chapter 13: predatory conduct: recent developments 1 predatory conduct: recent developments

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  • Predatory Conduct: Recent Developments

  • IntroductionCharges of predatory conduct are not newMicrosoft is only one of the latestgoes back to the days of Standard Oilmore recent examples of predatory pricingWal-MartAT&TAmerican AirlinesBut they face problems of credibilityprice low to eliminate rivalsthen raise priceso why dont rivals reappear?

  • Predatory pricing: myth or reality?Theoretical and empirical doubtspredation is generally not subgame perfect without uncertainty regarding the incumbentreturn to this belowMcGees argument that predation is dominated by another strategymerger is more profitable than predationso predation should not happentake an exampletwo period marketinverse demand P = A B(qL + qF)qF is output of leader and qF is output of followerleader is a Stackelberg quantity leaderboth leader and follower have constant marginal costs of c

  • An example of predationAt the Stackelberg equilibriumleader makes (A c)2/8Bfollower makes (A c)2/16Bif the leader were a monopolist it would make (A c)2/4BSuppose that the leader predates in period 1sets output (A c)/B to drive price to marginal costfollower does not enterleader reverts to monopoly output in period 2 but the follower does not enteraggregate profit is (A c)2/4B

  • An example of predation 2Suppose instead that the leader offers to merge with the follower in period 1monopoly in both periodsaggregate profit (A c)2/2Bso the leader can make a merger offer that the follower will acceptMerger is more profitable than predation but:merger may not be allowed by the authoritiesmonopoly powerwhat if there are additional potential entrants?may enter purely in the hope of being bought outMain point remains: threat of predation has to be credible if it is to work

  • Predation and imperfect informationSuppose that the entrant faces financial constraintsmust borrow to finance entryEntrant also faces uncertainty pre-entryfaces some probability of low returnsprivate information that can be concealed from bankincentive to misrepresentbank must then enforce removal of funding if low returns are reportedIncumbent then has incentive to take actions that increase probability of failure

  • Asymmetric information and limit pricingThe preemption games are ways of resolving the Chain-store paradoxindicate that it is rational for incumbents to make investments that are not profitable unless they deter entryAn alternative approach: information structuresuppose that an entrant does not have perfect information about the incumbents costsif the incumbent is low cost do not enterif the incumbent is high-cost enterdoes 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

  • A (simple) exampleIncumbent has a monopoly in period 1Threat of entry in period 2Market closes at the end of period 2Entrant observes incumbents actions in period 1These actions determine whether or not to enter in period 2Incumbent is expected to be high-cost or low-costno direct information on costsentrant knows that there is a probability p that the incumbent is low-costNeed to specify pay-offs in different situations

  • The Example (cont.)Incumbent profits in period 1 (in $million)low-cost firm acting as low-cost monopolist: $100mhigh-cost firm acting as high-cost monopolist: $60mhigh-cost adopting low-cost monopoly price: $40mIncumbent profits in period 2if no entry, profits according to true typeif entry occurs:low-cost incumbent: $50mhigh-cost incumbent: $20mEntrants profits in period 2competing against a low-cost incumbent: -$20,competing against a high-cost incumbent: $20m

  • The Example (cont.)NatureHigh-CostLow-CostI1I2High PriceLow PriceE3E4EnterStay OutIncumbent: 60 + 20 = 80 Entrant: 20Incumbent: 60 + 60 = 120 Entrant: 0EnterStay OutIncumbent: 40 + 20 = 60 Entrant: 20Incumbent: 40 + 60 = 100 Entrant: 0Low PriceEnterStay OutE5Incumbent: 100 + 50 = 150 Entrant: -20Incumbent: 100 + 100 = 200 Entrant: 0

  • The example 2With no uncertaintythe entrant enters if theincumbent is high-cost With uncertainty anda low price the entrantdoes not know ifhe is at E4 or E5

  • The example 3Consider a high-cost incumbenthigh price in period 1 - entry happens, profits are 80low price in period 1 - if no entry profits are 100low price in period 1 - if entry profits are 60A high-cost incumbent has an incentive to pretend to be low-costThe entrant knows thisSo a low-price of itself will not deter entryit is not a true signal of the incumbents typeOnly the probability that low-price means low-cost deters entry

  • The example 4Consider the profits of the entrant given that the incumbent sets a low-price in period 1if the incumbent is high-cost - profit is 20 with probability 1 - pif the incumbent is low-cost - profit is -20 with probability pso expected profit is 20(1 - p) - 20p = 20 - 40pWill the entrant not enter when it sees a low price?Only if p > 1/2Only 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

  • Limit pricing and uncertaintyMonopoly power can persist even if the incumbent is high-costEntry only takes place if entrants believe that the incumbent is high-costso entry is more likely when incumbents are expected to be weakentry then consistent with exit: efficient entrants drive out inefficient incumbents

  • Limit pricing and uncertainty 2Note: 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 setThis lower limit price therefore mitigates the resource misallocation effects of monopoly.

  • Long-term contracts as entry barriersCan 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 interestPost Chicago School Answer: Yes. Incumbent can write a contract that makes it in the customers interest to keep out a lower cost alternate supplierEssence of the Post-Chicago argumentA new entrant will earn a lot of surplusThe 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

  • An exampleThe Setup: One seller (the incumbent), one buyer and one potential entrantand two periodsBuyer is willing to pay $100 for a commodityIncumbent has cost of $50Potential entrant with cost c randomly distributed between 0 and $100 Contract between buyer and seller written in first period but covers 2nd periodEntrant decides whether or not to enter in 2nd periodBertrand competition post-entry

  • The example 2Competition and entry without a Long-term Contract No entry: the incumbent sets a price of $100Entry will occur only if entrants cost is c < $50Competition 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 lowIn this scenario, the buyers expected price is:P = x $100 + x $50 = $75 Expected Surplus = $25Buyer must be offered this surplus in any other contract

  • The example 3Competition and entry with a long-term contractCan 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 feeEntrant must now charge no more than $25price plus breach of contract fee must be no more than $75 so entry occurs only if c < $25, i.e. of the time. Buyer: of the time, it stays with the contract and pays $75. of the time it breaks the contract, pays entrant $25 and pays incumbent $50 breach-of-contract fee for a total of $75. Buyers expected surplus is $25 with contract as it was without the contract.

  • The example 4Incumbents Incentive to Offer the contract:Without the contract, incumbent wins the 2nd period competition 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 of the time. It will sell at P = $75, incur a cost of $50 for an expected profit of 0.75 x $25 = $18.75Lose the 2nd period competition 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, incumbents expected profit with the contract is $31.25 > $25. The incumbent prefers the contract.

  • Contracts and efficiencyIncumbents profit is greater with the contract$31.25 as against $25Buyers expected surplus is the same with and without the contractSo the contract will be offered and signedBut it is inefficientnet gain to incumbent and buyer of $6.25this is less than the entrants reduction in surplusWhy?

  • Contracts and efficiency 2Without the contractentrant stays out half the time when it enters it prices at $50expected cost is $25 (uniformly distributed on [$0, $50]expected surplus is therefore (50 25)x1/2 = $12.50With the contractentrant stays out three quarters of the timewhen it enters it prices at $25expected cost is $12.50expected surplus is (25 12.5)x1/4 = $3.13

  • Contracts and efficiency 2Deterring entry through the contract increases incumbent and buyer surplus by $6.25reduces entrants surplus by $12.50-$3.13 = $9.37reduction in surplus is greater than gain in surplusWhy?some desirable entry is preventedentrant with cost between $25 and $50 is more efficient than incumbentbut is


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