Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't

buy less gas at any one time and then bear the additional time cost of refueling in the near future. This is especially true in full-service stations, where less wealthy customers are more likely to buy just a few gallons in order to get the “service”—having the attendant wash the windows, check the oil and air pressure, etc.30
Since gas stations sell less full-service gallons per customer of regular gas than of supreme, they need to make up the difference by adding a higher premium to regular gas.
Predatory Pricing—Not as Easy as it Seems
One commonly discussed and particularly vicious method of maintaining a monopoly is through predatory pricing.31 This occurs when a firm slashes prices below its own cost of production, usually in an attempt to drive competitors out of business. A predatory firm doesn’t prevail due to the merits of its business plan; rather, its success depends on its willingness to lose money temporarily in order to shut down its competitors. Though cases are rarely serious enough to reach a courtroom, they certainly get attention when they do. Take the cases of Brown & Williamson cigarette makers and American Airlines: both faced high-profile court hearings over predatory pricing in the 1990s.32 This kind of publicity strengthens a common misperception that powerful corporations can engage in predatory pricing at will whenever they feel threatened by a competitor.
It seems perhaps that our entire economy is not really based on free competition, but rather on the overwhelming power of a few monopolies that can prevent other companies’ entry into the market. However, to the contrary, the strategy of predatory pricing is so riddled with contradictions that it actually ends up creating new incentives for competitors to join the market.33
Even under the best of circumstances for monopolists, predatory pricing is difficult. For predation to work, a predatory firm must not only slash prices, but also expand its output at this low price. If it does not expand production as it lowers prices, the firm will not be able to steal sales from its competitors. According to many economists, even if predators succeed in driving away competitors, the fruits of victory will prove short-lived. To merely recoup its losses from predation, after competitors are driven out of the market a predatory firm has to raise prices even higher than the price had been before the predation effort. But raising prices that high lures new firms into the market, which can easily undercut the predator’s new prices. This then forces the predator to slash its prices yet again in order to drive these new entrants from the market.34 This Ferris wheel of lowering and raising prices makes little economic sense.
In addition, because the predator has to expand its output to hold down prices, the losses incurred from predatory pricing easily exceed any subsequent profits from monopoly prices. The losses to the predator also typically exceed the losses suffered by the victim firms that are driven out.
Furthermore, predation can be overcome by using a tactic employed over 130 years ago by the famous robber baron Jay Gould, whose maneuver, while not carried out against a predatory firm, still demonstrated why predation is so difficult and thus so rare. Firms have always been able to trade in other companies’ stocks. In order to overcome the dominant position Western Union then enjoyed in the telegraph industry, Gould “shorted” Western Union’s stock. Shorting involves borrowing shares in a firm’s stock from a brokerage, selling them, and then repurchasing them later to return to the brokerage. When you short a company’s stock, you are betting that the stock price will fall sometime after you borrow and sell the shares, so that you can buy them back later for a lower price and pocket the difference. In Gould’s case, he shorted Western Union’s stock and then set up his own telegraph lines to compete against the company, making a bundle as Western Union’s stock fell. Gould and his partner made a million dollars each just on the stock deal.35 Not bad for the 1870s.
And this tactic is doubly effective against a predator. Suppose a predator has convinced everyone that it is willing to lose whatever money is necessary to drive out any firm that dares enter its market. Precisely because it is believed to be willing to lose a lot of money, it should never have to lose any; no one would even consider entering its market. While one might think that this strategy will keep firms from entering, actually the exact opposite is true; potential competitors have been given an additional incentive to enter the market because they can make extra cash by shorting the predator’s stock. The more the predator loses from the entry of the new firm and the slashing of its own prices, the more the new firm profits from the lost value of the predator’s stock.36
The irony is that the more committed the predator is to bear whatever cost is necessary to wipe out any potential competitors, the more profitable it is for a new firm to enter the market. In other words, the exact strategy needed to make predation profitable actually ensures its failure.
The Failure of Some Typical “Market Failure” Tales
Stories of everyday market failure are easy to find in popular literature. Calls for public vigilance against unscrupulous business agents, various minor scams, and instances where the market somehow doesn’t function properly have turned a tidy profit for a number of authors and economists. But there is often much more to these cases than meets the eye. Perceived rip-offs and alleged market failures oftentimes merely entail the market working in unexpected ways. Here are a few examples:
A Sour Lemon Story
A new car that was bought for $20,000 cannot be resold for more than perhaps $15,000. Why? Because the only person who might logically want to resell a brand-new car is someone who found the car to be a lemon. So even if the car isn’t a