Predatory Conduct: Recent Developments

1. Predatory Conduct: Recent Developments 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? 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(qL + qF) • qFis 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 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 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 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 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 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 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 Chapter 13: Predatory Conduct: recent developments

10. 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 Chapter 13: Predatory Conduct: recent developments

11. 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 With no uncertainty the entrant enters if the incumbent is high-cost The example 2 With uncertainty and a low price the entrant does not know if he is at E4 or E5 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 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 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 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. 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 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 2nd period • Entrant decides whether or not to enter in 2nd period • Bertrand competition post-entry 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 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 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 < $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. Chapter 13: Predatory Conduct: recent developments

20. The example 4 • Incumbent’s 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, incumbent’s expected profit with the contract is $31.25 > $25. The incumbent prefers the contract. 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? 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 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 Chapter 13: Predatory Conduct: recent developments

24. Chapter 13: Predatory Conduct: recent developments