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Unfair Competition #2

Last week I posed several scenarios of business competition and asked about them:

At what point do you decide that "unfair" competition ought to be prevented by government intervention? What form would the intervention take? What would happen to you, to your competitor, and to the customers?

Recall that you run a gasoline station with a small convenience store, and your competitor is a grocery store that also sells gasoline. Here's a quick list of the scenarios; refer to the earlier article for their full exposition:

  1. Competitor offers greater grocery selection.
  2. Competitor offers greater grocery selection and lower grocery prices.
  3. Competitor offers greater grocery selection and lower grocery prices and break-even gasoline prices.
  4. Competitor offers greater grocery selection and lower grocery prices and sells gasoline at a loss.
  5. Competitor is financed by an eccentric billionaire and sells all its products at a loss.
  6. Competitor is subsidized by a foreign government and sells all its products at a loss.

At the request of a reader we'll cover this extra scenario, too:

What if the grocery store was a nationwide chain that dropped its prices in new markets in order to drive out competition? Once the competition is gone, they raise their prices. The profits from the higher prices are used to offset the lower prices in other towns. The consumer benefits for a while until the competition closes. That benefit is reversed once the competition is driven out of town.

Few people would call scenario #1 unfair. This type of competition is normal … I'll even say inevitable. If this type of competition were unfair, so would be almost any other difference between competitors. If everyone had to sell the same products at the same prices there wouldn't be any meaningful competition at all. An economic theorist of the "pure and perfect competition" persuasion might find something to like about this but it's totally alien to real-world experience.

A great many people see unfairness in scenario #2. Think of the "big chain store" moving into town and taking the business away from the smaller "mom and pop" stores by virtue of its lower prices. It's such a prevalent view that it's been parodied.

The distinction of scenario #3 is that the competitor isn't even trying to be profitable in one of its product lines. The only way to successfully compete in this situation is to have lower costs in that area or to adopt the competitor's model of making money on other parts of the business. This form of competition can make it very difficult for others to remain in business selling a product at a price where no profit is made. This scenario was intended to suggest "predatory pricing".

Scenario #4 is merely a stronger version of #3. Because the gasoline is sold at a loss, the company must be internally subsidizing those sales, and many more people would consider this form of competition unfair. Assuming similar cost structures across the industry, it is impossible to remain in business without adopting this business model and the subsidy … and any "pure" retailer of the subsidized product (gasoline) will be unable to survive because they have no profit-making division from which to fund the subsidy. This extreme form of predatory pricing is typically called "dumping" and is condemned by groups such as the WTO.

Scenario #5 is designed to entirely sidestep the traditional arguments about "unfair" competition by turning the competitor into a charitable organization. Goodwill, for example, sells donated clothing by weight. Goodwill has no for-profit competitors in the used clothing market. This form of competition has been highly successful for Goodwill, and due to its nature as a charitable organization it is never criticized for its otherwise-scandalously-low product prices. Yet those low prices are a very effective barrier to entry against any would-be for-profit competitor. The twist here is that I asked you to imagine an eccentric billionaire subsidizing the business, when the reality is that the subsidy is provided by millions of ordinary individuals.

I presented scenario #6 last in order to shine light on a common hypocrisy. Protectionists very commonly argue that foreign subsidies are unfair to domestic businesses and should be neutralized with tariffs. But from the perspective of competitors and customers, there is no difference between low prices caused by charitable giving and low prices caused by foreign taxation and subsidy. The economic impact is rooted in the fact that the prices are low, not in the method by which they're sustained. If charitable giving is fair, why are foreign subsidies unfair? The economic effects of each are identical. (Remember, the subsidy is paid by some foreigner's taxes, and protectionsts don't care about foreigners anyway.)

Finally, let's consider the reader-suggested scenario. This is the textbook exposition of predatory pricing: A chain store subsidizing a new location in order to drive out competition before raising prices to earn higher than normal profits. A moment's reflection shows that this is economically similar to scenarios #5 and #6, with the important difference that in this case the subsidy is deliberately temporary. It's most similar to #6 because the non-local store locations can be mentally considered to be in a foreign country.

Now hang on while I pull a rabbit out of my hat.

If this form of competition is unfair, so must be charitable giving. The eccentric billionaire will eventually run out of money to give away, and customers will be faced with sharply higher prices. A scandal could cause donations to a charitable organization to dry up, and customers would be faced with sharply higher prices. The effects on competitors and consumers are the same when the subsidy ends, regardless of why the subsidy ends. The subsidy will have driven other competitors out of business and when the subsidy ends there will be only one seller left … who will stand to earn higher than normal profits. The only way to prevent these events from unfolding is to prevent charitable giving in the first place.

Furthermore, enacting tariffs to counter subsidies should be considered economically the same as a prohibition on charitable giving. If a foreign government wants to give our citizens cheaper products, who are we to complain? It's a gift. Yes, it's an unpredictable gift … it may affect any industry and may be revoked capriciously … but it's still a gift. Are we to forbid gifts merely because they aren't perpetual?

What this really comes down to is not a question of economics, but a question of psychology and ethics. People decide that certain forms of competition are fair or unfair not based upon economic effects but rather on what they perceive as the motives of those involved. Altruistic motives are permitted and selfish ones are forbidden.

Predatory pricing is okay if it's charitable. But it's not okay when done by foreigners, because they're trying to make us dependent. And it's not okay if someone's trying to make a profit from it.

I am abhorred by this popular understanding of what is fair and what is unfair. If the dividing line between legal action and illegal action is merely one of motive, the law becomes arbitrary and there is no justice. In civil law, where the legal standard is a preponderance of evidence, the prosecution and the defense are on even footing. Who do you suppose could make a more convincing argument about your true motive — an impartial prosecutor, servant of the public interest, or you … a suspected criminal who will obviously lie about your motive in order to avoid punishment?

Of course, the ethics is backwards, too.

I'll close with reader mail. Simon reminds us to consider the effects of subsidies and regulations designed to protect non-viable businesses:

Sure, if there was some kind of government intervention the gas station owner would probably be better off, but looking at the issue purely in terms of the gas station owner you lose sight of the bigger picture. The gas station customers end up paying artificially high prices to subsidise the gas station owner, they have less money to spend on other things, those things end up not being produced and people lose jobs. Not only that but peoples freedom has been impinged. Society is significantly worse off. In fact you could probably argue that not even the gas station owner is ultimately better off.

And Chris explains the new incentive created in the minds of the "protected":

I would build my business around obtaining the "fruits" of other peoples labor (the subsidy). This would mean my energy would go to navigating a bureaucracy NOT providing better prices AND/OR service to customers. Which answers your question about what happens to the consumers.

Tiny Island