HC4 Competition Policy and Regulation

7/27/2019 HC4 Competition Policy and Regulation

1/33

Transport Economics and ManagementCompetition policy and regulation

Eric Pels

[email protected]


2/33

TEM2

This lecture

Last time: market structures

Economic inefficiencies

This time: pricing, competition policy and regulation

General description

European Commission

Learning objective: understand why competition policy

exists, and be able to explain why competition policy isnot always successful (or useful).


3/33

TEM3

Pricing

Perfect competition: P=MC, welfare maximized

Monopoly: P>MC, profits maximized (not welfare)

Oligopoly:

Cournot: P>MC, profits maximized, not welfare

Bertrand: P=MC

Lets say were are a monopolist. Set output where MR=MC. Price determined by

inverse demand function.

Can we get higher profits than this?


4/33

TEM4

Price discrimination

Conditions:

Market power

Different groups of consumers (based on willingness-to-

pay, demand elasticity etc.)

segmentation.

Resale not possible.

Cost of discrimination may not exceed additional profits

Markets should be transparent Charge different (groups of) consumers different prices to

maximize profits price discrimination.

First, second and third degree.


5/33

TEM5

First degree price discrimination

Perfect discrimination: each unit of output sold at different

price.

Price determined by inverse demand curve.

What is the optimal output?

profits

Q*

Q

MC


6/33

TEM6

Second-degree price discrimination

Non-linear pricing: price depends on

how much you buy. Fundamentals.

Application (as in Mallard and Glaister)


7/33TEM7


Consumer decides on how much to

buy: Self selection constraints.

2 consumers; each spends ri to receive Xi

benefitsi(Xi)-ri>0 benefits1(X1)-r1> benefits1(X2)-r2

benefits2(X2)-r2> benefits2(X1)-r1


8/33TEM8


Consider an individualdemand function (for convenience,

marginal cost are 0)

Monopolists wants to supply X1 at a total price of A.

p

X

A

X1


9/33TEM9


Now consider two individualdemand functions

Monopolist would like to supply X1

at A+B+C and X2

at A

p

X

A

X1

B

C

X2


10/33TEM10


But: if consumer 1 also purchases X2 at a price of A,

he/she will get surplus B (self selection).

If the monopolist would charge A+C for X1,

consumer 1 get surplus B and the monopolist higher

profits. Can the monopolist get higher profits?

Make X2 unattractive for consumer 1.

Offering less of X2 (loss for monopolist) allows for

higher profits from X1.


11/33TEM11


p

X

A

X1

B

C

X2

Extra profit

(increase inC)

Loss (reduction

in A)

p

X

A

X1

B

CX2D

Equilibrium: marginal

benefit in reduction ofX2 = marginal cost

Consumer 2pays A for X2

Consumer 1 paysA+D+C for X1


12/33TEM12


Examples?


13/33TEM13

Third degree price discrimination

Set prices for different groups of consumers: examples?

p*

p*

Q* Q*

QQ

Segmentation based on willingness-to-pay and elasticity

MCMC


14/33TEM14

Competition policy

Ensure markets functions as close as possible to

perfect competition model

European Commission:

5 pillars

Subsidiarity: enforced by individual countries

Commission intervenes in situations with more than 1

country

National: competition authority


15/33TEM15

Competition policy

EC competition policy

Anti-competitivebehaviour

Mergercontrol

Encouragingcompetition

State-aidco

ntrol

Internationa

lcooperation

Subsidiarity


16/33TEM16

Competition policy: national

Subsidiarity

National firms

Does a firm have monopoly power? Theory: P=MC/(1+1/p)

Market definition: relevant markets

Market is allocation mechanism

Demand side substitution The ability of consumers to switch products following a change in

relative prices

Supply side substitution

Competitive constraint if third-party suppliers can switch production in

the short term without significant additional investments (costless

entry)


17/33TEM17

Demand side substitution

SSNIP (Small but Significant and Non-transitory Increase in Price)

US department of justice, 1982

smallest relevant market in which permanent increase in price ispossible

interview consumers

price increase of e.g. 5%

Consumers do not switch to alternatives: no (or limited) change in

demand Price increase profitable: regulation

Consumers switch to alternatives: change in demand

market is not relevant market for regulation, SSNIP test performed

on larger basket of products

Does this make sense?


18/33

TEM18

Marginal revenues

P

Q

Inverse demand ( a/b-1/b*Q )

Marginal revenues

MR positive ifp


19/33

Monopoly

TEM19

P

Q0

Marginal costs

Inverse demand

Marginal revenues

Average costs

Qm

Pm


20/33

Supply side substitution

SSS-test: can a third party enter the market? What assets are needed to produce the relevant products?

Can missing assets be acquired without the need for significant, irreversiblenew investments?

Are companies able to divert production from supply-side substitutes to the

relevant products, or are they contractually committed to continue production

of existing products?

Can unused plant capacity be brought into production at a reasonable cost?

Will consumers regard their products as valid substitutes for the existing set ofproducts?

TEM20


21/33

SSS

hypothetical example.

airport A serves passenger airlines, airport B serves

cargo airlines.

airport B increases charges. Can airport A step in?

airport A must set attractive charge for cargo airlines

incentives for a change

airport has enough capacity to be an alternative of supply

Airport is comparable in geographic catchment area

Airport is alternative for cargo airlines

cargo airlines must be able to easily switch demand

significant investments for specialized storage and warehouse facilities?

TEM21


22/33

TEM22

Regulation of monopoly

Cost-based Price should allow return on investment

Most common form: Rate of return regulation Limit the rate of return to capital: ROR=[pQ-wL-rK]/[pkK]

r=user cost of capital (depreciation), pk=purchase price of capital

ROR of 0 is competitive rate of return (no excess profits)

Regulated firm maximizes profits under the ROR-constraint

Problems with ROR: Fair ROR?

Different methods (capital asset pricing, comparative earnings etc.: finance

theory)

Information assymetry

Averch-Johnson effect: incentive to increase capital relative to labor to maximize

profits (Gold plating)


23/33

TEM23

Regulation of monopoly - ROR

Example Carlton and Perloff (2005)

P=100-Q

Q=LK

Labor price: 168

Capital price (user cost of capital): 168

Interest rate 10%

Cost of capital 1680

ROR=(PQ-168L-168K)/(1680K)


24/33


TEM24

K L Q price revenues cost profits MR MK Welfare ROR

6 4 24 76 1824 1680 144 52 34 432 1.43

6 5 30 70 2100 1848 252 40 31 702 2.50

6 6 36 64 2304 2016 288 28 28 936 2.86

6 7 42 58 2436 2184 252 16 26 1134 2.50

6 8 48 52 2496 2352 144 4 24 1296 1.43

6 9 54 46 2484 2520 -36 23 1422

7 4 28 72 2016 1848 168 44 32 560 1.43

7 5 35 65 2275 2016 259 30 28 871.5 2.20

7 6 42 58 2436 2184 252 16 26 1134 2.14

7 7 49 51 2499 2352 147 2 24 1347.5 1.25

7 8 56 44 2464 2520 -56 22 1512

7 9 63 37 2331 2688 -357 21 1627.5

8 4 32 68 2176 2016 160 36 30 672 1.19

8 5 40 60 2400 2184 216 20 27 1016 1.618 6 48 52 2496 2352 144 4 24 1296 1.07

8 7 56 44 2464 2520 -56 22 1512

8 8 64 36 2304 2688 -384 21 1664

8 9 72 28 2016 2856 -840 20 1752

9 4 36 64 2304 2184 120 28 28 768 0.79

9 5 45 55 2475 2352 123 10 25 1135.5 0.81

9 6 54 46 2484 2520 -36 23 1422

9 7 63 37 2331 2688 -357 21 1627.5

9 8 72 28 2016 2856 -840 20 1752

9 9 81 19 1539 3024 -1485 19 1795.5 Average ROR: 1.66

9.02 9.02 81.36 18.6 1516.5 3030.7 -1514.2 19 1795.56


25/33


TEM25

Q

MC

MRInverse demand

Profit maximum

Welfare maximizedOutput and price at average ROR


26/33

TEM26

Regulation of monopoly

Price-cap (CPI-X) regulation

Prices are allowed to increase by the consumer

price index, minus expected efficiency savings x.

Sets incentive for cost reduction and revenue

generation

Difficulty: firms have an incentive to undersupply

quality (postpone investments) to reduce costswith little reduction in revenues

e.g. rolling stock of railway company


27/33

TEM27

Efficiency analysis, benchmarking

Determining X

Cost minimization: minimize cost to produce given

output level.

Benchmarking: comparing business (performance

metrics) to industry bests.

Various tools

Frontier analysis

Cost frontier


28/33

Regression - frontier

TEM28

ln(C)

ln(X)

Most efficient observation (firm)Frontier

ln(C)=K+a*ln(X)+v


29/33

TEM29

Frontier analysis

Corrected OLS

Shift until all but one residuals are positive

add largest negative residual: ln(C)=K+a*ln(X)+v+max(v) = K+a*ln(X)+w

ln(C)=K+a*ln(X)+w C= eK*Xa*ew

Efficiency coefficient: EC = CMIN/C

(e

K

*X

a

*e

0

)/(e

K

*X

a

*e

w`

) = e

w

Same output can be obtained at fraction EC of costs

Stochastic frontier:

ln(C)=K+a*ln(X)+u+v, vhas normal distribution, u is non-negative error term


30/33

Alternative regulation methods

Sliding scale regulation

Tries to deal with information assymetry Give incentive to release information

sliding scale: higher cost firms have higher

regulated price

benchmark for profits; profits exceeding benchmarksplit between firm and consumers

Somewhere between CPI-X and cost-based

TEM30


31/33

Alternative methods

Yardstick competition

Regulator employs cost levels of identical firms todetermine regulated price

Mean average (marginal) cost of firms

Investment regulation

Excess demand: extra capacity comes at highercost. Price caps must allow higher charges.

Price monitoring

TEM31


32/33

TEM32

Summary

International and national rules

Does a company have monopoly power?

Does regulation give proper incentives?

Schiphol has strong position on market for provision of

infrastructure for take-offs and landings for O&D

passengers. Many airlines are very unlikely to leave

Schiphol for other airports (GAP, 2010).


33/33

33

Background slide 29: logarithms

alog(x)=q aq=x (raise a to the power q to get x)

ln(x)=elog(x) (raise e tot the power ln(x) to get x)

eln(x)=x

ln(ex)=x

ln(xy)=ln(x)+ln(y)

ln(xa

yb

)=aln(x)+bln(y)

HC4 Competition Policy and Regulation

Documents