Predatory Conduct: Recent Developments

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Predatory Conduct Recent Developments
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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
• ATT
• American Airlines
• But they face problems of credibility
• price low to eliminate rivals
• then raise price
• so why dont rivals reappear?

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Predatory pricing myth or reality?

• Theoretical and empirical doubts
• predation is generally not subgame perfect
  without uncertainty regarding the incumbent
• return to this below
• McGees 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

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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

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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

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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

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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 incumbents 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

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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 incumbents 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

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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
• Entrants profits in period 2
• competing against a low-cost incumbent -20,
• competing against a high-cost incumbent 20m

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The Example (cont.)
Incumbent 60 20 80 Entrant 20
Enter
High Price
Incumbent 60 60 120 Entrant 0
E3
Stay Out
High-Cost
Incumbent 40 20 60 Entrant 20
I1
Enter
Low Price
Nature
E4
Incumbent 40 60 100 Entrant 0
Stay Out
Low-Cost
I2
Enter
Incumbent 100 50 150 Entrant -20
Low Price
E5
Incumbent 100 100 200 Entrant 0
Stay Out
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The example 2
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 E4 or E5
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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 incumbents type
• Only the probability that low-price means
  low-cost deters entry

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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 gt 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

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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

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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.

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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 customers
  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

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An example

• The Setup One seller (the incumbent), one buyer
  and one potential entrantand 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

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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 entrants cost is c lt
  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 buyers expected price is
• P ½ x 100 ½ x 50 75 ? Expected Surplus
  25
• Buyer must be offered this surplus in any other
  contract

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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 lt 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.
• Buyers expected surplus is 25 with contract as
  it was without the contract.

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The example 4

• Incumbents 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, incumbents expected profit with the
  contract is 31.25 gt 25. The incumbent prefers
  the contract.

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Contracts and efficiency

• Incumbents profit is greater with the contract
• 31.25 as against 25
• Buyers 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 entrants reduction in
  surplus
• Why?

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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

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Contracts and efficiency 2

• Deterring entry through the contract
• increases incumbent and buyer surplus by 6.25
• reduces entrants 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

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