Transcript Predation
5.1 Predation • Predation = firm drives rival out of market by making it incur enough losses and then raises prises – Why would prey exit? – Why would prey stay out after price increased? – Can predator really recoup losses suffered during price war? Does predation make sense? – If predation is possible and profitable, how can we separate innocent aggressive competition from predation as restriction on competition? • Most cases apply Areeda-Turner test: P < LRMC, P < LRAVC, or P < LRATC + some other indications predation – Costs are hard to define and measure – Predation rare in case law. But is it really that rare? HKKK TMP 38E050 1 © Markku Stenborg 2005 Financial market imperfections 5.4 Predation • Old ”deep pocket” theory: richly endowed predator would charge low prices to drive out poorly endowed rival – Ignores possibility that profit-seeking investors would finance prey • Relation between prey and its investors – Predator seeks to manipulate that relationship and drive prey out of market or deter expansion into new markets – Pedatory strategy viable because of capital market imperfections – Investors face agency or moral hazard problems – Managers may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests – Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, imposing threat of termination in case of poor performance HKKK TMP 38E050 2 © Markku Stenborg 2005 • Debt-holders5.4 can threaten to liquidate firm or deny Predation new credit • VCs can refuse to extend additional financing when early performance is poor • Shareholders can decline to purchase additional equity if expected returns are low due to disappointing initial performance – Predatory pricing in product markets becomes possible when predator exploits termination threats to dry up financing of rival firm • Agency problems are particularly acute in financing of new enterprises – Uncertainty about cash flow in early stages – Losses may be unavoidable start-up costs or due to agency abuse – Mitigate moral hazard by agreeing to extend financing only when firms’ initial performance is adequate HKKK TMP 38E050 3 © Markku Stenborg 2005 • Predator may slash price to drain prey of sufficient funds to 5.4 Predation meet its loan commitments, forcing default • Predator can lower prey’s earnings to impair prey’s debt capacity by limiting collateral it can put up • Lower earnings may cause lenders to wrongly believe that firms’ profits are likely to be lower or riskier in future and therefore to stiffen their lending terms • Contract that minimizes agency problems will maximize incentive to prey Reputation • Predator lowers prices to mislead prey and potential entrants into believing that market conditions are unfavorable – Decision to enter or exit is based on evaluation of expected future revenues and costs – Most firms contemplating entry or exit do not have all information to determine future revenues and costs HKKK TMP 38E050 4 © Markku Stenborg 2005 – If incumbent firm5.4 is better informed than others about Predation cost or other market conditions, it may be able to influence the expectations – Incumbent firm can manipulate and distort market signals about profitability, and influence the expectations through pricing decisions or other actions • Predator seeks to establish reputation as price cutter, based on some perceived special advantage or characteristic – Reputation effects may be present when predator sells in two or more markets or in successive time periods within same market – One market or period serves as demonstration market with predatory conduct, and the other market or time period provides recoupment market, where predator reaps benefits – Reputation-induced belief reduces future entrant’s expected return and may deter entry HKKK TMP 38E050 5 © Markku Stenborg 2005 Signaling 5.4 Predation • Better informed predator reduces price to convince prey that market conditions are unfavorable – Aggregate demand is too low to justify presence of both firms in market or expansion by prey – Prey inferring weak demand from low price may be deterred from expanding or induced to leave market – Less plausible than previous predatory strategies • Test market and signal jamming theories plausible • Victim lacks knowledge and experience in market • Introduce new product or brand to probe market response by entering a limited “test market” • Predator may attempt to frustrate this market test by either of two predatory strategies HKKK TMP 38E050 6 © Markku Stenborg 2005 • Test market predation 5.4 Predation – Predator secretly cuts price to reduce entrant’s sales in test market – Induce entrant to believe that demand is low – Entrant abandons entry or enters on smaller scale • Signal jamming – Predator openly cuts price to distort test market results – Entrant can observe demand for its product only under exceptional circumstance of an ongoing price war – Market test is foiled, and entrant is unable to determine whether market demand for its product is sufficient to support entry • Cost signaling – Predator drastically reduces price to mislead prey to believe that she has lower costs – Predator trying to establish a reputation for low cost cuts price below the short run profit-maximizing level HKKK TMP 38E050 7 © Markku Stenborg 2005 – Observing predator’s price, prey rationally believes 5.4 low Predation there is at least probability that predator has lower costs – Lowers prey's expected return and causes prey to exit – Limiting factor in applying cost signaling theory is possible inconsistency between low price, predatory bluffing and subsequent recoupment – Attempt to raise price risks revealing signaling to prey and other potential entrants, causing them to upgrade estimates of market profitability Policy • Proof of scheme of predation only establishess that identified strategy is plausible • Need to show – Below cost pricing: avoidable or incremental cost, not AVC – Recoupment – Business justification? HKKK TMP 38E050 8 © Markku Stenborg 2005 • Financial market predation 5.4 Predation – Prey depends on external financing – Financing depends on its initial performance – Predation reduces initial performance and threatens preys financing and viability – Predator can finance predation internally or has better access to external finance as prey • Reputation – Multimarket predator faces localized competition – Predator faces threat of sequential entry – Reputation reinforces predatory strategy or increases probalility of future price cuts – Entrant observes previous exit or other adverse experiences HKKK TMP 38E050 9 © Markku Stenborg 2005 • Test market predation 5.4 Predation – Predator observes prey’s attempt to experiment on limited basis – Predator cuts price below following or anticipating entry – Price cut prevents prey from learning true demand conditions • Cost signaling – Predator might have lower or reduced costs – Predator reduces price – Prey believes that predator has lower costs – Possible cost reduction is sufficient to exit, deter entry or limit expansion HKKK TMP 38E050 10 © Markku Stenborg 2005