2 Introduction to Economics of Competition Law Part-II

Prof. S. Radha

Introduction

This chapter primarily tries to explain the concept of economic efficiency and takes the reader to the different approaches towards achieving economic efficiency. In doing so it also explains the conflict that might arise while choosing one over the other.This chapter also tries to help the reader understand the importance of market structures in the study of economics-of the utopian model of perfect competition and the concept of monopoly with its negative impact on social welfare. Different models of oligopoly and collusion between market players initiate the discussions on market power. It also tries to help the reader understand the factors that affect the market power of a firm in a given economy.

3.1.1Economic Efficiency

Economic efficiency is used in microeconomics in the production of a commodity. Production of a unit of good is economically efficient when that unit of the commodity is produced at the lowest possible cost.

Technological efficiency is the cost per unit of the technology used. In traditional economics it is defined as the capital-output ratio.

Within the concept of economic efficiency there are many other types of efficiency, namely, productive efficiency; allocative efficiency; and dynamic efficiency.

3.1.2 Productive Efficiency

Productive efficiency refers to producing goods and services with the optimal combination of inputs with minimum cost.

Productive efficiency implies producing at the Production Possibility Frontier(PPF). All points on the PPF represent different combinations of the total output produced at a given point of time (i.e. it is impossible to produce more of one good without producing less of another).

• Points A and B are productively efficient.
• Point C is inefficient because the resources of the economy are not utilised to the optimum and any point above the PPF is not possible unless there is a shift in the availability of resources for the production of either of the commodities or both.

3.1.3 Allocative Efiiciency

Allocative Efficiency, also called social efficiency implies the utilisation of the scarce resources for the availability of output to the whole economy and not just to the majority of the population. In the case of a firm allocative efficiency is the allocation of the resources to the best or optimal use so that the productivity of a given unit of the resource is maximum or efficient.

3.1.4 Dynamic Efficiency

The concept of dynamic efficiency is commonly associated with the Austrian Economist Joseph Schumpeter and it means technological progressiveness and innovation.

Neo-classical economic theory suggests that when existing firms in an industry, are highly protected by barriers to entry they will tend to be inefficient. Schumpeter argued that firms that are highly protected are more likely to undertake risky innovation, and generate dynamic efficiency.

Firms benefit from two types of innovation:

1. Process innovation occurs when new production techniques are applied to an existing product. For example, production of motor vehicles with firms constantly looking to develop new methods and production processes; and

2. Product innovation occurs when firms generate new or improved products, common in many consumer product markets, including electronics and communication.

3.2 Market Structure

3.2.1 Perfect Competition-Monopoly: A Competition inertia

The economic theory of competition has run into sharpening of the debates around competition and market structure. Competition and market structure are subject to debate on the ires of the monopoly power. That every competitive market structure has some degree of monopoly power is debatable in the market today . Perfect competition is a starting point for the understanding of competition and there is no presence of competitive interests in it amongst the firms in an industry. Monopoly is a market situation identifying firm itself as an industry in which intra industry comparison is not possible. Perfect competition, as Cournot, puts it, where “the effects of competition have reached their limit.”1 It is not an “ordering force” but rather an assumed “state of affairs”2 . It is an equilibrium situation in which price becomes a parameter from the standpoint of the individual firm and no market activity is possible.3

The classical concept of competition is a guiding force and that of the neoclassical concept of competition is a state of affairs and the two are incompatible, reflecting the difference between a condition of equilibrium and the behavioral pattern leading to it. Thus, the single activity best characterized the meaning of competition in classical economics, viz. price cutting by an individual firm in order to get rid of excess supplies becomes impossible under perfect competition as a standard. Even price competition, the essence of the competitive process for Adam Smith, is imperfect or monopolistic. Indeed, the perfectly competitive firm itself is but ‘a monopolist with a special environment’4

3.2.2 Debates on Competition-Market relationship

Competition equates prices and marginal costs and assures allocative efficiency in the use of resources. Resources move towards their most productive uses, and, the price is “forced” to the lowest level sustainable in the long run. When Adam Smith spoke of competition, it was in connection with the forcing of market price to its “natural” level or to the lowering of profits to a minimum. Competition was viewed as a price-determining force operating in, but not itself identified as, a market.

The neoclassical economics provided a for the perfection of the integration of the concepts of competition and market. Jevons’ mixture of the two has been widely imitated by the later contributors, and today a market is commonly treated as a subsidiary to competition, and a phenomenon of exchange.

3.2.3 Definition of Competition: A critique

In economic theory, the definition of competition did not relate itself to costs of production. Senior wrote, ‘…Under free competition, cost of production is the regulator of price. The question then is in the definition of competition whether MC=P is the desired optimum relating to the efficiency of the firm.

Another fundamental weakness of the competitive concept is its consistent failure to relate to economic growth. The essence of industrialization and economic growth with a changing production function and the development of new products, techniques, and forms of business organization came closer to Adam Smith and Schumpeter.

The discussions and debates on whether monopoly and Perfect Competition can be treated as a competitive market requires the basics on the characteristics of these market structures along with others. The details given below will throw light on the same.

3.2.4 Perfect Competition

Perfect competition as a market structure is characterised by a large number of buyers and sellers with the freedom of entry and exit, producing homogenous product and a zero advertising cost. It is assumed that the consumers have the perfect knowledge of the market and the factors of production are perfectly mobile between the firms. Each firm is a price taker where, market demand is equal to market supply.

Perfect competition is a benchmark with which other market systems are understood and their price and output decisions are measured. The equilibrium price of P=AR=MR is a measure profit maximising behaviour of firms in different competitive situations. The problem of asymmetric information flow does not arise in the perfect competition. But the disadvantage of the Perfect Competition market is that it does not give incentive for progress and innovation as against its possibility in the other market forms, especially Monopoly.

3.2.6 Monopoly

In the conventional definition of Economics, A pure monopoly is a situation of a single producer or seller in a market. The degree of monopoly power depends on the elasticity of demand for the commodity  in question and the capacity of the monopolist to divide the different markets so that price discrimination is possible. There is no consumer choice. For the purposes of regulation, monopoly power exists when a single firm controls 25% or more of a particular market.

Formation of monopolies:

Monopolies may be formed with various reasons:

Exclusive ownership of a scarce resource: It may be a commodity, service or a resource. For example, A specialist in Cardiology in a given town;

Monopoly of Government to certain essential services , such as Post Office,.

Monopoly in the Intellectual

A monopoly created following the merger of two or more firms

Key characteristics:

Monopolies can maintain super-normal profits in the long run. As with all firms, profits are maximised when MC = MR. At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible depicted with the area PABC. In the traditional economic approach monopoly power is one of price and profit maximization with a firm remaining a monopoly in the product, service and resource market. In the contemporary analysis it is the monopoly power determined generally by market share in the relevant market.

Monopoly & Efficiency Loss

Monopoly pricing creates a deadweight loss to a given firm and deficiency caused by inefficient allocation of resources.

In the absence of competition decision making is narrow and more often than not end up in decision making detrimental and suicidal to the monopolist’s prospects and existence itself. Monopoly can become less innovative over time. Abuse of monopoly power can lead to market failure

Monopoly and loss of social welfare

An unregulated monopoly is a welfare loss to both the consumers and the market and ultimately to the loss of social welfare.

The welfare losses of monopoly (or any form of market power) can be shown by illustrating the consumer and producer surplus on a graph.

6The diagram below considers the case where the firm is competing in a perfectly competitive market with an infinite number of identical firms, or has a monopoly on the market.

In the case of perfect competition, then the firm will simply produce at the competitive price, Pc, where the supply and demand curves interact. All firms are identical so will face identical supply curves – if this firm’s supply curve (marginal cost curve) was higher and it was unable to profitably produce at Pc then it would have gone out of business, and if its supply curve was lower and it was able to make profits then other firms would enter the market until all firms were making zero profits. When the firm produces at Pc it will supply quantity Qc.

When it has a monopoly, it instead produces at the point where MR = MC, i.e where the marginal revenue curve cuts the supply curve. This is quantity Qm which will sell for price Pm.

Now first consider the consumer and producer surplus in the case of perfect competition.

The yellow area shows consumer surplus and orange area shows producer surplus. The graph has been split into five areas, area a, b, c, d and e. Ignore the purple MR line cutting through areas a, b and d, the areas are just bounded by the blue supply and demand curves and the red dotted lines linking price and quantity combinations.

In the competitive case:

Consumer surplus= a+b+c+d

Producer surplus = d + e

Now consider the consumer and producer surplus in the case of monopoly.

Again yellow is consumer surplus, orange is producer surplus, and the colour grey, shows the ‘deadweight loss’ – the area that was surplus to consumers or producers in the competitive case but has now been lost.

In the monopoly case:

Consumer surplus = a

Producer surplus = b + d

Deadweight loss = c + e

The effect of going from perfect competition to monopoly is bad for consumers. Consumer surplus has been reduced by (b + c). Area b has gone from consumers to producers, so this is not an overall welfare loss, just a distributional change from consumers to producers.

However the monopoly is good for producers. Producer surplus has increased by (b – e) and as b is a larger area than e. This is a net gain.

Areas c and e are deadweight loss. Consumers have lost c and producers have lost e.This is because there is now less output being produced due to the quantity decreasing from Qc to Qm.

So overall the society loses out – there is a net welfare loss when the aggregate welfare of consumers and producers is taken into account, although producers are likely to be happy as they have gained at the expense of consumers. From an economic point of view, here there is an efficiency loss caused by going from perfect competition to monopoly.7

3.2.7 Oligopoly

Oligopoly is a competitive market structure with a few large firms engaged in the production or the supply/sale of a commodity. Each firm operating is a price maker but any decision making with regard to price or output is followed by other firms operating in the market setting at naught the purpose and expectation from such decision making. It is being explained with the ‘kinked demand curve’. There are barriers to entry and exit and firms may produce either differentiated or homogenous products. Oligopolists may end up in collusions affecting consumer welfare and small competing firms. Thus its distinctive feature is its interdependence.

The following are the various models developed for a multiple approach towards understanding oligopoly.

The Cournot Model

In 1838, Augustin Cournot introduced a simple model of duopolies that remains the standard model for oligopolistic competition. In addition to the assumptions stated above, the Cournot Duopoly model relies on the following:

Each firm chooses a quantity to produce.

All firms make this choice simultaneously.

The model is restricted to a one-stage game.

Firms choose their quantities only once.

The cost structure of the firms are public information.

In the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. Both firms know the market demand curve, and each firm knows 7 Ibid the cost structures of the other firm. The essence of the model is: each firm takes the other firm’s choice of output level as fixed and then sets its own production quantities.

The Bertrand model

The Bertrand Duopoly Model, developed in the late nineteenth century by French economist Joseph Bertrand, changes the choice of strategic variables. In the Bertrand model, rather than choosing how much to produce, each firm chooses the price at which to sell its goods. Rather than choosing quantities, the firms choose the price at which they sell the good.

All firms make this choice simultaneously.

Firms have identical cost structures.

The model is restricted to a one-stage game. Firms choose their prices only once.

Although the setup of the Bertrand Model differs from the Cournot model only in the strategic variable, the two models yield surprisingly different results. Whereas the Cournot model yields equilibriums that fall somewhere in between the monopolistic outcome and the free market outcome, the Bertrand model simply reduces to the competitive equilibrium, where profits are zero.

The Bertrand equilibrium is simply the no profit equilibrium. First, the Bertrand outcome is indeed equilibrium and is demonstrated as follows. Imagine a market in which two identical firms sell at market price P, the competitive price at which neither firm earns profits. Implicit in the argument is the assumption that at equal price, each firm will sell to half the market. If Firm 1 were to raise its price above the market price P, Firm 1 would lose all its sales to Firm 2 and would have to exit the market. If Firm 1 were to lower its price below P, it would be operating below cost and therefore at a loss overall. At the competitive outcome, Firm 1 cannot increase profits by changing its price in either direction. By the same logic, Firm 2 has no incentive to change prices. Therefore, the no profit outcome is equilibrium.

The Stackelberg model

The Stackelberg Duopoly Model of duopolies is very similar to the Cournot model. Like the Cournot model, the firms choose the quantities they produce. In the Stackelberg model, however, the firms do not move simultaneously. One firm holds the privilege to choose production quantities before the other. The assumptions underlying the Stackelberg model are as follows:

Each firm chooses a quantity to produce.

A firm chooses before the other in an observable manner.

The model is restricted to a one-stage game. Firms choose their quantities only once.8 The Dominant Firm Model While dominant firm or price leadership models are not common in basic economic theory, there are some courses that do go over this concept. It is a neat model, because it combines aspects from both a monopoly market and perfect competition. The basic idea behind this model is that there is one large firm, that behaves monopolistically (meaning that it has a marginal revenue curve, and is not a price taker), and the rest of the firms are so small and numerous that they behave according to perfectly competitive rules.

The dominant firm is the price leader, and the rest of the firms take this price as given, and respond to it by producing at a quantity where marginal cost is equal to this price (which is also the marginal revenue for these “fringe” firms).

The graph below shows a typical dominant firm model:

The black line represents industry demand, which is the total demand for the market (ie. the horizontal sum of individual demands).

The blue MCcf line represents the marginal cost for the competitive fringe. This represents the sum of the individual marginal cost curves for each of the firms participating in the perfectly competitive side of this market.

The green MCdf line represents the marginal cost for the dominant firm. The dominant firm is the firm acting as a monopolistically competitive firm, which can choose which price (within a range) it will charge its consumers.

The purple Ddf line represents the demand curve for the dominant firm. Not that the demand curve for the dominant firm is always below the industry demand curve, and becomes the industry demand curve after price level ‘F’ because all competitive firms exit the market.

Finally, the orange MRdf line represents the marginal revenue curve for the dominant firm. This line has twice the slope of the Ddf line and is intuitively identical to the MR line for a monopoly or monopolistically competitive firm.

The important points are labeled with different letters. The point ‘A’ represents the intersection of the industry (total) demand curve with the price axis. This is the price that must be charged for no quantity to be demanded. The point ‘B’ represents the price level that would be attained if there was no dominant firm. This is calculated by looking at where the perfectly competitive firms’ marginal cost curve crosses the industry demand curve which occurs at point ‘C’.

Since anyone can acquire the good or service at the price level of ‘B’, this is the maximum price that the dominant firm can charge for the good. This means that the “fringe” demand curve (the demand curve faced by the dominant firm) will begin at point ‘B’. The curve will be downward sloping, and will intersect the industry demand curve at a price of ‘F’. Also point ‘F’ is where the competitive fringe company’s marginal cost curve intersects the price axis (where quantity equals zero).

After we draw this “fringe” demand curve, we can derive the associated marginal revenue curve for the dominant firm. The point ‘G’ shows where the marginal revenue curve and the marginal cost curve of the dominant firm cross. This gives us the profit maximizing output quantity for the dominant firm, and if we draw that line up to the “fringe” demand curve, we see that it will intersect at point ‘D’, which is the optimal price charged for the good by the dominant firm.

Also Qcf shows the quantity supplied by the competitive fringe and Qdf shows the quantity supplied by the dominant firm. Unlike traditional supply and demand graphs, the total amount of goods supplied to the market in this graph is Qdf + Qcf, not simply one or the other.9

3.2.8 Collusion

It is a non-competitive agreement between rivals to disrupt the market equilibrium. The firms may collectively choose to influence the supply of a good, and/or agree to alter its price with a profit maximizing advantage. They may also collude by sharing private information with insider knowledge.

Cartels:

A group of companies or countries collectively attempt to affect market prices by control over production and selling. OPEC, is a cartel made up of sovereign states, not companies. Cartels are also called “trusts”.

Factors facilitating collusion:

Deadweight loss caused by cartels:

10The ideal cartel will seek to restrict quantity to raise the price of the good. By restricting quantity and increasing price, the firms attempt to increase the industries profits and therefore their own individual profits. The cartel will behave like a monopoly and will try to earn monopoly profits. When a cartel is formed, the ideal quantity and price is the monopoly quantity and price; so the cartel will produce an output where marginal cost (MC) is equal to marginal revenue (MR). In the figure below, the ideal cartel quantity is found by taking the point where MC=MR (point D) and going down to the x-axis; the price is found from taking the point where MC=MR and going up to the demand curve and over to the y-axis. The competitive price and quantity is at point C where the marginal cost is equal to the demand curve. Since the cartels produce at the monopoly output of point B, there exists a deadweight loss similar to the deadweight loss of a monopoly firm. The yellow shaded area A illustrates the deadweight loss in figure:

In competition, the optimal price and quantity occurs at point C where the marginal cost curve intersects the demand curve; the quantity of the good would be Qc at price Pc. Like a monopoly, the ideal cartel point is B on the demand curve above where marginal cost (MC) is equal marginal revenue (MR). With a cartel, the quantity of the good would be restricted to the monopoly quantity, which increases price to the monopoly level. The quantity would reduce to Qm and the price would increase to Pm. The total deadweight loss created by the cartel is equal to the yellow shaded area A.

Since a cartel produces less than the competitive quantity, the cartel acts inefficiently and creates a deadweight loss. The deadweight loss of a cartel can be described the same way as the deadweight loss for a monopoly. In the figure, the competitive output is at the intersection of marginal cost (MC) and the demand curve at point C. This is the most efficient output and the industry is in equilibrium. The consumer surplus (CS) is the gray shaded area A below the demand curve and above the price. The producer surplus (PS) is the green area B above the marginal cost (MC) curve and below price. Following figure has no deadweight loss since the industry is in equilibrium, producing the competitive output.

The output produced by this industry is in equilibrium. The price and quantity is at the QcQuantity competitive level so the output is efficient.  The consumer surplus (CS) is the gray shaded MR area A and the producer surplus (PS) is the green shaded area B.

Figure illustrates the deadweight loss for a cartel. When the cartel forms and reduces output to the monopoly output at MC=MR, the cartel will charge a higher price and a lower quantity than a competitive industry. At this new level, the consumer surplus becomes the gray shaded area A. The producer surplus is the green area B plus the green striped area D. Compared to the figure, the consumer surplus is reduced by areas D plus E while the producer surplus is reduced by area F. However, the cartel captures some consumer surplus, the green-stripped area D. Capturing consumer surplus is not considered part of the deadweight loss.

The gain in producer surplus to the cartel of area D is still smaller than the total loss to consumers (areas D plus E) and producers (area F) so there is a deadweight loss. The total deadweight loss to society is the areas E plus F; the loss in consumer surplus is E and the loss in producer surplus is F.

With the formation of a cartel, the consumer surplus is now area A and the producer surplus is D now areas B and D. T he loss in consumer surplus is area D and E and the loss in producer Qm Qc Quantity surplus is F. The gain in producer surplus is area D, captured by the cartel from consumer surplus when the cartel restricts quantity andMRraises price. The total loss in consumer surplus and producer surplus is greater than the small gain in producer surplus so a deadweight loss exists. The total deadweight loss is equal to the areas E and F.11

3.3 Market Power

Market power is the ability of a firm to remain above the competitive level using price advantage. It may be looked at from the duration and durability of dominant position of a firm in the relevant market. Barrier to entry explains the market power. Market share is the cause and effect of market power and a firm is assessed with dominance or abuse of dominance with the help of the market power it holds at a given point of time.

3.3.1 Importance of market power in competition analysis Market Concentration

In economics, market concentration is a function of the number of firms and their respective shares of the total production in the industry or in the market.

Measurement of market concentration

The concentration ratio measures the combined market share of the top ‘n’ firms in the industry. Share can be by sales, employment or any other relevant indicator. The value of ‘n’ is often five, but may be three or any other small number. If the top ‘n’ firms gain a high market share the industry is said to have become more highly concentrated.

The Herfindahl-Hirschman Index (HHI)

This is a measure of market concentration. The index is calculated by squaring the % market share of each firm in the market and summing these numbers. For example in a market consisting of only four firms with shares of 30%, 30%, 20% and 20% the Herfindahl Index would be 2600 (900 + 900+ 400+ 400).

The index can be as high as 10,000 if the market is a pure monopoly (100*)

The lower the index the more competitive the market is and can reach almost zero for perfect competition

If an industry has 1000 companies each with 0.1% market share then the index would only be 10 (1000 x 0.1*).

A joint OFT / Competition Commission merger guidelines note in the UK suggested that a market with a HHI measure exceeding 2,000 can be characterised as ‘highly concentrated. For example, if a local radio station market consisted of two companies with 40 per cent each, and of two companies with 10 per cent each, it would have an HHI of 3,400

The superior quality and accuracy of the Herfindahl Index over the simple concentration ratio can be seen when three markets are examined each with a four firm concentration ratio of 85%.

Assume that in each market the remaining 15% of the market is controlled by 15 firms each with 1% market share.

Market A: 40% 20% 20% 5% = 85% – (Herfindahl Index = 2440)

Market B: 25% 20% 20% 20% = 85% – (Herfindahl Index =1840)

Market C: 75% 5% 3% 2% = 85% (Herfindahl Index = 5678)12

References

• Economic by Joseph Stiglitz.
• Walter J. Wessels, Economics, 2000, Barron’s Publishing, USA.
• Stigler, G., Sherwin, R., 1985 The Extent of The Market. Journal of Law and Economics 28, 555–585.
• Edward H. Chamberlin, 1956 The Theory of Monopolistic Competition, Cambridge, Mass.:
• Harvard University Press Paul J. McNulty, 1968 Economic Theory and the Meaning of Competition, The Quarterly Journal of Economics, Vol. 82, No. 4 (Nov., 1968), pp. 639-656