Predation and its rate of return: the sugar industry, 1887-1914.

We show that the price wars following two major entry episodes were predatory. Our proof is twofold: by direct comparison of price to marginal cost, and by construction of a lower bound to predicted competitive price-cost margins that we show to exceed observed margins. Predation occurred only when its relative cost to the dominant firm, the American Sugar Refining Company (ASRC), was small. Its most clear effect was to lower the acquisition price of entrants and small incumbents. It may also have deterred future capacity additions and raised ASRC's share of industry profits. Predation operated by strengthening ASRC's reputation as a willing predator.

1. Introduction

* The continued exercise of market power depends upon deterring entry. Theory has clarified the range of rational strategies available to an incumbent. To assess whether such strategies are effectively used, we trace the evolution of the American sugar refining industry. We study entry following the formation of the Sugar Trust, later reorganized as the American Sugar Refining Company (ASRC), and focus on two sets of entrants, Spreckels and later Arbuckle Brothers and Doscher, who were met with sharp cuts in price. These price wars lasted about two years, with some interruptions, and included extended periods in which the price-cost margin fell to zero or below. We interpret these price wars as predation by ASRC.

Our evidence is based in part upon a direct comparison of price to marginal cost. As argued in Genesove and Mullin (1998), the simple technology of sugar refining and contemporary audits and testimony combine to provide a direct and credible measure of marginal cost. Because cost estimates can be controversial, we present a second test, based on competitive models, firms' capacities, and demand estimates. Using these, we construct predicted competitive price-cost margins and show that they exceed observed margins. This conclusion is robust to our measure of marginal cost, as it holds even when the non-raw-sugar component of marginal cost is assumed to be zero.

These claims engage us in two debates, one particular to the industry and the other more general. Whereas Zerbe (1969) attributes the price wars to a competitive response to entry, and their end to mergers, Eichner (1969) views the price wars as a predatory response to entry. The arguments evoke the more general debate about whether predation can be rational, and whether it occurs.

We view predatory pricing as "a reduction of price in the short run so as to drive competing firms out of the market or to discourage entry of new firms in an effort to gain larger profits via higher prices in the long run than would have been earned if the price reduction had not occurred" as in Joskow and Klevorick (1979, pp. 219-220). The predatory strategy could operate either by restricting the rival's cash flow or by altering its perception of market conditions or the incumbent's likely future actions.

Because compelling evidence of predation is rare, we devote much of the article to establishing that ASRC engaged in it. There are three additional findings. First, ASRC's demand for predation was downward sloping. We conceive of ASRC as "purchasing" losses for its rival by paying a price in forgone current profits. We measure this price as the ratio of ASRC's losses in the predatory war to the entrant's losses. The measure's usefulness is demonstrated by respites in both price wars in the summer, when sugar demand is high. We demonstrate that predation was relatively more costly to ASRC then, and so its extent was sensitive to its cost. Second, predation reduced the costs of acquiring competitors, as inferred from comparisons with counterfactual nonpredatory buyout prices. Both predatory episodes ended with ASRC's acquisition of a new entrant and other small incumbents. Three, most entrants made money overall, after experiencing both predatory and nonpredatory periods.

The plan of the article is as follows. In Section 2 we review the industry's history. Section 3 outlines the competitive environment in which ASRC operated: the cost structure, entry conditions, and possible modes of pricing behavior. Sections 4 and 5 address the two entry episodes. In Section 6 we address dynamic nonpredatory alternatives. Section 7 documents the effects of predation, as well as ASRC's rationale for preying, by means of internal rates of return to ASRC calculated under various theories of predation. We examine entrants' profitability in Section 8 and in Section 9 discuss and dismiss other ways in which ASRC might have deterred entry. Section 10 concludes.

2. Historical overview

* The Sugar Trust was formed in December 1887 as a consolidation of 18 firms controlling 80% of industry capacity. Refined prices rose 16%, and entry soon followed. (1)

The first entrant was Claus Spreckels Sr., who in December 1889 completed a plant in Philadelphia. That led to a two-year price war, and then to ASRC, the Trust's successor, acquiring the plant along with those of three Philadelphia firms that had not joined in 1887. These acquisitions were completed by April 1892. ASRC capacity rose to 15.2 million pounds per day and its share to 95%. Not all entrants were met by immediate price wars. Over the next several years, concentration slowly declined with the small-scale entry of five firms with an average capacity of 447,000 pounds per day, documented by Vogt (1908).

The next phase of competition began in 1898, with the entry of Arbuckle Brothers, the dominant U.S. coffee roaster. It owed that position to a patented packaging machine, which enabled it to sell coffee in small packages rather than in bulk. From 1892 to 1896, it applied the technology to sugar, buying it refined from ASRC and then reselling it packaged. In September 1896, Arbuckle Brothers announced its intention to enter sugar refining. ASRC entered coffee roasting a few months later by purchasing another firm, and a coffee price war ensued. Construction of the Arbuckle Sugar Refining plant took almost two years, and production began in August 1898.

Another entrant, the Doscher refinery, began production in November of that year. When fully operational, each plant had a million-pound daily capacity, which together reduced ASRC's capacity share from 88% to 77%. This precipitated a severe price war, marked by pricing at or below cost, shutdown by the independent refiners, and Doscher's partial shutdown. With the exception of one "respite" the price war continued until May 1900, when Doscher merged with two others to form the National Sugar Refining Company--a consolidation organized by the ASRC president, Henry Havemeyer, who received control of the new entity. Arbuckle Brothers remained in the industry.

The next several years witnessed both successful and unsuccessful entry attempts. Claus Spreckels Jr., the son, founded a refinery in 1901, achieving a toehold in the industry by 1902-1904. Adolph Segal, who in 1895 had constructed a refinery and then sold it to ASRC before it went into production, began construction of a second plant in 1901. Two years later, with the plant nearly complete, Segal's bankruptcy pushed the refinery into receivership. Production at the plant began only in 1912, after it had been sold and refurbished. In 1910 the federal government filed a monopolization suit against ASRC, seeking its dissolution. Although this case was not formally resolved until a 1922 consent decree, government victories in the American Tobacco and Standard Oil cases in 1911 led ASRC to relinquish control of the National. (2)

The industry's evolution is captured in Table A1 in the Appendix. The third through seventh columns report capacity and capacity shares for East Coast plants. (3) (The West Coast constituted a largely separate market from the East Coast, where sugar production was concentrated. (4) As the U.S. Department of Commerce (1976) indicates, the U.S. population was then heavily concentrated in the East, with 70% of the 1900 population east of the Mississippi and only 6% in the Pacific and Mountain regions. We therefore focus on the East Coast market.) These figures demonstrate ASRC's dominance. Its (adjusted) capacity share, which accounts for its control over the National from its 1901 founding until the 1911 antitrust-induced dissolution, generally exceeded 80%.

Table A1 shows two additional elements that will be central to our analysis. First, if we compare the capacity figures to the ninth column, "Eastern industry output" we see that ASRC capacity always sufficed to meet industry demand, while fringe capacity did not--before the Spreckels purchase and after the National sale it was generally half of industry output, and otherwise about a third. Second, if we compare the eleventh column, fringe's "estimated output" (5) to the fringe's "average annual capacity" (6) on the far right of the table, we see that in the non-price-war periods, the fringe generally produced close to capacity. (7) These observations, taken together, justify our use of the competitive models under capacity constraints that we present in Section 3.

3. The competitive environment

* Technology. Refined sugar was a homogeneous product, shipped to grocers in barrels, who then packaged it for consumers with no identifying mark. (8) Prices therefore tended to be uniform across firms within the East Coast market.