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. Review of 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.

3. Dominant firm’s demand is: D D (P) = D(P) - n*S(P) Industry Quantity Price N*S(P) = Fringe Supply D(P) At prices above this point, fringe supplies everything D D (P)

4. Dominant firm maximizes:P*D D (P) - c D (D D (P)). –Sets MR = MC Industry Quantity Price N*S(P) = Fringe Supply D(P) D D (P) MR D (P)MC D qDqD

5. Fringe supplies based on price set by dominant firm. Industry Quantity Price N*S(P) = Fringe Supply D(P) D D (P) MR D (P)MC D qDqD P* qFqF

6. Implications of Dominant Firm and Competitive Fringe Model Dominant firm supplies where MR D = MC D. –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.

7. 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.

8. Summary of 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 quantity and 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.

9. Industry Quantity Price D(P) Residual demand for PE qLqL

10. Industry Quantity Price D(P) MC PE ATC PE qLqL D PE MR PE q* At q*, entrant’s profit is negative

11. Critiques of Limit Pricing and Quantity Commitment Model Will incumbent really produce at q L 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.

12. Credibility of Threats “Threats” are actually just statements about what players will do in future rounds. For a threat to be credible, it must be optimal for the person making the threat to carry it through.

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

14. 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?

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

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

21. 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.

22. Capacity Expansion, con’t In a Cournot game with two firms, quantity produced is a function of the firms, MC. –BR for firm i: q i = (A+c j -2c i )/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.

23. Best Responses of the Two Firms qIqI q PE K 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 = q* I

24. 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?

25. Finding the Optimal K qIqI q PE Monopolist’s optimal quantity Minimum that Incumbent will produce if PE enters Max. PE will produce Maximum that Incumbent will produce if PE enters Min. PE will produce

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

27. 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”.

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

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

30. 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.

31. 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.

32. 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.

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

34. Limit Pricing con’t If incumbent is a low cost firm, pricing low will always provide as much profit as pricing high, so he will always price low if he is 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.

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

36. 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.

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