Price Erosion, in Finance and in Damages

“Price erosion” means two different things depending on who is using it, and the two meanings turn up in different rooms. In a capital budgeting meeting it describes what a new product does to the products you already sell. In a damages case it describes what a competitor’s conduct did to the price you were able to charge. The arithmetic is different, and so is what has to be proven.

The corporate finance meaning: erosion as cannibalization

In capital budgeting, erosion is the cash flow a firm loses on existing products because it launched a new one. It belongs in the analysis of the new project, not outside it.

The rule is that a project’s relevant cash flows are incremental to the firm as a whole. If a new model takes sales from the old model, the profit lost on the old model is a real cost of launching the new one, and a net present value that ignores it overstates the project.

A simple version: a manufacturer projects $4 million a year in contribution from a new product line. Roughly a quarter of those buyers would otherwise have bought the existing line, on which the firm earns $1.2 million of contribution a year. If the new line takes a quarter of that, the incremental contribution is $4.0m − $0.3m = $3.7 million, and that is the figure the NPV should be built on.

Two related terms travel with it. Cannibalization is the same idea stated from the product’s point of view. Erosion cost is the dollar amount of the lost contribution. Note that erosion counts only where the sales would genuinely have been retained: if a competitor was going to take those customers anyway, the cash flow was not the firm’s to lose, and treating it as erosion double-penalizes the new project.

The damages meaning: price erosion as a head of loss

In litigation, price erosion is the difference between the price a claimant actually charged and the higher price it would have charged but for the defendant’s conduct. It shows up most often in patent infringement, and also in antitrust and unfair competition matters.

The claim usually has two parts, and they are frequently confused:

• Lost profits on lost sales — units the claimant did not sell at all because the infringer sold them instead.
• Price erosion on the sales actually made — the margin given up on every unit the claimant did sell, because it had to meet a price it would not otherwise have had to meet.

The second component is often the larger of the two, because it applies to the whole of the claimant’s own volume rather than to the units it lost. It is also the harder one to prove.

Establishing the but-for price

Everything turns on a counterfactual price, and assertion will not carry it. The evidence that actually works is contemporaneous and documentary:

• Published price lists and the dates they changed.
• Internal pricing memoranda and board materials that state why a price was cut — the closer they are in time to the cut, the better.
• Pricing in a comparable market where the defendant was not present.
• The claimant’s own pricing before entry and after exit.
• Margin structure, which sets the floor beneath which a price cut makes no commercial sense.

The benchmark market has to be genuinely comparable, and that is where these claims most often come apart. A benchmark drawn from a market with different competitive structure — a concentrated segment used as the yardstick for a fragmented one — will not survive examination.

Elasticity: the objection that decides these cases

The single most important constraint on a price erosion claim is the law of demand. If the claimant would have charged more, it would have sold fewer units. A claim that asserts a higher price across the same volume is asserting that demand is perfectly inelastic, which is almost never true and almost never argued explicitly.

The Federal Circuit made this a requirement rather than a debating point in Crystal Semiconductor Corp. v. TriTech Microelectronics International, 246 F.3d 1336 (Fed. Cir. 2001). A patentee claiming price erosion must present evidence of the presumably reduced quantity it would have sold at the higher price. Crystal’s price erosion award was denied outright: its benchmark compared an oligopolistic market with a highly competitive one, and it offered no evidence of elasticity, of how many units it would have lost at the higher price, or of how competitors would have responded.

So a defensible price erosion analysis has to do three things at once: establish the but-for price, estimate the volume that would have been sold at it, and reconcile the two into a single figure. An analysis that does only the first is not a partial answer — it is the answer that was rejected.

A worked example

• Actual price over the damages period: $18.00 per unit · actual units sold: 500,000
• But-for price, supported by pre-entry price lists: $22.00
• Estimated elasticity implies volume at $22.00 of 430,000 units, not 500,000
• Incremental cost per unit: $11.00

Actual contribution: 500,000 × ($18.00 − $11.00) = $3.50m.
But-for contribution: 430,000 × ($22.00 − $11.00) = $4.73m.
Price erosion damages on sales made: $1.23m.

Ignoring elasticity would have produced 500,000 × $4.00 = $2.00m — roughly 63 percent higher, and unsupportable. Note also that the incremental cost figure does real work here: at 430,000 units some costs behave differently than at 500,000, and a serious analysis says which.

Where these claims fail

1. No elasticity evidence. The Crystal Semiconductor problem, and still the most common one.
2. A benchmark market that is not comparable. Different structure, different customers, different regulation.
3. Confusing a market-wide price decline with erosion. Prices in many product categories fall over time for reasons that have nothing to do with the defendant. The analysis has to separate the secular trend from the conduct.
4. Double counting against lost sales. A unit cannot be both a sale the claimant lost and a sale it made at a depressed price.
5. Ignoring how competitors would have responded. A higher but-for price may have invited entry, which changes the counterfactual.

What an economist contributes

Building the but-for price from the documentary record rather than from the claim, estimating elasticity from the claimant’s own transaction data where it exists and from comparable markets where it does not, separating the effect of the conduct from the category’s own price trend, and reconciling the erosion claim with any lost profits claim so the same unit is not counted twice.

Related: how lost profits are calculated · commercial litigation support · calculating reasonable royalties. Source: Crystal Semiconductor Corp. v. TriTech Microelectronics International, 246 F.3d 1336 (Fed. Cir. 2001).