Predatory Conduct

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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.

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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 dont
  affect price.

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• Dominant firms demand is
• DD(P) D(P) - nS(P)

At prices above this point, fringe supplies
everything
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• Dominant firm maximizesPDD(P) - cD(DD(P)).
• Sets MR MC

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• Fringe supplies based on price set by dominant
  firm.

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Implications of Dominant Firm and Competitive
Fringe Model

• Dominant firm supplies where MRD MCD.
• In some cases this is greater than quantity
  monopolist would supply, and in some cases less.
• Price will always be less than monopolists price
  would be.
• Why? Because competitive fringe serves to make
  dominant firms 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.

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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 doesnt 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.

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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 incumbents quantity and
  then decides whether to enter.
• Key assumption entrant believes that its entry
  decision will not affect the leaders output
  choice.
• By picking output level, incumbent can manipulate
  potential entrants profit from entry.

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At q, entrants profit is negative
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Critiques of Limit Pricing and Quantity
Commitment Model

• Will incumbent really produce at qL 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 incumbents threat -- it is not
  credible.

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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.

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Example
Entrant
X
X
Incumbent

• Find optimal strategy for each subgame (prune the
  tree).
• Find Entrants optimal action.

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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 PEs has enough capital to
  begin operations, but in time they will.
• How should Firm A price in this situation?

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Chain Store Paradox, cont

• If Firm A accommodates entry, each firm has a
  positive profit although ?A gt ?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.

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Chain Store Paradox, cont

• 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 PEs. 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.

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Chain Store Paradox, cont

• 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 arent credible.

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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.

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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.

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Incumbents Marginal Cost
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Capacity Expansion, cont

• 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 doesnt enter, the incumbent acts as a
  monopolist.

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Capacity Expansion, cont

• In a Cournot game with two firms, quantity
  produced is a function of the firms, MC.
• BR for firm i qi (Acj-2ci)/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.

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Best Responses of the Two Firms
K
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Capacity Expansion, cont

• By increasing K, the PEs 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 cant 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?

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Finding the Optimal K
Monopolists optimal quantity
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Can the incumbent keep the entrant out?
Depends on the PEs break even quantity.
If break even q above this quantity, PE will
never enter
Max. PE will produce
If break even q below this quantity, PE will
always enter
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Capacity Expansion, cont

• 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 gt M (the monopolists optimal quantity)
  the strategy is predatory.
• If the K lt 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.

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Extensive Form Capacity Expansion Game
Incumbent
High K
Low K
Potential Entrant
DNE
DNE
Enter
Enter
6,0
5,0
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Version 2
Incumbent
High K
Low K
Potential Entrant
DNE
DNE
Enter
Enter
3
6,0
5,0
4
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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.

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Limit Pricing and Imperfect Information

• Assume there is imperfect information, that is
  the potential entrant does not know about the
  incumbents 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.

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Limit Pricing cont

• 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
  incumbents 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.

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Limit Pricing Game
Nature
High cost, h P 1-?
Low cost, l P ?
Incumbent
P(l)
P(l)
P(h)
P(h)
PE
DNE DNE DNE
DNE
E E
E E
105,-2 1010,0
62,2
66,0
55,-2
510,0 42,2 46,0
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Limit Pricing cont

• 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.

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Limit Pricing Game
Nature
High cost, h P 1-?
Low cost, l P ?
Incumbent
P(l)
P(l)
P(h)
PE
DNE
DNE DNE
E
E E
105,-2 1010,0
62,2
66,0

42,2 46,0
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Limit Pricing cont

• When PE sees a low price, he doesnt know what
  costs are.
• Expected value from entry given a low price
  depends on the probabilty of each state
• ?(-2) (1-?)(2).
• If ? gt 0.5, entrants stays out, otherwise enters
  when he sees a low price.

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Limit Pricing Game
Nature
High cost, h P 1-?
Low cost, l P ?
Incumbent
P(l)
P(l)
P(h)
PE
DNE
DNE DNE
E
E E
105,-2 1010,0
62,2
66,0

42,2 46,0