Hunting unicorns? Experimental evidence on predatory...

Hunting unicorns? Experimental evidence on predatorypricing policies

Aaron Edlin, Catherine Roux, Armin Schmutzler, Christian Thöni

ECON

November 2015

A. Schmutzler (ECON) Experimental evidence on predatory pricing November 2015 1 / 32

1 Introduction1.1 Overview

Previous legal and economic literature has debated whetherbelow-cost predatory pricing is a relevant phenomenon

This paper considers above-cost predatory pricing (Edlin 2002):Low-cost monopolists may engage in post-entry price cuts;anticipation of these price cuts will prevent entry, in spite of highprices

We investigate whether standard and non-standard policies againstpredatory pricing can help

We provide experimental evidence confirming some aspects of theory(and leaving some puzzles)


1 Introduction1.2 Below-cost predatory pricing

Below-cost predatory pricing: Setting prices below costs with the goalof inducing exit or preventing entry in order to increase profits in thelong term

Several legal cases have dealt with the phenomenon

Chicago arguments have been put forward against it: with symmetricfirms, it is hard to recoup the short-term profit losses

Game theoretic arguments can support the idea: long purse, signaling,repeated games

Real-world evidence is rare

Experimental evidence is mixed


1 Introduction1.2 Below-cost predatory pricing

Are there so many theories of predation because it “is a common butvariegated phenomenon”or rather “for the same reason that 600 yearsago there were a thousand positions on what dragons looked like”?

“There is no suffi cient reason for antitrust law or the courts to take[predation] seriously.”Easterbrook (1981)

“Rare like an old stamp or rare like a unicorn?” (Elzinga, cited inGoeree et al., 2004)


1 Introduction1.3 Above-cost predatory pricing

Idea (Edlin 2001):

An effi cient firm that faces an ineffi cient potential entrant cancredibly threaten to limit price the entrant

This does not require going below the monopoly price pre-entry

Possible Problem: Incumbent can set the monopoly price, eventhough entry plus limit pricing would yield higher welfare

Standard policy measures do not address the problem:

Brooke Rule requires above-cost pricing: would not be violated by thisbehaviorBaumol Rule requires keeping prices low post exit: does not attractentry

Edlin Rule requires not lowering price too much after entry: Can thisinduce entry and/or reduce prices?


1 Introduction1.3 Above-cost predatory pricing

Basic empirical challenge:

If entrants do not enter for fear of predatory pricing, above-costpredatory pricing may have an effect without ever being observed

But if we see "insuffi cient entry" in the field, when can we attributethis to fear of above-cost predatory pricing?

It would be necessary to compare entry in a laissez-faire environmentand one where above-cost predatory pricing is diffi cult for legalreasons.

But how? —> Lab experiment


1 Introduction1.4 Role for a lab experiment?

Not:

Show that the SPE is (not) played

Find evidence for social preferences

Instead:

Understand whether fear of an anticipated off-equilibrium event caninfluence decisions

Allow for policy experimentation under similar conditions

Understand how players choose between various “somewhat rationalalternatives”


1 Introduction1.5 This paper

Theory:

In the SPE of finitely repeated versions of "above-cost predatorypricing games" there is no entry along the equilibrium path:

trivial with Laissez-Faire and Brooke rulemessy with Baumol and Edlin rule

prices are below monopoly only in the Edlin case

Experiment:

Entry deterrence at monopoly price is frequent, except in Edlin case

In the Edlin case, pre-entry prices are lower, and there is more entry

In all cases, there are price wars after entry

In all cases except Baumol, prices are at the monopoly level after exit


1 Introduction1.6 Overview

1 Introduction2 Experimental Set-Up3 Theory4 Experimental Results5 Discussion


2 Experimental Set-Up2.1 Overview

four treatments: LAISSEZ-FAIRE, BROOKE, EDLIN, BAUMOL

seven rounds per treatment, each consisting of a four-period game

two firms L and H with marginal costs cL < cH can produce ahomogenous good with demand D(p)

in stage 1, firm L decides whether to incur fixed costs F ofproduction, sets price thereafter

in stages 2-4, both firms simultaneously decide on participation, thensimultaneously choose prices

exit is irreversible

perfect information

no financial constraints


2 Experimental Set-Up2.2 Treatments

DefinitionAn incumbent in period t is a firm that had a market share of one inperiod t − 1 and is present in period t

LAISSEZ-FAIRE: No restrictions on prices.

BROOKE: An incumbent is not allowed to price below its ownmarginal cost in duopoly periods.

EDLIN: An incumbent is not allowed to price below η times itsprevious price (η ∈ (0, 1)) when the competitor is present.BAUMOL: If the competitor exits in period t after a duopoly period,an incumbent is not allowed to increase its price in period t or anylater period.


2 Experimental Set-Up2.3 Parameters

D(p) = 80− pPrice space: [0, 80]

cH = 30

cL = 20

F = 250

η = 0.8

Moreover:

Firms with equal prices share the market

Without entry, firms earn 50. Entry costs 200.


3 Theory3.1 Overview of Critical Prices

pBH , pBL : break-even prices

pM (cH ), pM (cL): monopoly prices

p∗ such that 0.8p∗ = pBL : entry-deterring price (Edlin)

Overview of Prices

0

cL

20

pBL

24.5

cH

30

pBH

35.6

p⇤

44.5

pM (cL)

50

pM (cH)

55 80

1

Note: pBL < cH ; p∗ < pM (cL)


3 Theory3.2 Tie-Breaking

(T1) In any situation where both firms charge the same price, but aprofitable short-term downward deviation for exactly one firm isfeasible, this firm wins the entire market (and becomes the incumbentin the next period).Examples: (ptL, p

tH ) = (cH ,cH ); (0.8p

t−1L , 0.8pt−1L );

(0.8pt−1H , 0.8pt−1H )

(T2) Suppose in t = 2, 3 both firms charge the same price, but neither firmis constrained. Fix a continuation strategy in t + 1. Suppose firm iprefers leaving the market in t to j rather than taking the market(and conversely for j). Then j wins the market.Example: In Baumol-Game (in period 2), L may want to let H win tobe free to set high prices later

(T3) If firm H is indifferent between entering and not entering given thesubsequent subgame strategies, it will not enter.


3 Theory3.3 Laissez Faire plus Brooke

PropositionThe Laissez Faire and Brooke Game both have a unique SPE in purestrategies without entry and L−monopoly prices.

(i) Player L participates in periods 1-4 if he has not exited before.(ii) H only participates if L has previously exited.(iii) Monopolists always set their respective monopoly prices(v) In periods in which both players participate, pLt = p

Ht = cH ; player L

has a market share of 1.


3 Theory3.4 Edlin

PropositionThe Edlin Game has an outcome-unique SPE without entry, in which firmL sets the entry-deterring price p∗ except in period 4 (pLH = p

m(cL)).(i) In period 4: If L previously exited or undercut H with p3 < p∗, only H isin the market (and sets its monopoly price). Otherwise only L is in themarket and sets the monopoly price.(ii) In periods 2-3: L deters entry (induces exit) unless restricted to set aprice above p∗; H undercuts L if possible; then exits in the next period. Lstays.

Outcome for L-incumbents, depending on 0.8pLt�1:

cH p⇤

L winsexit

H winsexit

H winsno exit

1


3 Theory3.5 Baumol

PropositionThe Baumol Game has an SPE without entry in which firm L sets itsmonopoly price.

(i) In periods 3 and 4, monopolists set the monopoly price unless restrictedby the Baumol constraint. When both firms are in the market, asymmetricBertrand equilibrium prices cH = 30 result.Only L participates unless (a) it previously exited or (b) priced below itsbreak-even price. With (a), only H participates (provided it can breakeven!); with (b), there is a mixed equilibrium with zero expected profits(ii) In period 2, behavior is similar, except that, in duopolies, there is acontinuum of prices [cH , p̃2] ≈ [30, 32.679], and H wins.


3 Theory3.6 Welfare Benchmarks

Welfare benchmarksWelfare:

Total surplus

Consumer surplus

Firm profits

1800

1550

-250

Regulated

MC-Mo.

1539.8

0

Regulated

AC-Mo.

0

1250

Bertrand

Duopoly

1248.8

628.6

620.2

Edlin

1-3

1211.6

583.9

627.7

Edlin

1-4

1100

650

450

Laissez-Faire

Brooke, Baumol

1

Figure:A. Schmutzler (ECON) Experimental evidence on predatory pricing November 2015 18 / 32

4 Experimental Results4.1 Overview

As expected, in Laissez-Faire and Brooke treatments there is littleentry, high pre-entry and post-exit prices

As expected, Edlin pre-entry prices are lower than in other treatments

As expected, Baumol post-exit prices are lower than in othertreatments

More surprisingly, Edlin encourages entry and yields substantialincumbent exit


4 Experimental Results4.2 Laissez-Faire Treatment

Overview of Prices:

Pre-Entry 49.6 (Prediction 50)

Post-Entry 34.9 (Prediction 30)

Post-Exit about 50.7 (Prediction 50)

Note: Post-Entry price is just below break-even price



0.0

5.1

.15

.2

<20 20 25 30 35 40 45 50

>50

<20 20 25 30 35 40 45 50

>50

Incumbent Entrant

Market share: 0% 50% 100%

Fre

quen

cy

Price

Figure: Histogram of the incumbents prices in phase PostEntry of treatmentLaissez-Faire.



33% of H firms never enter (58% in final round)

L usually undercuts H

Average Profit of H-entrants is -235

Entrants earn positive profits only in 13.4% of the competitiveconstellations

61% of H-entrants exit at some point



Summary:

Monopolistic Pre-Entry Prices

Limited entry

Price war after entry (usually won by L)

Frequent H-exit thereafter

Monopolistic Post-Exit Prices


4 Experimental Results4.3 Policies

30

35

40

45

50

55

1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7

PreEntry PostEntry PostExit

LaissezFaire

Brooke

Baumol

Edlin

Pri

ce incu

mben

t

Round

Figure: Incumbents prices in the three phases and across treatment: Dynamicsacross the seven rounds of the experiment.



Table 1: Price of H in PreEntry

Stage LaissezFaire Brooke Baumol Edlin

1 50.11 48.70 50.41 47.432 48.25 49.18 49.70 45.083 49.82 49.91 49.06 39.434 49.84 49.67 49.12 45.62

1

Figure: Price of H in PreEntry



Table 1: Price of H in PostEntry

Period LaissezFaire Brooke Baumol Edlin

2 35.55 37.22 37.56 39.833 34.48 32.67 35.13 34.554 34.09 33.81 36.71 31.72

1

Figure: Price of H in PostEntry



Table 1: Price of H in PostEntry

Period LaissezFaire Brooke Baumol Edlin

23 51.54 50.00 38.42 50.004 50.31 49.45 38.84 49.93

1

Figure: Price of H in PostEntry



Pricing: Summary

Pre-Entry Prices:

around monopoly price for LF, Brooke, BaumolLower (average 46.2) for Edlin; in particular in rounds 4-7

Post-Entry Prices:

Much lower than pre-entrySimilar across treatments

Post-Exit Prices:

around monopoly price for LF, Brooke, EdlinLower (average 38.7) for Baumol; in particular in rounds 4-7



0.2

.4.6

.81

0.2

.4.6

.81

1 2 3 4 5 6 7 1 2 3 4 5 6 7

1 2 3 4 5 6 7 1 2 3 4 5 6 7

LaissezFaire Brooke

Baumol Edlin

Incumbent exit

Entry & stay

Entry & exit

No entry

Fra

ctio

n

Round

Figure: Incumbents prices in the three phases and across treatment: Dynamicsacross the seven rounds of the experiment.



Participation: Summary(Focus on periods 4-7)

No entry is common in LAISSEZ FAIRE, BROOKE

No entry is less frequent in BAUMOL, very infrequent in EDLIN

In all treatments, a large fraction of entrants exits again

There is a surprising amount of ineffi cient and probably irrationalincumbent exit


5 Conclusion5.1 Summary of Good News

If we take this exercise seriously . . . . We have caught the unicorn!

When there are no relevant pricing restrictions

(apparent) fear of above-cost predatory pricing discourages entryPost-entry price wars induce exitPost-exit prices return to monopoly level

With post-entry pricing restrictions (Edlin)

There is more entryPre-entry prices decline

With post-exit pricing restrictions (Baumol)

There is an intermediate amount of entryPost-exit prices decline


5 Conclusion5.1 Summary

Discussion

In all treatments, there is substantial entry - experimental artefact?

In Edlin treatments, entry is extremely strong. Why?

In Edlin treatments, there is substantial incumbent exit. Why?

Post-entry behavior is quite similar —no differences in predation?


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