Predatory pricing was one of the major strategies used by the Standard Oil Company to gain its market power in its early years of establishment. This strategy eliminated the competitors from the market and left the company as the major supplier of oil in the USA. Predatory pricing strategy is a negative and unhealthy form of competition that eliminates rival businesses and results in the emergence of monopoly trade by the “predator” which is accompanied by its market inefficiencies such as reduced level of innovativeness and poor quality of products and services. Considering the harmful effects that predatory pricing can cause on the economy, it is important to understand its context under the Standard Oil Company and establish its effect on the economy as a whole.
Predatory Pricing Description
Predatory pricing is a situation where an already dominant firm sets the prices of its commodities very low over a long period of time so that its competitors leave the market and others are barred from entering (Arieli, Koren, & Smorodinsky, 2016). Assuming that the ‘predator’ and the ‘victims’ are operating in the same economy, predatory pricing intends to make the victims suffer significant losses in the course of business. Consequently, the victims’ operating expenses rises beyond their revenues. As a result, they are unable to sustain themselves in the industry at the predator set prices, the firms shut down their operations (Arieli, Koren, & Smorodinsky, 2016). Noteworthy, the predator also makes significant losses, referred to as foregone profits, in the expectation that they will be recovered by future gains. Simply, it implies that the firm has a reasonable expectation to gain market power, once the victims shut down, and that the profits from that point onwards will be sufficient to offset the present losses likely to be incurred.
History of Standard Oil and Predatory Pricing
Standard Oil Company was started in 1870 by Rockefeller, his brother William, among other individuals. The initial location was in Ohio, where they established a petroleum refining industry. During this period, the petroleum refining industry was still highly decentralized, with more than 250 competitors in the United States of America (Toprani, 2014). The capital necessary to enter into the oil refining industry was relatively low since the demand was very high for oil products, and the technological character of the process of the refinery was affordable. Thus, the number of refiners was relatively high. Standard Oil was amongst the refinery companies operating at that time. Basically, it had little market power. Actually, as late as 1870, Standard Oil only owned 10% of the industry market share (Toprani, 2014).
Once established, the company began to use a variety of cutthroat techniques in order to establish themselves and ‘consolidate’ the industry. To begin with, Standard Oil lowered the prices of its oil products to a level way below the selling price of its competitors. Although the notion of predatory pricing is highly opposed by some people as the strategy used by Standard Oil Company, the prices of their commodities were way below the average cost of production of the industry (Toprani, 2014). In fact, although the other firms were also effective in their way of production, none was able to meet half the price being charged by the company. Thus, many of the companies shut down their operations. Rockefeller used the opportunity to keep these firms through merging and acquisitions. During 1871-72, Rockefeller increased his interest in oil refinery business by purchasing 17 Cleveland refineries that operated in America at that time (Toprani, 2014). These acquisitions were a major step in the plan of predation. However, Rockefeller denied claims of predatory mechanism in the acquisition claiming that it was only a friendship agreement for the two companies to excel together. However, as Toprani (2014) noted in his analysis of Standard Oil, the move was a desperate attempt by Cleveland to remain in business after what they had discovered closing down was an unavoidable fate in the future. Additionally, Mr. Lewis Emery, who was a long-term producer of crude oil by the year 1870, had grown some interest in Octave Oil Company and Refinery and purchased it. In 1875, Emery closed down the company and sold it to the Standard Oil Company for $45,000. In a testimony given later, Mr. Emery said that the low prices set by the Standard Company had squeezed him out of the business together with other small refiners in Pennsylvania. As far as Standard Oil was concerned, its predatory plan was succeeding. In 1878, Holdship and Irwin, an oil refining firm that was unable to continue with its operations leased out its refinery to Standard Oil (Toprani, 2014). The refinery had an output of 1,000 barrels per day. Five years later, when the leasing agreement expired, they sold the assets to Standard Oil Company. Standard Oil Company went on to purchase more than 80% of the refining companies that existed before they entered the market. To maintain its predatory pricing mechanism functional, the company sought ways to keep its prices low relative to its competitors through reduction of its costs. By using its large volume of oil shipments, the company negotiated for various alliances with the railroads that gave it secret rebates (Toprani, 2014). As a result, the company reduced its shipping costs to a level that was far below the rates charged by other refining companies, a factor that enabled it to keep its prices lower than its competitors.
Why was Standard Oil Company Involved in Predatory Pricing?
Different things must have occurred in the minds of the people who enacted predatory price mechanisms. Firstly, the aim of the company was to kick out its competitors or acquire them. As Priest (2011) notes, prices were kept so low that competitors would not match them. Actually, most competitors were unable to cover up their costs of production at such prices. As Standard Oil expected, most of the companies that were initially in the market shut down. Some chose to merge with Standard Oil Company while others sold all their assets to the company. As a result, the intended purpose for which the mechanism was established was fulfilled.
Secondly, the company wanted to keep away potential entrants in the market. By the time the company began to conduct its predatory price mechanisms, there were more than 250 oil refining industries in the country. There were numerous opportunities for potential entrants into the market since demand for oil products was higher than the industry could manage to produce. However, predatory pricing kept away entrants since there was no probability that those firms would operate on profits basis. Noteworthy, Standard Oil Company controlled capital markets for purchases of goods needed for the purpose of building refinery industries, ensuring they were sold at high prices. Therefore, the company was determined to keep away new producers from the market.
Moreover, predatory pricing was intended to keep away importers from bringing in oil products in the country. As Priest (2011) indicates, Standard Oil used dubious means to threaten foreign firms from entering the market. In a report submitted to the court during the trial, Priest (2011) reports that one international importer indicated that he was required to avoid entry or else Standard Oil would lower its price by more than a half. As a result, the importer quit the market. Thus, the company intended to keep out external competition.
Once all the competitors were kicked out of business, the company would then proceed to take the largest share in the market. Evidently, the fact that there were no competitors indicated that Standard Oil Company was the only supplier in the market. Shockingly, the company raised its market share from 10% to 80% within a period of five years. This increase in market share was the original purpose for which predatory pricing mechanism began.
Lastly, the company wanted to monopolize the market, which was the end result of the whole process. Once the company had increased the market share to 80%, it automatically commanded a vast market power (Priest, 2011). Simply, market power is the ability to control the aspects of the market such as price and supply in complete disregard of the market forces. This kind of market control is the characteristic of a monopoly. By this time, the company had incentives to raise the prices since there was literally no competition. In what is referred to as payback period in predatory price mechanisms, the company raised the prices above the initial price before undercutting. Therefore, the long-term objective of the company was to establish a perpetual increase in profits through market control in a monopolized industry.
Is Predatory Pricing Lawful?
According to the constitution, predatory pricing is unlawful. The basis for the enactment of the law prohibiting predatory pricing is that this tactic leads to long-term adverse effects on consumers due to high prices (Hawkins, 2016). Currently, prohibition of predatory pricing can be found under the general rules on misuse of market power that are listed in section 46 (1) of the constitution or under a specific provision that deals with predatory pricing contained in section 46 (1AA) (Hawkins, 2016). Under section 46, a business with a substantial market share or power is prohibited from taking advantage of its power with the intention of damaging or eliminating a seller from business. Further, the act prohibits the business from preventing an individual from entering into a market or deterring him from engaging competitively in it (Hawkins, 2016). From the section, a business is said to have market power if the activities it carries out in the market such as production, marketing, sales, or transportation are not in any way constrained by the competitors. This definition implies that the business can make individual decisions in complete disregard of the other participants in the market without a considerable effect on its operations.
Section 46(1AA), applies to the conduct of businesses that were established after 25th September 2007 when the legislation was passed. The law prohibits businesses that have a substantial share in the market relative to that of competitors from selling goods at a price below the relevant cost over a sustained period of time (Hawkins, 2016). The relevant cost is established from the average costs of production of other firms in the industry. Therefore, a business is not allowed to act with an intention that drives away competition.
Generally, the provision of both acts makes predatory pricing unlawful. However, clarifications are made as to what predatory pricing and price cutting represent. Price cutting is considered to be a competitive strategy that can be adopted by any company from time to time. The difference between the two is defined by duration. If a company sustains low prices over a long period of time, then its price cutting strategy turns to be predatory pricing. Consequently, it becomes very hard to differentiate between the two in a court case since there is no specific provision on the duration as to when price-cutting turns to predatory pricing.
Effects on the Economy
The initial benefits of predatory pricing appear positive. The claims brought forward include the fact that consolidation leads to a net economic benefit to the economy through reduction of operating costs, and thus commodity prices. These benefits are seen to eliminate duplicate and inefficient companies through economies of scale as a result of producing a large volume of output (Granitz & Klein, 1996). Most economists contend with the notion that greater volume of output enables the companies to finance facilities that are larger and more efficient and devote more funds to research and technological developments.
However, all these factors ignore the long-term detrimental effects on the economy that result from the absence of market competition. Initially, monopolies reduce prices and improve the quality of products during the period in which they focus on eliminating competitors. However, history has shown that in many instances, monopolies lose the incentives to operate as they do when competition is finally eliminated. In fact, the incentive turns to increase prices and lowering the quality of products (Granitz, & Klein, 1996). On the contrary, free competition increases quality and lowers prices which lead to ‘efficient allocation of resources’.
In addition, monopolies lead to another major disadvantage in that they stifle innovation. Monopolies lose motivation to adopt or develop new technologies due to loss of competition (Granitz, & Klein, 1996). Moreover, they prevent competitors from bringing new innovations since they consider it a threat to their dominance. In some cases, monopolies have shown that they may indeed be major innovators. However, advancement in technology under monopolists is less when compared to what occur under perfect competition. Innovation is regarded as critical for any economic growth to occur. Thus, its suppression affects the economy negatively as a whole.
To sum up, it is evident that Standard Oil Company used the predatory pricing in a manner that negatively affected the economy of the country. The purpose of the strategy was to enable the company to establish market power. Having eliminated competition from the oil industry, the company was able to sell its products at a high cost by controlling the supply market price of oil. In this position, the company ensured that it made maximum profits and controlled possible threats from potential entrants of new businesses. In addition, it ensured that consumers did not have a choice of the product that they wanted to the consumer. Obviously, they only had to buy oil from Standard Oil Company since it was the only supplier. Due to the negative effects of predatory pricing, it was made illegal in the USA. In particular, it has very harmful to the economy since it made businesses to close down. Therefore, the practice of predatory pricing should not be allowed to thrive.
Arieli, I., Koren, M., &Smorodinsky, R. (2016).Predatory Pricing and Information Aggregation in Markets with a Common Value
Granitz, E., & Klein, B. (1996). Monopolization by” Raising Rivals’ Costs”: The Standard Oil case. The Journal of Law and Economics, 39(1), 1-47.
Hawkins, J. R. (2016). Predatory pricing in antitrust law and economics: A historical perspective. Eastern Economic Journal, 42(3), 491-493.
Priest, G. L. (2011). Rethinking the economic basis of the Standard Oil Refining monopoly: Dominance against competing cartels. S. Cal. L. Rev., 85, 499.
Toprani, A. (2014). Germany’s answer to Standard Oil: The Continental Oil Company and Nazi Grand Strategy, 1940–1942. Journal of Strategic Studies, 37 (6-7), 949-973.