ECON 115
1. Review Second Midterm 2. Final Problem Set (homework) 3. Predation and Limit Pricing 4. The Story of Alcoa 5. Alternative Views of Predation 6. Some Empirical Evidence
First Hour Review the midterm Hand out the problem set Introduction to predatory behavior. Limit pricing in theory. Credibility and capacity The story of Alcoa Second Hour Predatory conduct versus mergers: which is more effective? Imperfect information and predatory conduct Return to limit pricing Empirical analysis: testing for the presence of entry deterrence in the pharmaceutical business How to work a limit pricing problem
This is our final new lecture in IO. It will introduce the idea of predatory behavior; specifically limit pricing. We ll examine what limit pricing is, how it works and when it makes sense to use it. We will also look at two empirical examples of limit pricing. Limit pricing will be part of the final, so pay attention!
A firm that can restrict output to raise market price has market power. Microsoft (95% of operating systems in 2008!!) Campbell s (70% of can soup market) Why can t rivals compete away those positions? Why aren t new rivals lured in by high profits? Answer: firms with monopoly power may eliminate existing rivals prevent entry of new firms These actions are predatory conduct if they are profitable and if they drive out rivals. e.g., R&D to reduce costs is not predatory
Evolution of markets depends on many factors. Several stylized facts about entry Entry is common; Entrants are generally small-scale; Survival rate is low: >60% exit within 5 years; Entry is highly correlated with exit.
Interestingly, studies show that entry/exit is not consistent with the presence of excess profits. Rather, it seems to be an ongoing revolving door, which reflects repeated attempts by small firms to penetrate markets dominated by large firms. This does not necessarily prove predatory conduct. Surviving firms may possess superior technology, be more efficient or have better locations. But it may... Therefore, we need to understand predation if we are to identify it.
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 there exists an identifiable victim: a firm that was in the market but has left.
We are going to consider a model of limit pricing using what was developed previously, specifically the Stackelberg Model. Recall that the Stackelberg leader chooses output first. We also assume that: The entrant believes that the leader is committed to this output choice; and the entrant has decreasing costs over some initial level of output.
Then the entrant s residual demand is $/unit R 1 = D(P) - Q 1 P d P e R 1 q e MR e MC e AC e These are the cost curves for the potential entrant With the residual demand R 1, the entrant can operate profitably. Entry is not deterred by the incumbent choosing Q 1. Q d R e Q d Assume that the incumbent D(P) = Market commits Demand Q 1 to output Q 1 Quantity 10
$/unit P d P e Then the entrant s marginal revenue is MR e R 1 q e MR e At price P e entry is unprofitable Q d MC e R e AC e Q d The entrant equates marginal revenue with marginal cost D(P) = Market Demand Q 1 By committing to output Q d the incumbent deters entry. Market price P d is the limit price Assume instead that the incumbent commits to output Q d Quantity The entrant s residual demand is R e = D(P) - Q d 11
Committing to output Q d may be aimed either at eliminating an existing rival or driving away 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. 10
For predation to be successful and rational, the incumbent must convince the entrant that after it enters, the second firm will not find the market a profitable one. How can the incumbent credibly make this threat? Limit pricing only works if an incumbent can commit to producing limit output even if entry occurs. Therefore, credibility may hinge on capacity. 13
One possible mechanism: install capacity in advance of production. Installed capacity represents a commitment to a minimum level of output. The lead firm can manipulate entrants and perhaps deter entry through its capacity choice. But is this credible? Yes, if capacity is costly to install and irreversible. 14
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. The incumbent is willing to incur initial losses to maintain market control. 15
Some anecdotal evidence Alcoa Evidence that it consistently expanded capacity in advance of demand Safeway in Edmonton Evidence it aggressively expanded store locations in response to potential entry. DuPont in titanium oxide Rapidly expanded capacity in response to increases in rivals costs 16
Safeway DuPont Market: Edmonton, Ontario Titanium Oxide At start of period : 1964 At start of period: 1970 Safeway 25 stores; competitors 21 Safeway expands outlets; targets competitors locations and growth areas. Competitors falter DuPont 34% of market share High production costs & regulations hamper competitors. DuPont expands production by 60% At end of period: 1973 At the end of period: 1977 Safeway 35 stores; competitors 10 DuPont has 46% market share.
The Story of Alcoa (Aluminum Company of America) Aluminum discovered in 1807 Charles Hall discovers 1 st successful method for making aluminum in 1886. Hall founds Pittsburg Reduction Company in 1888 (renamed Alcoa in 1907). At the time of the company s founding, there were no known end uses for aluminum and the company had 0 customers.
The Story of Alcoa, continued Alcoa proceeds to create the aluminum market. Develops and promotes uses for aluminum: Wire Medical instruments Cooking utensils Alcoa reduces production costs: It discovers and exploits cheap bauxite from Arkansas; It constructs its own dams to obtain cheap hydroelectric power.
The Story of Alcoa, continued From 1910 1937 various business tried to enter and aluminum ingot market. None could dislodge Alcoa because: They constantly innovated to improve quality. They relentlessly drove down costs! Year Q (lb. of AL) P ($ per lb.) 1889 18,250 lb. $3.00 1937 500,000,000 lb. $.22
The History of Government vs. Alcoa 1912 Court extracts a consent degree no restrictive covenants [abandoned practice prior to 1912] 1925 FTC investigates charges of monopolization; in 1929, FTC exonerates Alcoa of charges. In 1937, the government again attacked Alcoa under the Sherman Antitrust Act.
In 1941, Judge Caffey ruled on the case and ultimately decided Alcoa was innocent of violating the Sherman Act. Dismissed Alcoa s use of restrictive agreements (it had a patent at the time). Found no monopoly over bauxite (controlled only 48% in Arkansas; nothing in other states). Found no monopoly over water power (had only 5 hydroelectric plants out of 1883 in the US).
Judge Caffey s ruling, continued. Dismissed Alcoa s monopoly of aluminum (found Alcoa made their own and nothing prevented other companies making aluminum). Found they were not illegally monopolizing aluminum sales (they earned their monopoly position through market competition). Found further there was substantial competition in the form of scrap and close substitutes such as steel, nickel, lead, copper.
Predictably, the government appealed Judge Caffey s ruling. The appeal was heard in 1944 and partially overturned. The appellate court s ruling was written by the famous American jurist, Learned Hand (real name).
Hand ruled Caffey had defined the aluminum ingot market incorrectly by excluding ingot made by Alcoa for its own use and including the scrap market. Once the former was included and the latter excluded, Hand transformed Alcoa s market share from 33% to 90%. (Substitute goods are often included in market definitions, so Hand was probably wrong.) Now supported by his analysis, Hand could rule that Alcoa was a monopoly.
Hand argued that Alcoa s superior skill, foresight and industry were exclusionary. He further argued they forestalled competition in part by stimulating demand and in anticipation doubled and redoubled its capacity. Thus Alcoa was condemned for being an efficient single supplier.
Ironically, the court refused to dissolve an aggregation which for so long has demonstrated its efficiency... Instead it hoped that many of the government s aluminum plants would be sold to other companies to create competition. That implemented after World War II, which enable Reynolds and Kaiser Aluminum to come into being.
We are going to finish with looking at limit pricing from three perspectives. (1)Why merging may be better than limit pricing to compete with potential new entrants. (2)Why asymmetric information may encourage firms to engage in limit pricing to deter entry. (3)Finally, we will look at a somewhat arcane example that gives some credence to the existence of predatory behavior. 28
Charges of predatory conduct are not new. Microsoft is only one of the latest examples. Claims go back to Standard Oil. More recent examples of predatory pricing are: Wal-Mart AT&T American Airlines Is predatory pricing believable? The logic is to price low to eliminate rivals and then to raise prices. Question: why don t rivals reappear? 29
There are theoretical doubts about predation. Theoretically, it is argued that predation is generally not subgame perfect. Selten: if a strategy chosen at the start of the game is optimal, it must be optimal throughout. This may be true with perfect information. McGee s ( 58, 80) also argued that predation is dominated by another strategy. Merger may be more profitable than predation. Therefore, predation should not happen. 30
Predatory pricing: myth or reality? To illustrate McGee, take this example: two period market inverse demand P = A B(q L + q F ) q L is output of leader and q F is output of follower leader is a Stackelberg quantity leader both leader and follower have constant marginal costs of c 31
An example of predation, continued At the Stackelberg equilibrium:* leader makes profit = (A c) 2 /8B follower makes (A c) 2 /16B if the leader were a monopolist it would make (A c) 2 /4B * Lecture 11, Slide 15 32
An example of predation, continued Suppose that the leader engages in predatory pricing in period 1 and sets output (A c)/b to drive price to marginal cost. The follower likely will not enter. Leader reverts to monopoly output in period 2; the follower still does not enter. Aggregate profit is (A c) 2 /4B 33
Alternatively, suppose that the leader offers to merge with the follower in period 1. Together they enjoy a monopoly in both periods. Aggregate profit = (A c) 2 /2B Therefore, the leader can make a merger offer that the follower will accept and be better off profit-wise. 34
Monopoly quantity = (A c)/2b Stackelberg Duopoly quantity L = (A c)/2b profit L = (A c) 2 /8B profit = (A c) 2 /4B quantity F = (A c)/4b profit F = (A c) 2 /16B
Merger is more profitable than predation, but: Merger may not be allowed by the authorities due to monopoly power. Also, what if additional potential entrants enter purely in the hope of being bought out? Main point remains: the threat of predation has to be credible if it is to work. 36
Suspicion of the reality of predation is associated with the Chicago School, which is very pro-market. Their thinking became dominant idea in the 70s and 80s. However, post-chicago economists have revitalized the idea of predation by focusing on imperfect information. We will examine two types of games: 1)Where the entrant has unique financial information about itself (but the bank doesn t!). 2)Where the entrant does not have good 37 information about its rival s costs.
As we will see, these preemption games are ways of resolving the Chain-store paradox. By indicating where it is rational for incumbents to make investments that a) are not profitable but which are pursued nonetheless because b) they deter entry. 38
The first example of imperfect information assumes a 2-period game where the entrant faces financial constraints; it must borrow to finance entry. Bank because it lacks reliable information about the entrant requires success in the first period to fund the entrant in the second. 39
Incumbent therefore has incentive to take actions that increase probability of failure. By cutting prices low in the first period, the incumbent sacrifices profits but raises the probability of the entrant s failure. This increases its chances of being a monopolist in the second period. 40
A second example involves asymmetric information and limit pricing. Suppose 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 A high-cost incumbent may have an incentive to pretend to be low cost to prevent entry perhaps by pricing as a low-cost firm. 41
Example of preemption using costs, continued. Incumbent has a monopoly in period 1; entry is threatened 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 either a high-cost or low-cost firm. The entrant has no direct information on costs, but the entrant knows that there is a probability p that the incumbent is low-cost. Need to specify pay-offs in different situations. 42
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 (low or high cost) 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 43
Enter Incumbent: 60 + 20 = 80 Entrant: 20 Nature High-Cost Low-Cost High Price I 1 Low Price E 3 E 4 Stay Out Enter Stay Out Incumbent: 60 + 60 = 120 Entrant: 0 Incumbent: 40 + 20 = 60 Entrant: 20 Incumbent: 40 + 60 = 100 Entrant: 0 I 2 Low Price Enter Incumbent: 100 + 50 = 150 Entrant: -20 E 5 Stay Out Incumbent: 100 + 100 = 200 Entrant: 0 44
With no uncertainty the entrant enters if the incumbent is high-cost Enter With uncertainty and a low price the entrant does not know if he is at E 4 or E 5 Incumbent: 60 + 20 = 80 Entrant: 20 Nature High-Cost Low-Cost High Price I 1 Low Price E 3 E 4 Stay Out Enter Stay Out Incumbent: 60 + 60 = 120 Entrant: 0 Incumbent: 40 + 20 = 60 Entrant: 20 Incumbent: 40 + 60 = 100 Entrant: 0 I 2 Low Price Enter Incumbent: 100 + 50 = 150 Entrant: -20 E 5 Stay Out Incumbent: 100 + 100 = 200 Entrant: 0 45
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. Therefore, a low-price in and of itself will not deter entry because it is not a true signal of the incumbent s type. Only the probability that low-price means lowcost deters entry. 46
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 = 20-40p Will the entrant not enter when it sees a low price? Only if p > ½ which means there is a sufficiently high probability that the incumbent is low cost. Provided that pretense is expected to work, a highcost incumbent has an incentive to set a limit price. 47
Monopoly power can persist even if the incumbent is high-cost. Entry only takes place if entrants believe that the incumbent is high-cost. Therefore, entry is more likely when incumbents are expected to be weak. 48
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. 49
The evidentiary requirements for prosecuting predatory pricing cases are high. Pricing below cost (Areeda and Turner) 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 50
It is difficult to test in a statistical sense for systematic entry deterrence. We need to identify markets: where entry was likely; and where the incumbent could do something to limit entry where deterrent actions can be identified Incumbent may not take any action if entry is not likely or if there is little it can do to stop entry. Incumbent may take action if entry is fairly likely in an effort to limit the number coming in. Efforts by incumbent to build brand loyalty may seem like entry deterrence but it may instead result in incumbent not needing to price aggressively when a rival enters, which makes entry easier. 51
Ellison and Ellison (2006) try to overcome these issues in a recent study of the pharmaceutical industry They look at the advertising behavior of companies in the case of 64 drugs about to lose their patents. Their first step is to identify those markets where entry following patent expiration was likely. 52
What is predatory or entry-deterring behavior here? Ellison and Ellison focus on advertising. They note that when one firm advertises a prescription drug, the benefits of that advertising spill over to rivals. The decision-makers with respect to pharmaceuticals are doctors. They will have a keen sense of the chemical identity of generic competitors. If an advertisement trumpets the ability of a particular statin to lower cholesterol, doctors understand that near identical statins will have the same effect. In this environment, an incumbent wishing to deter entry may advertise LESS. 53
Ellison & Ellison (2006) estimate the following equation: Advertising it Advertising i 1 = [ 1 Low + 2 Medium + 3 High]Time + i The dependent variable measures advertising for each firm i in each of the 12 months just prior to the patent expiration relative to the average level of advertising in each of the 24 months before that. 54
On the right-hand-side, the coefficient on the-time-topatent-expiration variable depends on what probability of entry category for that market Ellison and Ellison argue any entry-deterring efforts will only occur in the middle group. No need to deter entry when probability is Low Impossible to deter entry when probability is High So, given our understanding of entry deterrence, advertising should be low in Medium probability markets. That is, 2 should be negative. 55
Ellison & Ellison (2006) estimates are shown below: Advertising Intensity Time Trend By Category of Entry Probability, 64 Pharmaceutical Markets Coefficient Estimated Value Standard Error 1-0.007 0.013 2-0.032 0.009 3 0.009 0.007 2 is significantly negative. Firms facing a medium probability of entry after patent expiration do reduce their advertising in the months prior to that date. Some mild support for entry deterring behavior 56
Next week we collect the problem set, hand out the Take-home Final, and summarize what we ve learned. 57