433 Chapter 18 _________________________ POTENTIAL COMPETITION, LIMIT PRICING, AND PRICE ELEVATION FROM EXCLUSIONARY CONDUCT Robert E. Hall  Economists have made important progress in recent years in building quantitative models of the strategic interaction of sellers in markets that are imperfectly competitive. One important type of model deals with the possible entry of a new seller in competition with an incumbent monopolist or oligopoly. The analysis pictures the incumbent as creating an environment that depresses the expected profit of a potential entrant far enough to deter entry. The incumbents’ conduct may create natural barriers to entry—such as the use of low prices to build a base of loyal customers—or it may include artificial barriers, possibly in violation of antitrust law. I review this new class of models from the perspective of antitrust impact and damages. 1. Introduction Does potential competition limit the price of a product? Or does the price of an incumbent remain high until actual entry occurs? Modern competition theory provides clean answers to these questions. Potential competition can discipline price. Under certain conditions, the incumbent—acting before entry has occurred—will take actions that alter the environment in a way that reduces the payoff to entry and lowers the current price. To take a simple example, an incumbent company fearing entry installs extra machinery. A potential entrant knows that the company will have a lower variable cost in the future. The low cost implies that the incumbent would set a lower price if entry occurs than if the incumbent did not have the extra machinery. As a consequence of the incumbent’s extra capacity and lower cost, the potential entrant would receive a lower price. Under the right conditions, the entrant’s price would be too low to cover all of its costs, so it would choose not to enter. Thus the incumbent’s decision to install the extra machinery prevents entry. Further, as a result of having the extra capacity, the incumbent sets a lower price today, even though entry has not and will not occur. Potential competition has disciplined the price. If there were no possibility of entry, the incumbent would not choose the extra capacity, would have a higher level of cost, and would set a higher price. The possibility of entry limits the price that the incumbent will charge, which is why the phenomenon is called limit pricing.  Hoover Institution and Department of Economics, Stanford University. The author thanks Marc Van Audenrode and Jimmy Royer for their contributions to the project described in Section 5. Robert E. Hall, Potential Competition, Limit Pricing, and Price Elevation from Exclusionary Conduct, in 1 ISSUES IN COMPETITION LAW AND POLICY 433 (ABA Section of Antitrust Law 2008)