1. Chapter 9: Entry Deterrence and Predation 1 Entry Deterrence and Predation

2. Chapter 9: Entry Deterrence and Predation 2 Introduction A firm that can restrict output to raise market price has market power Microsoft (95% of operating systems) and Campbell’s (70% of tinned soup market) are giants in their industries 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? Answer: firms with monopoly power may –eliminate existing rivals –prevent entry of new firms These actions are predatory conduct if they are profitable only if rivals, in fact, exit –e.g., R&D to reduce costs is not predatory

3. Chapter 9: Entry Deterrence and Predation 3 Evolution of market structure Evolution of markets depends on many factors –one is relationship between firm size and growth Gibrat’s Law –begin with equal sized firms –each grows in each period by a rate drawn from a random distribution –this distribution has constant mean and variance over time –result is that firm size distribution approaches a log-normal distribution Very mechanistic –no strategy for growth Including strategic decision making affects distribution but not conclusion that firm sizes are unequal –What about the facts in the market place?

4. Chapter 9: Entry Deterrence and Predation 4 Monopoly power and market entry Several stylized facts about entry –entry is common –entry is generally small-scale so small-scale entry is relatively easy –survival rate is low: >60% exit within 5 years –entry is highly correlated with exit not consistent with entry being caused by excess profits “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. Chapter 9: Entry Deterrence and Predation 5 Predatory conduct 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 Outcome of either action is the same—the monopolist retains control of the market Legal action focuses on predatory pricing because this case has an identifiable victim –a firm that was in the market but that has left Consider first a model of limit pricing –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

6. Chapter 9: Entry Deterrence and Predation 6 A limit pricing model AC e MC e $/unit Quantity These are the cost curves for the potential entrant These are the cost curves for the potential entrant D(P) = Market Demand Assume that the incumbent commits to output Q 1 Assume that the incumbent commits to output Q 1 Q1Q1 Then the entrant’s residual demand is R 1 = D(P) - Q 1 Then the entrant’s residual demand is R 1 = D(P) - Q 1 R1R1 With the residual demand R 1, the entrant can operate profitably. Entry is not deterred by the incumbent choosing Q 1. With the residual demand R 1, the entrant can operate profitably. Entry is not deterred by the incumbent choosing Q 1. Assume instead that the incumbent commits to output Q d The entrant’s residual demand is R e = D(P) - Q d The entrant’s residual demand is R e = D(P) - Q d QdQd ReRe MR e qeqe PePe Then the entrant’s marginal revenue is MR e The entrant equates marginal revenue with marginal cost The entrant equates marginal revenue with marginal cost At price P e entry is unprofitable At price P e entry is unprofitable QdQd PdPd By committing to output Q d the incumbent deters entry. Market price P d is the limit price

7. Chapter 9: Entry Deterrence and Predation 7 Limit pricing Committing to output Q d 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? –could be claimed to be ad hoc to support the theory even if it holds, is monopoly at output Q d better than Cournot? –may not be if the entrant’s costs are low enough Credibility may relate output to capacity

8. Chapter 9: Entry Deterrence and Predation 8 Capacity expansion and entry deterrence For predation to be successful and rational –the incumbent must convince the entrant that the market after the entrant comes in will not be profitable one How can the incumbent credibly make this threat? One possible mechanism –install capacity in advance of production installed capacity is a commitment to a minimum level of output the lead firm can manipulate entrants through capacity choice the lead firm may be able to deter entry through its capacity choice –but is this credible? –capacity must be costly to install and should be irreversible

9. Chapter 9: Entry Deterrence and Predation 9 The Dixit model Consider a two-stage game –incumbent in period 1 installs capacity capacity K 1 costs r.K 1 to install in second period incumbent can produce up to K 1 at unit cost w capacity can be expanded in period 2 at additional cost r per unit capacity cannot be reduced in period 2 –potential entrant in period 2 observes incumbent’s capacity choice to enter and produce incumbent needs capacity K 2 which costs r.K 2 unit cost of production is w note: entrant will never install unused capacity –if entry takes place firms play a Cournot game in the second period Market demand: P = A – B(q 1 + q 2 )

10. Chapter 9: Entry Deterrence and Predation 10 The Dixit model 2 Costs for the incumbent are: –C 1 = F 1 + w.q 1 + r.K 1 for q 1 < K 1 ; marginal cost w –C 1 = F 1 + (w + r)q 1 for q 1 > K 1 ; marginal cost w + r Costs for the entrant are: –C 2 = F 2 + (w + r)q 2 ; marginal cost w + r Standard Cournot analysis gives the best response functions: –q* 1 = (A – w)/2B – q 2 /2 when q 1 < K 1 –q* 1 = (A – w – r)/2B – q 2 /2 when q 1 > K 1 –q* 2 = (A – w – r)/2B – q 1 /2provided that q* 2 > 0 for the entrant to enter it must expect to cover the sunk costs F 2 this implies a lower limit on the output that the entrant must make

11. Chapter 9: Entry Deterrence and Predation 11 The Dixit model 3 The incumbent’s best response function has a break in it at K 1 q2q2 q1q1 L’ L N’ N K1K1 The entrant’s best response function has a break where sunk costs are not covered R’ R Equilibrium depends upon these two breaks

12. Chapter 9: Entry Deterrence and Predation 12 The Dixit model 4 Consider the possibilities q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 Suppose that firm 2 enters Equilibrium must lie between T and V Where depends upon location of the break in R’R Firm 1’s output is greater than T 1 and smaller than V 1 So capacity choice lies between T 1 and V 1

13. Chapter 9: Entry Deterrence and Predation 13 The Dixit model 5 Now suppose that firm 2 does not enter q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 Must be that it cannot break even at output less than T 2 Then firm 1 would want to choose capacity M 1 –this is the monopoly output with MC = w + r M1M1 M2M2 S M 1 is actually the Stackelberg output level for firm 1 –firm 1 as market leader will never choose output and capacity less than M 1

14. Chapter 9: Entry Deterrence and Predation 14 The Dixit model 6 Suppose that the break in the entrant’s best response function lies at B L in R’T q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 M1M1 M2M2 S BLBL Incumbent chooses capacity M 1 and entry is deterred Suppose that the break in the entrant’s best response function lies at B S in TS BSBS Incumbent chooses capacity M 1 and entry is deterred Suppose that the break in the entrant’s best response function lies at B L in VR Incumbent chooses capacity M 1 and entry is accommodated BLBL

15. Chapter 9: Entry Deterrence and Predation 15 The Dixit model 7 Now suppose that the break in the entrant’s best response function lies at B* in SV q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 M1M1 M2M2 S Incumbent can choose to install capacity M ! and share the market Or install capacity B ! and maintain monopoly in the market B1B1 Choice depends upon relative profitability –If B* is “close to” S then use capacity to deter entry –If B* is “close to” V then accommodate entry as Stackelberg leader B*

16. Chapter 9: Entry Deterrence and Predation 16 Capacity expansion and entry deterrence 2 An example: –P = 120 - Q = 120 - (q 1 + q 2 ) –marginal cost of production $60 for incumbent and entrant –cost of each unit of capacity is $30 –firms also have fixed costs of F –incumbent chooses capacity K 1 in stage 1 –NOTE: incumbent will always produce at least K 1 in production stage—otherwise it throws away revenue that could help cover the cost of installed capacity –entrant chooses capacity and output in stage 2 –firms compete in quantities in stage 2.

17. Chapter 9: Entry Deterrence and Predation 17 Entry deterrence Entry may not occur –entrant’s costs are too high blockaded entry not predatory Entry may be accommodated –entrant’s costs are low incumbent takes advantage of its being first in the market but does not deter Entry may be strategically deterred –strategic deterrence profitable for the incumbent –installs excess capacity as an entry-deterring strategy –uses a credible commitment

18. Chapter 9: Entry Deterrence and Predation 18 Preemption and the persistence of monopoly A distinct but related issue is an incumbent investing early to prevent new entry –market may be a natural monopoly at current size –but expected to grow and attract entry Now we have an issue of timing It may be in the interests of an incumbent to preempt by –building new plants prior to a rival’s entry –adding new products prior to a rival’s entry Related to another issue –entrant may race to innovate to preempt entry A simple model:

19. Chapter 9: Entry Deterrence and Predation 19 Preemption and the persistence of monopoly 2 A market with an incumbent –current profit  M –market is expected to double in the next period and stay at the new size in perpetuity –to meet the new demand requires additional capacity at cost of F –the new capacity can be added: In first period or in second period By incumbent or by new entrant With no threat of entry –incumbent installs new capacity at beginning of second period –profit is 2  M minus cost of capacity With threat of entry may need to install capacity early

20. Chapter 9: Entry Deterrence and Predation 20 Preemption and the persistence of monopoly 3 Consider the entrant choosing in period 1 –suppose that competition is Cournot if entry occurs –entry in period 1 gives the entrant  e 1 =  C + 2  C /(1 – R) - F R is the discount factor = 1/(1+r) where r is the discount rate –entry in period 2 gives the entrant  e 2 = 2  C /(1 – R) – RF in present value terms –suppose  e 1 <  e 2 which implies (1 + r)  C < rF –entrant will enter in the second period

21. Chapter 9: Entry Deterrence and Predation 21 Preemption and the persistence of monopoly 4 What about the incumbent? –do nothing in period 1 entry takes place in period 2 earns 2  C /(1 – R) –install additional capacity in period 1 entry deterred earns 2  M /(1 – R) – F –install capacity early provided that 2(  M -  C )/(1 – R) > F provided that present value of additional profit from protecting monopoly is greater than the fixed cost Incumbent wants to maintain monopoly; entrant only shares in non-cooperative profits

22. Chapter 9: Entry Deterrence and Predation 22 Market preemption Why does the incumbent have a stronger incentive to invest “early”? –the incumbent is protecting a valuable monopoly –the entrant is seeking a share of the market –so the incumbent’s incentive is stronger –willing to incur initial losses to maintain market control

23. Chapter 9: Entry Deterrence and Predation 23 Evidence on predatory expansion Some anecdotal evidence Alcoa –evidence that consistently expanded capacity in advance of demand Safeway in Edmonton –evidence that it aggressively expanded store locations in response to potential entry DuPont in titanium oxide –rapidly expanded capacity in response to to changes in rivals’ costs –market share grew from 34% to 46%

24. Chapter 9: Entry Deterrence and Predation 24 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?

25. Chapter 9: Entry Deterrence and Predation 25 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(q L + q F ) q F is output of leader and q F is output of follower leader is a Stackelberg quantity leader both leader and follower have constant marginal costs of c

26. Chapter 9: Entry Deterrence and Predation 26 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

27. Chapter 9: Entry Deterrence and Predation 27 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

28. Chapter 9: Entry Deterrence and Predation 28 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

29. Chapter 9: Entry Deterrence and Predation 29 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

30. Chapter 9: Entry Deterrence and Predation 30 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

31. Chapter 9: Entry Deterrence and Predation 31 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

32. Chapter 9: Entry Deterrence and Predation 32 The Example 3 Nature High-Cost Low-Cost I1I1 I2I2 High Price Low Price E3E3 E4E4 Enter Stay Out Incumbent: 60 + 20 = 80 Entrant: 20 Incumbent: 60 + 60 = 120 Entrant: 0 Enter Stay Out Incumbent: 40 + 20 = 60 Entrant: 20 Incumbent: 40 + 60 = 100 Entrant: 0 Low Price Enter Stay Out E5E5 Incumbent: 100 + 50 = 150 Entrant: -20 Incumbent: 100 + 100 = 200 Entrant: 0

33. Chapter 9: Entry Deterrence and Predation 33 The example 4 With no uncertainty the entrant enters if the incumbent is high-cost With no uncertainty the entrant enters if the incumbent is high-cost With uncertainty and a low price the entrant does not know if he is at E 4 or E 5 With uncertainty and a low price the entrant does not know if he is at E 4 or E 5 Nature High-Cost Low-Cost I1I1 I2I2 High Price Low Price E3E3 E4E4 Enter Stay Out Incumbent: 60 + 20 = 80 Entrant: 20 Incumbent: 60 + 60 = 120 Entrant: 0 Enter Stay Out Incumbent: 40 + 20 = 60 Entrant: 20 Incumbent: 40 + 60 = 100 Entrant: 0 Low Price Enter Stay Out E5E5 Incumbent: 100 + 50 = 150 Entrant: -20 Incumbent: 100 + 100 = 200 Entrant: 0

34. Chapter 9: Entry Deterrence and Predation 34 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

35. Chapter 9: Entry Deterrence and Predation 35 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 = 20 - 40p 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

36. Chapter 9: Entry Deterrence and Predation 36 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

37. Chapter 9: Entry Deterrence and Predation 37 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.

38. Chapter 9: Entry Deterrence and Predation 38 Predation and Financial Constraints Two period model. Microhard and Newvel both start in the market. Fixed cost are F and monopoly and duopoly profits π M and π D Microhard may try to drive Newvel out in the first period by driving pricing down so each firm looses - ε = (π P – F ) If Newvel is credit constrained, it cannot borrow the necessary fixed cost for period 2 if it loses money in period 1 Microhard will predate if π M – F – ε > 2(π D – F) or π M – ε > 2π D – F Uncertainty and asymmetric information can generate credit constraints

39. Chapter 9: Entry Deterrence and Predation 39 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

40. Chapter 9: Entry Deterrence and Predation 40 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 2 nd period –Entrant decides whether or not to enter in 2 nd period –Bertrand competition post-entry

41. Chapter 9: Entry Deterrence and Predation 41 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

42. Chapter 9: Entry Deterrence and Predation 42 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 1 st period): In 2 nd 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.

43. Chapter 9: Entry Deterrence and Predation 43 The example 4 Incumbent’s Incentive to Offer the contract: –Without the contract, incumbent wins the 2 nd 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 2 nd 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.

44. Chapter 9: Entry Deterrence and Predation 44 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?

45. Chapter 9: Entry Deterrence and Predation 45 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

46. Chapter 9: Entry Deterrence and Predation 46 Naked Exclusion If there are initial economies of scale, the incumbent can contract with enough of the market to prevent the potential entrant from entering. Customers will agree to the contract because if the potential entrant does not enter, they will be charged monopoly price, so they are better off with the long-term contract If customers could coordinate to not take the long term contract, the entrant would enter and they would be better off, but often they cannot coordinate. Two Nash Equilibria: all consumers sign or none

47. Chapter 9: Entry Deterrence and Predation 47 Predatory Conduct and Public Policy The evidentiary requirements for prosecuting predatory pricing cases are high –Pricing below cost –The predator had a reasonable expectation of recouping the losses Very hard to distinguish predation from other pro- competitive behavior –Hard to measure marginal cost –Learning curves, network effects, and other externalities

48. Chapter 9: Entry Deterrence and Predation 48 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

49. Chapter 9: Entry Deterrence and Predation 49 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

50. Chapter 9: Entry Deterrence and Predation 50 Empirical Application: Entry Deterrence In The Pharmaceutical Industry 3 For this purpose, they estimate the equation: Entry i =constant + β 1 Rev i + β 2 Hosp i + β 3 Chronic i + εi –Entry i is a 1,0 dummy variable equal to 1 if there was entry within three years after patent expiration in market i –Rev i is the average revenue earned by the incumbent in market i for the three years before expiration –Hosp i 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

51. Chapter 9: Entry Deterrence and Predation 51 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

52. Chapter 9: Entry Deterrence and Predation 52 Empirical Application: Entry Deterrence In The Pharmaceutical Industry 5 Ellison & Ellison (2006) estimate the following equation: – 1 = [  1 Low +  2 Medium +  3 High]Time +  i Advertising it Advertising 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

53. Chapter 9: Entry Deterrence and Predation 53 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 profanity markets That is,  2 should be negative

54. Chapter 9: Entry Deterrence and Predation 54 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 CoefficientEstimated Value Standard Error 11 -0.0070.013 22 -0.0320.009 3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