1. Collusion and f0reclosure (predatory pricing)

2. 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

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

4. 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”)

5. 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

6. 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

7. 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

8. 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?

9. 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’

10. 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 +

11. 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

12. 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 ∗

13. 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

14. 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

15. 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)

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

17. 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)

18. 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”)

19. 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

20. 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

21. 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

22. 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

23. 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