EC365 Theory of Monopoly and Regulation Topic 1: Introduction 2013-14, Spring Term Dr Helen Weeds.

EC365 Theory of Monopoly and Regulation

Topic 1: Introduction

2013-14, Spring Term

Dr Helen Weeds

Key information (1)

Teaching:

Lectures: Thurs 3-5pm, weeks 16-25, LTB3

Classes: Tues 1-2pm, weeks 18 (28 Jan) to 25 & 31, LTB9

lecture notes and problem sets on ORB

Opportunity to present (optional):

10 minute presentation on competition case/academic paper of your choice

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Key information (2)

Assessment:

Term paper, submission date: 12 noon, Friday 2nd May.

Summer exam: 2 hours; answer any 2 questions from 5; questions mixture of maths and short essays.

The aggregate module mark is the larger of:

50% coursework mark + 50% final examination mark

or

100% final examination mark.

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Textbooks

General Cabral (2000) “Introduction to Industrial Organization”

Viscusi, Harrington & Vernon (2005) “Economics of Regulation and Antitrust”, 4th edn.

Case Studies Kwoka and White (2004) “The Antitrust Revolution: Economics,

Competition and Policy, 4th edn.

Kwoka and White (2008) “The Antitrust Revolution: Economics, Competition and Policy, 5th edn.

Useful websites

Newspapers and news websites: BBC News, Financial Times, The Economist

Competition authorities: UK Competition Commission – www.competition-commission.org.uk Office of Fair Trading – www.oft.gov.uk US Federal Trade Commission – http://www.ftc.gov/ US Department of Justice – www.justice.gov/atr/ European Commission – ec.europa.eu/competition/index_en.html

UK industry regulators: OFCOM – www.ofcom.org.uk OFGEM – www.ofgem.gov.uk OFWAT – www.ofwat.gov.uk Office of Rail Regulation – www.rail-reg.gov.uk

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DO FOR SUCCESS

Attend lectures Take notes Ask questions Review lecture presentations

Do the readings

Attend classes Do problem sets before class and review answers Take part in class discussions

You need be confident both to solve maths questions and to write detailed short essays

Do the term paper (insurance policy)

REVISE6

A Cheap Gag…

7Source: Hasbro, Facebook fan page

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Module outline

Introduction (weeks 1-2) background monopoly problems

Competition policy (3-6) routes to monopoly power: collusion, merger, exclusion vertical merger & restraints

Regulation of monopoly (7-9) natural monopoly, franchising regulation of monopoly liberalisation and deregulation

Presentations and debates (10)

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Lecture outline

Introduction to competition policy and regulation rationale for competition policy origins and historical development regimes: EU, UK, USA utility privatisation and regulation

Revision of basic concepts perfect competition monopoly oligopoly

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Rationale for competition policy

Economic efficiency allocative productive “perfect competition” condition of first fundamental theorem of welfare

economics

Wider economic benefits competitiveness and growth reform of UK competition policy in late 1990s/early 2000s based on

idea that competition is good for productivity and growth

Political interests protection of consumers competition as a substitute for state intervention?

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Competition policy regimes

European Union agreements between firms: Article 101 (formerly 81) TFEU single-firm conduct: Article 102 (formerly 82) TFEU merger control: EC Merger Regulation (1989, amended 2004)

United Kingdom agreements between firms: Chapter I of Competition Act 1998;

Enterprise Act 2002 (stronger measures against cartels) single-firm conduct: Chapter II of Competition Act 1998 merger control: Enterprise Act 2002

United States monopolisation (agreements & single-firm conduct): Sherman Act 1890 merger control: Clayton Act 1914

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Competition policy pre-history

Restraint of trade doctrine (common law)

Magna Carta (1225) right to “free customs”

The Dyer’s Case (1414) John, the Dyer, sued a colleague for breach of a covenant

“not to use his dyer’s craft within the town … for half a year” judge ruled that “the obligation is void, inasmuch as the

condition is against the common law … if the plaintiff were here he would go to prison until he should pay a fine to the king”

US antitrust policy

Origin: response to growth of “trusts” (cartels and monopolies) in the USA in the 1880s

Standard Oil trust 1882 founded by John D Rockefeller link controlled 88% of US refined oil production in 1890

American Tobacco Company 1892 a consortium of 5 companies founded by J.B. Duke covered 90% of cigarettes produced in the US

Both were broken up in 1911 following orders of the US Supreme Court

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US antitrust laws

Sherman Act 1890 Section 1: prohibits contracts, combinations & conspiracies

in restraint of trade Section 2: prohibits monopolisation, attempts to

monopolise & conspiracies to monopolise trade

Clayton Act 1914 prohibits price discrimination & some vertical restraints,

where these “substantially lessen competition” (SLC) merger control: SLC test

Federal Trade Commission (FTC) Act 1914: set up FTC

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EU & UK: agreements between firms

Art. 101 / Chapter I of Competition Act 1998 prohibits“ … all agreements between undertakings … which have as their object or effect the prevention, restriction or distortion of competition”

Includes price fixing limiting production or investment market sharing applying dissimilar conditions or supplementary obligations

Exemptions: agreements that are necessary to improve production or distribution promote technical progress

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EU & UK: abuse of dominance

Art. 102 / Chapter II of Competition Act 1998 prohibits“Any abuse ... of a dominant position”

Abuse includes imposing unfair prices or conditions limiting production or technical development applying dissimilar conditions or supplementary obligations

What is “dominance”? Is it the same as monopoly? “position of economic strength … which enables it to prevent effective

competition” (United Brands, 1978) “does not preclude some competition” (Hoffman-La Roche)

What is the “relevant market” within which the firm operates? econometric evidence on substitution between products

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Additional measures in the UKEnterprise Act 2002

Cartels [Part 6] makes cartelisation a criminal offence, carrying large fines and

possible imprisonment of individuals (up to 5 years) “dawn raid” investigatory powers granted to Office of Fair Trading leniency provisions third party damages

Market investigations [Part 4] Competition Commission (CC) may investigate an industry CC decides

“whether any feature, or combination of features ... prevents, restricts or distorts competition”

CC may impose behavioural or structural remedies

OFT & CC now merging into Competition and Markets Authority

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EU merger control

European Community Merger Regulation prohibits “A concentration which would significantly impede effective competition ... in particular as a result of the creation or strengthening of a dominant position”

[Council Regulation No. 139/2004, 20 January 2004]

Merger may be blocked, or remedies imposed to gain clearance

Airtours (2002): ECJ (appeal court) overturned Commission decision to block Airtours/First Choice merger Issue: interpretation of “collective dominance”:

does this include Cournot-style unilateral behaviour, or just collusion? Resulted in amendment to original (1989) merger regulation to include

unilateral effects [Regulation No. 4064/89]

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UK merger control

Pre-2003: Fair Trading Act 1973 public interest test

Competition Commission (formerly MMC) may find merger “against the public interest” and recommend remedies

decision taken by Secretary of State for Trade & Industry Tebbit Guidelines (1984): “to make references primarily on

competition grounds”

Since 2003: Enterprise Act 2002 [Part 3] prohibits a merger that

“has resulted, or may be expected to result, in a substantial lessening of competition”

Competition Commission makes finding and may impose remedies (except “certain public interest cases”)

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UK institutions

Office of Fair Trading (OFT) investigates agreements between firms and abuse of

dominance, under Competition Act 1998 prosecutes cartels, under Competition Act 1998 &

Enterprise Act 2002 refers mergers and market investigations to the CC

Competition Commission (CC) investigates mergers and markets referred by OFT

OFT and CC are merging to form the Competition and Markets Authority (CMA), which takes over in April 2014

Appeals: Competition Appeal Tribunal (CAT)

EU institutions

European Commission: Directorate-General for Competition (“DG Comp”) carries out investigations under

• Art. 101 (agreements between firms)• Art. 102 (abuse of dominance) • ECMR (merger control)

Chief Competition Economist: currently Massimo Motta

Appeals: General Court (previously Court of First Instance) European Court of Justice (ECJ)

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Utility regulation in the UK

Privatisation of utility industries in 1980s & 90s BT, British Gas, electricity supply industry, water, rail Natural monopoly elements Need for regulation: prices, service quality, investment

Sectoral regulators Ofcom: telecommunications, broadcasting, post Ofgem: gas and electricity Ofwat: water and sewerage Office of Rail Regulation (ORR): railways Civil Aviation Authority: aviation, airports

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Revision of basic concepts

Perfect competition definition outcomes

Monopoly profit maximisation outcomes

Oligopoly Cournot Bertrand

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Perfect competition benchmark

Assumptions1. Many atomistic suppliers

2. Homogeneous product

3. All firms have access to all technologies

4. Free entry (and exit): i.e. no sunk costs

5. Perfect information, e.g. all agents know all prices

Outcome Price = marginal cost Firms are price takers (demand faced by each firm is

horizontal, i.e. infinitely elastic, at this price level)

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Figure 1: The firm under perfect competition

A C

M C

p , c

q

p = M C = A C

D

q

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Implications of perfect competition

2 forms of efficiency

Allocative efficiency Consumption is efficient: the good is consumed by everyone who

values it at least as much as its cost Production is efficient: firms produce this output level

Productive efficiency Costs are minimised (given output level)

• Firms choose the cheapest technology and operate efficiently• Free entry ensures the “right” number of firms

[NB: static concepts]

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Competitive selection

Relax assumptions 3 & 4 3: Firms have access to different technologies (costs)

• firm discovers its relative efficiency after entry

4: Entry incurs a sunk cost

Outcomes Competitive selection: many firms enter the market;

less efficient quit, efficient stay• observation: simultaneous entry and exit

Differential profit rates persist; sunk costs can be recouped Productive efficiency is achieved (given technologies)

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Monopoly

Assumptions Single firm No threat of entry

Profit maximisation Raising price has two effects:

• Higher margin (p-c) from consumers who still buy (+)• Loss of sales to those who no longer buy, as price exceeds

willingness to pay (–)

Marginal revenue is the gain from raising output Condition: marginal revenue = marginal cost

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Figure 2: Monopoly pricing and outputp , c

qM R

q m

p m

M C

q c

D

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Numerical example

Assumptions Demand: Q = 100 – P Costs: MC = AC = £20

Competitive equilibrium Pc = MC = £20; Qc = 100 – 20 = 80

Monopolist’s profit maximisation = (P - MC)Q = (100 – Q – 20)Q d/dQ = 80 – 2Q=0 Pm = £60; Qm = 40

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Oligopoly

Competition between small number of firms (e.g. 2)

Static models: strategies chosen simultaneously Cournot (1838): firms compete in quantities Bertrand (1883): firms compete in prices

strategies chosen sequentially

Stackelberg: firms compete in quantities

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Cournot: firms compete in quantities

2 firms, 1 & 2, simultaneously choose quantities q1 and q2

Linear inverse demand fn: p = a – b(q1+q2)

Constant marginal cost c

Nash equilibrium: firm i chooses qi given choice of its rival Set qi to max i = (a – bqi – bqj – c) qi for i = 1, 2 where i j FOC: a – 2bqi – bqj – c = 0

Rearrange: Reaction function for firm i

Solve simultaneous equations:

Price Profit

jqb

caq

2

1

2 i

b

caqq

3 *

2*1

3

2cap

b

cai 9

2

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Figure 3: Cournot equilibrium q2

q1(q2): firm 1’s reaction function

qm Nash eqm q2* q2(q1): firm 2’s reaction function q1* qm q1

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n-firm Cournot oligopoly

Suppose n identical firms, each has cost c

Cournot outcomes Quantity per firm , Industry

Price

Profit per firm

As n : qi 0, Q , p c, 0 competitive outcomes

bn

caq

1 i

b

ca

n

nQ

1

1

n

ncap

bn

ca2

2

i1

b

ca

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Bertrand: firms compete in prices

What happens if firms instead choose prices?

Model 2 firms, homogeneous product Each sets price, assuming price set by its rival is given

Suppose firm 2 chooses p2 (c, pm] Firm 1 would undercut by (tiny) , and steal whole market Knowing this, 2 will undercut; 1 will undercut again …

Unique eqm: p1 = p2 = c; each receives ½ mkt D

Competitive outcome with just two firms!

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Figure 4: Bertrand equilibrium p2

Firm 1’s reaction function: p1(p2) pm p2(p1) c Nash eqm 45° c pm p1