Chapter 13: Predatory Conduct: recent developments 1 Predatory Conduct: Recent Developments.

Chapter 13: Predatory Conduct: recent developments

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Predatory Conduct: Recent Developments


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Introduction

• Charges of predatory conduct are not new– Microsoft is only one of the latest

– goes back to the days of Standard Oil

– more recent examples of predatory pricing• Wal-Mart

• AT&T

• American Airlines

• But they face problems of credibility– price low to eliminate rivals

– then raise price

– so why don’t rivals reappear?


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Predatory pricing: myth or reality?

• Theoretical and empirical doubts– predation is generally not subgame perfect without uncertainty

regarding the incumbent• return to this below

– McGee’s argument that predation is dominated by another strategy• merger is more profitable than predation

• so predation should not happen

– take an example• two period market

• inverse demand P = A – B(qL + qF)

• qF is output of leader and qF is output of follower

• leader is a Stackelberg quantity leader

• both leader and follower have constant marginal costs of c


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An example of predation

• At the Stackelberg equilibrium– leader makes (A – c)2/8B

– follower makes (A – c)2/16B

– if the leader were a monopolist it would make (A – c)2/4B

• Suppose that the leader predates in period 1– sets output (A – c)/B to drive price to marginal cost

– follower does not enter

– leader reverts to monopoly output in period 2 but the follower does not enter

– aggregate profit is (A – c)2/4B


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An example of predation 2

• Suppose instead that the leader offers to merge with the follower in period 1– monopoly in both periods

– aggregate profit (A – c)2/2B

– so the leader can make a merger offer that the follower will accept

• Merger is more profitable than predation but:– merger may not be allowed by the authorities

• monopoly power

– what if there are additional potential entrants?• may enter purely in the hope of being bought out

• Main point remains: threat of predation has to be credible if it is to work


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Predation and imperfect information

• Suppose that the entrant faces financial constraints– must borrow to finance entry

• Entrant also faces uncertainty pre-entry– faces some probability of “low” returns

• private information that can be concealed from bank

• incentive to misrepresent

• bank must then enforce removal of funding if low returns are reported

• Incumbent then has incentive to take actions that increase probability of failure


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Asymmetric information and limit pricing

• The preemption “games” are ways of resolving the Chain-store paradox– indicate that it is rational for incumbents to make investments that

are not profitable unless they deter entry

• An alternative approach: information structure– suppose that an entrant does not have perfect information about

the incumbent’s costs• if the incumbent is low cost do not enter

• if the incumbent is high-cost enter

– does a high-cost incumbent have an incentive to pretend to be low-cost - to prevent entry?

• for example by pricing as a low-cost firm


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A (simple) example

• Incumbent has a monopoly in period 1

• Threat of entry in period 2

• Market closes at the end of period 2

• Entrant observes incumbent’s actions in period 1

• These actions determine whether or not to enter in period 2

• Incumbent is expected to be high-cost or low-cost– no direct information on costs

– entrant knows that there is a probability p that the incumbent is low-cost

• Need to specify pay-offs in different situations


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The Example (cont.)

• Incumbent profits in period 1 (in $million)– low-cost firm acting as low-cost monopolist: $100m

– high-cost firm acting as high-cost monopolist: $60m

– high-cost adopting low-cost monopoly price: $40m

• Incumbent profits in period 2– if no entry, profits according to true type

– if entry occurs:• low-cost incumbent: $50m

• high-cost incumbent: $20m

• Entrant’s profits in period 2– competing against a low-cost incumbent: -$20,

– competing against a high-cost incumbent: $20m


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The Example (cont.)

Nature

High-Cost

Low-Cost

I1

I2

High Price

Low Price

E3

E4

Enter

Stay Out

Incumbent: 60 + 20 = 80 Entrant: 20


Enter

Stay Out



Low PriceEnter

Stay OutE5

Incumbent: 100 + 50 = 150 Entrant: -20



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The example 2With no uncertainty

the entrant enters if theincumbent is high-cost

With no uncertaintythe entrant enters if theincumbent is high-cost With uncertainty and

a low price the entrantdoes not know ifhe is at E4 or E5

With uncertainty anda low price the entrant

does not know ifhe is at E4 or E5

Nature

High-Cost

Low-Cost

I1

I2

High Price

Low Price

E3

E4

Enter

Stay Out



Enter

Stay Out



Low PriceEnter

Stay OutE5

Incumbent: 100 + 50 = 150 Entrant: -20



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The example 3

• Consider a high-cost incumbent– high price in period 1 - entry happens, profits are 80

– low price in period 1 - if no entry profits are 100

– low price in period 1 - if entry profits are 60

• A high-cost incumbent has an incentive to pretend to be low-cost

• The entrant knows this

• So a low-price of itself will not deter entry– it is not a true signal of the incumbent’s type

• Only the probability that low-price means low-cost deters entry


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The example 4

• Consider the profits of the entrant given that the incumbent sets a low-price in period 1– if the incumbent is high-cost - profit is 20 with probability 1 - p

– if the incumbent is low-cost - profit is -20 with probability p

– so expected profit is 20(1 - p) - 20p = 20 - 40p

• Will the entrant not enter when it sees a low price?

• Only if p > 1/2

• Only if there is a “sufficiently high” probability that the incumbent is low cost.

• Provided that pretence is expected to work a high-cost incumbent has an incentive to set a limit price


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Limit pricing and uncertainty

• Monopoly power can persist even if the incumbent is high-cost

• Entry only takes place if entrants believe that the incumbent is high-cost– so entry is more likely when incumbents are expected

to be weak

– entry then consistent with exit: efficient entrants drive out inefficient incumbents


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Limit pricing and uncertainty 2

• Note: the model shows how a high-cost firm can deter entry.

• However, to do this it must set a low price. – This is how it “fools” the would-be entrant.

• The threat of entry forces the incumbent to price below the monopoly price it would otherwise set

• This lower limit price therefore mitigates the resource misallocation effects of monopoly.


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Long-term contracts as entry barriers• Can an incumbent preclude entry by signing customers to

log-term contracts that can only be broken with penalty?– Chicago School Answer: No. Buyer cannot be forced to sign a

contract that is against its own best interest– Post Chicago School Answer: Yes. Incumbent can write a

contract that makes it in the customer’s interest to keep out a lower cost alternate supplier

• Essence of the Post-Chicago argument– A new entrant will earn a lot of surplus– The long-term contract can be written so as to limit entry by

making sure that much of any surplus generated by entry goes to the customer


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An example

• The Setup: One seller (the incumbent), one buyer and one potential entrant—and two periods– Buyer is willing to pay $100 for a commodity

– Incumbent has cost of $50

– Potential entrant with cost c randomly distributed between 0 and $100

– Contract between buyer and seller written in first period but covers 2nd period

– Entrant decides whether or not to enter in 2nd period

– Bertrand competition post-entry


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The example 2• Competition and entry without a Long-term Contract

– No entry: the incumbent sets a price of $100– Entry will occur only if entrant’s cost is c < $50– Competition between the entrant and the incumbent will mean the

entrant cannot price above $50. – No pressure for it to price below $50 even if c is very low– In this scenario, the buyer’s expected price is:– P = ½ x $100 + ½ x $50 = $75 Expected Surplus = $25– Buyer must be offered this surplus in any other contract


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The example 3• Competition and entry with a long-term contract

– Can the incumbent offer the buyer a contract that makes entry less probable?

• Yes.

– Consider the following contract (written in 1st period): • In 2nd period, incumbent sells to buyer at P = $75. • Buyer buys from incumbent unless the buyer pays a $50 breach of contract

fee

– Entrant must now charge no more than $25• price plus breach of contract fee must be no more than $75 • so entry occurs only if c < $25, i.e. ¼ of the time.

– Buyer: • ¾ of the time, it stays with the contract and pays $75. • ¼ of the time it breaks the contract, pays entrant $25 and pays incumbent $50

breach-of-contract fee for a total of $75. • Buyer’s expected surplus is $25 with contract as it was without the contract.


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The example 4• Incumbent’s Incentive to Offer the contract:

– Without the contract, incumbent wins the 2nd period competition ½ the time.

• It will sell at P = $100 and incur cost of $50 for an expected profit of $25.

– With the contract it will:• Win the 2nd period competition ¾ of the time. It will sell at P = $75,

incur a cost of $50 for an expected profit of 0.75 x $25 = $18.75• Lose the 2nd period competition ¼ of the time. It will then incur no

cost but receive a $50 breach of contract payment. Its expected profit will be 0.25 x $50 = $12.50.

– Overall, incumbent’s expected profit with the contract is $31.25 > $25. The incumbent prefers the contract.


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Contracts and efficiency

• Incumbent’s profit is greater with the contract– $31.25 as against $25

• Buyer’s expected surplus is the same with and without the contract

• So the contract will be offered and signed• But it is inefficient

– net gain to incumbent and buyer of $6.25

– this is less than the entrant’s reduction in surplus

• Why?


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Contracts and efficiency 2

• Without the contract– entrant stays out half the time

– when it enters it prices at $50

– expected cost is $25 (uniformly distributed on [$0, $50]

– expected surplus is therefore (50 – 25)x1/2 = $12.50

• With the contract– entrant stays out three quarters of the time

– when it enters it prices at $25

– expected cost is $12.50

– expected surplus is (25 – 12.5)x1/4 = $3.13


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Contracts and efficiency 2

• Deterring entry through the contract – increases incumbent and buyer surplus by $6.25

– reduces entrant’s surplus by $12.50-$3.13 = $9.37

– reduction in surplus is greater than gain in surplus

• Why?– some desirable entry is prevented

– entrant with cost between $25 and $50 is more efficient than incumbent

– but is deterred from entry


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Chapter 13: Predatory Conduct: recent developments 1 Predatory Conduct: Recent Developments.

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