Competition Policy

Market Power & Welfare

Market Power & Efficiency Allocative Efficiency Productive Efficiency Dynamic Efficiency

Why productive efficiency should be lower with a Monopolist: managerial slack

The “quite life” of a M. power brings with it managerial inefficiency but why less inefficient technologies should be selected?

Ownwers maximise profits, managers not necessarilythey care about their utility (wage, career, effort & time to put in the job)

Managers may also contract a remuneration that increases with profits, but they care also about other things

When they select the technology not necessarily they select the most efficient ones Principal-Agents models

P-A show that increasing competition in a monopolistic market leads the firm to be more efficient

Empirical evidence shows that firm productivity is higher in competitive markets

A Darwinian Mechanism:Competition selects Efficient Firms

In an industry with efficient and less-effcient firms competition forces inefficient firms to exitwelfare increases as output is produced at a lower cost (not possible under monopoly)

Empirically: competition increases industry productivity through entry and exit into the market

Ex. Telecoms in the US: monopoly provision of equipment by AT&T through its subsidiary Western Electricdivesture of AT&T and connection of private equipment to the network ended the monopoly 7 Bell companies free to buy equipment by any supplier entry and exit into the industrythe larger share of output by efficient firms explains the rise of productivity into the industry

Welfare & the Number of firms As market power decrease with the N of firms one could

conclude that the larger N then the larger is Welfare But the existence of fixed (set-up) costs induce scale

economiesTRADE-OFF N increasesmore competitionlower prices higher

consumer surplus BUT duplication of fixed costloss of productive efficiency

Net effect on welfare? Ambigous It is not correct to implement a policy maximising N in an

industry (use subsidies to promote entry or preventing exit ....- competition policy is about defending competition not competitors)

Dynamic Efficiency: to what extent firms introduce new products or new procecces

A Monopolist has lower incentives to innovate

Process innovation: reduces costs CL < CH

Innovation cost: F ΠL Profit with New

Process ΠH Profit with

OldProcess A Monopolist innovates if

ΠL - ΠH > FIt considers the additional

profit

Same decisions with competition

With current technology all firms bear CH and P=CH & make Π = 0

A firm has the chance to adopt the new tech. and operates with CL < CH

Then this firm gets Π > 0The firm innovates if

ΠL > F less strict condition (whole profit is considered)

Competition and Innovation Competition pushes firms to innovate in order to to

improve their relative position The absence of competition (monopoly or collusion)

reduces the incentive to innovate Market structure & innovation: an environment with

some competition but also enough market power from innovative activities is the most conducive to R&D

Increasing competition when there is “already enough” not necessarily increases welfare

Firms’incentive to innovate are due not only by competition but also from the opportunity of appropriating the results of R&D

Too strong competition reduced appropriabilityreduced incentive to innovate

Incentives to invest in R&D Competition stimulates innovation, but so does the

expectations to appropriate investments in R&D through extra-profits

Let’suppose perfect competition and no-one can appropriate innovations (no patent system or compulsory licensing) If one firm adopts a lower cost tech. all rivals can do do same

After an innovation all firms charge P = cL and make Π = 0 F cannot be recovered no innovation

Extreme case BUT shows that market power may be important to keep the incentives to innovatepublic policies should maintain the incentives

Property rights protection Trade off betwee ex-ante efficiency (preserve incentives to

innovate) and ex post efficiency (once the innovation is there, wide diffusion among firms is better)

Time consistency problem: before innovations governments can promise that the innovator can appropriate it, but once the R&D results are obtained the Gov. had better to renege on the promise and allow innovation to be adopted by the maximal N of firms

Firms would anticipate the Gov. Incentives and make no innovation problem of committment for the Gov.

Patent laws are a way to commit not to expropriate the innovation ex-post

Optimal design of patent laws: breadth and lengthtoo broad protection discourages rival firms – too narrow lead rival firms to make artificial incrmental innovation (patent infringement)

Extend to copyright, trademark (intellectual PR)and investment (tout court PR)Essential facilities

Monopoly: will the market fix it all?

Suggestion: the market mechanism can prevent even a monopolist from excercising market power

1.Coase Conjecture: a monopolist cannot keep high prices because consumers anticipate it will reduce prices in the future

2.Contestable markets: with free entry and exit higher prices will trigger entry

Durable goods monopolist A durable good producer will price at MC even

if it is a monopolist With 2 groups of consumers: high and low

valuationfirstly sell at higher prices to high valuation consumers once they bought the good, decrease prices to sell to low valuation consumers BUT high valuation consumers anticipate the future price reduction and will abstain from buying until prices are lower (unless they incur a cost for delaying..) as a result the monopolist cannot set higher prices in the first period

Durable goods monopolist With many consumers with valuation p:MC ≤ P ≤ PM the

monopolist in each period reduce the price to those that have not previously bought the good since each consumer expects that P = MC then each consumer will postpone purchases until P=MC The Monopolist looses market power (paradox….require infinite life)

The Monopolist should find a way to commit not to reduce price in the future

Example: contract with “most favoured nation clause”: the M specify that - if it ever decreases price - those who bought at higher prices are entitled to a reimbursement of the price difference it is a credible commitment

But in conclusion: if consumers incur costs in delaying purchases then the monopolist cannot exploit its market power

Contestable markets Extra-profit and market power are

temporary Π attract entry and erode market power

Little scope for competition policy? Market forces re-establish a better social result

Consider an Industry with an incumbent & a potential entrant with equal access to the technology: TC = F + cq the incumbent will not charge PM but the AC = (F/q)+c

Market Power may not decrease with free entry: Switching costs changing supplier may imply transaction costs &

learning costs Switching cost may be artificially created: frequent

flyer programs or costs of closing bank accounts--> product differentiation is created

EX: before opening a bank account all services are homogenous--> after it must be convenient to switch due to the cost of closing the account

With switching cost new entrants should wait to gain market shares...large price-cuts should be offered

Competition in markets with switching costs Ex. Two new entrants in a Market with switching costs. Firms charge prices simultaneously in each period--

>different degree of competition in each period In the 2nd period firms have captive customers (lock-in) --

>lower demand elasticity-->higher prices More aggressive competition in the 1st period to gain

market shares Net effect on welfare: ambigous The presumption that switching costs decrease

competition is reinforced in models with n periods Conclusion: Sw. Cost make entry more difficult and

market less competitivenegative effects on welfare