Chapter 12: Limit Pricing and Entry Deterrence 1 Limit Pricing and Entry Deterrence

Chapter 12: Limit Pricing and Entry Deterrence 2 Introduction A firm that can restrict output to raise market price has market power Microsoft (95% of operating systems) and Campbell’s (70% of tinned soup market) are giants in their industries 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? Answer: firms with monopoly power may –eliminate existing rivals –prevent entry of new firms These actions are predatory conduct if they are profitable only if rivals, in fact, exit –e.g., R&D to reduce costs is not predatory

Chapter 12: Limit Pricing and Entry Deterrence 3 Evolution of market structure Evolution of markets depends on many factors –one is relationship between firm size and growth Gibrat’s Law –begin with equal sized firms –each grows in each period by a rate drawn from a random distribution –this distribution has constant mean and variance over time –result is that firm size distribution approaches a log-normal distribution Very mechanistic –no strategy for growth Including strategic decision making affects distribution but not conclusion that firm sizes are unequal –What about the facts in the market place?

Chapter 12: Limit Pricing and Entry Deterrence 4 Monopoly power and market entry Several stylized facts about entry –entry is common –entry is generally small-scale so small-scale entry is relatively easy –survival rate is low: >60% exit within 5 years –entry is highly correlated with exit not consistent with entry being caused by excess profits “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

Chapter 12: Limit Pricing and Entry Deterrence 5 Predatory conduct 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 Outcome of either action is the same—the monopolist retains control of the market Legal action focuses on predatory pricing because this case has an identifiable victim –a firm that was in the market but that has left Consider first a model of limit pricing –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

Chapter 12: Limit Pricing and Entry Deterrence 6 A limit pricing model AC e MC e $/unit Quantity These are the cost curves for the potential entrant These are the cost curves for the potential entrant D(P) = Market Demand Assume that the incumbent commits to output Q 1 Assume that the incumbent commits to output Q 1 Q1Q1 Then the entrant’s residual demand is R 1 = D(P) - Q 1 Then the entrant’s residual demand is R 1 = D(P) - Q 1 R1R1 With the residual demand R 1, the entrant can operate profitably. Entry is not deterred by the incumbent choosing Q 1. With the residual demand R 1, the entrant can operate profitably. Entry is not deterred by the incumbent choosing Q 1. Assume instead that the incumbent commits to output Q d The entrant’s residual demand is R e = D(P) - Q d The entrant’s residual demand is R e = D(P) - Q d QdQd ReRe MR e qeqe PePe Then the entrant’s marginal revenue is MR e The entrant equates marginal revenue with marginal cost The entrant equates marginal revenue with marginal cost At price P e entry is unprofitable At price P e entry is unprofitable QdQd PdPd By committing to output Q d the incumbent deters entry. Market price P d is the limit price

Chapter 12: Limit Pricing and Entry Deterrence 7 Limit pricing Committing to output Q d 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? –could be claimed to be ad hoc to support the theory even if it holds, is monopoly at output Q d better than Cournot? –may not be if the entrant’s costs are low enough Credibility may relate output to capacity

Chapter 12: Limit Pricing and Entry Deterrence 8 Capacity expansion and entry deterrence For predation to be successful and rational –the incumbent must convince the entrant that the market after the entrant comes in will not be profitable one How can the incumbent credibly make this threat? One possible mechanism –install capacity in advance of production installed capacity is a commitment to a minimum level of output the lead firm can manipulate entrants through capacity choice the lead firm may be able to deter entry through its capacity choice –but is this credible? –capacity must be costly to install and should be irreversible

Chapter 12: Limit Pricing and Entry Deterrence 9 The Dixit model Consider a two-stage game –incumbent in period 1 installs capacity capacity K 1 costs r.K 1 to install in second period incumbent can produce up to K 1 at unit cost w capacity can be expanded in period 2 at additional cost r per unit capacity cannot be reduced in period 2 –potential entrant in period 2 observes incumbent’s capacity choice to enter and produce incumbent needs capacity K 2 which costs r.K 2 unit cost of production is w note: entrant will never install unused capacity –if entry takes place firms play a Cournot game in the second period Market demand: P = A – B(q 1 + q 2 )

Chapter 12: Limit Pricing and Entry Deterrence 10 The Dixit model 2 Costs for the incumbent are: –C 1 = F 1 + w.q 1 + r.K 1 for q 1 < K 1 ; marginal cost w –C 1 = F 1 + (w + r)q 1 for q 1 > K 1 ; marginal cost w + r Costs for the entrant are: –C 2 = F 2 + (w + r)q 2 ; marginal cost w + r Standard Cournot analysis gives the best response functions: –q* 1 = (A – w)/2B – q 2 /2 when q 1 < K 1 –q* 1 = (A – w – r)/2B – q 2 /2 when q 1 > K 1 –q* 2 = (A – w – r)/2B – q 1 /2provided that q* 2 > 0 for the entrant to enter it must expect to cover the sunk costs F 2 this implies a lower limit on the output that the entrant must make

Chapter 12: Limit Pricing and Entry Deterrence 11 The Dixit model 3 The incumbent’s best response function has a break in it at K 1 q2q2 q1q1 L’ L N’ N K1K1 The entrant’s best response function has a break where sunk costs are not covered R’ R Equilibrium depends upon these two breaks

Chapter 12: Limit Pricing and Entry Deterrence 12 The Dixit model 4 Consider the possibilities q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 Suppose that firm 2 enters Equilibrium must lie between T and V Where depends upon location of the break in R’R Firm 1’s output is greater than T 1 and smaller than V 1 So capacity choice lies between T 1 and V 1

Chapter 12: Limit Pricing and Entry Deterrence 13 The Dixit model 5 Now suppose that firm 2 does not enter q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 Must be that it cannot break even at output less than T 2 Then firm 1 would want to choose capacity M 1 –this is the monopoly output with MC = w + r M1M1 M2M2 S M 1 is actually the Stackelberg output level for firm 1 –firm 1 as market leader will never choose output and capacity less than M 1

Chapter 12: Limit Pricing and Entry Deterrence 14 The Dixit model 6 Suppose that the break in the entrant’s best response function lies at B L in R’T q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 M1M1 M2M2 S BLBL Incumbent chooses capacity M 1 and entry is deterred Suppose that the break in the entrant’s best response function lies at B S in TS BSBS Incumbent chooses capacity M 1 and entry is deterred Suppose that the break in the entrant’s best response function lies at B L in VR Incumbent chooses capacity M 1 and entry is accommodated BLBL

Chapter 12: Limit Pricing and Entry Deterrence 15 The Dixit model 7 Now suppose that the break in the entrant’s best response function lies at B* in SV q2q2 q1q1 L’ L N’ N R’ R T V T2T2 T1T1 V2V2 V1V1 M1M1 M2M2 S Incumbent can choose to install capacity M ! and share the market Or install capacity B ! and maintain monopoly in the market B1B1 Choice depends upon relative profitability –If B* is “close to” S then use capacity to deter entry –If B* is “close to” V then accommodate entry as Stackelberg leader B*

Chapter 12: Limit Pricing and Entry Deterrence 16 Capacity expansion and entry deterrence 2 An example: –P = Q = (q 1 + q 2 ) –marginal cost of production $60 for incumbent and entrant –cost of each unit of capacity is $30 –firms also have fixed costs of F –incumbent chooses capacity K 1 in stage 1 –NOTE: incumbent will always produce at least K 1 in production stage—otherwise it throws away revenue that could help cover the cost of installed capacity –entrant chooses capacity and output in stage 2 –firms compete in quantities in stage 2.

Chapter 12: Limit Pricing and Entry Deterrence 17 Entry deterrence Entry may not occur –entrant’s costs are too high blockaded entry not predatory Entry may be accommodated –entrant’s costs are low incumbent takes advantage of its being first in the market but does not deter Entry may be strategically deterred –strategic deterrence profitable for the incumbent –installs excess capacity as an entry-deterring strategy –uses a credible commitment

Chapter 12: Limit Pricing and Entry Deterrence 18 Preemption and the persistence of monopoly A distinct but related issue is an incumbent investing early to prevent new entry –market may be a natural monopoly at current size –but expected to grow and attract entry Now we have an issue of timing It may be in the interests of an incumbent to preempt by –building new plants prior to a rival’s entry –adding new products prior to a rival’s entry Related to another issue –entrant may race to innovate to preempt entry A simple model:

Chapter 12: Limit Pricing and Entry Deterrence 19 Preemption and the persistence of monopoly 2 A simple market with an incumbent –current profit  M –market is expected to double in the next period and stay at the new size in perpetuity –to meet the new demand requires additional capacity at cost of F –the new capacity can be added: In first period or in second period By incumbent or by new entrant With no threat of entry –incumbent installs new capacity at beginning of second period –profit is 2  M minus cost of capacity With threat of entry may need to install capacity early

Chapter 12: Limit Pricing and Entry Deterrence 20 Preemption and the persistence of monopoly 3 Consider the entrant choosing in period 1 –suppose that competition is Cournot if entry occurs –entry in period 1 gives the entrant  e 1 =  C + 2  C /(1 – R) - F R is the discount factor = 1/(1+r) where r is the discount rate –entry in period 2 gives the entrant  e 2 = 2  C /(1 – R) – RF in present value terms –suppose  e 1 <  e 2 which implies (1 + r)  C < r.F –entrant will enter in the second period

Chapter 12: Limit Pricing and Entry Deterrence 21 Preemption and the persistence of monopoly 4 What about the incumbent? –do nothing in period 1 entry takes place in period 2 earns 2  C /(1 – R) –install additional capacity in period 1 entry deterred earns 2  M /(1 – R) – F –install capacity early provided that 2(  M -  C )/(1 – R) > F provided that present value of additional profit from protecting monopoly is greater than the fixed cost Incumbent wants to maintain monopoly; entrant only shares in non-cooperative profits

Chapter 12: Limit Pricing and Entry Deterrence 22 Market preemption Why does the incumbent have a stronger incentive to invest “early”? –the incumbent is protecting a valuable monopoly –the entrant is seeking a share of the market –so the incumbent’s incentive is stronger –willing to incur initial losses to maintain market control

Chapter 12: Limit Pricing and Entry Deterrence 23 Evidence on predatory expansion Some anecdotal evidence Alcoa –evidence that consistently expanded capacity in advance of demand Safeway in Edmonton –evidence that it aggressively expanded store locations in response to potential entry DuPont in titanium oxide –rapidly expanded capacity in response to to changes in rivals’ costs –market share grew from 34% to 46%