Global Antitrust Institute Economics Institute for Competition Enforcement Officials

Transcription

1 Global Antitrust Institute Economics Institute for Competition Enforcement Officials November 2015

2 Overview - Select Topics Individual Choice, Demand, and Welfare Cost, Production, and Supply Markets and the Competitive Process Competition and Monopoly Market Definition and Market Power The Economics of Efficiencies Vertical Restraints The Economics of Innovation and Intellectual Property

3 Individual Choice, Demand, and Welfare

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5 Tells us how responsive consumers are to changes in price η = % Change in Quantity Demand % Change in Price (This is a negative number but is often expressed as a positive number.) Demand is elastic when η is greater than 1 Demand is inelastic when η is less than 1 Demand is unit elastic when η =1

6 Elasticity of Demand P η > 1 (elastic range, MR > 0) η < 1 (inelastic range, MR < 0) MR D If demand is elastic, a 1% decrease in the price will result in a greater than 1% increase in quantity. Q

7 An important result in economics says that the markup of the monopoly price p* over marginal cost is higher, the less elastic is demand. Lerner Index: P* MC = -1 P* η This formula is basis for critical loss analysis and diversion analysis for implementing the SSNIP test.

8 P Lerner Index η > 1 (elastic range, MR > 0) MC P * P*-MC η < 1 (inelastic range, MR < 0) Q* MR D Q

9 P Lerner Index MC P * P*-MC P*-MC D Q* MR Q * D MR Q

10 First Law of Demand: The lower the price at which one can buy a good, the more will one purchase, have, use, or consume (Demand Curves slope downwards). Alchian and Allen, Exchange and Production: Competition, Coordination, & Control, 3d ed, Wadsworth, Stigler s Law of Demand and Supply Elasticities: All demand curves are inelastic, and all supply curves are inelastic too. George J. Stigler, 1982 Nobel Prize winner for Economics, from The Intellectual and the Marketplace, enlarged edition, Harvard University Press (1984) at 75.

11 Consumer welfare is the difference between the value each individual places on a good or service they purchase (measured by their maximum they are willing to pay) and the price they pay for it. Social welfare is the difference between the value each individual places on a good or service they purchase (measured by their maximum willingness to pay) the cost to society of the scarce resources that went into providing that good or service. Roughly speaking the difference between social welfare and consumer welfare goes to firms as profits, which then get distributed to their shareholders

12 P Consumer Welfare Based on Willingness to Pay MC Consumer Surplus P c Producer Surplus Q c Q

13 P P * The Monopoly Pricing Problem Transfer from Consumers to Producers Deadweight Loss MC P c Q* Q c Q

14 P P * Application to cartels Transfer from Consumers to Producers Deadweight Loss MC P c Q* Q c Q When firms collude to raise price consumer welfare decreases for two reasons: (1) some consumers who valued the product don t get it anymore (quantity declines) and (2) other consumers pay more for the product and get less consumer surplus. 14

15 Cost, Production, and Supply

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17 Type of Costs Fixed Does not vary with output Variable Varies with output Total = Fixed + Variable Marginal Change in total costs associated with small changes in output

18 Economies of Scale As output expands, cost per unit tends to decline. Why? After some point, as output expands, cost per unit tends to rise. Why? Cost ATC Economies of Scale Constant Returns to Scale Diseconomies of Scale Output

19 Economies of Scale Short run vs. long run: Cost ATC 4 ATC 1 ATC 2 ATC 3 LRAC Output/year

20 Profit Maximization Always produce where Marginal Revenue = Marginal Cost Why? MR > MC à expand output, because marginal profits from each unit MR < MC à reduce output, because losing profits on each unit

21 Market Supply As with market demand, market supply is the horizontal summation of individual firms supply curves. Opportunity cost: lowest cost resources come into use first.

22 What Changes the Market Supply Curve? Costs of inputs Changes in technology / productivity Changes in number of firms/capacity in the industry Supply elasticity: short-run v. long run

23 Efficiency of Market Allocation Maximizing Societal Welfare In equilibrium, the size of the pie producer + consumer surplus is maximized. Prices as information Markets produce information in form of prices Prices send signals to producers and consumers about relative scarcities Incentives to enter Price coordinates activities among strangers

24 Markets and the Competitive Process

25 Equilibrium Price MC p* MV q* Quantity

26 p*, q* properties spontaneity competitive auction process price signals value minimum demand maximum supply coordinates maximum total value marginal conditions resources used for every unit where MV > MC

27 Maximizing Social Welfare (= CS + PS) Price MC p* MV q* Quantity

28 Consumer Surplus (= WTP price) Price MC p* CS MV q* Quantity

29 Producers Surplus (= price opp cost) Price MC p* PS MV q* Quantity

30 Social Welfare (= CS + PS) Price MC p* CS PS MV q* Quantity

31 So Here s the Pie (SW = CS + PS) Price MC p* CS PS MV q* Quantity

32 Competition and Monopoly

33 Perfect Competition Assumptions: Individual firms too small to affect market price Perfect information Homogenous product Free entry and exit Firms are Price Takers Assumptions not realistic, but predictions serve as useful benchmark for many situations

34 Individual firm in perfect competition Maximize profits: Marginal Revenue = Marginal Cost Marginal revenue à additional revenue from each additional unit sold In perfectly competitive market Price = Marginal Revenue. Why? Individual Firm MC = S P=MR q i

35 Individual firm in perfect competition Market Firm MC S = ΣMC i P* P=MR = D D Q=Σq i q i

36 Adjustments to changes in demand Market Firm MC S ATC P 1 Profit P 1 =MR 1 P* P*=MR* D D 1 Q M Q 1 q i q i 1

37 Adjustments to changes in demand P 1 P* Market S S 1 Firm Profit Loss MC ATC P 1 =MR 1 P*=MR* D D 1 Q M Q 1 Q 2 q i q i 1

38 Welfare Analysis of Perfect Competition Allocative Efficiency: Price = MC The price we pay reflect the true cost to society of scarce resources used in production. Efficient consumption and production decisions. Productive Efficiency: Production at lowest possible total cost Always produce at Price = Marginal Cost Zero economic profits in long run, so P=ATC, but P = MC à MC = ATC in long run equilibrium MC = ATC at minimum ATC

39 Market Power Firms that face a downward sloping demand curve have the ability to affect their price by altering outputà Market Power Market power comes from relaxing the assumptions of perfect competition: Differentiated products Imperfect information Barriers to entry Private agreements to restrain competition Public policies that restrict competition Most firms enjoy some modicum of market power

40 Market Power $12 P $10 $8 $6 $4 $2 Demand $0 -$ Q Marginal Revenue -$4

41 Monopoly $12 P Monopoly Price & Output with MC = $4 $10 $8 $6 $4 Profits DWL MC = ATC $2 Demand $0 -$ Q Marginal Revenue -$4

42 Welfare consequences from Monopoly Deadweight loss Rent seeking But, market power alone is not bad

43 Static v. Dynamic Competition Competition in the market Competition for the market: The hope for monopoly profits stimulates risk-taking behavior involving investment and innovation. This is also called dynamic competition. Disruptive technologies: Apple products displacing Microsoft as a dominant force in computing (which displaced IBM). Google Android platform now surpassing Apple.

44 Monopoly: The Dynamic View Antitrust law recognizes the value of dynamic competition: The opportunity to charge monopoly prices at least for a short period is what attract business acumen in the first place; it induces risk taking that produces innovation and economic growth. To safeguard the incentive to innovate, the possession of monopoly power will not be found unlawful unless it is accompanied by an element of anticompetitive conduct. Verizon Communications Inc. v. Law Offices of Curtis v. Trinko, LLP., 540 U.S. 398 (2004).

45 Market Definition and Market Power

46 Defining Market Power Market power is the ability to raise prices above those that would be charged in a competitive market. Supreme Court in NCAA n.38 (1984) A merger enhances market power if it is likely to encourage one or more firms to raise price, reduce output, diminish innovation, or otherwise harm customers as a result of diminished competitive constraints or incentives. Horizontal Merger Guidelines at 2 (Aug. 2010)

47 Monopoly Power Supply=MC Lost Consumer Surplus Pm Pc Marginal Revenue Demand Qm Qc The purple-shaded area reflects lost consumer surplus from paying higher prices and not getting some valuable output

48 Intellectual History of Structural Economic Thinking Much of industrial organization economics has been directed at studying whether there is a systematic relationship between the number of firms and prices. Analytical foundations in Cournot model 1950s-60s: Structure-Conduct-Performance Paradigm - Relationship Between Concentration & Price - Market Structure Predicts Performance - Barriers to Entry

49 Cournot: # of Firms, Prices, and Output Competitive Quantity Monopoly Price 900" 60" 800" 50" 700" EQUILIBRIUM)QUANTITY) 600" 500" 400" 300" 200" 100" Oligopoly Quantity Monopoly Quantity EQUILIBRIUM)PRICE) 40" 30" 20" 10" Oligopoly Price 0" 1" 2" 3" 4" 5" 6" 7" 8" 9" 10" 11" 12" 13" 14" 15" NUMBER)OF)FIRMS) 0" 1" 2" 3" 4" 5" 6" 7" 8" 9" 10" 11" 12" 13" 14" 15" NUMBER)OF)FIRMS) Competitive Price = MC

50 The Rise of the SCP Paradigm Joe Bain and other Harvard Economists ( ) Structure: # of buyers and sellers, barriers to entry, product differentiation, vertical integration Conduct: Advertising, R&D, pricing, merger, contracts, collusion Performance: price, efficiency, quality, profits, welfare Concentrated market structure thought to be very useful predictor of performance and advocated significant antitrust intervention

51 The Fall of the SCP Paradigm Empirical evidence shows that SCP paradigm work relating market structure and profit does not exhibit systematic relationship Demsetz, Brozen, others Market structure very poor predictor of competitive performance, including price, output, innovation So what else can we do?

52 Why Define Markets? Old antitrust rationale: count the number of firms competing in the market to make predictions about post-merger prices Modern rationale: to identify the nature and sources of competition and how the conduct or transaction at issue might affect consumers Who competes in this space? Which firms constrain each other s pricing decisions? Which are closest substitutes to a significant fraction of consumers?

53 Economic Tools for Market Definition Older approach Practical indicia of functional interchangeability between or among products Modern economic tools Hypothetical Monopolist Test ( HMT ) The SSNIP Test is the most common method of implementing the HMT Critical Loss Analysis

54 The Hypothetical Monopolist Test A group of products and a geographic area such that a hypothetical profit-maximizing firm likely would impose at least a small but significant and nontransitory increase in price. Depends mostly on demand substitution but supply substitution also matters. Not designed to test whether a firm is already exercising significant market power or dominance

55 Hypothetical Monopolist Test: Conceptual Underpinnings Suppose there are three potential goods in a market: 1, 2, and 3 How to we determine whether products 2 and 3 belong in the same market as product 1 Products in the market 1, 2?, 3? 2? 3? Products outside the market

56 Hypothetical Monopolist Test: Conceptual Underpinnings Could an hypothetical monopolist of product 1 profitably sustain a small but significant and non-transitory increase in price? If yes, the market includes only 1. If no, the relevant antitrust market must include products 2 and/ or 3. How to identify products 2 and 3? The ones that are closest in product space to product 1.

57 Modern Approach Measure intensity and closeness of competition rather than counting the number of firms Implicitly assumes competition from all firms inside the market is identical Measuring upward pricing pressure Unilateral pricing effects analysis

58 Williamson Tradeoff Model

59 Understanding Terms Consider the merger of Firm A with Firm B Firm A sells Product 1 Firm B sells Product 2 Diversion Ratio (DR 12 ): the percentage of unit sales lost by Product 1, when its price rises, that are captured by Product 2 Related to cross-elasticity of demand Consider a small increase in P 1 which causes, in turn, a reduction in the unit sales of Product 1 Some of these lost sales will be diverted to Product 2 Value of Diverted Sales (VDS): DR 12 X (P 2 C 2 ) The number of units diverted to Product 2 multiplied by the margin between price and incremental cost on that Product Intuitively, the VDS is the opportunity cost of the merged firm selling an additional unit of Product 1

60 Pre-Merger Pricing Relationship Between Margin and Elasticity $/Q 14 Demand (Quantity = 14 Price) Raise price until: Benefit = Cost equivalent to Q 1 x (P 1 -P 0 ) = (P 0 -c) x (Q 1 -Q 0 ) P 1 P 0 equivalent to Q 1 x ΔP = (P 0 -c) x (-ΔQ) equivalent to Q 1 ΔP = (P 0 -c) (-ΔQ) P 0 Q 1 ΔP P 0 Q 1 ΔP c equivalent to 1 = Margin x Elasticity equivalent to 1 = Margin Elasticity Q 1 Q 0 Quantity

61 The Role of Margins and Diversion Ratios Graphically $/Q Demand Recaptured Diversion Price-Increase Benefit/Cost Analysis Pre-Merger Benefit = $3.5 Cost = $3.5 Net Benefit = $0 Post Merger MC=6 Benefit = $3.5 Cost = $3.5 Recaptured Diversion Net Benefit = Recaptured Diversion Quantity

62 UPP in the HMGs Adverse unilateral price effects can arise when the merger gives the merged entity an incentive to raise the price of a product previously sold by one merging firm and thereby divert sales to products previously sold by the other merging firm, boosting the profits on the latter products. Taking as given other prices and product offerings, that boost to profits is equal to the value to the merged firm of the sales diverted to those products. The value of sales diverted to a product is equal to the number of units diverted to that product multiplied by the margin between price and incremental cost on that product.

63 UPP & GUPPI Recall Value of Diverted Sales is an indicator of UPP and is an opportunity cost of the merged firm selling an incremental unit of Product 1 VDS = DR 12 X (P 2 C 2 ) The next step is to scale this measure of UPP in proportion to the price of Product 1 (P 1 ) This gives: [DR 12 X (P 2 C 2 )] / P 1 This is known as the gross upward pricing pressure index, or GUPPI Gross because it does not include downward pricing pressure actors such as efficiencies

64 What is a merger simulation model? Model of competition in an industry that allows the effect on prices of increased concentration to be measured directly Requires assumption of oligopoly interaction: Typically based on Bertrand differentiated products model Necessary inputs: pre-merger elasticities, marginal costs, prices

65 Steps to Merger Simulation 1) Choose form of oligopoly interaction Choose consumer demand 2) Calibrate model to perfectly predict pre-merger conditions Prices, shares, elasticities 3) Compute the post-merger equilibrium, which internalizes the competition among merging products

66 Presumptions of Merger Simulation Merger simulation presumes that the fundamental nature of the competitive interaction is not changed by a merger. Merger simulation presumes that everything outside the model is unaffected by the merger.

67 Benefits of Merger Simulation Discipline of equilibrium prediction Assumptions can and should be tested against the established facts Modeling indicates: why price effects are large or small how experts reached different conclusions where resources should be concentrated Calculation replaces intuition

68 Problems with merger simulations elasticity issues Relatively small inaccuracies in elasticity estimates can have significant effects on predicted post-merger price rises Example Firm 1 Firm 2 Firm 3 Firm 4 4 firms pre-merger Firms 2 and 3 merging Market shares of 63%, 16%, 5% and 15% respectively Elasticities as follows: Firm Firm Firm Firm

69 Problems with merger simulations elasticity issues Predicted post-merger price rises under three alternative functional forms are Linear AIDS Log-linear Firm Firm Firm Firm

70 Problems with merger simulations elasticity issues Predicted post-merger price rises as own-price elasticities vary by +/- 10% Δ ε ii Before After % Change Linear AIDS Linear AIDS Linear AIDS Firm 2 +10% Firm 3 +10% Firm 2-10% Firm 3-10%

71 Merger Simulation and GUPPIs GUPPI does not assume oligopoly interaction of form of demand Recall that GUPPIs simply calculated the value of diverted sales scaled to monetary units but DO NOT estimate actual price increases GUPPI and linear demand Poor man s merger simulation First-order approximation

72 Simulation Critiques Merger simulations omit important factors Barriers to entry and expansion Buyer power Potential for post-merger coordination Always predicts a price increase Can compute marginal cost reduction necessary to offset price increase Empirical validity of predictions in question

73 The Economics of Efficiencies

74 Overview Will efficiencies be passed through to consumers? How do we weigh efficiencies and predicted harm?

75 Assumptions I will assume that: A set of marginal cost efficiencies that are merger-specific and cognizable have been identified. The relevant legal standard is consumer welfare.

76 How Does a Monopolist Choose Its Price? A monopolist balances: The good news from an additional sale: more revenue. The bad news from an additional sale: the marginal unit s cost of production. The monopolist chooses the price at which these things are equal.

77 The Monopolist s Decision Dollars Price 1 Marginal Cost Curve 1 Demand Curve Output 1 Quantity Marginal Revenue Curve

78 What Happens if Marginal Cost Falls? A profit maximizing monopolist sets MR = MC Recall that a monopolist balances: The good news from an additional sale: more revenue. The bad news from an additional sale: the marginal unit s cost of production. The monopolist chooses the price at which these are equal. A decrease in cost means that the bad news falls, and the monopolist increases output until good news and bad news are equal again.

79 The Effect of A Cost Shock Dollars Note: pass-through rate is 50% for monopolist facing linear demand Price 1 Price 2 Marginal Cost Curve 1 Marginal Cost Curve 2 Demand Curve Output 1 Output 2 Marginal Revenue Curve Quantity

80 The Form of Competition is Important for Efficiencies Analysis How efficiencies are passed through depends upon the structure of competition. In the previous example, the monopolist faced a downward sloping demand. Now consider a setting in which firms compete to win procurement auctions. Suppose that firms A and B, who compete with firm C, are merging.

81 Balancing Price and Quality Effects Straightforward if can translate quality effects into prices and willingness to pay But what about price effects and incommensurate quality improvements? Example: Hospital mergers & quality of health care defenses

82 Maximizing Competitive Intensity Requires Tradeoffs If we agree that many relevant forms of competition relate inversely to each other and that no plausible method exists for converting intensities of different forms of competition into a common unit of intensity, then, it would seem, we must also agree [antitrust] is logically impossible to carry out if its goal is interpreted as increasing the overall intensity of competition. Harold Demsetz (1991).

83 Williamson Tradeoff Model

84 Quality Efficiencies What sort of evidence would be required to substantiate a quality efficiencies defense? The Demsetz question: what to do in cases where there is some evidence that the market would increase price and increase quality?

85 Welfare Effects of Mergers P = Less Consumer Surplus = More Consumer Surplus? P2? P1 P2 Q2? Q1? Q2 Q

86 Effect on Incumbents Who Have Stocks of the Monopolized Input MC1 P1 MCo SSNIP Q1 Qo = quantity produced with current stocks

87 Common Cost Increases May Be Largely Passed Through P2 P1 MC2 MC1 Market Demand Q2 Q1

88 The Economics of Vertical Restraints

89 Vertical Restraints Definition: Contractual relationships between a supplier (manufacturer) and distributor (retailer) restricting the conditions under which the latter may sell or distribute the supplier s product Examples: Resale Price Maintenance (RPM), exclusive territories, MSRP, cooperative advertising programs, tying, exclusive dealing

90 Why Does A Manufacturer Want to Restrain Dealers At All? A manufacturer generally desires retail competition because it increases sales This is the single monopoly profit theorem For the monopolist more sales more profit Key: why might imposing restraints on a retailer or distributor increase output/ sales?

91 Economics of Vertical Restraints Answer: Vertical restraints solve incentive conflicts between the manufacturer and retailer. The supplier may want the retailer to do something to increase sales that he would not do without payment (i.e., pre-sale services, such as promotional effort, demonstrations, shelf space, displays, etc.). Where does this incentive conflict come from? Externalities.

92 Fundamental Incentive Conflict in Distribution Chain The benefits of the retailer s pre-sale demand enhancing activities are not fully internalized by the retailer Conflict in incremental profit margins between manufacturer and retailer for many products (e.g., soda, microprocessors, cereal) Cannibalization effects --- promoting Coke reduces Pepsi sales If these conflicts could be overcome, the retailer would supply the services and overall output would go up

93 Other Efficiencies of Vertical Restraints Horizontal or inter-dealer externalities This is the discount dealer problem where the consumer consumes the services at outlet 1 for free but purchases product from discount outlet 2 which does not provide services. Example: shop there buy it here; repeat sale mechanism Dealer quality problems In the absence of a contractual restraint, the dealer may free-ride on the manufacturer s brand name by supplying low quality because the cost will be shared by the manufacturer, i.e., dealer does not pay full price for shirking on quality.

94 Anticompetitive Theories of RPM Manufacturer collusion. RPM might be used by manufacturers who wish to fix retail rather than upstream prices. Why might this strategy be preferable? Retailer collusion. RPM to facilitate a retail cartel Foreclosure. RPM contracts pay retailers to exclude rivals, e.g. Coke uses RPM contracts to compensate retailers for giving them all the shelf space. This is the traditional bubble diagram where manufacturer couples exclusivity or partial exclusivity with compensation (RPM, discounts, etc.). What do these theories predict happens to market prices? What about to market output?

95 Procompetitive Theories of RPM Prevent Discount Dealer Free-Riding Telser (1960) Applies to incentives to provide certain free-rideable services Align incentives between manufacturer and retailer to promote in the absence of free-riding Klein & Murphy (1988) More general account Empirical evidence (Lafontaine & Slade) supports procompetitive theories

96 RPM Economic Theory Predictions Economic Theory Predicted Impact on Price Predicted Impact on Output Collusion - Dealer or manufacturer >0 <0 Foreclosure / RRC >0 <0 Promotional Services >0 >0 Dealer Quality >0 >0 Prevent Inter-Dealer Discount Free-Riding >0 >0

97 Anticompetitive Exclusion: Exclusionary Market Power Conduct that allows a firm (or group of firms), to Achieve, enhance or maintain market power, by Disadvantaging competitors, and thus Harming consumers

98 Potential Exclusionary Conduct Exclusionary Group boycotts Exclusive Dealing With Input suppliers With Customers Tying arrangements Vertical mergers Refusals to deal 1

99 Exclusionary Conduct Paradigms Predatory Pricing (Chicago-School Paradigm) Reduce price as an investment Cause rival to exit, at which point the firm can raise price to monopoly level Focuses on impact of price reductions Raising Rivals Costs (Post-Chicago Paradigm) Raise competitors costs, which leads them to reduce output and raise price, which permits firm to raise its price Focuses on impact of foreclosing competitors access to inputs or customers Some conduct arguably might be characterized either way. Example: loyalty/exclusivity discounts; bundling discounts

100 Efficient Exclusive Contracts: Buyer-Driven Exclusives Coke Pepsi Fast Food Chain Restaurants Restaurants may gain from the increased competition for exclusives, in terms of a lower input price -- which may be passed on to consumers.

101 Facilitating Promotion With Exclusives Economic analysis of the efficiencies of exclusive dealing contracts is based upon two common sense business propositions. 1. Manufacturers often want their dealers to supply more promotion than the dealers would independently decide to provide 2. By creating undivided dealer loyalty, exclusive dealing increases dealer incentives to increase promotion of the manufacturer s product

102 Facilitating Promotion With Exclusives Based upon two common sense business propositions. #1. Manufacturers often want dealers to supply more promotion than the dealers would independently provide Manufacturers and dealers face incentive conflict because dealers do not take into account manufacturer profits from on incremental sales created by some forms of promotion (e.g. eye-level shelf space) #2. By creating undivided dealer loyalty, exclusive dealing increases dealer promotional incentives

103 Dealer Free-Riding Incentives Compensating dealers for increased promotion Slotting fees Wholesale price discount Resale Price Maintenance Exclusive territories Ensuring dealer performance Inherent dealer performance problem Dealers have incentive to free-ride on the manufacturer s compensation arrangement This dealer free-riding might occur in a variety of ways Exclusive dealing can solve these free riding problems

104 Summary Modern antitrust analysis expresses greater concern for RRC conduct than price predation Harm to competition, not merely competitors, the appropriate focus Four-step RRC analytical framework focuses on overall impact on consumers Step 1: RRC Step 2: POP Step 3: Efficiencies Step 4: Overall effect Each step involves fact-intensive inquiry

105 Measuring Foreclosure: Relevant Metrics and Tests Foreclosure rate and contract duration Exclusive dealing practices are thought to be less likely to be anti-competitive when: the foreclosure rate (the share of the market that is denied from rivals) is low the duration of the exclusive contracts is short Courts routinely grant summary judgment when exclusive dealing practices generate foreclosure rates < 40% But, there is not a consensus on how to measure the foreclosure rate

106 Foreclosure Hypothetical The blue and red segments are parts of the same antitrust market Shares in the blue segment (60% of market): Incumbent = 100%; Rival = 0% Shares in the red segment (40% of market): Incumbent = 55%; Rival = 45% Each blue customer participates in the Incumbent s exclusive dealing program Zero red customers participate in the Incumbent s exclusive dealing program

107 Foreclosure Hypothetical Input Markets: Distribution 60 PERCENT OF MARKET Blue Customers I=100/R=0 40% OF MARKET Red Customers I=55/ R=45 Output Market Incumbent Rival Consumers

108 Naïve Foreclosure? Definition 1 ( Naïve Foreclosure) The foreclosure rate is the fraction of the market that is participating in the discount program In our example, the foreclosure rate would be 60%, as the entire blue segment (which comprises 60% of the entire market) is participating in the discount / exclusive dealing program Note if we change exclusive dealing program to loyalty discount program where discount if retailer gives 80 percent of sales then still 60% even though I = 80 and R = 20 These highlight the point that the right foreclosure metric must be tied to the theory of harm

109 Naïve Foreclosure Hypothetical: NFR = 80%? Input Markets: Distribution 60 PERCENT OF MARKET Blue Customers I=80/R=20 40% OF MARKET Red Customers I=80/ R=20 Output Market Incumbent Rival Consumers

110 What s Wrong with Naïve Foreclosure? Definition 1 ( Naïve Foreclosure) The foreclosure rate is the fraction of the market that is participating in the discount program Economics: Naïve foreclosure is completely detached from RRC theory of harm What we are trying to measure is if excluded rival can reach MES Naïve foreclosure doesn t so that Church & Dwight example where shares with exclusivity program and without it are the same --- what is EFFECT of exclusivity? These highlight the point that the right foreclosure metric must be tied to the theory of harm

111 But For Foreclosure Definition 2 ( But-for foreclosure rate) The foreclosure rate is the additional share of the market that the firm obtained due to the discount practice Suppose we were to use the Incumbent s share in the red segment as a proxy for what its share would be in the blue segment in the absence of the discount practice In our example, the foreclosure rate would be 60% x (100% - 55%) = 27% Advantage that more accurately measures impact of exclusive dealing program

112 Naïve Foreclosure Definition 2b Same as above, but expressed as a fraction of the contestable share Given that the Incumbent s but-for share would be 55% (in each segment), it can be argued that only 45% of the market is contestable But does high foreclosure in contestable portion of the market related to RRC theory? Does it make economic sense in measuring likelihood rival can compete for distribution sufficient to reach MES? In our example, the foreclosure rate would be 33% (=15% / (1-55%))

113 Predatory Pricing and Bundled Discounts A revolution in predatory pricing law based largely upon an analysis of error costs In particular, courts responded to evidence in economic literature showing apparent low probability of false negatives and intuitively large cost of false positives from preventing low prices

114 Error Cost Matrix for Predatory Pricing Antitrust Liability Based Upon Predatory Pricing No Antitrust Liability Based Upon Predatory Pricing Truly Anticompetitive Correct Positive (Liability) False Negative Error (failure to address predatory pricing) Truly Procompetitive False Positive (condemn procompetitive pricing behavior) Correct Negative Outcome (No Liability)

115 The Economics of Predatory Pricing Basic Predation Theory: pricing at a level designed to drive out competitors until one can effectively charge the monopoly price or charge it for a longer period of time. The following assumptions underlie this theory in its basic form: - Rival has little or no access to capital markets - There are substantial barriers to entry - Rivals have limited counterstrategies These problems have caused some commentators and courts to be very skeptical about predatory pricing

116 Cost of Predation Monopoly Profits (π M per period) time t=0 Non Predation Profits (π D per period) time

117 Cost of Predation Monopoly Profits (π M per period) time t=0 Non Predation Profits (π D per period) time

118 Monopoly Profits (π M per period) time Cost of Predation t=0 Non Predation Profits (π D per period) time

119 Cost of Predation Monopoly Profits (π M per period) Non Predation Profits (π D ) time t=0 Non Predation Profits (π D per period) time

120 Brooke Group Price below relevant measure of cost Dangerous probability of recoupment: Rule of reason style analysis focusing on market conditions: barriers to entry, concentration, financial strength, pricing incentives

121 Areeda-Turner Test and Above Cost Safe Harbor The basic economic logic of the first prong of the Areeda- Turner test is that observing single product pricing below cost raises some questions about the motivation of the pricing strategy.

122 Areeda-Turner Test and Above Cost Safe Harbor The basic economic logic of the first prong of the Areeda- Turner test is that observing single product pricing below cost raises some questions about the motivation of the pricing strategy. Rules versus Standards Per Se Illegal Rule of Reason Per Se Legality

123 The Economics of Innovation and Intellectual Property

124 Two Types of Competition Competition in the market: The existence of multiple firms that seek consumer business and offer consumer choice. This is also called static competition. Competition for the market: The act of striving against another force for the purpose of achieving dominance or attaining a reward or goal. This is also called dynamic competition.

125 Dynamic Competition Between Firms for the Market Firms race to secure leading position By being first to market with a product or service (iphone) By finding a niche (left-handed guitars) By creating a brand (Lexus) By coming up with new idea for product or service or way for producing something more cheaply (search-based advertising). Firms try to ward off rivals to recover their investments and risk taking via First-mover advantages Intellectual property rights Switching costs Entry barriers such as economies of scale and network effects.

126 Monopoly: The Dynamic View (Not All Bad) Most new businesses fail and lose money. 60% of new businesses fail in first five years. Venture capitalists need to fund about 10 firms to get 1 success. Monopoly profits can be the prize for winning competitions in which most people lose. 32% of pharmaceutical profits in the US come from 0.16% of drugs that were developed. The hope for monopoly profits stimulates risk-taking behavior involving investment and innovation Leads to new products that can provide significant consumer value.

127 Monopoly: The Static View P MC P * P c Q* Q c Q The yellow and red shaded areas reflects lost consumer surplus from paying higher prices and not getting some valuable output

128 Monopoly: The Dynamic View P MC P * P c Q* Q c Q The yellow green and blue shaded areas reflect created social welfare from the creation of new products

129 Intellectual Property Rights Property rights A legally enforceable power to exclude others from using a resource without need to contract with them Costs of property rights Cost of transfer Rent seeking costs to obtain property right Costs of protection and enforcement IPRs hard to protect because they have public good characteristics remember adding users does not impost costs on other IP users and can be hard to exclude others

130 Intellectual Property Rights and Use Costs Property rights Based on broad and simple rules of exclusion. Non rival nature of information (public good) suggest use costs or costs of exclusion are great. Given high costs of exclusion, why use property rights/exclusion to generate creation incentives? Simple exclusion strategy may be optimal despite higher use costs. Use costs are limited through limits on IPRs: Limited times for patents (20 years from filing) Standards for patentability (novel, non-obvious) or copyrightability (original expression) Subject matter, scope (idea/expression), fair use.

131 U.S. Antitrust Agencies 1995 IP Guidelines Key Principles: 1. The vast majority of licensing restraints have procompetitive effects and therefore are analyzed under the rule of reason (i.e., an effects-based approach). 2. For the purposes of antitrust analysis, IP is treated as essentially comparable to any other form of property, tangible or intangible. 3. IP does not necessarily confer market power as there will often be sufficiently close actual or potential substitutes. 4. Competitive effects must be analyzed in comparison to what would have happened in the absence of a license.