In Search of Predatory In Search of Predatory PricingPricing

R. Mark Isaac and Vernon L. R. Mark Isaac and Vernon L. SmithSmith

Is Predatory Pricing Observable in a Is Predatory Pricing Observable in a Laboratory Environment?Laboratory Environment?

OutlineOutline

Overview of Research Procedures and Overview of Research Procedures and ResultsResults

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

The Plato Posted Offer ProcedureThe Plato Posted Offer Procedure Alternative HypothesesAlternative Hypotheses Experimental ResultsExperimental Results ConclusionsConclusions

Overview of Research Procedures Overview of Research Procedures and Resultsand Results

AssumptionsAssumptions1.1. Two firms- one large, one smallTwo firms- one large, one small2.2. Scale economies- larger firm has a relative cost Scale economies- larger firm has a relative cost

advantageadvantage3.3. ““Deep pocket” possessed by the advantaged firmDeep pocket” possessed by the advantaged firm4.4. Sunk entry costsSunk entry costs5.5. Complete information regarding competitors‘ costsComplete information regarding competitors‘ costs6.6. Induced RivalryInduced Rivalry7.7. Antitrust RulesAntitrust Rules

- Semi permanent price reduction rule- Semi permanent price reduction rule- Quantity expansion limit- Quantity expansion limit

Overview of Research Procedures Overview of Research Procedures and Resultsand Results

Predatory pricing distinct fromPredatory pricing distinct from Competitive pricesCompetitive prices Shared monopoly pricingShared monopoly pricing Dominant firm priceDominant firm price Edgeworth- style price cyclesEdgeworth- style price cycles

Overview of Research Procedures Overview of Research Procedures and Resultsand Results

First series of experiments conducted with First series of experiments conducted with conditions 1-3 (3 experiments)conditions 1-3 (3 experiments)

Second series conducted with conditions 1-4 Second series conducted with conditions 1-4 Third series of experiments conducted with Third series of experiments conducted with

conditions 1-5conditions 1-5 The fourth series induced rivalry amongst The fourth series induced rivalry amongst

competitorscompetitors In the fifth series the large firm acted as In the fifth series the large firm acted as

confederate of the experimentersconfederate of the experimenters Two additional antitrust restrictions imposed in Two additional antitrust restrictions imposed in

addition to conditions 1-4.addition to conditions 1-4.

Overview of Research Procedures Overview of Research Procedures and Resultsand Results

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

Distinction between low prices due to Distinction between low prices due to “good competition” and “bad predation” “good competition” and “bad predation” exists in literatureexists in literature

Based on literature the trading Based on literature the trading environment consists of firms producing a environment consists of firms producing a homogenous product in a posted offer homogenous product in a posted offer market with full demand revelationmarket with full demand revelation

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

1.1. Number of firmsNumber of firms

- Single Predator- Single Predator

- Singular Prey - Singular Prey (Salop 1981, p.11)(Salop 1981, p.11)

- Plural Prey - Plural Prey (Scherer 1980, p.335; Kreps and (Scherer 1980, p.335; Kreps and Wilson Wilson 1982; Milgrom and Roberts 1982; Selton 1982; Milgrom and Roberts 1982; Selton 1978)1978)

- Two firm market (- Two firm market (Coursey, Isaac and Smith (CIS) Coursey, Isaac and Smith (CIS) 1984; Isaac and Smith 1984)1984; Isaac and Smith 1984)

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

2. Costs of the Firms2. Costs of the Firms Predator and Prey distinguished by costs Predator and Prey distinguished by costs

(Mcgee 1958, p.40)(Mcgee 1958, p.40)

- Predator and Prey “Predator and Prey “may”may” or “ or “may not”may not” have have equal costs equal costs (Ordover and Willig 1981 p.308; Salop 1981, p.19)(Ordover and Willig 1981 p.308; Salop 1981, p.19)

- Predator and Prey “Predator and Prey “do not”do not” have identical costs have identical costs (Geskins in Scherer 1980, p.338)(Geskins in Scherer 1980, p.338)

- To create conditions favorable to predation To create conditions favorable to predation predator given an important cost advantagepredator given an important cost advantage

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

3. Deep Pocket3. Deep Pocket- Predator has capital market advantage - Predator has capital market advantage

(Wall Street Journal, 1993)(Wall Street Journal, 1993)

- “The length of its purse assures it of - “The length of its purse assures it of victory.”victory.”

(Edwards in Scherer, 1980)(Edwards in Scherer, 1980)

- Predator given double the endowment of - Predator given double the endowment of PreyPrey

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

4. Sunk Cost entry and reentry barriers4. Sunk Cost entry and reentry barriers Small firms face barriers to entrySmall firms face barriers to entry Economies of scale not the only barrier to Economies of scale not the only barrier to

entry entry (CIS, 1984)(CIS, 1984)

Additional Sunk cost of entry and exitAdditional Sunk cost of entry and exit

(Ordover and Willig, 1981, p.305)(Ordover and Willig, 1981, p.305) Large firm also has incumbent knowledge advantage Large firm also has incumbent knowledge advantage

(Salop, (Salop, 1981)1981)

Each seller obtains permit before entering the marketEach seller obtains permit before entering the market

(CILS, 1984)(CILS, 1984)

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

5. Information5. Information- Firms have complete information about - Firms have complete information about

rivals’ costs rivals’ costs (Salops, 1981; Kreps and Wilson,1982 and Milgrom and (Salops, 1981; Kreps and Wilson,1982 and Milgrom and

Roberts, 1982) Roberts, 1982)

- Large and Small firm swapped position for Large and Small firm swapped position for there to be full information of rivals cost there to be full information of rivals cost structures.structures.

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

6. Rivalry6. Rivalry- Predation dependent on the intent of the Predation dependent on the intent of the

predatorpredator- In one series rival intent to exclude small In one series rival intent to exclude small

firmfirm

Predatory Pricing from Literature to Predatory Pricing from Literature to Experimental DesignExperimental Design

7. Predatory Pricing Antitrust Program.7. Predatory Pricing Antitrust Program.- Semi permanent price reduction regulation Semi permanent price reduction regulation

on large firmon large firm- All of large firm's price reductions had to be All of large firm's price reductions had to be

maintained for five consecutive periodsmaintained for five consecutive periods

- Output expansion limitOutput expansion limit- Small firm bought permit to produceSmall firm bought permit to produce- Large firm could not expand its output for two Large firm could not expand its output for two

periodsperiods

The Plato Posted Offer ProcedureThe Plato Posted Offer Procedure

Posted- Offer Institution Posted- Offer Institution (Plott and Smith 1978)(Plott and Smith 1978)

Seller sets “take it or leave it” price Seller sets “take it or leave it” price Quantities selected by buyers subject to Quantities selected by buyers subject to

sellers’ capacity limitssellers’ capacity limits

Used the posted offer mechanism Used the posted offer mechanism programmed for the Plato computer programmed for the Plato computer system system (Ketcham, Smith and Williams, 1984)(Ketcham, Smith and Williams, 1984)

The Plato Posted Offer ProcedureThe Plato Posted Offer Procedure

Buyers and sellers sit on separate terminals and trade for 25 periodsBuyers and sellers sit on separate terminals and trade for 25 periods Display screen shows subject’s record sheetDisplay screen shows subject’s record sheet

Maximum units that can be purchased (sold)Maximum units that can be purchased (sold) Each units marginal valuation (cost)Each units marginal valuation (cost) Buyers and sellers can cash rewards equal to the difference between Buyers and sellers can cash rewards equal to the difference between

the marginal value (selling price) and the purchase price (marginal cost)the marginal value (selling price) and the purchase price (marginal cost) No penalties for carryover ordersNo penalties for carryover orders

Each period begins with sellers setting a price and corresponding quantity Each period begins with sellers setting a price and corresponding quantity and Plato calculates the resulting profitand Plato calculates the resulting profit

Each seller sees the other sellers only after both have entered their offersEach seller sees the other sellers only after both have entered their offers The buyers were then randomly ordered by Plato using a computerized The buyers were then randomly ordered by Plato using a computerized

subroutine under the assumption that demand was fully revealed subroutine under the assumption that demand was fully revealed Sellers were not told what the final period of the experiment would beSellers were not told what the final period of the experiment would be

Alternative HypothesisAlternative Hypothesis

Alternative oligopolistic pricing behaviorsAlternative oligopolistic pricing behaviors

Any behavioral hypothesis might apply as Any behavioral hypothesis might apply as long as one or both firms chooses priceslong as one or both firms chooses prices

Alternative HypothesisAlternative Hypothesis Predatory PricingPredatory Pricing

Price lower than short-run optimal pricePrice lower than short-run optimal price Price that deters entry or drives out competitorsPrice that deters entry or drives out competitors

- Firm A is the Predator when the following conditions holdFirm A is the Predator when the following conditions hold

AA

AA

BA

AA

QAVCQP

QQP

QMinACQP

QMCQP

)()(

8&]65.2,$60.2[$)(

)()(

)()(

Alternative HypothesisAlternative Hypothesis

Competitive EquilibriumCompetitive Equilibrium Price cutting less severe than predationPrice cutting less severe than predation

Dominant Firm EquilibriumDominant Firm Equilibrium

3&7 BA QQ

3&6

84.2$

BA

DF

QQ

P

]76.2,$66.2[$& BA PP

Alternative HypothesisAlternative Hypothesis

Edgeworth Price cyclesEdgeworth Price cycles Price cuts of A matched by B until all incentives Price cuts of A matched by B until all incentives

are wiped offare wiped off Prices cut till Prices cut till

Shared MonopolyShared Monopoly Tacit collusion Tacit collusion

79.2$ BA PP

43.3$Pr&5,21.3$ MMM ofitQP

Experimental ResultsExperimental Results

Experimental ResultsExperimental Results

Experimental ResultsExperimental Results

Experimental ResultsExperimental Results

Experimental ResultsExperimental Results

The absence of Predatory PricingThe absence of Predatory Pricing In series 1 no seller posted predatory pricesIn series 1 no seller posted predatory prices In instances when prices were in the In instances when prices were in the

predatory range the quantities were not predatory range the quantities were not predatorypredatory

Such behavior only in period 1Such behavior only in period 1• Early period price experimentationEarly period price experimentation• Super-sophisticated signal of predation in futureSuper-sophisticated signal of predation in future

Series 2Series 2 With the introduction of sunk costs no predatory With the introduction of sunk costs no predatory

pricing price quantity pairs chosen in the 69 pricing price quantity pairs chosen in the 69 observationsobservations

In 54 cases the smaller firms contested the market In 54 cases the smaller firms contested the market with permitswith permits

Series 3Series 3 Despite perfect knowledge regarding competitors Despite perfect knowledge regarding competitors

costs no predatory behaviorcosts no predatory behavior Small firms remained in the market in all 54 instancesSmall firms remained in the market in all 54 instances

Experimental ResultsExperimental Results

Experimental ResultsExperimental Results

Series 4Series 4 The introduction of $1.00 reward for rivalistic The introduction of $1.00 reward for rivalistic

behavior failed to generate any predatory behavior failed to generate any predatory behaviorbehavior

Small firm did not exit the marketSmall firm did not exit the market

Generally there are no price quantity pairs Generally there are no price quantity pairs that lie in the predatory range, however that lie in the predatory range, however there are instances when the large firms there are instances when the large firms behavior was suggestive of predatory behavior was suggestive of predatory behaviorbehavior

Experimental ResultsExperimental Results

The dominant firm price setting model is The dominant firm price setting model is the most observed price setting behaviorthe most observed price setting behavior Of the 9 experiments 6.5 can be described by Of the 9 experiments 6.5 can be described by

the dominant firm modelthe dominant firm model Only two of the 10 experiments were Only two of the 10 experiments were

edgeworthianedgeworthian Signaling a move towards monopoly prices Signaling a move towards monopoly prices

rather than competitive behaviorrather than competitive behavior

Experimental ResultsExperimental Results

ConclusionConclusion

Unable to produce predatory pricing in Unable to produce predatory pricing in structural environmentstructural environment

Dominant firm equilibrium is predominantDominant firm equilibrium is predominant