REVIEW: LECTURES 9.1, 9.2 AND 10.1, CARTELS AND COMPETITIVE CONSTRAINTS

Review 19 September 2013Date

ANTITRUST ECONOMICS 2013Alexis G. PirchioCPI

Elisa MariscalCIDE, Global Economics Group

2Overview

Review

Cartels: The Economics of Price Fixing

Cheating and Detection

Competitive Constraints and Market

Power

3

Replicating the Monopoly Outcome with a Cartel: Agreements on Price and Output

Cartels: The Economics of Price Fixing

4The Economics of Price Fixing

• Illegal by virtue of the behavior regardless of its intent or effect, the “inherent nature” of the practice is injuriously restraining trade.

• There is no allowable defense (though some industries are exempted)• Focus in on the existence of an agreement (see Kaplow, Competition

Policy and Price Fixing for critique).

Price fixing is per se illegal in the U.S., E.U. and many other jurisdictions.

• There is an extremely high likelihood that the practice can have only an anti-competitive effect.

• It is very difficult and costly to investigate claims of pro-competitive vs. anti-competitive effects, making a per se approach economical

• The practice can be defined specifically enough so that companies can identify what they are, and are not, allowed to do

Per se prohibitions should be reserved for practices for which:

5Cartel Price Paths

Citric Acid

Railroads

Lysine

6Fact About Cartel Data

Biased sample because we only observe discovered cartels.

Suppose only the less effective cartels are caught.

• Cartel duration has been underestimated.• Welfare losses have been underestimated.

Suppose only the more effective cartels are caught because the less effective ones collapse before being discovered.

• Cartel duration has been overestimated.• Welfare losses have been overestimatedPolicy challenge: How can we measure the

efficacy of cartel enforcement policies, when we cannot measure the number of cartels in an economy?

Harrington, CRESSE Lectures, 2011

7Price Agreements

Suppose there are 20 competing firms, all identical. With competition they each charge a competitive price of $5 dollars, and each sell 100,000 units (for a total 2 million units) and just earn a competitive return.If they each agree to charge $20, they each sell 50,000 on average (for a total 1 million units) and make $750,000 of monopoly profit each ($15 * 50,000) for a total of $15 million. [How does output get allocated?]

MR

PM = $20

PC = $5

2,000,0001,000,000

D

Q

P

MC

Monopoly

Perfect competition

Profit margin of $15 a unit and total profitof $15 million.

8Output Agreements

Competing firms in the example could achieve monopoly price if they each agreed to offer only 50,000 units to the market:

• Divided up by geographic regions so that each sold 50,000 units• Divided up by customers so that each had customers to whom they could sell

50,000 units onlyWe have assumed firms are all the same size and have the same bargaining power. They could also divide things so that some got a larger share of profits by getting a larger region or more (or better) customers.

Which is better: price agreement or output agreement?

9Cartels with Two-Sided Platforms

Replicating the monopoly outcome requires fixing prices (or allocating output) on both sides

• If competing newspapers could fix subscription and advertising prices they could exactly replicate the monopoly outcome

• Note that this issue is different than “customers” on one side colludingIf one side is constrained to zero then fixing price on the other side replicates monopoly outcome

• If competing shopping malls fixed rental prices but shoppers continued to get in for free they could replicate the monopoly outcome

If a cartel can’t fix price on one side then:

• Monopoly profits get competed away if competition is intense on other side

• Profits might increase relative to the competition level, but this is still suboptimal—they don’t realize the full cartel potential—if there is imperfect competition on other side

Fixed priced to buyers,not clear to sellers

10

The incentives to cheat and methods aimed at detecting and punishing cheaters

Cheating and Detection

11Incentives to Cheat on a Cartel Agreement

Could an individual firm do better than with the cartel?

The answer is always “yes” when it is certain that the other firms stick with their cartel agreement (this case is unrealistic of course).The answer may be “yes” whenever the gains from cheating exceed the losses from either punishment or from de-stabilizing the cartel. The “cheater” just needs to make enough extra profit long enough in order to outweigh the losses of the cartel breaking down or possible “retribution”. Effective cartels must be able to detect and punish cheating.

12Detecting Cheating

Given incentives to cheat cartels and their participants must be able to detect firms that are deviating from the agreement.

Some market situations make it easier to detect cheating:

• Goods are homogeneous• Pricing is transparent• Customer relationships are well known

Cartel and its members can also devise special arrangements to make it easier to detect cheating

13Incentives to Cheat on a Price AgreementSuppose firms 2 …. 20 charge the cartel (monopoly) price of $20.

Suppose firm 1 drops its price to $19.95.

Then all customers will buy from firm 1 (in a frictionless world).

• Firm 1 gets monopoly profits of almost $15 million (up from 750,000)• Firms 2 … 20 get nothingTo avoid detection it could drop price but increase

sales just enough not to be detected. A successful cheater can’t be too greedy.

If many firms cheat competition reemerges.

14Output Allocation and Cheating

Exclusive territories: if a firm has exclusive rights to a region, the appearance of a competitor alerts firm to cheating.

Exclusive customers: if a firm has exclusive rights to a customer then the defection of that customer alerts firm to cheating.

Exclusive contract wins: with bidding rigging, one firm is designated to be the winner of each contract; deviation is detected instantly.But some of these methods can also raise suspicions and increase likelihood of detection. Some cartels therefore incorporate some flexibility.

15Punishing Cheating: Price Wars

If rivals deviate from agreed on price this period then lower price to competitive level next period.

This strategy leads to price wars where periods of high prices are followed by price wars.

To end price wars firms move back to collusive equilibrium.

16Importance of Cheating for Antitrust EnforcementAbility to detect and prevent cheating is key to

organizing and maintaining a cartel. Cartels are more likely to exist when detection and prevention of cheating are possible.

Detection and punishment methods leave traces of evidence that authorities can look for.

Certain seemingly legal practices may “facilitate” detection and prevention of cheating and therefore authorities may want to prohibit or monitor these.

An authority looking for evidence of a cartel• First look at role of cheating• Then detection/punishment methods• Conclude by looking at “facilitating practices”

17Factors that Facilitate a Cartel

Facilitating factors include anything that increases the gains from operating a cartel, helps detect cheating on a cartel, and enables punishment of cheaters.

Facilitating factors include:

• Structural features of the market (number of firms, entry conditions, etc.)• Institutional features (information exchanges, joint facilities, etc.)• Contractual relationships and methods of transacting between buyers and

sellers.

18What Can Competition Authorities Do?

Head them off at the pass – Sharp prohibitions/warnings in the Law

• Forbid/limit practices that facilitate cartels (Information exchange, MFNs, RPM—but are these practices ever efficient?)

• Prohibit mergers that will facilitate collusion (e.g. ones that eliminate a maverick player or increase the likelihood of coordinated effects)

Hunt them down – Assign resources, prioritize, enforce• Focus investigative efforts on industries that have features that facilitate cartels—but

are these cartels the most damaging or the easier ones to detect?• Screening technologies• Dawn raids when enough suspicion—requires specialized know-how and can be legally

challenging in some jurisdictionsGet them to squeal – Leniency Programs

• Encourage cartel members to report each other (leniency programs)• Get employees to be “whistleblowers”

Carry a big stick – Deterrence • Fines• Jail, Debarment• Private Damages

19Head Them Off At The Pass: Facilitating Practices

A facilitating practice is an activity that makes collusion more likely or more effective, either by making coordination easier or making it easier to sustain a collusive agreement.

A facilitating practice may be prosecuted either as an anti-competitive agreement in and of itself or as circumstantial evidence of price fixing.

Some examples include:• Information exchange of current individual firm sales or prices• Announcements of future price changes• List (or posted) pricing with no discounts• Most favored consumer clauses, meeting competition clauses• Delivered or basing point pricing

20Information Exchange Agreements Help CollusionExchanging future pricing intentions help coordinate price

Exchanging past prices help police price agreement

Exchanging demand and cost data so that firms have:• A more common set of beliefs (this makes it more likely that, without express communication, they can settle on the same collusive price)

• More precise estimates of demand

21

Firms Often Cooperate For Pro-Competitive Reasons

Joint facilities to obtain scale economies (e.g. Computer Reservation Systems).

Standard setting to obtain network economies and reduce transactions costs for consumers (see Lecture 4) (DVD standards).

Solving various market imperfections (e.g. Portobello Road Antique Dealers).Exchanging information (costs, best practices, etc.) for pro-competitive reasons (e.g. all trade associations). Cooperatives, joint ventures, standard setting organizations, and other horizontal combinations pose difficult problem for antitrust.Engage in obvious efficiency enhancing activities.

22Efficiencies from Cooperation

Sharing of facilities and reduction in duplicative costs

Realization of network effects through e.g. standardization

Cooperation may be essential to the creation of a product (sports leagues, payment cards)

23Hunt Them Down: Enforcement

Stages in the process: screen, verify, prosecute

• Screening: Identifying markets where collusion is suspected.

• Verification: Systematically distinguish between collusion and competition.

• Prosecution: Developing economic evidence to determine guilt.Two empirical methods for screening: structural, behavioral

• Structural: Identifying industry traits conducive to collusion.

• Behavioral: Identifying collusive behavioral patterns.

24

Get them to Squeal: the Economics of Leniency Programs

A cartel shares common characteristics with organized crime

• Cooperation within an illegal environment means that there is a corporate governance problem at its core

• Repeated interaction, monitoring, threats and reactions against cheaters, means that participants acquire important information about all their co-conspirators

A viable cartel requires that 2 conditions be fulfilled

• Participation Constraint: E(Profit from participating in the cartel) – E(Cost of Punishment)>0

• Incentive Compatibility Constraint:Under incomplete information and different types of agents, the participant will find it in its interest to act in accordance with the cartel rules.

A successful leniency program weakens a cartel by maximizing conflict of interest among its members and reducing the compatibility of interests

25Carry a Big Stick: Customer Damages’ Purpose

Compensation to harmed consumers

Deterrence and resistance of cartels

• Additional financial penalties to fines levied by the government.• Create added incentives for customers to monitor, report, and investigate.

Customer damages – US• Treble damages: Multiplier serves deterrence since the probability of being

caught and paying penalties is well below one.• Indirect purchasers cannot sue for damages except in some states.• Class action suits used when many customers each incur a small loss.

26The Economics of Damages

Damages inflicted by firm i from colluding in period t are calculated to be:

• [ Pic(t) – Pi

bf(t) ] * Qic(t)

Pic(t) – Pi

bf(t) is the overcharge

Qic(t) is the number of units sold by firm i in period

t.

Pic(t) is the observed (collusive) price charged by

firm i in period t.

Pibf(t) is the “but for” (or counterfactual) price for

firm i in period t.

Harrington, CRESSE Lectures, 2011

27 Competitive Constraints and Market Power

28Definitions of Market Power

Ability of a firm to raise prices significantly above the competitive level

• “Significant” required because almost all firms have some degree of short-run market power as a result of product differentiation and location.

• No consensus on what “significant” means• Competitive level often taken as p=MC

Ability of a firm to take actions that a competitive firm couldn’t do that significantly harm consumers such as impose contractual restraints, prevent entry, and so forth.

• Market power not always manifested in price• Firms compete on many dimensions besides price

29Monopoly, Perfect Competition, and Market Power

QCQM

PM

PC

Supply = MC

Demand

MR

Q

P

Monopoly price significantly above competitive levelsAnd significantly above marginal cost

Textbook description of competitive industry but need to be careful in using in practice.

30Level Versus Changes in Market Power

  Merger Unilateral Conduct

Level Background information that may affect concern over the change

Can the firm impose anticompetitive constraints?

Change Will the merger increase market power of merged firms?

Do the anticompetitive constraints increase market power and thereby harm consumers?

Why we care about market power?

31Market Power and Competitive Constraints

Market power is a measure of the extent to which “competitive constraints” limit the ability of a firm to dictate prices or other competitive conditionsAn inquiry should make sure that simple approaches to assessing market power (e.g. market share, concentration) don’t obscure consideration of the full spectrum of competitive constraints since that is what market power is supposed to summarize

The source of competitive constraints come from the demand side and from the supply side.

32Competitive Constraints Can Limit Market Power

Demand Supply

Substitutes in demand based on products and geography

Product repositioning

Consumer switching costs Elasticity of supply

Two-sided platform constraints resulting from loss of complementary sales/indirect network effects

Barriers to entry including scale economies, network effects, regulation

Innovation and feature competition

Innovation and feature competition

33

$0

$1

$2

$3

$4

$5

$6

$7

0 1 2 3 4 5 6 7 8 9 10

Pric

e pe

r Pin

t

Pints of Beer Demanded (Millions per Year)

Pub Beer

Demand-Side Substitution and the Marginal Consumer

A,B, C, D are at “the margin” of buying or not buying beer

F is an “average consumer” of beer (from O to C)

O

G is not a consumer of beer at current prices

The “average” consumer may not switch to a substitute product in response to a small price increase; the producer needs to worry about what consumers “at the margin” between buying and not buying the product, will do.

G

D C

F

B

A

34Entry, contestability and Supply-side Substitution

New Entry

• Can new firms get in quickly when prices go up? [Barriers to entry]

Expansion• Could current rivals expand production easily by switching production

lines from other products? [Excess capacity, time to respond, availability of inputs, flexibility in technology and factors of production…]

Product repositioning

• Could current rivals make their products more competitive by adding or changing features?

35Barriers to Entry Debate

Bain

• Any advantage existing firms have that enable them to raise price above short-run competitive level.

• Corresponds to what many competition authorities and courts use

Stigler

• Costs that new firms bear that existing firms don’t• Helps to emphasize that firms must incur investments to enter and

expand and realize a return from that.• Not really a barrier if entrant must incur these same investments.

36End of Review, Next Class Topic 10.2

Topic 10.2

Role and Definition of Market Power

Market Power Measurement

Multi-Sided Platforms and Market Power