Legal, technological, or resource barriers to entry. Decreasing average total costs or subadditive costs (natural monopoly)

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1 Incentives? Incentives? Market Power The simplest departure from the price-taking equilibrium model is when agents (firms) stop treating price as out of their control: they have market power, and the price or quantity they pick will their profits. Why does market power occur? Legal, technological, or resource barriers to entry Decreasing average total costs or subadditive costs (natural monopoly) (which is Google?) The Monopolist: Linear demand We ll work with a simple version of the quasilinear representative consumer model, where u(q, m) = aq b 2 q2 + m, and the budget constraint is pq + m = w. Then the consumer s problem is which gives the linear demand curve which we ll stick with for this section. max aq b q 2 q2 pq + w, p(q) = a bq, 1

2 The Monopolist: Linear demand What would happen in the price-taking equilibrium? marginal cost, so that a bq = c, and q = a c. b Set price equal to The Monopolist: Linear demand The monopolist s problem, then, is max p(q)q C(q) F q where C(q) are variable costs and F is the fixed or sunk cost. variable costs, max(a bq)q cq F q So the FONC is and the profit-maximizing quantity is exactly half the efficient quantity. a bq bq c = 0, q = a c 2b, With linear The Monopolist: General rule What is the monopolist doing, in general? The FONC for max p(q)q C(q) F q is p(q) c (q) }{{} + p (q)q }{{} = 0. Marginal profit from marginal sale Change in revenue current sales The Monopolist: Lerner index To get more economic intuition on the magnitude of the problem, we ll convert the first-order condition into a Lerner index: p(q) c (q) p(q) }{{} Lerner index = dp(q) dq q p(q) = 1 ε d (q), where ε d q is the price elasticity of demand. The Lerner index then says that the fraction of the price that is attributable to market power p(q) c (q) 2

3 is proportional to the inverse of the price elasticity of the demand curve. Smaller less elastic goods will have larger margins, higher profits, and more inefficiency. Monopolists facing more inelastic demand make more money, and the losses to society are greater. Regulatory Solution: Ramsey Pricing Why not regulate the price, making it equal to marginal cost? (1) The monopolist usually has fixed costs, F, so that imposing of marginal cost pricing would lead to losses, and (2) marginal cost is not observable impose a zero profit condition like in a price-taking equilibrium so the monopolist can recover his fixed costs Then the monopolist solves subject to p(q)q c(q) = F. max p(q)q c(q) F q Traditional Solution: Ramsey Pricing This gives a Lagrangian with FONC s L = p(q)q c(q) λ(p(q)q c(q) F ), (1 λ )(p (q )q + p(q ) c (q )) = 0 (p(q )q c(q )) F = 0. The first equation is the standard monopoly FONC, saying that the Lerner index should be -1/elasticity of demand p(q ) c (q ) p(q ) = 1 ε d (q ) and the second equation says that average cost pricing is Ramsey-optimal: p(q ) = c(q ) + F q. 3

4 Regulatory Solution: Ramsey Pricing In the p(q) = a bq, and c(q) = cq example, p Ramsey = c(q) + F q = c + F q, so the answer is to set the price equal to the firm s marginal cost plus the average fixed cost; this spreads fixed costs out over all the sales it makes. Note that letting the firm freely maximize and then taxing its profits doesn t work. Regulatory Solution: Ramsey Pricing How does Ramsey/average cost pricing compare to price-taking equilibrium? If the cost function is linear and there are no fixed costs, C(q) = cq, so that p(q ) = cq q = c, and Ramsey pricing is efficient. If the cost function is linear and there are fixed costs, C(q) = cq + F, so that p(q ) = cq + F q = c + F q, and Ramsey pricing will be nearly efficient as long as enough quantity is produced relative to fixed costs (eg, a natural monopoly). Regulatory solution: Ramsey pricing Pros: Cons: Average total cost is observable, unlike marginal cost, so this is possible in practice (public utilities, drugs, and other industries have been regulated this way; transfer pricing within firms (PwC)) If costs are close to linear, Ramsey pricing is (almost) optimal No reason to think costs are almost linear, so losses might still be large While ATC is observable, it might be complicated or costly for a regulator to measure them In practice, the regulator has to set the price schedule before the monopolist decides what to do: this requires knowing the demand curve and the firm s cost curve, which might be difficult to measure or forecast Economic profits are not always bad: innovation and investment often come from profits 4

5 Regulatory Solution: break up the monopolist You could call this the nuclear option. In the early 1980 s, the Bell telephone system/at&t was broken up into one long-distance carrier along with Bell labs, and seven regional companies that were independently owned. To break up a very tight network is something quite unprecedented, said Alfred D. Chandler Jr., professor of business history at the Harvard Business School. It was one of the best managed companies in the world for a long time. You go overseas and people there can t understand why we re breaking up A.T.&T. We ll get new technologies rushing forward, said Ithiel de Sola Pool, director of the research program on communications policy at the Massachusetts Institute of Technology. It is the dumbest thing that has ever been done, said Charles Wohlstetter, chairman of Continental Telecom Inc., an independent telephone company. You don t have to break up the only functioning organization in the country to spur innovation. Regulatory Solution: break up the monopolist This article presents a new test for subadditivity of the cost function... Applying ths test to the Bell System using time-series data, we reject the hypothesis that the Bell System s cost function is subadditive at the output levels produced between We find limited evidence that the Bell System did not optimally decentralize itself during these years and was therefore operating inefficiently. A Test for Subadditivity of the Cost Function with an Application to the Bell System, David S. Evans; James J. Heckman. The American Economic Review, Vol. 74, No. 4. (Sep., 1984), pp Subadditive means C(q + q ) C(q) + C(q ), so that there are scale economics: rejecting his hypothesis means that Bell was not really a natural monopoly, and breaking it up was potentially a good idea. Regulatory Solution: break up the monopolist Often, regulators are unwilling to do something this drastic: Federal Baseball Club of Baltimore, Inc. v. National League of Professional Baseball Players: comes down to interstate commerce clause The players, it is true, travel from place to place in interstate commerce, but they are not the game. Not until they come into contact with their opponents on the baseball field and the contest opens does the game come into existence. It is local in its beginning and in its end. Nothing is transferred in the process to those who patronize it. Supreme Court decision 5

6 USFL v. NFL: The United States Football League suffered what both sides considered a resounding defeat in United States District Court in Manhattan yesterday when a jury found that the National Football League had violated antitrust law but awarded the U.S.F.L. only $1 in damages... Although the jury found that the N.F.L. violated Section 2 of the Sherman Antitrust Act by having and willfully acquiring or maintaining a monopoly, in that it could control prices or exclude competition NYT article Oligopoly Most industries are actually not monopolies or perfectly competitive, but somewhere in the middle: firms have price power, but don t control the whole market Why do oligopolies arise? Standard barriers to entry Product differentiation The relevant policy concerns are usually about mergers and collusion Oligopoly What happens when there are N > 1 firms instead of just one, where each knows it has market power? We imagine each firm takes the quantity choices of its opponents as fixed and selects its own quantity to maximize its profits We then find the quantity choices for all the firms at which each firm s forecasts about its opponents are correct This is called a Cournot Equilibrium or a Nash equilibrium: it s just like a pricetaking equilibrium, except that what you take as given instead of the price are the choices of your opponents. Oligopoly Suppose all the firms are the same, so firm i of N s costs are just C(q i ) = cq i. Then a typical firm i faces the problem max (a b(q 1 + q q i q N )) q i cq i q i Firm i takes the quantities of the other firms as given, and chooses his quantity to maximize the above profit function, giving the FONC N a bq i c = 0. j=1 q j 6

7 Now, since the firms are all the same, we ll look for a solution where they all do the same thing: q i = q for all i, so that (a Nq ) bq c = 0. Oligopoly This gives q = 1 N + 1 a c, b which is between the monopoly ((a c)/2b) and perfectly competitive (a c) quantities. The total quantity produced in the market is Nq, or and the price is Q = N a c N + 1 b p = a N N + 1 (a c) = a 1 N N N + 1 c. Notice, as N gets large, p gets closer and closer to c: the perfectly competitive outcome. Oligopoly: Convergence to perfect competition If the price for N firms is consider the quantity p N c, which is p 1 N = a N N N + 1 c, p N c = 1 a constant (a c). N + 1 N So the oligopoly price converges to the competitive price (c) at a rate of 1/N: this is really fast. At 10 equally competitive firms, you re about 1/10-th the distance from the competitive price; at 100, you re about 1/100 the distance. In the presence of competition, oligopoly prices converge to competitive ones at a speed of O(1/N), so the best regulatory policy is usually to encourage competition. Experimental evidence 7

8 Average price by number invited CFA Number Invited Oligopoly: Merger analysis and the HHI But firms don t want entry: they want to merge. Why? Economize on fixed costs (welfare-enhancing) Increase market power by pooling patents/resources (welfare-reducing) Increase market power by reducing competition (welfare-reducing) The Herfindahl-Hirschman Index is intended to be a measure of industrial concentration, defined as N HHI = where s i is i s share of total industry production, q i /Q. If all the firms have a small market share, they presumably have little market power, and HHI is closer to zero. If a single firm does the vast majority of the production, then HHI is closer to one. So this gives a zero-to-one-measure of the competitiveness of an industry. Oligopoly: Merger analysis and the HHI The Department of Justice actually uses the HHI to decide whether a proposed merger presents a threat to competition. The Horizontal Merger Guidelines state: i=1 An H below 0.01 indicates a highly competitive industry An H below 0.15 indicates an unconcentrated industry s 2 i 8

9 An H between 0.15 to 0.25 indicates moderate concentration An H above 0.25 indicates high concentration If the industry is moderately or highly concentrated, or if a merger would lead to a large increase in the HHI, the DOJ will typically investigate or challenge the merger. Oligopoly: Merger analysis and the HHI For our simple model, each firm produces q = (a c)/(b(n + 1)), so s i = 1/N. Then we have N ( ) 2 1 HHI = = 1 N N, Then the guidelines say: i=1 An H with 100 or more firms indicates a highly competitive industry An H with more than 7 firms indicates an unconcentrated industry An H between 4 to 7 firms indicates moderate concentration An H with fewer than 4 firms indicates high concentration Oligopoly: Merger analysis and Market Definition Here is a case that makes the issue of market definition clearer: In 2007, the FTC challenged a merger between Whole Foods and Wild Oats, arguing that they were premium natural and organic supermarkets, distinct from conventional supermarkets. Apart from Whole Foods and Wild Oats, the only other PNOS identified by the FTC were Earth Fare in southeastern states and New Seasons in Oregon. Whole Foods/Wild Oats argued that they were basically a really nice supermarket The Whole Foods CEO hadn t helped when he previously said, Safeway and other conventional retailers... cant really effectively focus on Whole Foods Core Customers without abandoning 90 percent of their own customers The merger was ultimately allowed, since the case was nutty Merger analysis and Market Definition An important feature of the case was: 9

10 Based largely on testimony and studies from the defendants experts, the court found that conventional stores such as Safeway, Delhaize America, Krogers, and others had repositioned themselves to offer more natural and organic products and would operate to constrain Whole Foods in the post-merger market. It found that grocery shoppers are price sensitive and frequently engage in cross-shopping, i.e., buying various grocery items from different stores in their local areas, and purchasing many, if not the majority, of their items at conventional stores. ABA analysis of ruling Things went differently in FTC v Staples, when Staples tried to acquire Office Dept in the late 1990 s: The court ruled that office superstores were a distinct market The merger was blocked, since it would have reduced the market to three firms and considerably increased concentration Oligopoly: Merger analysis and the HHI Pros: Cons: The HHI is intuitive: larger market shares usually means more market power Gathering and computing market share data is easy The guidelines seem reasonable The entire economic analysis will hinge on market definition, and this has had lasting implications The HHI somewhat arbitrary: it s not really tied to consumer welfare in any way Market power might not necessarily be driven by market share, or small produces might be taking the most advantage of their consumers Collusion Collusion is when firms coordinate to act like a monopolist. There are two flavors: Explicit collusion firms get together and decide how to manipulate prices and the penalty for deviating Tacit collusion without saying so, firms settle into an unspoken agreement to manipulate prices For the economist, both are the same thing, pretty much: illegal contracts are not enforceable in court, so whether or not it s tacit or explicit, the agreement must be enforced by the threat of punishment from within the cartel. (They are not the same for lawyers) 10

11 Collusion: mechanics To keep things simple, suppose there s two firms, and they can charge a high price or low price. If they both charge high prices, they split the monopoly profit, π monopoly /2 If they both charge low prices, they each get profits of zero If one charges a high price and the other charges the low price, the one charging the low price gets π undercut > π monopoly /2 and the one charging the high price gets zero The interest rate is 0 < r < 1, so the firms discount future payoffs at a rate of δ = r. For such a firm, the value of an asset that pays out one dollar a day forever is 1 + δ + δ 2 + δ = 1 1 δ. Collusion: mechanics Now, one firm says to the other (over a call on throwaway cellphones or through an interview in the WSJ) We are killing each other charging competitive prices I am going to raise my price, because reasons If you follow me and we raise our prices together, I will continue to maintain a high price If you charge a low price ever again, I will go back to charging low prices See how if the other firm agrees this is in its best interests to follow this requires no courts, no explicit agreements, nothing? Collusion: mechanics Does the other firm agree to the collusive agreement? If it refuses, its payoff is If it agrees, its payoff is π monopoly 2 + δ π monopoly 2 π u + δ0 + δ = π u + δ 2 π monopoly = π monopoly δ 11

12 So agreeing is profitable if or π monopoly δ π undercut, δ π undercut π monopoly /2 π undercut. So if firms are sufficiently patient the interest rate (price of future consumption) is low enough then collusion can be profitable, whether tactic or explicit. 12