Economics and Competition Law

1. Personal views of author. Does not represent opinion or position of any institutions to which he is affiliated. Economics and Competition Law David Stallibrass UIBE – November 2011

2. Who am I? 2001 1998 2004 2005 2011

3. Objective of lecture • To introduce the role of economics in competition law, discuss some key concepts, and have fun.

4. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

5. Objective of competition law • To reduce the negative effects of market power • Three concepts: • Markets • Market power • Its negative effects

6. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

7. Markets • Standard model of how a “market” works • The more expensive something is, the less people will buy it. This creates a demand curve. • The more a firm can sell something for, the more of it will be made. This creates a supply curve. Price supply demand Quantity

8. Markets • Standard model of how a “market” works • Where the two curve intersect, the market clears • Supply = demand, and everyone is happy • This “market price” is an almost magic creation of millions of views and decisions Price supply Magic price demand Magic quantity Quantity

9. Competitive markets • In a competitive markets, firms price at cost • The supply curve consists of the minimum average costs of a sequence of firms, arranged in ascending order Price supply Magic price demand Magic quantity Quantity

10. Competitive markets • If all firms are identical, then… • …becomes flat • This is the standard model for a “competitive market” • The market price is the same as the marginal cost of each of the firms in the market Price Magic price = Marginal cost supply demand Magic quantity Quantity

11. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

12. Market power • If there is only one firm in the market… • …it can choose the price it wishes to sell at… • …and consumers will decide how much they want to buy. • The firm will set the price that maximises the firms profit Price demand Quantity

13. Market power • The firm maximises the profit by… • …setting the Marginal Revenue it would gain from selling an extra item to be equal to… • …the Marginal Cost it would cost to produce an extra item Price New price > Marginal cost Marginal Cost Marginal Revenue demand New quantity Quantity

14. Society is worse off with market power • The makes some profit, but… • …the consumers who buy the good pay more for it… • …and some consumers no longer buy the good at all! Price Firm makes profit, and consumers pay more – just a transfer of wealth But the benefit lost to consumers that no longer buy is a “deadweight loss” Monopoly price New quantity Quantity

15. And innovation can be harmed • Compare the rents to innovation in a monopoly to a duopoly. • In a monopoly, innovation will let you sell a bit more, at a slightly higher price • If you don’t innovate, you’ll still do ok! Price Quantity

16. And innovation can be harmed • Compare the rents to innovation in a monopoly to a duopoly. • In a duopoly, innovation may let you capture the whole market • If you don’t innovate, you’ll exit the market Price Quantity

17. Causes of market power • OFT definition: • “Market power can be thought of as the ability profitably to sustain prices above competitive levels or to restrict output or quality below competitive levels.” • Causes of market power • Agreements  • Mergers  • Abuse of a dominant position  • Success 

18. Agreements • Some agreements between firms are positive • Many contractual agreements setting out how firms interact help reduce risk • But agreements involving price, quantity, maker sharing are harmful • Directly decrease competitiony • Minimal (or no) benefits to society

19. Mergers • Positive effects of a merger • Efficiencies • Speedy market transitions • Etc. • Negative effects of a merger • Unilateral price rises • Co-ordinated price rises • Possible foreclosure

20. Abuse of a dominant position • Firms that are “dominant” in a market can use that market power to extend that market power • Foreclosure • Predation • But a complex area – often dominant because successful

21. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

22. Play Compete! • Lets say the market consists of six identical firms • Each firm decides how many dongxithey will make, and then sell • The market then decides the price according to the following formula: • Price = 100 – Total Number of Dongxi Made • Each firm faces a constant marginal cost of ¥10. So it is possible to lose money!

23. Rules • First: get into 6 groups • Then: • In your groups, decide how many dongxi to make • Write it on a piece of paper • Hold up the paper when I ask (all at the same time) • Each firm decides how many dongxithey will make, and then sell • We compute the results, and play again!

24. Example 1 Market price is less than market cost, so no one makes a profit! The firm who makes the largest amount, makes the largest loss

25. Example 2 All firms make relatively few, keep the market price high, and all make a profit

26. Example 3 One firm makes twice as many as the others, and makes twice as much profit

27. Example 4 All firms make 20 units, and the market price becomes 0! The firms have to give their dongxi away!

28. Lets play! • Round 1 • Round 2 • Round 3 • Round 4 • BREAK • Round 5 • Round 6 • Round 7 • Discussion

29. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

30. Recap • Market power can be bad • Bad market power can come from mergers or agreements that lead to firms no longer competing with each other within a market • The higher proportion of the market involved, the worse the harm • …but how do we define the market?

31. Question: what’s in the same market? Nokia phone Desktop Android phone Android tablet Netbook iPhone iPad Laptop MP3 players Kindle

32. Market definition • “A market” is a concept created by economist. It implies a bright line – anything outside of the bright line is not in the market

33. Market power • Standard way to define a market is with reference to why we’re defining it: • Would a “hypothetical monopolist” of the proposed market be able to profitably raise price? • This is called the Small, but Significant Non-transitory Increase in Price (SSNIP) test • Traditionally a 5% - 10% price rise for a year

34. SSNIP test in practice eg 7-11 in Guomao Start narrow add in other shops Imaginemonopolist imposes 5-10% price rise Widen NotProfitable 1) Customers go to other shops, and/or 2) Other shops enter the market Stop: Market Defined Convenience stores in Chaoyang district

35. SSNIP test in practice • Two reasons why it may not be profitable to raise price: • Demand side substitution: consumers go elsewhere • Supply side substitution: other firms enter the market because it is now profitable to do so • Key conceptual difficulty: the “cellophane fallacy” • Key technical difficulty: where to get the data?

36. The cellophane fallacy • Dupont successfully argued that Cellophane and other wrapping material were in the same market • It wasn’t profitable for them to raise their price • BUT as we’ve seen, firms always set their price at a level where it would not be profitable to raise it! • Not such a problem with mergers, but a problem in dominance cases

37. The cellophane fallacy How to work out “competitive price?” How to work out “impact on profit?”

38. Getting the data • Working out the “competitive price” • In merger analysis, can often assume that current price is reasonably competitive • In dominance, there is a chance that current price is the monopoly price • Need to look at profitability… • …but looking at profitability is really hard • Calculating fair return on risk • Off-balance sheet investments • Separating business functions

39. Working out impact on profit πS=QS x (PS – C) πN=QN x (PN – C) πS> πN if (QN – QS ) / QS < (PS – C) / (PN – C) - 1 • Once we know starting price, new price, and starting profit… • …we can calculate the amount of quantity that the price rise would need to lose to make it unprofitable… • …this is the Critical Loss (in %) Price PN PS C QN QS Quantity

40. Estimating actual loss • Still not there yet (though we’ve estimated C, PS , and πS) • We need to know the likely loss of Q if P increases 10% • Four ways of estimating: • Asking people – consumer surveys, customer surveys, diversion rations, etc. • Looking at historical price data • Looking at internal marketing documents • Guessing

41. Recent developments in merger analysis • UK (at least at first phase) • Moving towards “frame of reference” rather than strict market definition • Upward Pricing Pressure • Look at “closeness of competition” of two competitors, rather than market definition and market shares

42. Topics covered • Overview of economics of competition law • Markets • Market power • Problems with market power • Play Compete! • Basic tools of economic analysis • Market definition • Interaction between economics and law

43. Economics and competition law • Two areas where economics and competition law intersect: • Economics can help design an efficient law • Economics can help determine when the law is broken

44. Designing an efficient law • In competition law and economics, the objective is to use economics to design a law that maximises welfare, while minimising enforcement and compliance costs: • MIN [ • Type 1 error + • Type II error + • enforcement cost + • compliance cost] Almost impossible to measure!

45. Objective • Requires accuracy • Close mapping of economics and empirical evidence of harm and benefit • Requires effectiveness • Self assessment by firms • Predictability of courts and administrative bodies • Proportionate punishment

46. Options for an efficient law • A range of options for legal test • Further nuanced by: • Blockexemptions based on market share • Prioritisation of competition authourities Rebuttable presumption of illegality Per se illegal Legal “Rule of reason” Economics used to determine “rule of reason” or rebut “presumption of illegality”

47. Example use of economics in UK competition law

48. Further reading • Films • A Beautiful Mind (the man who invented Nash equilibrium) • The Informant (pretty accurate story of the inside of a cartel) • Books • Straight economics: “The Economics of EC Competition Law”, Bishop and Walker, 2010 (third edition) • Mixed with policy (slightly less well written):“Competition Policy, Theory and Practice”, Massimo Motta, 2006 • Based on cases:“Cases in European Competition Policy: The Economic Analysis”, 2009, Edited by Bruce Lyons

49. Contact details • economics@davidstallibrass.com • PRC Tel: (+86) 186 1155 0686 • www.davidstallibrass.com