Finance 510: Microeconomic
Analysis
Anti-Competitive Behavior
Market Dominance
Campbell’s Soup has accounted for 60% of the
canned soup market for over 50 years
Sotheby’s and Christie’s 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!
Entry/Exit and Profitability
Bananas
p
p
Apples
S
S
D’
D
D’
q
D
q
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!!
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.
The data suggests that most industries are like revolving doors –
there is always a steady supply of new entrants trying to survive.
Entrants
Market
Dominated
by
Incumbents
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?
Predatory Pricing vs. Profit Maximizing
Remember, firms are also profit maximizing. Specifically, they are
always looking for ways to minimize costs
p
MC (Short Run)
P
P’
MC (Long Run)
D
Q Q’
q
MR
Predatory pricing describes actions that are profitable only if they drive
out rivals or discourage potential rivals!
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)
p
D2 ( P)  D( P)  qˆ1
P̂
Market
Demand
D(P)
q̂1
q
Firm
One’s
output
choice
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)
p
If Firm 2 chooses to enter, it will
maximize profits by choosing q2
P̂
~
P
~
( P  MC )q2  F
MC
D(P)
q
q2
Negative profits for the
entrant will deter entry.
MR
Can Firm one commit to its entry deterring production level?
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)
Extensive form of the game
Stage 1: Incumbent chooses capacity k1
This capacity can be increased
later, but not decreased
Stage 2: Entrant makes entry decision
No Entry: Incumbent
remains a monopoly
OR
Entry: Incumbent and
Entrant play cournot
(Choosing production
levels)
Capacity and Marginal Cost
mc
w r
w
q
mc
k1
w r
q
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
Best Responses
As in the initial Cournot analysis, we can
derive Firm two’s best response to firm 1
However, with the fixed cost, firm 2 must
produce at a minimum scale to earn positive
profits
q2
Positive
Profits
Firm 2’s “break even point”
q~2
Negative
Profits
Firm 2
q1
Best Responses
Firm 1’s response function has a “kink”
at its initial capacity constraint.
q2
Given an initial capacity choice
by firm 1, this would be the
Nash equilibrium in stage two
q~2
k1
Firm 2
q1
Nash Equilibrium with entry deterrence
q2
To deter entry, Firm one has to choose
its initial capacity such that:
Firm 2’s 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.
q~2
k1
Firm 2
q1
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 1970’s 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 work…the competition fell from 21
stores to 10)
In the 1970’s, 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.
There have been numerous cases involving predatory pricing
throughout history.
Standard Oil
American Sugar Refining Company
Mogul Steamship Company
Wall Mart
AT&T
Toyota
American Airlines
There are two good reasons why we would most likely not see predatory
pricing in practice
1. It is difficult to make a credible threat (Remember the
Chain Store Paradox)!
2. A merger is generally a dominant strategy!!
Predation vs. Merger
Again, lets use the Stackelberg Leadership model from before. Two
firms (incumbent and entrant) – both with marginal cost (c). They
face the market demand curve
P  A  BQ
We have already shown the following
qA
A

A  c

2B
2

A  c

8B

A  3c 
P
Ac
qB 
4B
4
A
2

A  c

16 B
As a monopoly, Firm A would
earn higher profits:
M
2

A  c

4B
The predatory pricing strategy would be to charge a price equal to
marginal cost today (earn zero profits) to prohibit entry and then
act as a monopolist tomorrow
Tomorrow
Today
2

A  c

0
4B
Average
2

A  c

8B
At the very least, you could offer to merge with the entrant and split the
profits 50/50
Today
Tomorrow

A  c

2
8B
2

A  c

8B
Average
2

A  c

8B
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:
1. Can predatory pricing be a
rational strategy?
2. Can we distinguish predatory
pricing from competitive pricing?
3. If we find evidence for predatory
pricing, what do we do about it?
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!
Defendant
Product
Year
Fine
F. Hoffman-Laroche
Vitamins
1999
$500M
BASF
Vitamins
1999
$225M
SGL Carbon
Graphite Electrodes
1999
$135M
UCAR International
Graphite Electrodes
1998
$110M
Archer Daniels Midland
Lysine & Citric Acid
1997
$100M
Haarman & Reimer
Citric Acid
1997
$50
HeereMac
Marine Construction
1998
$M49
In other words…Cartels happen!
Antitrust Criminal Division Fines ($ Millions)
1000
900
800
700
600
500
400
300
200
100
0
1993
1994
1995
1996
1997
1998
1999
Cartel Formation
In a previous example, we had three firms, each with a marginal cost
of $20 facing a market demand equal to
P  120  20Q
If we assume that these firms engage in Cournot competition, then
we can calculate price, quantities, and profits
q  1.25M
Firm Output
Q  3q  3.75
P  $45
  $31
Industry Output
Market Price
Firm Profits
Total industry profit is $93
Cartel Formation
In a previous example, we had three firms, each with a marginal cost
of $20 facing a market demand equal to
P  120  20Q
If these three firms can coordinate their actions, they could
collectively act as a monopolist
Qm  2.5M
q  Q / 3  .83M
P  $70
 m  $125
Splitting the profits equally gives
each firm profits of $41.67!!
Cartel Formation
While it is clearly in each firm’s 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!
Cartels - The Prisoner’s Dilemma
The problem facing the cartel members is
a perfect example of the prisoner’s
dilemma !
Clyde
Cooperate
Jake
Cheat
Cooperate
$20 $20
$10
$40
Cheat
$40
$15
$15
$10
But we know that cartels do happen!!
We can assume that carte members are interacting repeatedly over time
Cartel agreement made at time
zero.
0
1
Play
Cournot
Game
Play
Cournot
Game
Time
2
Play
Cournot
Game
3
Play
Cournot
Game
4
Play
Cournot
Game
5
Play
Cournot
Game
Cartel members might cooperate now to avoid being punished
later
However, we’ve 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)
Multiple Nash Equilibria can allow collusion to happen
Acme
What is the Nash
Equilibrium in this game?
Allied
$105
The existence of multiple
equilibria allow for the
possibility of credible
threats (and, hence,
collusion)
$130
$160
$105
$130
$160
$7.32
$7.32
$7.25
$8.25
$5.53
$9.38
$8.25
$7.25
$8.50
$8.50
$7.15
$10
$9.38
$5.53
$10
$7.15
$9.10
$9.10
Multiple Nash Equilibria can allow collusion to happen
Acme
As in the previous case, a
price of $160 can’t be
enforced in the last period of
play, which causes things to
unravel
“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.
Allied
Consider this strategy:
$105
$130
$160
$105
$130
$160
$7.32
$7.32
$7.25
$8.25
$5.53
$9.38
$8.25
$7.25
$8.50
$8.50
$7.15
$10
$9.38
$5.53
$10
$7.15
$9.10
$9.10
Two Period Example
Acme
Period 2: Is charging a
price equal to $130 optimal
for both firms?
Yes…it’s a Nash
equilibrium!
Yes! If you charge $130 today,
you will be punished with $105
tomorrow – it’s a credible threat
because ($105, $105) is a Nash
Equilibrium!
Allied
Period 1: Is charging a
price equal to $160 optimal
for both firms?
$105
$130
$160
$105
$130
$160
$7.32
$7.32
$7.25
$8.25
$5.53
$9.38
$8.25
$7.25
$8.50
$8.50
$7.15
$10
$9.38
$5.53
$10
$7.15
$9.10
$9.10
$9.10  $8.50  $17.60
$10  $7.32  $17.32
(Cooperation)
(Cheating)
Cooperation also occurs with an infinite horizon (i.e. the
game never ends!!)
Cartel agreement made at time
zero.
0
1
Play
Cournot
Game
Play
Cournot
Game
Time
2
Play
Cournot
Game
3
Play
Cournot
Game
4
Play
Cournot
Game
5
Play
Cournot
Game
Firms will cooperate when its in their best interest to do so!
PDV (Cooperation)  PDV (Cheating )
Cartels are easier to maintain when there are higher annual profits and
interest rates are low!
Where is collusion most likely to occur?
The central problem with a cartel is as follows:
 A   B   cartel
Combined profits under the cartel are
greater than the non-cooperative
situation
However, its possible that
 cartel
A 
2
or
 cartel
B 
2
Member firms might be able to earn
more in the non-competitive case
than they would in the cartel
Cartels require coordination to be maintained…this can be difficult!
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)
April 15,1996 (“Grape Nut Monday”): Post Cereal, the
third largest ready-to-eat cereal manufacturer
announced a 20% cut in its cereal prices
Kellogg’s 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)
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!
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?
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.
Price Matching
Acme
Allied
High Price
Low Price
High Price
$12 $12
$5
$14
Low Price
$14
$6
$6
$5
Price Matching Removes the off-diagonal possibilities. This
allows (High Price, High Price) to be an equilibrium!!
Detecting Collusion
In general, it is difficult to distinguish cartel behavior from
regular competitive behavior (remember, the government does
not know each firm’s costs, the nature of demand, etc)
Signs of Potential Collusion
Phantom Bids (collusive bidding shows
lower variance than non-collusive)
Little relationship between bids and costs
Little relationship between bids and
information sets
Excess Capacity (as a means of retaliation)