Finance 30210: Managerial Economics

Anti-Competitive Behavior

Campbell’s Soup has accounted for 60% of the canned soup market for over 50 years

Market Dominance

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

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p

q qD

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D’D’

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)

Bananas Apples

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.

EntrantsMarket Dominated by Incumbents

Exits

The data suggests that most industries are like revolving doors – there is always a steady supply of new entrants trying to survive.

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

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MC (Short Run)

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MC (Long Run)

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Predatory pricing describes actions that are optimal only if they drive out rivals or discourage potential rivals!

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q

Limit PricingConsider 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)

12 ˆ)()( qPDPD Market Demand

Firm One’s output choice

1q̂

pD pD2

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D(P)q

Limit PricingConsider 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)

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2q

P~

If Firm 2 chooses to enter, it will maximize profits by choosing 2q

FqMCP 2)~(Negative profits for the entrant will deter entry.

Can Firm one commit to its entry deterring production level?

1q

2q

Firm 2

Firm 1’s “entry deterring” output

Profit maximizing output

Entry deterrence generally involves overproducing today to drive your opponent out of business!

Firm 1

Overproduction by firm 1.

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 productionOne 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 1kThis capacity can be increased later, but not decreased

Stage 2: Entrant makes entry decision

No Entry: Incumbent remains a monopoly

Entry: Incumbent and Entrant play cournot (Choosing production levels)

OR

1q

2q

Firm 2

Nash Equilibrium with entry deterrence

2~q

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.

1k

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.

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!!

Standard Oil American Sugar Refining CompanyMogul Steamship Company Wall MartAT&T Toyota American Airlines

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 $50M

HeereMac Marine Construction 1998 $49M

In other words…Cartels happen!

Cartel Formation

In a previous example, we had three firms, each with a marginal cost of $20 facing a market demand equal to

32120120 qqqP If we assume that these firms engage in Cournot competition, then we can calculate price, quantities, and profits

31$45$

75.3325.1

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PqQMq

Firm Output

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

QP 20120 If these three firms can coordinate their actions, they could collectively act as a monopolist

125$70$

83.3/5.2

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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

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Clyde

Cooperate Cheat

Cooperate $20 $20 $10 $40

Cheat $40 $10 $15 $15

The problem facing the cartel members is a perfect example of the prisoner’s dilemma !

But we know that cartels do happen!!

Time 0 1 2 3 4 5

Play Cournot Game

We can assume that cartel members are interacting repeatedly over time

Play Cournot Game

Play Cournot Game

Play Cournot Game

Play Cournot Game

Play Cournot Game

Cartel agreement made at time zero.

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)

Cartel members might cooperate now to avoid being punished later

$105 $130 $160

$105 $7.32

$7.32

$8.25 $7.25

$9.38 $5.53

$130 $7.25

$8.25

$8.50 $8.50

$10 $7.15

$160 $5.53

$9.38

$7.15 $10

$9.10

$9.10

Alli

ed

Acme

Multiple Nash Equilibria can allow collusion to happen

The existence of multiple equilibria allow for the possibility of credible threats (and, hence, collusion)

$105 $130 $160

$105 $7.32

$7.32

$8.25 $7.25

$9.38 $5.53

$130 $7.25

$8.25

$8.50 $8.50

$10 $7.15

$160 $5.53

$9.38

$7.15 $10

$9.10

$9.10

Alli

ed

Acme

Multiple Nash Equilibria can allow collusion to happen

As in the previous case, a price of $160 can’t be enforced in the last period of play, which causes things to unravel

Consider this strategy:“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.

$105 $130 $160

$105 $7.32

$7.32

$8.25 $7.25

$9.38 $5.53

$130 $7.25

$8.25

$8.50 $8.50

$10 $7.15

$160 $5.53

$9.38

$7.15 $10

$9.10

$9.10

Alli

ed

Acme

Two Period Example

Period 2: Is charging a price equal to $130 optimal for both firms?

Yes…it’s a Nash equilibrium!

Period 1: Is charging a price equal to $160 optimal for both firms?

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! 60.17$50.8$10.9$

32.17$32.7$10$ (Cheating)

(Cooperation)

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 marketEntry 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

Suppose that you and your fellow cartel members have plants/customers located around the country. How should you set your price schedules?

Example

Mill Pricing (Free on Board)

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

A common “mill price” is set for everyone. Then, each customer pays additional shipping costs.

Basing Point PricingA common “basing point” is chosen. Then, each customer pays factory price plus delivery price from the basing point.

Advantages of Basing Point PricingCustomers 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

High Price Low Price

High Price $12 $12 $5 $14

Low Price $14 $5 $6 $6

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Price Matching Removes the off-diagonal possibilities. This allows (High Price, High Price) to be an equilibrium!!