1. HKKK TMP 38E050 © Markku Stenborg 2005 1 5.1 Predation Predation = firm drives rival out of market by making it incur enough losses and then raises prises –Why would prey exit? –Why would prey stay out after price increased? –Can predator really recoup losses suffered during price war? Does predation make sense? –If predation is possible and profitable, how can we separate innocent aggressive competition from predation as restriction on competition? Most cases apply Areeda-Turner test: P < LRMC, P < LRAVC, or P < LRATC + some other indications  predation –Costs are hard to define and measure –Predation rare in case law. But is it really that rare?

2. HKKK TMP 38E050 © Markku Stenborg 2005 2 5.4 Predation Financial market imperfections Old ”deep pocket” theory: richly endowed predator would charge low prices to drive out poorly endowed rival –Ignores possibility that profit-seeking investors would finance prey Relation between prey and its investors –Predator seeks to manipulate that relationship and drive prey out of market or deter expansion into new markets –Pedatory strategy viable because of capital market imperfections –Investors face agency or moral hazard problems –Managers may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests –Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, imposing threat of termination in case of poor performance

3. HKKK TMP 38E050 © Markku Stenborg 2005 3 5.4 Predation Debt-holders can threaten to liquidate firm or deny new credit VCs can refuse to extend additional financing when early performance is poor Shareholders can decline to purchase additional equity if expected returns are low due to disappointing initial performance –Predatory pricing in product markets becomes possible when predator exploits termination threats to dry up financing of rival firm Agency problems are particularly acute in financing of new enterprises –Uncertainty about cash flow in early stages –Losses may be unavoidable start-up costs or due to agency abuse –Mitigate moral hazard by agreeing to extend financing only when firms’ initial performance is adequate

4. HKKK TMP 38E050 © Markku Stenborg 2005 4 5.4 Predation Predator may slash price to drain prey of sufficient funds to meet its loan commitments, forcing default Predator can lower prey’s earnings to impair prey’s debt capacity by limiting collateral it can put up Lower earnings may cause lenders to wrongly believe that firms’ profits are likely to be lower or riskier in future and therefore to stiffen their lending terms Contract that minimizes agency problems will maximize incentive to prey Reputation Predator lowers prices to mislead prey and potential entrants into believing that market conditions are unfavorable –Decision to enter or exit is based on evaluation of expected future revenues and costs –Most firms contemplating entry or exit do not have all information to determine future revenues and costs

5. HKKK TMP 38E050 © Markku Stenborg 2005 5 5.4 Predation –If incumbent firm is better informed than others about cost or other market conditions, it may be able to influence the expectations –Incumbent firm can manipulate and distort market signals about profitability, and influence the expectations through pricing decisions or other actions Predator seeks to establish reputation as price cutter, based on some perceived special advantage or characteristic –Reputation effects may be present when predator sells in two or more markets or in successive time periods within same market –One market or period serves as demonstration market with predatory conduct, and the other market or time period provides recoupment market, where predator reaps benefits –Reputation-induced belief reduces future entrant’s expected return and may deter entry

6. HKKK TMP 38E050 © Markku Stenborg 2005 6 5.4 Predation Signaling Better informed predator reduces price to convince prey that market conditions are unfavorable –Aggregate demand is too low to justify presence of both firms in market or expansion by prey –Prey inferring weak demand from low price may be deterred from expanding or induced to leave market –Less plausible than previous predatory strategies Test market and signal jamming theories plausible Victim lacks knowledge and experience in market Introduce new product or brand to probe market response by entering a limited “test market” Predator may attempt to frustrate this market test by either of two predatory strategies

7. HKKK TMP 38E050 © Markku Stenborg 2005 7 5.4 Predation Test market predation –Predator secretly cuts price to reduce entrant’s sales in test market –Induce entrant to believe that demand is low –Entrant abandons entry or enters on smaller scale Signal jamming –Predator openly cuts price to distort test market results –Entrant can observe demand for its product only under exceptional circumstance of an ongoing price war –Market test is foiled, and entrant is unable to determine whether market demand for its product is sufficient to support entry Cost signaling –Predator drastically reduces price to mislead prey to believe that she has lower costs –Predator trying to establish a reputation for low cost cuts price below the short run profit-maximizing level

8. HKKK TMP 38E050 © Markku Stenborg 2005 8 5.4 Predation –Observing predator’s low price, prey rationally believes there is at least probability that predator has lower costs –Lowers prey's expected return and causes prey to exit –Limiting factor in applying cost signaling theory is possible inconsistency between low price, predatory bluffing and subsequent recoupment –Attempt to raise price risks revealing signaling to prey and other potential entrants, causing them to upgrade estimates of market profitability Policy Proof of scheme of predation only establishess that identified strategy is plausible Need to show –Below cost pricing: avoidable or incremental cost, not AVC –Recoupment –Business justification?

9. HKKK TMP 38E050 © Markku Stenborg 2005 9 5.4 Predation Financial market predation –Prey depends on external financing –Financing depends on its initial performance –Predation reduces initial performance and threatens preys financing and viability –Predator can finance predation internally or has better access to external finance as prey Reputation –Multimarket predator faces localized competition –Predator faces threat of sequential entry –Reputation reinforces predatory strategy or increases probalility of future price cuts –Entrant observes previous exit or other adverse experiences

10. HKKK TMP 38E050 © Markku Stenborg 2005 10 5.4 Predation Test market predation –Predator observes prey’s attempt to experiment on limited basis –Predator cuts price below following or anticipating entry –Price cut prevents prey from learning true demand conditions Cost signaling –Predator might have lower or reduced costs –Predator reduces price –Prey believes that predator has lower costs –Possible cost reduction is sufficient to exit, deter entry or limit expansion