Introduction to course

This lecture

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