chapter 13: predatory conduct: recent developments 1 predatory conduct: recent developments
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Chapter 13: Predatory Conduct: recent developments
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Predatory Conduct: Recent Developments
Chapter 13: 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
Incumbent: 60 + 60 = 120 Entrant: 0
Enter
Stay Out
Incumbent: 40 + 20 = 60 Entrant: 20
Incumbent: 40 + 60 = 100 Entrant: 0
Low PriceEnter
Stay OutE5
Incumbent: 100 + 50 = 150 Entrant: -20
Incumbent: 100 + 100 = 200 Entrant: 0
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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
Incumbent: 60 + 20 = 80 Entrant: 20
Incumbent: 60 + 60 = 120 Entrant: 0
Enter
Stay Out
Incumbent: 40 + 20 = 60 Entrant: 20
Incumbent: 40 + 60 = 100 Entrant: 0
Low PriceEnter
Stay OutE5
Incumbent: 100 + 50 = 150 Entrant: -20
Incumbent: 100 + 100 = 200 Entrant: 0
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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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