ANTITRUST ECONOMICS 2013
David S. Evans
University of Chicago, Global Economics Group
TOPIC 13:
STRATEGY
Date
Elisa Mariscal
CIDE, Global Economics Group
PREDATORY AND OTHER PRICING
Topic 13| Part 2
7 November 2013
Overview
2
Part 1
Part 2
Price Discrimination
and Other Complex
Pricing
Predatory Pricing
Limit Pricing
Loyalty Rebates
3
Predatory Pricing
Classic Predatory Pricing
4
Firm A faces competitor B. Assume both are charging price p.
Firm A and B have the same constant average and marginal cost
MC.
Suppose Firm A sells at a price less than MC, and therefore increases
sales but at a loss.
Firm B has two options: either match Firm A’s price and sell at a loss
too or exit.
Firm A can drive B out if A is better able to withstand the losses (larger,
better capitalized, etc.)
After Firm B is driven out, Firm A raises prices to monopoly level; if it
can keep the price high enough it can recoup its losses during the
“predation” period and make some profits too.
But Does Classic Predation Make Sense?
5
Why can’t the prey play this game too? If the prey does, there’s no
certainty that the predator will win the price war it has started.
It is very expensive: the dominant firm may be losing money on lots of
sales.
It is very risky: maybe the entrant is more efficient or better capitalized
(maybe the predator doesn’t know); maybe other firms come in.
The predator faces certain costs today with uncertain returns in the
future.
There is a debate about how frequent real predatory pricing is.
See McGee on Standard Oil and Yamey on fighting ships.
Modern Predatory Pricing Based on Game Theory
6
Recent theories of predation are based on the idea that the
“predator” may exploit imperfect information of the entrant (or its
investors) to deter entry or force exit.
These theories are based on game-theoretic models and provide a
more rigorous basis for predatory pricing allegations.
They generally assume information asymmetry (predator knows more
than prey) or asymmetric access to capital markets (predator has
more liquidity than prey).
Theory identifies specific circumstances and assumptions under which
predatory pricing can occur and is a rational strategy.
Developing a Reputation for Being Ruthless
7
If an incumbent faces a stream of potential entrants, a price war with
early entrants creates a reputation for being “tough”.
By reducing price in one market a predator can induce the prey (or
other companies) to believe that the predator will cut prices in other
markets or in the predatory market itself at a later time.
As long as the signal is perceived as credible, this strategy may
discourage entry from later entrants, and enable multi-market
recoupement of predatory losses.
Fooling the Entrant into Thinking it is Less Efficient
8
Strategies of predation based on signaling may be developed by firms
that possess information that the potential entrant does not have.
The entrant does not know if the incumbent is weak (has a relatively
high cost) or strong (low cost).
The entrant, however, observes the incumbent’s price before entering.
Therefore, the incumbent will have an incentive to reduce price,
inducing the prey to believe that the predator has lower costs, when in
fact the predator has no cost advantage.
A variant of this approach is demand signaling: the predator cuts price
to induce the prey to believe that demand is much softer than it
actually is.
Using “Deep Pockets” to Predate
9
“Financial market predation” formalizes the “deep pocket” or “long
purse” story and challenges the assumption that the prey can readily
obtain capital under predatory conditions.
A cash-rich firm can sustain a longer period of loss-making profits than a
cash-constrained firm. The cash-rich firm will recoup losses by earning
monopoly profits once the cash-constrained firm has left the market.
Intuition:
• Asymmetric information (lenders don’t have or have little knowledge of
the industry) makes capital markets imperfect
• If capital markets are imperfect, a firm's assets (cash and retained earnings)
determine its ability to raise external funds
• Therefore, predation causes the prey's profits to fall, reduces its assets and
limits its ability to raise capital.
• The banks observe the decline, but cannot tell whether it is due to
predation or to poor performance.
• Lending to the prey becomes more risky, and banks reduce or withdraw
their financial support, obliging the prey to exit.
Distinguishing “Good” Low Prices From “Bad” Low
Prices (Competitive vs. Predatory)
10
(1) What economic evidence—that the courts could obtain—would
help distinguish low pricing that decreases consumer welfare from
low pricing that increases consumer welfare?
(2) Given that the law does not require certainty in establishing guilt,
what rule would help balance the cost of condemning “good” low
prices with the cost of not condemning “bad” low prices?
Neither question has a clear-cut economic answer and this had led
to a great deal of debate over the years.
There is NO Good Definition of Predation for
Formulating a Rule
11
Ideally, we would like a definition such that if we had perfect
information we would be confident that banning “predatory
pricing”, so defined, would improve consumer welfare.
Definitions offered are imprecise because one can come up with
plausible examples where banning predatory pricing under those
definitions would not necessarily improve consumer welfare and vice
versa.
Price is Lower Than Average Total Cost (ATC)
12
Logic: firm would not operate in the long run at a price that did not
cover its average costs.
Problem:
• Situations where firms may set price less than average total cost to
maximize profits in the short to medium term such as overinvestment in
capital and sunk costs.
• Generally economics tells us that firms look to marginal cost for pricing
and average total cost only for entry and exit decisions.
• There is related behavioral economics and accounting literature though
which suggests that p=ATC may be used in practice by firms.
Price is Lower Than Marginal Cost (MC)
13
Logic: A firm would ordinarily not sell at price less than marginal cost
because it would be losing money on each unit.
Problem: There are situations in which it is sensible to price below
marginal cost.
• These include:
• “Penetration pricing” where firms are trying to make a market for a
product by getting consumers to experience it and generate word of
mouth;
• “Network” markets in which low prices generate share;
• “Two-sided” markets in which it is optimal permanently to give a
product away to one side (e.g. You don’t pay for your Facebook
page even though it costs Facebook something to maintain it).
• Also, it is hard to measure marginal cost in practice.
Legal Analysis: Cost-Based Tests of Predation
14
Existing Producer A
• Cost of Production = $5/unit.
Entrant B
• Cost of Production = $8/unit
Scenario 1 (PREDATORY):
• A charges $4/unit (Price below marginal cost to A)
• B must leave the market
Scenario 2 (LEGITIMATE)
• A charges $7/unit (price above marginal cost to A)
• B must still leave the market
Profit-Sacrifice Test
15
Logic: The firm would not have charged the price unless it expects to
earn increase profits from the exclusion of rivals.
Problems:
• In winner-take-all markets, the winner necessarily benefits from the low
prices only as a result of winning the market for himself (this applies to
many high-technology markets).
• Also many firms price low hoping to reduce sales of their rivals and
increase their own sales. However, even if they raise prices later it is not
clear that we want to discourage this behavior. Issue is what is overall
impact on consumer welfare including entry decisions.
Areeda-Turner Average Variable Cost Test
16
Areeda and Turner (two Harvard law professors) proposed using
average variable cost because it is close to the right economic
concept (marginal cost) but easier to measure in practice than
marginal cost.
• Reliance on this test by the US courts wiped out many predatory pricing
cases (See Brannon and Ginsburg, Comp. Pol’y Int’l).
Problems:
• Average variable cost still hard to measure
• Same situations for pricing below MC apply
• On the other hand could result in false negatives when MC>p>AVC
Brooke Group Recoupment Test
17
Price is less than cost (not entirely specified) and there is a realistic
probability that the predator will be able to “recoup” its losses
Logic: The recoupment prong provides a sanity check on the cost
test; it wouldn't make sense for a company to incur costs on
predation unless it has a prospect of raising prices and making the
money back. Recoupment is also a proxy for consumer harm; if
prices can’t be raised then even if the competitor has been forced
out of the market, consumers are benefiting from low prices.
Problems: difficult for plaintiffs to establish recoupment; some argue
that this errs in permitting predatory pricing. After Brooke Group very
few successful predatory pricing cases in the US.
Error Costs and the Role of Prior Beliefs for
Predatory Pricing
18
Likelihood of predatory behavior—are predatory strategies credible?
Are they likely to work?
Accuracy of test—how accurately could we distinguish true
predatory behavior from competitive behavior (if we rely on marginal
cost, how accurately can we measure it in practice? how good are
the authorities and judicial system in applying tests? etc.)
Cost of mistakes—absolving predators results in costs of monopoly;
convicting innocent eliminates low prices.
Long-run effects of rule—too lenient rule encourages predation; too
strict a rule discourages competition.
Error Costs and the Role of Prior Beliefs
19
Basic Assessment of error costs depends upon:
• Likelihood that firms will engage in predatory strategies.
• Likelihood that the court can distinguish good from bad practices.
Likelihood of bad pricing
Accuracy
High
Low
High
Strict
Moderate
Low
Moderate
No Rule
20
Conditional Rebates and
Multiproduct Pricing
Anticompetitive Strategies Involving Rebates and
Bundled Pricing
21
Firms can use “non-linear” pricing to predate against rivals and to
seek to exclude rivals from the market.
“Non-linear” price refers to any situation in which the price is not the
same across different units of sales.
A “conditional rebate” is a payment for achieving certain sales
targets and is problematic when, in effect, the payment is for the
exclusion of a rival to the detriment of consumers.
A “bundled price” is a price for purchasing several goods together
(see above) and is problematic when the effective price for a
component is predatory and thereby forces a rival from the market.
Conditional Rebates
22
“Conditional rebates are rebates granted to customers to reward
them for a particular form of purchasing behavior. The usual nature
of a conditional rebate is that the customer is given a rebate if its
purchases over a defined reference period exceed a certain
threshold, the rebate being granted either on all purchases
(retroactive rebates) or only on those made in excess of those
required to achieve the threshold (incremental rebates).”
• European Commission, Guidance on the Commission's Enforcement
Priorities in Applying Article 82 EC Treaty to Abusive Exclusionary Conduct
by Dominant Undertakings, 3 December 2008.
We will focus on retroactive conditional rebates since they are most
likely to have anticompetitive effects.
Retroactive Rebates
23
Consider the following contract for a buyer pertaining to widgets
produced by company D:
• You will pay $20 for our widgets.
• If you buy 90% of your widgets from us we will give you a 20% discount on
all widgets.
• The contract term is annual from 1 January – 31 December
The buyer needs to purchase 1000 widgets as an input into
something else it is making.
Retroactive Rebates can Lead to a Range of
Negative Incremental Prices
24
Purchases
Cost
Discount
Effective Price based on
increments of 25 units
700
725
750
775
800
825
850
875
900
925
950
975
1000
$ 14,000
$ 14,500
$ 15,000
$ 15,500
$ 16,000
$ 16,500
$ 17,000
$ 17,500
$ 18,000
$ 18,500
$ 19,000
$ 19,500
$ 20,000
$0
$0
$0
$0
$0
$0
$0
$0
$ 3,596
$ 100
$ 100
$ 100
$ 100
$ 20
$ 20
$ 20
$ 20
$ 20
$ 20
$ 20
$ 20
-$ 124
$ 16
$ 16
$ 16
$ 16
Normal price charged by dominant widget maker
$ 20
Suppose an entrant wants to sell 100 widgets. The effective price paid to the incumbent for 9011000 units is $20 x 100 - 0.2 x $20 x 1000= $2000- $4000 =- $2000.
Retroactive Rebates and Cheap Exclusion
25
Suppose the entrant has a niche kind of widgets for which demand is
around 100.
The dominant firm’s pricing scheme makes it uneconomic for the
buyer to buy from the new widget maker.
One view is that the dominant widget maker has paid $2000 to keep
the entrant out so that this is similar to costly predatory pricing.
But suppose that the profit maximizing price for the buyer is $16 at
which price it would ordinarily buy 900-1000 widgets. By structuring
the contract this way the dominant firm essentially offers the buyer a
price of $16 and effectively charges the firm $2000 for being disloyal
(i.e. buying 100 units from someone else).
Bad Cheap Exclusion or Good Low Prices?
26
The retroactive rebate could exclude an entrant that is trying to get
“on the shelf” or get a foothold in the market or fringe firms have
small shares of the market.
It makes most sense for pricing to a distributor who then sells several
varieties of a product to end consumers.
The retroactive rebates could also be a way to offer volume
discounts and to align the distributor’s interests with the sellers.
Which of these explanations is right?
Does the Conditional Rebate Exclude an Equally
Efficient Rival?
27
Arguments against:
• There’s competition for exclusive contracts with buyers and other firms
can and do compete.
• At any point in time a significant amount of the market is “up for grabs”
through competition to win the exclusive or almost exclusive business of
rivals.
• Other sellers could match $16 for more than 100 units (10%) and buyers
are interested in that.
Arguments for:
• New entrants appeal to small group of end customers initially limiting
demand to modest shares or dominant firm is a “must carry” product for
a significant group of customers.
• Contracts are long term and rivals can’t compete often “for the
contract”.
• The conditional rebate prevents fringe firms from capturing any
significant share thereby preserving monopoly power.
Multiproduct pricing
28
Multi-product firm (e.g. 3M or Procter & Gamble) offer discount
based on the total volume a buyer purchases from them or offers a
package price for a group of unrelated goods (shampoo and
diapers).
It is possible that the pricing could result in a “marginal price” for one
of the elements of the bundle that an equally efficient firm could not
beat.
This is like predatory pricing. The difficulty is figuring out how to
measure the “marginal price” and the “marginal cost”.
This is a controversial topic but see EC Guidelines and U.S.
Department of Justice Report.
End of Part 2, Next Class Topic 14
29
Part 1
Part 2
Vertical
Restraints
Overview
Non-Price
Vertical
Restraints
SingleMonopoly
Profit Theorem
and Its
Price Vertical
Restraints
Tying and
Bundling
Vertical
Mergers