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EC365 Theory of Monopoly and Regulation Topic 1: Introduction

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

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EC365 Theory of Monopoly and Regulation Topic 1: Introduction

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  1. EC365 Theory of Monopoly and RegulationTopic 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

  3. Key information (2) • Assessment: • Term paper, submission date: 12 noon, Friday 2nd 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.

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

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

  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 andto write detailed short essays • Do the term paper (insurance policy) • REVISE

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

  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. 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. 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. 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. 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 link • 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

  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. 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. 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. 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. 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. 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. 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)

  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. Revision of basic concepts • Perfect competition • definition • outcomes • Monopoly • profit maximisation • outcomes • Oligopoly • Cournot • Bertrand

  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. Figure 1: The firm under perfect competition

  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. 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. 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. Figure 2: Monopoly pricing and output

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

  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. Cournot: firms compete in quantities • 2 firms, 1 & 2, simultaneously choose quantities q1 and q2 • Linear inverse demand fn: p = a – b(q1+q2) • Constant marginal cost c • Nash equilibrium: firm i chooses qi given choice of its rival • Set qi to max i = (a – bqi – bqj – c) qi for i = 1, 2 where i  j • FOC: a – 2bqi – bqj – c = 0 • Rearrange: Reaction function for firm i • Solve simultaneous equations: • Price Profit

  33. Figure 3: Cournot equilibrium

  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  : qi  0, Q  , p  c,   0 • competitive outcomes

  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 p2 (c, pm] • Firm 1 would undercut by (tiny) , and steal whole market • Knowing this, 2 will undercut; 1 will undercut again … • Unique eqm: p1 = p2 = c; each receives ½ mkt D • Competitive outcome with just two firms!

  36. Figure 4: Bertrand equilibrium

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