EC365 Theory of Monopoly and Regulation Topic 5: Exclusion

1. EC365 Theory of Monopoly and RegulationTopic 5: Exclusion 2013-14, Spring Term Dr Helen Weeds

2. Routes to monopoly power Monopoly power Collude Exclude Merge

3. Lecture outline • Strategic entry deterrence • limit pricing (old-style) • capacity investment • asymmetric information and signalling • Predation • Chicago view • financial constraints • asymmetric information models • Policy toward predation • Areeda-Turner test • cases

4. Sunk costs as a barrier to entry • [Stiglitz 1987] • Assumptions (1) 2 firms: incumbent (I) already operating potential entrant (E) considering entry (2) homogeneous good (3) identical, constant marginal costs (4) price competition (5) small sunk entry cost,  • Will entry occur?

5. Solving the entry game • Find the SPNE

6. Variations on entry game • Change assumptions (2) differentiated products (4) Cournot competition • Similar effect • Entrant can gain some post-entry profit • entry depends on size of  • small : entry occurs • large : entrant stays out • Sufficiently large sunk cost is a barrier to entry

7. Strategic entry deterrence • 3 categories of entry conditions (Bain) • Blockaded entry • natural barriers: entry is unprofitable even if incumbent does not respond to entry (i.e. sets monopoly P or Q) • Deterred entry • incumbent takes actions to prevent entry • Accommodated entry • entry deterrence is too costly • incumbent may take actions to soften effects of entry

8. Limit pricing • [Bain (1956), Modigliani (1958), Sylos-Labini (1962)] • Idea: reduce price to make entry (just) unprofitable • 2-stage game • incumbent I chooses q • entrant E observes q, decides to enter or not • PL = “limit price” • corresponds to qL that (just) keeps entrant out

9. Setting the limit price • Entrant faces residual demand D' (given incumbent’s output) • Choose qL s.t. tangency between D' and AC E = 0

10. Limit pricing in normal form

11. Limit pricing in extensive form

12. Making entry deterrence credible • Intertemporal linkage between • incumbent’s action at stage 1 • environment affecting entrant at stage 2 • Methods of entry deterrence • sunk cost or commitment which affects post-entry equilibrium • actions which affect beliefs of entrant, making entry unattractive

13. Sunk investment as entry deterrence • [Spence (BJE 1977), Dixit (EJ 1980)] • Investment in stage 1 • e.g. spare capacity, marginal cost reduction • Incumbent has higher post-entry q (in equilibrium) • Investment must be sunk • if reversing investment would increase post-entry payoff, incumbent cannot commit not to do this • Sunk investment: cannot be reversed

14. Capacity as entry deterrence (Dixit 1980) • Inverse demand: P = a – bQ • Cost function: Ci = F + wqi + rKi where qi Ki • SRMC = w (capacity installed) • LRMC = w + r • 3 stage game • Stage 1: firm 1 (incumbent) chooses capacity K1 • Stage 2: firm 2 (entrant) observes K1 and decides to enter or not; entry incurs fixed cost F • Stage 3: if entry, firms compete in quantities • capacity is sunk & cannot be decreased: K1' K1

15. Solving the game: third stage • Reaction functions entrant: R2(q1) = {a – bq1 – (w+r)}/(2b) incumbent: R1(q2) = {a – bq2 – w}/(2b) up to K1 {a – bq2 – (w+r)}/(2b) above K1 • Equilibrium at intersection of reaction functions • Position of equilibrium depends on firm 1’s first period capacity choice, K1

16. Reaction functions 2’s reaction fn is R2 (MC=w+r) 1’s reaction fn is R1 until K1 then moves down to R1' Eqm at intersection, E Eqm anywhere between A & B, depending on choice of K1 NB: A is Nash eqm without stage 1 capacity investment

17. Second stage • Entry incurs fixed cost F • When is entry unprofitable for firm 2? Take account of • profit in stage 3 • fixed cost F • Define Z = point on 2’s reaction function where 2 = 0 • If firm 1 can ensure stage 3 equilibrium is to right of Z (i.e. where 2 < 0), firm 2 will not enter

18. Blockaded entry • Suppose Z is close to A • to right of Z, 2 < 0: 2 will not enter • Blockaded entry • 1’s monopoly capacity choice is K1 = R1'(0) • this is to right of Z • 2 will not enter anyway

19. Strategic entry deterrence • Z is just to the left of B • 1’s monopoly K1 = R1'(0) is not sufficient to deter entry: 2 would enter • increase K1 to D so that entry is just deterred • incumbent (as monopolist) uses entire K1

20. Accommodated entry • Z is to the right of B • entry cannot be deterred • find point on R2 that maximises 1 • choose capacity S (Stackelberg leader)

21. Dupont case study (Cabral ch. 15) • Largest producer of titanium dioxide in 1970 • significant cost advantage over rivals (different ore) • environmental regulation disadvantaged competitors • strong financial position • Adopted strategy of expanding capacity • satisfied all increases in demand • deterred entry or expansion by its rivals • market share: 1972: 30%; 1980: 56% • By 1985, 5 of the 6 rivals had exited

22. Asymmetric information • Entrant’s beliefs can be used as basis for intertemporal linkage • Alternative to sunk investment models • 2 models • repeated games: “chain store paradox” • signalling: limit pricing revisited

23. Chain store paradox (Selten 1978, KMRW 1982) • Non-credible threat to fight • entry in a single market • (no sunk investment) • Solve for SPNE

24. Repeated game • Infinite number of repetitions • no “final round” • fight to maintain reputation (if  sufficiently high) • entry is deterred • Finite number of repetitions • final stage T is one-shot game: I will accommodate • no point fighting to maintain reputation in stage T–1 • or in stage T–2 … • incumbent always accommodates • entry occurs in stage 1

25. Incomplete information about I’s type • Entrant is unsure of incumbent’s type • RATIONAL: accommodates entry • THUG: always fights entry • Entrant’s beliefs (prior) • small probability  > 0 that incumbent is a THUG • Updating of beliefs • belief  is maintained while fighting observed • if accommodation seen even once, set =0 • Outcome • fighting is observed early on • towards end, incumbent will accommodate

26. Signalling to deter entry • Milgrom & Roberts (1982): credible limit pricing • Entrant (E) is unsure about incumbent’s costs, and makes an assessment based on observed price • low price  very efficient incumbent  stay out • high price  inefficient incumbent  enter market • Incumbent (I) may find it worthwhile to set a low price, to pretend that its costs are low and deter entry

27. Signalling model • Incumbent (I) has cost level c where • Asym information: true cost is known to I but not to E • Entry is profitable iff c = cH • not profitable if c = cLor E(c) = 0.5cH + 0.5 cL • Two-stage game • I chooses PI which is observed by E • E chooses stay out or enter  monopoly or duopoly

28. Equilibrium in signalling model • Two types of equilibria are possible • Separating equilibrium   • cL is too low for H-type to mimic L-type • L-type I sets low price, no entry  monopoly • H-type I sets high price, entry occurs  duopoly • Pooling equilibrium • H-type can mimic L-type by setting low period 1 price • period 1 price reveals no information • no entry occurs

29. Predation • Three elements • initial price cut • target (prey) incurs losses • predator makes lower profit, or a loss (sacrifice) • intent to induce exit • price increase after exit of rival (recouping sacrifice) • Welfare assessment • initial price cut is good for consumers • subsequent price rise is detrimental • long-run impact is negative

30. Does predation make sense? • Profit sacrifice by the predator • since the (alleged) predator is usually a large firm, a predatory price war is particularly costly to this operator (as it sells more units) • Recoupment • once rivals are excluded the predator raises prices to recoup its predatory “investment”… but why don’t rivals (or other firms) re-enter? • if large sunk costs form a barrier to (re-)entry, then there is also a large option value of staying in: predation should not be successful in the first place

31. Predation: Chicago view • PERIOD 1 • P: Predate or • accommodate? • T: Exit or stay? • PERIOD 2 • P: Predate? • Find SPNE

32. Chicago argument • Rational target will stay • Non-credible threat to continue predation • rational to stay in; predator will accommodate • Target may need to fund its loss during predation • d > L: this is worthwhile • target may lack funds • bank should be willing to lend amount L to target

33. Financial constraints and predation • Long-purse theories (Benoit, 1984) • Complete information • who can survive longest? • financially weaker firm quits at start (backwards induction) • Incomplete information • some fighting to update information, then one quits • Signal-jamming (Fudenberg & Tirole, 1986) • Principal-agent problem between managers and financiers • Financial backers cannot tell whether losses are due to • predation: losses and see it out • bad market or weak firm: withdraw funding

34. Predation with asymmetric information • Analogues of entry deterrence models based on asymmetric information • (1) Repeated games • chain store paradox • establish predatory reputation in a repeated game • e.g. Stagecoach in local bus markets • (2) Asymmetric information about costs • signalling model of entry deterrence • prey cannot tell whether its rival’s low pricing is due to low costs or predation

35. Detecting predation • Predatory intent • virtually unprovable • except when internal docs or explicit threats • Initial price cut • could be normal competitive behaviour • rational to cut price somewhat in response to entry • look for profit sacrifice: Areeda-Turner benchmark • Recoupment of predatory losses (esp. US) • barriers to immediate re-entry (e.g. predatory reputation) • recoupment in other markets

36. Areeda-Turner test (1975) • Compare alleged predatory price with costs • price < S-R marginal cost  predation • losses are avoidable, so must be predatory • Difficulties and criticisms • defining & measuring SRMC not always straightforward • not necessary: can predate with p  (MC, AC): grey area • not sufficient: other explanations for below-cost pricing • introductory pricing • early development of network market • learning by doing

37. Southdown Motor Services (MMC 1993) • Southdown: incumbent bus operator in Bognor Regis • 1987 deregulation: Easy Rider entered on two bus routes • March 1991: Southdown introduced service 242, with high frequency and timed to be just before Easy Rider on both routes • loss-making for Southdown: revenues < drivers’ wages • weakened Easy Rider: sold out to Southdown in May 1992 • MMC’s findings and recommendation • new service was intended to be predatory • loss of competition would raise prices and lower service quality • price control (RPI) and no reduction in service on these routes,for two years

38. American Airlines case • See case on reading list: • Kwoka & White edition 4, Case 20: Aaron Edlin and Joseph Farrell, “The American Airlines case: a chance to clarify predation policy”