Are judges leading economic theory? Sunk costs, the threat of entry and the competitive process.

• Author: Kleit, Andrew N.

1. Introduction

   Since 1984, antitrust law has shown a growing respect for the threat of entry as a condition to immunize from legal challenge a merger that otherwise would be believed to significantly increase the probability of collusion. Yet the economics literature, strictly interpreted, would imply that a collusive agreement should not fear entry in the presence of positive sunk costs. This suggests that either the judiciary is leading economic theory or that the importance of entry conditions in merger analysis is likely to decline in the future as courts incorporate the latest economic learning into the case law.

   In this paper, we attempt to bring theoretical form to a particular entry argument that has found favor in the courts. We suggest that sunk costs may not be a major impediment to entry when a group of customers can commit to an entry enhancing strategy. Buyers have strong incentives to adopt such strategies, because they benefit directly from the resulting lower prices. The simplest example involves a large buyer that is able to guarantee an entrant a market for its product. Long term contracts or even informal purchase commitments (backed by customer reputation) may also allow the entrant to obtain a guarantee of sufficient business to make the entry profitable. Once entry is thought likely to occur, the existing competitors may be unwilling to attempt a price increase of any magnitude. Thus, the threat of entry can maintain competitive prices even in the presence of sunk costs.

   In section II, we motivate the analysis by discussing the current controversy over the role entry conditions play in an antitrust merger review. Then we discuss the necessary assumptions for a model of how the threat of entry can deter any price increase in the presence of sunk costs. We note that these conditions are different from those commonly used in the economic literature. Section III contains the details of our general sunk cost model. We illustrate how large buyers, uncertainty, the cost of collusion and market growth can interact to maintain competitive pricing. We also discuss how economies of scale can affect the threat of entry. The general applicability of the model is discussed in section IV with empirical evidence from recent federal court antitrust litigation.

2. Entry in Antitrust - And Economics

   Starting with U.S. v. Waste Management, 743 F.2d 976 (2d Cir. 1984), courts have consistently found against the government in highly concentrated industries with few or no apparent barriers to entry.(1) In a recent merger case, the Department of Justice (DOJ) attempted to reverse this trend by advancing a restrictive legal approach to entry. The DOJ argued that the only way to defeat a presumption of an anticompetitive effect based on high concentration is "by a clear showing that entry into the market by competitors would be quick and effective." Judge (now Supreme Court Justice) Clarence Thomas, writing for the Court of Appeals for the District of Columbia Circuit, rejected the government's approach, concluding that it is unrealistic to expect such strong proof in the context of a merger case and even if a firm never enters a market, the threat of entry can stimulate competition.(2) Thus, one could conclude that some showing of entry barriers is now a necessary condition for a merger to violate the antitrust laws.

   During the 1980s, the official government policy on entry, written into the DOJ Guidelines [25, 12], was somewhat unclear, stating both

   If entry into a market is so easy that existing competitors could not succeed in raising price for a significant period of time, the Department is unlikely to challenge mergers in that market.

   and

   In assessing the ease of entry into a market, the Department will consider the likelihood and probable magnitude of entry in response to a "small but significant and nontransitory" increase in price.

   The Guidelines then defined the magnitude of "small but significant" as a five percent price increase (although this figure was to be adjusted for special industry conditions) and interpreted the time frame for "nontransitory" as generally two years.

   The first quote suggested that the DOJ would focus on how entry conditions affected the expected profitability of a nontransitory price increase. The threat of entry within a two year time period could render a price increase unprofitable, if the expected expansion of output lowered the long run price sufficiently to reduce the profits of the colluding firms below the level associated with competitive behavior. This point was implicitly recognized in a footnote to the Guidelines that posited that the prospect of entry may have a deterrent effect on the exercise of market power.

   The second quote highlighted the more tangible effects of entry. By focusing on the likelihood and magnitude of entry, the Guidelines suggested that it is the magnitude of entry that would occur during a two year period that should be considered. As entry became more likely to prevent or eliminate an anticompetitive price increase within two years, the government indicated that it was less likely to challenge the merger.

   The two analyses illustrated different approaches to the entry question. The first approach relied on information that suggests that the threat of entry would deter a price increase, while the second suggested sufficient entry should occur in two years to return the market to competitive equilibrium. The first method was compatible with the classical microeconomic theory of markets in which profits attract entry. In contrast, the second approach appeared to consider the idea that sunk costs may prevent entrants from investing in a market in response to supracompetitive prices, because entry could depress the price below the competitive level.

   The government appears to have made an attempt to integrate the two approaches in the 1992 revision of the Guidelines. Although the direct focus of the 1992 Guidelines [26] is on the likelihood (in combination with the timeliness and sufficiency) of entry, the discussion is general enough such that the threat of entry could be addressed in the analysis.(3) In particular, the 1992 Guidelines attempt to determine if the profitability of entry is undermined by the scale necessary for efficient entry. In determining if the minimum viable scale of entry would depress price below the competitive level, the Guidelines require consideration of market growth, vertical integration or forward contracting (large buyers) and anticipated accommodation by the incumbents.(4) To the extent that the ease of forward contracting impacts on the threat of entry, the Guidelines appear to recognize a defense based on the threat of entry defeating an anticompetitive price increase.

   One theoretical justification for the court's (and potentially the 1992 Guidelines') position can be found in the contestability literature. Baumol, Panzar, and Willig [3] show how the threat of entry into a perfectly contestable market can be sufficient to deter price from rising above competitive levels, regardless of the level of concentration in the market. As Schmalensee [22, 42] observes, however, the contestable market result may describe an "empty box". In practice, the zero (or extremely small) sunk cost requirement for contestability appears unlikely to be met. Without this condition, contestability theory seems to have little to tell us about the threat of entry for antitrust policy.

   Consider, for example, a competitive market with a few competing firms facing potential entrants with small but significant sunk costs. Should the firms in that market decide to collude and raise price, they have no apparent reason to fear entry. While a prospective entrant may observe prices that would make entry profitable, those prices are, from the point of view of the entrant, merely a mirage. As soon as a new firm enters the market, the collusive agreement dissolves and prices will be driven below the pre-entry competitive level. Thus, the entrant will not capture profits from supra-competitive prices, instead the entrant will lose money on its sunk costs, even though it has a cost structure identical to its entrenched competitors. Entry in such circumstances would appear illogical. Knowing this, incumbent firms would appear able to raise their prices collusively without the worry of entry. [24, 886, 890; 12, 386-9].

   Our purpose here is to present a model that shows circumstances when the threat of entry can deter such a price rise in the presence of sunk costs.(5) We note that a model of entry in this context should have several features. First, it should have positive sunk costs. Second, it is desirable that the model have a marginal cost pricing equilibrium with more than one firm. Previous models in the literature, such as Gelman and Salop [11] and Scheffman and Spiller [20] have assumed an industry with constant (horizontal) marginal cost curves and positive sunk costs. In such an industry, Bertrand competition generates marginal cost pricing and firms are unable to recoup their sunk costs. Thus, the first firm in the market may expect to retain a monopoly position, because entry is unprofitable. If entry should occur, Bertrand competition should continue until only one firm remains in the market. Either case may be of limited interest to antitrust policy, which implicitly adopts the preservation of marginal cost pricing as a policy goal.

   Third, entry should threaten to lower the long run returns to the colluding firms. If entry only reduces incumbents' returns back to their previous level of zero economic profits, they will have little to lose by colluding. They will choose to collude, taking the chance of gaining positive profits and the "risk" of zero profits, rather than face the certitude of gaining zero profits. Thus, entry must pose a risk to incumbents' quasi-rents to have a possibility to deter a price increase.

   Fourth, it...