AntiCompetitive Behavior

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Finance 30210 Managerial Economics

• Anti-Competitive Behavior

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Market Dominance
Campbells Soup has accounted for 60 of the
canned soup market for over 50 years
Sothebys and Christies have controlled 90 of
the auction market for two decades (each holds
50 of its own domestic market)
Intel has held 90 of the computer chip market
for 10 years.
Microsoft has held 90 of the operating system
market over the last 10 years
On average, the number one firm in an industry
retains that rank for 17 28 years!
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Entry/Exit and Profitability
Bananas
Apples
S
S
D
D
D
D
Its normally assumed that as demand patterns
shift, resources are moved across sectors as
the price of bananas rises relative to apples,
there is exit in the apple industry and entry in
the banana industry (bananas are more profitable)
THIS IS INCONSISTANT WITH THE FACTS!!
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Evolving Market Structures.Some Facts
Entry is common Entry rates for industries in
the US between 1963 1982 averaged 8-10 per
year.
Entry occurs on a small scale Entrants for
industries in the US between 1963 1982 averaged
14 of the industry.
Survival Rates are Low 61 of entrants will
exit within 5 years. 79.6 exit within 10 years.
Entry is highly correlated with exit across
industries Industries with high entry rates
also have high exit rates
Entry/Exit Rates vary considerably across
industries Clothing and Furniture have high
entry/exit, chemical and petroleum have low
entry/exit.
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The data suggests that most industries are like
revolving doors there is always a steady supply
of new entrants trying to survive.
Market Dominated by Incumbents
Entrants
Exits
The key source of variation across industries is
the rate of entry (which controls the rate of
exit)
Is this a result of predatory practices by the
incumbents?
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Predatory Pricing vs. Profit Maximizing
Remember, firms are also profit maximizing.
Specifically, they are always looking for ways to
minimize costs
MC (Short Run)
P
P
MC (Long Run)
D
Q
Q
MR
Predatory pricing describes actions that are
optimal only if they drive out rivals or
discourage potential rivals!
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Limit Pricing
Consider the Stackelberg leadership example.
Firm one chooses its output first. This leaves
Firm two the residual demand. Also, assume that
there is a fixed cost of production (F)
Market Demand
Firm Ones output choice
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Limit Pricing
Consider the Stackelberg leadership example.
Firm one chooses its output first. This leaves
Firm two the residual demand. Also, assume that
there is a fixed cost of production (F)
If Firm 2 chooses to enter, it will maximize
profits by choosing
Negative profits for the entrant will deter entry.
MC
D(P)
MR
Can Firm one commit to its entry deterring
production level?
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Entry deterrence generally involves overproducing
today to drive your opponent out of business!
Profit maximizing output
Firm 1
Firm 1s entry deterring output
Firm 2
Overproduction by firm 1.
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Using capacity choice as a commitment device
Recall, that the problem with threatening
potential entrants is that the threat needs to be
credible (Remember the chain store paradox). One
way around this is to tie your hands in advance
by choice of production capacity.

• Lets again use a modified version of the
  Stackelberg leadership game
• Two firms- an incumbent and a potential entrant
  facing a downward sloping market demand
• Both firms have a fixed cost of production
• One the fixed cost has been paid, production
  requires one unit of labor (at price w) and one
  unit of capacity (at price r)

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Extensive form of the game
Stage 1 Incumbent chooses capacity
This capacity can be increased later, but not
decreased
Stage 2 Entrant makes entry decision
No Entry Incumbent remains a monopoly
Entry Incumbent and Entrant play cournot
(Choosing production levels)
OR
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Capacity and Marginal Cost
In period two, the initial capacity choice for
the incumbent is now a fixed cost. Therefore,
the incumbent has a cost advantage as long as it
stays within its initial capacity choice
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Best Responses
As in the initial Cournot analysis, we can derive
Firm twos best response to firm 1
However, with the fixed cost, firm 2 must produce
at a minimum scale to earn positive profits
Positive Profits
Firm 2s break even point
Negative Profits
Firm 2
Firm 1s output target
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Best Responses
Firm 1s response function has a kink at its
initial capacity constraint.
Given an initial capacity choice by firm 1, this
would be the Nash equilibrium in stage two
Firm 2
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Nash Equilibrium with entry deterrence

• To deter entry, Firm one has to choose its
  initial capacity such that
• Firm 2s best response will be its break even
  point (with profits equal to zero)
• Firm one is operating at its initial capacity
  chosen in period 1.

Firm 2
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Capacity as a Predatory Practice
In 1945, the US Court of Appeals ruled that Alcoa
was guilty of anti-competitive behavior. The
case was predicated on the view that Alcoa had
expanded capacity solely to keep out competition
Alcoa had expanded capacity eightfold from 1912
1934!!
In the 1970s Safeway increased the number of
stores in the Edmonton area from 25 to 34 in an
effort to drive out new chains entering the area
(It did workthe competition fell from 21 stores
to 10)
In the 1970s, there were 7 major firms in the
titanium dioxide market (A whitener used in paint
and plastics). Dupont held 34 of the market but
had a proprietary production technique that
generated less pollution. When stricter
pollution controls were imposed, Dupont increased
its market share to 60 while the rest of the
industry stagnated.
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There have been numerous cases involving
predatory pricing throughout history.

• Standard Oil
• American Sugar Refining Company
• Mogul Steamship Company
• Wall Mart
• ATT
• Toyota
• American Airlines

There are two good reasons why we would most
likely not see predatory pricing in practice

• It is difficult to make a credible threat
  (Remember the Chain Store Paradox)!

• A merger is generally a dominant strategy!!

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The Bottom Line
There have been numerous cases over the years
alleging predatory pricing. However, from a
practical standpoint we need to ask three
questions

• Can predatory pricing be a rational strategy?
• Can we distinguish predatory pricing from
  competitive pricing?
• If we find evidence for predatory pricing, what
  do we do about it?

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Price Fixing and Collusion
Prior to 1993, the record fine in the United
States for price fixing was 2M. Recently, that
record has been shattered!
In other wordsCartels happen!
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Antitrust Criminal Division Fines ( Millions)
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Cartel Formation
In a previous example, we had three firms, each
with a marginal cost of 20 facing a market
demand equal to
If we assume that these firms engage in Cournot
competition, then we can calculate price,
quantities, and profits
Firm Output
Industry Output
Total industry profit is 93
Market Price
Firm Profits
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Cartel Formation
In a previous example, we had three firms, each
with a marginal cost of 20 facing a market
demand equal to
If these three firms can coordinate their
actions, they could collectively act as a
monopolist
Splitting the profits equally gives each firm
profits of 41.67!!
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Cartel Formation

• While it is clearly in each firms best interest
  to join the cartel, there are a couple problems
• With the high monopoly markup, each firm has the
  incentive to cheat and overproduce. If every
  firm cheats, the price falls and the cartel
  breaks down
• Cartels are generally illegal which makes
  enforcement difficult!

Note that as the number of cartel members
increases the benefits increase, but more members
makes enforcement even more difficult!
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Cartels - The Prisoners Dilemma
The problem facing the cartel members is a
perfect example of the prisoners dilemma !
Clyde
Jake
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But we know that cartels do happen!!
We can assume that cartel members are interacting
repeatedly over time
Cartel agreement made at time zero.
0
1
2
3
4
5
Time
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Cartel members might cooperate now to avoid being
punished later
However, weve already shown that if there is a
well defined endpoint in which the game ends,
then the collusive strategy breaks down (threats
are not credible)
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Multiple Nash Equilibria can allow collusion to
happen
Acme
The existence of multiple equilibria allow for
the possibility of credible threats (and, hence,
collusion)
Allied
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Multiple Nash Equilibria can allow collusion to
happen
Acme
As in the previous case, a price of 160 cant be
enforced in the last period of play, which causes
things to unravel
Allied
Consider this strategy We both charge 160
until the last period. That period we will both
charge 130. If you cheat, I will punish you by
charging 105.
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Two Period Example
Acme
Period 2 Is charging a price equal to 130
optimal for both firms?
Yesits a Nash equilibrium!
Allied
Period 1 Is charging a price equal to 160
optimal for both firms?
Yes! If you charge 130 today, you will be
punished with 105 tomorrow its a credible
threat because (105, 105) is a Nash Equilibrium!
(Cooperation)
(Cheating)
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Cooperation also occurs with an infinite horizon
(i.e. the game never ends!!)
Cartel agreement made at time zero.
0
1
2
3
4
5
Time
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Play Cournot Game
Firms will cooperate when its in their best
interest to do so!
Cartels are easier to maintain when there are
higher annual profits and interest rates are low!
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Where is collusion most likely to occur?
High profit potential
The more profitable a cartel is, the more likely
it is to be maintained

• Inelastic Demand (Few close substitutes,
  Necessities)
• Cartel members control most of the market
• Entry Restrictions (Natural or Artificial)

Its common to see trade associations form as a
way of keeping out competition (Florida Oranges,
Got Milk!, etc)
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April 15,1996 (Grape Nut Monday) Post Cereal,
the third largest ready-to-eat cereal
manufacturer announced a 20 cut in its cereal
prices
Kelloggs eventually cut their prices as well
(after their market share fell from 35 to 32)
The breakfast cereal industry had been a stable
oligopoly for years.what happened?

• Supermarket generic cereals created a more
  competitive pricing atmosphere
• Changing consumer breakfast habits (bagels,
  muffins, etc)

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Where is collusion most likely to occur?
Low cooperation costs
If it is relatively easy for member firms to
coordinate their actions, the more likely it is
to be maintained

• Small Number of Firms with a high degree of
  market concentration
• Similar production costs
• Little product differentiation

Some cartels might require explicit side payments
among member firms. This is difficult to do when
cartels are illegal!
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Where is collusion most likely to occur?
Low Enforcement Costs
If it is relatively easy for member firms to
monitor and enforce cartel restrictions their the
cartel is more likely to be maintained
Example
Suppose that you and your fellow cartel members
have plants/customers located around the country.
How should you set your price schedules?
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Suppose you have factories in Chicago and Detroit
while your chief competitor has plants in
Pittsburgh and Baltimore Your customers are
located in Cleveland, Dallas, and Atlanta
Mill Pricing (Free on Board)
A common mill price is set for everyone. Then,
each customer pays additional shipping costs.
Basing Point Pricing
A common basing point is chosen. Then, each
customer pays factory price plus delivery price
from the basing point.
Advantages of Basing Point Pricing

• Customers in each location are quoted the same
  price from all producers.
• With FOB pricing, mill price is the strategic
  variable (i.e. a price cut affects all consumers)
  while with basing point pricing, each consumer
  location is a strategic variable. This makes
  retaliatory threats more credible.

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Price Matching
Acme
Allied
Price Matching Removes the off-diagonal
possibilities. This allows (High Price, High
Price) to be an equilibrium!!
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Detecting Collusion
In general, it is difficult to distinguish cartel
behavior from regular competitive behavior
(remember, the government does not know each
firms costs, the nature of demand, etc)
Signs of Potential Collusion

• Little relationship between price and costs
• Little relationship between price and information
  sets
• Excess Capacity (as a means of retaliation)