Introduction to course

This lecture

  • two parts

    • first, how the course is organized

    • then introduction to competition policy

    • recommended reading: Massimo Motta, 2004, Competition Policy: theory and practice, Cambridge University Press.

expectations

  • we expect you to prepare each lecture

  • watch video lecture beforehand

  • prepare exercises to be discussed in class

  • follow the datacamp lectures on python

  • for next lecture: install python

    • look here to see how this should be done

grade

  • your grade is the average of

    • 2 assignments

    • 1 exam

    • class and datacamp participation

  • each has the same weight (25%)

  • assignments are mandatory and involve programming in python

  • class participation is mandatory and involves exercises from previous exams

  • part of the class participation is finishing the datacamp course in time

  • grades for assignments and class participation can only be used this academic year

assignments

  • assignments can be done alone or in a team of 2 students

  • for the programming assignments, you will do simulations

  • next lecture will be an introduction to python

  • during the other lectures, we will also show you how to program in python

  • attend (on the web) the datacamp courses on python and finish the course in time!

  • we know this is new for (most of) you

  • with python we can bring the theory to life

  • as python is new, you are allowed to help each other a bit with this

  • however, assignments are made independently by each team

python

  • good idea to look into python in the following weeks

  • when you get stuck, you can google

  • but some basic knowledge saves you a lot of time!

  • with python notebooks you can program and explain what you do in the same file

  • learn a bit of markdown and latex

details

Competition law

EU law

  • EU law is structured as follows:

    • Article 101: agreements between firms

      • horizontal agreements: cartels, collusion, joint ventures

      • vertical agreements: manufacturer and wholesaler or wholesaler and retailer

    • Article 102: abuse of a dominant position

      • price discrimination, predatory behavior, tying and bundling, refusal to supply

    • Merger Regulation: when one firm plans to acquire another firm, the Commission has to be notified

why needed?

  • economists tend to believe that markets work well

  • welfare theorems: Pareto efficient allocations

  • why do we need a competition authority (CA)?

imperfections

  • welfare theorems assume firms are price takers

  • in real world firms have (market) power to set prices

  • first year micro: monopolist setting prices leads to deadweight loss

  • under total welfare standard: welfare loss equals deadweight loss (\(DWL\))

  • under consumer welfare standard: loss equals \(DWL+PS\)

  • CA tries to prevent monopolies from emerging through mergers

  • when firm is dominant, CA tries to prevent firm from abusing this position

objective CA

  • EU and US tend to put more emphasis on CS than on PS

    • firms can fight for themselves

    • harder to organize consumers because of free riding problems

    • against: consumers are also shareholders

  • EU every now and again states as a goal promotion of market integration

    • political objective; hard to formalize in economics

    • EU forbids price discrimination across national borders

    • but from economic point of view can be welfare enhancing

market power

efficiency

  • Nickell (JPE, 1996): firms with market power are less efficient

    • with market power, less reason to “worry”

    • moral hazard: more competitive the market, firms and managers work harder to survive

    • selection: with market power, inefficient firm can survive; cannot happen in a competitive market

  • Aghion et. al (QJE, 2005) find that more competition leads to more innovation

  • Michael Porter (1990): competition is necessary to stimulate firms to innovate

not always bad

  • patents give firms incentives to innovate

    • ex post we lose welfare but we gain ex ante through the introduction of products

  • Government can regulate a monopolist: ACM (formerly, OPTA) regulates KPN

  • Coase: durable good monopolist competes with itself

    • if monopolist cannot commit, reduce prices over time

    • \(p=mc\) with monopoly

  • contestable market: firm may be only seller but \(p<p^m\)

    • potential entrants discipline the firm

    • barrier to entry is formed by sunk entry cost (not fixed cost)

    • taxi market: entry cost is not the price of a mercedes; can be resold

Too competitive?

  • Mankiw and Whinston (RAND, 1986): two externalities market entry

    • business stealing effect: excess entry

    • appropriability effect: too few firms enter

create power

  • Outperform other firms:

    • \(n \geq 2\) firms compete in prices, \(i\)’s cost function: \(C(q_i) = c_i q_i\)

    • \(c_1 \leq c_2 \leq ... \leq c_n\)

    • \(c_1 < c_2\) implies 1 is monopolist, \(p_1 = c_2\)

  • switching costs: offer frequent flyer miles or coupons for loyal customers

    • if customer gathered enough miles, optimal to keep on using this airline

    • though consumers love loyalty schemes, they create market power and lead to higher prices

  • network effects: network effects keep incumbents in the market when there are superior (potential) entrants

  • exclude rivals:

    • incumbent beer brewer sells to pubs and restaurants if they only sell incumbent’s beer brands

    • raises entry cost for newcomers

network effects

  • consumers value both intrinsic quality of product and how many other people use it

    • this is different from consuming ice-cream

    • when you decide on your operating system (Linux, Mac, Windows); relevant how many of your friends use the same os

    • utility good \(i\): \(u_i = v_i + \nu(n_i) - p_i\)

    • \(1\) is incumbent product with \(n_1 >0\)

    • new product 2 with \(v_2 > v_1\) but nobody uses it yet

    • even with \(p_2 = c_2 < p_1\) can be that \(v_1 + \nu(n_1) - p_1 > v_2 + \nu(0) - p_2\)

  • network effect gives incumbent market power

    • small differences at the start lead to completely different outcomes

defining markets

relevant market

  • not much damage can be done by firms that are small players

    • if two firms with each a market share of 1 percent want to merge, no reason to block such a merger

    • but when Microsoft or Google act suspiciously, we do worry

  • market share is important in competition policy cases

  • market share \(=\) firm’s revenue divided by total market revenue

  • but what is the total market?

    • if you sell apples, is the relevant market apples or fruit?

  • economists do not tend to worry about relevant market

    • find out directly whether a merger leads to higher prices; whether a practice is welfare reducing

  • European Courts do require a definition of the relevant market

procedure

  • guiding principle: “a relevant market is worth monopolizing”

  • relevant market is a collection of products and regions such that a (hypothetical) monopolist would be able to increase prices profitably (but from which benchmark?)

    • contains all substitute products and regions which provide competitive constraint on the products and regions under consideration

  • you wonder whether bananas in the Netherlands form a relevant market:

    • ask: if there would be a (hypothetical) monopolist on the Dutch banana market, would she be able to profitably raise prices by 5 to 10 percent (ceteris paribus: assuming all other prices remain constant)?

    • if so, bananas in the Netherlands is a relevant market (perhaps bananas in Brabant is already a relevant market)

    • if not, expand the market and see whether on this expanded market a hypothetical monopolist would be able to profitable raise prices

substitution

  • demand side substitution: if consumers would switch from bananas to kiwis after the price increase, the question becomes whether bananas and kiwis together form a relevant market

  • supply side substitution: if suppliers of banana liquor would start to sell bananas after the price increase, question becomes whether the combined market of bananas and banana liquor form a relevant market

  • geographic market: if consumers would start to buy bananas in Belgium after the price increase, the question becomes whether bananas in the Netherlands and Belgium form a relevant market

  • question is: is the market under consideration worth monopolizing?

  • relevant market is smallest set of products worth monopolizing

SSNIP test

  • this is known as SSNIP test: small but significant non-transitory increase in prices

    • “small but significant” is often taken to mean 5-10%

    • “non-transitory”: if this could be profitably done for 5 days only, the market is not worth monopolizing

  • in economic terms, relevant question concerns elasticities

    • if price of \(x\) is increased by 10%, by which percentage does demand fall? e.g. because consumers buy outside the region

    • if drop in demand is big, price rise is not profitable; market for \(x\) is not worth monopolizing

    • or by which percentage does supply increase?

fallacies

  • applying SSNIP test can lead to two “famous mistakes”:

    • toothless fallacy: marginal vs average consumer

    • cellophane fallacy: starting point for price increase

toothless fallacy

  • Commission in United Brands case: defining relevant market on the basis of the average consumer

  • Commission argued that very young and very old (those without teeth) did not consider other fruit a substitute for bananas

  • Commission concluded that bananas is a relevant market

  • however, when a (hypothetical) monopolist raises its price, question is not whether average consumer moves away, but whether marginal consumer substitutes away

  • if enough consumers at the margin substitute away, price increase is not profitable (although a number of consumer may be captive)

other examples

  • some people do not like sparkling water; for them still and sparkling water are not substitutes

    • yet, still and sparkling water are on same relevant market if enough consumers (at the margin) switch from still to sparkling if the price of still water is increased by 10%

  • aftermarkets: cheap ink-jet printer of brand \(X\) but cartridges are sold by \(X\) at a high price

    • do cartridges of \(X\) form a relevant market

    • probably not: although you will be stuck if \(X\) increases price, buyers of new printers substitute away from \(X\) because its cartridges are so expensive

    • buyers of new printers are the marginal consumers

    • if enough marginal consumers switch away from \(X\), rise in cartridge prices is not profitable

    • if so, market for \(X\) cartridges is not a relevant market


  • are Rolex and Casio watches in the same market?

    • some people argue they are not because they sell at completely different prices and are of completely different quality

    • correct question: do consumers at the margin switch from Rolex to Casio if price of Rolex watches is increased by 10%

    • CES utility function \(u(x,y)=(a x^\theta + b y^\theta)^{1/\theta}\)

    • whether goods are substitutes is determined by \(\theta\)

    • if \(a >> b\) then price of \(X\) will be higher than price of \(Y\)

cellophane fallacy

  • SSNIP test considers price increase of 5-10%, but from which benchmark?

  • depends on the question that you want to answer

  • benchmark price differs between merger cases and Article 101, 102 cases

  • definition of relevant market is different for different questions

  • merger case: whether the merger between two firms leads to price increase

    • question is whether at current prices merged firm has enough market power to raise prices

    • benchmark price is current price on the market

  • abuse of a dominant position case: current price not necessarily the right benchmark

cellophane case

  • US case: Du Pont argued that cellophane was not a separate relevant market

    • empirical evidence showed that it competed closely with other packaging materials such as aluminium foil and wax paper

  • Du Pont sole supplier of cellophane

  • on the wider market of packaging materials it had a smaller market share

  • US Supreme Court agreed that because of these other packaging materials Du Pont could not increase prices further

  • from this it does not follow that Du Pont did not have market power

    • as a monopolist Du Pont had increased the price of cellophane to such an extent that other (inferior) packaging materials now became substitutes

  • observation that Du Pont’s cellophane did compete with these other materials strongly suggests that Du Pont did abuse its market power by charging excessive prices for cellophane

benchmark price

  • in abuse case, current price level is not necessarily right benchmark for SSNIP test

  • sometimes take competitive price (or the price prevailing under effective or workable competition) as a benchmark

  • Du Pont as monopolist was able to raise price of cellophane profitably by 10% from the competitive price

  • if you try to determine whether a firm has abused her market power by raising prices, relevant market should be determined with competitive prices as benchmark (not current prices)

  • recall that a profit maximizing monopolist cannot profitably increase her price by 10% at current prices

concentration and market power

market share

  • tendency among lawyers to interpret high market share as a signal of market power

  • not necessarily correct:

    • two firms \(1,2\) producing a homogenous good

    • \(p = 1- (q_1+q_2)\)

    • firm’s marginal costs: \(c_1=0,c_2=c< 0.5\)

    • Cournot competition implies (check) \(q_1^C = \frac{1+c}{3},q_2^C = \frac{1-2c}{3},p^C=\frac{1+c}{3}\)

    • Bertrand competition: \(q_1^B=1-c,q_2^B=0,p^B=c\)

    • Bertrand outcome is more competitive than Cournot

    • Bertrand market is more concentrated than Cournot market

    • lack of competition under Cournot allows less efficient firm 2 to enter

    • high concentration can be sign of intense competition

summary

  • in this lecture we have seen:

    • how EU competition law is structured

    • why we need CA and what its objectives are (can be)

    • what the welfare losses are due to monopoly/market power

    • why market power is not always bad

    • why high concentration does not always signal market power

    • ways in which firms create market power

    • how to define relevant market and avoid two fallacies