Chapter 6: Market Size and Scale Effects © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Market Size Matters European leaders always viewed integration as compensating small size of European nations Implicit assumption: market size good for economic performance Facts: integration associated with mergers, acquisitions, etc. In Europe and more generally, ‘globalisation’ © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Facts M&A activity is high in EU much M&A is mergers within member state about 55% ‘domestic’ Remaining 45% split between: one is non-EU firm (24%), one firm was located in another EU nation (15%) counterparty’s nationality was not identified (6%). © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Facts Distribution of M&A quite varied big 4: share M&As much lower than share of the EU GDP. I, F, D 36% of the M&As, 59% GDP. Except UK small members have disproportionate share of M&A. © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Facts Why M&A mostly within EU? Why UK’s share so large? Non harmonised takeovers rules. some members have very restrictive takeover practices, makes M&As very difficult others, UK, very liberal rules lack of harmonisation means restructuring effects very impact by member states. © Baldwin&Wyplosz The Economics of European Integration

Economic Logic Verbally liberalisation  de-fragmentation  pro-competitive effect  industrial restructuring (M&A, etc.) RESULT: fewer, bigger, more efficient firms facing more effective competition from each other © Baldwin&Wyplosz The Economics of European Integration

Economic logic: background Monopoly case Demand Curve Price Price Marginal Revenue Curve Marginal Cost Curve Demand Curve P’ P* A P” B D Marginal Cost C E Q’ Q* Q’+1 Sales Sales © Baldwin&Wyplosz The Economics of European Integration

Economic logic: background Duopoly case, example of non-equilibrium price price Firm 1’s expectation of sales by firm 2, Q2 Firm 2’s expectation of sales by firm 1, Q1 p1’ Demand Curve (D) Demand Curve (D) p2’ Residual Demand Curve firm 1 (RD1) Residual Demand Curve firm 2 (RD2) A1 MC A2 MC x1’ Firm 1 sales x2’ Firm 2 sales Residual Marginal Revenue Curve firm 1 (RMR1) Residual Marginal Revenue Curve firm 2 (RMR2) © Baldwin&Wyplosz The Economics of European Integration

Economic logic: background Duopoly & oligopoly case, equilibrium outcome price Typical firm’s expectation of the other firm’s sales price Typical firm’s expectation of other the other firms’ sales p* D D p** RD RD’ A MC A MC RMR RMR’ sales x* 2x* x** sales 3x** Duopoly Oligopoly © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration BE-COMP diagram Mark-up (m) COMP curve BE (break-even) curve m’ n’ mmono mduo n=1 n=2 Number of firms © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Details of COMP curve Mark-up price p' mmono A’ p" mduo B’ D Monopoly mark-up Duopoly mark-up COMP curve R-D (duopoly) Marginal cost curve MC B A Number of firms n=1 n=2 R-MR MR (monopoly) Typical firm’s sales xduo xmono © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Details of BE curve Mark-up (i.e., p-MC) euros price Home market po=mo+MC Demand curve BE A AC>po ACo=po B A po mo B AC<po AC MC n” no n’ Number of firms Sales per firm Co Total sales x”= Co/n” x’= Co/n’ xo= Co/no © Baldwin&Wyplosz The Economics of European Integration

Equilibrium in BE-COMP diagram euros Price Mark-up Home market Demand curve BE E’ E’ p’ p’ m' E’ AC COMP MC n’ Number of firms x’ Sales per firm C’ Total sales © Baldwin&Wyplosz The Economics of European Integration

No-trade-to-free-trade integration euros price Mark-up Home market only Demand curve BE BEFT E’ E’ E’ 1 p’ p’ m' C E” E” E” p” p” A mA A pA AC COMP MC n’ n” 2n’ Number of firms x’ x” Sales per firm C’ C” Total sales © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Economic Logic Integration: no-trade-to-free-trade: BE curve shifts out (to point 1) Defragmentation PRE typical firm has 100% sales at home, 0% abroad; POST: 50-50 Can’t see in diagram Pro-competitive effect: Equilibrium moves from E’ to A: Firms losing money (below BE) Pro-competitive effect = markup falls short-run price impact p’ to pA Industrial Restructuring A to E” number of firms, 2n’ to n”. firms enlarge market shares and output, More efficient firms, AC falls from p’ to p”, mark-up rises, profitability is restored Result: bigger, fewer, more efficient firms facing more effective competition Welfare: gain is “C” © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration State aid (subsidies) 2 immediate questions “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?” “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?” The answer to both questions is “Yes”. Turn first to the economics of subsidies and EU’s policy © Baldwin&Wyplosz The Economics of European Integration

Economics: restructuring prevention Consider subsidies that prevent restructuring Specifically, each governments make annual payments to all firms exactly equal to their losses i.e. all 2n’ firms in Figure 6-9 analysis break even, but not new firms Economy stays at point A This changes who pays for the inefficiently small firms from consumers to taxpayers. Mark-up BE BEFT E’ 1 m' E” mA A COMP n’ n” 2n’ Number of firms © Baldwin&Wyplosz The Economics of European Integration

restructuring prevention: size of subsidy Pre-integration: fixed costs = operating profit = area “a+b” Post-integration: operating profit = b+c ERGO: Breakeven subsidy = a-c NB: b+c+a-c=a+b euros Price Mark-up COMP Demand curve BEFT E’ E’ p’ a AC A A pA pA A b c MC 2n’ Number of firms Sales per firm Total sales x’ C’ CA xA= 2CA/2n’ © Baldwin&Wyplosz The Economics of European Integration

restructuring prevention: welfare impact Change producer surplus = zero (profit is zero pre & post) Change consumer surplus = a+d Subsidy cost = a-c Total impact = d+c euros Price Mark-up COMP Demand curve BEFT E’ E’ p’ a AC d A A pA pA A b c MC 2n’ Number of firms Sales per firm Total sales x’ C’ CA xA= 2CA/2n’ © Baldwin&Wyplosz The Economics of European Integration

Only some subsidise: unfair competition If Foreign pays ‘break even’ subsidies to its firms All restructuring forced on Home 2n’ moves to n”, but all the exit is by Home firms Unfair Undermines political support for liberalisation © Baldwin&Wyplosz The Economics of European Integration

EU policies on ‘State Aids’ 1957 Treaty of Rome bans state aid that provides firms with an unfair advantage and thus distorts competition. EU founders considered this so important that they empowered the Commission with enforcement. © Baldwin&Wyplosz The Economics of European Integration

Anti-competitive behaviour Collusion is a real concern in Europe dangers of collusion rise as the number of firms falls Collusion in the BE-COMP diagram COMP curve is for ‘normal’, non-collusive competition Firms do not coordinate prices or sales Other extreme is ‘perfect collusion’ Firms coordinate prices and sales perfectly Max profit from market is monopoly price & sales Perfect collusion is where firms charge monopoly price and split the sales among themselves © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Economic effects collusion will not in the end raise firm’s profits to above-normal levels. 2n’ is too high for all firms to break even. Industrial consolidation proceeds as usual, but only to nB. Point B Zero profits earned by all. prices higher, pB> p”, smaller firms, higher average cost Mark-up BEFT mmono Perfect collusion A B pB E” Partial collusion p” COMP n=1 n” nB 2n’ Number of firms © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration Economic effects The welfare cost of collusion (versus no collusion) four-sided area marked by pB, p”, E” and B. price Demand curve Mark-up BEFT pmono mmono Perfect collusion A B B pB E” Partial collusion E” p” COMP n=1 n” nB Number of firms Total sales CB © Baldwin&Wyplosz The Economics of European Integration

© Baldwin&Wyplosz The Economics of European Integration EU Competition Policy To prevent anti-competitive behavior, EU policy focuses on two main axes: Antitrust and cartels. The Commission tries: to eliminate behaviours that restrict competition (e.g. price-fixing arrangements and cartels) to eliminate abusive behaviour by firms that have a dominant position Merger control. The Commission seeks: to block mergers that would create firms that would dominate the market. © Baldwin&Wyplosz The Economics of European Integration