart in the Real World

JULY 01, 1997 by LAWRENCE W. REED

In the literature of anti-capitalism, the dominant bogeyman is unquestionably the big, private, profit-seeking company. Is there a sin imaginable that hasn’t been laid at the doorstep of those who own or manage large firms?

Defenders of capitalism have produced powerful arguments and voluminous evidence exposing much of the anti-capitalist literature as mythology—attacks that seem plausible on the surface but which dissolve when set against either economic principles or practical experience.

One of the more common attacks concerns a strategy that, according to the mythology, big companies employ often and successfully against their smaller competitors. It is known as predatory price-cutting, commonly understood as the practice of underselling rivals to bankrupt them, and then raising prices to take advantage of the absence of competition.

Recently, when an anti-capitalist professor raised this issue, I asked him if his state-subsidized university was engaging in this very thing by charging tuition that did not cover its instructional costs. Private colleges, I pointed out, can’t combat this competition by relying on taxes to level the playing field. My professor friend responded by arguing that predatory price-cutting assumes an evil intent, and no government really intends to drive private colleges from the market by establishing its own universities. Besides, he said, we must look at the actual effects: private colleges indeed exist and even thrive, in spite of the subsidized competition.

In referring to actual effects, the professor was unwittingly making a point that undermined his case. Predatory price-cutting is a theory that, more often than not, falls apart when it leaves the classroom and enters the real world. The fact is, in a free market, large firms rarely attempt it and when they do, they usually fail at it. Even large firms that have the power of government on their side find it much harder to succeed as predators than the theory at first suggests.

The early experiences of a company that is celebrating its 100th anniversary this year provide an interesting case in point. The Dow Chemical Company—an industrial giant famous for its aspirin, chlorine products, and plastic wrap—was once a prey that many expected would not survive.

Herbert Dow, the founder, had already started two other chemical companies by 1897: one went broke, and the other fired him. Crazy Dow was what the folks in Midland, Michigan called him. Like David fighting Goliath, he did battle head-on with large German chemical monopolies and eventually toppled them from world dominance. It was hard to tell, in the end, who was really the predator and who was really the prey.

Dow’s key product was bromine, which he could sell as a sedative or as a chemical to develop photographs. He invented a process to separate bromine from the sea of brine underneath the city of Midland. With gusto, Dow sold his bromine inside the United States, but not outside—at least not at first.

The Germans had been the dominant supplier of bromine since it first was mass-marketed in the mid-1800s. No American dared compete overseas with the powerful German cartel, Die Deutsche Bromkonvention, which fixed the world price for bromine at a lucrative 49 cents a pound. Customers either paid the 49 cents or they went without. Dow and other Americans sold bromine inside the United States for 36 cents. The Bromkonvention made it clear that the Americans were lucky to be allowed to sell at all, and that if they tried to sell outside America the cartel would flood the American market with cheap bromine and drive them all out of business.

By 1904, Dow was ready to break the rules: He moved to sell bromine in Europe and Japan at a price well below that of the cartel. Before long, the Bromkonvention went on a rampage. It poured bromides into America at 15 cents a pound, well below its fixed price of 49 cents, and also below Dow’s 36-cent price.

Was Dow the helpless little guy, about to be smashed by the evil German capitalists just like the predatory price-cutting theorists would have predicted? Quite the contrary, he was the quintessential entrepreneurial genius who gives capitalism its cutting edge. He had his agent in New York discreetly buy hundreds of thousands of pounds of German bromides at the cartel’s 15-cent price. Then Dow repackaged the German bromides and sold them in Europe—including Germany—at 27 cents a pound. When this 15-cent price was made over here, Dow said, instead of meeting it, we pulled out of the American market altogether and used all our production to supply the foreign demand. This, as we afterward learned, was not what they anticipated we would do.

Indeed, as historian Burton Folsom reveals in his forthcoming book, Empire Builders: The Vision and Influence of Michigan’s Early Entrepreneurs, the Germans were befuddled. They expected to run Dow out of business; and this they thought they were doing. But why was U.S. demand for bromine so high? And where was this flow of cheap bromine into Europe coming from? Was one of the Bromkonvention members cheating and selling bromine in Europe below the fixed price? The tension in the cartel was dramatic. According to Dow, the German producers got into trouble among themselves as to who was to supply the goods for the American market.

The confused Germans kept cutting U.S. prices—first to 12 cents and then to 10.5 cents a pound. Dow meanwhile kept buying these cheap bromides and reselling them in Europe for 27 cents. By the time the Bromkonvention finally caught on to what Dow was doing, it had lost the price-cutting war. Dow had secured new markets for his own company with his competitors’ product, and he was now in a position to build a chemical giant. He went on to beat foreign, government-subsidized cartels in dyes and magnesium. Consumers of ever cheaper and better products were the biggest winners.

The predatory price-cutting charge is most commonly applied to the early history of John D. Rockefeller’s Standard Oil Company. But here, too, the record departs from the rhetoric. Professor John S. McGee, writing in the October 1958 Journal of Law and Economics, showed conclusively that Rockefeller did not engage in the practice because he was smart enough to know that other entrepreneurs weren’t helpless nitwits who would take it lying down. (For a more complete explanation, see either McGee’s article or my own in the March 1980 issue of The Freeman, Witch-Hunting for Robber Barons: The Standard Oil Story.)

Anti-capitalist literature is rife with demons, monsters, and other assorted bogeymen, but so are fairy tales.

ASSOCIATED ISSUE

July 1997

ABOUT

LAWRENCE W. REED

Lawrence W. (“Larry”) Reed became president of FEE in 2008 after serving as chairman of its board of trustees in the 1990s and both writing and speaking for FEE since the late 1970s. Prior to becoming FEE’s president, he served for 20 years as president of the Mackinac Center for Public Policy in Midland, Michigan. He also taught economics full-time from 1977 to 1984 at Northwood University in Michigan and chaired its department of economics from 1982 to 1984.

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