Regulation throughCompetition Policy

Roger WareQueen’s University

January 2010

Consumer Surplus, Producer Surplus, Total

Surplus• Consumer Surplus is the difference

between the consumer's willingness to pay for another unit of output and the price actually paid.

• Producer Surplus is the difference between what a producer receives (price) and marginal cost – the minimum required to ensure supply.

• Total Surplus is just the sum of Consumer and Producer Surplus

Consumer Surplus and Producer Surplus

Market Power

• A firm has market power if it finds it profitable to raise price above marginal cost.

• A firm with market power is often called a price maker (as opposed to a price taker in a competitive market)

• The exercise of market power involves a loss of surplus to society, often called “deadweight loss”

Monopoly Pricing

P(Q) MCMR(Q)

Measurement of Deadweight Loss

The Competition Act (1986)92. (1) Where, on application by the Commissioner, the Tribunal finds that a merger or

proposed merger prevents or lessens, or is likely to prevent or lessen, competition substantially

• (a) in a trade, industry or profession,• (b) among the sources from which a trade, industry or profession obtains a product,• (c) among the outlets through which a trade, industry or profession disposes of a

product, or• (d) otherwise than as described in paragraphs (a) to (c),• the Tribunal may, subject to sections 94 to 96,• (e) in the case of a completed merger, order any party to the merger or any other

person• (i) to dissolve the merger in such manner as the Tribunal directs,• (ii) to dispose of assets or shares designated by the Tribunal in such manner as the

Tribunal directs, or• (iii) in addition to or in lieu of the action referred to in subparagraph (i) or (ii), with

the consent of the person against whom the order is directed and the Commissioner, to take any other action, or

• (f) in the case of a proposed merger, make an order directed against any party to the proposed merger or any other person

• (i) ordering the person against whom the order is directed not to proceed with the merger,

Efficiency Exception

• 96. (1) The Tribunal shall not make an order under section 92 if it finds that the merger or proposed merger in respect of which the application is made has brought about or is likely to bring about gains in efficiency that will be greater than, and will offset, the effects of any prevention or lessening of competition that will result or is likely to result from the merger or proposed merger and that the gains in efficiency would not likely be attained if the order were made.

Oligopoly Theory

• Studies the intermediate cases of competition between monopoly and perfect competition

• Many, many theories – from Cournot (1838) to Bertrand (1883) to highly mathematical 20th century game theory models.

Oligopoly theory – cont’d

• Central component of horizontal merger analysis because we need to understand why a merger that leads to an increase in concentration may imply increased market power and welfare losses for consumers

• Merger guidelines distinguish between unilateral and coordinated effects, roughly corresponding to the economists concepts of non-cooperative and cooperative oligopoly models

Concentration and Market Power

• As the number of competitors in a market increases, when a firm increases its price, more substitutes are available to a consumer who diverts away from the price increase leading to a more elastic firm-specific demand curve.

• Thus, each firm in an oligopoly faces a firm-specific demand curve that describes how demand for its own products will respond to changes in the prices of those products.

• Although the exact properties of firm specific demand will vary with the nature of the oligopoly equilibrium, firm specific demand is always more elastic than market demand

Barriers to Entry

• Market power cannot persist without barriers to entry – this is almost an axiom of economic reasoning.

• Barriers can be structural, economies of scale, large fixed costs of entry, network effects

• Or legal and statutory – airlines before deregulation, wireless market in Canada today

IV. Economic Analysis of Mergers

Market Definition

• A key stage in most contested competition cases is the market definition process.

• Key component is the Hypothetical Monopolist Test, abbreviated HM

Market Definition 2

• A market is defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profit-maximizing firm …

• likely would impose at least a ``small but significant and nontransitory " increase in price (SSNIP)

Case Example - Propane

• The elasticity of demand for propane

• Estimates were prepared by several experts

• Some assumed a constant elasticity, some a linear (straight line) demand curve

• Consensus was that the elasticity was around -1

Critical Elasticities and Whole Foods

• A Critical Elasticity is a device to help identify a market – if the elasticity for a given product boundary is small enough, than the HM would impose a SSNIP

• Critical Loss Analysis the percentage reduction in sales from a 5% price increase that would just make it unprofitable

Oligopoly Models

• Important because modern merger analysis in Competition Law depends on the notion of an oligopoly equilibrium

• Important distinction between unilateral effects analysis and coordinated effects analysis.

Unilateral Effects

• Without any ability to coordinate pricing, after a merger each firm’s unilateral strategy may be to increase price.

Coordinated Effects

• If firms are able to coordinate on pricing, or tacitly collude, a merger may make such coordination more likely, and hence the likelihood of harm to the consumer.

• Particularly likely if the merger involves the absorption of a maverick firm.

The Cellophane Fallacy• In merger cases, the objective is to

identify mergers that would, if carried through, substantially lessen competition by creating (more) market power.

• In abuse of dominance (monopolization) cases the analysis requires demonstrating that the firm has already attained market power.

• In the latter case, the use of the HM test at prevailing prices is inappropriate, and involves the famous Cellophane Fallacy

The Cellophane Fallacy 2• At the prevailing price we would not

expect the monopolist to profitably impose an SSNIP for its existing product. If it were profitable, the monopolist would have already done so!

• In the Cellophane case, at the prevailing price for du Pont's cellophane food wrap, other flexible wrapping materials were viable substitutes for consumers.

• The appropriate price from which to apply the HM test in an Abuse of Dominance case is the competitive price.

II Vertical Pricing Issues and Exclusionary

Practises• resale price maintenance• An upstream manufacturer imposes

price restriction on downstream retailers

• Could be a price ceiling or price floor, but usually the latter

• Very common before these practises were outlawed in 1951 in Canada, and at a similar time in the USA and other OECD countries

rpm continued

• Telser (1960) identified two explanations for rpm– a practise for manufacturers to

facilitate cartel formation– the famous free riding theory

More complex theories

• Winter (2009) has argued in several papers that rpm is necessary to coordinate the incentives of retailers between price and local service expenditures.

• With only a wholesale price as an instrument, manufacturers cannot correct externalities that arise between the retailers incentives to choose price and service levels

Predatory Pricing

• Predatory pricing describes attempts by dominant firms to prevent entry by attacking the entrant with low prices, usually “targeted” at the entrants customers rather than all of the dominant firm’s customers

• The economic theories of predatory pricing have always been controversial- the Chicago School has always been sceptical

Predatory pricing – cont’d

• The puzzle: if a firm prices below its own costs in order to drive an entrant out – how is it going to recoup those lost profits?

• Price-cost tests are often unable to deal with the true “opportunity cost” of a sale at a low price (Roche, Air Canada)

Exclusionary Practises

• Exclusive Dealing – one of the more interesting and hotly debated practises among economic theorists and competition lawyers

• Canada Pipe, Peace Health important cases