Download 5.4 Predation

5.1 Predation
• Predation = firm drives rival out of market by making it incur
enough losses and then raises prises
– Why would prey exit?
– Why would prey stay out after price increased?
– Can predator really recoup losses suffered during price
war? Does predation make sense?
– If predation is possible and profitable, how can we
separate innocent aggressive competition from predation
as restriction on competition?
• Most cases apply Areeda-Turner test: P < LRMC, P < LRAVC,
or P < LRATC + some other indications  predation
– Costs are hard to define and measure
– Predation rare in case law. But is it really that rare?
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© Markku Stenborg 2005
Financial market imperfections
5.4 Predation
• Old ”deep pocket” theory: richly endowed predator would
charge low prices to drive out poorly endowed rival
– Ignores possibility that profit-seeking investors would
finance prey
• Relation between prey and its investors
– Predator seeks to manipulate that relationship and drive
prey out of market or deter expansion into new markets
– Pedatory strategy viable because of capital market
imperfections
– Investors face agency or moral hazard problems
– Managers may take excessive risks, shield assets from
creditors, dilute outside equity, fail to exert sufficient
effort, or otherwise fail to protect investors’ interests
– Suppliers of capital can mitigate these agency problems
by extending financing in staged commitments, imposing
threat of termination in case of poor performance
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• Debt-holders5.4
can threaten
to liquidate firm or deny
Predation
new credit
• VCs can refuse to extend additional financing when
early performance is poor
• Shareholders can decline to purchase additional
equity if expected returns are low due to
disappointing initial performance
– Predatory pricing in product markets becomes possible
when predator exploits termination threats to dry up
financing of rival firm
• Agency problems are particularly acute in financing of new
enterprises
– Uncertainty about cash flow in early stages
– Losses may be unavoidable start-up costs or due to
agency abuse
– Mitigate moral hazard by agreeing to extend financing
only when firms’ initial performance is adequate
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• Predator may slash price
to drain prey of sufficient funds to
5.4 Predation
meet its loan commitments, forcing default
• Predator can lower prey’s earnings to impair prey’s debt
capacity by limiting collateral it can put up
• Lower earnings may cause lenders to wrongly believe that
firms’ profits are likely to be lower or riskier in future and
therefore to stiffen their lending terms
• Contract that minimizes agency problems will maximize
incentive to prey
Reputation
• Predator lowers prices to mislead prey and potential entrants
into believing that market conditions are unfavorable
– Decision to enter or exit is based on evaluation of
expected future revenues and costs
– Most firms contemplating entry or exit do not have all
information to determine future revenues and costs
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– If incumbent firm5.4
is better
informed than others about
Predation
cost or other market conditions, it may be able to
influence the expectations
– Incumbent firm can manipulate and distort market
signals about profitability, and influence the expectations
through pricing decisions or other actions
• Predator seeks to establish reputation as price cutter, based
on some perceived special advantage or characteristic
– Reputation effects may be present when predator sells in
two or more markets or in successive time periods within
same market
– One market or period serves as demonstration market
with predatory conduct, and the other market or time
period provides recoupment market, where predator
reaps benefits
– Reputation-induced belief reduces future entrant’s
expected return and may deter entry
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© Markku Stenborg 2005
Signaling
5.4 Predation
• Better informed predator reduces price to convince prey that
market conditions are unfavorable
– Aggregate demand is too low to justify presence of both
firms in market or expansion by prey
– Prey inferring weak demand from low price may be
deterred from expanding or induced to leave market
– Less plausible than previous predatory strategies
• Test market and signal jamming theories plausible
• Victim lacks knowledge and experience in market
• Introduce new product or brand to probe market response
by entering a limited “test market”
• Predator may attempt to frustrate this market test by either
of two predatory strategies
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• Test market predation
5.4 Predation
– Predator secretly cuts price to reduce entrant’s sales in
test market
– Induce entrant to believe that demand is low
– Entrant abandons entry or enters on smaller scale
• Signal jamming
– Predator openly cuts price to distort test market results
– Entrant can observe demand for its product only under
exceptional circumstance of an ongoing price war
– Market test is foiled, and entrant is unable to determine
whether market demand for its product is sufficient to
support entry
• Cost signaling
– Predator drastically reduces price to mislead prey to
believe that she has lower costs
– Predator trying to establish a reputation for low cost cuts
price below the short run profit-maximizing level
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– Observing predator’s
price, prey rationally believes
5.4 low
Predation
there is at least probability that predator has lower costs
– Lowers prey's expected return and causes prey to exit
– Limiting factor in applying cost signaling theory is
possible inconsistency between low price, predatory
bluffing and subsequent recoupment
– Attempt to raise price risks revealing signaling to prey
and other potential entrants, causing them to upgrade
estimates of market profitability
Policy
• Proof of scheme of predation only establishess that identified
strategy is plausible
• Need to show
– Below cost pricing: avoidable or incremental cost, not
AVC
– Recoupment
– Business justification?
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• Financial market predation
5.4 Predation
– Prey depends on external financing
– Financing depends on its initial performance
– Predation reduces initial performance and threatens
preys financing and viability
– Predator can finance predation internally or has better
access to external finance as prey
• Reputation
– Multimarket predator faces localized competition
– Predator faces threat of sequential entry
– Reputation reinforces predatory strategy or increases
probalility of future price cuts
– Entrant observes previous exit or other adverse
experiences
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• Test market predation
5.4 Predation
– Predator observes prey’s attempt to experiment on
limited basis
– Predator cuts price below following or anticipating entry
– Price cut prevents prey from learning true demand
conditions
• Cost signaling
– Predator might have lower or reduced costs
– Predator reduces price
– Prey believes that predator has lower costs
– Possible cost reduction is sufficient to exit, deter entry or
limit expansion
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© Markku Stenborg 2005