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

2. Chapter 13: Predatory Conduct: recent developments 2 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?

3. 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(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

4. 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

5. 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

6. 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

7. 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

8. Chapter 13: Predatory Conduct: recent developments 8 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

9. Chapter 13: Predatory Conduct: recent developments 9 The Example (cont.) 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

10. Chapter 13: Predatory Conduct: recent developments 10 The Example (cont.) 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

11. Chapter 13: Predatory Conduct: recent developments 11 The example 2 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

12. Chapter 13: Predatory Conduct: recent developments 12 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

13. Chapter 13: Predatory Conduct: recent developments 13 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

14. 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

15. 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.

16. 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

17. Chapter 13: Predatory Conduct: recent developments 17 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

18. Chapter 13: Predatory Conduct: recent developments 18 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

19. Chapter 13: Predatory Conduct: recent developments 19 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.

20. Chapter 13: Predatory Conduct: recent developments 20 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.

21. 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?

22. 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

23. Chapter 13: Predatory Conduct: recent developments 23 Contracts and efficiency 2 Deterring entry through the contract –increases incumbent and buyer surplus by $6.25 –reduces entrant’s surplus by $12.50-$3.13 = $9.37 –reduction in surplus is greater than gain in surplus Why? –some desirable entry is prevented –entrant with cost between $25 and $50 is more efficient than incumbent –but is deterred from entry

24. Chapter 13: Predatory Conduct: recent developments 24