Bryan Caplan  

What Does Public Schooling Teach Us About Predatory Pricing?

Even When More Isn't Merrier, ... Economics must be harder than ...
Public schools provide education free of charge.  The result, unsurprisingly, is overwhelming market dominance.  Almost 90% of school-age kids attend public school.  Most people think this is a great thing.  Maybe they're right, maybe they're wrong.  Either way, though, public schooling can teach us quite a bit about predatory pricing.

Predatory pricing is one of the simplest business practices to explain: Sell at a loss until you bankrupt your competitors.  When you think about it, public schools apply this predatory strategy to an extreme degree.  They don't just sell education at a loss.  They "sell" education for free! 

What can we learn from this epiphany?  First and foremost, predation is a lot less effective than you'd think.  After practicing predation to the utmost degree, public schools have only captured 90% of the market. 

This is particularly striking when you realize that public schools - unlike normal businesses - can afford to practice predation indefinitely.  When a normal business practices predation, competitors naturally wonder, "How long can the predator keep this up?"  For private schools, in contrast, there is no light at the end of the tunnel.  They keep serving 10% of the market even though they know in their bones that public schools' predatory pricing will continue without interruption.

A further lesson: In popular nightmares, predation works because its effects are lasting.  Sell at a loss, kill each and every one of your competitors, and no rival will dare to challenge you for many a moon.  Once you realize that public schools currently practice extreme predatory pricing, though, it's hard to take popular nightmares seriously. 

Try this thought experiment.  Public schools suddenly lose all their tax funding.  (This could result from a voucher system, or just hard-core austerity).  Now that schools have to cover their expenses with tuition, how long will public schools retain their 90% market share?  If predation really had lasting effects, you'd expect competitors to remain scarce and scared for years, safeguarding public schools' incumbent advantage.  In practice, though, I suspect that almost everyone - regardless of ideology - would expect public schools to lose at least half of their market share over the following decade.  Driving the competition out of business with insanely low prices is not akin to salting the earth so nothing ever grows there again.  Not even close.

Bottom line: The example of public schools should deter any normal business from pursing a predatory strategy.  If permanently giving your product away for free only yields a 90% market share, what's the best that could happen if a normal business temporarily sold for 10% below cost?  Customers should hope firms will be cocky enough to try predation.  The long-run monopoly prices are sheer speculation - and the short-run discounts are undeniable.  Unless, of course, your tax dollars are funding the discounts.

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COMMENTS (14 to date)
Philo writes:

"If predation really had lasting effects, you'd expect competitors to remain scarce and scared for years [even after public schools lost their public funding], safeguarding public schools' incumbent advantage." This seems to ignore the reason predation is supposed to work: potential competitors will expect that the firm that practiced predation in the past would do so again if new competitors appeared. Now, if public schools lost their public funding, this would change their situation so much that their past behavior could not be projected into the future. Obviously it would have become at least *much harder* for them to practice predation, as they had done when they were publicly funded. Potential competitors would have much less to fear (unless they expected the loss of public funding to be quite short-lived).

Scott Freelander writes:

Bryan Caplan,

No offense, but this strikes me as incredibly naive. You paint with a very broad stroke here and, much more importantly, provide no data.

I think you're better off erasing this post before too many people read it, because it isn't even worthy of a freshman in economics.

I understand this is a blog post, but this does not make you look good. You can say you were ill.

Someone from the other side writes:

+1 to what Scott says.

The theory about predatory pricing may work for undifferentiated products but school is hardly one of those.

If you were to argue that public school is a pretty sad product that, while people are compelled to buy it, still isn't able to reach all consumers even for free, then maybe I could see a point.

Rajat writes:

I strongly agree with this post. Fears about predation are fundamentally about incumbent firms with market power driving out competitors and then - having done so - cashing in forever more. Bryan's thought experiment shows that except in very specific cases (I would say natural monopoly-type industries such as electricity networks), any driving out of competitors will only be transient; with the result that the attempt at predation is unlikely to be profitable. It's a mystery why competition regulators cannot see this.

BC writes:

Nice observations here. If the point is that predatory pricing alone is not sufficient to permanently drive competitors out of business, then this public school example would seem to establish that. However, that doesn't necessarily imply that predatory pricing will never work nor even that it won't often work. I would offer the two following counterarguments:

(1) The government may be sacrificing market share to please various constituent groups, such as teachers unions. Perhaps, if the government were singularly focused on establishing permanent monopoly, they could have done so.

(2) Perhaps, there is a (lack of) selection effect. For-profit firms are most likely to try predatory pricing only when it is likely to work. In contrast, government may engage in predatory pricing even when it is unlikely to work, again to please various constituencies.

In short, maybe government examples are not the best ones as the failure may be due to government incompetence or bad incentives. I would agree though that, given that predatory pricing is not sufficient to establish monopoly, that would suggest that a certain burden of proof should be met that predatory pricing would be harmful in a particular situation before such predatory pricing should be prohibited.

Eric Hosemann writes:

I'm still trying to figure out how public schooling is "free." The costs associated with providing it are fairly well perceived by its consumers--in many places people shop for it by comparing property tax levels. When school districts need to cover additional costs they must float the idea of an increased levy, which isn't always a sure thing. Maybe a better way to put it is that inspite of a monopoly backed by force, public schools can capture only 90% of the market.

Mike H writes:

Bryan is using "free" as shorthand for zero marginal cost. You've already shelled out the money, so you can either take the now "free" education, or spend more money on a private school.

BW writes:

(Using my initials rather than name as I'm about to discuss the industry I work in...)

I think there's a missing point here. Schooling is a good that can effectively be provided by anybody. Yes, there are laws requiring licensing of teachers, but nothing suggesting that licensed teachers can only work for public schools. Barriers to entry are meaningful (i.e. capital & red tape) but not overwhelming, but there are no economies of scale or intellectual property issues that make it impossible for a new entrant to succeed.

Contrast that to, say, the hard drive industry (and you can expand this to many technology firms). The barriers to entry are enormous. Economies of scale are huge. And most importantly, the intellectual property environment basically locks out new entrants.

The currently remaining HDD vendors have cross-license agreements with each other. Why? Because without them, no HDD vendor could POSSIBLY produce anything without violating the IP of other market players. So everyone has to play nice.

But let's say a new entrant wants to come into the market. Not only do they need money, and LOTS of it, but they need technology. They need technology so profound that it allows them to either produce HDDs via some new method that doesn't violate existing IP, or is so incredibly groundbreaking that the remaining players are willing to allow them into the cross-licensing fold in exchange for access to it.

Not going to happen. If anything, the new entrant will be bought out and folded into an existing player (after all, we're talking about an industry that has executed two multi-billion dollar consolidation mergers in the last 3 years, and the players in the industry are flush with cash).

The effect of predatory pricing, when balanced against an IP regime and economies of scale that make new entrants infeasible, can effectively lock out new entrants and insulate an industry from competition...

Just look at the 5-year charts for STX and WDC if you want to see what the consolidation has done to earnings and where the P/E trades at... Noting that 2011-2012 is when Seagate, then #2, bought Samsung's HDD division which was #5, and when WD, then #1, bought HGST, which was then #3. That consolidated the worldwide HDD industry from 5 firms to 3.

vikingvista writes:

As usual, a very astute observation that I will be shamelessly stealing from you.

Hasn't it been long observed that the drama of fear mongering of predatory pricing (even when not misapplied as, e.g., with Standard Oil which truly did reduce costs and did not need to expend profits on lowering prices) far exceeds the realities? You mention one reason (inferior product) that predatory pricing fails. But there are others, e.g., required debt increases marginal costs relative to existing competitors and future upstarts.

Perhaps the most frequently observed successful application of predatory pricing, is when an upstart company needs to *create* market share for itself that is sufficient to achieve a particular profitable economy of scale. I don't see the marketophobes gnashing their teeth over upstarts expending debt to maintain prices competitive with established giants.

Wouldn't such established giants then be expected to lobby for anti-predatory pricing legislation? Oh wait, it is the giants who usually do, isn't it?

Dale writes:

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Tom West writes:

I'm can't agree with Bryan's example. "Predatory pricing" *has* driven out the vast majority of entrants in the market.

In fact, the only thing that's left is a tiny rump of schools that serve people who are actually looking for a *different* product than the one's the public system is "selling". In fact, there's barely a single for-profit institution that hasn't been driven out of the market.

Moreover, if the public schools started charging tuition, I'd be willing to bet most for-profit companies would stay out of the market for decades, on the basis that the public system might go back to its "predatory practices" at any time.

mobile writes:

If everything at Wal-Mart were free, at least 10% of the population would still shop somewhere else just to distinguish themselves from the common people.

Tracy W writes:

Tom West, actually Sweden changed its rules to allow for-profit schools, without shutting down the state system, and it got a bunch of for-profit schools.

Tom West writes:

Thanks. I had no idea that Sweden had for-profit schools. Very interesting article.

The article does mention they took a decade to come in to the market, mind, but still, it wasn't "decades", as I figured.

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