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The Relationship Between Market Structure and Price

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The Relationship Between Market Structure and Price 5 The Relationship between Market Structure and Price Merger investigations usually seek to determine whether the change in market struc- ture caused by a merger will have a significant impact on the market outcomes for consumers. The outcome of most direct concern will be price although quality or choice effects may also be important though typically longer term and usually more difficult to assess. At the core of merger assessment then is the expected relationship between the number and size of firms operating in the market, market structure, and the prices or qualities that result from the competitive process. Economic theory predicts that market structure affects prices. Under reasonably general conditions, a reduction of the number of players will result in an increase in market prices all else equal. This prediction forms the basis for the “unilateral effect” of a merger, where, post-merger, the new merged firm will usually have a unilateral incentive to raise prices above their pre-merger levels.This unilateral effect in turn may lead others to have an incentive to raise prices and this in turn usually reinforces the original unilateral incentive to increase prices. We term the former effect a “unilateral” effect since it is the incentive a single firm has to unilaterally increase prices. We term the latter effect a “multilateral” incentive since it involves independent actions by multiple parties each of which enjoy an incentive to increase prices following a merger. We will see that such effects are fairly generic in mergers involving firms that produce substitutes for one another. This chapter explores the frameworks which can help competition agencies when they try to identify this effect in practice. Practically all models of competition predict that a change in market structure will have consequences for market prices. Still, empirically assessing the actual relation between structure and price is by no means always an easy activity. Nonetheless, we will see that several empirical strategies can be used to approximate the extent of an increase in prices that will result when concentration occurs. Understanding the underlying theoretical rationale for the relationship between structure and price will be important in order to design an appropriate way of empirically measuring the effect, so we will spend some time describing the basic underlying theory. We then present examples of methodologies that estimate the effects of market structure on price. Our examples are designed 5.1. Framework for Analyzing the Effect of Market Structure on Prices 231 Price or quantity Entry game competition among active firms Stage: Stage 1 Stage 2 Determinant: N ( p1, . , pN) or (q1, . , qN) Figure 5.1. A two-stage game. to provide practical guidance on appropriate data sets and techniques that could be considered for such analysis and also to point to a number of the potential problems previous investigators have faced when trying to identify the way in which price is likely to change with market structure. Identifying the relationship between price and market structure is hard for a num- ber of reasons. For example, whichever particular methodology we choose, we will need to address the difficult issue of identifying a causal link between market structure and the market outcomes—in particular price. In addition, if we adopt a longer-term perspective, both the number of active firms and the number and type of potential entrants may, on occasion, also constrain pricing power. If so, then in assessing the likely effect of a change of market structure one may also want to evaluate the constraint exerted by potential competitors. These are just two of a large number of potential difficulties analysts in competition agencies often come across. We outline a number of other difficulties below and then go on to describe potential solutions to these problems that the literature has developed. 5.1 Framework for Analyzing the Effect of Market Structure on Prices We begin our discussion of the relationship between market structure and market outcomes by discussing the effect that the number of active firms has on the ruling equilibrium price or prices in the market under a variety of assumptions about the nature of competition. We then progress to examine methods which can be used to move our model from being purely a theoretical analysis into a framework that is appropriate for undertaking empirical work. Specifically, in the next section, we examine the potential drivers of the decision to enter a market and consider the effect that such entry has on the competitive process and also how we can learn about market power by observing such entry decisions. We structure our study of the effect of market structure on prices by considering the following two-stage game. At stage one, firms decide whether or not to enter the market. If they enter, they incur a cost which is sunk (irrecoverable) at stage two. We call N the number of firms that decide to enter the market at stage 1. At stage two, the N active firms compete among themselves in prices or quantities. The game is represented in figure 5.1. In what follows, we follow the economics 232 5. The Relationship between Market Structure and Price literature in analyzing such a game by starting with the examination of stage two and then proceeding “backward” to discuss stage one, the entry stage in the next section.1 5.1.1 Theoretical Predictions about the Effect of Structure on Prices Many economic models of competition can be embedded into this general two- stage structure and each will predict a relationship between market structure and market prices. We will establish the result for three important cases, namely the models in which firms are (1) price-takers, (2) oligopolists competing in prices, and (3) oligopolists competing in quantities. By examining these three canonical cases we are able to examine the mechanisms by which market structure can affect equilibrium prices. For example, we will see that, generally, a merger between two firms producing substitutes will tend to result in higher prices. Such results form the theoretical backbone of the investigations of the unilateral and multilateral effects of mergers. 5.1.1.1 Market Structure among Price-Taking Firms The structure of market supply can be important for economic efficiency in a price- taking environment since where production takes place will usually matter for the aggregate costs incurred to produce any given level of output. That is, the number of firms that are producing will usually have an effect on the total costs of production. That in turn matters because the pricing pressures that firms face are determined by the intersection of market demand and market supply, which in a price-taking envi- ronment is determined by the industry’s marginal costs of production. A reduction in the number of firms will, except in special circumstances, reduce the aggregate supply to the market and hence induce the price to rise. Higher prices in turn induce increases in supply from at least one remaining active firm that, if it suffers from diseconomies of scale, will nonetheless find it profitable to produce extra output despite higher unit costs. Because of the potential diseconomies of scale, a lower number of firms may result in higher prices required to sustain a given level of aggre- gate output. Generally therefore, assuming a price-sensitive demand and firm-level diseconomies of scale, an equilibrium involving a reduced set of firms will involve lower quantities and higher prices. A price-taking firm operates in a homogeneous product environment where quantity is usually the firm’s decision variable. It solves the following profit-maximization problem, max pi qi C.q i /; qi 1 Technically, we examine equilibria of such games using “backward induction” to find the pure- strategy subgame perfect Nash equilibrium of the game; see your favorite game theory textbook. 5.1. Framework for Analyzing the Effect of Market Structure on Prices 233 where C is the total cost function describing the total costs of producing a given level of output qi such that, for example, 1 2 cq i dq F if qi > 0; C C 2 i C D ( 0 if qi 0: D In this model, beyond the first unit of production, marginal costs increase with production and there is a limit to the efficient production scale. Solving the maxi- mization problem describes the optimal quantity that this firm will want to supply at each announced price: p c p c > if pi qi C.q i / 0 at qi ; q d D d i D 8 <0 otherwise: Next, suppose there: are N symmetric active firms, each of which have produced positive amounts so that their (the firm’s) supply function can be summarized as q .p c/=d , we may sum to give the market supply function: i D p c QSupply N : Market D d If we further assume linear individual demands and S identical consumers so that the market demand is QDemand S.a bp/ and that equilibrium price p is determined Market D by the intersection of supply and demand, we may write p c QSupply N Market D d S.a bp / D QDemand; D Market which is an equilibrium relationship that we may solve explicitly to give the equilibrium price: Nc Sda p C : i D N Sbd C Note, in particular, that the equilibrium price depends on N , that is the market structure, and also on the cost and demand parameters including the size of the market. Note also that with symmetric single-product firms, market structure can be completely described by the number of firms. Richer models will require a more nuanced description.
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