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Lecture Notes: Industrial Organization Joe Chen 9.4 138 Predation The exit inducement game is essentially the same as the entry deterrence game, as discussed when we studied the taxonomy of business strategies. Hence, one shall not be surprised that the limit pricing model also applies to the inducement of exit. A more “colorful” term, used frequently by IO people, for the exit inducement game is predation. Loosely, an aggressive behavior (e.g., charging an abnormally low prices) aims to drive out rivals can be considered as predation. An incumbent can prey on a potential entrant(s), or on another firm already in the market (a predator preys). Nevertheless, predation usually refers to exit inducement. It is difficult to define predation theoretically. In general, we can decompose a predator’s action into two components. The first (direct effect) indicates how this action directly affects the predator’s profit, if we take the rival’s behavior, e.g., an exit decision, as fixed. The second (strategic effect) reflects the influence of this action on the rival’s behavior. One may then define predation as the reflection of this strategic effect on the predator’s behavior. It is even more difficult to define predation in practice. The observation of a low price may simply be an innocent competitive act intended to maximize profit. But it may also have strategic purpose of inducing exit. The early tests of predatory behavior were based on cost. The Areeda-Turner test, used in many antitrust cases, states that a price below the short-run marginal cost should be unlawful and that the short-run marginal cost can be approximated by the average variable cost. Put aside the question that if the approximation is proper, the Areeda-Turner test undermines the underlying driving force of predation. What is important is the trade-off between the sacrifice of the current profit and the gain from monopolization. One possibility is to look at the incumbent’s intertemporal price path. For instance, suppose that the incumbent firm cuts its price when entry occurs. This might indicate predatory behavior to drive the entrant out of the market. However, the incumbent’s residual demand falls when a competitors enters, which may justify a lower price. The labeling of a truly competitive price cut as predation is called a “type-I” error. Conversely, Lecture Notes: Industrial Organization Joe Chen 139 suppose that the incumbent does not lower its price when entry occurs. This does not mean that the incumbent does not engage in anticompetitive behavior. The incumbent may have been practicing limit pricing before entry, and—having been unsuccessful in deterring entry— may have felt no need to cut its price further. A predatory behavior goes undetected is called a “type-II” error. The design of any test will have to face these two types of errors. 9.5 Predation for Merger The Chicago School argues that it cannot be rational to engage in predatory (limit) pricing in order to induce exit. The arguments is that merging with the rival is a dominant strategy to realize monopoly power. For example, the predator can make an offer to the prey that would be preferred by both to the predatory outcome. Competition—especially predatory competition—destroys industry profit, and therefore, firms have incentives to avoid it. This argument has been attacked on two fronts. First, The predator may face potential entrants in the market in question or in other markets where it operates. If it does not fight in the market in question, it can be seen as a sign of “weakness”. This may encourage other firms to enter the market in question and/or other markets, because potential entrants anticipate that, rather than being preyed upon, they will make profits in those markets or else will be bought out at good prices. Second, the buyout price can depend on the predator’s pre-merger behavior. If predatory pricing lowers the buyout price to the extent that it covers the cost of predation, predation seems natural. In this subsection, we examine the second idea. Let’s go back to the structure of the limit pricing model except that after the entrant enters and before the second-period price competition takes place, the incumbent can make a merger offer to the entrant. If the offer is turned down, duopoly prevails as it is in the limit pricing model; if the offer is accepted, the incumbent remains a monopoly. The entrant learns the incumbent’s cost after turning down the merger offer and before waging the price competition. Naturally, we assume that a monopoly makes more profit than a duopoly. Lecture Notes: Industrial Organization Joe Chen 140 Let’s also assume the following condition: D2H > D2L > 0, so that firm 2 (the entrant) would enter if it were not bought out. © H H ª (pm , D2 ), (p∗1 , D2L ) , where p∗1 < pL m , and is defined by: M1H − M1H (p∗1 ) = δ(D2H − D2L ), (*) is a separating equilibrium. Why? Note that in a separating equilibrium, the incumbent’s cost structure is revealed. Thus, after observing pH m , the entrant accepts being bought out if and only if the offer is no less than D2H ; after observing p∗1 , it accepts offers no less than D2L . Hence, the benefit when the high-cost type pretends that it were of the low-cost type is the difference in the merger prices: δ(D2H − D2L ), while the cost of pretending is the loss of the first-period profit of: M1H − M1H (p∗1 ). Note also that if the low cost type charges pL m , it gains in the first period by: M1L − M1L (p∗1 ), ∗ while it also raises the merger price (observing pL 1 6= p1 , the entrant believes that the incumbent is of the high-cost type) by : δ(D2H − D2L ). The single-crossing condition, M1L − M1L (p∗1 ) < M1H − M1H (p∗1 ), and equation (*) ensures that the low-cost type will not charge pL m . Finally, note that the low-cost type will not mimic the high-cost type by charging pH m. Lecture Notes: Industrial Organization Joe Chen 141 What’s the welfare effect compared to the equilibrium of the complete information case, ª © H H L (pm , D2 ), (pL m , D2 ) ? Again, it is possible that predatory (limit) pricing improves welfare. However, this result is not robust. 9.6 The “Long Purse” Story For all the models that we’ve discussed so far, the incumbent (predator) tries to convey bad news to its rivals. Nevertheless, the predation does not affect the rival’s real prospects, only the perception of these prospects. An alternative and popular theory of predatory pricing states that a firm with substantial financial resources (has a “long purse” or a “deep pocket”) can prey on a weaker rival. Because the strong or big firm can sustain losses for a long period of time, it can drive the weak or small firm out of the market. Cutthroat competition may affect the rivals’ real prospects, as the rivals cannot raise enough resources to carry on. However, it is not clear why the prey faces a financial constraint. It is in the interest of the creditors not to impose financial constraints. Thus, people argue that some imperfection in the capital market is essential to the “long purse” story. One needs to establish a link between the equity (wealth) of a firm and its profit. Consider a firm who seeks to finance an investment project of size K. Let E denote the firm’s wealth (equity), E < K. The firm needs to borrow an amount D = K − E from e ∈ [Π, Π], distributed as F (·) with a bank. The investment yields a random profit of: Π e < (1 + r)D, the firm probability density function f (·). Let r be the rate of interest. So, if Π goes bankrupt and retains nothing. Let the bankruptcy cost be B. The bank’s expected profit is: V (D, r) = [1 − F ((1 + r)D)] (1 + r)D + Z (1+r)D Π e − B)f (Π)d e Π. e (Π Suppose the banks are competitive so that the cost of their funds is r0 . Then the zero-profit condition: V (D, r) = (1 + r0 )D, determines the the rate of interest: r(D, r0 ). Assume: dr/dD > 0. Lecture Notes: Industrial Organization Joe Chen 142 The firm invests in this project when its expected profit exceeds (1 + r0 )E, the opportunity cost of the wealth. Let W denote the net expected profit from the investment. Then, W≡ = Z Π (1+r)D Z Π (1+r)D = Z Π (1+r)D h i e − (1 + r)D f (Π)d e Π e − (1 + r0 )E Π h i e − (1 + r)D f (Π)d e Π e − (1 + r0 )K + (1 + r0 )D Π h i e − (1 + r)D f (Π)d e Π e − (1 + r0 )K + V (D, r) Π e − (1 + r0 )K − F ((1 + r)D)B. = E[Π] Note that the first two terms equal the investment’s net value in a perfect financial world and the third term represents the expected bankruptcy cost. It is clear that a higher (lower) level of equity makes the investment more attractive (formidable): dW/dE > 0. Mathematically, a higher equity lowers the probability of bankruptcy and therefore reduces the expected bankruptcy cost. Intuitively, a higher equity lowers the amount that needs to borrow. This lowers the interest rate r. Now consider a 2 × 2 model. Firm 1 has no financial constraint. Firm 2 must finance an investment K between the two periods if it wants to remain in the market. Firm 2’s equity after the first period depends on its retained earnings after first-period competition. By preying in the first period, firm 1 reduces first 2’s first-period retained earnings and therefore reduces its second-period equity. Thus, firm 2 finds staying in the market less attractive. Predation is successful if it drives E down enough so that W = 0. The “long purse” story states that insufficient retained earnings, stemming in part from the rival’s predatory behavior, may prevent young or financial constrained firms from expanding or from renewing their equipment. The story relies on the presumption that outside financing is more costly than insider financing (retained earnings). It is actually the asymmetric information between the borrower and the lenders that matters.