Economics of Competition St. John’s, Antigua March 2016 Desroy Reid Competition Analyst, Fair Trading Commission (Jamaica)

Outline Objectives Economics and Competition Law Market Structures and Firm Conduct Market Power and Price Elasticity of Demand Market Share and Market Concentration Market Definition

Objectives The Objectives of this presentation are to: Introduce economic theories that underlie competition law Examine how competition authorities define markets, measure market concentration and market power

Economics and Competition Law Definitions Competition Law Set of rules of conduct  market outcome Economics Importance of Economics to Competition Law Structure-Conduct-Performance Opportunity cost

Economics and Competition Law Ideal for governments looking to maximize its society’s welfare Benefits of Competition Total Surplus Maximum Consumer: Increase in choices & reduction in prices Producer: Access to cheaper to inputs

Market Structures Other Market Structures include: Monopoly Oligopoly Monopolistic competition

Market Structures Entry and Exit Number of Buyers and Sellers Information Product Homogeneity

Perfect Competition Structural Characteristics Many buyers and sellers Perfect Information Homogenous Goods No barriers to entry or exit Behavioral Characteristic Firms are price takers Structural Conduct Performance – Economists focus on conduct and not on the price

Perfect Competition Existence of Perfectly Competitive Markets? Agricultural Markets

Monopoly Structural Characteristic Behavioural Characteristic One Seller No close substitutes No entry possible Behavioural Characteristic Price makers

Monopolies Barriers to Entry and Monopolies Economies of scale Exclusive Access to technology or resource License

Monopoly Natural Monopolies Only one supplier can exist profitably in the market High capital cost; Largest volume, lowest production cost firm APUA (Water)

Oligopoly Structural Characteristics: Behavioural Characteristic Few firms High Barriers to entry Differentiated/Undifferentiated Products Behavioural Characteristic Interdependence of Firms Strategic Interaction

Monopolistic Competition Structural Characteristics Many Firms Differentiated Products Low Barriers to Entry and Exit Behavioural Characteristics Price Maker

Monopolistic Competition Summary Market Structures C H A R T E I S T I Monopoly Oligopoly Monopolistic Competition Perfect Competition Number of Firms One Few Few or Many Many Freedom of Entry and Exit Restricted/ Blocked Restricted Unrestricted Information Not Perfect Perfect   Product Homogeneity Differentiated Differentiated / Undifferentiated Undifferentiated Example Electricity, Water Computers, Cars, Milk, detergents Bottled Water, Shoes, Clothing Agricultural Products Price Maker or Price Taker Maker Taker Government Intervention – eliminate; use old one

Market Power and Price Elasticity of Demand Definition Price above competitive price Price Elasticity of Demand sensitivity of demand to a price change Introduce cross price elasticity of demand

Market Power and Price Elasticity of Demand Measuring Market Power Lerner Index Relates market power and price elasticity of demand Formula: P = market price; MC = marginal cost; E = price elasticity of demand.

Market Power and Price Elasticity of Demand In summary Lerner Index and Price Elasticity of Demand Competition Authorities’ Market Power Interest Abuse of market power Price Manipulation

Market Share and Market Concentration Measuring market share Sales Market Concentration Definition Small number of firms = Large % of Market Proximity of competition to market structures Max. monopoly; Min. perfect competition

Market Concentration Method 1: Herfindahl Hirschman Index (HHI) Example: In a market consisting of five firms with shares of 40%, 25%, 20%, 10% and 5% the HHI would be equal to: (402 + 252 + 202 + 102 + 52 = 2750)

Market Concentration Method 2: Concentration Ratio Total Output produced by firms Using the HHI example information calculate the four firm concentration ratio: 40% + 25% + 20% + 10% = 95% Four-Firm concentration ratio 40% competitive

Market Definition Identify and define the boundaries of competition between firms Who is competing with whom Market Power

Market Definition Are Pepsi, Coca-Cola and Water in the same market? Too Narrow (overstate) or Too Broad (understate)

Market Definition Firm Large Market Market Share Smaller Market Dupont (1956) Packaging Material 20% Cellophane >75% Philadelphia National Bank (1963) U.S.A 4% Philadelphia 36% Xerox (1975) Copy Machines 65% Plain Paper Copy Machines >90% Change quota to share; market share proxy of market power

Hypothetical Monopolist Test Aka Small but Significant Non-transitory Increase in Price (SSNIP) HMT/SSNIP Test: Logic: Is a “market” worth monopolizing? Start with smallest possible market and ask if a 5% price increase is profitable If yes, then the market is defined as the substitutes outside the “market” must be weak If not, then firm does not have sufficient market power to profitably raise price.

Hypothetical Monopolist Test So, next closest substitute is added to the relevant market and test repeated. Process continues until the point is reached where a hypothetical monopolist could profitably impose a 5% price increase. Thus the group worth monopolizing pulls in all of the relevant substitutes Market then define

SSNIP Example Are Coca-Cola, Pepsi, and Bottled Water in the same market? Step 1: Smallest Possible Market – Coca Cola Step 2: Is a 5% increase in PRICE profitable If yes, Market defined. If no, Move on to step 3 Step 3: Include substitute (Pepsi) and go back to Step 2 Flow diagram

Summary Table 2. Summary of Presentation Market Structure Market Power Market Share Market Concentration Perfect Competition None Minute Low concentration Monopoly Significant All Fully concentrated Oligopoly Some Highly Concentrated

Hypothetical Exercise SunSea is a small country in the Caribbean with a population of 10 people. On the island only three beverages are consumed: K-Kola, Phlepsi and bottled water. K-Kola and Phlepsi are sold for $100 while bottled water is sold for $70. Things have been this way for some time. The recession has however seen an increase in the cost of K-Kola and its suppliers now have to pay $80 for each unit of K-Kola.

Hypothetical Exercise Last month Mr. Badum, the chief executive officer of Koca Planet (the sole distributor of K-Kola in SunSea), noted that his companies accounts shows that that five SunSeanians drank K-Kola on average per week. Based on his calculations, his weekly revenue is $500 (5 people who drank K-Kola X $100 price of K-Kola). With the increase in the cost of K-Kola he now spends a total of $400 (5 bottles X $80 unit cost) to supply the five K-Kolas demanded weekly, which gives him a weekly profit of $100 ($500-$400). Mr. Badum is contemplating increasing the price of K-Kola by 10%. He seeks your advice in determining if that 10% increase is profitable.

Hypothetical Exercise All members of your group are citizens of SunSea and drink K-Kola. Conduct a survey among your group to determine if this increase is profitable by asking each member of the group what they would do if the price of K-Kola were to increase by 10%? Would they switch to phlepsi or bottled water (given these are the only substitutes) or would they continue buying K-Kola? Based on your calculations and the responses from your group members, what is the market for K-Kola? If Phlepsi had 3 customers and bottled water had 2 customers, what would be the market share of all three market participants? Calculate the Herfindahl Hirschman Index.

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