Understanding Limit Pricing and Entry Deterrence in Industrial Organization

1. Lecture 12 ECON 4100: Industrial Organization Limit Pricing and Entry Deterrence

2. Introduction • A firm that has market power can restrict output by a large enough amount that the market price rises • Firms such as Microsoft (95% of PC operating systems) and Campbell’s (70% of the tinned soup market) stand virtually alone as the giants in their respective industries • Moreover, Microsoft, Campbell’s and other have maintained their dominant position for many years • Why can’t existing rivals compete away the position of such firms? • Why aren’t new rivals lured by the profits of such dominant corporations?

3. Introduction • Why can’t existing rivals compete away the position of such firms? • Why aren’t new rivals lured by the profits of such dominant corporations? • Answer: firms with monopoly power may • eliminate existing rivals • prevent entry of new firms • Actions that eliminate existing or potential rivals is predatory conduct • Conduct is predatory if it is profitable only if rivals, in fact, exit (e.g., R&D to reduce costs is not predatory) • It seems to make no sense unless the advantages of keeping competitors out are considered

4. Monopoly Power and Market Entry • Several stylized facts about entry • entry is common • entry is generally small-scale (small-scale entry is relatively easy) • survival rate is low: over 60% of entrants exit within 5 years • entry is highly correlated with exit (just check the cases of clothing, furniture, retailing, etc) • not consistent with entry being caused by excess profits (it must be that what makes entry easy also makes exit easy!) • “revolving door” • reflects repeated attempts to penetrate markets dominated by large firms • Not always easy to prove that this reflects predatory conduct • But we need to understand predation it if we are to find it

5. Predation, Predatory Pricing, and Limit Pricing • Predatory actions come in two broad forms • Limit pricing: prices so low that entry is deterred • Predatory pricing: prices so low that existing firms are driven out • From an economic perspective, the outcome of either action is the same—the monopolist retains control of the market • But most legal action focuses on predatory pricing because this case has an identifiable victim—a firm that was in the market but that has left

6. Predation, Predatory Pricing, and Limit Pricing • Can we construct a model of either limit pricing or predatory pricing? YES! • Stackelberg leader chooses output first • entrant believes that the leader is committed to this output choice • entrant has decreasing costs over some initial level of output (In this sense we could call the model one of limit output)

7. Then the entrant’s residual demand is R1 = D(P) - Q1 By committing to output Qd the incumbent deters entry. Market price Pd is the limit price A Limit Pricing Model These are the cost curves for the potential entrant $/unit With the residual demand R1, the entrant can operate profitably.Entry is not deterred by the incumbent choosing Q1. At price Pe entry is unprofitable R1 The entrant equates marginal revenue with marginal cost MCe The entrant’s residual demand is Rd = D(P) - Qd Pd ACe Assume that the incumbent commits to output Q1 Assume instead that the incumbent commits to output Qd Then the entrant’s marginal revenue is MRd Pe D(P) = Market Demand Rd MRd Quantity qe Qd Q1 Qd

8. Limit Pricing (cont.) • The strategy of committing to output QD may be aimed either at eliminating an existing rival or driving out a potential entrant. Either way, several questions arise: • Is limit pricing more profitable than other strategies? • Is the output commitment credible? • If output is costly to adjust then commitment is possible • why should this property hold? • even if it holds, is monopoly at output Qd better than Cournot?

9. Predation and Merger • The legal case history is dominated by charges of predatory pricing—essentially, the strategy of setting the low price PD—in order to drive out competitors • This is because there is a visible victim who will complain • Think about Rockefeller and his tactics with Standard Oil

10. Predation and Merger • The legal case history is dominated by charges of predatory pricing—essentially, the strategy of setting the low price PD—in order to drive out competitors • McGee (1958) questioned the logic of such behavior • For predatory pricing to be rational two conditions are necessary • rise in post-predatory profits compensates for the price war • there is no alternative more profitable strategy that achieves the same objective • but merger is more profitable than predation • predation has low or negative profits during predation • merger does not • Basic point: predation must be part of a dominant strategy

11. Predation and Merger (cont.) • McGee’s main argument • Two-period game—If incumbent takes predatory action in Period 1=> incumbent becomes a monopoly in Period 2 • Predation: incumbent earns low or zero profit in Period 1 and then monopoly profit in Period 2, while Rival earns zero or less in Period 1 and exits

12. Predation and Merger (cont.) • McGee’s main argument (cont.) • It is a better strategy to merge with the entrant and act as a monopolist from the start (you should start sleeping with your enemy from the start) • Buy out entrant for say half of the monopoly profit in Period 1 • Newly merged firm is a monopolist in both Periods 1 and 2 • Initial incumbent still gets all the monopoly profit in Period 2 but now gets half of that profit in Period 1 • Both incumbent and entrant do better than under predation

13. Predation and Merger (cont.) • Problems with the McGee analysis • merger is a public event: may not be allowed if it monopolizes • predation may improve the terms of the merger (attack the other firm and weaken it: then negotiate a more favorable merger!) • merger may encourage additional entry of firms hoping to be bought • Still, McGee’s argument makes clear that logical argument about predation must be carefully constructed • In particular, while merger may not be a dominant strategy there is still the question as to how the incumbent credibly commits to produce QD

14. Next: Dynamic strategic interaction and credible commitment