Limit Pricing, Capacity Expansion and Entry Deterrence

Introduction
A firm that can restrict output to raise market price has market power Microsoft, Kodak, IBM, Telecom are giants in their industries Have maintained their dominant position for many years
Why cant existing rivals compete away the position of such firms? Why arent new rivals lured by the profits?

Answer: firms with monopoly power may

eliminate existing rivals prevent entry of new firms

These actions are predatory conduct if they are profitable only if rivals, in fact, exit
e.g., R&D to reduce costs is not predatory

Barriere allentrata
> 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

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

 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 < SME, hanno costi > dei concorrenti.

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

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

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

Then the entrants residual limit pricing A demand is R1 = D(P) - Q1 $/unit

model (Bain, Sylos Labini)

These are the cost curves for the potential entrant By committing to output

Pd Pe

With the residual demand R1, Qd the incumbent deters the entrant canPe entry is entry. Market price Pd At price operate profitably. Entry is not deterred by the unprofitable is the limit price R1 incumbent choosing Q1. The entrant equates MC marginale The entrants residual revenue AC demand is with marginale cost Assume instead that Assume Then the entrants - Qd that the e = D(P) R the marginal revenueincumbent commits d is MReincumbent D(P) =to output Q Market output commits to Demand Q 1
MRe qe Qd Re Quantity Qd Q1

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

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

Whether an Incumbent Pays to Prevent Entry

First stage

Second stage Do not enter Do not pay Entrant Enter

(p i , pe ) ( pm , $0)

( pd , pd = R F )

Incumbent Pay for exclusive rights (entry is impossible) ( pm b , $0)

Noncredible Threat

Cournot output

( pi , pe ) ($300, $300)

Incumbent Large output

( $100, $100)

Game Trees for the Deterred Entry and Stackelberg Equilibria

(a) Entrant s Fixed Cost Is $100. Do not enter Accommodate (q i = 30) Entrant Enter Incumbent Deter (q i = 40) Do not enter ($800, $0) Entrant Enter (b) Entrant s Fixed Cost Is $16. Do not enter Accommodate (q i = 30) ($900, $0) Entrant Enter Incumbent Deter ( q i = 52) Entrant Enter ($208, $0) Do not enter ($450, $209) ($416, $0) ($400, $0) ($450, $125) ($900, $0) (pi , p e )

Entrants Best Response and Profit

P = 60 Q = 60 (qi + qj) mc = 0, Best response: qi = 30 qj/2 [P = A BQ] [qi = (A mc)/2B qj/2]

Cournot and Stackelberg Equilibria

(a) Best-Response Curves q e , Units per period

60
Incumbents best-response curve

30 ec es Entrant s best-response curve

20 15

0 (b) Incumbents Profit

20

30

60 qi , Units per period

p i , $ per period
450 400

pi

20

30

60 qi , Units per period

Incumbent Commits to a Large Quantity to Deter Entry Fixed cost of entry = $100

(a) Entrant s Best-Response Curve

q e , Units per period 30

Entrant s best-response curve

15 10

es

ed

0 (b) Incumbent s Profit i , Incumbent s Profit per period, $ 900 800

30

40 60 q , Units per period

pm pi
450

ps

30

40 60 q , Units per period

Incumbent Loss If It Deters Entry

(a) Entrant s Best-Response Curve q e , Units per period

30

Entrants best-response curve

Fixed cost of entry = $16

15

es

0 (b) Incumbent s Profit

30

52 60 q i , Units per period

p i , $ per period
900

pm

450 416

pi

ps
0 30 52 60 q i , Units per period

Conclusioni / 1
Se il costo di entrata molto alto, il monopolista pu produrre loutput di monopolio senza preoccuoarsi della minaccia di entrata entrata bloccata Se il costo di entrata 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 capacit produttiva appena sufficiente a scoraggiare lentrata entrata scoraggiata

Conclusioni / 2
Lespansione della capacit produttiva una strategia credibile di deterrenza allentrata solo se i costi sono elevati e irrecuperabili (sunk).

Investment Game Tree

Do not enter Do not invest Entrant

( pi , pe ) ($900, $0)

Enter
Incumbent Invest Do not enter Entrant Enter

($400, $300) ($500, $0)

($132, $36)

Raising-Costs Game Tree

Do not enter
Do not raise costs Entrant

(p i , pe ) ($10, $0)

Enter
Incumbent Do not enter

($3, $3)

($6, $0)

Raise costs $4

Entrant

Enter

( $1, $1)

Evidence on Strategic Entry Deterrence