1. Limit Pricing and Entry Deterrence
ECON 4100: Industrial Organization
Lecture 12
Limit Pricing and Entry Deterrence

2. Introduction
A firm that has market power can restrict output by a large enough amount that the market price rises
Firms such as Microsoft (95% of PC operating systems) and Campbell’s (70% of the tinned soup market) stand virtually alone as the giants in their respective industries
Moreover, Microsoft, Campbell’s and other have maintained their dominant position for many years
Why can’t existing rivals compete away the position of such firms?
Why aren’t new rivals lured by the profits of such dominant corporations?

3. Introduction Answer: firms with monopoly power may
Why can’t existing rivals compete away the position of such firms?
Why aren’t new rivals lured by the profits of such dominant corporations?
Answer: firms with monopoly power may
eliminate existing rivals
prevent entry of new firms
Actions that eliminate existing or potential rivals is predatory conduct
Conduct is predatory if it is profitable only if rivals, in fact, exit (e.g., R&D to reduce costs is not predatory)
It seems to make no sense unless the advantages of keeping competitors out are considered

4. Monopoly Power and Market Entry
Several stylized facts about entry
entry is common
entry is generally small-scale (small-scale entry is relatively easy)
survival rate is low: over 60% of entrants exit within 5 years
entry is highly correlated with exit (just check the cases of clothing, furniture, retailing, etc)
not consistent with entry being caused by excess profits (it must be that what makes entry easy also makes exit easy!)
“revolving door”
reflects repeated attempts to penetrate markets dominated by large firms
Not always easy to prove that this reflects predatory conduct
But we need to understand predation it if we are to find it

5. Predation, Predatory Pricing, and Limit Pricing
Predatory actions come in two broad forms
Limit pricing: prices so low that entry is deterred
Predatory pricing: prices so low that existing firms are driven out
From an economic perspective, the outcome of either action is the same—the monopolist retains control of the market
But most legal action focuses on predatory pricing because this case has an identifiable victim—a firm that was in the market but that has left

6. Predation, Predatory Pricing, and Limit Pricing
Can we construct a model of either limit pricing or predatory pricing? YES!
Stackelberg leader chooses output first
entrant believes that the leader is committed to this output choice
entrant has decreasing costs over some initial level of output
(In this sense we could call the model one of limit output)

7. A Limit Pricing Model By committing to output Qd the incumbent deters
Then the entrant’s residual demand is
R1 = D(P) - Q1
By committing to output
Qd the incumbent deters
entry. Market price Pd
is the limit price
A Limit Pricing Model
These are the cost curves
for the potential entrant
$/unit
With the residual demand R1, the entrant can operate profitably. Entry is not deterred by the
incumbent choosing Q1.
At price Pe entry is
unprofitable R1
The entrant equates
marginal revenue
with marginal cost
MCe
The entrant’s residual
demand is
Rd = D(P) - Qd Pd
ACe
Assume instead that the incumbent commits to output Qd
Assume that the
incumbent commits
to output Q1
Then the entrant’s marginal revenue is MRd Pe
D(P) = Market Demand Rd
MRd
Quantity qe Qd Q1 Qd

8. Limit Pricing (cont.)
The strategy of committing to output QD may be aimed either at eliminating an existing rival or driving out a potential entrant.
Either way, several questions arise:
Is limit pricing more profitable than other strategies?
Is the output commitment credible?
If output is costly to adjust then commitment is possible
why should this property hold?
even if it holds, is monopoly at output Qd better than Cournot?

9. Predation and Merger
The legal case history is dominated by charges of predatory pricing—essentially, the strategy of setting the low price PD — in order to drive out competitors
This is because there is a visible victim who will complain
Think about Rockefeller and his tactics with Standard Oil

10. Predation and Merger
The legal case history is dominated by charges of predatory pricing—essentially, the strategy of setting the low price PD — in order to drive out competitors
McGee (1958) questioned the logic of such behavior
For predatory pricing to be rational two conditions are necessary
rise in post-predatory profits compensates for the price war
there is no alternative more profitable strategy that achieves the same objective
but merger is more profitable than predation
predation has low or negative profits during predation
merger does not
Basic point: predation must be part of a dominant strategy

11. Predation and Merger (cont.)
McGee’s main argument
Two-period game—If incumbent takes predatory action in Period 1=> incumbent becomes a monopoly in Period 2
Predation: incumbent earns low or zero profit in Period 1 and then monopoly profit in Period 2, while Rival earns zero or less in Period 1 and exits

12. Predation and Merger (cont.)
McGee’s main argument (cont.)
It is a better strategy to merge with the entrant and act as a monopolist from the start (you should start sleeping with your enemy from the start)
Buy out entrant for say half of the monopoly profit in Period 1
Newly merged firm is a monopolist in both Periods 1 and 2
Initial incumbent still gets all the monopoly profit in Period 2 but now gets half of that profit in Period 1
Both incumbent and entrant do better than under predation

13. Predation and Merger (cont.)
Problems with the McGee analysis
merger is a public event: may not be allowed if it monopolizes
predation may improve the terms of the merger (attack the other firm and weaken it: then negotiate a more favorable merger!)
merger may encourage additional entry of firms hoping to be bought
Still, McGee’s argument makes clear that logical argument about predation must be carefully constructed
In particular, while merger may not be a dominant strategy there is still the question as to how the incumbent credibly commits to produce QD

14. Next: Dynamic strategic interaction and credible commitment