The Dominant Firm:

A game of luck and strategy

Richard Conway
07534043
1. Introduction

Dominant firms are an inevitable by product of the competitive system of

markets that many industrialized countries today enjoy. Straddling the line
somewhere between monopoly and interdependent oligopoly, they can deliver
some of the benefits of monopoly without all of the associated costs.

However, when dominance is maintained through perverse set of practices - at

odds with competition authorities ideas of fair play – the benefits of this market
structure can be easily overwhelmed by the welfare costs imposed on society at
large.

As we don’t live in a perfect world, market forces are not always enough to
impede the inefficient allocation of resources that dominance can create.
Government intervention is hence justifiable and required in certain
circumstances.

The following essay will entail a brief exposition of how firms come to be
dominant in their respective markets and subsets, two basic pricing models, a
discussion of strategic methods for protecting said dominance, policy
considerations, and the conclusion that regulation is necessary, but such firms
are a necessary evil in some cases.

2. Attaining dominance

Several traits are common to firms in dominant positions across industries,

geographical markets and product types. First mover advantage, leadership
skills, cost advantages through economies of scale, strategic uses of patents and
technology, effective marketing and product promotion strategies, input
control, and size/market experience, all position companies in dominant
market positions (and are not necessarily anticompetitive strategies).

Dominance itself isn’t a matter of contention. It’s the manner in which such
pricing power is maintained.
3. Limit pricing models

Limit pricing models represent the most basic way a firm can maintain a
dominant market position. I shall describe two.

i. Static limit price model

The static limit price model forwarded by Marshall (1923) concerns itself with
protection of dominance in its most basic form – price competition with
entrants in a time independent setting.

We view the market as one in which the dominant incumbent has a degree of
pricing power and economic profits are present. Post-entry profits act as an
incentive for small fringe firms to enter the market.

If entry is blockaded – the dominant firm maximizes profits as in a monopoly

situation, and still entry is unprofitable – we treat the market as monopolistic.
This is the case where the entrant’s AC curves would place them below the
residual demand curve, where not even a normal rate of return is attainable
(given that the incumbent sets the leader quantity, and therefore price, under a
monopolistic optimization problem).

If entry is not blockaded, the main factor determining entrance is the cost
structure of the potential entrants. If many of these costs (mainly fixed) are
sunk, their full value will not be obtainable in resale markets. Thus, the
composition of costs and inclusion of sunk items will affect the entrant’s cost of
capital.

The incumbent has two choices when facing entry. It may flood the market
with output, depressing the entrant’s residual demand curve below the
entrant’s cost curve, making post entry production unprofitable (even
eliminating normal profit). It’s worth noting here that mere ability to create
excess capacity can act as a signal to potential entrants that the firm is willing
to pursue such a strategy. The price war itself need not actually happen.

Four factors determine whether a limit pricing strategy will be pursued:

1. Size of the market

2. Potential entrant’s average costs
3. The level of sunk costs in the entrant’s cost structure
4. Information that the dominant firm has on the entrant.
Given the above, a limit pricing strategy or an accommodative strategy will be
chosen depending on which will yield the greater profits in the static scenario.
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It’s worth bringing up the other extreme in our discussion, as it acts as our
benchmark case, just as perfect competition does to market structure analysis.
This is the idea of perfectly contestable markets (Baumol, 1977). It states that if
no sunk costs exist, new entrants may attain the same AC curve as the
dominant incumbent upon entry. Economic profits may then be quickly eroded
by entrants, who will leave again once supernormal profits (SNPs) are no longer
present (‘hit-and-run entry’). Therefore, only way the dominant firm can
preclude entry is by producing at a level that generates zero economic profit.

It should be noted that contestable markets, like perfect competition, are not
observed in reality. This is because they require perfect contestability – i.e. zero
sunk costs. This is an unrealistic assumption.

ii. Dynamic limit price model

The static model presented previously is a case of optimization with no

considerations of time. However, simple reasoning tells us that market entry
will take time. This time variable introduces a trade-off between future and
current profits.
Three variables influence this trade-off:

a. The discount rate – The higher the opportunity cost of capital to the
firm, the higher the cost of postponing current income for future
income.
b. Fringe expansion rate – the quicker fringe firms may take output, the
lower the dominant firm will set price. This is a function of technological
factors, and the level of post-entry profits.
c. Profit difference between the scenarios – in a large market with low
costs of entry, limit price will be close to marginal cost (MC) and limit
profit will be small. Hence present profits will overwhelm future profits,
and the firm is likely to take profits in the short run rather than protect
longer-term profitability.

All the above factors are weighed up in a trade-off between future and current
profits. What we see in many scenarios is an initial high price set by the
dominant firm, which will be subsequently dropped over time (International Air
Industries, Inc., and Vebco, Inc v. American Excelsior Company). It should be
noted that such a strategy is legal as long as doesn’t break the Areeda-Turner
rule (P>AVC). Hence we face a policy distinction between injury to competition
and injury to competitors.

4. Other dominance strategies

i. Merger

Obviously prohibited by the antitrust authorities, the merger of two firms with
high market shares is the most straightforward way to attain market power
(Standard Oil v. U.S). Mergers with such intentions are blocked under the EU
and US antitrust law. However, even when allowed, such mergers are not
always the perfect option for the creation pricing power.

Monopolization itself allows firms to increase prices as market power increases

(Lerner, 1934). This incentivizes firms to consolidate. However, there are other
effects that must be taken into consideration. For one, there is a free-rider
effect. This limits consolidation, as small firms have incentives to remove
themselves from consolidation processes and free ride on attempts by the
consolidated entity to raise prices. Furthermore, large firms have a different
incentive to invest capital than small firms because large firms internalize the
effect of their investment on prices.

The three above forces will then balance to dictate the likelihood of a merger or
not, even before any intervention by antitrust authorities (Gowrisinkaran and
Holmes, 2002).

ii. Direct cost based strategies

Firms may work to raise cost industry wide cost levels in an effort to make
fringe operation uneconomical. For example, a dominant firm may agree to
union demands for increased wage levels, or bid up the price of common inputs
to the production process (Salop and Scheffman, 1983). The idea is that
increased costs can be recouped through increased pricing power.

Such a strategy may be more attractive than predatory pricing strategies for
several reasons. Firstly, competition with high cost firms is preferred to that
with low cost rivals. Secondly, it may be relatively cheap to hike competitors’
costs when compared with the large losses incurred thorough predatory
pricing. The credibility of such a strategy is also enhanced by the irreversibility
of the cost increases and the low cost of implementation. Furthermore, in the
United Mine Workers v. Pennington case, the cost to the competitive fringe was
raised more than that of the dominant firms (Williamson, 1968).

iii. Product differentiation and advertising

Advertising may act as a barrier to entry by raising costs for fringe competitors.
These costs are sunk, as reputation and goodwill are both non-transferable
intangible assets. The lagged effect of advertising also comes into play –
increasing the need for capital market funding for fringe competitors, and
creating an absolute cost advantage for incumbents. Efficiencies of scale may
also be present due to repetition benefits and minimum public exposure levels,
increasing the MES for entrants. Finally, proliferation of advertising by
established competitors may interfere with that of new firms – the ‘noise’ effect
– creating an entry barrier by increasing costs to overcome the advertising
already on the market (Comanor and Wilson, 1947).
Product differentiation may also be achieved through differences in key
characteristics – such as location or substitutability – or quality. This serves to
create relevant product markets for the dominant firm’s product alone,
enhancing pricing power.

iv. Vertical integration

Dominant firms may integrate vertically to create necessary sunk costs that will
place fringe competitors at a cost disadvantage. Integration can be either
backward into input control (United States Steel Corporation v. U.S.), or forward
into distribution channels and wholesaling. This is an attractive option as, if
done right, it should not reduce revenue or output.

Linnemer (2002) puts forward some interesting welfare considerations on the

topic. He shows that integration may be improve welfare by shifting production
away from inefficient producers and to the more efficient firm due to increased
input costs. The implication is that antitrust authorities should show more
leniency towards large firms in cases where there is a strong link between
market share (measured by the Herfindahl index) and production efficiency.

v. Capacity expansion

Excess capacity can act as a signal to fringe firms of intent to compete in a

price war. This is relevant in situations where efficient expansions in capacity
may only be realized by large plant sizes. The maintenance of excess capacity
therefore acts as a competition-restricting investment.

vi. Predatory pricing

Predatory pricing is an investment in market power. It occurs where a firm

floods the market, reducing down price with the intention of foreclosing
competition. The firm will sustain losses in the short run, supported instead by
profits in other markets. Once competitors have exited, market power will be
regained and economic profits earned via price hikes. This is only a viable
option in the case of imperfect information (reducing capital market support of
fringe firms) and high sunk costs (preventing hit and run entry).
The attractiveness of such a strategy is determined by the discounted sum of
post-predatory profits, net of the intermediate losses. However, this risky
strategy must be viewed in light of lower risk alternatives such as vertical
integration.

From a policy perspective, Arreda-Turner rule (1975) determines that this

occurs when the dominant firm reduces price below AVC – a threshold for
antitrust intervention.

vii. Innovation, research and development, and patents

Patents confer legal product or process monopolies to innovating firms. Their

aim is to encourage innovation and R&D to correct the disparity between social
rates of return and private rates. However, firms may employ the strategic use
of patents to increase the time it takes to imitate products and the cost
involved. This is done by acquiring patents on small variations of the product or
process.

There is obviously an inherent conflict between competition and the patent

system. However, in aggregate, this legal system is usually seen as welfare
enhancing.

viii. Tying, bundling, and exclusive dealing

Tying, bundling and exclusive dealing can facilitate the maintenance of market
power. Tying has the effect of harming other companies in the same market
that offer single products instead of the tied good. Bundling can blockade entry
by higher cost single product firms, reducing competition. Exclusive dealing
contracts also foreclose downstream markets for producers, protecting
dominant firms.

These methods are often among the more subtle methods used to maintain
dominance.

5. Conclusion & policy stance

Efficiencies and consumer welfare are the guiding economic principles used in
evaluating ‘competition on the merits’ from a policy perspective. We must be
careful not to shelter less efficient rivals from competition in an attack on
dominant firm efficiency or output. In many cases, the benefits of increased
output to consumer welfare must be weighed against the loss of competitive
pressure by fringe rivals.

However, we must also temper these concerns with the need to further
regulate welfare reducing examples of dominance, such as more subtle forms
like tying and bundling.

Dominance is a fact of life in many industries where governments have

condoned pricing power through the patent system or intellectual property
rights. In such cases, increasing private return is seen as justified in light of the
large public benefits of innovation and product development.

In light of dissatisfaction with unpredictable results, questionable analytical

methods and the complex case law employed by antitrust authorities the world
around, some scholars have proposed a new set of tests to determine the
legitimacy of dominant firm conduct (OECD, June 2006). These include the
profit sacrifice test, the no economic sense test, the equally efficient firm test,
and the consumer welfare-balancing test. These, in conjunction with legal
precedent can clarify the reasoning behind competition agencies’ decisions and
make the process more transparent both for firms and consumers.

In conclusion, we’ve seen a number of methods that dominant firms can both
lawfully and unlawfully maintain market power in the medium-to-long-term.
Policy takes a reasoned approach in weighing societal benefits with welfare
losses due to pricing power, and judging on the basis of the net effect.
Legitimacy of dominance should be judged on a case-by-case basis, and
however much we the concept, in some cases it may be deemed a necessary
evil for in technology and efficiency in the long run.

Word count: 2102

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