1. REVIEW:LECTURES 9.1, 9.2 AND 10.1, CARTELS AND COMPETITIVE CONSTRAINTS Review19 September 2013 Date ANTITRUST ECONOMICS 2013 Alexis G. Pirchio CPI Elisa Mariscal CIDE, Global Economics Group

2. 2 Overview Review Cartels: The Economics of Price Fixing Cheating and Detection Competitive Constraints and Market Power

3. Replicating the Monopoly Outcome with a Cartel: Agreements on Price and Output Cartels: The Economics of Price Fixing 3

4. 4 The Economics of Price Fixing Illegal by virtue of the behavior regardless of its intent or effect, the “inherent nature” of the practice is injuriously restraining trade. There is no allowable defense (though some industries are exempted) Focus in on the existence of an agreement (see Kaplow, Competition Policy and Price Fixing for critique). Price fixing is per se illegal in the U.S., E.U. and many other jurisdictions. There is an extremely high likelihood that the practice can have only an anti-competitive effect. It is very difficult and costly to investigate claims of pro-competitive vs. anti-competitive effects, making a per se approach economical The practice can be defined specifically enough so that companies can identify what they are, and are not, allowed to do Per se prohibitions should be reserved for practices for which:

5. 5 Cartel Price Paths Citric Acid Railroads Lysine

6. 6 Fact About Cartel Data Biased sample because we only observe discovered cartels. Cartel duration has been underestimated. Welfare losses have been underestimated. Suppose only the less effective cartels are caught. Cartel duration has been overestimated. Welfare losses have been overestimated Suppose only the more effective cartels are caught because the less effective ones collapse before being discovered. Policy challenge: How can we measure the efficacy of cartel enforcement policies, when we cannot measure the number of cartels in an economy? Harrington, CRESSE Lectures, 2011

7. 7 Price Agreements Suppose there are 20 competing firms, all identical. With competition they each charge a competitive price of $5 dollars, and each sell 100,000 units (for a total 2 million units) and just earn a competitive return. If they each agree to charge $20, they each sell 50,000 on average (for a total 1 million units) and make $750,000 of monopoly profit each ($15 * 50,000) for a total of $15 million. [How does output get allocated?] MR P M = $20 P C = $5 2,000,0001,000,000 D Q P MC Monopoly Perfect competition Profit margin of $15 a unit and total profit of $15 million.

8. 8 Output Agreements Divided up by geographic regions so that each sold 50,000 units Divided up by customers so that each had customers to whom they could sell 50,000 units only Competing firms in the example could achieve monopoly price if they each agreed to offer only 50,000 units to the market: We have assumed firms are all the same size and have the same bargaining power. They could also divide things so that some got a larger share of profits by getting a larger region or more (or better) customers. Which is better: price agreement or output agreement?

9. 9 Cartels with Two-Sided Platforms If competing newspapers could fix subscription and advertising prices they could exactly replicate the monopoly outcome Note that this issue is different than “customers” on one side colluding Replicating the monopoly outcome requires fixing prices (or allocating output) on both sides If competing shopping malls fixed rental prices but shoppers continued to get in for free they could replicate the monopoly outcome If one side is constrained to zero then fixing price on the other side replicates monopoly outcome Monopoly profits get competed away if competition is intense on other side Profits might increase relative to the competition level, but this is still suboptimal—they don’t realize the full cartel potential—if there is imperfect competition on other side If a cartel can’t fix price on one side then: Fixed priced to buyers, not clear to sellers

10. The incentives to cheat and methods aimed at detecting and punishing cheaters Cheating and Detection 10

11. 11 Incentives to Cheat on a Cartel Agreement Could an individual firm do better than with the cartel? The answer is always “yes” when it is certain that the other firms stick with their cartel agreement (this case is unrealistic of course). The answer may be “yes” whenever the gains from cheating exceed the losses from either punishment or from de-stabilizing the cartel. The “cheater” just needs to make enough extra profit long enough in order to outweigh the losses of the cartel breaking down or possible “retribution”. Effective cartels must be able to detect and punish cheating.

12. 12 Detecting Cheating Given incentives to cheat cartels and their participants must be able to detect firms that are deviating from the agreement. Goods are homogeneous Pricing is transparent Customer relationships are well known Some market situations make it easier to detect cheating: Cartel and its members can also devise special arrangements to make it easier to detect cheating

13. 13 Incentives to Cheat on a Price Agreement Suppose firms 2 …. 20 charge the cartel (monopoly) price of $20. Suppose firm 1 drops its price to $19.95. Firm 1 gets monopoly profits of almost $15 million (up from 750,000) Firms 2 … 20 get nothi ng Then all customers will buy from firm 1 (in a frictionless world). To avoid detection it could drop price but increase sales just enough not to be detected. A successful cheater can’t be too greedy. If many firms cheat competition reemerges.

14. 14 Output Allocation and Cheating Exclusive territories: if a firm has exclusive rights to a region, the appearance of a competitor alerts firm to cheating. Exclusive customers: if a firm has exclusive rights to a customer then the defection of that customer alerts firm to cheating. Exclusive contract wins: with bidding rigging, one firm is designated to be the winner of each contract; deviation is detected instantly. But some of these methods can also raise suspicions and increase likelihood of detection. Some cartels therefore incorporate some flexibility.

15. 15 Punishing Cheating: Price Wars If rivals deviate from agreed on price this period then lower price to competitive level next period. This strategy leads to price wars where periods of high prices are followed by price wars. To end price wars firms move back to collusive equilibrium.

16. 16 Importance of Cheating for Antitrust Enforcement Ability to detect and prevent cheating is key to organizing and maintaining a cartel. Cartels are more likely to exist when detection and prevention of cheating are possible. Detection and punishment methods leave traces of evidence that authorities can look for. Certain seemingly legal practices may “facilitate” detection and prevention of cheating and therefore authorities may want to prohibit or monitor these. First look at role of cheating Then detection/punishment methods Conclude by looking at “facilitating practices” An authority looking for evidence of a cartel

17. 17 Factors that Facilitate a Cartel Facilitating factors include anything that increases the gains from operating a cartel, helps detect cheating on a cartel, and enables punishment of cheaters. Structural features of the market (number of firms, entry conditions, etc.) Institutional features (information exchanges, joint facilities, etc.) Contractual relationships and methods of transacting between buyers and sellers. Facilitating factors include:

18. 18 What Can Competition Authorities Do? Forbid/limit practices that facilitate cartels (Information exchange, MFNs, RPM— but are these practices ever efficient?) Prohibit mergers that will facilitate collusion (e.g. ones that eliminate a maverick player or increase the likelihood of coordinated effects) Head them off at the pass – Sharp prohibitions/warnings in the Law Focus investigative efforts on industries that have features that facilitate cartels—but are these cartels the most damaging or the easier ones to detect? Screening technologies Dawn raids when enough suspicion—requires specialized know-how and can be legally challenging in some jurisdictions Hunt them down – Assign resources, prioritize, enforce Encourage cartel members to report each other (leniency programs) Get employees to be “whistleblowers” Get them to squeal – Leniency Programs Fines Jail, Debarment Private Damages Carry a big stick – Deterrence

19. 19 Head Them Off At The Pass: Facilitating Practices A facilitating practice is an activity that makes collusion more likely or more effective, either by making coordination easier or making it easier to sustain a collusive agreement. A facilitating practice may be prosecuted either as an anti- competitive agreement in and of itself or as circumstantial evidence of price fixing. Information exchange of current individual firm sales or prices Announcements of future price changes List (or posted) pricing with no discounts Most favored consumer clauses, meeting competition clauses Delivered or basing point pricing Some examples include:

20. 20 Information Exchange Agreements Help Collusion Exchanging future pricing intentions help coordinate price Exchanging past prices help police price agreement A more common set of beliefs (this makes it more likely that, without express communication, they can settle on the same collusive price) More precise estimates of demand Exchanging demand and cost data so that firms have:

21. 21 Firms Often Cooperate For Pro-Competitive Reasons Joint facilities to obtain scale economies (e.g. Computer Reservation Systems). Standard setting to obtain network economies and reduce transactions costs for consumers (see Lecture 4) (DVD standards). Solving various market imperfections (e.g. Portobello Road Antique Dealers). Exchanging information (costs, best practices, etc.) for pro- competitive reasons (e.g. all trade associations). Cooperatives, joint ventures, standard setting organizations, and other horizontal combinations pose difficult problem for antitrust. Engage in obvious efficiency enhancing activities.

22. 22 Efficiencies from Cooperation Sharing of facilities and reduction in duplicative costs Realization of network effects through e.g. standardization Cooperation may be essential to the creation of a product (sports leagues, payment cards)

23. 23 Hunt Them Down: Enforcement Screening : Identifying markets where collusion is suspected. Verification: Systematically distinguish between collusion and competition. Prosecution: Developing economic evidence to determine guilt. Stages in the process: screen, verify, prosecute Structural: Identifying industry traits conducive to collusion. Behavioral: Identifying collusive behavioral patterns. Two empirical methods for screening: structural, behavioral

24. 24 Get them to Squeal: the Economics of Leniency Programs Cooperation within an illegal environment means that there is a corporate governance problem at its core Repeated interaction, monitoring, threats and reactions against cheaters, means that participants acquire important information about all their co-conspirators A cartel shares common characteristics with organized crime Participation Constraint : E(Profit from participating in the cartel) – E(Cost of Punishment)>0 Incentive Compatibility Constraint : Under incomplete information and different types of agents, the participant will find it in its interest to act in accordance with the cartel rules. A viable cartel requires that 2 conditions be fulfilled A successful leniency program weakens a cartel by maximizing conflict of interest among its members and reducing the compatibility of interests

25. 25 Carry a Big Stick: Customer Damages’ Purpose Compensation to harmed consumers Additional financial penalties to fines levied by the government. Create added incentives for customers to monitor, report, and investigate. Deterrence and resistance of cartels Treble damages: Multiplier serves deterrence since the probability of being caught and paying penalties is well below one. Indirect purchasers cannot sue for damages except in some states. Class action suits used when many customers each incur a small loss. Customer damages – US

26. 26 The Economics of Damages [ Pi c(t) – P ibf(t) ] * Q i c(t) Damages inflicted by firm i from colluding in period t are calculated to be: Pi c(t) – P ibf(t) is the overcharge Qi c(t) is the number of units sold by firm i in period t.Pi c(t) is the observed (collusive) price charged by firm i in period t.Pi bf(t) is the “but for” (or counterfactual) price for firm i in period t. Harrington, CRESSE Lectures, 2011

27. Competitive Constraints and Market Power 27

28. 28 Definitions of Market Power “ Significant” required because almost all firms have some degree of short-run market power as a result of product differentiation and location. No consensus on what “ significant” means Competitive level often taken as p=MC Ability of a firm to raise prices significantly above the competitive level Market power not always manifested in price Firms compete on many dimensions besides price Ability of a firm to take actions that a competitive firm couldn’t do that significantly harm consumers such as impose contractual restraints, prevent entry, and so forth.

29. 29 Monopoly, Perfect Competition, and Market Power QCQC QMQM PMPM PCPC Supply = MC Demand MR Q P Monopoly price significantly above competitive levels And significantly above marginal cost Textbook description of competitive industry but need to be careful in using in practice.

30. 30 Level Versus Changes in Market Power MergerUnilateral Conduct Level Background information that may affect concern over the change Can the firm impose anticompetitive constraints? Change Will the merger increase market power of merged firms? Do the anticompetitive constraints increase market power and thereby harm consumers? Why we care about market power?

31. 31 Market Power and Competitive Constraints Market power is a measure of the extent to which “competitive constraints” limit the ability of a firm to dictate prices or other competitive conditions An inquiry should make sure that simple approaches to assessing market power (e.g. market share, concentration) don’t obscure consideration of the full spectrum of competitive constraints since that is what market power is supposed to summarize The source of competitive constraints come from the demand side and from the supply side.

32. 32 Competitive Constraints Can Limit Market Power DemandSupply Substitutes in demand based on products and geography Product repositioning Consumer switching costsElasticity of supply Two-sided platform constraints resulting from loss of complementary sales/indirect network effects Barriers to entry including scale economies, network effects, regulation Innovation and feature competition

33. 33 Demand-Side Substitution and the Marginal Consumer A,B, C, D are at “the margin” of buying or not buying beer F is an “average consumer” of beer (from O to C) O G is not a consumer of beer at current prices The “average” consumer may not switch to a substitute product in response to a small price increase; the producer needs to worry about what consumers “at the margin” between buying and not buying the product, will do. G DC F B A

34. 34 Entry, contestability and Supply-side Substitution Can new firms get in quickly when prices go up? [Barriers to entry] New Entry Could current rivals expand production easily by switching production lines from other products? [Excess capacity, time to respond, availability of inputs, flexibility in technology and factors of production…] Expansion Could current rivals make their products more competitive by adding or changing features? Product repositioning

35. 35 Barriers to Entry Debate Any advantage existing firms have that enable them to raise price above short-run competitive level. Corresponds to what many competition authorities and courts use Bain Costs that new firms bear that existing firms don’t Helps to emphasize that firms must incur investments to enter and expand and realize a return from that. Not really a barrier if entrant must incur these same investments. Stigler

36. 36 End of Review, Next Class Topic 10.2 Topic 10.2 Role and Definition of Market Power Market Power Measurement Multi-Sided Platforms and Market Power Topic 11.1 Overview of Market Definition and Market Power in Competition Policy General Principles of Market Definition Hypothetical Monopolist Test