Predatory Conduct Recent Developments Chapter 13 Predatory Conduct

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

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? Chapter 13: Predatory Conduct: recent developments 2

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 13: Predatory Conduct: recent developments 3

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 13: Predatory Conduct: recent developments 4

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 13: Predatory Conduct: recent developments 5

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 13: Predatory Conduct: recent developments 6

Asymmetric information and limit pricing • The preemption “games” are ways of resolving the Chainstore 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 lowcost - to prevent entry? • for example by pricing as a low-cost firm Chapter 13: Predatory Conduct: recent developments 7

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 Chapter 13: Predatory Conduct: recent developments 8

The Example (cont. ) • 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 13: Predatory Conduct: recent developments 9

The Example (cont. ) Enter 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 + 20 = 80 Entrant: 20 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 13: Predatory Conduct: recent developments 10

With no uncertainty The ifexample 2 the entrant enters the incumbent is high-cost With uncertainty Incumbent: 60 + 20 =and 80 Enter a low Entrant: price 20 the entrant does not know if High Price Incumbent: 60 + 60 = 120 E 3 he is at E or E 5 Stay Out Entrant: 0 4 High-Cost Nature I 1 Low Price Enter E 4 Stay Out Low-Cost I 2 Enter Low Price E 5 Stay Out 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 13: Predatory Conduct: recent developments 11

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 Chapter 13: Predatory Conduct: recent developments 12

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 high-cost incumbent has an incentive to set a limit price Chapter 13: Predatory Conduct: recent developments 13

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 13: Predatory Conduct: recent developments 14

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 13: Predatory Conduct: recent developments 15

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 Chapter 13: Predatory Conduct: recent developments 16

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 2 nd period – Entrant decides whether or not to enter in 2 nd period – Bertrand competition post-entry Chapter 13: Predatory Conduct: recent developments 17

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 Chapter 13: Predatory Conduct: recent developments 18

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 1 st period): • In 2 nd 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. Chapter 13: Predatory Conduct: recent developments 19

The example 4 • Incumbent’s Incentive to Offer the contract: – Without the contract, incumbent wins the 2 nd 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 2 nd 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 2 nd 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. Chapter 13: Predatory Conduct: recent developments 20

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? Chapter 13: Predatory Conduct: recent developments 21

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)x 1/2 = $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)x 1/4 = $3. 13 Chapter 13: Predatory Conduct: recent developments 22

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 Chapter 13: Predatory Conduct: recent developments 23

Chapter 13: Predatory Conduct: recent developments 24