Barriers to Entry II

Cabral chap 12
 Product Proliferation

• The ready-to-eat cereal industry may be characterized by

relatively low economies of scale and relatively low levels of
technology.
• So entry into this industry is easy from a technological point
of view.
• Between the 1950s and 1970s, there was virtually no entry of
new firms into the industry even though all incumbent firms
(Kellogg, General Mills, General Foods and Quaker Oats)
made significant profits.
• Although the number of firms did not change, the number of
brands sold by the incumbent firms increased from 25 to 80.
• Why are profits so high and no entry is observed, even
though entry seems relatively easy? Why did the number of
brands increase so rapidly, while number of firms didn’t?
• Breakfast cereals are definitely not a homogeneous product.
We will therefore consider a simplified version of the
Hotelling model to analyze this industry.
• Suppose that for simplicity that cereals are defined by one
single characteristic—sweetness. At one extreme we have
corn flakes and at the other extreme we have chocos.
• Finally we make the assumption that there is no price
competition: p1 = p2 = p^, p1 and p2 are the prices set by the
first and second firms.
• If we consider the case when there is an incumbent firm that
moves first (firm 1) and a potential firm (firm 2) that moves
second.
• If firm 1 can choose only one variety of cereal, then it will
choose to locate at middle of the segment at ½.
• If firm 1 chooses to locate to the right of ½, then firm 2 will
locate immediately to the left of firm 1; if firm 1 locates to the
left of ½, firm 2 will locate immediately to the right of firm 1.
• In either case, firm 1 will receive a market share of less than
50%, whereas locating at ½ guarantees a 50% market share.
• If F is the cost of creating a new variety of cereal, and
suppose F < p^/2. Then firm 2 will optimally decide to create
a new cereal and enter the industry.
• The new cereal will be located at ½ or arbitrarily close to it;
firm 2 will get 50% of the market and net profits = p^/2 – F,
the same as firm 1.
• Suppose that firm 1 initially creates two varieties of cereal,
one located at ¼ and one at ¾. Wherever firm 2 decides to
locate, the maximum market share it can get is ¼.
• If firm 2 locates at ½, it sells to all consumers whose
preference is greater than 3/8 (mid-point of ¼ and ½) and
lower than 5/8 (mid-point of ½ and ¾).
• If the cost of creating a new variety is greater than p^/4, firm
2 would receive negative profits, no matter what its location;
it would be better off staying out of the market.
• Firm 1, in turn receives p^ times 1 (total revenue) minus 2F
(TC of developing two varieties of cereal).
• If F is less than p^/2, then this is positive and greater than
what firm 1 would get from launching one variety only. In fact
profits under the two-variety strategy are p^ - 2F = 2(p^/2 – F),
while profits under the one-variety strategy are only p^/2 – F.
• This example explains what happened in the ready to eat
cereals industry—no new firms but a large number of
products launched by the incumbent.
• The number of varieties is greater than the incumbent would
find optimal if there were no threat of entry. Launching more
varieties is only optimal insofar as it deters entry.
• Just like the Hotelling model can be interpreted as a model of
product differentiation and a model of location, the strategy
of product proliferation can be interpreted as a location
strategy.
• An incumbent bank opening multiple branches, or a fast food
chain opening multiple locations.
• In these cases, an entry deterrence strategy would imply a
higher density of locations than the incumbent would find
optimal if there was no threat of entry.
 Predation
• If an incumbent monopolist cannot prevent entry, it can still
try to induce exit of its competitors in order to gain monopoly
power.
• Practices that are aimed at making rivals exit the industry –
predation.
• An important form of predation—pricing below cost to induce
exit—predatory pricing.
• In an earlier example we discussed how KLM matched
EasyJet’s low fare entry into the London-Amsterdam segment
of airline industry. The low price was a big blow to EasyJet’s
strategy.
What is predatory pricing?
• In the example given above, how can we be sure that KLM’s
objective behind matching EasyJet’s price was to induce it to
exit the market?
• We have seen earlier that adding more firms to the market
also decreases price.
• In fact, in a homogeneous-product market where firms do not
collude, going from one to two competitors implies a price
drop from monopoly price to MC.
• So how can we be sure that KLM’s price drop is not simply a
shift from one equilibrium to another equilibrium (with exit
not being at all intended)?
• One possible answer is that, given its lighter structure, EasyJet
has lower costs than KLM. EasyJet’s strategy is to charge low
fares, which implies keeping low margins.
• For these reasons, it is likely that, by matching EasyJet’s price,
KLM was making losses.
• These losses can be justified only if KLM actually intended to
drive EasyJet out of the market (or at least, increase the
probability of exit).
• In particular, if KLM was pricing below cost (which is likely, but
not clear), then the argument would gain some weight. Had
KLM been sure that EasyJet was going to stay in the market, it
would probably not have incurred losses by pricing below cost.
• Hence, it is difficult to prove intent just by looking at price
levels.
• It is very difficult to distinguish between pro-competitive
behavior (pricing close to cost, at a very low margin) and anti-
competitive behavior (pricing below cost to make the rival exit).
 The Chicago School and Long-Purse Theories of
Predatory Pricing
• A more radical criticism of the predatory interpretation of
KLM’s strategy is that rational players should never exit when
they are preyed upon—consequently, rational predators
should never engage in predation.
• This view is associated with the Chicago school of thought.
• Suppose there are two time periods. In the first period, the
incumbent must decide whether or not to set low prices.
• If it does, both incumbent and newly arrived prey make losses
L in the first period (could be the first year of entrant’s
operation).
• If the incumbent does not act aggressively, then both
incumbent and entrant receive duopoly profits πD.
• At the end of the first period, the entrant must decide
whether or not to stay in the market.
• In the second period, if the entrant exits, then the incumbent
receives monopoly profits πM . Otherwise the same situation in
the first period is repeated.
• If the entrant decides to stay into the second period, then the
incumbent’s optimal strategy is clearly not to behave aggressively
—the entrant’s decision not to exit has already been made, and
so, from the incumbent’s perspective, it’s a choice between
positive profits πD and negative profits –L.
• Let us now consider the first period. Suppose the incumbent acts
aggressively, the entrant will be making losses –L.
• Should it exit the industry? The answer is No.
• The incumbent’s threat to keep prices low is not credible—if the
entrant remains in the market, the incumbent eventually will find
it optimal not to behave aggressively. So the entrant should not
exit.
• Finally, a rational incumbent knows how a rational entrant
behaves and should avoid aggressive behavior in the first place.
• The Chicago School argument is, therefore, that no predatory
behavior should be observed in practice.
• If an incumbent responds to entry by lowering its price, this is
simply the competitive effect of a decrease in concentration—
something to be welcomed.
• The problem with this argument is that it relies too much on
“rationality” and “perfect information.”
• Suppose that the entrant does not have enough resources to
sustain losses in the first period and has to borrow from a
bank to survive. Chicago school suggests that a bank would
be willing to lend money, having seen through the equilibrium
in the second period.
• Suppose, more realistically, the bank is not always willing to
lend money.
• Specifically, the competing firms expect the bank to refuse a
loan with probability p.
• An entrant would want to stay in the market while the
incumbent is pricing low as long as the initial loss L, is less
than what it expects to gain in the future—πD times the
probability that the bank will give a loan: 1- p .
(1 – p) πD > L
• For an incumbent, aggressive behavior in the first period may
also be an optimal strategy. By accommodating entry, the
incumbent receives πD + πD , duopoly profits in each period.
• By behaving aggressively, the incumbent loses L in the first
period and in the second period ( p. πM ) for the entrant will
have exited if the bank does not lend money. If the entrant
gets the loan, the incumbent will have to settle for πD.
• Behaving aggressively in the first period is optimal for the
incumbent if p. πM> L + (1 – p) πD .
• According to this alternative view, if the preceding conditions
are satisfied, then
1) predation is observed in practice;
2) it is rational for the incumbent to be a predator and for the
prey to resist aggressive behavior; and
3) p percent of the times, predation is successful in driving
competition out of the market.
• In this theory of predatory pricing, the important difference
between firms is that one firm is financially constrained,
needing to apply for a bank loan and the other is not.
• For this reason, the theory is known as the long-purse or
deep-pocket theory of predatory pricing.
 Other Explanations for Predatory Pricing
• Low Cost Signaling—For KLM, pricing low might be a way of
sending EasyJet the message that KLM’s costs are low and that,
consequently, there is no room for an additional firm to make
money in the same market. One example of this signaling theory
of predation is given by the American Tobacco Company. Between
1891 and 1906, American Tobacco acquired 43 small companies
(mostly regional firms), and established a quasi monopoly.
• In most cases, before attempting to buy a rival, AT would engage in
(alleged) predatory pricing effectively imposing losses on the
target firm. Estimates show that this would lower the cost of
buying rivals by up to 60%.
• After observing AT’s low prices, the small firms would think that
AT’s cost was low and that it wouldn’t be able to compete against
it—settle for a lower selling price.
• Reputation for Toughness: By pricing aggressively, the incumbent may
acquire a reputation for being “tough,” so that in the future (or in other
markets) no more entry will take place.
• The case of the aspartame industry, is a good example: Monsanto
retaliated against Holland Sweetener’s entry into the European market
by lowering prices substantially.
• One interpretation of this strategy is that Monsanto wanted to make
sure that no competitors entered the US market, its most important
territory, where the aspartame patent was due to expire later than in
Europe.
• Another example is of British Airways. In the 1970s, BA successfully
fought Laker Airways’ entry into the transatlantic market. Laker went
out of business. In the 1980s, it took similar measures in response to
entry by Virgin Atlantic, although with less successful results. In the
1990s, the “victims” have been EasyJet and Virgin. One possible result
of this series of aggressive actions is that BA now has gained the
reputation for being a tough competitor, thus discouraging future entry
into its markets.
As Virgin Atlantic’s President Richard Branson
once stated, “The safest way to become a
millionaire is to start as a billionaire and invest
in the airline industry.”
• Growing Markets : A third explanation for predatory pricing
applies to growing markets where long-term success requires
a significant market share from early on. Example-in the
market for operating systems, it is important to start with a
good installed base of adopters, so that third-party
application software developers have an incentive to write
software running on the operating system; new users in turn
will be attracted and a sort of snowball effect takes place.
• The snowball effect can also work in the opposite way: lacking
a good starting installed base, an operating system may be
doomed to fail.
• In this context, predatory pricing early on may be successful in
that it prevents rivals from achieving the critical market share
necessary to survive in the market.
• An example of this type of predatory pricing is cable TV
competition in Sacramento, California. In 1983, Sacramento
Cable TV (SCT) was awarded a first franchise. In 1987, a
second franchise was given to Cable America.
• The latter started off by laying down a cable system across
700 homes (small fraction of market), but planning to expand
to the entire Sacramento area. The company’s initial offering
was 36 channels for $10 per month, which compared
favourably to SCT’s $13.50 for 40 channels.
• SCT responded quickly by selectively cutting its rates in the
area where Cable America had entered: the new offer was of
3 months of free service and then continued service at $5.75
per month.
• After 7 months, Cable America quit.
• Predatory pricing may be successful when:
– The prey is financially constrained
– Low prices signal low costs or the predator’s “toughness,” and
– Capturing a minimum market share early on is crucial for long-term
survival.

• In all these cases, low pricing by the predator induces the prey
to exit the market.
 Non-pricing Predatory Strategies
• Predatory pricing is not the only form of predation.
• One of the best examples for the theory presented earlier is
Microsoft’s MS-DOS dominance in the market for operating
systems.
• Microsoft’s strategy did not consist of directly lowering the
price of MS-DOS. Microsoft imposed contractual terms
whereby computer manufacturers would have to pay
Microsoft per computer sold and not per copy of MS-DOS
shipped.
• This implied that the opportunity cost of selling a computer
with MS-DOS was very small, in fact—zero: A fee would have
to be paid to Microsoft regardless of whether MS-DOS was
included or not.
• Largely based on this strategy, Microsoft was able to keep rivals DRI
and IBM out of the market for DOS operating systems and
managed to establish MS-DOS/Windows as the dominant operating
system.
• By the time the Department of Justice induced Microsoft to
abandon its practices, the installed base of MS-DOS was already
sufficiently high to create a self-sustaining advantage for Microsoft.
• Another class of non-price exclusionary strategies is bundling or
tying.
• At one point, Kodak, who held a dominant position in the market
for cameras, designed its new film and camera in a format that was
incompatible with other existing film formats. One interpretation of
this strategy is that it forced rival film manufacturers out of the
market.
• Similarly, IBM, who dominated the computer industry for a long
time, would incorporate increased amounts of storage into its CPUs
to prevent sales by plug compatible memory manufacturers.
• In 1994, world wide web was taking its first steps.
• Jim Clark and Marc Andreessen founded Mosaic
Communications Corpn—web browser Netscape.
• Netscape was given free to some users but licensed to
businesses.
• 1995 when Netscape was earning a healthy revenue stream.
• Microsoft was releasing Internet Explorer as a part of the
Windows 95 distribution; browser was bundled with the OS.
• Browser Wars
• IE market share rose very rapidly. Microsoft—quality and
features
• Netscape– unfair bundling strategy.
• 1998, Microsoft was sued for abuse of dominant position.
Later, also sued in Europe by EU competition policy watch
dog.
 Bundling and Tying
• Tying of two products (or services) occurs when a
seller sells one good (tying good) on the condition that
the buyer buys the other good (tied good) from that
seller or imposes on the buyer the requirement that
s/he will not purchase the other good from another
seller.

• Bundling is a general term describing selling

collections of goods as a package. In pure bundling,
the individual goods are not sold separately but only in
combination, so it is essentially equivalent to tying. In
mixed bundling, the individual goods, as well as the
package, are available.
 Public Policy Towards Predation
• Predation is one of the most difficult areas of antitrust and
competition policy. There is a lot of disagreement among
economists about general principles and about actual decisions
on different cases.
• Why is there such divergence of opinion?
1. Does Predation Exist?
The theoretical debate on whether predatory pricing exists in
practice is still on.
2. Identifying Predatory Behavior?
Even if we agree that predatory pricing exists, we still have to
distinguish it from simple, straightforward, competitive
behavior: more competition means lower prices and possibly
exit, even if no firm is trying to drive its rivals out of the market.
• In the US, a crucial step in distinguishing competition from
predation is the Areeda-Turner test: Prices should be
regarded as predatory if they fall below MC.
• However, this does not solve the problem, because a firm
might price well below short-run MC with the sole purpose
of moving down its learning curve (and with no anti-
competitive intent).
• Alternatively, one may look for post-exit price increases. If
there is predatory intent, the predator must have a
reasonable expectation of recouping short-run losses in the
long-run, after exit has taken place. E.g., is of Spirit Airlines
versus Northwest Airlines. When Spirit entered one of
Northwest’s markets, the latter responded by slashing its
fares. Soon after Spirit exited, prices went back up, in fact, to
higher levels than before Spirit’s entry.
 3. Welfare Effects
• Even if we are able to identify pricing with the clear intent of
driving rivals out of the market, we still have to address the
third question: Why should predatory pricing be illegal? Even
from a consumer’s perspective, there is a trade-off to be taken
into account.
• Predatory pricing implies that, with some probability, the prey
will exit the market, leaving the predator with monopoly or
near-monopoly power. We must however, weigh lower short-
run prices against possible higher future prices. The lower
prices are not very relevant when the predator’s price cuts are
selective, as in the Sacramento Cable TV case (only 700
customers benefitted from the predator’s price cuts).
• Skepticism about the (alleged) negative effects of predatory
pricing is especially relevant in industries with important
network externalities
• This refers to the case when consumers benefit from there
being other consumers who are buying the same product.
The Macintosh operating system is worth little to a consumer
when a few other users adopt the same OS. It is more difficult
to exchange files when the other party is based on a different
platform.
• If few consumers buy the Mac OS, little software will be
developed for it. In the context of network industries, like
operating systems, preventing predatory behavior may be a
mixed blessing. On the one hand, a competitor is saved for
the industry; on the other hand, less standardization is
achieved.