Joven Liew Jia Wen Industrial Economics I Notes. What is competition?

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1 Industrial Economics I Notes What is competition? Competition in markets is generally considered a good thing (welfare economics) Competition authorities look at whether change in market structure or firm behaviour can result in increase in welfare Consider whether the existing one is the best potential one in terms of welfare perspective Economists tend to look at total economic welfare: consumer surplus + producer surplus (profit) In many competition investigations, focus is on consumer welfare Consumer surplus = diff between consumer s valuation of the good and the price she effectively pays for (area above price and below demand curve) Producer surplus = sum of all profits made by producers in the industry (area below price and above marginal cost or supply curve) Welfare is lowest when monopoly price and welfare is highest when P= MC Must consider dynamic component of welfare, future welfare matters too. Ex. If firm knows that it cannot cover fixed cost, there is no innovation and future welfare is reduced at P = MC Main issue is to not have producer surplus at the expense of consumer surplus Rivalry, entry, efficiency and innovation Allocation, dynamic and productive efficiency Allocative efficiency P= MC Productive efficiency: Whether firms are producing at minimum cost given technology (any point on PPC is productive efficient but does not indicate other efficiencies) Dynamic efficiency: Are new technologies developed? Competition authorities may have broader perspectives such as consider impact on whole EU market, national security and economic growth ex. During Global Financial Crisis, banks are allowed to merge to be kept solvent. Take into acc the financial stability of the economy Difficult to tell apart genuine competitive strategies from predatory ones Perfect competition Many consumers, none large relative to size of market Many producers, none large relative to size of market Price takers, cannot influence market price No government intervention Firms maximize profits and consumers maximize utility No strategic interaction Homogeneous products Free entry and exit into industry and no barriers of entry and exit All players have perfect information Simultaneous moves

2 Firms cannot influence input price and output price and use MR=MC to decide on output Short run market equilibrium is P = MC Long run market equilibrium is P = LRAC Zero economic profit No entry or exit at long run eq Industry supply = N (firm s supply) Allocative efficiency attained because P = MC Technical efficiency attained because it operates at LRAC minimum cost But no dynamic efficiency because firm earns zero economic profit in the long run, no incentive to innovate as no short term monopoly rent to earn, no profit to reinvest in the long run In the short run maybe innovate to get minimum cost Perfect competition provides stylized benchmark But not realistic Underpins competition policy because we hope firms can deliver outcomes as close to that of perfect competition Used for wider policy options and welfare analysis Monopoly Monopoly is a sufficient but not necessary condition for competition problems It is a very specific circumstance Alternatively, we can consider competition as everything except monopoly but non-monopoly situations can also have competition concerns Many consumers, none relative to size of market ONE FIRM No government intervention Firm maximizes profits, consumers maximize utility No strategic interaction Unique product No entry and exit of industry, high barriers to entry (other firms cannot access the technology at the same cost) Monopolist may overinvest in capacity, carry out predatory pricing, foreclose access of rivals to crucial inputs, switching costs that cause incumbent firms to retain market power All players have perfect information Firm is price maker and consumers are price takers Downward sloping demand curve and MR curve is below that Allocative inefficiency because P > MC Rent seeking

3 Productive inefficiency because of X inefficiency, monopoly does not seek to be at minimum cost, happy to be earning its high profits Dynamic efficiency because short term monopoly rents encourage innovation but unlikely if no threat of entry There is deadweight loss Elasticity of demand determines the ability to price above marginal cost and hence deadweight loss area Posner state that the social cost of monopoly is deadweight loss + monopoly s rent Firms use resources to become monopolies and protect monopoly position Opportunity cost of resources not captured in the deadweight loss triangle Firms invest up to potential rent of monopoly Excess R&D spent to protect patent, spend to create barriers of entry, overinvest in capacity or lobbying expenses Leibenstein states that monopoly likes a quiet life, can stay in business and earn profit without minimizing cost (X-inefficiency) Monopoly is happy to live with high monopoly profit even if with more effort, they could get more. Empirical evidence has shown that monopoly may not want to put in effort to find new technologies even if they increase profit. No competitive pressure to minimize cost and if putting effort is costly for managers, they will not do so. Monopoly may be least cost if natural monopoly -upfront fixed costs are high -average cost declines over the whole range of output -marginal cost lies below average cost over the whole range of output -least cost if have one firm producing rather than many firms -depends on technology or cost characteristics of firms Temporary monopoly profit is needed for innovation so it is not a cause of concern for competition Potential to earn short term monopoly rent spur innovation and is good for dynamic efficiency (Justification for patents). Short term market power is a powerful incentive for firms to innovate and invest. Basis for Austrian school of thought that competition is a dynamic process so it is okay to have potential short term monopoly rent with threat to entry Austrian idea of creative destruction

4 -start with monopoly but potential entry so competitors see the profits and enter and erode monopoly profits -get competitive equilibrium in the long run -short term monopoly to deliver long term dynamic efficiency Main concern comes when there is long term monopoly profits coupled with absence of innovation and barriers to entry Effective competition, market power and dominance Most markets sit in a spectrum between monopoly and perfect competition Monopoly and perfect competition are only stylized extremes of the market We want to focus if merger will result in SLC (substantial lessening of competition) Competition act chapter 1 precludes agreements that prevent, restrict or distort competition Competition act chapter 2 relate to abuse of dominant position by firm or groups of firms Focus whether current market conditions have an adverse effect on competition No clear definition of what effective competition means Evidence of rivalry (but in perfect competition, there is no active firm rivalry yet there is allocative efficiency) Absence of restraints on firm s activities by other firms (firms have agreements with each other for production or improvement of efficiency but cartel is prohibited by law) Horizontal agreements: agreements among competitors Vertical agreements: agreements between firms at different stages of production (manufacturer and retailer) No firm can influence market price (each firm will try to have some market power to influence price) If we use perfect competition benchmark of pricing, majority of the markets would require investigation because nearly all markets have some form of P>MC Effective competition is characterized by absence of market power Market power is the ability to profitably priced above competitive price (MC) over a sustained period of time Characteristics of market power include: restrict output, profitably increase price Own price elasticity of demand, cross price elasticity of demand and price elasticity of supply A firm with significant market power considered dominant in relevant market Ability to prevent effective competition acting independently of competitors, customers and consumers Competitive constraints from competitors or consumers are ineffective Firm is free from competitive constraint

5 Rules of thumb measures of dominance as starting point for investigations Market shares used to signal dominance (shares of 50% and above in European Court of Justice) Commission works with rule of thumb of 40% to 45% High market share necessary but not sufficient condition Consider potential changes over time, whether it is temporary monopoly position Scope for consumer countervailing buyer power Whether conduct is an abuse of market power Whether conduct reduces consumer welfare Evidence of market power/dominance is not a breach of competition law. Need evidence of such power being abused and detriment to consumers Ultimately, Markets have to be investigated on a case-to-case basis Not a tick-box approach Factors that influence market competition are informed by economic models and concepts There is no single definition of effective competition Need market-specific analysis to evaluate impact on welfare Structure-Conduct-Performance Model (SCP) Structure determines conduct Assumes profit maximization and price competition Structure determines performance via impact on conduct Useful framework to identify core issues in industrial economics Explain determinants of competition and outcomes of competition Market structure here is determined to be exogenous and not influenced by firm behaviour Need to take into account interrelationship between S, C, P Market structure describes the market: relative size and scale of firms, products homogeneity, potential for exit and entry in market, barriers to entry, characteristics of consumers, extent of vertical integration Market structure informs us the extent to which firms take account of interactions Market structure affects behaviour, outcomes and welfare Market structure is exogenous and market concentration indicators can indicate market structure (number, size and distribution of firms) SCP model tells us that if there are concerns with structure, there are likely to be concerns with conduct and performance Conduct looks at pricing, product differentiation, advertising, R &D, innovation, expansion and contraction decision, collusion, mergers, how firms compete However, price and cost data are difficult to obtain and not easy to get a rationale for conduct

6 Performance: Profitability, total welfare, consumer welfare, sales, quality and quantity of products, technological progress, productive efficiency, allocative efficiency, wealth distribution It is difficult to assess performance, whether to use economic or accounting profits, which costs to use, which time period are we looking at Limitations to SCP model Market conditions usually don t fit nicely into S, C, P boxes It focuses on static conditions but market is dynamic Vague on relationships between S, C, P Firms are not always profit maximisers No consideration of uncertainty or imperfect information Market structure may not be exogenous Too much focus on market concentration and market structure Need to look at feedback effects that sometimes conduct can affect market structure too, relationship between S, C, P is not one-directional Price below marginal cost to drive out competitors to create barrier to entry Influence type of information to consumers or firms can collude High profits in performance can attract other firms to enter market and affect market structure Firms usually have incentives to maintain or increase market power Variables in S, C, P are difficult to measure Over-reliance on profit focus Markets may not be as predictable as model suggests Demand conditions, supply conditions and government policies may affect S, C, P Demand conditions: tastes and preferences, elasticities, availability of alternatives, switching behaviour, method of purchase, buyer power Supply conditions: technology, cost structure, factor inputs, macroeconomy, supplier power, ownership Government policies: Tax policy, competition regulation policies, subsidies, environmental policy, trade policy Chicago school with Austrian foundations always argue against policy intervention to promote competition because market will correct any short run market power/dominance issue (collusive agreements will break down over time, monopoly profits are temporary But some argue against Chicago school that this only happens in theoretical models. Contestable Theory states that the threat of entry is sufficient to influence firm behaviour In Practice, we need a lot of in-depth analysis to look at impact of consumer welfare