MANAGERIAL ECONOMICS An Analysis of Business Issues

1. MANAGERIAL ECONOMICSAn Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2. Chapter 20: Competition and Competition Policy Objectives: After studying the chapter, you should understand: 1. the alternative concepts of competition and monopoly power 2. the rationale for competition law 3. the policies towards market dominance and restrictive trade practices

3. Alternative Concepts of Competition andMonopoly Power Traditional concepts: Perfect competition: • In fact no competition; no product differentiation, no advertising, brand name, etc.; all firms are price-takers. Imperfect competition: • Monopoly: pure monopoly, which faces no competition, is a rare case. • Oligopoly and monopolistic competition (developed by Robinson and Chamberlin in the 1930s).

4. Adam Smith: The forcing of market price to its “natural level” or to the lowering of profits to a minimum Schumpeter: Competition as a process involving mainly the dynamic innovations of the entrepreneur (“creative destruction”) Linking competition with economic growth and development

5. Knight: What competition actually means is simply the freedom of the individual to deal with any and all other individuals and to select the best terms as judged by himself, among those offered. Copeland: He criticised the traditional concepts of competition as too passive; competition involves the active effort to improve the terms on which one trades e.g. the competition for a position of monopoly power.

6. The Search for “Workable Competition” Clarke (1940): • “Workable competition is defined as the most desirable forms of competition, selected from those that are practically possible.” • cannot have perfect competition; all forms of competition are of the second-best. Austrian view (Reekie, 1979): • Competition is not a state; it is a process taking place through time which is never in equilibrium; competition is a dynamic process.

7. Structure-conduct-performanceParadigm • Turning away from theory and examine the facts about industries’ activities, in order to identify those factors that lead firms to behave in unacceptable ways, and those that lead to satisfactory performance • Many different relationships were examined but the most common hypothesis to be tested was on profitability of an industry

8. The Contestable Markets Approach • Baumol, Panzar and Willig (1982): A perfectly contestable market: entry is free, exit is costless, existing firms and entrants compete on equal terms, potential entrants are not deterred from entering by the threat of retaliatory price-cutting by incumbents. Result: • The benefits (competitive price, no “excessive” returns) associated with perfect competition will accrue, even though there are very few firms in the industry. • The importance of sunk costs (those costs, which cannot be eliminated, even by stopping production) as the major real deterrent to entry.

9. Contestable Markets: Policy implications: 1. Small number of firms/high concentration doesn't imply monopoly power. 2. Increase the contestability of market, e.g. reducing sunk costs by tax advantages for rapid depreciation/rental contracts, improving the efficiency of the second-hand equipment markets.

10. Natural monopoly Example 1: TC (1) = 6 TC (2) = 8 Q1. How many firms are most efficient?

11. Subadditivity: a condition for natural monopoly: cost of supplying by a single firm is lower than by any combination of several firms (due to scale economies or scope economies). The cost of supplying via a single system is less than the cost of supplying via multiple systems. • Sustainability: a natural monopoly is sustainable if there exist prices that will not attract entry; a natural monopoly is non-sustainable if there exist no prices that will not attract entry, even though single firm supply is efficient. *In Example 1, is the market subadditive? Is it sustainable?

12. Example 2: TC (1) = 6 TC (2) = 8 TC (3) =13 Q1.How many firms are most efficient? Is the market subadditive? Is it sustainable? Q2.The market is vulnerable to (inefficient) entry.

13. “Cream-skimming” and “destructive competition”: when a rival takes a profitable component of the incumbent's business, leaving the incumbent with a loss on the rest; entry restrictions (government protection of natural monopoly) may be needed. Note: When the average cost is decreasing, the industry is a natural monopoly. But a natural monopoly does not necessarily imply downward sloping average cost curve.

14. The Rationale for Competition Law Measuring the costs of monopoly • Allocative inefficiency • X-inefficiency • Rent dissipation

15. Allocative inefficiency of monopoly: Harberger (1954): He used U.S. manufacturing industry profit data for the stable period 1924-1928 to measure allocative inefficiency due to monopoly. • To measure the excessive profits earned by monopolists in various industries, by comparing to the average rate of return. • Assumption: unitary elasticity of demand.

16. Result: he generalised his findings from manufacturing industry to the whole economy and argued that the loss was 0.1% of GNP only; monopoly’s waste had been overstated. Such a small loss did not justify any government intervention. What are the problems of Harberger’s measurement? There are other costs of monopoly in addition to allocative inefficiency.

17. X-inefficiency of monopoly: Leibenstein (1966): The lack of competitive pressure under monopoly results in higher total cost of production, i.e. total cost can be reduced if the market structure is changed. • X-inefficiency: higher total cost because of shirking, poor monitoring, lack of motivation to improve/innovate, government protection, etc. • Result: monopoly's waste was underestimated.

18. Welfare (Social) cost of monopoly Buchanan and Tullock (1967), and Posner's (1975): Tariffs, quotas, monopolies, and any other artificial barriers to entry will have redistributive effects. • Firms or individuals will spend resources to obtain political favours, i.e. rent-seeking activities to make or prevent wealth transfers. Monopoly rent is dissipated in the competitive process for monopoly rights. • Result: resources are wasted and loss due to monopoly should be even greater.

19. Policies towards Market Dominance and Restrictive Practices The Concept of Market Dominance • Federal Communications Commission (FCC) in the United States: • “a carrier (firm) is to be declared dominant only if it possesses market power in the relevant product and geographic market.” (1995) • The Merger Guidelines of the U.S. Department of Justice and the Federal Trade Commission define the relevant market as: • “the narrowest product and geographic area in which a hypothetical monopolist could profitably raise and maintain prices above the competitive level significantly (of the order of 5%) for a substantial period of time.”

20. The Concept of Market Dominance • Other indicators used in assessing market power in the relevant market: • Market share, the degree of price correlation in the market, supply elasticity of the market, demand elasticity of the product, and the degree of substitutability between products. • Abuse of market dominance, not market dominance per se, is important.

21. The Measurement of Market Concentration • Concentration ratio: the market share of the largest 3 or 4 firms in the market. • Herfindahl Index = si2 where si is the share of ith firm. (i.e. the sum of the squares of the market shares of all firms in the market.) • Reciprocal of Herfindahl Index: the number-of-firms equivalent. Q. What are the problems of these measures?

22. Competition Policies in the United States Anti-trust laws: • In 1890, the U.S. Congress passed the Sherman Anti-trust Act in response to the alleged monopolistic behaviour of the railroad, tobacco, steel, and oil trusts of that time. • A trust: is a combination of firms that form to set price and output as a single, monopolistic firm.

23. Competition Policies in the United States The Sherman Anti-trust Act (1890): • prohibits firms from restraining trade to lessen competition. • Section 1: prohibits collusive combinations and conspiracies that lessen competition. • Section 2: prohibits firms from monopolising or attempting to monopolise a market.  The Clayton Act (1914): • addresses the potential anti-competitiveness of price discrimination, tying arrangement, exclusive arrangements, and mergers. • the focus is on restraining the growth of monopoly at an early stage.

24. Competition Policies in the United Kingdom and the European Union In the United Kingdom • Early period: Monopolies and Restrictive Practices Act (1948). •  Current period: The Fair Trading Act (1973): The Director General of Fair Trading has the power to refer a monopoly situation (more than 25% of the market share) to the Monopolies and Mergers Commission (MMC, now Competition Authority); the process is time-consuming. • The Competition Acts (1980 and 1998): gives the power to the Director to investigate the practice of a single firm if he believes it to be engaged in anti-competitive practices (restrict, distort or prevent competition).

25. Within the European Union (EU) • Competition policies are covered in Articles 81 and 82 of the Treaty of Amsterdam (previously Articles 85 and 86 of the Treaty of Rome) • Any abuse of a dominant position within the EU, or a substantial part of it, shall be prohibited in so far as it affects trade between member states. • All agreements and concerted practices between undertakings, which have as their object or effect the prevention, distortion or restriction of competition within in the EU, and which affect trade between member states, shall be prohibited.