Kilpailu-%20ja%20yhti

1
Kilpailu- ja yhtiöoikeuden taloustiede

• Teacher Markku Stenborg, PhD (Penn State)
• Research Fellow, ETLA, http//www.etla.fi/
• Innovation, regulation, and the changing terms of
  competition in wireless telecommunications funded
  by Nokia and Tekes, http//brie-etla.org/
• Economics of OSS
• Senior Research Scientist, HIIT,
  http//www.hiit.fi
• Managing Privacy and Trust in Mobile P2P
• Consultant at CEA
• Previously
• Assistant Prof with Turku Business School
• Senior Adviser at Finnish Competition Authority
• Senior Manager at KPMG Transaction Services
• email markku.stenborg_at_etla.fi
• During this week room M 12 (3rd floor, Optimi)

2
Kilpailu- ja yhtiöoikeuden taloustiede

• Course homepage http//www.cea.fi/joe.htm
• This course covers theoretical and empirical
  issues related to Economics of strategic
  competition and competition policy
• Price and non-price competition
• Strategies to affect competition
• Market delineation
• Dominance
• Mergers
• Cartels and coordination of market conduct
• Vertical restrictions
• Focus more on Economics, less on Law

3
Kilpailu- ja yhtiöoikeuden taloustiede

• No textbook, but we will look at some papers and
  EU and Finnish notices and cases
• Some useful reading
• Aalto-Setälä et al. (2003) Kilpailulait ja laki
  julkisista hankinnoista, 3rd ed. (or 2nd ed.,
  2001)
• Besanko, Dranove, Shanley (2000) Economics of
  Strategy
• Cabral (2000) Introduction to Industrial
  Organization
• Carlton Perloff (2000) Modern Industrial
  Organization
• Church Ware (2000) Industrial Organization
  Strategic Approach
• Motta (2004) Competition Policy Theory and
  Practice
• Whinston (2003) Lectures on Antitrust Economics,
  draft at http//www.csio.econ.nwu.edu/
• I assume you have grasp of basic Economics
  concepts such as demand, marginal benefit and
  cost, supply, efficiency, surplus,

4
Kilpailu- ja yhtiöoikeuden taloustiede

• Luennot
• ma 13.9. klo 16-20, sali B6
• ti 14.9. klo 10-14, sali MA155
• ke 15.9. klo 14-18, sali MA155
• to 16.9. klo 10-14, sali B6
• pe 17.9. klo 10-14, sali MA155
• Final exams
• Ke 29.9. klo 12-16, sali K4
• Ti 12.10. klo 14-18, sali K4
• 22 questions, 11 answers
• One case, one more technical question
• Two straightforward explanations
• Prize best student receives Aalto-Setälä et al.
  Kilpailulait ja laki julkisista hankinnoista, 3rd
  ed, Tietosanoma 2003.

5
Course Outline

• 1. History and objectives of competition policy
• Introduction and objectives for competition
  policy
• Suggested reading Motta, Ch 1, Kovacic and
  Shapiro (1999) Antitrust Policy A Century of
  Economic and Legal Thinking, UC Berkeley,
  Working Paper No. CPC99-09
• 2. Market power and welfare
• Market power, allocative and productive
  efficiency
• Competition policy and innovation
• Market power and entry
• Aalto-Setälä et al. Ch 8.1-2
• 3. Market delineation and market power
• Product and geographic market definition
• How to measure market power
• Aalto-Setälä Ch 7 US Merger Guidelines,
  http//www.usdoj.gov/atr/public/guidelines/hmg.htm
  , Section 1 "Market Definition"
• Case Commission's Volvo/Scania decision

6
Course Outline

• 4. Oligopoly, cartels and tacit collusion
• How oligopolists compete
• What is collusion
• Factors that facilitate collusion
• Ex-ante and ex-post measures to fight collusion
• Aalto-Setälä Ch 5.1-2 Stenborg (2004) Forest
  for the Trees Economics of Joint Dominance
  Europe Economics (2001) Distinguishing between
  Competitive and Dominant Oligopolies in Merger
  Control
• 5. Horizontal mergers
• Incentives to merge
• Competitive and welfare effects of mergers
• Which variables matter? How to deal with merger
  cases?
• Aalto-Setälä Ch 15 Epstein and Rubinfeld (2001),
  Merger Simulation A Simplified Approach with
  New Applications, Antitrust Law Journal
• Case Commission's UPM/Haindl and Volvo/Scania
  decisions

7
Course Outline

• 6. Vertical restraints
• Vertical externalities double marginalization
• Vertical restraints to internalize externalities
• Welfare effects of vertical restraints
• Foreclosure exclusive dealing and other
  instruments
• Aalto-Setälä Ch 9.1-2 Dobson Waterson (1996)
  Vertical Restraints and Competition Policy, OFT
  Research Paper 12
• Case
• 7. Predatory practices
• Predatory prices long-purse, reputation,
  financial market effects
• Tests of anti-competitive behavior
• Aalto-Setälä Ch 8.1-2, 8.4.7
• Grout (2001) Recent Developments in the
  Definition of Abusive Pricing in European
  Competition Policy, http//www.bris.ac.uk/Depts/C
  MPO/workingpapers/wp23.pdf
• Case

8
1. Intro Competition Law and Policy

• Why do we need competition law and policy?
• Economic competition is self-steering process
  that guides production, distribution, pricing,
  etc. decisions
• Competition is an efficient way to organize many
  activities in society
• Efficient Pareto optimal maximize well-being
  or surplus generated by production and exchange,
  from assets possessed in society
• Allocative efficiency
• Productive or X-efficiency
• Dynamic efficiency
• Market power and restraints on competition
• reduce efficiency and/or
• restrict and disturb self-guiding process on
  markets

9
1. Intro Competition Law and Policy

• Goals of competition laws
• Promote efficiency?
• Obviously,
• but with nonprice competition simple formulas
  for efficiency (consumer surplus producer
  surplus) are deceptive and misleading
• What is efficiency?
• Do not strive for perfect competition but promote
  workable competition
• With non-price competition, consumer welfare
  becomes multi-dimensional
• Customers have preferences over quality, speed
  and security of supply, introduction of new
  products and services, etc.
• These may not be measurable
• And even if they are measurable, value judgments
  are necessary for efficiency analysis

10
1. Intro Competition Law and Policy

• Protect economic freedom and opportunity by
  promoting competition, so that competition can
  create
• lower prices
• better quality
• greater choice
• more innovation
• Sometimes competition laws have also other goals
• In EU, competition laws are used to promote
  single market within EU
• Competition laws also protect SMEs in some cases
• These other goals can conflict with the main goal
  of protecting economic freedom and opportunity

11
1.1 Competition Laws

• 1. Restrictions on Competition
• Article 81(1) of EU Treaty states that
• agreements between undertakings, decisions by
  associations of undertakings and concerted
  practices which have as their object or
  effect the prevention, restriction or distortion
  of competition within the Common Market shall
  be prohibited
• Article 81 covers much more than formal cartel
  arrangements
• Not only collusion, but also many beneficial
  forms of horizontal and vertical cooperation are
  prohibited
• Browse (http//www.europa.eu.int/comm/competition/
  )
• Guidelines on the applicability of Article 81 of
  the EC Treaty to horizontal cooperation
  agreements
• The Competition rules for supply and distribution
  agreements
• Guidelines on Vertical Restraints

12
1.1 Competition Laws

• 2. Abuse of Market Power
• Article 82 states that
• Any abuse of a dominant position shall
  be prohibited . Such abuse may, in particular,
  consist in
• imposing unfair purchase or selling prices or
  other unfair trading conditions
• limiting production, markets or technical
  development to the prejudice of consumers
• applying dissimilar conditions to equivalent
  transactions with other trading parties, thereby
  placing them at a competitive disadvantage
• making the conclusion of contracts subject to
  acceptance by the other parties of supplementary
  obligations which, by their nature or according
  to commercial usage, have no connection with the
  subject of such contracts.
• Read määräävän markkina-aseman väärinkäyttö at
  http//www.kilpailuvirasto.fi/

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1.1 Competition Laws

• Per se and rule of reason
• Per se conduct is prohibited if it fulfills the
  legal test regardless of other issues
• Rule of reason conduct is prohibited if its
  negative consequences outweigh the positive
• Articles 81 and 82 of EU Treaty seem to be per se
• But to prove that firm has abused its dominant
  position, authorities must
• show that the firm has dominant position
• conduct was abusive
• In practice, Article 82 has flavor of rule of
  reason analysis
• Article 81(1) does not apply to insignificant
  restrictions
• Article 81(3) and Commission Notices exempt
  various restrictions
• Article 81(1) also has flavor of rule of reason

14
1.1 Competition Laws

• In some legal systems, many vertical restraints
  are dealt with rule of reason
• Eg. previous Finnish law
• A priori, effects of vertical restraints to
  competition and efficiency are ambiguous
• Many vertical restraints are solutions to
  problems, not problems for competition
• Vertical restraints can align private incentives
  in supply and distribution
• Double marginalization (two vertical monopolies)
• Hence the Block exemptions

15
1.1 Competition Laws

• 3. Merger review
• Transactions that lead to increase in market
  power or to some other competition problems may
  be prohibited
• Illegal to monopolize markets by MAs
• In EU
• A concentration which would significantly
  impede effective competition in particular as
  a result of the creation or strengthening of a
  dominant position, shall be declared incompatible
  with the common market.
• EU previously had pure dominance-test
• US the effect of such acquisition may be
  substantially to lessen competition, or to tend
  to create a monopoly
• Usually, SLC-test poses lower threshold for
  intervention
• Monopoly is US legal jargon ? dominant position ?
  monopoly in Economics textbooks

16
1.2 Market Power in Case Law

• Read Motta, Ch 2 3, and Volvo/Scania decision,
  Market Definition section pp 5-21
• Assessment of market power in abuse and merger
  cases
• Define relevant antitrust markets
• Evaluate market power within the relevant markets
• Relevant markets are defined basically by demand
  substitution
• Only those goods that provide immediate and
  intense competitive constraints to each other
  belong to the same relevant market
• In some instances, also supply substitution and
  entry by potential competitors are taken into
  account in market delineation

17
1.2 Market Power in Case Law

• Market power on relevant markets is analyzed
• calculate market shares
• analyze competitive strengths of firms
• evaluating degree of actual competitive pressure
  firm faces
• entry barriers and other supply substitution
• In abuse cases, analyze whether conduct of
  dominant firm was misuse of market power
• In EU, dominant firms have special obligations
• Dominant firms cannot use their market power to
  impair conditions of competition
• Idea is to protect competition, not competitors

18
2. Economics of Market Definition

• Read EU and US Guidelines on relevant markets
• http//www.europa.eu.int/comm/competition/antitrus
  t/relevma_en.html
• http//www.usdoj.gov/atr/public/guidelines/hmg.htm
  
• Why we need to define relevant antitrust markets
  in case law?
• To calculate meaningful market shares
• Market shares tell us something about market
  power
• Market shares do not need to imply or correlate
  with market power
• More on this in Oligopoly and Merger sections
• Identify main competitors and competitive
  constraints
• We are interested in market definition only to
  extent it helps in analyzing market power
• Sometimes we can identify and measure market
  power w/o defining markets
• More on this will follow (Merger section)

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2.1 How to define markets? SSNIP

• On which set of goods market power can be
  exercised? Which goods compete immediately with
  each other
• Market for cars? Separate markets for minivans,
  luxury sedans, large family cars, compacts,
  subcompacts?
• Relevant antitrust market is something that can
  be monopolized
• If it cannot be monopolized, it is too narrow
• Then important competitive pressures are left out
  of candidate market
• Test Small but Significant Non-temporary
  Increase in Price
• Take a small set of substitute goods and a
  geographic area
• Assume all goods produced by hypothetical
  monopoly
• Incentive to permanently increase prices by 5-10
  ?
• Yes candidate market relevant market
• Proceed to analyze market power etc
• No candidate market lt relevant market
• Include more goods and repeat

20
2.1 How to define markets? SSNIP

• Logic Goods on relevant market create intense
  competition to each other
• Once this competition is removed, incentive to
  increase price
• If strong competition remains, price increase is
  not possible, and goods do not constitute
  relevant market
• Leave out significant constraints on market
  power, candidate market is too small
• Keep in firms and products that are not
  significant constraints, market is too large
• Price increase leads to
• Consumers substitute away
• Outside producers increase output or enter
• SSNIP asks how much demand shifts away for a
  price increase and does this make price increase
  non-profitable?

21
2.1 How to define markets? SSNIP

• SSNIP in Economics jargon What is demand
  elasticity for this set of goods?
• Basically elastic demand ? market too narrow,
  inelastic demand ? relevant antitrust market
• But recall effects from costs and supply
  subsitituition
• Digression on demand
• Individual demand is ultimately derived from
  customer preferences
• Hold everything else constant and vary the price
  of the good ? customers demand curve
• Demand as function of own price vs shifts in
  demand function
• Sum up all customer demands ? market demand
• Note economics textbooks (sort of) assume
  relevant market has been defined when discussing
  demand

22
2.1 How to define markets? SSNIP

• Market demand vs firm demand
• Demand for colas vs demand for Coca-Cola, say?
• What happens after market-wide price increase?
• Marshallian demand based on ceteris paribus
  assumption and measures effect of price change by
  keeping all other prices constant
• Merger Guidelines assume that the terms of sale
  of all other products are held constant
  Marshallian demand
• Direct demands are hard to estimate
• Suppose condidate for relevant market has n goods
  and their demand depend on each others prices
• Need to estimate at least n2 parameters to get
  any info on Marshallian demand
• Price change in some goods do not leave all other
  prices constant

23
2.1 How to define markets? SSNIP

• Residual demand curve is the demand curve faced
  by an individual firm
• Residual demand total market demand curve -
  supply of all other firms in market
• qi Q(p) - qj
• Residual demand curve incorporates effects of
  changes in prices of other products in response
  to changes in this products price
• Residual demand is good tool for market
  definition to as it is relatively easy to
  estimate from data available
• We do not observe demand curves, but price-output
  pairs, determined jointly in equilibrium
• Can one identify demand and supply?
• Need econometrics to get from data to demand curve

24
2.2 Critical Elasticity of Demand and Loss

• SSNIP-test should be applied by estimating own
  elasticity of demand
• What value of elasticity is large enough for
  concluding that given set of goods comprise
  relevant market?
• NotationP0 Current observed priceP1 P0
  plus some specified price increase tC Marginal
  costL (P C)/P price-cost margin or
  Lerner-index T Price increase deemed
  significant (eg. 0.05 or 0.1)T (P1 P0)/P0
• elasticity of demand
• Assume C is constant, profits are then (P-C)Q - F
• For profitable price increase, profits with
  higher price must at least equal profits from
  selling more at lower price

25
2.2 Critical Elasticity of Demand and Loss

• Break-even condition is Q(P0)(P0 C) Q(P1)(P1
  C)where P1 break-even price
• Rearranging Q(P1)/Q(P0) (P0 C)/(P1 C)
• Using definitions of T and L
• For linear demand Q (A - P)/B
• Recall elasticity of demand here is e(P0) P0/(A
  - P0), which gives Q(P1)/Q(P0) 1 - Le(P0)
• Break-even requires Q(P1)/Q(P0) L/(LT) so this
  gives usL/(MT) 1 Te(P0), and solving gives
  us critical elasticitye(P0) 1/(LT)

26
2.2 Critical Elasticity of Demand and Loss

• When demand is isoelastic, break-even elasticity
  ise(P0) log(LT) log(L)/log(1T)
• Critical sales loss for a price increase
  proportionate decrease in quantity sold as a
  result of the price increase large enough to make
  price increase unprofitable
• Sales loss resulting from price P0 ? P1 is1 -
  Q(P1)/Q(P0)
• For linear demand Q (AP)/B we can write this
  as1 Q(P1)/Q(P0) 1 (A P1)/(A P0) (P1
  P0)/P0P0/(A P0) Te(P0)
• Applying break-even value of e(P0) derived above
  gives value for break even critical sales loss Y
  T/(LT)
• If actual sales-loss after price increase is less
  than Y, it is profitable to increase price
• The break-even value of the critical sales loss
  is the same for both linear and isoelastic demand
  curves

27
2.2 Critical Elasticity of Demand and Loss

• Relationship between market power index L, and
  critical e and Y for 5 price increase L e Y
  50 1.82 9.1 40 2.22 11.1 30 2.86 14.3 20 4.0
  0 20.0 10 6.67 33.3
• Cross-Price Elasticity
• Sometimes in case law market definition is based
  on cross-price elasticity of demand
• Cross price elasticity of demand eij
  (dQi/dPj)/(Qi/Pj), where Qi and Pi denote the
  quantity and price of products i and j
• Cross price elasticity How demand for good i
  reacts to price increase of good j?
• Sounds like nice idea to delineate markets goods
  belong to same relevant market if they are
  good-enough substitutes

28
2.2 Critical Elasticity of Demand and Loss

• Rule used in some competition cases
• Goods i and j are on same market if cross-price
  elasticity is large enough and otherwise are on
  different markets
• Cross price elasticity is not a good measure for
  market delineation
• Market delineation is not question of how much
  demand will flow from i to j as Pi increases
• Cross-price elasticity is usually not symmetric,
  eij ? eji
• eij i and j on same mkt and eij i and j on
  different mkt is possible
• Even if a cross price elasticity is small, market
  need not be narrow, as there may be many other
  goods that restrict the market power of
  hypothetical monopolist
• If there are many substitutes, price increase
  will divert demand to many goods ? cross price
  elasticity must be small
• This indicates competition, not sepatate markets

29
2.2 Critical Elasticity of Demand and Loss

• Price and cross price elasticities are connected
• Own-price elasticity 1 weighted average of
  all cross-price elasticities
• Weight share of income in relation to share of
  income of the good in question
• Cellophane Fallacy
• US Supreme Court high cross price elasticy
  between cellophane and paper wrapping ? relevant
  market wider than cellophane ? Du Pont not
  dominant
• Also SSNIP test ignores fact that firm may
  already have market power
• Firm with market power wants to increase price to
  level where competition constrains start to bite
• Demand usually turns more elastic as price
  increases

30
2.2 Critical Elasticity of Demand and Loss

• Then goods actually outside of relevant market
  seem to be substitutes
• High cross price elasticy indication of use of
  market power, not an indication of wide market
• Cellophane fallacy means that different approach
  is required in abuse of dominance cases

31
3. Market Power

• Market power ability to profitably charge P gt
  MC
• Some sources of market power
• Only few firms active in the market
• Products are differentiated, and some customers
  prefer one firms product to other
• Firm that attempts to steal customers from its
  competitor must reduce price a lot
• Then firms have less incentives to lower their
  prices
• Capacity constraints
• Firm have less incentive to win more customers,
  giving other firms incventives to charge higher
  prices
• Customers are not informed of all firms prices
• Incentive to lower price is reduced
• Switching costs
• Each firm monopolizes its customer base
• Cartel or collusion (later in Oligopoly section)

32
3. Market Power

• Market power is source of inefficiency
• Allocative inefficiency
• Harberger triangle
• Rent seeking
• X-inefficiency
• Less need to control costs or to concentrate on
  key capabilities
• Less need to provide value to customers
• Dynamic inefficiency
• Less incentive to innovate
• Market power allows restrictions on competition
• Entry deterrence
• Predation
• Price squeeze
• Cartel or collusion

33
3. Market Power

• Monopolys profit maximization
• Assuming constant MC, monopolys profits are?
  P(Q) - C Q - F
• To maximize profits, set d?/dQ 0
• d?/dQ P(Q) Q dP/dQ - C 0 (MR - MC 0) ?
• P(Q) - C -Q dP/dQ
• Divide both sides by P
• (P - C)/P -(Q/P)(dP/dQ)
• Rewrite this as L 1/e
• L Lerner Index
• e elasticity of market demand
• Under perfect competition or perfectly elastic
  demandP C, hence L 0
• L is usefull measure of market power 0 L 1/e
• If we can estimate P, e and C, we can estimate
  market power L

34
3.1 Measuring Market Power

• To measure market power, we need to estimate
  demand consistently
• Basic idea how well other goods substitute for
  goods produced by firm i and constrain its market
  power?
• Answer elasticity of residual demand
• Residual demand does not tell who or what
  constrains market power
• Straightforward approach is to specify system of
  demand equations q D(pr), where q is vector of
  quantities demanded, p is a vector of prices, and
  r is a vector of exogenous variables that shift
  demand
• Need to define D(.) in a way that is both
  flexible and consistent with economic theory
• Problem 1 Number of parameters estimated
  increases with square number of products
• 10 firms, each with 20 brands ? 40 000
  elasticities

35
3.1 Measuring Market Power

• Problem 2 Simultaneity
• Equilibrium price and quantity determined jointly
  by demand and supply schedule
• Price increase by i is followed by rivals ? need
  to take into account how rivals react ? residual,
  not market demand
• Problem 3 Simple approach ignores consumer
  heterogeneity
• Solutions to problems include
• 1) assume problems away
• 2) assume symmetric representative consumer
• 3) assume multi-stage budgeting
• 4) use discrete choice/address models
• 1. Avoid problem
• Focus on aggregate demand
• All eastbound rail traffic, not differentiated
  across cities
• Focus on narrowly defined product
• Self service 87 octane

36
3.1 Measuring Market Power

• Focus only on sub-markets
• Particular segment in beer industry
• This is enough in some cases
• 2. Symmetric representative consumer
• Use Constant Elasticity of Substitution (CES)
  utility function
• Dimensionality problem is solved by imposing
  symmetry between products
• Estimation involves a single parameter,
  regardless of number of products, and can be
  achieved using simple econometrics
• Cross-price elasticities are restricted to be
  equal, regardless of how close the products are
• Are MB and Opel equally good substitues to BMW?
• This restriction can have important implications
  and in many cases would lead to the wrong
  conclusions
• For some industries or cases this model of
  differentiation is adequate, for most markets
  this is not

37
3.1 Measuring Market Power

• 3. Separability and multi-stage budgeting
• Divide products into smaller groups and allow for
  flexible demand within each group
• Multi-stage budgeting
• Consumer allocates expenditure in stages
• at highest stage expenditure is allocated to
  broad groups (food, housing, clothing,
  transportation)
• at lower stages group expenditure is allocated to
  sub-groups (cereal, bread, cheese, ..)
• until expenditures are allocated to individual
  products
• At each stage, allocation decision is function of
  only that groups total expenditure and prices of
  commodities in that group (or price indexes for
  the sub-groupings)
• Then we have cross elasticities between Opel
  sedan and VW sedan, between Opel van and VW van,
  and between sedan and van categories, but not
  between Opel sedan and VW van
• Reduces number of parameters to be estimated

38
3.1 Measuring Market Power

• Three stage system
• Top level overall demand for the product (cars
  or ready-to-eat cereal)
• Middle level demand for different segments
  (sedan, suv, stw, minivan or family, kids,
  adults cereal)
• Bottom level brand demand corresponding to
  competition between different brands within each
  segment
• 4. Discrete Choice Models
• Model products as bundles of characteristics
• sweetness, fiber content,
• alcohol content, bitterness, ...
• horsepower, length, ...
• Preferences are defined over characteristics
  space
• Each consumers chooses the product with best
  characteristics for her
• use bus if U(bus) gt U(car), U(train), U(walk), ...

39
3.1 Measuring Market Power

• Discrete choice models yield Logit demands (under
  some assumptions)
• prob that n chooses i has logistic distribution
• Dimension of characteristics relevant dimension
  for empirical work
• Heterogeneity is modeled and estimated explicitly
• Can be estimated using individual or aggregate
  market data
• Comparison
• Symmetric average consumer models least adequate
  for modeling demand for differentiated products
• Problem all goods are assumed to be equally
  close, equally good substitutes
• Logit models widely used because they are simple
• Multi-level model requires a priori segmentation
  of market into relatively small groups, which
  might be hard to define

40
3.1 Measuring Market Power

• Typically, multi-stage budgeting models assume
  all consumers consume all products
• For broad categories like food and shelter
  reasonable
• For differentiated products, it is unlikely that
  all consumers consume all varieties
• Multi-stage budgeting model is closer to
  classical estimation methods and neo-classical
  theory, and more intuitive to understand
• Discrete choice models require characteristics of
  products, are more technical to use, and rely on
  distributional assumptions and functional forms

41
3.2 Application

• Nevo (2001) uses discrete choice models
  succesfully
• Panel of quantities and prices for 25 brands of
  cereal in 65 U.S. cities over 20 quarters, using
  scanner data
• Estimate own price and cross-price demand
  elasticities
• Compute price-cost margins implied by three
  industry structures
• each brand on its own
• actual structure of few multi-product firms
• monopoly or collusion
• Markups implied by current industry structure and
  imperfect competition match observed price-cost
  margins
• High margins due to consumers' willingness to pay
  for favorite brand, and to pricing decisions that
  take into account substitution between own brands
• Market power entirely due to the firms' ability
  to maintain portfolio of differentiated products
  and influence perceived product quality through
  advertising

42
4 Oligopoly

• Topics
• Basic models of oligopolistic competition
• How can firms change rules of game to their
  advantage?
• How can firms avoid intensive rivalry?
• When cartel or implicit collusion is stable?
• Read or review
• Chapter on Oligopoly in any modern Micro or
  Industrial Organization textbook, and/or
• Europe Economics report available at
  http//europa.eu.int/comm/enterprise/library/lib-c
  ompetition/libr-competition.html
• I will use game theoretic reasoning and Nash
  equilibrium, so you should soon get comfortable
  with these ideas
• Note topics following oligopoly (Collusion and
  Mergers) will be based on oligopoly theory

43
4.1 Cournot or Quantity Competition

• Assumptions
• Market demand price function of total quantity
  produced,p p(q), eg. p a bq
• Assume 2 firms on relevant market denoted by i
  and j
• Firms produce quantities qi and qj
• Firms have constant marginal costs ci
• No threat of entry
• Profits for firm i Total Revenue - Total
  Costs ?i pi(qi,qj) qi - c(qi,qj)
  p(qiqj)-ciqi
• Note i's profit depends on what rival j does,
  unlike in monopoly or perfect competition
• Firm faces a problem of strategic interaction or
  plays a game
• How much will i want to produce?
• Depends on how much i expects j to produce, qje
• How much will j want to produce?
• Depends on how much j expects i to produce, qie

44
4.1 Cournot or Quantity Competition

• Note, for each qje, there is an optimal
  outputqi(qje) argmax ?i(qi,qje)
• qi(qje) is called is reaction function
• Compare with monopoly profit max
• Problem
• i needs to put himself on js position and try to
  predict how j will behave
• j needs to put himself on is position and try to
  predict how i will behave
• i needs to to put himself on js position and try
  to predict how j will think how i will behave
• j needs to ... predict how i will think how j
  will behave
• etc. ad inf.

45
4.1 Cournot or Quantity Competition

• Solution
• Suppose both i and j know p(q), ci and cj, and
  also expect that rival will produce
  profit-maximizing quantity
• qi(q-ie) argmax ?j(qi,q-ie)
• Then i should choose qi argmax ?i(qi,qj) and
  jqj argmax ?j(qj,qi)
• Each firm chooses its strategy taking rivals
  equilibrium strategy as given
• Firm i needs to predict js equilibrium
  production
• Simultaneously but individuallymax ?i
  p(qiqj)qi - cqi max ?j p(qiqj)qi - cqj
• At a maximum, small change in output should not
  increase profits differentiating each max
  problem yieldsd?i/dqi qi(dp/dqi) p(qiqj) -
  ci 0 d?j/dqj qj(dp/dqj) p(qiqj) - cj 0

46
4.1 Cournot or Quantity Competition

• These are familiar 1st order conditions MR - MC
  0
• Compare with monopoly profit max
• Plug in p(qiqj) a - b(qiqj) and solve for
  qi(qje) and qj(qie), you get reaction fns
• (1) qi(qj) (a - ci)/2b - qj/2
• (2) qj(qi) (a - cj)/2b - qi/2
• Solve simultaneously eg, insert qj(qi) from
  (2) into (1) to replace qj to get Cournot-Nash
  equilibrium quantities
• (3) qi (a cj - 2ci)/3b
• (4) qj (a ci - 2cj)/3b
• Note Each firms is on her reaction function
• In equilibrium, no firm has incentive to alter
  her strategy choice unilaterally

47
4.1 Cournot or Quantity Competition

• Insert then qi and qj to demand function to get
  equilibrium price p, and then plug these to
  profit function to get equilibrium profits
• Reaction functions (1) and (2) are
  downward-slopingdqi(qi)/dqj -1/2 lt 0
• This also applies to more general Cournot games
• If j increases her production (eg, due to
  reduction in marginal cost cj), i will want to
  reduce his output
• Lower action by one firm induces higher reaction
  from rivals
• Note, these are equilibrium reactions
• Strategies qi are here strategic substitutes
• Downward-sloping reaction functions ? strategic
  substitutes

48
4.1 Cournot or Quantity Competition

• Properties of Cournot-Nash Equil
• Go back to reaction functions (1) and (2), and
  rewrite as
• (5) p(q) - ci -qi dp/dqi p ?
• (6) Li si/e, where
• si qi/q is is market share, q ?iqi, Li
  (p - ci)/p is firm is mark-up or Lerner
  Index e  -p(q)/qp(q) is elasticity of market
  demand
• (6) is basic Cournot pricing formula
• Compare to monopolys profit max condition
• In Cournot-Nash equilibrium, market share
  determined by
• firms relative cost efficiency
• Each firm has limited mkt power
• is marginal revenue MRi is p qip, so
• p - MRi qip(q) gt 0 ? MR gt MC

49
4.1 Cournot or Quantity Competition

• Smaller market shares s (or more rivals) ?
  smaller mark-up, more vigorous competion reduces
  mark-up
• Greater demand elasticity ? larger mark-up, less
  competitive equilibrium
• Mark-up is proportional to firm market share
• Market shares are directly related to firms
  cost-efficiency ci
• Market shares determined by cost-efficiency
• Less efficient firms are able to survive
• sj gt 0 even if cj gtgt min c
• Average industry-wide mark-up ?i si (p - ci)/p
  MU
• In Cournot-Nash equil, MU ?i si2/e HHI/e,
  where HHI is the Herfindahl-Hirschman Index
• Market performance negatively related to HHI
• These properties give some basis for competition
  policy opposing mergers on oligopolistic markets
• What if competition is not Cournot-type?

50
4.2 Bertrand or Price Competition

• In reality, firms choose and compete with prices,
  not quantities
• Often prices are easier to adjust than quantities
• Who chooses prices in Cournot game?
• Cournot unrealistic model?
• Naive thought firms select prices as in (6)
  above pi st.
• (pi - ci)/pi si/e?
• Bertrand paradox No
• Model identical product, mkt demand q q(p),
  eg. q  a bp
• Demand for firm i
• pi gt pj ? i cannot sell at all, qi 0pi pj
  ? i and j split demand, qi q(p)/2pi lt pj ? i
  sells total mkt demand, qi q(p)
• Note small change in rivals price causes huge
  change in firms demand

51
4.2 Bertrand or Price Competition

• Suppose cj ci c
• If i charges pi gt c, j can increase her profits
  by undercutting i slightly
• If i charges pi lt c, i is making losses but j can
  guarantee ?j 0 by staying out of mkt
• ? Only equil price can be pi pj c
• Duopoly enough for perfect competition!
• Result depends crucially on
• firms able and willing to serve all customers at
  announced price
• identical products
• customers have complete information eg on prices
  ? firms have no bargaining power wrt customers

52
4.2 Bertrand or Price Competition

• Product Differentation and Price Competition
• Simple example only
• Products are imperfect substitutes, demands are
  symmetric
• qi a - fpi gpj
• Assume constant marginal costs ci
• Product differentation is assumed fact, not
  designed by firms
• g/f measures degree of product differentation
  (how?)
• Profit for i here
• ?i (pi - ci)(a - fpi gpj)
• Bertrand-Nash equilibrium found similarly as
  above
• Firm i maximizes profits wrt to strategy variable
  pi
• Solve for reaction functions
• Find where reaction functions intersect
• Then solve for equilibrium prices, quantities,
  and profits

53
4.2 Bertrand or Price Competition

• Reaction functions slope up
• The higher the price i charges, the higher the
  price rival j wants to charge
• Prices are strategic complements
• Higher strategy draws a higher reaction from
  rivals
• Upward-sloping reaction functions ? strategic
  complements
• Capacity Constraints and Price Competition
• Firms first choose capacities q and then select
  prices p?
• We have a 2-stage game (more on this later)
• In equilibrium, higher price than without
  capacity constraints
• Intuition
• Limited capacity ? business stealing not
  attractive option
• ? want to price less aggressively ? rivals price
  less aggressively
• ? higher profits

54
4.2 Sum Up

• Cournot outcome possible with price competition
• Interpret Cournot capacity competition
  followed by price competition
• Under some assumptions
• Cournot
• Markets where production desicions in advance,
  price is flexible, and storage costs arehigh
• Consistent with empirical evidence
• Bertrand
• More realistic assumptions, less realistic
  outcome?
• Generalized price competition models more
  consistent

55
4.3 Dynamic Competition

• Simplest way to model dynamic rivalry is to
  introduce two stages
• Model js reactions to strategic moves by firm i
• Firms try change game they are playing
• Idea Choose a strategy now that affects game you
  play tomorrow so that your expected profits
  increase
• Capacity-Price -model above an example Smaller
  capacity now ? reduce ability to compete
  aggressively in future ? draw less aggressive
  reactions from rivals ? higher profit
• Stackelberg Oligopoly
• Stackelberg-Cournot game Firm i chooses its
  output first, and j after is choice
• Precommitment by i is relevant, not physical
  timing of moves
• Solve by backward induction
• First look at last possible moves of the game
• Then work backward to beginning of game, as in
  dynamic programming

56
4.3 Dynamic Competition

• Last move
• Firm i chooses his capacity first
• When j chooses her capacity, she knows is
  capacity qiS
• j's optimal capacity determined by her reaction
  function (2)
• qj(qi) a/2b - qi/2
• Penultimate move
• To design good strategy, i must put himself on
  js shoes and try to think how he would behave
  were he the last to move
• i chooses qiS to maximize profits, taking as
  given is reaction function, not equilibrium
  output as in Cournot game
• i chooses best point from rivals reaction
  function
• Plug (2) into is profit function (a -
  b(qiqj))qi and solve for qiS
• Plug qiS back to (2) and solve for qj, and then
  solve for prices and profits

57
4.3 Dynamic Competition

• In Stackelberg game, is profits higher and js
  lower than in Cournot game
• First-mover advantage
• Intuition Commit to flood the market ? induce
  rival to lower output ? increases your profit
• Equilibrium above subgame perfect Nash
  equilibrium
• Also other Nash equil possible
• i announces to produce qi s.t. p(qi) lt cj if j
  enters
• This is not be credible i will not want to
  undertake threat should j enter (more on this
  later)
• Crucial reasons 1) commitment, 2) strategies
  substitutes
• In Stackelberg-Bertrand duopoly, there is second
  mover advantage
• Once rival has committed to a price, firm has
  strong incentives to undercut

58
4.4 Modeling Dynamic Competition

• 2 time periods, denoted by 1 and 2
• Firm i can take strategic action k on period 1
• k Advertising, RD, product design,
• Strategic action measured by its cost
• Strategy k is sunk on 2nd period, i cannot revoke
  it
• k is investment, precommitment
• On period 2, i and j compete
• To concentrate on strategic effects, assume k
  does not affect js demand or costs directly
• is 2nd period profits are ?i(qi,qj,k)
• is 1st period profits are ?i (qi,qj,k) - k
• k shifts is 2nd period profit fn
• Strategic move k alters is own incentives to
  choose later 2nd period tactics

59
4.4 Modeling Dynamic Competition

• To find equilibrium, solve for by backward
  induction starting from 2nd period game
• 2nd period
• For any given k, equilibrium again given
  byd?i/dqi 0d?i/dqj 0
• 2nd period reaction functions qi(qj,k) and
  qj(qi,k), and optimal tactics qi(k) are now
  functions of k
• Equilibrium profits are ?i(qi(k),qj(k),k)
• 1st period
• How to choose k?
• Profits are ?i(qi(k),qj(k),k) - k
• To find max profit, differentiate ?i wrt k to get
  MR MC 0 this gives

60
4.4 Modeling Dynamic Competition

• First term is zero because i will choose second
  stage tactic qi std?i/dqi 0 we have
• LHS 2nd term direct effect
• LHS 1st term strategic effect
• RHS Direct cost of commitment
• How can k alter js 2nd period tactics since k
  does not directly affect js profits?
• Strategic move k alters is own incentives to
  choose ? alters js incentives to react ? changes
  is profits
• Sign of strategic effect is equal to sign of

61
4.4 Modeling Dynamic Competition

• Three effects
• How commitment k changes is own optimal tactics
• How j reacts to changes in is incentives
• How is profits are affected by changes in js
  tactics
• Strategic effect gt 0 ? overinvest in k
• Strategic effect lt 0 ? underinvest in k
• Example Cost reduction in Cournot and Bertrand
  games
• How reaction functions shift as marginal costs of
  j are decreased?
• Example Increased marketing in Cournot and
  Bertrand games
• How reaction functions shift as j increases her
  marketing expenses?

62
4.4 Modeling Dynamic Competition

• Taxonomy for Strategies
• Strategic substitutes vs complements
• Cournot game strategic substitutes
• Bertrand game strategic complements
• Commitment makes firm tough vs soft
• Investment k makes i tough
• i will produce more or price below
• k shifts is rf right and up in Cournot game
• k shifts is rf right and down in Bertrand game
• Investment k makes i soft
• i will produce less or price above
• k shifts is rf left and down in Cournot
• k shifts is rf left and up in Bertrand

63
4.4 Modeling Dynamic Competition
Stage 2 variables are Commitment makes firm Commitment makes firm
Stage 2 variables are Tough Soft
StrategicComplements(eg, prices) Puppy Dog Ploy Strategic effect lt 0 Commitment cause rivals behave more aggressively Fat Cat Effect Strategic effect gt 0 Commitment cause rivals behave less aggressively
StrategicSubstitutes(eg, capacities) Top-Dog Strategy Strategic effect gt 0 Commitment cause rivals behave less aggressively Lean and Hungry Look Strategic effect lt 0 Commitment cause rival behave more aggressively
64
4.4 Modeling Dynamic Competition

• Strategic Incentives to Commit in Cournot
• Commitment makes firm tough
• Reaction function shifts outward
• Firm will produce more for all given rivals
  output
• Example Marginal cost reducing innovation
• Strategic effect might outweigh direct effect ?
  Invest even if NPV lt 0!
• Beneficial strategic side-effect
• Top-Dog Big or strong to become aggressive
• Commitment makes firm soft
• Firm will produce less for all given rivals
  output
• Reaction function shifts inward
• Example Marginal cost increasing entry into
  other mkt
• Negative strategic side-effect
• Lean and Hungry Look Refrain from expanding to
  avoid weakness

65
4.4 Modeling Dynamic Competition

• Strategic Incentives to Commit in Bertrand
• Commitment makes firm tough
• Firm will underprice
• Reaction function shifts inward
• Example MC-reducing innovation
• Negative side-effect
• Puppy-Dog Ploy stay small or weak to avoid
  agressive competition ? Do not lower costs!
• Commitment makes firm soft
• Firm will overprice
• Reaction function shifts outward
• Beneficial side-effect
• Example Target small niche, Product
  differentation
• Fat-Cat Effect Become soft to attract only weak
  competition ? Sumo-strategy

66
4.4 Modeling Dynamic Competition

• Need to look more than just direct effects of
  irreversible decisions
• Nature of future competition affects incentives
  to make investments or commitments now
• Need to look at how equilibrium changes, not just
  first effetcs
• Examples of 1st Stage Commitments
• Build excess capacity ? deter entry
• Enter and underinvest ? avoid attracting tough
  competition
• RD reduce costs ? price aggressively / gain mkt
  share
• Build large customer base, costly to switch ?
  less competition in future
• Underinvest in marketing ? less loyal customers ?
  become aggressive in 2nd stage
• Overinvest in marketing ? loyal customers ?
  become soft in 2nd stage

67
5 Cartels and Collusion

• Competition leads to less than jointly maximal
  profit ? firms have incentives to avoid
  competition
• These incentives are basis for competition policy
• Explicit cartels, implicit tacit collusion
• How would these show up in reaction fn picture?
• How Can We Detect Cartels and Collusion?
• Hard without smoking gun
• Lerner Index L (p - ci)/p si/e?
• If p, si and e known, make inference on p - ci
• Often not practical p, ci and e not known
  accurately enough
• But with good enough data this can be done
• Identical prices?
• Not evidence for cartel
• Perfect competition ? identical prices

68
5.1 Explicit Cartel

• Intuition
• Few competitors ? easy to form cartel/collude
• Many competitors ? hard to form cartel/collude
• Selten (1973) 4 is few, 6 is many
• Intuition with 6 firms, staying outside cartel
  gives more than joining cartel with 5 other firms
• Result from 2-stage model
• 1. Decide to join/stay out
• 2. Choose output
• If n gt 5, best strategy in stage 1 is to stay out
• If n lt 5, best strategy in stage 1 is join cartel

69
5.2 Implicit Collusion

• Implicit agreement or understanding not to
  compete
• Eg. firms agree on monopoly price and output
• But this is unstable
• Cheating and undercutting gives even higher
  profits than collusion, if rivals adher to
  agreement
• Need mechanism to remove incentives for cheating
• "Stick-and-Carrot" Theory
• Cheating draws punishment and low profits in
  future
• Collusion draws rewards (high profits)
• Deters from cheating on promise to fix prices
• Future reward ? Collude now
• Requires that future matter
• How to punish? Price war an example
• Punishment will also hurt the punisher
• Need incentives to punish

70
5.2 Implicit Collusion

• Collusion in Bertrand Competition
• Model firms interact repeatedly
• Assume c 0, mkt demand q a - bp
• Per period profits now ?it pit qit(pit, pjt)
• Bertrand equilibrium price for one-shot game 0
• On each period t each firm chooses price pit
  knowing all previous prices pit-s, s 1,2,3,
• No end-game problem repeat per-period game
  infinitely many times
• Or Prob(next period is last) lt 1
• Future matters but less than today firms
  discount future profits with discount factor 0 lt
  ? lt 1

71
5.2 Implicit Collusion

• Owners of firms value monetary stream m such that
  mt1 ?mt,
• where r is discount (or interest) rate, P
  probability that game ends after this period and
  k firm's marginal cost of capital
• Firm goal maximize present value of per-period
  profit stream
• Vi St dtpit
• Strategy?
• Plan ahead how to play entire game
• What per-period moves to choose after any history
• Think players desing strategy before game starts
  and then leave computers to execute strategy

72
5.2 Implicit Collusion

• Examples of simple strategies
• One-shot Bertand price always
• Tit-for-Tat do today what rival did yesterday
• pi1 pM pit pM if pjt-1 pM, else pit 0
• Equilibrium No incentive to change strategy
• Is "always one-shot Bertrand equil behavior
  still an equil strategy?
• Yes if i always chooses pit 0, best j can do
  is to choose pjt 0 ? ?it 0
• Both always charge monopoly price and earn ?it
  ?iM/2 gt 0 equilibrium?
• If j always charges pjt pM, what should i do?
• Look at reaction function i should choose pit
  pM- ?
• If i deviates from pM, it earns higher profits
  every period ?iD pM- ? gt pM/2 (D deviate or
  defect), henceViD St dt ?it(piD,pjM) gt ViM
  St dt ?it(piM,pjM)

73
5.2 Implicit Collusion

• ? Strategy always monopoly price is not in
  equilibrium
• Grim Strategy (GS)
• Choose pi1 pM
• Choose pit pM if pjt-1 pM
• Else always choose pit 0
• Suppose j knows i plays GS what is best for j?
• GS is best reply (among others)
• ? GS is a best reply against itself
• ? Both firms using GS is an equilibrium
• Punishment needs to be credible, otherwise it is
  only empty threat
• There must be incentives to start punishment
• Punishment must be part of equilibrium path from
  that moment onward, so that no firm will want to
  deviate from punishment
• One-shot Nash equil behavior always credible
  punishment

74
5.2 Implicit Collusion

• GS punishes defection forever
• Punishment "too hard", lesser punishment suffices
• Optimal punishment shortest number of periods T
  such that extra profits gained by defection are
  vanished
• Stay on intended equil path earn ?M/2 each
  period
• Temptation gain ?M - ?M/2 - ? ?M/2 - ? during
  defection
• Punishment earn zero profits long enough so that
  profits (defect punishment) lt profits
  (collusion)
• Minimum length of sufficient punishment depends
  on discount factor d
• Often optimal punishment is minimax strategy of
  per period game, ie tougher than one-shot equil
  behavior
• GS easy to use
• Point here collusive outcome, not details how one
  supports outcome

75
5.2 Implicit Collusion

• Folk Therorem" Any outcome that leaves each
  player more than one-shot minmax outcome is
  sustainable as an equilibrium outcome in
  infinitely repeated game
• There are many equilibrium strategies
• Anything is in equil
• No predictive power without more assumptions
• Generally collusion is sustainable if temptation
  to defect is low enough and punisment following
  the deviation strong enough
• Firm wants to keep colluding if present value of
  devi-ating is smaller than present value of
  adhering to collusive agreement
• PV of collusion here
• ViC ?t?t?it(piC,pjC) piC/(1-?)
• as ?t dt 1/(1-d) if d lt 1

76
5.2 Implicit Collusion

• PV of deviation profits reaped during deviation
  present value of profits earned during
  punishment
• ViD ?D ?t?t?it(piP,pjP) ?D ? piP/(1-?)
• Note here punishment assumed to be infinitely
  long
• Collusion is sustainable if
• Incentive to deviate depends on discount factor
• If discount factor is too low to support
  collusion, either toughen up punishment or try to
  lower degree of collusion
• Longer or harder price war
• Reduce collusive prices from monopoly price
• Note punisments are never observed
• None used since threat is enough

77
5.2 Implicit Collusion

• Collusion with Imperfect Information
• What if firms cannot observe rivals' exact prices
  nor outputs?
• Don't know if rival defected ? know when to start
  price war
• No threat of price war ? collusion not
  sustainable?
• Use other info Sales were less tha