An Introduction to Predation

1. An Introduction to Predation Eric Emch, OECD eric.emch@oecd.org

2. Introduction • Single-firm conduct is the most challenging area of antitrust analysis. • Primary challenge is distinguishing predation/foreclosure (bad) from intense competition (good) • Overly aggressive intervention can discourage intense competition, with high costs to society • Goals of this talk • To identify and discuss key questions of economic theory in the context of existing legal rules • Review economics of actual cases related to predation

3. Outline of Talk • Unified theory vs. single firm “boxes” • Predation: classic story and its critique • Predation: modern game theoretic analysis • Legal tests • Recent cases

4. Is There Unified Theory of Single Firm Conduct? • Not in practice. Some possibilities that have been floated: • “No economic sense” test • “Equally efficient competitor” test • Welfare test • But, none of these are perfect, and there is no consensus on a single framework

5. Some Legal “Boxes” For Single Firm Conduct (In US) • Price Predation: Price below cost + recoupment • Tying: In the United States, “per se illegal.” In practice, structured rule of reason. • Refusals to deal: US DOJ advocates “no economic sense” test in Trinko brief, some of which is adopted by Supreme Court • Bundling: “Ortho test” of bundling as effective predation; but LePages decision foregoes this test • Exclusive dealing: Extent of “market access”

6. Price Predation: “Classic” Story • Dominant firm prices product very low with the express purpose of driving competitors out of business • Dominant firm outlasts competitors during loss period (“long purse”). Once competitors exit, predator raises price to recoup losses and make extra profits • Consumer and total welfare harmed • But does this make sense…?

7. Critique of Classic Story • Predator, with larger market share and capturing even more with low prices, should incur more losses than prey • Financial markets should be willing to fund prey for this reason. Prey can “wait it out.” • Consumer inventory behavior: won’t consumers stock up in the predatory period and make recouping losses more difficult? • Selten’s “chain store paradox”: Predatory strategy unwinds via backwards induction from final period • For critiques, see, e.g., Easterbrook (Chicago Law Review 1981), McGee (JLE 1958)

8. “Post-Chicago” View • Predation may be more targeted, and therefore less costly, than Chicago view assumes. • Chicago view assumes complete information, no principal-agent problems • Under incomplete information on various dimensions, predation can be a rational strategy

9. Predation As “Signaling” • Predation signals efficient incumbent or aggressive posture; incomplete information means that this costly signal may induce exit/lack of entry and ultimately be profitable • Kreps and Wilson (Journal of Economic Theory 1982) • Milgrom and Roberts (Econometrica 1982) • Also, “signal-jamming” predation; “test market” predation

10. A Simple Signaling Model of Predation • Two periods, t=1, 2. Potential entrant (E) in each period • Incumbent firm (I) is either “strong” or “weak”. May, for instance, correspond to low cost vs. high cost. • Probability x: incumbent is strong; (1-x): is weak • Strong incumbent: πP> πA;; Weak incumbent: πP<πA ; πM = monopoly profits • “P”= predate (low price); “A” = accommodate (high price) Reference: Motta book, pp. 423-426

11. A Simple Signaling Model of Predation (2) • Entrant has prior belief x about incumbent strength and updates prior based on observed period 1 behavior • Equilibrium is where each firm is choosing best strategy based on other firm’s strategy and (consistent) belief about type • “Predation” occurs when a weak incumbent acts like a strong incumbent in period 1 to cause period 2 potential entrant not to enter. Is predation an equilibrium?

12. A Simple Signaling Model of Predation (3) • “Separating equilibrium” • Weak incumbent accommodates, strong fights. Too costly for weak to imitate strong • Occurs if πA+δπA > πP+δπM for weak incumbent • “Pooling equilibrium” • Weak and strong both fight period 1 • Entrant does not enter • Must be that x πP+(1-x)πA <0 for entrant • But not really predation, since entry would not occur in static game

13. A Simple Signaling Model of Predation (4) • “Semi-separating equilibrium” in mixed strategies exists where • First entrant enters • Second entrant enters if first accommodated • Second enters with some probability if first is fought • Strong incumbent fights in both periods • Weak incumbent sometimes fights in period 1 • Weak incumbent accommodates in period 2 • Thus, a weak firm may “predate” to signal strength, keep entry out

14. Predation as Exploitation of Principal-Agent Problems • Bolton-Scharfstein (AER, 1990) • Basic logic: a bank will not give a firm unconditional funding, due to principal-agent problems in financing • Predation leads to poor firm performance which leads to a cutback in external financing, which may lead to exit

15. What is a “Principal-Agent” Problem? • This is the name used for a broad category of contract design problems that economists have studied in which one party, the "principal" tries to write a contract to induce another party "the agent" to achieve some outcome he likes.   • For instance, the owners of a firm want to write a contract to induce managers to maximize their profits.   Now, one might think that the optimal solution to this problem is simply to write a contract that says:   if you acheive x profit, the maximum possible, you are compensated with y dollars, otherwise you get zero. The reason that this contract won't be signed is due to future uncertainty.  Who knows if x profit is achievable?  Suppose the agent does everything right and still doesn't acheive x profit? Why would the agent sign such a contract? • Problems arise due to hidden actions and hidden information that manifest themselves after the contract is written.   •  Generally, principal agent problems highlight inefficiencies that come about due to an inability to write what is called a "complete contingent contract," a contract that specifies payoffs depending on all possible states of the world

16. Bolton/Scharfstein Model of Predation • Two firms, A & B. B depends on external financing. • Two periods with possible profit realizations π1 (low) and π2 (high) each period. • Firms incur fixed cost F each period • B and financier sign contract at time zero that specifies period 1 payment and probability of period 2 financing as a function of period 1 reported profits • Optimal contract terminates period 2 financing upon low reported period 1 profits • Possibility of predation changes optimal contract, and predation still sometimes occurs in equilibrium

17. Where Are We Now? • Consensus that welfare-reducing predation can happen • Semi-consensus that classic price predation is probably rare and difficult to identify • Difficulties in identification, and balancing type I vs. type II errors, lead courts to rely on price-cost tests + recoupment criteria

18. Legal Test • Brooke Group Test in US, other jurisdictions use similar criteria • Part 1: Finding Price Below Cost • Part 2: Finding Likelihood of Future Recoupment of Losses

19. Price-Cost Tests • Areeda-Turner test (P<AVC presumptively illegal) • Bolton, Baumol test (P<AAC/AIC presumptively illegal) • Joskow-Klevorick test (P<ATC presumptively illegal) • Problem is that none of these is either necessary or sufficient for harm from predation • Areeda-Turner probably most popular in United States • EC Article 82 Discussion Paper advocates P<AAC presumption of predation. AAC<P<ATC, may be predation but no presumption

20. Price-Cost Tests (2) Profit-Maximizing Price Profits P=ATC P=AAC Price P=AVC

21. Problems with Price-Cost Tests • Price below even marginal cost not always predatory • Introductory prices to promote consumer learning • Two-sided markets: price below “cost” on one side of market may be efficient • Network effects/scale economies may make below cost pricing efficient during initial periods • Price above cost may be predatory in some sense if strategy involves profit sacrifice and recoupment

22. Recoupment Criterion • Are market conditions susceptible to recouping losses? • Entry barriers • Few firms left to reap profits • Inelastic demand • Is this a market structure screen? Or a test for consumer harm?

23. Evidence of Price Predation • So rare that it minimizes errors to never prosecute it? There are some examples, both empirical and experimental, of actual predation • Case study #1: Sugar industry (Genesove and Mullin RAND 2006) • Case study #2: British shipping cartel (Scott Morton JEMS 1997) • Experimental evidence: (Jung, Kagel, and Levin RAND 1994)

24. US v. American Airlines (2001) • American’s response to LCC entry at DFW hub is low fares, more capacity. Is this competition or exclusion? • DOJ presents evidence that the expansion made no business sense unless it made the LCC’s pull back. • Recoupment possible due to reduction in competition on DFW routes and development of reputation. • DOJ advances four price-cost tests that various episodes fail. • American emphasizes price vs. short-run AVC • Court, focusing on American’s price test, rules for American in Summary Judgment phase

25. 3M v. LePages (2003, US private suit) • Disadvantaged competitor (LePages) alleges 3M used bundled discounts, exclusive deals to unfairly exclude it from transparent tape market • What is the standard for illegality? LePages never precisely defines. • 3M wants conduct evaluated under Brooke predation standard. • En banc Appeals court ultimately rules for LePages without defining a standard • Appeals court initially overturns District Court ruling for LePages, but reversed en banc. Supreme Court doesn’t hear case

26. Conclusion • Lack of clear economic (and legal) consensus about how to judge predation, exclusionary acts • Extreme care is required in prosecuting, since these “bad acts” (e.g., low prices, new marketing strategies) are hard to distinguish from intense competition, which antitrust laws are expressly designed to encourage • Articulating clear standards is important for consistency, continued evolution of thinking

27. Some References • Motta, Massimo, Competition Policy: Theory and Practice, Cambridge University Press, 2004 (in particular Section 7.2: “Predatory Pricing.”) • DG Competition discussion paper on the application of Article 82 of the Treaty to exclusionary abuses (Brussels, December 2005) • Easterbrook, F. (1981). “Predatory Strategies and Counterstrategies,” University of Chicago Law Review 48:263-337. • Kreps, D. and R.Wilson, 1982, “Reputation and Imperfect Information,” Journal of Economic Theory 27: 253-279. • Bolton, G. and D. Scharfstein, 1990, “A Theory of Predation Based on Agency Problems in Financial Contracting,” American Economic Review, 80: 93-106. • Milgrom, P. and J. Roberts, 1982, “Predation, Reputation and Entry Deterrence.”Journal of Economic Theory 27: 280-312. • David Genesove & Wallace Mullin, 2006, “Predation and its Rate of Return: The Sugar Industry 1887-1914,” RAND Journal of Economics 37(1): 47-69. • Scott Morton, F, 1997 “Entry and Predation: British Shipping Cartels 1879-1929.” Journal of Economics and Management Strategy 6:679-724. • Jung, Y.J. , J. Kagel,and D. Levin, 1994, "On the Existence of Predatory Pricing: An Experimental Study of Reputation and Entry Deterrence in the Chain-Store Game," RAND Journal of Economics 25(1): 72-93 . • United States of America v. AMR Corporation, American Airlines, Inc., and American Eagle Holding Corporation. 140 F. Supp. 2d 1141 (2001). • LePage’s Inc. v. 3M, 324 F.3d 141 (3d Cir. 2003), cert. denied, 124 S. Ct. 2932 (2004)