Introduction to Competition Economics

University of Sydney Law School Competition Law 2015

HoustonKemp.com Previous lecture • Demand and supply model › Complements and substitutes › Elasticities › Marginal cost › Economies and diseconomies of scale • Perfect competition vs monopoly › Number of firms › Barriers to entry › Homogeneity of product • Economic welfare and efficiency: › Consumer and producer surplus › Deadweight loss

HoustonKemp.com 2 Efficiency and welfare

Price Dead weight loss Consumer Monopoly surplus Marginal cost / price Supply PC price Producer surplus Demand

Monopoly PC Quantity output output

HoustonKemp.com 3 Efficiency and welfare

• Allocative efficiency • Productive efficiency • Dynamic efficiency

HoustonKemp.com 4 Market power

• Ability to profitably raise price above perfect competitive level is called ‘market power’ • The logic of the monopoly model… › Firms produce and sell less than in a competitive market › There is deadweight loss / inefficiency …holds for any firm with market power • Market power is a form of ‘market failure’ › The privately optimal decision ≠ the socially optimal decision › In this case: private pricing decision does not maximise welfare

HoustonKemp.com 5 What do we do about market power?

• Some market power is good… › Incentive to innovate/differentiate › And so it is not illegal to have or use market power • But ‘substantial’ market power can be bad › Regulation is sometimes used when there is significant and enduring market power (eg electricity distribution) › If used for the purpose of deterring or preventing entry or substantially damaging a competitor (s46) › If it is achieved through collusion or mergers (substantial lessening of competition, s50)

HoustonKemp.com 6 Outline for today

• In PC/monopoly there is no strategic interaction… • Game theory: › Static games › Dynamic games • Models of markets based on game theory: › Bertrand (price) competition › Cournot (quantity) competition

HoustonKemp.com 7 Game Theory A tool for analysing strategic interactions

HoustonKemp.com Game Theory • Key features of interactive decision-making: › Who are the decision-makers? › In what order do they make decisions? › What actions are available? › What are their motives or preferences over outcomes? • A game is a formal representation of this, with elements: › Players › Timing: . Simultaneous or sequential actions . One-shot or repeated game › Actions (can be discrete or continuous) › Payoffs › Strategies (“if she does this, I do that…”) › Equilibrium or equilibria

HoustonKemp.com 9 Static games

• A one-shot, simultaneous action game • Represented by the ‘normal form’ matrix. • Example: Prisoners’ Dilemma Prisoner 1 Betray Co-operate Betray 2 years 3 years 2 years No jail Prisoner 2 Co-operate No jail 1 year 3 years 1 year

• What will be the outcome (equilibrium)?

HoustonKemp.com• 10 Static games – equilibrium concepts

• Dominant strategy equilibrium: › Is there a “dominant strategy” that yields a higher payoff regardless of the other player’s action? Dominant Prisoner 1 strategy Betray Co-operate Dominant strategy Betray 2 years 3 years 2 years No jail Prisoner 2 Co-operate No jail 1 year 3 years 1 year

• The dominant strategy equilibrium (betray, betray) is inferior for both players to the alternative (co-operate, co-operate)

HoustonKemp.com 11 Nash equilibrium: another solution concept

• There is not always a dominant strategy equilibrium • Define a “best response” function as the optimal choice given your rival’s action • Nash equilibrium: › The intersection of best response functions › i.e. all players are playing their best responses › Given their rivals’ actions, in a Nash equilibrium no player has an incentive to change their own action › Note a DSE is automatically a Nash equilibrium as well

HoustonKemp.com 12 Example of Nash equilibrium • A ‘co-ordination game’ of development of new technology › Assume two firms: a TV manufacturer and a broadcaster › There are costs to both of investing in HDTV technology which will only be recouped if the other also invests TV manufacturer Invest Don’t invest Invest 100 20 100 – 50 Broadcaster Don’t invest – 50 20 20 20

• Nash equilibria: (invest, invest) & (don’t invest, don’t invest) • What would happen if the game were sequential? 13 HoustonKemp.com Sequential games

• Backward induction • Represent sequential games and repeated games in the “extensive form” M Invest Don’t invest

B B Don’t Invest Invest Don’t invest invest

(M, B) = (100, 100) (–50, 20) (20, –50) (20, 20)

HoustonKemp.com 14 Ultimatum game

• A one-shot sequential game • There is a pile of chocolate to be divided amongst 2 players • Player 1 proposes a split (e.g. 50:50, 80:20, 90:10) • Player 2 accepts or rejects the offer › If player 2 accepts, the chocolate is divided as proposed › If player 2 rejects, neither player receives any chocolate

HoustonKemp.com 15 Ultimatum game - results

• How many rejected the offer? • How many offered 50% to the other player? • How many offered less than 50% to the other player? • How many offered more than 50% to the other player? • Assume one shot game with perfectly rationale players • Backward induction • Player 2 should accept any amount greater than 0 • Player 1 should offer smallest amount possible • Outcomes often different to theory because repeated game, fairness etc

HoustonKemp.com 16 Break

HoustonKemp.com 17 Models of oligopoly Examining firm conduct when there are few players

HoustonKemp.com Price competition

• When firms compete on price, what is the optimal strategy and how competitive will the market be? • Assume imperfect substitutes • ‘Best responses’: the higher your rival’s price, the higher your own: P Firm A b.r. Q Firm Q b.r.

300 Nash equilibrium: the 200 intersection of best responses

200 300 PA

HoustonKemp.com 19 Demand increases when rival sets higher price

Price

Firm A increase price

Demand (Firm Q)

Quantity

HoustonKemp.com 20 Price competition (continued) • Perfect substitutes: “Bertrand competition”

PJ 45° line

T b.r. J b.r.

Nash equilibrium: the intersection of best responses MCJ

P MCT T • Best response: price just below your competitor (but not < MC) • Nash equilibrium: P=MC, zero profit • Are just two firms sufficient to generate a perfectly competitive market?

HoustonKemp.com 21 Quantity competition: the Cournot model

• Firms set quantities and let the market determine a price • Can represent setting of capacities followed by capacity-constrained price-setting • Cournot quantity ‘best responses’: › Firms choose quantity such that Marginal Revenue = MC › MR can be broken down into . Additional revenue from one additional sale, which depends on the price (and therefore quantity sold) . Loss of revenue from lower price on existing sales, which depends upon how much the increase in the firm’s output alters the price

HoustonKemp.com 22 Demand falls when rival produces more

Price

Firm T increases output

Demand (Firm J)

Quantity

HoustonKemp.com 23 Quantity competition: the Cournot model

QJ 1000 Firm T b.r. Nash equilibrium: the intersection of best responses 500

Firm J b.r.

QT 500 1000 • The best response to 0 is the monopoly quantity (e.g. 500) • The best response to the PC quantity (e.g. 1000) is 0 • The Nash equilibrium sees P > MC, with the price-cost margin decreasing as the number of firms increases • For n=1 and n=∞ Cournot produces the monopoly and PC models

HoustonKemp.com 24 Cournot illustrated

Price

Monopoly price …as n ↑ Cournot P (n=2)

Cournot P (n=3) Demand PC price Marginal cost MR (n=1)

Monopoly Cournot Cournot PC Quantity output Q (n=2) Q (n=3) output

HoustonKemp.com 25 Applications of Game Theory Insights into firm behaviour

HoustonKemp.com Example: Monopoly with entry deterrence

Monopolist

Small Large capacity capacity

Entrant Entrant Don’t Don’t Enter Enter enter enter

Profits for (M, E) = (20, 20) (60, 0) (0, –20) (40, 0)

• An example of ‘strategic commitment’ • The threat of entry can discipline a monopolist into more competitive pricing; a ‘contestable market’

HoustonKemp.com 28 Predatory pricing

• A firm ‘predator’ sets a low price for sufficient period such that rival (or rivals) exit • Typically involves › Loss of profit by predator when set low prices initially; and › Phase where predator is able to set higher prices when faces less competition – need market power • What is the difference between predation prices and competitive prices? › Risk of stifling competition

HoustonKemp.com 29 Predatory pricing theories

• Reputation models › Incumbent make a loss fighting entrants in order to discourage others • Deep pocket theory › Small firm’s borrowing is restricted • Signalling › Incumbent signals that it has very low costs

HoustonKemp.com 30 Repeated prisoners dilemma (RPD) and collusion Nash eqm in one Firm 1 shot game Compete Collude Compete 5 1 5 14 Firm 2 Collude 14 10 1 10

14 Firm 1 payoff from 10 always collude Firm 1 payoff from 5 compete today

Number of Payoff per period (firm 1) (firm per period Payoff 1 2 3 periods from now

HoustonKemp.com 31 According to this RPD model, firms are more likely to collude when.. • They are patient • Frequent interactions between firms › Benefit of cheating is small • Cheating is easy to detect • Fewer firms

• Necessary conditions for collusion: › Agree on collusive outcome › Monitor collusion and punish cheaters › Prevent entry (or accommodate)

HoustonKemp.com 32 How can we stop collusion?

• Market outcomes of collusion and competition look the same • No competition authority has detected collusion by examining market outcomes alone • Leniency programs in combination with large fines and are very effective: › Create a strong incentive to apply for leniency › “unquestionably, the single greatest investigative tool available to anti-cartel enforcers” Scott D. Hammond U.S. Department of Justice

HoustonKemp.com 33