Lecture 1 Final Complete EC337

Lecture 1 Economic Principles & Course Overview: 

EC337 Industrial Economics 2: Market Economics, Competition and Regulation Department of Economics University of Warwick Module Leader: Dr. Chris Doyle 5 October 2011 Lecture 1 Economic Principles & Course Overview

Slide 2: 

Module Leader: Dr . Chris Doyle (Office S2.104) Online course details and lecture slide packs available at: http://www2.warwick.ac.uk/fac/soc/economics/ug/modules/3rd/ec337 Teaching format: 2 lectures per week, 12-1pm Monday, Room MS0.3 & 11-12pm Wednesday, Room MS0.3 Lectures start Wednesday 5 October and end Wednesday 7 December 2011 Assessment methods: Coursework (20%) – comprising one in-class problem set with four short questions (10%) and one group PowerPoint presentation (10%) and an exam (1.5 hours) in the Summer Term (80%). The examination will have two sections. Section A will have two short questions and is compulsory; Section B will have three questions from which one is selected. The 2010/11 exam paper provides an illustration of the exam template. Office hours: Monday 2-3pm; Thursday 2-3pm (Weeks 2-10, Term 1 only)

Course overview: 

Course overview Economic principles Competition law Benchmark cases in the EU The anatomy of a competition case Market definition Two-side and multi-sided markets Mergers and unilateral effects Upward pricing pressure Coordinated effects Coordinated effects – notable cases Cartels Pricing abuses Vertical restraints Refusal to supply Margin squeezing Intellectual property and competition policy

What is competition?: 

What is competition? Rivalry among companies in and/or for markets Rivalry occurs in terms of prices, altered or improved products, techniques of production, brand awareness, reputation, the provision of information to consumers, after-sales service, etc. Rivalry can occur across: Products (objective characteristics - substitutes) Geography (location – geographic substitutes, arbitrage) Time (future entry/exit)

Is competition desirable?: 

Is competition desirable? “In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so.” Adam Smith (1776) The Wealth Of Nations , Book II, Chapter II, p.329, para. 106 The First fundamental theorem of welfare economics states that any Walrasian equilibrium (full market clearing) is Pareto-efficient First demonstrated graphically by Abba Lerner and mathematically Harold Hotelling, Oskar Lange, Maurice Allais, Kenneth Arrow and Gerard Debreu The theorem holds under general conditions. Sufficient conditions include complete markets, price-taking behaviour and local non-satiation of preferences The First fundamental theorem of welfare economics supports the assertion made by Adam Smith, but highlights limitations (e.g. no public goods, externalities, monopoly power, etc.)

Effective competition: 

Effective competition Perfect competition is a theoretical benchmark and not in itself typically the goal of competition policy In practice competition agencies and policy makers strive to achieve and maintain what is often termed effective or workable competition Effective competition derives from William G.Shepherd (1997) “Dim Prospects: effective competition in telecommunications, railroads and electricity” The Antitrust Bulletin , Spring pp. 151-175 Shepherd talks of effective competition as requiring internal and external conditions The internal conditions are: (a) a reasonable degree of parity among the competitors; and (b) a high enough number of competitors to prevent effective collusion among them to rig the market. The external condition is easy entry. Effective competition denotes the idea that firms should be subject to a reasonable degree of competitive constraint from actual and potential competitors as well as from customers

Australian Consumer and Competition Commission (ACCC) on Effective Competition: 

Australian Consumer and Competition Commission (ACCC) on Effective Competition “Is more than the mere threat of competition – it requires that competitors be active in the market, holding a reasonably sustainable market position; requires that, over the long run, prices are determined by underlying costs rather than the existence of market power (a party may hold a degree of market power from time to time); requires that barriers to entry are sufficiently low and that the use of market power will be competed away in the long run, so that any degree of market power is only transitory; requires that there be ‘independent rivalry in all dimensions of the price/product/service [package]’; and does not preclude one party holding a degree of market power from time to time, but that power should ‘pose no significant risk to present and future competition”. Source: http:// www.australiancompetitionlaw.org/glossary/competition.html

Independent Commission on Banking Final Report, September 2011: 

Independent Commission on Banking Final Report, September 2011 “In banking markets as elsewhere, what matters is not competition in the abstract but competition to provide what customers want – effective competition. In markets that work well, suppliers compete vigorously with each other, and with the real threat of entry by other firms, to provide a choice of products to well-informed customers. Moreover , this happens without damaging side effects on others. Customers, though individually small, enjoy the power of informed choice . Where markets are not working well, customers lack that power and suppliers’ incentives can be distorted. Competition may then be weak and/or a mixed blessing. For example, competition might be directed not at serving customers well but at luring them into superficially appealing bad deals – as with the sale of much payment protection insurance (PPI) in recent years. And competition might have damaging side effects – as with ineffective food safety or pollution regulation, or with financial system risk created by lax and under-capitalised lending. The interconnected nature of financial institutions heightens the risk of such side effects arising .” [see also slide 10 below] Source : Page 153 at http:// bankingcommission.s3.amazonaws.com/wp-content/uploads/2010/07/ICB-Final-Report.pdf

Factors that may impede effective competition: 

Factors that may impede effective competition Monopoly power or concentrated markets The ability to make prices rather than to take prices as given Horizontal restrictions among competitors e.g. cartels Vertical restraints e.g. distribution agreements, denying access (refusing to deal) Asymmetric and/or incomplete information Entry barriers Consumer switching costs Coordination devices facilitating collusion

What is competition policy?: 

What is competition policy? “The set of policies and laws which ensure that competition in the marketplace is not restricted in such a way as to reduce economic welfare” Massimo Motta (2004) Competition Policy: Theory and Practice , CUP “Competition policy is judicious regulation to bring about the best in laissez-faire” John Vickers, Competition Economics , Lecture to the Royal Economic Society, 4 December 2003 (then Chairman of the OFT) “Competition is a basic mechanism of the market economy and encourages companies to provide consumers products that consumers want. It encourages innovation, and pushes down prices. In order to be effective, competition needs suppliers who are independent of each other, each subject to the competitive pressure exerted by the others.” EC DG Competition website (at October 2011) “The underlying problem in such cases, however, is not competition but the frameworks – including consumer protection and financial regulation – in which competition takes place. To blame competition would be to misdiagnose the problem . A more comprehensive analysis is needed. In short, a distinction is needed between ‘good competition’ to serve customers well, and ‘bad competition’ that exploits customer unawareness or, for example , creates a race to the bottom on lending standards .” Independent Commission on Banking Final Report, September 2011 page 153

Market power and competition policy: 

Market power and competition policy Competition policy is primarily focussed on dealing with costs associated with market power Market power leads to excess profits, which if persistent and not legitimised by law is indicative of ineffective competition and market failure Indicators of market failure therefore may include Concentrated markets (oligopoly) Entry barriers Restrictive practices High profits and stable market shares

Market power and market structures: 

Market power and market structures Market power is associated typically with concentrated markets (oligopolistic markets) Theory characterises oligopoly as strategic interaction involving firms choosing variables such as price, quantity (capacity), R&D, advertising, quality, etc. Illustration of market power Linear demand : P(Q) = a - bQ Zero fixed costs, constant marginal cost: c> 0 where a>2c We will consider and compare: Monopoly and Cournot duopoly Assume a=130 , b=1 and c=10

Market power and market structures: 

Market power and market structures Monopoly

Market power and market structures: 

Market power and market structures Cournot oligopoly (duopoly)

Market power and market structures: 

Market power and market structures Cournot oligopoly (n-firms)

Market power and market structures: 

Market power and market structures Cournot oligopoly (Lerner Index)

Market power and market structures: 

Market power and market structures Cournot oligopoly (Herfindahl Index)

Objectives of competition policy: 

Objectives of competition policy Effective competition Choice Promoting innovation Driving prices towards costs Minimisation of deadweight losses Maximisation of consumer surplus Balancing static and dynamic efficiency – achieving desirable incentives Price Quantity Demand Supply p c q c q m p m Blue shaded area Consumer Surplus Green shaded area Deadweight Loss Red shaded area Producer Surplus

Instruments of competition policy: 

Instruments of competition policy Legal framework provides deterrence Prohibitions subject to penalties, fines and possibly criminal sanctions Investigative powers Dawn raids, requesting data, etc. Cease and desist orders Public awareness programmes Mystery shopping Leniency programmes Whistleblowing Remedies Behavioural (much of the above) Structural (divestiture, functional separation, change entry requirements, etc.)

Take-away questions: 

Take-away questions What is the value of the deadweight loss in the Cournot duopoly example above ? 800 Calculate the industry output and equilibrium price for the above Cournot oligopoly model Q=80 and P=50 Why is the Lerner Index a measure of market power and show why it can never exceed 1 ? Measures price-cost mark-up, maximum value is 1 when MC=0 In a Bertrand model of oligopoly what factors may result in positive profits ? Examples, differentiated products, search costs Using the Cournot model of oligopoly, what does a higher Herfindahl Index predict ? Higher price If there are 5 firms in a market with market shares 20 %, 24 %,18 %, 21 % and 17% what is the Herfindahl Index? What is the change in the Herfindahl Index if firms with shares 20% and 24% merge? H=2,030 and changes to 2,990 an increase of 960