Predatory Conduct

1. Predatory Conduct • What is predatory conduct? • Any strategy designed specifically to deter rival firms from competing in a market. • Primary objective of predatory conduct is to influence the behavior of rivals. • For an action to be seen as “predatory” it must only be profitable if it causes rival to exit market or deters a potential entrant.

2. Predatory Conduct vs. Strategic Competiton • Strategic competition: when a firm acts to improve its future position in a market. • Example: Raising the cost of entry into a market. • Predatory -- designed to deter entry. • Example: Investing in cost-reducing capital. • Strategic -- will improve firm’s market position. May also deter entry or cause rival to exit, but is not necessarily predatory.

3. Dominant Firm and Competitive Fringe Model • One dominant firm in the industry. • Acts as a price maker. • Large number of small firms, the “competitive fringe”. • Act as price takers. • Dominants firm moves first and sets the price. • Fringe firms supply based on the price. • Similar to Stackelberg, except followers don’t affect price.

4. c’(q) = MC Price P* = MR Firm Quantity q* Dominant Firm/Fringe Model, con’t • Like Stackelberg, work backwards. • Fringe firms maximize Pq - c(q). • Set MR = MC and solve.

5. nS(P) = Fringe Supply Price Industry Quantity • Supply for each fringe firm = S(P). S(P) is the firm’s marginal cost curve. • Total fringe supply = nS(P).

6. Price nS(P) = Fringe Supply DD(P) D(P) Industry Quantity • Dominant firm’s demand is: DD(P) = D(P) - nS(P) At prices above this point, fringe supplies everything

7. Price nS(P) = Fringe Supply MRD(P) MCD D(P) DD(P) qD Industry Quantity • Dominant firm maximizes:P·DD(P) - cD(DD(P)). • Sets MR = MC

8. Price nS(P) = Fringe Supply MRD(P) MCD P* D(P) DD(P) qD qF Industry Quantity • Fringe supplies based on price set by dominant firm.

9. Implications of Dominant Firm and Competitive Fringe Model • Dominant firm supplies where MRD = MCD. • In some cases this is greater than quantity monopolist would supply, and in some cases less. • Price will always be less than monopolist’s price would be. • Why? Because competitive fringe serves to make dominant firm’s demand more elastic, so the firm has less power to price above marginal cost. • Note that the dominant firm does not drive the fringe out of the market in this model.

10. Numerical Example • D(P) = 100 - 2P. • Competitive fringe supply = P/2. • DD(P) = D(P) - fringe supply = 100 - 2P - P/2 = 100 - 5P/2. • So QD = 100 - 5P/2  P = 40 - 2QD/5. • Then MRD = 40 - 4QD/5.

11. Numerical Example, con’t • Assume dominant firm’s MC = 20. • Set MR = MC 40 - 4Q/5 = 20 4Q/5 = 20  Q = 25. • P = 40 - 2QD/5 = 40 - 2(25)/5 = 30 • Fringe supplies P/2 = 30/2 = 15.

12. Compare DF/CF to Monopoly • DM(P) = 100 - 2P  P = 50 - QM/2. • MR = 50 - QM. • 50 - QM = 20 (= MC)  QM = 30. • PM = 50 - 30/2 = 35. • Q of DF + CF = 25 + 15 = 40, P = 30.

13. Repeated Version Dominant Firm and Competitive Fringe Model • What if there was more than one period? • Dominant firm could kill competitive fringe by pricing so low that fringe would not produce. • In a one-shot game, generally doesn’t maximize current profits, and therefore not done. • Once fringe dies, dominant firm can price at monopoly level. • Profitability of plan depends on cost of killing fringe and relative size of monopoly profits.

14. Predatory Pricing • Pricing low enough to drive away competition and then raising price once competition gone. • Initially, low price (price war) is beneficial to consumers (think Walmart vs. Mom and Pops). • Eventually, if price increases due to lack of competition, consumers lose out.

15. Criticisms of DF/CF Model • Price not the only way dominant firm can compete. • Brand loyalty. • Absorb fringe through merger. • Competitive fringe may fight back.

16. Limit Pricing and Quantity Commitment Model • Incumbent in the market acts as a Stackelberg leader and chooses an output level. • Potential entrant sees incumbent’s quantityand then decides whether to enter. • Key assumption: entrant believes that its entry decision will not affect the leader’s output choice. • By picking output level, incumbent can manipulate potential entrant’s profit from entry.

17. Residual demand for PE Price D(P) qL Industry Quantity

18. DPE Price MRPE MCPE ATCPE D(P) q* qL Industry Quantity At q*, entrant’s profit is negative

19. Critiques of Limit Pricing and Quantity Commitment Model • Will incumbent really produce at qL once the entrant is in the market? • Only if there is someway he can commit to this level, otherwise the two firms will split the market as in Cournot. • If there is no way to commit, entrant will not believe the incumbent’s threat -- it is not credible.

20. Stay Out Enter Low P Low P High P High P 2,2 -1,0 0,5 0,0 Example Entrant X X Incumbent • Find optimal strategy for each subgame (prune the tree). • Find Entrant’s optimal action.

21. Chain Store Paradox • Firm A has a store in each of 20 markets. • In each market, there is a single local potential entrant. (Different PE in each market.) • Currently none of the PE’s has enough capital to begin operations, but in time they will. • How should Firm A price in this situation?

22. Chain Store Paradox, con’t • If Firm A accommodates entry, each firm has a positive profit although A > PE. • Think Cournot with heterogeneous costs. • If Firm A fights, he can price low enough so that PE = 0. • Think Bertrand with heterogeneous costs. • However if A fights, profit is less than if A accommodates. • Assume A will have to maintain low price to keep PE out of the market.

23. Chain Store Paradox, con’t • Should Firm A price low in the “first” market (i.e., market where entry occurs first) and drive the competitor out? • Will lose money, but this market will serve as an example for the other PE’s. “Proof” that A will fight. • Dynamic game -- must work backwards. • In the “last” market, Firm A will not price low because that decreases total profit. • Dominant strategy is to accommodate entry.

24. Chain Store Paradox, con’t • In the “last” market, Firm A accommodates. • In the next to the last market, no need to prove threat to PE in last market, since A will always accommodate. Therefore, Firm A should also accommodate the PE in the next to the last market. • And so on… • Thus the “paradox”: even in a chain of markets, predatory threats aren’t credible.

25. Critiques of Chain Store Paradox • Requires a fixed number of markets. • If there are an infinite number of markets, or even just the possibility of additional markets, you can find situations under which predatory action is credible. • In such a case, a firm may want to develop a reputation as a tough competitor.

26. Capacity Expansion to Deter Entry • aka the Dixit Capacity Expansion Model. • Same basic setup: one incumbent firm and one potential entrant. • Incumbent decides how large to build its plant (i.e., how much capacity to build). • With a plant of size K, the incumbent can produce up to K units at a marginal cost of w. • To produce more than K units, he faces an additional MC of r for each unit above K.

27. w+r w K Quantity Incumbent’s Marginal Cost

28. Capacity Expansion, con’t • It costs the potential entrant F to enter the market. • If the PE enters, the firms choose quantity as in a Cournot game. • Since the PE must build his capacity and produce simultaneously, he faces a MC of w + r. • If the PE doesn’t enter, the incumbent acts as a monopolist.

29. Capacity Expansion, con’t • In a Cournot game with two firms, quantity produced is a function of the firms, MC. • BR for firm i: qi = (A+cj-2ci)/3B. • As long as the incumbent produces less than K, he has a lower MC, and thus will produce more than the entrant and make a larger profit.

30. qPE For output less than K, incumbent has lower MC and is on this BR curve For output greater than K, incumbent has higher MC and is on this lower BR curve q*PE qI = q*I Best Responses of the Two Firms K

31. Capacity Expansion, con’t • By increasing K, the PE’s optimal quantity (and profit) is decreased, which makes entry less profitable. • In some cases, it may not be profitable for the PE to enter at all (if he can’t cover F). • Is the threat of the incumbent producing a high quantity of output credible? • Yes. It is his Best Response. • How does the incumbent pick K?

32. qPE Minimum that Incumbent will produce if PE enters Max. PE will produce Min. PE will produce Maximum that Incumbent will produce if PE enters qI Finding the Optimal K Monopolist’s optimal quantity

33. qPE If break even q in this range, choice of K is critical Min. PE will produce qI Can the incumbent keep the entrant out? Depends on the PE’s “break even” quantity. If break even q above this quantity, PE will never enter Max. PE will produce If break even q below this quantity, PE will always enter

34. Capacity Expansion, con’t • If the incumbent picks K* so that the BR for the PE would be just below the break even quantity, the PE will not enter the market. • If K* > M* (the monopolist’s optimal quantity) the strategy is predatory. • If the K* < M*, the incumbent will build capacity equal to M*, as this is the level at which he will produce. This is not predatory, but is termed “blockaded entry”.

35. L H I L H L H PE L H 3,1 1,0 1,-1 0,-2 1,1 0,0 2,-1 1,-2 Extensive Form Capacity Expansion Game Incumbent High K Low K Potential Entrant DNE DNE Enter Enter 6,0 5,0

36. L H I L H L H PE L H 1,1 0,0 2,-1 1,-2 3,1 1,0 1,-1 0,-2 Version 2 Incumbent High K Low K Potential Entrant DNE DNE Enter Enter 3 6,0 5,0 4

37. Final Comments on the Capacity Expansion Model • If the capacity cost is not sunk, if it can be recovered, then the threat is not credible. • Model is consistent with evidence that early firms maintain market share -- early firms are able to make capacity commitments that give them Stackelberg leadership role. • In several antitrust cases, firms have been found guilty of attempting to monopolize a market by expanding capacity.

38. Limit Pricing and Imperfect Information • Assume there is imperfect information, that is the potential entrant does not know about the incumbent’s true cost and efficiency. • It may be possible for the incumbent to “fool” the potential entrant with his pricing and discourage the entrant from entering.

39. Limit Pricing con’t • Incumbent is a low cost firm with probability  and is a high cost firm with probability (1-). • PE knows the probabilities, but not what the incumbent’s cost actually is. PE is a high cost firm for sure. • In first period, incumbent prices. After seeing price, PE decides whether to enter. • Once PE makes entry decision, incumbent prices based on actual cost.

40. Limit Pricing Game Nature Low cost, l P =  High cost, h P = 1- Incumbent P*(l) P*(h) P*(l) P*(h) PE DNE DNE DNE DNE E E E E 10+5,-2 10+10,0 6+2,2 6+6,0 5+5,-2 5+10,0 4+2,2 4+6,0

41. Limit Pricing con’t • If incumbent is a low cost firm, pricing low will always provide at least as much profit as pricing high, so he will price low if low cost. • Since the incumbent will only price high if he is a high cost firm, if PE sees high price, he assumes high cost and enters. • However, incumbent may try to masquerade as a low cost firm, so if PE sees a low price, he knows the incumbent could be bluffing.

42. Limit Pricing Game Nature Low cost, l P =  High cost, h P = 1- Incumbent P*(l) P*(l) P*(h) PE DNE DNE DNE E E E 10+5,-2 10+10,0 6+2,2 6+6,0 4+2,2 4+6,0

43. Limit Pricing con’t • When PE sees a low price, he doesn’t know what costs are. • Expected value from entry given a low price depends on the probabilty of each state: • (-2) + (1-)(2). • If  > 0.5, entrants stays out, otherwise enters when he sees a low price.

44. Limit Pricing Game Nature Low cost, l P =  High cost, h P = 1- Incumbent P*(l) P*(l) P*(h) PE DNE DNE DNE E E E 10+5,-2 10+10,0 6+2,2 6+6,0 4+2,2 4+6,0