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Unit 4(b) : Predatory Pricing - Coggle Diagram
Unit 4(b) : Predatory Pricing
Predatory Pricing is an exclusionary abuse, it is a means to achieving a position whereby they can raise prices above the competitive level.
1.1 Suppose an incumbent sets a non profit maximising price following entry, that is the incumbent could have set a price higher to earn profits, and this price is aggressive enough to drive out the entrant, or deters a future entrant considering to enter the market, it indicates a predatory strategy. The higher profit will then result from evicting the entrant, or profit sacrifice in the short run exceeds the benefit of deterring the rival in the long run.
1.2 The predator's price has no Legitimate Business Purpose, and achieves its profits by exclusion.
1.3 Ingredients of a classic predation strategy:
Is there an intent?
Did the incumbent price below cost?
Is there a possibility that the losses will be recouped?
was there a deviation from short run profit maximisation while the prey was still in the market?
Pricing below costs lies at the heart of Akzo in Europe and the Areda-Turner test in the US.
If price is below marginal cost, there is a presumption of predatory behaviour, since losses are made on each unit sold and the predator would make higher profits if it reduced output.
If price is above marginal cost, there is a legitimate reason for the behaviour.
2.1 It might be argued that the relevant counterfactual in assessing whether low prices are predatory, should be the sale of the last unit at the short run profit maximising price, rather than a situation where the last unit is not sold at all.
The Areeda and Turner test advocates marginal cost as the threshold for checking if there is a presumption for predation. In practice, marginal costs are hard to measure, and for this reason, average variable cost can be considered a good proxy.
In ECS/Akzo, the Commission also suggested that price was just one of the many elements dominant firms can use to force a player out of the market. Therefore, marketing and other investments must be given careful consideration. Additionally, it adds average total costs to the average variable cost, because there may be situations where the optimal prices may lie below average total costs and as such these may not be considered to be predatory.
Below average variable cost: indicates predation
Above average variable cost but below average total costs: indicates predation but further evidence that the dominant undertaking wants to foreclose a competitor is required.
Above average total costs: does not indicate predation
The Commission uses a slightly different threshold to average variable cost - the commission uses average avoidable cost (AAC), which are those costs that the firm stops incurring if it stops a particular activity. If revenues derived from a firm are less than those costs that they would avoid if they stopped the activity, then the firm would be better of ceasing that activity altogether.
AAC would be > AVC because it involves fixed costs and they differ from average total costs because they dont include common costs or that are fixed over a relevant period of time.
Two advantages of the AAC: Provides a precise distinction between the variable cost and the fixed cost, includes product specific fixed costs.
Art 82 guidance highlights that AAC considers all factors that may contribute to the identification of predation including sunk costs and any excess capacity that the firm can use to predate.
The commission's alternative for average total costs is Long Run Average Incremental Cost or LRAIC. In many cases this will be the same as ATC. Where they will differ is when a multi product firm incurs some costs that are common to more than one product - such costs are not incremental and therefore will not be included in the LRAIC. ATC however includes these prices.
The analysis of predation largely depends on the relevant time horizon. The OFT suggests that the relevant time period is when the predatory price was in force or expected to have been in force.
Suppose a large firm executes a predatory strategy, and the entrant exits almost immediately, given the short time period, there are likely to be few variable costs and the strategy is less likely to be found predatory.
But if the entrant remains in the market for a long period of time, more costs become variable and the AAC benchmark increases and it is more likely that the strategy is found to be predatory.
For longer time horizons, competition policy must show special focus on excess capacity.
The Role of Intent in predatory pricing is important.
Different theories of Predation
3.1 Reputation Theory
This is when a dominant firm can take some steps to deter entry in the markets it operates in: More generally, whenever a firm enters a market served by an incumbent, the entrant has to form expectations of how the incumbent will react to entry.
When an entrant has already entered the market, the incumbent will accommodate entry and adopt a profit-maximising price cut given that the entrant is in the market.
An alternative strategy is to respond more aggressive and cause a price war that is sufficiently aggressive that the entrant loses sufficient money to retire hurt. Although cost of fighting may have been worth more than the monopoly was was worth compared to sharing the market, the act of fighting sends a strong signal to any future entrant.
After the entrant E1 has had a fight, another entrant E2 may choose whether to enter T2 (another town). However, after E2 observes aggressive price war in E1, probability that he will react more aggressively is higher. At this point, E2 may decide to stay out of the market. If E2 decides to enter the market, incumbent will respond with a price war.
Reputation effect can extend to same markets across periods, across product markets and across geographic markets.
Theories of predation are especially important when entry can be frequent. For example, Microsoft-Netscape.
3.2 Deep Pocket Theory of Predation
If the incumbent has a deeper pocket, then they both know that if the price war becomes fight to death, the incumbent will outlast the entrant.
3.3 Signal Jamming
In practice, firms can raise capital from capital markets and their capital isn't necessarily fixed.
If firms are making losses, the firm may either be fundamentally unprofitable or it maybe the prey of a predator and it will become profitable eventually when the predation stops.
Signal jamming theory of predation describes a situation where an incumbent cuts prices to get into a price war at a time when the prey needs extra capital - or predation makes the entrant need extra capital - but the act of predation causes uncertainty in the financial markets and causes it to decline finance or raise the cost of capital.
3.3 Predatory Capacity Expansion
This occurs when the entrant enters at a time where there is excess capacity in the market, and the excess capacity is unavoidably sunk and price falls to variable cost, which is significantly below average total cost.
3.4 Other forms of Predation
Predatory advertising
Predatory product variety
Predatory product announcements
-Predatory scheduling
3.5 Selective Price-Cutting albeit above total average cost also amounts to an abuse (i.e. not just below cost predation).
Recoupment
If it is not possible that a firm will recoup its losses, then it is unlikely that the firm is predating. Moreover, if there is little chance of recoupment, there is little evidence of harm to consumers.
Defences for pricing below cost:
Introductory and promotional pricing
Network Externalities
End of line clearance sales
Systems : some products are not stand alone products but are sold with complementary products - razor and razor blades- therefore the manufacturer can be permitted t sell razors under MC, and blades above MC.
Two sided markets