1. Predatory Conduct: Recent Developments
Chapter 13: Predatory Conduct: recent developments

2. Chapter 13: Predatory Conduct: recent developments
Introduction
Charges of predatory conduct are not new
Microsoft is only one of the latest
goes back to the days of Standard Oil
more recent examples of predatory pricing
Wal-Mart
AT&T
American Airlines
But they face problems of credibility
price low to eliminate rivals
then raise price
so why don’t rivals reappear?
Chapter 13: Predatory Conduct: recent developments

3. Predatory pricing: myth or reality?
Theoretical and empirical doubts
predation is generally not subgame perfect without uncertainty regarding the incumbent
return to this below
McGee’s argument that predation is dominated by another strategy
merger is more profitable than predation
so predation should not happen
take an example
two period market
inverse demand P = A – B(qL + qF)
qF is output of leader and qF is output of follower
leader is a Stackelberg quantity leader
both leader and follower have constant marginal costs of c
Chapter 13: Predatory Conduct: recent developments

4. An example of predation
At the Stackelberg equilibrium
leader makes (A – c)2/8B
follower makes (A – c)2/16B
if the leader were a monopolist it would make (A – c)2/4B
Suppose that the leader predates in period 1
sets output (A – c)/B to drive price to marginal cost
follower does not enter
leader reverts to monopoly output in period 2 but the follower does not enter
aggregate profit is (A – c)2/4B
Chapter 13: Predatory Conduct: recent developments

5. An example of predation 2
Suppose instead that the leader offers to merge with the follower in period 1
monopoly in both periods
aggregate profit (A – c)2/2B
so the leader can make a merger offer that the follower will accept
Merger is more profitable than predation but:
merger may not be allowed by the authorities
monopoly power
what if there are additional potential entrants?
may enter purely in the hope of being bought out
Main point remains: threat of predation has to be credible if it is to work
Chapter 13: Predatory Conduct: recent developments

6. Predation and imperfect information
Suppose that the entrant faces financial constraints
must borrow to finance entry
Entrant also faces uncertainty pre-entry
faces some probability of “low” returns
private information that can be concealed from bank
incentive to misrepresent
bank must then enforce removal of funding if low returns are reported
Incumbent then has incentive to take actions that increase probability of failure
Chapter 13: Predatory Conduct: recent developments

7. Asymmetric information and limit pricing
The preemption “games” are ways of resolving the Chain-store paradox
indicate that it is rational for incumbents to make investments that are not profitable unless they deter entry
An alternative approach: information structure
suppose that an entrant does not have perfect information about the incumbent’s costs
if the incumbent is low cost do not enter
if the incumbent is high-cost enter
does 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
Chapter 13: Predatory Conduct: recent developments

8. Chapter 13: Predatory Conduct: recent developments
A (simple) example
Incumbent has a monopoly in period 1
Threat of entry in period 2
Market closes at the end of period 2
Entrant observes incumbent’s actions in period 1
These actions determine whether or not to enter in period 2
Incumbent is expected to be high-cost or low-cost
no direct information on costs
entrant knows that there is a probability p that the incumbent is low-cost
Need to specify pay-offs in different situations
Chapter 13: Predatory Conduct: recent developments

9. Chapter 13: Predatory Conduct: recent developments
The Example 2
Incumbent profits in period 1 (in $million)
low-cost firm acting as low-cost monopolist: $100m
high-cost firm acting as high-cost monopolist: $60m
high-cost adopting low-cost monopoly price: $40m
Incumbent profits in period 2
if no entry, profits according to true type
if entry occurs:
low-cost incumbent: $50m
high-cost incumbent: $20m
Entrant’s profits in period 2
competing against a low-cost incumbent: -$20,
competing against a high-cost incumbent: $20m
Chapter 13: Predatory Conduct: recent developments

10. Chapter 13: Predatory Conduct: recent developments
The Example 3
Incumbent: = 80 Entrant: 20
Enter
High Price
Incumbent: = 120 Entrant: 0 E3
Stay Out
High-Cost
Incumbent: = 60 Entrant: 20 I1
Enter
Low Price
Nature E4
Incumbent: = 100 Entrant: 0
Stay Out
Low-Cost I2
Enter
Incumbent: = 150 Entrant: -20
Low Price E5
Incumbent: = 200 Entrant: 0
Stay Out
Chapter 13: Predatory Conduct: recent developments

11. the entrant enters if the incumbent is high-cost
With uncertainty and
a low price the entrant
does not know if
he is at E4 or E5
With no uncertainty
the entrant enters if the
incumbent is high-cost
The example 4
Nature
High-Cost
Low-Cost I1 I2
High Price
Low Price E3 E4
Enter
Stay Out
Incumbent: = 80 Entrant: 20
Incumbent: = 120 Entrant: 0
Incumbent: = 60 Entrant: 20
Incumbent: = 100 Entrant: 0 E5
Incumbent: = 150 Entrant: -20
Incumbent: = 200 Entrant: 0
Chapter 13: Predatory Conduct: recent developments

12. Chapter 13: Predatory Conduct: recent developments
The example 3
Consider a high-cost incumbent
high price in period 1 - entry happens, profits are 80
low price in period 1 - if no entry profits are 100
low price in period 1 - if entry profits are 60
A high-cost incumbent has an incentive to pretend to be low-cost
The entrant knows this
So a low-price of itself will not deter entry
it is not a true signal of the incumbent’s type
Only the probability that low-price means low-cost deters entry
Chapter 13: Predatory Conduct: recent developments

13. Chapter 13: Predatory Conduct: recent developments
The example 4
Consider the profits of the entrant given that the incumbent sets a low-price in period 1
if the incumbent is high-cost - profit is 20 with probability 1 - p
if the incumbent is low-cost - profit is -20 with probability p
so expected profit is 20(1 - p) - 20p = p
Will the entrant not enter when it sees a low price?
Only if p > 1/2
Only 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
Chapter 13: Predatory Conduct: recent developments

14. Limit pricing and uncertainty
Monopoly power can persist even if the incumbent is high-cost
Entry only takes place if entrants believe that the incumbent is high-cost
so entry is more likely when incumbents are expected to be weak
entry then consistent with exit: efficient entrants drive out inefficient incumbents
Chapter 13: Predatory Conduct: recent developments

15. Limit pricing and uncertainty 2
Note: 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 set
This lower limit price therefore mitigates the resource misallocation effects of monopoly.
Chapter 13: Predatory Conduct: recent developments

16. Long-term contracts as entry barriers
Can 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 interest
Post Chicago School Answer: Yes. Incumbent can write a contract that makes it in the customer’s interest to keep out a lower cost alternate supplier
Essence of the Post-Chicago argument
A new entrant will earn a lot of surplus
The 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
Chapter 13: Predatory Conduct: recent developments

17. Chapter 13: Predatory Conduct: recent developments
An example
The Setup: One seller (the incumbent), one buyer and one potential entrant—and two periods
Buyer is willing to pay $100 for a commodity
Incumbent has cost of $50
Potential entrant with cost c randomly distributed between 0 and $100
Contract between buyer and seller written in first period but covers 2nd period
Entrant decides whether or not to enter in 2nd period
Bertrand competition post-entry
Chapter 13: Predatory Conduct: recent developments

18. Chapter 13: Predatory Conduct: recent developments
The example 2
Competition and entry without a Long-term Contract
No entry: the incumbent sets a price of $100
Entry will occur only if entrant’s cost is c < $50
Competition 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 low
In this scenario, the buyer’s expected price is:
P = ½ x $100 + ½ x $50 = $75  Expected Surplus = $25
Buyer must be offered this surplus in any other contract
Chapter 13: Predatory Conduct: recent developments

19. Chapter 13: Predatory Conduct: recent developments
The example 3
Competition and entry with a long-term contract
Can 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 fee
Entrant must now charge no more than $25
price plus breach of contract fee must be no more than $75
so entry occurs only if c < $25, i.e. ¼ of the time.
Buyer:
¾ of the time, it stays with the contract and pays $75.
¼ of the time it breaks the contract, pays entrant $25 and pays incumbent $50 breach-of-contract fee for a total of $75.
Buyer’s expected surplus is $25 with contract as it was without the contract.
Chapter 13: Predatory Conduct: recent developments

20. Chapter 13: Predatory Conduct: recent developments
The example 4
Incumbent’s Incentive to Offer the contract:
Without the contract, incumbent wins the 2nd period competition ½ 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 ¾ of the time. It will sell at P = $75, incur a cost of $50 for an expected profit of 0.75 x $25 = $18.75
Lose the 2nd period competition ¼ 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, incumbent’s expected profit with the contract is $31.25 > $25. The incumbent prefers the contract.
Chapter 13: Predatory Conduct: recent developments

21. Contracts and efficiency
Incumbent’s profit is greater with the contract
$31.25 as against $25
Buyer’s expected surplus is the same with and without the contract
So the contract will be offered and signed
But it is inefficient
net gain to incumbent and buyer of $6.25
this is less than the entrant’s reduction in surplus
Why?
Chapter 13: Predatory Conduct: recent developments

22. Contracts and efficiency 2
Without the contract
entrant stays out half the time
when it enters it prices at $50
expected cost is $25 (uniformly distributed on [$0, $50]
expected surplus is therefore (50 – 25)x1/2 = $12.50
With the contract
entrant stays out three quarters of the time
when it enters it prices at $25
expected cost is $12.50
expected surplus is (25 – 12.5)x1/4 = $3.13
Chapter 13: Predatory Conduct: recent developments

23. Empirical Application: Entry Deterrence In The Pharmaceutical Industry
It is difficult to test in a statistical sense for systematic entry deterrence. We need to identify markets:
where entry was likely; and
where the incumbent could do something to limit entry
where deterrent actions can be identified
Incumbent may not take any action if entry is not likely or if there is little it can do to stop entry.
Incumbent may take action if entry is fairly likely in an effort to limit the number coming in
Efforts by incumbent to build brand loyalty may seem like entry deterrence but it may instead result in incumbent not needing to price aggressively when rival enters, which makes entry easier
Chapter 13: Predatory Conduct: recent developments

24. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 2
Ellison and Ellison (2006) try to overcome these issues in a recent study of the pharmaceutical industry
They look at the advertising behavior of companies in the case of 64 drugs about to lose their patents
Their first step is to identify those markets where entry following patent expiration was likely
Chapter 13: Predatory Conduct: recent developments

25. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 3
For this purpose, they estimate the equation:
Entryi =constant + β1Revi + β2Hospi + β3Chronici + εi
Entryi is a 1,0 dummy variable equal to 1 if there was entry within three years after patent expiration in market i
Revi is the average revenue earned by the incumbent in market i for the three years before expiration
Hospi is the fraction of drug revenues paid by hospitals
Chronic is 1 if the drug treats a chronic/acute condition and 0 otherwise
Because they estimate a Probit equation, the results give the probability of entry as a function of market features
They identify three market types where the probability of entry is: 1) low; 2) medium; and 3) high
Chapter 13: Predatory Conduct: recent developments

26. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 4
What is predatory or entry-deterring behavior here? Ellison and Ellison focus on advertising.
They note that when one firm advertises a prescription drug, the benefits of that advertising spill over to rivals
The decision-makers with respect to pharmaceuticals are doctors. They will have a keen sense of the chemical identity of generic competitors.
If an advertisement trumpets the ability of a a particular hydrochloride to alleviate depression, doctors understand that near identical hydrochlorides will have the same effect
In this environment, an incumbent wishing to deter entry may advertise LESS
Chapter 13: Predatory Conduct: recent developments

27. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 5
Ellison & Ellison (2006) estimate the following equation:
Advertisingit Advertisingi
– 1 = [1Low + 2Medium + 3High]Time + i
The dependent variable measures advertising for each firm i in each of the 12 months just prior to the patent expiration relative to the average level of advertising in each of the 24 months before that
The dependent variable measures advertising for each firm i in each of the 12 months just prior to the patent expiration relative to the average level of advertising in each of the 24 months before that
Chapter 13: Predatory Conduct: recent developments

28. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 6
On the right-hand-side, the coefficient on the time to patent expiration variable depends on what probability of entry category for that market
Ellison and Ellison argue any entry-deterring efforts will only occur in the middle group
No need to deter entry when probability is Low
Impossible to deter entry when probability is High
So, given our understanding of entry deterrence, advertising should be low in Medium probality markets
That is, 2 should be negative
Chapter 13: Predatory Conduct: recent developments

29. Chapter 13: Predatory Conduct: recent developments
Empirical Application: Entry Deterrence In The Pharmaceutical Industry 7
Ellison & Ellison (2006) estimates are shown below
Advertising Intensity Time Trend By Category of Entry Probability, 64 Pharmaceutical Markets
Coefficient
Estimated
Value
Standard
Error 1
-0.007
0.013 2
-0.032
0.009 3
0.007
2 is significantly negative. Firms facing a medium probability of entry after patent expiration do reduce their advertising in the months prior to that date
Some mild support for entry deterring behavior
Chapter 13: Predatory Conduct: recent developments