Competition, Regulation & Business Strategy.

1. University of Hong Kong Faculty of Business & Economics Master of Economics Competition, Regulation & Business Strategy.

2. COURSE THEMES (Theoretical Part) • The application of economics to competition policy. • Elements of competition law • Relevant doctrine in competition law • Applied focus • Emphasis on competition environment actual cases application • Analyses how economics has shaped competition policy and the application of the law

3. Reading List • Wide ranging and diverse • Core Text • Motta, Massimo, Competition Policy: Theory and Practices, Cambridge, 2004. • Kwoka, J. & L. White (eds.), The Antitrust Revolution: Economics, Competition and Policy, OUP, 4th Edition. 2004. • Industrial Organization Text • Martin, S., Industrial Economics: Economic Analysis and Public Policy, MacMillan, 1994. • Scherer, F & D. Ross, Industrial Market Structure & Economic Performance, Houghton Mifflin Company, 1990.

4. Reading List • Theoretical book about competition policy and regulation • Phlips, L., Competition Policy: A Game-Theoretic Perspective, Cambridge University Press, 1995. • Viscusi, W., J. Vernon and J. Harrington, Economics of Regulation and Anti-trust, D.C. Heath and Company, 1992 • Introduction to European Competition Law • Rodgers, B. J. & A. MacCulloch, Competition Law and Policy in European Community and U.K., Cavendish, 2002.

5. Websites of Various Competition Agencies • US DoJ www.doj.gov and FTC www.ft.gov both have good economics sections and where DoJ full case files. • OFT www.oft.gov.uk where have a good series of research papers. • OECD www.oecd.org, click on topics and then competition. • EU Competition Commission http://europa.eu.int/comm/competition/index_en.html

6. COURSE OUTLINE (THEORETICAL PART) • Introduction to competition policy. • Market Definition, Market Power & Dominance • Horizontal Restraints • Horizontal Mergers • Vertical Restraints • Abuse of Dominance.

7. Case Study • US Case Study to illustrate the crucial concepts of competition law application in business world. • The Second Part of the Course • Hong Kong Case Study about the effect of competition environment and regulatory environment on business strategy

8. Introduction to Competition and Competition Policy • Content • The Role of Competition in a Market Place • Market is efficient? • Role of Competition • Types of Competition • What Competition Policy is? • Hong Kong Competition Policy • And what for? • Evolution of the Competition Law • Objectives of Competition Law • Elements of Competition Law • Role of Economics

9. Competitive Market Maximizes Welfare Supply CS E P* PS Demand Q* QUnits per year

10. Deadweight Loss of Monopoly CS p, $ per unit MC PM PC MR=MC PS Demand MR 0 Q Q m Q , Units per day c

11. Potential Competition • A mechanism to control the exploitation of the market power • Hypothesis about the effect of the potential competition to the market • Limit pricing • Dynamic limit pricing • Contestable market • Market efficiency

12. Limit Pricing • Incumbent produces QL instead of monopoly output (QM). • Resulting price, PL, is lower than monopoly price (PM). • Residual demand curve is the market demand (DM) minus QL . • Entry is not profitable because entrant’s residual demand lies below AC. • Optimal limit pricing results in a residual demand such that, if the entrant entered and produced Q units, its profits would be zero. • Lower the monopoly profit, lower the deadweight loss and increase the consumer surplus $ Entrant's residual demand curve M P L P AC P = AC M D Quantity L Q M Q Q

13. Dynamic Limit Pricing • Considering strategic behaviour, when limit pricing occurs, dominant firms will still earn profits that persist above normal profits and entry is generally followed by price competition and incumbent (approximately) maintain their pre-entry outputs. • In a dynamic markets, where scale or technical requirements do not restrict entry, the competitive potential depends on the expected profits. • Dominant firms will earn supra-normal profits, but these profit will gradually erode in the long run. $ M P Entrant's residual demand curve AC P L M P = AC D New AC Quantity L Q M Q Q

14. Contestable Market • In a perfectly contestable market, industry prices and outputs are defined as “sustainable” if no new firm can choose lower prices and operate profitably by serving all or part of demand at he new prices. • A contestable market as any market which can only be equilibrium if the market price-quantity vector is sustainable. • Hit and run entrants that are able and willing to enter an industry whenever profit opportunities arise. Such entry make is possible only when all barriers to entry and exit are eliminated.

15. Contestable Market • If price response of incumbent is very quick, hit and run entry becomes risky if there are any suck costs. • Therefore in a contestable market, established firms can still maintain supra-normal profits even if suck costs of entry are small.

16. Market Efficiency • Chicago School of industrial organization. • Without denying the importance of imperfect competition, the Chicago School represents that market evolution refects differential efficiency • Dominant firms owe their position to superior performance, not to strategic behaviour or the history entry into the industry, and profits are simply the rents that accrue to superior technology. • Markets are “workable” competitive.

17. Competition Policy – Definition. • The set of policies and laws which ensure that competition in the marketplace is not restricted in a way as to reduce economic welfare or more general, that is detrimental to society • Motta (2004) Competition Policy Theory and Practices. • Hong Kong SAR Government Statement on Competition Policy 1998 • http://www.compag.gov.hk/policy/content.htm

18. Competition Law – Definition. • Competition Policy can in terms of several policy components: • Market liberalization policy • Deregulation • Most important the competition provisions • Modern competition law can be viewed as a basic system of rules which are designed as far as possible to allow markets to function properly. It is designed to prohibit abuses of market power, whether by an individual firm or by a group of firms acting collectively, but otherwise to allow markets to operate unhindered. • Scherer and Ross (1990) Industrial Market Structure and Economic Performance.

19. ORIGINS • “Antitrust in this modern form is a North American invention.” (Scherer and Ross). • “American anti-trust law is not only ‘law’ but also a socio-political statement about our society” (Sullivan, The Political Economy of the Sherman Act: The First One Hundred Years, Oxford 1991). • Competition law is never only about economic regulation of the market

20. US Anti-trust Law form the Base • US is the dominant economic power in the 20th century, the effect of its competition policy • Certainly reflected in EU law both in its origins and several reform as EU countries see the policy help the US competitiveness. • A legacy of WWII. • How to deal with Vertical Restraints • Regulation 1/2003 – Most Dramatic Overhaul of EU competition law in its 40 year history. • http://europa.eu.int/eur-lex/lex/LexUriServ/LexUriServ.do?uri=CELEX:32003R0001:EN:HTML • Concentration Measures • SSNIP Test • Merger Analysis • Leniency

21. Evolution of US Anti-trust Law • In US, there are six phases • Before Sherman Act (the 2nd half of the 19th century) • Early days of the Sherman Act (1890-1914) • Ascent of the rule of reason (1915-1936) • Emphasis on market structure and per se rule (1936-1972) • Ascent of the Chicago School (1973-1991) • Towards a Post-Chicago Synthesis (since 1992)

22. Evolution of US Ant-trust Law • Sherman Act was enacted in 1890. • Section 1 prohibits contracts, combinations and conspiracies which restrain trade, and prescribes imprisonment and fines for violators. • Section 2 prohibits monopolization, attempts to monopolize and conspiracies to monopolize “any part of the trade or commerce amongst the several states, or with foreign nations.” • However, monopoly position is not by itself illegal. • The law carries imprisonment penalties up to 3 years.

23. Evolution of US Ant-trust Law • Early days of the Sherman Act (1890-1914) • Trans-Missouri Freight Association (1897) clearly established that price agreements were illegal, per se Rule on horizontal price fixing (horizontal restraint). • Dr. Miles v. Park & Sons (1991) established resale price maintenance (vertical restraint) per se illegal. • Terminal Railroad (1912) established the obligation to give access to essential facilities on reasonable terms (abuse of dominance).

24. Evolution of US Ant-trust Law • In Standard Oil Co. v. United States (1911), US Supreme Court left four enduring marks in dealing with dominant firm and mergers • Bright line test, 90% share as proof of monopoly • Established “rule of reason” as the basic method of anti-trust analysis with some per se rules • Classifying somebehavior asabuse of dominance • Divesting into 34 parts • Clayton Act of 1914 was introduced to extend the anti-trust legislation to cover mergers capable of reducing competition. • FTC Act 1914

25. Evolution of US Ant-trust Law Ascent of the rule of reason (1915-1936) • Ascent of “associationalist” vision of business-government relations • Executive branch discourages aggressive prosecution by DJ and FTC • Robinson-Patman Act 1936 against price discrimination seek to protect small business against the core value of competition policy • In Great Depression, the court lost confidence in the market system so as the competition process.

26. Evolution of US Ant-trust Law Emphasis on market structure and per se rule (1936-1972) • Some Chicago economists advocated robust anti-trust enforcement • Search for ways to simplify the burden of proof required in Chicago Board of Trade case usually favor defendants. • “conscious parallelism” is not per se illegal • Establish several per se illegal vertical restraint conducts such as tie-in arrangement, market allocation, group boycotts, resale geographical limitation, joint venture of exclusive sale territories.

27. Evolution of US Ant-trust Law Emphasis on market structure and per se rule (1936-1972) • Court slighted efficiency rationales for alleged abuse of dominance, Procter & Gamble (1967). • Simple market share measures routinely determined outcomes. • Supreme Court antipathy towards mergers and doubts about market forces as indefensible, Brown Shoe (1962). • Divergence between the academic development in economics and the court’s thinking.

28. Evolution of US Anti-trust Law Ascent of the “Chicago School” (1973-1991) • Two academic connecting to Chicago School stress on efficiency rationale made an impact on judges and commentators during 70s • Bork (1978) The Anti-trust Paradox • Posner (1976) Anti-trust Law: Economic Perspectives • Chicago School critique and of the loss of competitiveness of US firm abroad caused a change in the enforcement attitudes of anti-trust law in the US. • Turning point case GTE-Sylvania (1977), the Supreme Court ruled that non-price vertical restraints should be subject to a rule of reasons. • In Reagan Administration, a hand-off approach. • Number of private case drop from 1611 in 1977 to 638 in 1989.

29. Evolution of US Anti-trust Law Towards a Post-Chicago Synthesis (since 1992) • Swing back to the middle ground between interventionism of the 60s and the laisse-faire of the 80’s • Apply economic theories such as game theory, asymmetry information, transaction cost economics and network economics to the anti-trust cases, Kodak v ITS (1992). • High profile case emerged such as Microsoft and other intellectual property right case focus the debate on innovation and dynamic competition. • Strengthen against cartels: international vitamin cartel with prison sentences.

30. EU Competition Law • The objective of setting up a Community in Europe is to ensure a system with free movements of goods, services, labor and capital and that competition in the internal market is not distorted. • Article 81 Control of Anti-competitive Agreements • Article 82 Control of Dominance • http://europa.eu.int/comm/competition/antitrust/legislation/entente3_en.html#article

31. Competition Policy Objectives. • Main Objectives • Increase welfare (Total surplus) • Increase consumer welfare (consumer surplus) • Defense of smaller firms • Other Political Objectives • Promoting market integration • Economic freedom • Fighting inflation • Fairness and equity

32. In Practice Other Objectives • US – Restraining political power. • Imposed on Germany for political reasons. • EU – Market integration – traditionally more important. • South Africa – Address racial segregation - Fairness • Often fundamental difference in approach between lawyers and economists.

33. Politics of Competition Policy • Rivals of economic ideologies, the “Chicago School” and the “Harvard School” – efficiency of the market and firm, and rationality of individuals. • Social reasons –prevent short-term economic crisis. • Political reasons – prevent/maintain accumulation of excessive power. • National strategic reason. • Industrial policy • Trade policy

34. Competition is unfair. • “Competition by its nature is deliberate and ruthless. Competitors jockey for sales, the more effective competitors injuring the less effective by taking sales away. Competitors almost always try to ‘injure’ each other in this way... these injuries are the inevitable result of the competition section 46 [of the Australian Trade Practices Act] is designed to foster”. • Queensland Wire Industries Pty. Ltd. v. The Broken Hill Proprietary Company Limited, [1989] ATPR 20-925.

35. Elements of a Competition Law • For example Competition Provisions in Hong Kong Chapter 106 Telecommunication Ordinances 7K • (1) A licensee (entity) shall not engage in conduct which, in the opinion of the Authority, has the purpose or effect of preventing or substantially restricting competition in a “telecommunications” market.(2) The Authority in considering whether conduct has the purpose or effect prescribed under subsection (1) is to have regard to relevant matters including, but not limited to- • agreements to fix the price in a “telecommunications” market; • an action preventing or restricting the supply of goods or services to competitors; • agreements between licensees to share any “telecommunications” market between them on agreed geographic or customer lines; • the conditions of relevant “licences”.

36. Elements of a Competition Law • Control of Dominance Provisions in Hong Kong Chapter 106 Telecommunication Ordinances 7L • (1) A licensee in a dominant position in a telecommunications market shall not abuse its position • (2) A licensee is in a dominant position when, in the opinion of the Authority, it is able to act without significant competitive restraint from its competitors and customers. • (5) The Authority may consider conduct to fall within the conduct referred to in subsection (4) as including, but not limited to- • (a) predatory pricing; • (b) price discrimination limited competition • (c), (d) & (e) making conclusion of contracts subject to …terms or conditions or arrangements that limited competition or discrimination in supply of services to competitors.

37. Other Elements • Merger Control Provisions in Hong Kong Chapter 106 Telecommunication Ordinances 7P. • Imposing Price Control on Dominance Service Provider in Chapter 106 7G. • Control of Misleading and Deceptive Conduct in Chapter 106 7M. • Non-discrimination Provisions in Chapter 106 7N.

38. Per Se Rule • Per se v. Rule of Reason • From the outset distinction drawn between arrangements that are anti-competitive almost by definition and those which may have legitimate justifications. • Per se rule means that only need to prove the conduct such as a cartel agreement, no need to show economic harm.

39. Per Se Rule • “[T]here are certain agreements or practices which because of their pernicious effect on competition and lack of any redeeming virtue are conclusively presumed to be unreasonable and therefore illegal without elaborate inquiry as to the precise harm they have caused or the business excuse for their use.” • Northern Pacific Railroad Co. v. US, 356 US 1 (1958), 5.

40. Per Se Rule • Minimises the costs of enforcement because removes requirement to show that an arrangement is harmful; • Risk of error reduced by limiting per se rule to behaviour that is clearly harmful. • Largely limited to price fixing.

41. Per Se Rule • “Economists are almost unanimous in the condemnation of cartels, especially those engaged in price fixing, because no expert has satisfactorily established that consumers will benefit from price fixing. On the contrary, economic analysis can show that cartels are inefficient and lessen consumer welfare. It is therefore, not surprising that antitrusters have the closest meeting of minds on the baleful influence of cartels.” • Breit and Elzinga, (1989): The Antitrust Casebook. • “Hard-core price fixers are intentional conspiracies to steal from consumers, and the negligible probability that the outcome is efficient can safely be ignored. We also believe that erroneous findings of guilt in criminal antitrust cases are negligible.” • Werden and Simon, (1987): Why Price-Fixers Should Go to Jail, Antitrust Bulletin 24(4): 917-37.

42. Per Se Rule • “The current per se prohibition of price fixing is warranted on the basis that the occurrence of efficiency-enhancing price fixing agreements is rare, that the benefits of identifying and permitting efficiency enhancing price fixing agreements in a court setting are outweighed by the enforcement and judicial costs of a competition test and the benefit from the certainty induced by such clear rules.” • Hilmer Report National Competition Policy, Australia 1983.

43. UK Competition Act, 2002 • UK Enterprise Act 2002, S.179 creates specific cartel offence. • Included to avoid the need to have complex economic evidence presented to juries in such cases. • Competition Act, 2002 • Criminal sanctions. • Somewhat unusual in EU

44. UK Competition Law Section 6(2) • “…it shall be presumed that an agreement between competing undertakings, a decision made by an association of competing undertakings or a concerted practice engaged in by competing undertakings the purpose of which is to- • (a)    directly or indirectly fix prices with respect to the provision of goods or services to persons not party to the agreement, decision or concerted practice, • (b)   limit output or sales, or • (c)    share markets or customers, • has as its object the prevention, restriction or distortion of competition in trade in any goods or services in the State or in any part of the State or within the common market, as the case may be, unless the defendant proves otherwise.”

45. Penalties • Fines up to 4m euro or 10% of turnover, whichever sum is greater. • Similar level of fines for individual managers and directors • In case of s6(2) offences maximum jail sentences of up to 5 years for individual managers and directors • NB Makes these arrestable offences

46. Is There an Economic Case for Criminal Penalties? • Need to distinguish between cartels and other practices. • Strong economic consensus that cartels are harmful. • In most other cases economics suggests that it depends on the circumstances. • Thin line between abuse of dominance and aggressive competition. • Criminal Provisions in Competition Act • Distinguish between “hard-core” cartel activities - in s.6(2) – and other offences. • Serious question whether criminal sanctions appropriate in non-cartel cases. • Dividing line between what is ok and what is not is unclear. • Counterproductive - risk deterring competitive behaviour.

47. Is There an Economic Case for Criminal Penalties? • Cartels are different. • “Cartels are organised and operated by individuals and companies who calculate that they stand to earn substantial profits from such behaviour. The people behind cartels are not petty crooks; they are clever sophisticated business executives who have risen to senior management positions in their companies.” Massey and Daly

48. Are Fines a Deterrent? • Until mid 1970s cartels a misdemeanour in US law. • History of repeat offenders. • See also US vitamins and citric acid cases • Success of US Leniency programme.

49. Fining Companies Not Enough • Moral hazard problems • Individual executives make decisions on part of the company. • Stand to gain personally… • …perverse incentive unless they also face penalties. • Fines merely a cost of doing business. • Perverse incentives of civil fines by incorporating the likelihood of being fined and amount of fine in the price markup in cartel. • In almost 50% of cases optimal fine would have bankrupt the company.

50. Individual Fines • Problem of ensuring that company does not pick up the tab. • New Zealand examining ways of legislating to prevent this but arguably becomes even more difficult to enforce. • UK DTI survey 83% of competition law experts in favor of criminal (jail) penalties.