ECON 325

Pricing Theory and Strategies

Outline Six:  Pricing - Ethics and Legal Issues

Sources:  The Strategy and Tactics of Pricing by T. Nagle, H. Hogan and J. Zale; “The Antitrust Attorney Blog” by Jarod Bona; “Predatory Pricing Laws:  Hazardous to Consumers Health,” by Donald J. Boudreaux; other sources in the text.

 

Ethical Considerations Regarding Pricing

First, there are a lot of opinions about what is and is not ethical with respect to pricing. 

Therefore, the best thing to do as a pricing strategist is to determine your own principles with respect to pricing and follow them!  This sounds like moral relativism but actually doesn’t have to be. 

The principles upon which you make your decision could come from “an objective truth” – that is what you believe to be true under all circumstances and across time.

Others might simply believe that all morality is situational.  You have to make that decision when making your decisions about pricing.

So let’s look at some examples of principles someone might follow when making a pricing decision:

The Pricing Strategy is Ethical When:

Implication

1.     Both parties in the trade are acting voluntarily (and are adults).  There is no force involved.

People are capable of making, and are responsible for, their own decisions.  People make decisions – their “environment” does not make them do things against their interest.

 

2.     There is no fraud involved.

People are honest with respect to what is being bought for the price (and the price is clearly and honestly stated).

 

3.     Both parties have the same information when making the trade. 

No sales without full disclosure. 

Does this mean that both parties have to disclose the highest price they are willing to pay or the lowest price they are willing to accept?

 

 

4.     The seller does not “exploit” a buyer’s needs.

At what level of profit does exploitation take place?

Example:  life-saving drugs, water, etc.

 

 

5.     All price differences are justified by cost differences.

Everyone must be charged the same price regardless of willingness and ability to pay.

Example:  Price discrimination would be considered unethical.

 

6.     It provides equal access to goods regardless of one’s ability to pay.

Exchanges could not be made for personal gain (profit).

 

 

 

 

Ethical Considerations of Outcomes

What if a pricing strategy “seems” unethical at first glance – or at least not very nice – however, it leads to outcomes that are very beneficial to a lot of people.

Should these outcomes be considered?

Example:  Price Gouging.

            What is it?

In some places it is illegal – probably because it appears to break ethical principle #4 we discussed above.  The profit made is considered “excessive” and greedy.

But can you think of an outcome from “price gouging” that helps a lot of people (besides the sellers)?

 

 

 

Graph:

 

 

 

 

 

Another Example:  Price Discrimination

Again, some might object to some people being charged a lower price than others.

But can you think of an outcome from price discrimination that helps a lot of people (besides the sellers)?

 

 

Just some things to think about.

 

 

 

 

 

Legal Issues and Pricing

Many of the legal issues concerning pricing in the United States are based on the idea that competition is a good thing and pricing strategies that harm competition should be illegal.

Antitrust laws are typically based on this idea.  These laws are enforced by both government and private parties.  The Antitrust Division of the Department of Justice is empowered to bring criminal and civil actions, although the former are reserved primarily for price-fixing (which we will discuss) and hardcore cartel activity.  Also, the Federal Trade Commission (FTC) may bring civil actions, as can private parties.

Now there are a lot more private suits – whereas it used to be that government was behind most suits.

 

With respect to the antitrust laws - keep in mind how competition is usually defined by antitrust enforcers:

            The structure of the industry is often the deciding factor:

 

So market share and/or how “concentrated” the industry is (concentration ratios) are often used as evidence of a lack of competition.

There have been some change regarding this however, and rivalry (a behavioral definition of competition) is sometimes taken into consideration.  So the structure of the industry is not as important as what the firms in the industry are actually doing that impacts consumers.

Oftentimes though it is not consumers that are taken into account – but competitors – because again, if there are fewer competitors, there is, by definition, less competition – and that is seen as harming consumers (although that might not be the case at all).

Per Se Antitrust Violation vs. Rule of Reason

Some pricing strategies are seen as per se illegal – basically all cases are seen as illegal.

            Horizontal price fixing:

 

            Market allocation among competitors:  "I won't sell in your market if you don't sell in mine."

                        (horizontal territorial restrictions)

 

            Bid rigging:

Assume a contract is awarded through a competitive bidding process.  If there is some kind of coordination among bidders – this is bid rigging.  There are different ways of doing it:  for example competitors agree in advance which firm will win the bid.

 

 

            Certain forms of group boycott:

Any company may, on its own, refuse to do business with another firm, but an agreement among competitors not to do business with targeted individuals or businesses may be an illegal boycott..

For instance, a group boycott may be used to implement an illegal price-fixing agreement. In this scenario, the competitors agree not to do business with others except on agreed-upon terms, typically with the result of raising prices. Seen as similar to a cartel.

            Tying agreements:

 

But now – some of these cases are decided on the basis of Rule of Reason:

Each case is looked at – must be proven that there is a substantial decrease in competition that causes more harm than efficiencies or pro-competitive benefits of the action.

 

Economics and Illegal (or potentially illegal) Pricing Practices

Let’s look at some of the more popular pricing practices that have been prosecuted under the antitrust laws.

1.     Price-fixing

 

a.     Horizontal: competitors agree on price or key terms of sale affecting price (for example how much will be sold by each competitor).

 

b.    Vertical: supplier and reseller agree on the price the reseller will charge or on the price related terms of resale for the supplier’s products.

 

Let’s first look at horizontal price fixing (basically a cartel).

What is the economic argument against cartels actually being successful – therefore antitrust laws are basically not necessary and wasteful?

 

 

 

 

                     

 

When would this theory not work?

 

 

Now let’s look at:

vertical price fixing (resale price fixing – Resale Price Maintenance – RPM).

What is RMP?

 

Now considered to be under the rule of reason criteria (under federal antitrust law) – although for many years was per se illegal.

What is the arguments as to why RPM should be considered “anti-competitive” behavior?

1.     1.  If multiple manufacturers adopt RPM – why is this “suspicious” behavior?

 

 

 

2.     2.  If retailers want RMP – why is this suspicious behavior?

 

 

 

3.     3.  If one or more of the parties to the RPM agreement possess so-called “market power” – why is RPM considered anti-competitive?

 

Trying to get rid of the competition.

 

What are the pro-competitive arguments for RPM?  That is, why do firms want to use this pricing strategy?  Basically all of these induce “inter-brand” competition (competition between brands):

1.     1.  RPM encourages the retailer to invest in customer friendly services (like demonstrations, knowledgeable employees, promotions, etc.):

 

 

2.     2.  RPM diminishes free riding by low-cost sellers:

 

 

 

3.     3.  RPM helps a manufacturer maintain a premium reputation (if the manufacturer is engaging in “prestige pricing” – they don’t want it to be undermined by retailers.

 

 

 

 

 

4.     4.  RPM helps a new entrant establish a high quality reputation and also helps to induce the retailers of the new entrant to invest in promotion and customer services for the product.

 

 

 

Predatory Pricing

What is it? 

 

Why has it been considered illegal? 

 

 

Why do economists contend that predatory pricing is not a problem?

1.     The predator will suffer more losses than the prey.  Why?

 

 

Comeback:  “the longer purse” argument.

 

How did Boudreaux respond?  With capital markets why can’t the prey borrow money to wage the war against the predator? 

 

2.     Opportunity cost of the funds lost during the pricing war.  Could just be more productive or enhance product quality.

 

 

3.     So even if the predator becomes a monopoly – which is very unlikely – what will keep firms from entering the market at that point?  After all – the monopoly will be making a lot of profit – inducing entry.  A predator will want quick exit of the prey – but:

Industries in which exit is quick are industries in which new entry is quick; industries in which new entry is slow are industries in which exit is slow.

The predator will not be able to recoup its losses.

 

What makes the difference? 

Industry specific vs. capital with alternative uses: 

 

 

 

Conclusion:  Policies Against predatory pricing Are a Problem Because:

1.     Funds spent to go after firms for predatory pricing are wasted – they are not necessary.

 

 

2.     Predatory pricing prohibitions decrease rivalry: 

 

Isn’t cutting prices the essence of competition? 

The very ability to sue rivals for predation decreases healthy competition.

 

3.     Consumers are the losers from laws against cutting prices!!