Informative Pricing

1
Informative Pricing

• How should you use prices to guide behaviour?

2
Price Signals for Entry

• Traditional Economic Model
• Demand/Supply and Perfect Competition (You worked
  through this material online for Topic 8)
• The prevailing price, P, signals entry

P - c
Enter
Only enter if P gt c
Stay Out
0
3
Perfect Contestability

• Suppose there is a single incumbent in an
  industry
• Incumbent has fixed costs, F, and unit marginal
  costs, cI
• A natural monopoly as the cost of industry
  output, Q, is lowest with a single firm
• Suppose also that there is a potential entrant
  who can enter at any time with the same fixed
  costs but a marginal cost of cE.
• Then if cE gt cI, the incumbent will limit price
  at P cE F/Q (the average cost of the entrant)
• If cI gt cE, the entrant enters and drives the
  incumbent out with a limit price of P cI
  F/Q (the previous incumbents average cost)

4
Requirements

• Perfect contestability requires
• no barriers to entry or to exit (i.e., sunk
  costs)
• no small scale entry
• Small scale entry condition
• If some smaller firms with heterogeneous costs
  can enter into production, they can capture some
  market share
• Price still equals the incumbents average cost
  but industry output is distributed across firms
  of different sizes
• The incumbent fails to achieve efficient
  economies of scale

5
Sunk Costs

• Suppose that the incumbent has already incurred
  sunk costs but the entrant has not
• This is a barrier to entry
• With even small sunk costs, an equally efficient
  entrant will not enter
• Pre-entry incumbent charges monopoly price
• Post-entry incumbent and entrant price Bertrand
• So if entrant anticipates this, knows that it
  will not recover sunk costs hence will not
  enter.
• Limit pricing does not appear to make sense
• Perhaps it is a signal of strength?

6
Predatory Pricing

• If faced with a more efficient entrant or if an
  entrant mistakenly enters (with small sunk costs)
  can the incumbent reverse this?
• Predatory pricing is where the incumbent prices
  below competitive prices (maybe below cost) to
  drive an entrant out.
• Is predatory pricing credible?
• How do you know if predation has occurred?
• Should it be barred, after all it is good for
  consumers?

7
Multi-Market Retaliation

• If two incumbents operate in two geographic
  markets, will they enter each others market?
• The case of Rural Press

8
Bundling

• By offering a bundle, can an entry barrier be
  created?
• The case of petrol and supermarket retailing

9
Summary

• Prevailing prices can signal the profitability of
  entry in competitive conditions
• When there are entry barriers, strategy becomes
  important
• However, incumbent threats must be credible.