Economic analysis of the market - 1

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1 Economic analysis of the market - 1 Paolo Buccirossi Rome, April

2 Questions 1. What are the desirable properties (the goals ) of a system to trade (buy and sell) goods or services? 2. Is competition a proper instrument to achieve these goals? 3. What is the set of transactions (the market ) that we have to consider to assess whether competition works properly? 2

3 Question 1 1. What are the desirable properties (the goals ) of a system to buy (or sell) goods or services? 2. Is competition a proper instrument to achieve these goals? 3. What is the set of transactions (the market ) that we have to consider to assess whether competition works properly? 3

4 Notions of efficiency Allocative efficiency: a (static) property of a market (the system through which the exchange of products occurs) Productive efficiency: a (static) property of the system(s) through which goods and services are produced and distributed Dynamic efficiency: a property of the system of production and exchange to be assessed over time 4

5 Allocative efficiency Allocative efficiency All consumers that derive from the consumption of a product a benefit larger than the social cost of producing the same good are allowed to consume the product All consumers that derive a benefit lower than the social cost of producing the same good are excluded from the consumption of the product 5

6 P Lear - Laboratorio di economia, antitrust, regolamentazione Consumer and producer surplus CS PS S D Q Consumer surplus = area of red triangle Producer surplus = area of green triangle 6

7 Allocative efficiency and social welfare When the condition of allocative efficiency is satisfied (ceteris paribus) the social welfare (consumer surplus + producer surplus) is maximum P CS PS Suppose P = 6 Lost surplus (deadweight loss) S D Q 7

8 Productive efficiency Output is produced with the minimum amount of input (technical efficiency), and Output is produced at the minimum cost (economic efficiency) 8

9 Dynamic efficiency Innovation New (more efficient) production processes New products New distribution systems (e.g. ecommerce) 9

10 Question 2 1. What are the desirable properties (the goals ) of a system to buy (or sell) goods or services? 2. Is competition a proper instrument to achieve these goals? 3. What is the set of transactions (the market ) that we have to consider to assess whether competition works properly? 10

11 Efficiency and competition/1 Competition and allocative efficiency Equilibrium in a perfectly competitive market price = marginal cost Perfect competition guarantees an efficient allocation 11

12 Market power Market power: the ability of one or more firms to price above the perfectly competitive level Lerner Index L = 0 (perfect competition); L = 1 (maximum market power) Market power determines an inefficient allocation of resources 12

13 Trade-offs You can t always get what you want 13

14 Efficiency and competition/2 Competition and productive efficiency p Economies of scale p 2 More efficient to concentrate production within few firms, possibly one (natural monopoly) p 1 A B Q 2 Q 1 MC 1 MC 2 D 14 Q

15 Innovation Lear - Laboratorio di economia, antitrust, regolamentazione Efficiency and competition/3 Competition and dynamic efficiency Two effects of competition Escape competition effect Schumpeterian effect Innovation depends on incentives Inverted-U relationship high low low Competition high 15

16 Summary and discussion Various notions of efficiency (allocative, productive, dynamic) Competition is desirable because it always improves allocative efficiency However it may be limited to achieve productive efficiency or to foster innovation Which type of efficiency is the one we should care the most? When market power is not a problem or a major problem? 16

17 Question 3 1. What are the desirable properties (the goals ) of a system to trade (buy and sell) goods or services? 2. Is competition a proper instrument to achieve these goals? 3. What is the set of transactions (the market ) that we have to consider to assess whether competition works properly? 17

18 A quick intro to competition law Two main rules that regulate firms conducts 1. Prohibition of agreements and concerted practices that restrict competition (e.g. cartels) (Art. 101 TFEU) 2. Prohibition of abuses of dominant position (Art. 102 TFEU) Merger control regulation 18

19 Art. 101 (1) TFEU The following shall be prohibited as incompatible with the internal market all agreements between undertakings, decisions by associations of undertakings and concerted practices which may affect trade between Member States and which have as their object or effect the prevention, restriction or distortion of competition within the internal market, and in particular those which: (a) directly or indirectly fix purchase or selling prices or any other trading conditions; (b) limit or control production, markets, technical development, or investment; (c) share markets or sources of supply; (d) apply dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (e) make the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts. 19

20 Art. 101 (3) TFEU The provisions of paragraph 1 may, however, be declared inapplicable in the case of: any agreement or category of agreements between undertakings, any decision or category of decisions by associations of undertakings, any concerted practice or category of concerted practices, which contributes to improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit, and which does not: (a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives; (b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in question. 20

21 Art. 102 TFEU Any abuse by one or more undertakings of a dominant position within the internal market or in a substantial part of it shall be prohibited as incompatible with the internal market in so far as it may affect trade between Member States. Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts. 21

22 Basic elements of a market A very general definition Market: a group of buyers and sellers of a certain set of products in a specific geographic area Need to focus on: Buyers Sellers Products Areas 22

23 The relevant market The relevant market is the portion of trade where Sellers compete to attract buyers Competition can be effectively distorted or eliminated One or more firms can exert a significant and durable market power Smallest market principle The relevant market is the smallest portion of trade where 23

24 Hypothetical monopolist test Suppose that some products in a given area are supplied by a single firm (the hypothetical monopolist ) Would it possible (profitable) for the HM to adopt a Small but Significant and Non-transitory Increase in Price (SSNIP) above the competitive level? Yes: the products and the areas considered form a RM No: the products and the areas considered do not form a RM 24

25 Iterative process Start from the smallest set of products (and areas) and apply the HM test If the answer to the test is yes, then stop (you have identified the market) Otherwise add the products or the areas that would impede the HM to exert a significant and durable market power (competitive constraints) 25

26 Competitive constraints Demand-side: products (or areas) that are perceived as substitutes by consumers Supply-side: firms that produce products that are not substitutes but can immediately and at almost no cost start producing substitute products Substitutability on the demand-side is the most effective competitive constraint 26

27 An example/1 Two firms producing bottled water merge. What is the relevant market? still water still + sparkling water still + sparkling water + soft drinks 27

28 Example/2 Would consumers switch to sparkling water in case of a SSNIP of still water? Would they switch to fruit juice, or carbonated drinks in case of a SSNIP of bottled water? Can firms producing sparkling water swiftly start selling still water? Can firms producing soft drinks swiftly start selling bottled water? 28

29 How much substitution: critical loss analysis Profit of the HM before the SSNIP: (p c)q(p) SSNIP: x% Profit of the HM after the SSNIP: (p(1+x) c)q(p(1+x)) The HM is indifferent if (p(1+x) c)q(p(1+x))= (p c)q(p) where: = critical loss 29

30 Critical loss: An example Current price of product A is 1; marginal cost is 0.8; quantity sold is 1,000 units Unit margin: (1 0.8) = 0.2; total profit: (0.2 1,000) = 200 Suppose the HM raises the price by 5%; the new price is 1.05 How many units of A should consumers continue to buy to leave the hypothetical monopolist with a total profit of 200? Unit margin after the SSNIP: ( ) = 0.25 Profit after the SSNIP: (0.25?) = 200? = 800 The HM is indifferent if demand drops by 200 units i.e. by 20% = critical loss 30

31 How much substitution: a significant minority In the example a 20% loss in demand is sufficient to defeat a SSNIP The size of the significant minority depends on the level and function of costs and on the level of the current price Once identified the critical loss (CL), try to predict the actual loss (AL) If AL > CL then the products considered are not a RM; if AL < CL the products form a RM 31

32 Relevant market in practice Assessing demand-side substitutability Products characteristics and intended use Price related evidence Evidence on past substitution Assessing supply-side substitutability Switching and sunk costs Time to market 32

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