Topic 10: Price Signals

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Topic 10 Price Signals

• How can you use prices to guide behaviour?
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Price Signals for Entry

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

P - c
Enter
Only enter if P gt c
Stay Out
0
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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)

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Sunk costs as a barrier to entry

• 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?

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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 (???)

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Multi-Market Retaliation

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

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Bundling

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

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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 to
  matter