ECON 330 Lecture 22 Wednesday, December 11

Today’s lecture Entry deterrence and predatory pricing … and a few words on research and development

A quick summary of Monday’s lecture We talked about “entry deterrence”. Strategies that incumbent firms (firms already in the market) use to try to stop new firms entering their profitable markets. Output expansion The incumbent chooses it output level so large that a profitable entry becomes impossible. This works only if Entry costs of the newcomer are sufficiently large The incumbent’s choice of output level prior to entry is irreversible.

Let’s try this one…

Stage 1: Firm T decides whether to open another shop Stage 1: Firm T decides whether to open another shop. Stage 2: Firm S decides whether to enter the local market by opening its first coffee-shop. The profits are: πT = nT(11 − 4nT − 2nS) πS = nS(7 − 4nS − 2nT) nT is the number of stores of firm T; nS is the number of stores of firm S.

FIRM T πT = nT(11 − 4nT − 2nS); FIRM S πS = nS(7 − 4nS − 2nT) PROFITS FIRM T πT = nT(11 − 4nT − 2nS); FIRM S πS = nS(7 − 4nS − 2nT) 1. If Firm S were not a potential entrant, would Firm T open a second coffee shop? ANSWER: NO. If nS = 0, then with 1 shop T’s profits are πT = 1x(11 − 4x1 − 2x0) = 7, with 2 shops profits are πT = 2x(11 − 4x2 − 2x0) = 6. 2. Will Firm S enter the market if Firm T doesn’t open another coffee shop? ANSWER: YES. If nT = 1, then with 1 shop S’s profits are πS = 1x(7 − 4x1 − 2x1) = 1. Entry brings positive profits to S. 3. Will Firm S enter the market if Firm T opens another coffee shop? ANSWER: NO. If nT = 2, then with 1 shop S’s profits are πS = 1x(7 − 4x1 − 2x2) = -1. Entry brings negative profits to S. 4. Will firm T deter entry by opening a second coffee shop in the neighborhood? ANSWER: YES. If nT = 2, then S will not enter (nS = 0), T’s profits will be πT = 2x(11 − 4x2 − 2x0) = 6; If nT = 1, then S enters (nS = 1), T’s profits will be πT = 1x(11 − 4x1 − 2x1) = 5!

End of the exercise…

Now a slightly different story Predatory pricing: Forcing the rivals to exit

Predation The incumbent can gain monopoly power by inducing the exit of its rivals. To achieve this goal the incumbent usually charges a very low price. This is called predatory pricing. This kind of behavior is called predation. Pricing below cost is illegal under competition laws in most countries.

Predation (Cont’d) If the incumbent is pricing below marginal cost, then it is clear that it is engaged in predation. But this is very difficult to prove in a court of law. The firm’s marginal cost is difficult to measure, even more difficult to transmit that information to the courts.

Predation (Cont’d) In reality, it is very difficult to distinguish … aggressive competitive behavior (a very low price-cost margin) from anti-competitive behavior (pricing below cost to induce the exit of rivals).

The Chicago school’s view on predatory pricing It doesn’t exist!

The Chicago school’s (George Stigler) view on predation A rational firm should never exit when preyed upon. Consequently, rational firms should never engage in predation.

The Chicago school, (Cont’d) True predatory pricing is rare because it is an irrational practice. Even worse, competition laws designed to prevent predatory pricing only inhibit competition. This view was taken by the US Supreme Court in the 1993 case Brooke Group v. Brown & Williamson Tobacco, … and the Federal Trade Commission has not successfully prosecuted any company for predatory pricing since.

Back to those two mysterious statements… A rational firm should never exit when preyed upon. Consequently, rational firms should never engage in predation.

What does that mean?

Consider a simple two-period model. In the first period, both the incumbent (I) and the entrant (E) are in the market. In the second period, the entrant may exit.

A simple model of predation: profits In a period in which E is in If I chooses predation (sets low prices), both I and E get π = –L (both firms make a loss!). If I does not choose predation, each of them get πD > 0. In a period in which E is not in I gets monopoly profits πM > πD.

Naïve thinking… I prices below cost in period 1, forces heavy losses on E. E thinks that predation will continue in period 2 if he stays, so E exits at the end of period 1.

Is it really so? Lets start with the second period. Suppose E stayed. What is I’s optimal action in period 2? Predation or no predation? Remember: there is no period 3! I’s profit in second period: πI = –L if predation, πI = πD if no predation I’s optimal action is “no predation”

So… if E is rational, then E should not expect that I will engage in predation in period 2. This line of reasoning assumes that I is also rational! Then E will not exit at the end of period 1, no matter what I has done in period 1. E thinks in a rational way about the rational I’s future (Period 2) actions. Anticipating that E will stay in the second period, I has no incentive to do predation in the first period.

This is Chicago School’s view then: Credible predation doesn’t exist!

Now… Attempts to bring back the theory of predatory pricing back to life!

The Long-purse theory What if E doesn’t have enough cash to sustain the first period loss of L? Perhaps it can borrow money from a bank? Possible if πD > L. and if… Firms and banks are rational. Information is perfect.

Long-purse theory (Cont’d) Suppose E does not have enough cash to sustain losses in the first period, so it has to borrow money from banks to survive in the first period. But now, let’s assume that … due to asymmetric information, banks may not lend money. Suppose that banks will refuse a loan with probability x > 0.

x = the probability that E will be refused a loan to finance period 1 losses and must exit if it makes a loss in period 1 After predatory pricing by I in the first period, E will stay in the second period only with probability 1 ‒ x. I’s expected payoff to predation is: ‒L + (1‒x)πD + xπM. I’s expected profit to no predation is: 2πD.

x = the probability that E will be refused a loan Predation is optimal if ‒L + (1‒x)πD + xπM > 2πD. ‒L + πD ‒ xπD + xπM > 2πD. ‒L ‒ xπD + xπM > πD. Rewrite this condition and solve for x: Interpretation: If πD is very small, and I’s losses are not too large, then predation is more likely.

Long-purse theory (last words) The key assumption is that that one firm (Entrant) is financially constrained while the other (Incumbent) is not. It is also called deep-pocket theory.

End of the lecture