Entry Deterrence and Predation Chapter 9 Entry Deterrence

Entry Deterrence and Predation Chapter 9: Entry Deterrence and Predation 1

Introduction • A firm that can restrict output to raise market price has market power • Microsoft (95% of operating systems) and Campbell’s (70% of tinned soup market) are giants in their industries • Have maintained their dominant position for many years – Why can’t existing rivals compete away the position of such firms? – Why aren’t new rivals lured by the profits? • Answer: firms with monopoly power may – eliminate existing rivals – prevent entry of new firms • These actions are predatory conduct if they are profitable only if rivals, in fact, exit – e. g. , R&D to reduce costs is not predatory Chapter 9: Entry Deterrence and Predation 2

Evolution of market structure • Evolution of markets depends on many factors – one is relationship between firm size and growth • Gibrat’s Law – begin with equal sized firms – each grows in each period by a rate drawn from a random distribution – this distribution has constant mean and variance over time – result is that firm size distribution approaches a log-normal distribution • Very mechanistic – no strategy for growth • Including strategic decision making affects distribution but not conclusion that firm sizes are unequal – What about the facts in the market place? Chapter 9: Entry Deterrence and Predation 3

Monopoly power and market entry • Several stylized facts about entry – entry is common – entry is generally small-scale • so small-scale entry is relatively easy – survival rate is low: >60% exit within 5 years – entry is highly correlated with exit • not consistent with entry being caused by excess profits • “revolving door” • reflects repeated attempts to penetrate markets dominated by large firms • Not always easy to prove that this reflects predatory conduct • But we need to understand predation it if we are to find it Chapter 9: Entry Deterrence and Predation 4

Predatory conduct and limit pricing • Predatory actions come in two broad forms – Limit pricing: prices so low that entry is deterred – Predatory pricing: prices so low that existing firms are driven out • Outcome of either action is the same—the monopolist retains control of the market • Legal action focuses on predatory pricing because this case has an identifiable victim – a firm that was in the market but that has left • Consider first a model of limit pricing – Stackelberg leader chooses output first – entrant believes that the leader is committed to this output choice – entrant has decreasing costs over some initial level of output Chapter 9: Entry Deterrence and Predation 5

A limit pricing model Then the entrant’s the is residual demand RThese are the cost curves $/unit 1, residual With demand entrant for potential entrant Bythe committing to output R 1 =the D(P) - Q 1 can operate profitably. Entry is not deterred by the d Q the incumbent deters incumbent choosing Q 1. d entry. Market price P Then the entrant’s is the limit price e e R 1 At price P entry is The marginal revenue is entrant’s MR residual The entrant equates MC unprofitable e demand is marginal revenue Assume instead that ACe Re = D(P) - Qd with marginal cost the incumbent Assume that the d commits to output Q incumbent commits D(P) = Market Demand to output Q 1 Re Pd Pe MRe qe Qd Qd Q 1 Quantity Chapter 9: Entry Deterrence and Predation 6

Limit pricing • Committing to output Qd may be aimed either at eliminating an existing rival or driving out a potential entrant. • Either way, several questions arise: – Is limit pricing more profitable than other strategies? – Is the output commitment credible? – If output is costly to adjust then commitment is possible • why should this property hold? – could be claimed to be ad hoc to support theory • even if it holds, is monopoly at output Qd better than Cournot? – may not be if the entrant’s costs are low enough • Credibility may relate output to capacity Chapter 9: Entry Deterrence and Predation 7

Capacity expansion and entry deterrence • For predation to be successful and rational – the incumbent must convince the entrant that the market after the entrant comes in will not be profitable one • How can the incumbent credibly make this threat? • One possible mechanism – install capacity in advance of production • installed capacity is a commitment to a minimum level of output • the lead firm can manipulate entrants through capacity choice • the lead firm may be able to deter entry through its capacity choice – but is this credible? – capacity must be costly to install and should be irreversible Chapter 9: Entry Deterrence and Predation 8

The Dixit model • Consider a two-stage game – incumbent in period 1 installs capacity • • capacity K 1 costs r. K 1 to install in second period incumbent can produce up to K 1 at unit cost w capacity can be expanded in period 2 at additional cost r per unit capacity cannot be reduced in period 2 – potential entrant in period 2 observes incumbent’s capacity choice • to enter and produce incumbent needs capacity K 2 which costs r. K 2 • unit cost of production is w • note: entrant will never install unused capacity – if entry takes place firms play a Cournot game in the second period • Market demand: P = A – B(q 1 + q 2) Chapter 9: Entry Deterrence and Predation 9

The Dixit model 2 • Costs for the incumbent are: – C 1 = F 1 + w. q 1 + r. K 1 for q 1 < K 1; marginal cost w – C 1 = F 1 + (w + r)q 1 for q 1 > K 1; marginal cost w + r • Costs for the entrant are: – C 2 = F 2 + (w + r)q 2 ; marginal cost w + r • Standard Cournot analysis gives the best response functions: – q*1 = (A – w)/2 B – q 2/2 when q 1 < K 1 – q*1 = (A – w – r)/2 B – q 2/2 when q 1 > K 1 – q*2 = (A – w – r)/2 B – q 1/2 provided that q*2 > 0 • for the entrant to enter it must expect to cover the sunk costs F 2 • this implies a lower limit on the output that the entrant must make Chapter 9: Entry Deterrence and Predation 10

The Dixit model 3 • The incumbent’s best response function has a break in it at K 1 • The entrant’s best response function has a break where sunk costs are not covered • Equilibrium depends upon these two breaks q 2 L’ N’ R’ Chapter 9: Entry Deterrence and Predation R N K 1 L q 1 11

The Dixit model 4 q 2 • Consider the possibilities • Suppose that firm 2 enters • Equilibrium must lie between T and V • Where depends upon location of the break in R’R • Firm 1’s output is greater than T 1 and smaller than V 1 • So capacity choice lies between T 1 and V 1 L’ N’ R’ T 2 T V V 2 R N T 1 Chapter 9: Entry Deterrence and Predation V 1 L q 1 12

The Dixit model 5 q 2 L’ • Now suppose that firm 2 does not enter • Must be that it cannot break even at output less than T 2 • Then firm 1 would want to choose capacity M 1 N’ – this is the monopoly output with MC = w + r • M 1 is actually the Stackelberg output level for firm 1 – firm 1 as market leader will never choose output and capacity less than M 1 R’ T 2 M 2 V 2 T T 1 Chapter 9: Entry Deterrence and Predation S N M 1 V R V 1 L q 1 13

The Dixit model 6 • Suppose that the break in the entrant’s best response function lies at BL in R’T • Incumbent chooses capacity M 1 and entry is deterred • Suppose that the break in the entrant’s best response function lies at BS in TS T 2 M • Incumbent chooses capacity 2 V 2 M 1 and entry is deterred q 2 L’ N’ R’ BL TB S S V N T 1 M 1 V 1 L BL • Suppose that the break in the entrant’s best response function lies at BL in VR • Incumbent chooses capacity of Stackelberg leader output M 1 and entry is accommodated Chapter 9: Entry Deterrence and Predation R q 1 14

The Dixit model 7 • Now suppose that the break in the entrant’s best response function lies at B* in SV • Incumbent can choose to install capacity of Stackelberg leader output and share the market • Or install capacity B 1 and maintain monopoly in the T 2 M 2 market V 2 • Choice depends upon relative profitability q 2 L’ N’ R’ T T 1 S B*V N M 1 B 1 V 1 L R q 1 – If B* is “close to” S then use capacity to deter entry – If B* is “close to” V then accommodate entry as Stackelberg leader Chapter 9: Entry Deterrence and Predation 15

Capacity expansion and entry deterrence 2 • An example: – – – P = 120 - Q = 120 - (q 1 + q 2) marginal cost of production $60 for incumbent and entrant cost of each unit of capacity is $30 firms also have fixed costs of F incumbent chooses capacity K 1 in stage 1 NOTE: incumbent will always produce at least K 1 in production stage—otherwise it throws away revenue that could help cover the cost of installed capacity – entrant chooses capacity and output in stage 2 – firms compete in quantities in stage 2. Chapter 9: Entry Deterrence and Predation 16

Entry deterrence • Entry may not occur – entrant’s costs are too high • blockaded entry • not predatory • Entry may be accommodated – entrant’s costs are low • incumbent takes advantage of its being first in the market • but does not deter • Entry may be strategically deterred – strategic deterrence profitable for the incumbent – installs excess capacity as an entry-deterring strategy – uses a credible commitment Chapter 9: Entry Deterrence and Predation 17

Evidence on predatory expansion • Some anecdotal evidence • Alcoa – evidence that consistently expanded capacity in advance of demand • Safeway in Edmonton – evidence that it aggressively expanded store locations in response to potential entry • Du. Pont in titanium oxide – rapidly expanded capacity in response to to changes in rivals’ costs – market share grew from 34% to 46% Chapter 9: Entry Deterrence and Predation 18

Introduction of Predatory Pricing • 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? Chapter 9: Entry Deterrence and Predation 19

Predatory pricing: myth or reality? • Theoretical and empirical doubts – predation is generally not subgame perfect without uncertainty regarding the incumbent • return to this below – Mc. Gee’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(q. L + q. F) q. F is output of leader and q. F is output of follower leader is a Stackelberg quantity leader both leader and follower have constant marginal costs of c Chapter 9: Entry Deterrence and Predation 20

An example of predation • At the Stackelberg equilibrium – leader makes (A – c)2/8 B – follower makes (A – c)2/16 B – if the leader were a monopolist it would make (A – c)2/4 B • 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)2/4 B Chapter 9: Entry Deterrence and Predation 21

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)2/2 B – 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 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 Chapter 9: Entry Deterrence and Predation 22

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 Chapter 9: Entry Deterrence and Predation 23

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 Chapter 9: Entry Deterrence and Predation 24

• • 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 lowcost – 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 Chapter 9: Entry Deterrence and Predation 25

The Example 2 • Incumbent profits in period 1 (in $million) – low-cost firm acting as low-cost monopolist: $100 m – high-cost firm acting as high-cost monopolist: $60 m – high-cost adopting low-cost monopoly price: $40 m • Incumbent profits in period 2 – if no entry, profits according to true type – if entry occurs: • low-cost incumbent: $50 m • high-cost incumbent: $20 m • Entrant’s profits in period 2 – competing against a low-cost incumbent: -$20, – competing against a high-cost incumbent: $20 m Chapter 9: Entry Deterrence and Predation 26

The Example 3 High Price E 3 Enter Incumbent: 60 + 20 = 80 Entrant: 20 Stay Out Incumbent: 60 + 60 = 120 Entrant: 0 Enter Incumbent: 40 + 20 = 60 Entrant: 20 High-Cost Nature I 1 Low Price E 4 Stay Out Low-Cost I 2 Enter Low Price E 5 Stay Out Incumbent: 40 + 60 = 100 Entrant: 0 Incumbent: 100 + 50 = 150 Entrant: -20 Incumbent: 100 + 100 = 200 Entrant: 0 Chapter 9: Entry Deterrence and Predation 27

With uncertainty and With no uncertainty The ifexample a 4 low price the entrant enters the does not incumbent is high-cost Incumbent: 60 +know 20 = 80 if Enter Entrant: 20 at E 4 or E 5 he is High Price E 3 Stay Out High-Cost Nature I 1 Low Price Enter E 4 Stay Out Low-Cost I 2 Enter Low Price E 5 Stay Out Incumbent: 60 + 60 = 120 Entrant: 0 Incumbent: 40 + 20 = 60 Entrant: 20 Incumbent: 40 + 60 = 100 Entrant: 0 Incumbent: 100 + 50 = 150 Entrant: -20 Incumbent: 100 + 100 = 200 Entrant: 0 Chapter 9: Entry Deterrence and Predation 28

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 lowcost deters entry Chapter 9: Entry Deterrence and Predation 29

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) - 20 p = 20 - 40 p • 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 highcost incumbent has an incentive to set a limit price Chapter 9: Entry Deterrence and Predation 30

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 Chapter 9: Entry Deterrence and Predation 31

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. Chapter 9: Entry Deterrence and Predation 32

Predatory Conduct and Public Policy • The evidentiary requirements for prosecuting predatory pricing cases are high – Pricing below cost – The predator had a reasonable expectation of recouping the losses • Very hard to distinguish predation from other procompetitive behavior – Hard to measure marginal cost – Learning curves, network effects, and other externalities Chapter 9: Entry Deterrence and Predation 33