Review of Industrial OQanization 11: 767-770, 1996. @ 1996 Kluwer Academic Publishers. Printed in the Netherlands.

Is Predation Rational? Is It Profitable? - A Reply

WALTER ADAMS’, JAMES W. BROCK2 and NORMAN P. OBST3 ‘Department of Economics, Trinity University (XL: ‘Department of Economics, Miami Universi& &fond OH 45056, US.A.; ‘Department of Economics, Michigan State University, US.A.

We appreciate the respondents’ encomiums to our theoretical expertise. But we beg to differ from our critics’ interpretation of the facts in the Liggett case.

First, the evidence of predatory intent, predatory conduct, and predatory impact in strewn throughout the extensive court records. Commenting on this evidence, the District Court found Liggett’s complaint “buttressed by numerous Brown & Williamson (B&W) documents written by top executives. These documents, indi- cating B&W’s anticompetitive intent, are more voluminous and detailed than any other reported case. This evidence not only indicates B&W wanted to injure Liggett, it also details an extensive plan to slow the growth of the generic cigarette segment” (District Court, p. 354). These documents - prepared by high-ranking B&W offi- cials, including a vice-president for finance, a senior financial analyst, and a special company-wide ‘task force’ - reveal a systematically organized, brilliantly articu- lated plan for containing competition in low-priced generics, and for preventing this product innovation from disturbing the oligopolistic stability of the cigarette industry generally. The B&W documents were so explicit, and emphasized the pre- dation campaign so frequently, that the District judge “later called the documents ‘smoking guns’ and mused that ‘I don’t think Liggett] would have imagined some of this stuff that’s been written down’.“’ The Supreme Court agreed, acknowledg- ing the existence of “sufficient evidence in the record from which a reasonable jury could conclude that for a period of approximately 18 months, B&W’s prices on its generic cigarettes were below its costs. . . and that this below-cost pricing imposed losses on Liggett that Liggett was unwilling to sustain . . . ” (Supreme Court. p. 2592).

Second, when it came to assessing the predation charge, however, the courts ignored the evidence that rendered predatory “recoupment” feasible. The courts disregarded what they earlier had explicitly acknowledged: persistently high con- centration, high barriers to entry, and decades of tacitly collusive, noncompetitive oligopolistic behavior. Neither the decision of the District Court, nor the Court of Appeals, nor the Supreme Court rested on contextual evidence of predation and recoupment. Instead, all relied upon an unproved theoretical assertion that preda-

’ Wall Street Journal, 5 March 1990, p. 1.

768 W. ADAh4S ET AL.

tion is so inherently ‘irrational’ that it is unlikely to occur in practice - especially in a case like Ligge& where tacit coordination among oligopolists was charged. Thus, the District Court held that despite B&W’s predatory intent. it “could not have had a reasonable possibility of injuring competition” because there was no “economically plausible way to recoup its losses” (District Court, p. 358). The court concluded that “[tlacit collusion among the major cigarette manufacturers is a dubious theory of market power” (District Court, p. 355) - apparently incog- nizant that such collusion was at the heart of the Supreme Court’s conviction of these cigarette oligopolists in 1 946.2

Affirming the District Court’s rulings the Court of Appeals held that recoupment by an oligopolist is never a realistic possibility. Oligopoly pricing, said the court, simply does not “provide an economically rational basis” for recouping predatory losses (Circuit Court, p. 342). Without denying that B&W had acted predatorily to discipline Liggett, the court ruled as a matter of law that it would have been irrational for an oligopolist to have so acted. According to the Court’s “economic logic”, only a monopolist (actual or prospective) or a member of a formally organized cartel could profit front charging below-cost prices to discipline a rival: An oligopolist’s below-cost investment in disciplinary pricing would never pay because an alleged predator could never be “certain” that fellow oligopolists (1) would tmderstand that it was disciplining a maverick rather than attempting to expand its own market share; (2) would refrain from trying to expand their own market shares; or (3) would continue their tacitly collusive pricing pattern of prior decades.

Likewise, the Supreme Court acknowledged evidence that “[cligarette manu- facturing has long been one of America’s most concentrated industries;” that “for decades, production has been dominated by six firms~’ that the “cigarette industry also has long been one of America’s most profitable, in part because for many years there was no significant price competition among the rival firms;” that “list prices for cigarettes increased in lock-step, twice a year, for a number of years, irrespective of the rate of inflation, changes in the costs of production, or shifts in consumer demand;” and that “(s)ubstantial evidence suggests that in recent decades, the industry reaped the benefits of prices above the competitive level” (Supreme Court, pp. 2582-2583). Despite its recognition of all this evidence, however, the Court’s majority proceeded to ignore it and declared that predatory pricing is “generally implausible”, and is “even more improbable” when it requires “coordinated action among several fhms” (Supreme Court, p. 2590). Such an “anticompetitive minuet”, the Court asserted, “is most difficult to compose and perform, even for a disciplined oligopoly” (Id.).3

* American Tobacco Co. v. United States, 328 US. 791 (1946). 3 In so holding, the Court ignored not only its own observations, but those of other disinterested

professionals. A financial analysis of the industry prepared by the investment firm Merrill Lynch in 1983 described the oligopoly’s market power in straightforward terms: “The cigarette companies . . . have usually played the part of a well managed oligopoly, pricing up aggressively. They have rarely indulged in excessive price promotions for any sustained period. Demand for cigarettes is relatively

IS PREDATION RATIONAL? IS IT PROFITABLE? - A REPLY 769

Third the predatory campaign against Liggett succeeded in all salient respects - as even the Supreme Court’s majority pointed out! “Recoupment” consisted of terminating Liggett as an independent competitive threat: Its share of cigarette sales plunged from nearly 6% in 1984, to 2.8% in 1988,4 and to 1% in 1994.5 Oligopoly control of pricing in the discount segment was established, while the threat of independent price competition spilling over into the oligopoly’s high-price, high- profit branded cigarettes was eliminated: By the summer of 1986, the Court’s majority observed, “a pattern of twice yearly increases in tandem with the full- priced branded cigarettes was established. The dollar amount of these increases was the same for generic and full-priced cigarettes, which resulted in a greater percentage price increase in the less expensive generic cigarettes and a narrowing of the percentage gap between the list price of branded and (generic) cigarettes . . . ” (Supreme Court, p. 2595). In fact, by 1989 the oligopoly succeeded in raising prices of “low-price” cigarettes to a level above that of full-price cigarettes only four years earlier (Supreme Court, p. 2601).6 Thus, the price gap between generics and regular brands had been narrowed; a maverick rival had been disciplined by pricing below cost; the oligopoly had recouped its investment by protecting the profitability of its full-price branded cigarettes; and B&W had averted the loss of some $400 million which it would have incurred if Liggett had not been subjected to predatory discipline.

In short, predation was not only plausible, it actually happened. “Recoupment” by an oligopolist was not only possible; it was predictable. As Justice Stevens put it in his dissent: “the professional performers who had danced the minuet for 40 to 50 years would be better able to predict whether their favorite partners would follow them in the future than would an outsider, who might not know the difference between Haydn and Mozart (Supreme Court, p. 2605).

Finally, as for “context”, the Liggett case is only the latest episode in a century- old scenario of predation in the tobacco industry. Until Liggett, courts have consis- tently found that tobacco oligopolists (as well as monopolists) have successfully used predation to attain and maintain market power (U.S. v. American Tobacco (19 11): Porto Rican American Tobacco Co. v. American Tobacco (1929); U.S. v. American Tobacco Co. et al. (1946)). Undeterred by the dogma that, as a matter of economic logic, rational firms could not, would not, and did not resort to this anti-

inelastic, enabling them to price up more aggressively than is the case for many other companies. They face virtually no threat of entry by a new competitor, as is ofien the case in many other consumer lines”. Plaintiffs Exhibit 233, Liggett Croup, Inc. v. Brown & Williamson Tobacco Corp., 74g F. Supp 344 (M.D.N.C. 1990).

’ Based on Professor Elzinga’s ( 199 1) calculations reprinted in Antitrust Law & Economics Review 23,89.

’ N&w York limes 27 April 1994, p. C6. ’ Brown & Williamson’s subsequent acquisition of the American Tobacco Company, another

declining old-line producer tempted into low-price generic cigarettes, disposed of an additional small but potentially disruptive firm. As one industry analyst observed of this purchase, “They picked up a little market share and eliminated a competitor that was causing serious price problems”, Wall Street Journal, 24 April 1994, p. B5.

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competitive tactic, the tobacco predators repeatedly and unabashedly proceeded to demonstrate that they could do it, would do it, and did do it - and that they made it pay.

References Adams, Walter and Brock, James W. (1996) ‘Predation, “rationality” and judicial somnambulance’,

US Cin. Law Rev. 64,811. Adler, Stephen J. and Freedman, Alix M. (1990) ‘Tobacco suit exposes ways cigarette firms keep the

profits fat’, Wall Street Journal, 5 March, p. 1. American Tobacco Co. v. United States, 147 F. 2d 93 (6th Cir. 1944). American Tobacco Co. v. United States, 328 U.S. 781 (1946). Brooke Group v. Brown & Williamson Tobacco, 113 S, Ct. 2578 (1993). Elzinga, Kenneth G. (1991) ‘Predatory pricing requires 60% market share: no “oligopoly” recoupment

without firm “market power” ‘, Antitrust Law & Economics 73,89. Gilpin, Kenneth N. (1994) ‘American Tobacco to B.A.T.‘, New YOI-k Times, 27 April, p. C 1. Liggett Group v. Brown & Williamson Tobacco, 748 F. Supp. 344 (M.D.N.C. 1990). Liggett Group v. Brown & Williamson Tobacco, 964 F, 2d 335 (4th Cir. 1992). Porto Rican American Tobacco Co. v. American Tobacco Co., 30 F. 2d 234 (2d Cir. 1929), cert.

denied, American Tobacco Co. v. Pot-to Rican-American Tobacco Co., 279 U.S. 858 (1929). United States v. American Tobacco Co., 221 U.S. 106 (1911). United States v. American Tobacco Co., 191 F. 371 (S.D.N.Y. 1911).