TOPIC 13: PREDATORY AND OTHER PRICING STRATEGY

Topic 13| Part 2 7 November 2013Date

ANTITRUST ECONOMICS 2013David S. EvansUniversity of Chicago, Global Economics Group

Elisa MariscalCIDE, Global Economics Group

2Overview

Part 1

Price Discrimination and

Other Complex Pricing

Limit Pricing

Part 2

Predatory Pricing

Loyalty Rebates

3 Predatory Pricing

4Classic Predatory Pricing

Firm A faces competitor B. Assume both are charging price p.

Firm A and B have the same constant average and marginal cost MC.

Suppose Firm A sells at a price less than MC, and therefore increases sales but at a loss.

Firm B has two options: either match Firm A’s price and sell at a loss too or exit.

Firm A can drive B out if A is better able to withstand the losses (larger, better capitalized, etc.)

After Firm B is driven out, Firm A raises prices to monopoly level; if it can keep the price high enough it can recoup its losses during the “predation” period and make some profits too.

5But Does Classic Predation Make Sense?

Why can’t the prey play this game too? If the prey does, there’s no certainty that the predator will win the price war it has started.

It is very expensive: the dominant firm may be losing money on lots of sales.

It is very risky: maybe the entrant is more efficient or better capitalized (maybe the predator doesn’t know); maybe other firms come in.

The predator faces certain costs today with uncertain returns in the future.

There is a debate about how frequent real predatory pricing is. See McGee on Standard Oil and Yamey on fighting ships.

6Modern Predatory Pricing Based on Game Theory

Recent theories of predation are based on the idea that the “predator” may exploit imperfect information of the entrant (or its investors) to deter entry or force exit.

These theories are based on game-theoretic models and provide a more rigorous basis for predatory pricing allegations.

They generally assume information asymmetry (predator knows more than prey) or asymmetric access to capital markets (predator has more liquidity than prey).

Theory identifies specific circumstances and assumptions under which predatory pricing can occur and is a rational strategy.

7Developing a Reputation for Being Ruthless

If an incumbent faces a stream of potential entrants, a price war with early entrants creates a reputation for being “tough”.

By reducing price in one market a predator can induce the prey (or other companies) to believe that the predator will cut prices in other markets or in the predatory market itself at a later time.

As long as the signal is perceived as credible, this strategy may discourage entry from later entrants, and enable multi-market recoupement of predatory losses.

8Fooling the Entrant into Thinking it is Less Efficient

Strategies of predation based on signaling may be developed by firms that possess information that the potential entrant does not have.

The entrant does not know if the incumbent is weak (has a relatively high cost) or strong (low cost).

The entrant, however, observes the incumbent’s price before entering.

Therefore, the incumbent will have an incentive to reduce price, inducing the prey to believe that the predator has lower costs, when in fact the predator has no cost advantage.

A variant of this approach is demand signaling: the predator cuts price to induce the prey to believe that demand is much softer than it actually is.

9Using “Deep Pockets” to Predate

“Financial market predation” formalizes the “deep pocket” or “long purse” story and challenges the assumption that the prey can readily obtain capital under predatory conditions. A cash-rich firm can sustain a longer period of loss-making profits than a cash-constrained firm. The cash-rich firm will recoup losses by earning monopoly profits once the cash-constrained firm has left the market.

• Asymmetric information (lenders don’t have or have little knowledge of the industry) makes capital markets imperfect

• If capital markets are imperfect, a firm's assets (cash and retained earnings) determine its ability to raise external funds

• Therefore, predation causes the prey's profits to fall, reduces its assets and limits its ability to raise capital.

• The banks observe the decline, but cannot tell whether it is due to predation or to poor performance.

• Lending to the prey becomes more risky, and banks reduce or withdraw their financial support, obliging the prey to exit.

Intuition:

10

Distinguishing “Good” Low Prices From “Bad” Low Prices (Competitive vs. Predatory)

(1) What economic evidence—that the courts could obtain—would help distinguish low pricing that decreases consumer welfare from low pricing that increases consumer welfare?

(2) Given that the law does not require certainty in establishing guilt, what rule would help balance the cost of condemning “good” low prices with the cost of not condemning “bad” low prices?

Neither question has a clear-cut economic answer and this had led to a great deal of debate over the years.

11

There is NO Good Definition of Predation for Formulating a Rule

Ideally, we would like a definition such that if we had perfect information we would be confident that banning “predatory pricing”, so defined, would improve consumer welfare.

Definitions offered are imprecise because one can come up with plausible examples where banning predatory pricing under those definitions would not necessarily improve consumer welfare and vice versa.

12Price is Lower Than Average Total Cost (ATC)

Logic: firm would not operate in the long run at a price that did not cover its average costs.

• Situations where firms may set price less than average total cost to maximize profits in the short to medium term such as overinvestment in capital and sunk costs.

• Generally economics tells us that firms look to marginal cost for pricing and average total cost only for entry and exit decisions.

• There is related behavioral economics and accounting literature though which suggests that p=ATC may be used in practice by firms.

Problem:

13Price is Lower Than Marginal Cost (MC)

Logic: A firm would ordinarily not sell at price less than marginal cost because it would be losing money on each unit.

Problem: There are situations in which it is sensible to price below marginal cost.

• These include:• “Penetration pricing” where firms are trying to make a market for a product

by getting consumers to experience it and generate word of mouth;• “Network” markets in which low prices generate share; • “Two-sided” markets in which it is optimal permanently to give a product

away to one side (e.g. You don’t pay for your Facebook page even though it costs Facebook something to maintain it).

• Also, it is hard to measure marginal cost in practice.

14Legal Analysis: Cost-Based Tests of Predation

Existing Producer A

• Cost of Production = $5/unit.

Entrant B

• Cost of Production = $8/unit

Scenario 1 (PREDATORY):• A charges $4/unit (Price below marginal cost to A)• B must leave the market

Scenario 2 (LEGITIMATE)• A charges $7/unit (price above marginal cost to A)• B must still leave the market

15Profit-Sacrifice Test

Logic: The firm would not have charged the price unless it expects to earn increase profits from the exclusion of rivals.

Problems:• In winner-take-all markets, the winner necessarily benefits from the low prices

only as a result of winning the market for himself (this applies to many high-technology markets).

• Also many firms price low hoping to reduce sales of their rivals and increase their own sales. However, even if they raise prices later it is not clear that we want to discourage this behavior. Issue is what is overall impact on consumer welfare including entry decisions.

16Areeda-Turner Average Variable Cost Test

Areeda and Turner (two Harvard law professors) proposed using average variable cost because it is close to the right economic concept (marginal cost) but easier to measure in practice than marginal cost.

• Reliance on this test by the US courts wiped out many predatory pricing cases (See Brannon and Ginsburg, Comp. Pol’y Int’l).

Problems:

• Average variable cost still hard to measure• Same situations for pricing below MC apply• On the other hand could result in false negatives when MC>p>AVC

17Brooke Group Recoupment Test

Price is less than cost (not entirely specified) and there is a realistic probability that the predator will be able to “recoup” its lossesLogic: The recoupment prong provides a sanity check on the cost test; it wouldn't make sense for a company to incur costs on predation unless it has a prospect of raising prices and making the money back. Recoupment is also a proxy for consumer harm; if prices can’t be raised then even if the competitor has been forced out of the market, consumers are benefiting from low prices.Problems: difficult for plaintiffs to establish recoupment; some argue that this errs in permitting predatory pricing. After Brooke Group very few successful predatory pricing cases in the US.

18

Error Costs and the Role of Prior Beliefs for Predatory Pricing

Likelihood of predatory behavior—are predatory strategies credible? Are they likely to work?Accuracy of test—how accurately could we distinguish true predatory behavior from competitive behavior (if we rely on marginal cost, how accurately can we measure it in practice? how good are the authorities and judicial system in applying tests? etc.)Cost of mistakes—absolving predators results in costs of monopoly; convicting innocent eliminates low prices.

Long-run effects of rule—too lenient rule encourages predation; too strict a rule discourages competition.

19Error Costs and the Role of Prior Beliefs

Basic Assessment of error costs depends upon:

• Likelihood that firms will engage in predatory strategies.• Likelihood that the court can distinguish good from bad practices.

  Likelihood of bad pricing

Accuracy High Low

High Strict Moderate

Low Moderate No Rule

20 Conditional Rebates and Multiproduct Pricing

21

Anticompetitive Strategies Involving Rebates and Bundled Pricing

Firms can use “non-linear” pricing to predate against rivals and to seek to exclude rivals from the market.

“Non-linear” price refers to any situation in which the price is not the same across different units of sales.

A “conditional rebate” is a payment for achieving certain sales targets and is problematic when, in effect, the payment is for the exclusion of a rival to the detriment of consumers.A “bundled price” is a price for purchasing several goods together (see above) and is problematic when the effective price for a component is predatory and thereby forces a rival from the market.

22Conditional Rebates

“Conditional rebates are rebates granted to customers to reward them for a particular form of purchasing behavior. The usual nature of a conditional rebate is that the customer is given a rebate if its purchases over a defined reference period exceed a certain threshold, the rebate being granted either on all purchases (retroactive rebates) or only on those made in excess of those required to achieve the threshold (incremental rebates).”

• European Commission, Guidance on the Commission's Enforcement Priorities in Applying Article 82 EC Treaty to Abusive Exclusionary Conduct by Dominant Undertakings, 3 December 2008.

We will focus on retroactive conditional rebates since they are most

likely to have anticompetitive effects.

23Retroactive Rebates

Consider the following contract for a buyer pertaining to widgets produced by company D:

• You will pay $20 for our widgets.• If you buy 90% of your widgets from us we will give you a 20% discount on all

widgets.• The contract term is annual from 1 January – 31 December

The buyer needs to purchase 1000 widgets as an input into something else it is making.

24

Retroactive Rebates can Lead to a Range of Negative Incremental Prices

Purchases Cost DiscountEffective Price based on increments of 25

units700 $ 14,000 $ 0 $ 20725 $ 14,500 $ 0 $ 20750 $ 15,000 $ 0 $ 20775 $ 15,500 $ 0 $ 20800 $ 16,000 $ 0 $ 20825 $ 16,500 $ 0 $ 20850 $ 17,000 $ 0 $ 20875 $ 17,500 $ 0 $ 20900 $ 18,000 $ 3,596 -$ 124925 $ 18,500 $ 100 $ 16950 $ 19,000 $ 100 $ 16975 $ 19,500 $ 100 $ 16

1000 $ 20,000 $ 100 $ 16Normal price charged by dominant widget maker $ 20

Suppose an entrant wants to sell 100 widgets. The effective price paid to the incumbent for 901-1000 units is $20 x 100 - 0.2 x $20 x 1000= $2000- $4000 =- $2000.

25Retroactive Rebates and Cheap Exclusion

Suppose the entrant has a niche kind of widgets for which demand is around 100.

The dominant firm’s pricing scheme makes it uneconomic for the buyer to buy from the new widget maker.

One view is that the dominant widget maker has paid $2000 to keep the entrant out so that this is similar to costly predatory pricing.But suppose that the profit maximizing price for the buyer is $16 at which price it would ordinarily buy 900-1000 widgets. By structuring the contract this way the dominant firm essentially offers the buyer a price of $16 and effectively charges the firm $2000 for being disloyal (i.e. buying 100 units from someone else).

26Bad Cheap Exclusion or Good Low Prices?

The retroactive rebate could exclude an entrant that is trying to get “on the shelf” or get a foothold in the market or fringe firms have small shares of the market.

It makes most sense for pricing to a distributor who then sells several varieties of a product to end consumers.

The retroactive rebates could also be a way to offer volume discounts and to align the distributor’s interests with the sellers.

Which of these explanations is right?

27

Does the Conditional Rebate Exclude an Equally Efficient Rival?

Arguments against:

• There’s competition for exclusive contracts with buyers and other firms can and do compete.

• At any point in time a significant amount of the market is “up for grabs” through competition to win the exclusive or almost exclusive business of rivals.

• Other sellers could match $16 for more than 100 units (10%) and buyers are interested in that.

Arguments for:

• New entrants appeal to small group of end customers initially limiting demand to modest shares or dominant firm is a “must carry” product for a significant group of customers.

• Contracts are long term and rivals can’t compete often “for the contract”.• The conditional rebate prevents fringe firms from capturing any significant share

thereby preserving monopoly power.

28Multiproduct pricing

Multi-product firm (e.g. 3M or Procter & Gamble) offer discount based on the total volume a buyer purchases from them or offers a package price for a group of unrelated goods (shampoo and diapers). It is possible that the pricing could result in a “marginal price” for one of the elements of the bundle that an equally efficient firm could not beat.

This is like predatory pricing. The difficulty is figuring out how to measure the “marginal price” and the “marginal cost”.

This is a controversial topic but see EC Guidelines and U.S. Department of Justice Report.

29End of Part 2, Next Class Topic 14

Part 1

Vertical Restraints Overview

Single-Monopoly Profit Theorem and Its

Tying and Bundling