Collusion and f0reclosure (predatory pricing)

Notions of collusion Legal notion of collusion: explicit coordination of firms’ market strategies achieved through some form of direct or indirect communication Economic notion of collusion: modification of of the market equilibrium benefitting firms and harming buyers

Economic theory of collusion In order to collude firms must be able to solve two problems: A coordination problem An enforcement problem

Coordination problem Define an acceptable way to share the benefit of collusion Find a practical method to achieve the agreed repartition of benefits Examples: fix a selling price; set the maximum output; allocate clients or areas to share the market (these are called the “terms of coordination”)

Enforcement problem Each firm has a (short run) incentive to deviate (cheat) from the terms of coordination Deviations (cheating) may be discouraged by a mechanism that allow firms to Monitor the other firms’ market conduct, and Punish deviators Collusion is feasible if the threat of punishment is Credible Timely Sufficiently harsh

Prisoner’s dilemma 5,5 1,10 10,1 2,2 2 Players: A e B 2 strategies for each player (Collude or cheat) Pay-offs as in the matrix Prisoner’s dilemma B Collude Cheat A Coll. 5,5 1,10 10,1 2,2

Static equilibrium One Nash equilibrium in dominant strategies : (Cheat, Cheat) This equilibrium is inefficient from the players’ point of view They can be better off if they cooperate (collude) Prisoner’s dilemma B Collude Cheat A Coll. 5,5 1,10 10,1 2,2

Infinitely repeated PD Trigger strategy : Collude in the first period If the outcome of the previous period is (Collude, Collude) then play ‘Collude’ Otherwise play ‘Cheat’ forever This strategy includes: A promise: ‘if you cooperate (collude), I will cooperate’ A threat: ‘if you cheat, I will cheat too and… forever’ Are this promise and this threat credible?

Trigger strategy equilibrium/1 The threat is credible: (Cheat, Cheat) is a static equilibrium In each period if the other player cheats the best response is ‘Cheat’ The promise is credible if each player is sufficiently ‘patient’

Trigger strategy equilibrium/2 Suppose that a firm is in the first period or in any period such that the outcome of the previous period was (Collude, Collude) The other player plays according to the trigger strategy (TS) and the firm has to decide whether to follow the TS or deviate If the firm follows the TS it plays ‘Collude’, otherwise it plays ‘Cheat’ If it follows the TS it obtains: 5 + δ*5 + δ2*5 + δ3*5 + … If it deviates it obtains: 10 + δ*2 + δ2*2 + δ3*2 +

Trigger strategy equilibrium/3 Meaning of δ: Discount factor: present value of a future payment Probability that the game continues The firm (rationally) follows the TS if: 10 + δ*2 + δ2*2 + δ3*2 + …≤ 5 + δ*5 + δ2*5 + δ3*5 + … That is if: 10 – 5 = 5 (short run gain from deviation) lower than… (δ*5 + δ2*5 + δ3*5 + …) – (δ*2 + δ2*2 + δ3*2 + …) = 3*(δ/(1- δ)) (the sacrifice of future profits caused by the end of cooperation ) δ ≥ 5/8

General condition Let 𝜋 𝐶 = collusive profit 𝜋 𝐷 = deviation profit 𝜋 𝑃 = profit in the punishment phase The incentive compatibility constraint (ICC) becomes 𝑡=0 ∞ 𝛿 𝑡 𝜋 𝐶 ≥ 𝜋 𝐷 + 𝑡=1 ∞ 𝛿 𝑡 𝜋 𝑃 Which yields: 𝛿≥ 𝜋 𝐷 − 𝜋 𝐶 𝜋 𝐷 − 𝜋 𝑃 ≡ 𝛿 ∗

Collusive equilibrium The enforcement problem can be solved if: The short-run gains from deviation are low The (expected) loss caused by a deviation is high Any factor that lowers the gain from deviation and/or increases the gain from collusion makes collusion more stable

Market characteristics that affect the likelihood of collusion Number of firms and degree of concentration Collusion is more likely if there are few firms and the market is concentrated Symmetry (in terms of market shares, costs, technology …) makes coordination easier and mitigates the incentive compatibility constraint Barriers to entry Collusion is sustainable only if there are barriers that prevent the entry of new competitors Multimarket contacts Collusion is easier if it takes place between firms that compete simultaneously in a number of markets, provided that: firms have asymmetric positions in these markets and the level of symmetry increases if these markets are taken as an aggregate

Factors that facilitate collusion Market transparency (prices, volume sales) (improves monitoring) Frequency of the transactions (makes punishment more timely) A stable or expanding market (makes punishment more harsh)

Facilitating practices Direct communication among firms Information exchange Cross-shareholding Best pricing policy

Predatory pricing Exclusionary practices: deter entry or forcing exit of a rival Possible violation of Art. 102 TFEU Difficult to identify – not easily distinguished from competitive actions that benefit consumers EX. Price reductions by an incumbent following entry (to be followed by price increase after exclusion)

Deep Pocket Theory The main explanation of predation has been “Deep Pocket” predation: A dominant firm may drive out a small firm with a price-war causing losses to both but the small one has not the financial resources to resist a price-war (a “small pocket”)

McGee (1958) criticisms Due to its larger market share a large firm will suffer greater losses than a small one Predation is rational only if the predator raises prices, after the prey exits from the market but the small firm can re- enter after the price increase or sell the assets to another firm becoming a new rival If the small firm could obtain funding from banks, predation cannot be successful and anticipating the result the incumbent will avoid it Predation is inefficient as it destroys profits, better to merge with the rival to preserve high profits

Counterarguments The incumbent can price-discriminate and decrease price only in those markets where the small firm is competing, the predator can preserve high margin on most units and reduce the cost of predation Enter-Exit-Re-entering can imply sunk costs Capital markets are imperfect, predation affects the risk of lending money reducing financial resources available Merger is not an alternative: a)New competitors will be attracted by the perspective of being bought; b)Antitrust laws may not allow the merger; c) Predation and mergers are not mutually exclusive options

The sacrifice test The dominant firm is deliberately incurring losses or foregoing profits in the short term (referred to hereafter as ‘sacrifice’), so as to foreclose one or more of its actual or potential competitors with a view to strengthening or maintaining its market power

Price/cost test Price above ATC (or LRIC) lawful Price below AVC (or AAC) unlawful Price between AVC and ATC (or between AAC or LRIC) lawful unless there is convincing evidence of an exclusionary intent

Efficiency justifications for below-cost pricing A firm may price below cost to: compensate for switching costs, reach a critical mass of consumers if network externalities exist achieve economies of scale or move along the learning curves sell complementarity products Remember: a decision to lower the price can improve allocative efficiency