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EC365 Theory of Monopoly and Regulation Topic 1: Introduction 2013-14, Spring Term Dr Helen Weeds.

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Presentation on theme: "EC365 Theory of Monopoly and Regulation Topic 1: Introduction 2013-14, Spring Term Dr Helen Weeds."— Presentation transcript:

1 EC365 Theory of Monopoly and Regulation Topic 1: Introduction 2013-14, Spring Term Dr Helen Weeds

2 Key information (1) Teaching:  Lectures: Thurs 3-5pm, weeks 16-25, LTB3  Classes: Tues 1-2pm, weeks 18 (28 Jan) to 25 & 31, LTB9  lecture notes and problem sets on ORB Opportunity to present (optional):  10 minute presentation on competition case/academic paper of your choice 2

3 Key information (2) Assessment:  Term paper, submission date: 12 noon, Friday 2 nd May.  Summer exam: 2 hours; answer any 2 questions from 5; questions mixture of maths and short essays.  The aggregate module mark is the larger of: 50% coursework mark + 50% final examination mark or 100% final examination mark. 3

4 4 Textbooks General  Cabral (2000) “Introduction to Industrial Organization”  Viscusi, Harrington & Vernon (2005) “Economics of Regulation and Antitrust”, 4 th edn. Case Studies  Kwoka and White (2004) “The Antitrust Revolution: Economics, Competition and Policy, 4 th edn.  Kwoka and White (2008) “The Antitrust Revolution: Economics, Competition and Policy, 5 th edn.

5 Useful websites Newspapers and news websites:  BBC News, Financial Times, The Economist Competition authorities:  UK Competition Commission – www.competition-commission.org.ukwww.competition-commission.org.uk  Office of Fair Trading – www.oft.gov.ukwww.oft.gov.uk  US Federal Trade Commission – http://www.ftc.gov/http://www.ftc.gov/  US Department of Justice – www.justice.gov/atr/www.justice.gov/atr/  European Commission – ec.europa.eu/competition/index_en.html UK industry regulators:  OFCOM – www.ofcom.org.ukwww.ofcom.org.uk  OFGEM – www.ofgem.gov.ukwww.ofgem.gov.uk  OFWAT – www.ofwat.gov.ukwww.ofwat.gov.uk  Office of Rail Regulation – www.rail-reg.gov.ukwww.rail-reg.gov.uk 5

6 DO FOR SUCCESS Attend lectures  Take notes  Ask questions  Review lecture presentations Do the readings Attend classes  Do problem sets before class and review answers  Take part in class discussions You need be confident both to solve maths questions and to write detailed short essays Do the term paper (insurance policy) REVISE 6

7 A Cheap Gag… 7 Source: Hasbro, Facebook fan page

8 8 Module outline Introduction (weeks 1-2)  background  monopoly problems Competition policy (3-6)  routes to monopoly power: collusion, merger, exclusion  vertical merger & restraints Regulation of monopoly (7-9)  natural monopoly, franchising  regulation of monopoly  liberalisation and deregulation Presentations and debates (10)

9 9 Lecture outline Introduction to competition policy and regulation  rationale for competition policy  origins and historical development  regimes: EU, UK, USA  utility privatisation and regulation Revision of basic concepts  perfect competition  monopoly  oligopoly

10 10 Rationale for competition policy Economic efficiency  allocative  productive  “perfect competition” condition of first fundamental theorem of welfare economics Wider economic benefits  competitiveness and growth  reform of UK competition policy in late 1990s/early 2000s based on idea that competition is good for productivity and growth Political interests  protection of consumers  competition as a substitute for state intervention?

11 11 Competition policy regimes European Union  agreements between firms: Article 101 (formerly 81) TFEU  single-firm conduct: Article 102 (formerly 82) TFEU  merger control: EC Merger Regulation (1989, amended 2004) United Kingdom  agreements between firms: Chapter I of Competition Act 1998; Enterprise Act 2002 (stronger measures against cartels)  single-firm conduct: Chapter II of Competition Act 1998  merger control: Enterprise Act 2002 United States  monopolisation (agreements & single-firm conduct): Sherman Act 1890  merger control: Clayton Act 1914

12 12 Competition policy pre-history Restraint of trade doctrine (common law) Magna Carta (1225)  right to “free customs” The Dyer’s Case (1414)  John, the Dyer, sued a colleague for breach of a covenant “not to use his dyer’s craft within the town … for half a year”  judge ruled that “the obligation is void, inasmuch as the condition is against the common law … if the plaintiff were here he would go to prison until he should pay a fine to the king”

13 US antitrust policy Origin: response to growth of “trusts” (cartels and monopolies) in the USA in the 1880s Standard Oil trust 1882  founded by John D Rockefeller linklink  controlled 88% of US refined oil production in 1890 American Tobacco Company 1892  a consortium of 5 companies founded by J.B. Duke  covered 90% of cigarettes produced in the US Both were broken up in 1911 following orders of the US Supreme Court 13

14 14 US antitrust laws Sherman Act 1890  Section 1: prohibits contracts, combinations & conspiracies in restraint of trade  Section 2: prohibits monopolisation, attempts to monopolise & conspiracies to monopolise trade Clayton Act 1914  prohibits price discrimination & some vertical restraints, where these “substantially lessen competition” (SLC)  merger control: SLC test Federal Trade Commission (FTC) Act 1914: set up FTC

15 15 EU & UK: agreements between firms Art. 101 / Chapter I of Competition Act 1998 prohibits “ … all agreements between undertakings … which have as their object or effect the prevention, restriction or distortion of competition” Includes  price fixing  limiting production or investment  market sharing  applying dissimilar conditions or supplementary obligations Exemptions: agreements that are necessary to  improve production or distribution  promote technical progress

16 16 EU & UK: abuse of dominance Art. 102 / Chapter II of Competition Act 1998 prohibits “Any abuse... of a dominant position” Abuse includes  imposing unfair prices or conditions  limiting production or technical development  applying dissimilar conditions or supplementary obligations What is “dominance”? Is it the same as monopoly?  “position of economic strength … which enables it to prevent effective competition” (United Brands, 1978)  “does not preclude some competition” (Hoffman-La Roche) What is the “relevant market” within which the firm operates?  econometric evidence on substitution between products

17 17 Additional measures in the UK Enterprise Act 2002 Cartels [Part 6]  makes cartelisation a criminal offence, carrying large fines and possible imprisonment of individuals (up to 5 years)  “dawn raid” investigatory powers granted to Office of Fair Trading  leniency provisions  third party damages Market investigations [Part 4]  Competition Commission (CC) may investigate an industry  CC decides “whether any feature, or combination of features... prevents, restricts or distorts competition”  CC may impose behavioural or structural remedies OFT & CC now merging into Competition and Markets Authority

18 18 EU merger control European Community Merger Regulation prohibits “A concentration which would significantly impede effective competition... in particular as a result of the creation or strengthening of a dominant position” [Council Regulation No. 139/2004, 20 January 2004] Merger may be blocked, or remedies imposed to gain clearance Airtours (2002): ECJ (appeal court) overturned Commission decision to block Airtours/First Choice merger  Issue: interpretation of “collective dominance”: does this include Cournot-style unilateral behaviour, or just collusion?  Resulted in amendment to original (1989) merger regulation to include unilateral effects [Regulation No. 4064/89]

19 19 UK merger control Pre-2003: Fair Trading Act 1973  public interest test Competition Commission (formerly MMC) may find merger “against the public interest” and recommend remedies  decision taken by Secretary of State for Trade & Industry  Tebbit Guidelines (1984): “to make references primarily on competition grounds” Since 2003: Enterprise Act 2002 [Part 3]  prohibits a merger that “has resulted, or may be expected to result, in a substantial lessening of competition”  Competition Commission makes finding and may impose remedies (except “certain public interest cases”)

20 20 UK institutions Office of Fair Trading (OFT)  investigates agreements between firms and abuse of dominance, under Competition Act 1998  prosecutes cartels, under Competition Act 1998 & Enterprise Act 2002  refers mergers and market investigations to the CC Competition Commission (CC)  investigates mergers and markets referred by OFT OFT and CC are merging to form the Competition and Markets Authority (CMA), which takes over in April 2014 Appeals: Competition Appeal Tribunal (CAT)

21 EU institutions European Commission: Directorate-General for Competition (“DG Comp”)  carries out investigations under Art. 101 (agreements between firms) Art. 102 (abuse of dominance) ECMR (merger control)  Chief Competition Economist: currently Massimo Motta Appeals:  General Court (previously Court of First Instance)  European Court of Justice (ECJ) 21

22 22 Utility regulation in the UK Privatisation of utility industries in 1980s & 90s  BT, British Gas, electricity supply industry, water, rail  Natural monopoly elements  Need for regulation: prices, service quality, investment Sectoral regulators  Ofcom: telecommunications, broadcasting, post  Ofgem: gas and electricity  Ofwat: water and sewerage  Office of Rail Regulation (ORR): railways  Civil Aviation Authority: aviation, airports

23 23 Revision of basic concepts Perfect competition  definition  outcomes Monopoly  profit maximisation  outcomes Oligopoly  Cournot  Bertrand

24 24 Perfect competition benchmark Assumptions 1.Many atomistic suppliers 2.Homogeneous product 3.All firms have access to all technologies 4.Free entry (and exit): i.e. no sunk costs 5.Perfect information, e.g. all agents know all prices Outcome  Price = marginal cost  Firms are price takers (demand faced by each firm is horizontal, i.e. infinitely elastic, at this price level)

25 25 Figure 1: The firm under perfect competition

26 26 Implications of perfect competition 2 forms of efficiency Allocative efficiency  Consumption is efficient: the good is consumed by everyone who values it at least as much as its cost  Production is efficient: firms produce this output level Productive efficiency  Costs are minimised (given output level) Firms choose the cheapest technology and operate efficiently Free entry ensures the “right” number of firms [NB: static concepts]

27 27 Competitive selection Relax assumptions 3 & 4  3: Firms have access to different technologies (costs) firm discovers its relative efficiency after entry  4: Entry incurs a sunk cost Outcomes  Competitive selection: many firms enter the market; less efficient quit, efficient stay observation: simultaneous entry and exit  Differential profit rates persist; sunk costs can be recouped  Productive efficiency is achieved (given technologies)

28 28 Monopoly Assumptions  Single firm  No threat of entry Profit maximisation  Raising price has two effects: Higher margin (p-c) from consumers who still buy (+) Loss of sales to those who no longer buy, as price exceeds willingness to pay (–)  Marginal revenue is the gain from raising output  Condition: marginal revenue = marginal cost

29 29 Figure 2: Monopoly pricing and output

30 30 Numerical example Assumptions  Demand: Q = 100 – P  Costs: MC = AC = £20 Competitive equilibrium  P c = MC = £20; Q c = 100 – 20 = 80 Monopolist’s profit maximisation   = (P - MC)Q = (100 – Q – 20)Q  d  /dQ = 80 – 2Q=0  P m = £60; Q m = 40

31 31 Oligopoly Competition between small number of firms (e.g. 2) Static models: strategies chosen simultaneously  Cournot (1838): firms compete in quantities  Bertrand (1883): firms compete in prices strategies chosen sequentially  Stackelberg: firms compete in quantities

32 32 Cournot: firms compete in quantities 2 firms, 1 & 2, simultaneously choose quantities q 1 and q 2 Linear inverse demand fn: p = a – b(q 1 +q 2 ) Constant marginal cost c Nash equilibrium: firm i chooses q i given choice of its rival  Set q i to max  i = (a – bq i – bq j – c) q i for i = 1, 2 where i  j  FOC: a – 2bq i – bq j – c = 0  Rearrange: Reaction function for firm i Solve simultaneous equations: Price Profit

33 33 Figure 3: Cournot equilibrium

34 34 n-firm Cournot oligopoly Suppose n identical firms, each has cost c Cournot outcomes  Quantity per firm, Industry  Price  Profit per firm As n   : q i  0, Q , p  c,   0  competitive outcomes

35 35 Bertrand: firms compete in prices What happens if firms instead choose prices? Model  2 firms, homogeneous product  Each sets price, assuming price set by its rival is given Suppose firm 2 chooses p 2  (c, p m ]  Firm 1 would undercut by (tiny) , and steal whole market  Knowing this, 2 will undercut; 1 will undercut again … Unique eqm: p 1 = p 2 = c; each receives ½ mkt D Competitive outcome with just two firms!

36 36 Figure 4: Bertrand equilibrium


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