In Search of Predatory Pricing

1. In Search of Predatory Pricing R. Mark Isaac and Vernon L. Smith

2. Is Predatory Pricing Observable in a Laboratory Environment?

3. Outline • Overview of Research Procedures and Results • Predatory Pricing from Literature to Experimental Design • The Plato Posted Offer Procedure • Alternative Hypotheses • Experimental Results • Conclusions

4. Overview of Research Procedures and Results • Assumptions • Two firms- one large, one small • Scale economies- larger firm has a relative cost advantage • “Deep pocket” possessed by the advantaged firm • Sunk entry costs • Complete information regarding competitors‘ costs • Induced Rivalry • Antitrust Rules - Semi permanent price reduction rule - Quantity expansion limit

5. Overview of Research Procedures and Results • Predatory pricing distinct from • Competitive prices • Shared monopoly pricing • Dominant firm price • Edgeworth- style price cycles

6. Overview of Research Procedures and Results • First series of experiments conducted with conditions 1-3 (3 experiments) • Second series conducted with conditions 1-4 • Third series of experiments conducted with conditions 1-5 • The fourth series induced rivalry amongst competitors • In the fifth series the large firm acted as confederate of the experimenters • Two additional antitrust restrictions imposed in addition to conditions 1-4.

7. Overview of Research Procedures and Results

8. Predatory Pricing from Literature to Experimental Design • Distinction between low prices due to “good competition” and “bad predation” exists in literature • Based on literature the trading environment consists of firms producing a homogenous product in a posted offer market with full demand revelation

9. Predatory Pricing from Literature to Experimental Design • Number of firms - Single Predator - Singular Prey (Salop 1981, p.11) - Plural Prey (Scherer 1980, p.335; Kreps and Wilson 1982; Milgrom and Roberts 1982; Selton 1978) - Two firm market (Coursey, Isaac and Smith (CIS) 1984; Isaac and Smith 1984)

10. Predatory Pricing from Literature to Experimental Design 2. Costs of the Firms Predator and Prey distinguished by costs (Mcgee 1958, p.40) • Predator and Prey “may” or “may not” have equal costs (Ordover and Willig 1981 p.308; Salop 1981, p.19) • Predator and Prey “do not” have identical costs (Geskins in Scherer 1980, p.338) • To create conditions favorable to predation predator given an important cost advantage

11. Predatory Pricing from Literature to Experimental Design

12. Predatory Pricing from Literature to Experimental Design 3. Deep Pocket - Predator has capital market advantage (Wall Street Journal, 1993) - “The length of its purse assures it of victory.” (Edwards in Scherer, 1980) - Predator given double the endowment of Prey

13. Predatory Pricing from Literature to Experimental Design • 4. Sunk Cost entry and reentry barriers • Small firms face barriers to entry • Economies of scale not the only barrier to entry (CIS, 1984) • Additional Sunk cost of entry and exit (Ordover and Willig, 1981, p.305) • Large firm also has incumbent knowledge advantage (Salop, 1981) • Each seller obtains permit before entering the market (CILS, 1984)

14. Predatory Pricing from Literature to Experimental Design • 5. Information - Firms have complete information about rivals’ costs (Salops, 1981; Kreps and Wilson,1982 and Milgrom and Roberts, 1982) • Large and Small firm swapped position for there to be full information of rivals cost structures.

15. Predatory Pricing from Literature to Experimental Design 6. Rivalry • Predation dependent on the intent of the predator • In one series rival intent to exclude small firm

16. Predatory Pricing from Literature to Experimental Design 7. Predatory Pricing Antitrust Program. • Semi permanent price reduction regulation on large firm • All of large firm's price reductions had to be maintained for five consecutive periods • Output expansion limit • Small firm bought permit to produce • Large firm could not expand its output for two periods

17. The Plato Posted Offer Procedure • Posted- Offer Institution (Plott and Smith 1978) • Seller sets “take it or leave it” price • Quantities selected by buyers subject to sellers’ capacity limits Used the posted offer mechanism programmed for the Plato computer system (Ketcham, Smith and Williams, 1984)

18. The Plato Posted Offer Procedure • Buyers and sellers sit on separate terminals and trade for 25 periods • Display screen shows subject’s record sheet • Maximum units that can be purchased (sold) • Each units marginal valuation (cost) • Buyers and sellers can cash rewards equal to the difference between the marginal value (selling price) and the purchase price (marginal cost) • No penalties for carryover orders • Each period begins with sellers setting a price and corresponding quantity and Plato calculates the resulting profit • Each seller sees the other sellers only after both have entered their offers • The buyers were then randomly ordered by Plato using a computerized subroutine under the assumption that demand was fully revealed • Sellers were not told what the final period of the experiment would be

19. Alternative Hypothesis • Alternative oligopolistic pricing behaviors • Any behavioral hypothesis might apply as long as one or both firms chooses prices

20. Alternative Hypothesis • Predatory Pricing • Price lower than short-run optimal price • Price that deters entry or drives out competitors • Firm A is the Predator when the following conditions hold

21. Alternative Hypothesis • Competitive Equilibrium • Price cutting less severe than predation • Dominant Firm Equilibrium

22. Alternative Hypothesis • Edgeworth Price cycles • Price cuts of A matched by B until all incentives are wiped off • Prices cut till • Shared Monopoly • Tacit collusion

23. Experimental Results

24. Experimental Results

25. Experimental Results

26. Experimental Results

27. Experimental Results • The absence of Predatory Pricing • In series 1 no seller posted predatory prices • In instances when prices were in the predatory range the quantities were not predatory • Such behavior only in period 1 • Early period price experimentation • Super-sophisticated signal of predation in future

28. Experimental Results • Series 2 • With the introduction of sunk costs no predatory pricing price quantity pairs chosen in the 69 observations • In 54 cases the smaller firms contested the market with permits • Series 3 • Despite perfect knowledge regarding competitors costs no predatory behavior • Small firms remained in the market in all 54 instances

29. Experimental Results • Series 4 • The introduction of $1.00 reward for rivalistic behavior failed to generate any predatory behavior • Small firm did not exit the market Generally there are no price quantity pairs that lie in the predatory range, however there are instances when the large firms behavior was suggestive of predatory behavior

30. Experimental Results • The dominant firm price setting model is the most observed price setting behavior • Of the 9 experiments 6.5 can be described by the dominant firm model • Only two of the 10 experiments were edgeworthian • Signaling a move towards monopoly prices rather than competitive behavior

31. Experimental Results

32. Conclusion • Unable to produce predatory pricing in structural environment • Dominant firm equilibrium is predominant