The Economics of Predation: What Drives Pricing When There is Learning-by-Doing?

David Besanko, Ulrich Doraszelski and Yaroslav Kryukov

No 2011-E8, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: Predatory pricing . a deliberate strategy of pricing aggressively in order to eliminate competitors . is one of the more contentious areas of antitrust policy. This paper uses a modern industry dynamics framework to characterize predatory pricing by isolating a Firm’s equilibrium predatory incentives. We present a dynamic stochastic game with learning-by-doing and entry and exit similar to the one studied by Cabral & Riordan (1994) and Besanko, Doraszelski, Kryukov & Satterthwaite (2010), and we compute the Markov perfect equilibria of this game over a wide range of parameter values. Our computational analysis reveals that equilibria involving behavior that resembles conventional notions of predatory pricing can arise for plausible parameter values. We then show how the equilibrium pricing condition can be decomposed into a variety of advantage-building and advantage-denying motives. We use our decomposition to formulate six alternative definitions of predatory incentives, including those implied by the economic definitions of predation offered by Ordover & Willig (1981) and Cabral & Riordan (1997). To assess the impact of these incentives on equilibrium behavior, for each definition, we compute counterfactual equilibria in which firms .ignore. the predatory incentives, and we then compare metrics of industry structure, conduct and performance (e.g., price, Herfindahl index, consumer surplus, and total surplus) under the counterfactual equilibria to those metrics in the actual equilibria. The economic impact of predatory incentives that emphasize the direct marginal impact of price on the likelihood of rival exit is relatively small for a wide range of parameter values. By contrast, the definitions of predatory incentives that have the greatest negative impacts on industry evolution and welfare are those that are fairly strict. For instance, if predatory incentives are defined to be the advantage-denying motive, we find these incentives have a significantly negative impact on long-run price, market concentration, per-period consumer surplus, and per-period total surplus, with minimal compensating benefits to consumers in the short and intermediate runs as the industry transitions to maturity. Our results have implications for how one might structure a “marginal profit” implementation of a profit sacrifice standard for establishing predatory pricing.

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