1. Entry Deterrence and Predation
Chapter 9: Entry Deterrence and Predation

2. Chapter 9: Entry Deterrence and Predation
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 9: Entry Deterrence and Predation

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 9: Entry Deterrence and Predation

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 9: Entry Deterrence and Predation

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 9: Entry Deterrence and Predation

6. A limit pricing model By committing to output Qd the incumbent deters
entry. Market price Pd
is the limit price
A limit pricing model
Then the entrant’s residual demand is
R1 = D(P) - Q1
These are the cost curves
for the potential entrant
With the residual demand R1, the entrant can operate profitably. Entry is not deterred by the
incumbent choosing Q1.
$/unit
Then the entrant’s marginal revenue is MRe R1
At price Pe entry is
unprofitable
The entrant’s residual
demand is
Re = D(P) - Qd
The entrant equates
marginal revenue
with marginal cost
MCe Pd
Assume instead that the incumbent commits to output Qd
ACe
Assume that the
incumbent commits
to output Q1 Pe
D(P) = Market Demand Re
MRe
Quantity qe Qd Q1 Qd
Chapter 9: Entry Deterrence and Predation

7. Chapter 9: Entry Deterrence and Predation
Limit pricing
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?
could be claimed to be ad hoc to support the theory
even if it holds, is monopoly at output Qd better than Cournot?
may not be if the entrant’s costs are low enough
Credibility may relate output to capacity
Chapter 9: Entry Deterrence and Predation

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 9: Entry Deterrence and Predation

9. Chapter 9: Entry Deterrence and Predation
The Dixit model
Consider a two-stage game
incumbent in period 1 installs capacity
capacity K1 costs r.K1 to install
in second period incumbent can produce up to K1 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 K2 which costs r.K2
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(q1 + q2)
Chapter 9: Entry Deterrence and Predation

10. Chapter 9: Entry Deterrence and Predation
The Dixit model 2
Costs for the incumbent are:
C1 = F1 + w.q1 + r.K1 for q1 < K1; marginal cost w
C1 = F1 + (w + r)q1 for q1 > K1; marginal cost w + r
Costs for the entrant are:
C2 = F2 + (w + r)q2 ; marginal cost w + r
Standard Cournot analysis gives the best response functions:
q*1 = (A – w)/2B – q2/2 when q1 < K1
q*1 = (A – w – r)/2B – q2/2 when q1 > K1
q*2 = (A – w – r)/2B – q1/2 provided that q*2 > 0
for the entrant to enter it must expect to cover the sunk costs F2
this implies a lower limit on the output that the entrant must make
Chapter 9: Entry Deterrence and Predation

11. Chapter 9: Entry Deterrence and Predation
The Dixit model 3 q2
The incumbent’s best response function has a break in it at K1 L’
The entrant’s best response function has a break where sunk costs are not covered N’ R’ R
Equilibrium depends upon these two breaks N L q1 K1
Chapter 9: Entry Deterrence and Predation

12. Chapter 9: Entry Deterrence and Predation
The Dixit model 4 q2 q1 L’ L N’ N R’ R
Consider the possibilities
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 T1 and smaller than V1 T T2 V
So capacity choice lies between T1 and V1 V2 T1 V1
Chapter 9: Entry Deterrence and Predation

13. Chapter 9: Entry Deterrence and Predation
The Dixit model 5 q2 q1 L’ L N’ N R’ R T V T2 T1 V2 V1
Now suppose that firm 2 does not enter
Must be that it cannot break even at output less than T2
Then firm 1 would want to choose capacity M1
this is the monopoly output with MC = w + r
M1 is actually the Stackelberg output level for firm 1
firm 1 as market leader will never choose output and capacity less than M1 S M2 M1
Chapter 9: Entry Deterrence and Predation

14. Chapter 9: Entry Deterrence and Predation
The Dixit model 6 q2 q1 L’ L N’ N R’ R T V T2 T1 V2 V1 M1 M2 S
Suppose that the break in the entrant’s best response function lies at BL in R’T
Incumbent chooses capacity M1 and entry is deterred
Suppose that the break in the entrant’s best response function lies at BS in TS BL BS
Incumbent chooses capacity M1 and entry is deterred BL
Suppose that the break in the entrant’s best response function lies at BL in VR
Incumbent chooses capacity of Stackelberg leader output M1 and entry is accommodated
Chapter 9: Entry Deterrence and Predation

15. Chapter 9: Entry Deterrence and Predation
The Dixit model 7
Now suppose that the break in the entrant’s best response function lies at B* in SV q2 q1 L’ L N’ N R’ R T V T2 T1 V2 V1 M1 M2 S
Incumbent can choose to install capacity of Stackelberg leader output and share the market
Or install capacity B1 and maintain monopoly in the market B*
Choice depends upon relative profitability B1
If B* is “close to” S then use capacity to deter entry
If B* is “close to” V then accommodate entry as Stackelberg leader
Chapter 9: Entry Deterrence and Predation

16. Capacity expansion and entry deterrence 2
An example:
P = Q = (q1 + q2)
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 K1 in stage 1
NOTE: incumbent will always produce at least K1 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 9: Entry Deterrence and Predation

17. Chapter 9: Entry Deterrence and Predation
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 9: Entry Deterrence and Predation

18. 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%
Chapter 9: Entry Deterrence and Predation

19. Introduction of Predatory Pricing
Charges of predatory conduct are not new
Microsoft is only one of the latest
goes back to the days of Standard Oil
more recent examples of predatory pricing
Wal-Mart
AT&T
American Airlines
But they face problems of credibility
price low to eliminate rivals
then raise price
so why don’t rivals reappear?
Chapter 9: Entry Deterrence and Predation

20. Predatory pricing: myth or reality?
Theoretical and empirical doubts
predation is generally not subgame perfect without uncertainty regarding the incumbent
return to this below
McGee’s argument that predation is dominated by another strategy
merger is more profitable than predation
so predation should not happen
take an example
two period market
inverse demand P = A – B(qL + qF)
qF is output of leader and qF is output of follower
leader is a Stackelberg quantity leader
both leader and follower have constant marginal costs of c
Chapter 9: Entry Deterrence and Predation

21. An example of predation
At the Stackelberg equilibrium
leader makes (A – c)2/8B
follower makes (A – c)2/16B
if the leader were a monopolist it would make (A – c)2/4B
Suppose that the leader predates in period 1
sets output (A – c)/B to drive price to marginal cost
follower does not enter
leader reverts to monopoly output in period 2 but the follower does not enter
aggregate profit is (A – c)2/4B
Chapter 9: Entry Deterrence and Predation

22. An example of predation 2
Suppose instead that the leader offers to merge with the follower in period 1
monopoly in both periods
aggregate profit (A – c)2/2B
so the leader can make a merger offer that the follower will accept
Merger is more profitable than predation but:
merger may not be allowed by the authorities
monopoly power
what if there are additional potential entrants?
may enter purely in the hope of being bought out
Main point remains: threat of predation has to be credible if it is to work
Chapter 9: Entry Deterrence and Predation

23. Predation and imperfect information
Suppose that the entrant faces financial constraints
must borrow to finance entry
Entrant also faces uncertainty pre-entry
faces some probability of “low” returns
private information that can be concealed from bank
incentive to misrepresent
bank must then enforce removal of funding if low returns are reported
Incumbent then has incentive to take actions that increase probability of failure
Chapter 9: Entry Deterrence and Predation

24. Asymmetric information and limit pricing
The preemption “games” are ways of resolving the Chain-store paradox
indicate that it is rational for incumbents to make investments that are not profitable unless they deter entry
An alternative approach: information structure
suppose that an entrant does not have perfect information about the incumbent’s costs
if the incumbent is low cost do not enter
if the incumbent is high-cost enter
does a high-cost incumbent have an incentive to pretend to be low-cost - to prevent entry?
for example by pricing as a low-cost firm
Chapter 9: Entry Deterrence and Predation

25. Chapter 9: Entry Deterrence and Predation
A (simple) example
Incumbent has a monopoly in period 1
Threat of entry in period 2
Market closes at the end of period 2
Entrant observes incumbent’s actions in period 1
These actions determine whether or not to enter in period 2
Incumbent is expected to be high-cost or low-cost
no direct information on costs
entrant knows that there is a probability p that the incumbent is low-cost
Need to specify pay-offs in different situations
Chapter 9: Entry Deterrence and Predation

26. Chapter 9: Entry Deterrence and Predation
The Example 2
Incumbent profits in period 1 (in $million)
low-cost firm acting as low-cost monopolist: $100m
high-cost firm acting as high-cost monopolist: $60m
high-cost adopting low-cost monopoly price: $40m
Incumbent profits in period 2
if no entry, profits according to true type
if entry occurs:
low-cost incumbent: $50m
high-cost incumbent: $20m
Entrant’s profits in period 2
competing against a low-cost incumbent: -$20,
competing against a high-cost incumbent: $20m
Chapter 9: Entry Deterrence and Predation

27. Chapter 9: Entry Deterrence and Predation
The Example 3
Incumbent: = 80 Entrant: 20
Enter
High Price
Incumbent: = 120 Entrant: 0 E3
Stay Out
High-Cost
Incumbent: = 60 Entrant: 20 I1
Enter
Low Price
Nature E4
Incumbent: = 100 Entrant: 0
Stay Out
Low-Cost I2
Enter
Incumbent: = 150 Entrant: -20
Low Price E5
Incumbent: = 200 Entrant: 0
Stay Out
Chapter 9: Entry Deterrence and Predation

28. the entrant enters if the incumbent is high-cost
With uncertainty and
a low price the entrant
does not know if
he is at E4 or E5
With no uncertainty
the entrant enters if the
incumbent is high-cost
The example 4
Nature
High-Cost
Low-Cost I1 I2
High Price
Low Price E3 E4
Enter
Stay Out
Incumbent: = 80 Entrant: 20
Incumbent: = 120 Entrant: 0
Incumbent: = 60 Entrant: 20
Incumbent: = 100 Entrant: 0 E5
Incumbent: = 150 Entrant: -20
Incumbent: = 200 Entrant: 0
Chapter 9: Entry Deterrence and Predation

29. Chapter 9: Entry Deterrence and Predation
The example 3
Consider a high-cost incumbent
high price in period 1 - entry happens, profits are 80
low price in period 1 - if no entry profits are 100
low price in period 1 - if entry profits are 60
A high-cost incumbent has an incentive to pretend to be low-cost
The entrant knows this
So a low-price of itself will not deter entry
it is not a true signal of the incumbent’s type
Only the probability that low-price means low-cost deters entry
Chapter 9: Entry Deterrence and Predation

30. Chapter 9: Entry Deterrence and Predation
The example 4
Consider the profits of the entrant given that the incumbent sets a low-price in period 1
if the incumbent is high-cost - profit is 20 with probability 1 - p
if the incumbent is low-cost - profit is -20 with probability p
so expected profit is 20(1 - p) - 20p = p
Will the entrant not enter when it sees a low price?
Only if p > 1/2
Only if there is a “sufficiently high” probability that the incumbent is low cost.
Provided that pretence is expected to work a high-cost incumbent has an incentive to set a limit price
Chapter 9: Entry Deterrence and Predation

31. Limit pricing and uncertainty
Monopoly power can persist even if the incumbent is high-cost
Entry only takes place if entrants believe that the incumbent is high-cost
so entry is more likely when incumbents are expected to be weak
entry then consistent with exit: efficient entrants drive out inefficient incumbents
Chapter 9: Entry Deterrence and Predation

32. Limit pricing and uncertainty 2
Note: the model shows how a high-cost firm can deter entry.
However, to do this it must set a low price.
This is how it “fools” the would-be entrant.
The threat of entry forces the incumbent to price below the monopoly price it would otherwise set
This lower limit price therefore mitigates the resource misallocation effects of monopoly.
Chapter 9: Entry Deterrence and Predation

33. Predatory Conduct and Public Policy
The evidentiary requirements for prosecuting predatory pricing cases are high
Pricing below cost
The predator had a reasonable expectation of recouping the losses
Very hard to distinguish predation from other pro-competitive behavior
Hard to measure marginal cost
Learning curves, network effects, and other externalities
Chapter 9: Entry Deterrence and Predation