Lecture 3: Entry, exit and predation Tom Holden io.tholden.

org

A few footnotes to last week. Entry deterrence. Predatory pricing.

Deep pockets. Signalling. Other models. Dixit-Spence. Fudenburg and Tirole.

The Centipede game:

Consider two players: Alice and Bob. Alice moves first. At the start of the game, Alice has two piles of coins in front of her: one pile contains 4 coins and the other pile contains 1 coin. Each player has two moves available: either "take" the larger pile of coins and give the smaller pile to the other player or "push" both piles across the table to the other player. Each time the piles of coins pass across the table, the quantity of coins in each pile doubles. For example, assume that Alice chooses to "push" the piles on her first move, handing the piles of 1 and 4 coins over to Bob, doubling them to 2 and 8. Bob could now use his first move to either "take" the pile of 8 coins and give 2 coins to Alice, or he can "push" the two piles back across the table again to Alice, again increasing the size of the piles to 4 and 16 coins. The game continues for a fixed number of rounds or until a player decides to end the game by pocketing a pile of coins. Source: https://secure.wikimedia.org/wikipedia/en/wiki/Centipede_game _%28game_theory%29

Suppose it is Alices turn and the fixed number of pushes has expired.

Now think about what Bob would do the turn before.

Then Alice has no choice but to take the big pile, which is of size 8 where 2 is the size of the smaller pile.

Now think what Alice would do the turn before that, etc.

At that point, the big pile is of size 4 and the small pile is of size . So he can either take 4 now, or wait and get 2 from Alice.

Last week I stated:

Marginal consumer always pays her valuation, so no effect on consumer surplus. I should have said: no effect on consumer surplus beyond the effect via the increased quantity.
0

Consumer surplus is: total quantity produced.

Differentiate with respect to , which gives: = .

where is the

To see the first term, recall that if = + , then = 0 , and = . 0 Second and third terms come from using the product rule on .

But under symmetric constant MC Cournot:

+ = Thus effect of a one unit increase in quantity (coming from an increase in ) on CS is: . Equals zero only if = which happens when = .

Recall that we showed under Cournot the number of firms increases less than proportionately with market size.

Bresnahan and Reiss (1991)

Call the market size required to support exactly firms +1 . We should have +1 > They find this holds for small , but for 4,
Suggestive of attaining perfect competition. Implications for rationing rules? (I.e. to grow by one firm, market size needs to grow by a larger amount than the number of firms.)
+1

Campbell and Hopenhayn (2005)

+1 .

Regress average firm size in an industry on number of firms and assorted controls. Find firms are larger in larger industries.

Entry reduces incumbents profits, so they would prefer to discourage rivals from entering. How should firms act to do this?
Given a potential entrant does enter, the incumbent will then accommodate them.

This in turn makes entrance look more tempting to start with. Commitment devices are needed.

In an SPNE you cant promise to do crazy things off the equilibrium path.

Suppose capital investment is irreversible.

Once youve built a factory, its there for good. Capital then becomes a commitment device. Caveat: requires that firms cant rent out their factories.

The model:

Incumbent firm (), potential entrant () Market inverse demand function , where = + (sum of incumbent and entrant quantities). Production is via the Leontieff (perfect complements) production function: = min ,
is firm s labour. Hired at a cost of per unit. is firm s capital. Bought at a cost of per unit.

Three stage game:

1. The incumbent buys some capital. 2. The potential entrant decides whether or not to enter (paying a fixed cost if she does). 3. The firms simultaneously decide on output (i.e. how much extra capital to buy and labour to hire).

Let be the capital firm bought in stage one.

Firm has a marginal cost of if < . Firm has a marginal cost of + if > .

Firm faces a marginal cost of + (since it doesnt have any capital yet).

Standard Cournot with marginal cost +

+ +

Full Dixit-Spence

Assume linear demand = 0 1 . Profits of firm are: 0 1 +

FOC: 0 1 + 1 = 0

Profits of firm are: 0 1 +

FOC Leads to:

I.e.:

0 1 21

0 1 21

Under monopoly where has an MC of + : 0 = . Under monopoly where has an MC of : 0 . =

0 , then we get this outcome. So if
21

< 0 , then we get this outcome. So if

21

21

For intermediate , the solution has = .

21

Under Cournot where has an MC of + : 0 . (Exercise: verify) = =

So if < So if
31 31 0 , 31

Under Cournot where has an MC of : = 0 + 0 2 , = . (Exercise: verify) 3 0 + 1 , then 31

then we get this outcome.

For intermediate , the solution has = , 0 1 meaning: = . 21

we get this outcome.

will enter if and only if her expected profits from doing so (given the chosen in stage 1) exceed . In our linear example:
0 0
31 1 0 31 + If 0 , then s profits are: If < 0 , then s profits are: 31 2 1 0 31 21

The higher is , the less likely is to invest.

Otherwise, s profits are: 0 1 0 1 +

0 31

0 + 31

0 31

0 1 21

0 2 31

0 2 . 91

0 2 2 . 91

0 1 2 . 41

Ineffectively impeded entry: If s profits at point are greater than , then they will always make a profit by entering.

Blockaded entry: If s profits at point are less than , then they can never make a profit. So sets capacity (and output) at the monopoly level.
also does this if at the monopoly capacity makes a loss if she enters.

Otherwise: Then there must be some point , on the section of to the right of the monopoly quantity, such that firm makes zero profits.
Firm will either choose this point to deter entry, or act as in the previous (Stackelberg) case, in order to accommodate entry. (Which happens will depend on parameters.)

Given firm will choose the optimal response to s capacity, this is like Stackelberg. If the Stackelberg solution is in then firm will choose that point. Otherwise it will choose .

Big exercise: derive the conditions under which firm is a monopolist in stage 3 in our linear example.

Fudenburg and Tirole (1984) present a two stage game:

1. 2.
An increase in means more aggressive behaviour, i.e.
1 2 2 1

Firm 1 makes some investment (could be in capital, R&D, advertising, etc etc.) Firm 1 and firm 2 compete (could be in prices, quantities or anything else). Firm chooses and makes profits 1 , 2 , .
< 0. < 0 and

Assume:

For all , there are (best-response) functions 1 2 and 2 1 which give the optimal choice of 1 given 2 and the optimal choice of 2 given 1 , respectively. For all , there is some point 1 , 2 which is a Nash equilibrium of the second stage game. The Nash equilibrium is stable.

Technical condition requires 0 <

1 2 2 1 2 1

< 1.

Effect of investment on profits if accommodating is given by: 1 1 , 2 , 1 1 , 2 , 1 = 1 +

1 1 , 2 1 1 , 2 , + 2 direct effect strategic effect =0 , 2

If the direct effect is small then, the effect on profits has the 2 . opposite sign to Analysis for deterring entry comes from firm 2s profits.

2 2 1 1 2 2 1 So = + = 1 2 1 1 2 2 1 2 2 1 + + 1 2

2 = 2 1 2 by the definition of Nash equilibrium.

Rearranging: 1 2 1

2 1 2 = 2 1 2 1 1 2 2 1 + 1

These derivations are non-examinable (before you complain)

But do read the paper for the examples.

By the stability assumption, 1 positive.

1

If firm 2s profits do not directly depend on , (as they did not with the Dixit-Spence model) then 2 1 = 0.

Thus, at least providing the direct effect of on firm 2s profits is small, increasing will increase 2 if 2 1 1 2 is positive.

1 2 2 1 2 1

is

First factor: if firm 1 is acting tough, does firm 2 want to act tougher itself? Second factor: does increasing make firm 1 tougher or softer in the second stage?

More on that first factor,

If this is negative, then 1 and 2 are called strategic substitutes. Quantities under Cournot competition are an example, since the reaction functions slope down. (You produce a lot, I want to produce less.) If this is positive, then 1 and 2 are called strategic complements. We will see that prices under price competition with differentiated products are an example. (You price high, I may as well price high too.)

2 1 1

Optimal strategy Strategic substitutes (downward sloping)

Investment makes incumbent tough A: Top dog D: Top dog

Investment makes incumbent soft A: Lean and hungry D: Lean and hungry A: Fat cat D: Lean and hungry

Strategic complements A: Puppy dog D: Top dog (upwards sloping)

where:

A = accommodate entry, D = deter entry, Top dog = be big to look tough, Puppy dog = be small to look soft, Lean and hungry look = be small to look tough, Fat cat = be big to look soft.

Examples Strategic substitutes (downward sloping)

Investment makes incumbent tough Irreversible capacity investment followed by Cournot competition.

Investment makes incumbent soft Backstop investment followed by a patent race granting monopoly to the winner (and the backstop if both fail). Informative advertising (where some consumers who see an advert in the first period return to the incumbent at any price) followed by price competition.

Strategic complements Production with (upwards sloping) learning by doing (lowering marginal costs), with (differentiated product) price competition in the second period.

Ghemawat (1984) looks at DuPonts decision in 1972 whether or not to undertake a large investment project. Kadiyali (1996) looks at entry into the photographic film industry.

The practice of setting a low price now in order to get higher profits in the long-run (via discouraging entry, or encouraging exit). Cannot be optimal under complete information with perfect capital markets.

Once entry occurs the incumbent will change their price (and the potential entrant knows this). If a firm attempts to drive out a rival by setting a low price then the rival should borrow to cover its losses in the short term. Knowing this firms should not attempt predatory pricing in the first place.

Three sequential decisions, two sale periods, two firms ( and ).

1. 2.
1. 2.

Firm chooses whether or not to enter. Firm (if they entered) and firm simultaneously set prices and pay an overhead cost of < 1. Then:
Markets open the first time and sales take place. If firm has made a loss out of this decision, then they must ask the bank for a loan, else they have to declare bankruptcy and exit. The loan is granted with probability 1 . Markets open the second time and sales take place.
28 5

3.
1.

Market demand is =

Firm (if they are still in) and firm simultaneously set prices, again paying an overhead cost of < 1. Then:

Assume firms compete on price, but (for simplicity) assume prices can only take integer values. (Looking at differentiated products without this restriction would give very similar results.)
So in the Bertrand equilibrium, both firms price at 1 and make a profit of Assume further that marginal costs are equal to . Under monopoly 0 = + thus makes a profit of 2 2
1 12 2

.
8 5

= 18 = .
5

28 5

8 5

1 2

8 5

1 2

, which implies = 2. The firm

1 2

1 2

= 1.

Second sale period:

First sale period, firm :

If firm chooses price 1 (or above), then firm wants to enter and set a price of 1, making positive profits. If firm chooses a price of 0, then if firm enters, clearly they should set a price greater than 0, and make a loss of (only) . They will be prepared to do this if 1 1 > .
Key insight: if this does not hold they will not enter in period zero, and if they dont enter, firm wont set the predatory price.

If there are two firms they will play the Bertrand solution and both make positive profits of 1 .

First sale period, firm :

Firm is prepared to gamble on the loan getting turned 18 down if + 1 > 2.

5

Firm prefers a loss then guaranteed monopoly if which is true automatically since < 1.

But cannot guarantee a monopoly in the second period, because would not enter if they were guaranteed no second period profits. Will never do this if = 0, since 1 < 1 < 2. I.e. with perfect capital markets predatory pricing will never be observed. 1 1 But if e.g. = and = , then is prepared to wait out 2 5 1 1 2 1 predatory pricing since 1 1 = 1 1 = > = 2 5 5 5 and firm is prepared to perform predatory pricing since 18 1 18 1 1 21 + 1 = > 2. + 1 =
5 2 5 2 5 10

18 5

> 2

Suppose firm either has an MC of either , or and that 3 3 5 firm has an MC of . Firm knows its MC, but firm 3 believes the two possibilities are equally likely. Again assume an integer pricing constraint.
5 2

An alternative explanation for predation is that setting a low price acts as a signal that the firm has low marginal cost (when such marginal costs are not observed).
Milgrom and Roberts (1982)

Demand is 1 at any price less or equal to 3 (and zero above that point). Both firms have overhead cost of
1 3

per period.

Suppose that somehow at the end of period 1 firm found 2 out that firm s MC was . (And that firm knew that firm 3 had found this out.) Conversely, if finds out that s MC is , then wants to 3 stay.
5

If firm does not exit, then Nash play dictates that both firms should set their price equal to 2. Exercise: verify. At this price, firm makes a profit (net of overheads) for the period of 5 1 1 1 2 = (i.e. a loss). 3 2 3 6 Thus firm wants to exit if it finds out firm is low cost.

Exercise: verify this and show that both firms set a price equal to 3. Both firms setting a price equal to 2 is a Nash equilibrium of the sub-game. Why can this not happen here?

If firm is high cost and sets the same price then they 5 1 5 1 make a loss if + 3 < 0, i.e. if < 1.
3 3 3 3

If firm is low cost and sets a price < that induces firm to exit after one period then firm makes a profit if 2 1 2 1 + 3 > 0, i.e. if > 1. 3 3 3 3 So if firm sees = 0, they know firm must be low cost, and so they do indeed exit.

Just remains to specify first period behaviour.

Exercise: verify that firm always setting a price equal to 2 and firm setting their price to 0 if they have low MC or 2 otherwise is a Nash equilibrium (and is the start of the SPNE described here). Is there another? Which do and prefer?

Reputation for toughness (Kreps and Wilson 1982). Predatory pricing enables firms to acquire a reputation for being tough.
Again, imperfect information about payoffs. This time though it is uncertainty about whether the incumbent gets some extra utility from fighting.

Growing markets, with some non-linearity that means success depends on being large early e.g. financial constraints/VC funding, lock-in, patent races. Non-price predation. E.g. bundling IE with Windows.

The empirical evidence broadly supports the conclusions of the Cournot model, though other rationing rules may come closer to the data. Irreversible investment before Cournot competition may discourage entry. If it does not accommodation results in Stackelberg like behaviour. More generally, the behaviour needed to deter entry depends on the slope of the reaction functions and the effect of investment on how tough a firm appears. Predatory pricing does not happen in the perfect world of classical economics.

You should be able to classify examples of the four cases. But under imperfect capital markets or partial information it may happen in a variety of different ways.