Limit Pricing, Capacity Expansion and Entry Deterrence

1
Limit Pricing, Capacity Expansion and Entry
Deterrence
2
Introduction

• A firm that can restrict output to raise market
  price has market power
• In many industries there are giants
• Microsoft control 90 of PC OS
• Intel control 90 of PC processor
• Campbell control 60 of US canned soup sales
• Sothebys and Christies control 90 of auction
  markets
• These firms have substantial market power and, as
  a consequence, high profits
• Have maintained their dominant position for many
  years
• The N1 firm in an industry retains the rank for
  somewhere between 17 and 28 years
• Why cant existing rivals compete away the
  position of such firms?
• Why arent new rivals lured by the profits?

3
Introduction 2

• Answer firms with monopoly power may
• eliminate existing rivals
• prevent entry of new firms
• Issue of antitrust law Sherman act it is
  illegal to monopolize or attempt to monopolize.
• These actions are predatory conduct if they are
  profitable only if rivals, in fact, exit or
  entrants give up entry
• e.g., RD to reduce costs is not predatory, even
  if it makes market position improve

4
Stylized Facts

• Entry is common
• US entry rate of 8 to 10 on annual basis from
  1963 to 1982
• Similar trends in other developed countries
• When entry occurs is by larger small scale entry
• Survival rate of entrants is quite low
• 61.5 of entrants exit after 5 years
• 79.5 of entrants exit after 10 years
• Rate of entry is correlated to rate of exit
  within the same industry
• Across industries rate of entry and exit vary
  considerably
• High rates clothing, furniture,
• Low rates chemical, petroleum
• ..

5
Intuition

• Mostly small firms enter
• Eventually fail and exit
• Only to be replaced by a new cohort of small
  firms
• So, there are repeated attempts and repeated
  failures of small firms to penetrate markets
  dominated by large incumbent
• And we want to know whether survival of entrants
  can be related to explicit predatory conduct by
  incumbent firms

6
Barriere allentrata

• gt Bain (1956) approccio strutturalista.
• BE situazione in cui le imprese esistenti
  possono aumentare i loro prezzi di vendita al di
  sopra dei costi minimi di produzione senza
  indurre rivali potenziali all'entrata.
• Vantaggi assoluti nei costi
• Economie di scala
• Differenziazione del prodotto

7

• Vantaggi assoluti nei costi. Quando l'impresa
  esistente può produrre la stessa quantità del
  potenziale entrante a costi inferiori.
• learning by doing
• brevetti su tecnologie di processo più efficienti
• condizioni migliori nell'acquisto di inputs (es.
  capitali finanziari, sconti)

8

• Economie di scala. BE se la scala minima
  efficiente rappresenta una porzione rilevante
  della domanda.
• Le nuove imprese
• se entrano alla SME aumentano troppo l'offerta ?
  abbassano i prezzi ? riducono i profitti
• se entrano ad una scala lt SME, hanno costi gt dei
  concorrenti.

9

• Differenziazione del prodotto. Fedeltà alla
  marca. I potenziali entranti devono sostenere
  investimenti in pubblicità, o praticare forti
  sconti.
• gt Stigler (1968)
• BE costo di produzione che deve essere sostenuto
  dai potenziali entranti ma che non è sostenuto
  dalle imprese esistenti.

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BARRIERS TO ENTRY

• Blockaded entry market conditions are such that
  no additional firm can profitably enter the
  market, even if the incumbent produces the
  monopoly output so it is unnecessary for the
  incumbent to act strategically to prevent entry.
• Deterred entry the incumbent acts to prevent an
  additional firm from entering because it pays to
  do so.
• Accomodated entry it doesnt pay for the
  incumbent to prevent entry through strategic
  action

11
Predatory conduct and limit pricing

• 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 samethe
  monopolist retains control of the market
• Legal action focuses on predatory pricing because
  this case has an identifiable victim
• a firm that was in the market but that has left
• Consider first a model of limit pricing
• Stackelberg leader chooses output first
• entrant believes that the leader is committed to
  this output choice
• entrant has decreasing costs over some initial
  level of output

12
A limit pricing model (Bain, Sylos Labini)
Then the entrants residual demand is R1 D(P)
- Q1
By committing to output Qd the incumbent
deters entry. Market price Pd is the limit price
These are the cost curves for the potential
entrant
/unit
With the residual demand R1, the entrant can
operate profitably.Entry is not deterred by the
incumbent choosing Q1.
At price Pe entry is unprofitable
R1
The entrant equates marginal revenue with
marginal cost
MCe
The entrants residual demand is Re D(P) - Qd
Pd
ACe
Assume that the incumbent commits to output Q1
Assume instead that the incumbent commits to
output Qd
Then the entrants marginal revenue is MRe
Pe
D(P) Market Demand
Re
MRe
Quantity
Q1
qe
Qd
Qd
13
Limit pricing

• Committing to output Qd may be aimed either at
  eliminating an existing rival or driving out 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
• why should this property hold?
• could be claimed to be ad hoc to support the
  theory
• even if it holds, is monopoly at output Qd better
  than Cournot?
• may not be if the entrants costs are low enough
• Credibility may relate output to capacity

14
Capacity expansion and entry deterrence

• For predation to be successful and rational
• the incumbent must convince the entrant that the
  market after the entrant comes in will not be
  profitable one
• How can the incumbent credibly make this threat?
• One possible mechanism
• install capacity in advance of production
• installed capacity is a commitment to a minimum
  level of output
• the lead firm can manipulate entrants through
  capacity choice
• the lead firm may be able to deter entry through
  its capacity choice
• but is this credible?
• capacity must be costly to install and should be
  irreversible
• eg uranium processing plant, for which each
  other industry has little use.
• gt the plant cannot be resold if the firms
  decides it no longer needs it

15

• Incumbent incurs into cost now (t1) to deter
  rivals entry decision later (t2)
• The analytical treatment is really hard
• However it is easier to understand strategic
  interaction using extensive form games

16
The Game Tree

• t1 Incumbents time to move
• Chooses between bearing a costly and irreversible
  investment (eq.capacity) or not bearing it.
• The investment cost is given by C

Pay C
t1
Incumbent
No pay C
17

• t2 entrant moves.
• Having seen whether the incumbet has invested or
  not, the entrant has to decide whether to Enter
  the market or Stay out

E
t2
Pay C
Entrant
NE
t1
Incumbent
E
No pay C
Entrant
NE
18

• t3 Incumbent reacts to entrants choice at
  previous period
• If entry has taken place, Incumbent chooses
  between Fight and Accomodate

(3,-1)
Fight
Incumbent
E
Pay C
Accomodate
(4-C,5)
Entrant
NE
t1
(8-C,0)
t2
t3
(-1,-1)
Incumbent
Fight
Incumbent
E
Accomodate
No pay C
(4.5,4.5)
Entrant
NE
(8,0)
19
Solution (SPE)
In this subgame Accomodate is chosen only if
4-Cgt3 Or Clt1
(3,-1)
Fight
Incumbent
E
Backward Induction Look for SPE in each
Sugame Starting from the end
Pay C
Accomodate
(4-C,5)
Entrant
NE
t1
(8-C,0)
t2
t3
(-1,-1)
Incumbent
Fight
Incumbent
E
Accomodate
No pay C
(4.5,4.5)
Entrant
NE
(8,0)
20
In this subgame Clt1gt incumbent chooses
Accomodate gt entrant chooses Enter Cgt1gt
incument chooses Fight gt entrany chooses
Not to Enter
The size of the initial irreversible sunk cost
is crucial in shaping the equilibrium for the
game
(3,-1)
Fight
Incumbent
E
Pay C
Accomodate
(4-C,5)
Entrant
NE
t1
(8-C,0)
t2
t3
(-1,-1)
Incumbent
Fight
Incumbent
E
Accomodate
No pay C
(4.5,4.5)
Entrant
NE
(8,0)
21

• Up to now, backward induction has highlighted the
  following SPE
• Incumbent in t3 Subgames
• Accomodate in t3 if Enter in t2 if No capacity
  in t1
• Accomodate in t3 if Clt1, if Enter in t2 if
  Capacity in t1
• Fight in t3 if Cgt1, if Enter in t2 if Capacity
  in t1
• Entrant in t2 Subgames
• Entry in t2 if No capacity in t1
• Entry in t2 if Capacity in t1 if and only if
  Clt1
• Stay out t2 if Capacity in t1 if and only if
  Cgt1

22

• We have to deal with the last (but not least)
  Subgame
• It is the subgame that coincides with the whole
  game
• We are back at t1 where our game starts
• Incumbent has to choose between investing in
  capacity or not
• If investment cost is low (Clt1)gt He chooses not
  to invest
• If investment cost is high (3.5gtCgt1)gt He chooses
  to invest
• If investment cost is really high (Cgt3.5)gt He
  chooses not to invest

23
Clt1
(3,-1)
Fight
Incumbent
E
Pay C
Accomodate
(4-C,5)
Entrant
NE
t1
If Clt1 Incumbent will be Passive, Entrant will
enter Incumbent will Accomodate
(8-C,0)
t2
(-1,-1)
Incumbent
t3
Fight
Incumbent
E
Accomodate
No pay C
(4.5,4.5)
Entrant
NE
(8,0)
24
3.5gtCgt1
If Cgt3.5 Incumbent will be Passive Entrant will
Enter Incumbent will Accomodate
(3,-1)
Fight
Incumbent
E
Pay C
Accomodate
(4-C,5)
Entrant
If 3.5gtCgt1 Incumbent will be Aggressive, Entrant
will Stay Out Incumbent will Fight
NE
t1
(8-C,0)
t2
(-1,-1)
Incumbent
t3
Fight
Incumbent
E
Accomodate
No pay C
(4.5,4.5)
Entrant
NE
(8,0)
25
Whether an Incumbent Pays to Prevent Entry

As long as Cournot profits are smaller than
monopolist profits minus the sunk cost, then
the incumbent will choose To pay for the
exclusive right
Second stage
First stage
p
,
p
)
(
i
e
Do not enter
(
p
, 0)
m
Do not pay
Entrant
Enter
(
p
,
p



d
d
Incumbent
Pay for exclusive rights (entry is impossible)
(

b
, 0)
p


m
26
Noncredible Threat
(
p
,
p
)
i
e
Cournot output
(300, 300)
Incumbent
Large output
(

100,

100)
27
Game Trees for the Deterred Entry and
Stackelberg Equilibria
(a) Entrant

s Fixed Cost Is 100.
(
p
,
p
)
i
e
Do not enter
(900, 0)
q
30)
Accommodate (
i
Entrant
Enter
(450, 125)
Incumbent
Do not enter
(800, 0)
Deter (
q
40)
i
Entrant
Enter
(400, 0)
(b) Entrant

s Fixed Cost Is 16.
Do not enter
(900, 0)
Accommodate (
q
30)
i
Entrant
Enter
(450, 209)
Incumbent
Do not enter
(416, 0)
Deter (
q
52)
i
Entrant
Enter
(208, 0)
28
Entrants Best Response and Profit P 60 Q
60 (qi qj) P A BQ mc 0, Best
response qi 30 qj/2 qi (A mc)/2B
qj/2

29
Cournot and Stackelberg Equilibria
(a) Best-Response Curves
q
, Units
e
per period
60
Incumbent

s best-response curve
30
e
c
20
e
s
15
Entrant

s
best-response curve
0
30
20
60
q
, Units per period
i
(b) Incumbent

s Profit
p
, per period
i
450
400
p
i
0
30
20
60
q
, Units per period
i
30
Incumbent Commits to a Large Quantity to Deter
Entry Fixed cost of entry 100
(a) Entrant

s Best-Response Curve
q
, Units per period
e
30
Entrant

s best-response curve
e
s
15
e
d
10
0
30
40
60
q
, Units per period
(b) Incumbent
s Profit

p
, Incumbent

s
i
Profit per period,
900
800
p
m
p
i
450
p
s
0
30
40
60
q
, Units per period
31
Incumbent Loss If It Deters Entry Fixed cost of
entry 16
(a) Entrant

s Best-Response Curve
q
, Units per period
e
30
Entrant

s best-response curve
e
s
15
0
30
52
60
q
, Units per period
i
(b) Incumbent

s Profit
p
, per period
i
900
p
m
450
416
p
i
p
s
0
30
52
60
q
, Units per period
i
32
Conclusioni / 1

• Se il costo di entrata è molto alto, il
  monopolista può produrre loutput di monopolio
  senza preoccuoarsi della minaccia di entrata ?
  entrata bloccata
• Se il costo di entrata è molto basso, il
  monopolista dovrebbe scegliere il livello di
  produzione ottimale lungo la funzione di reazione
  dellentrante ? entrata accomodata
• Per valori intermedi del costo di entrata, il
  monopolista sceglie una capacità produttiva
  appena sufficiente a scoraggiare lentrata ?
  entrata scoraggiata

33
Conclusioni / 2

• Lespansione della capacità produttiva è una
  strategia credibile di deterrenza allentrata
  solo se i costi sono elevati e irrecuperabili
  (sunk).

34
Investment Game Tree
(
p
,
p
)
i
e
Do not enter
(900, 0)
Do not invest
Entrant
Enter
(400, 300)
Incumbent
Do not enter
(500, 0)
Invest
Entrant
Enter

(132,
36)
35
Raising-Costs Game Tree
(
p
,
p
)
i
e
Do not enter
(10, 0)
Do not raise costs
Entrant
Enter
(3, 3)
Incumbent
Do not enter
(6, 0)
Raise costs 4
Entrant
Enter
(
1,

1)

36
Evidence on Strategic Entry Deterrence