Competition Theory and Policy Economic Issues Miguel Fonseca

Overview Competition policy is a core part of Industrial Organisation; We will only be able to (briefly) cover 3 particular areas, which are closely related: –Market Power; –Horizontal Mergers; –Vertical Integration. We will cover some of the theory and current policy issues.

Suggested Readings Theory: S. Martin, Industrial Economics, Chs. 2, 3 & 4. A bit more advanced: Church and Ware, Industrial Organization, Chs.2, 4 Available online at: homepages.ucalgary.ca/~jrchurch/page4/page5/files/Poste dIOSA.pdf Case study information can be found here: oft/

Limiting case 1: perfect competition Basic model Key Assumptions: –A1: Many “atomistic” buyers and sellers; –A2: Homogenous product; –A3: Free entry and exit; –A4: Complete and perfect knowledge. Under these assumptions, the price each firm charges for a unit of the good should equal its marginal cost of production (P=MC)

Limiting case 2: monopoly The other extreme market structure. Key Assumpions: –A1: One seller, many buyers; –A2: No entry.

Dominant firms So far we have been talking about markets where all the firms are roughly the same size. However, in some industries, you usually find one large firm which takes a lion’s share of the market and several smaller ones. For instance: Software (Microsoft), computer processors (Intel), household products (Proctor & Gamble), breakfast cereals (Kellogg)

Dominant firms (cont.) Depending on the cost structure of both the entrant and the incumbent, limit pricing may be a successful strategy to deter entry. Is it credible? Incumbent Entrant Out In LPCP

Dominant firms (cont.) Incumbent’s threat of pricing the entrant out of the market is not credible if the game is only played once. If the game is repeated indefinitely, the threat is credible as long as the discounted stream of profits from limit pricing is larger than the short- term profit of allowing entrant into the market.

Incomplete information If the incumbent’s costs are too high, limit pricing may not be an option. But, the potential entrants may not know this… Incumbent Entrant Out In LP CP Out LPCP Incumbent’s costs are low: prob = p Incumbent’s costs are high: prob = (1-p) Nature Incumbent

Incomplete information (cont.) In this game, two types of equilibria are possible: –A pooling equilibrium, where the both types of incumbent set the limit price as if its costs were low. –A separating equilibrium, where the incumbent allows entry to occur if its costs are high and sets the limit price if its costs are low.

Other strategies to obtain or maintain dominance So far we have looked at the “standard” tool for deterring entry: output. There are other ways firms may deter entry. Mergers Raising rivals’ costs e.g. Increasing wage rates in the industry; bidding up the price of essential inputs.

Other strategies (cont.) Expanding capacity –Allowing for excess capacity signals a firm’s long-term ambitions to clients, as well as its willingness to defend its position from potential entrants. Vertical integration –More on this in two weeks’ time. Product differentiation –Filling the market with different brands. E.g. P&G own 9 different brands of clothes detergents. Tying & exclusive deals

US policy towards market power The Sherman Antitrust Act (1890) –Section 1: Every contract, combination in the form of trust or otherwise, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal. Every person who shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felony… –Section 2: Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony…

US policy (cont.) The Clayton Act (1914) –Section 2: prohibits price discrimination IF it is deemed to likely to be anticompetitive. –Section 3: prohibits three different types of marketing practices: Exclusive dealing contracts; Requirement contracts; both types tie a customer to a particular supplier; Tying contracts. –Section 7: prohibits anticompetitive mergers More on this next week!

European policy toward market power Treaty of Rome (1957), Articles 81 and 82. –Article 82: –Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common 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 the 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.

EU Competition Policy Goals Undistorted competition; Consumer Welfare; Economic Integration; Promotion of small- & medium-sized companies; Merger control.

Case study: Microsoft vs. EU Commission Microsoft is a software company which originally specialised in operating systems (OS) It has a dominant position in the PC OS market with a market share of about 95%. It also specialises in consumer software (like Powerpoint!), which are designed to run on its OS systems (Windows XP, Vista).

Microsoft vs. EU Commission In 1998, Sun Microsystems complained that Microsoft had refused to provide interface information necessary for Sun to be able to develop products that would "talk" properly with Windows PCs. Sun claimed that without this, it would not be able to compete on an equal footing in the market for work group server operating systems.

Microsoft vs. EU Commission This meant that MS products would perform better on PCs than any competing products. The commission’s investigation found that MS’s non- disclosure of this information to rivals tilted consumers’ choices in favour of MS server products. The commission established a link between this practise and growing MS market share. The commission also investigated MS for tying Windows Media Player to Win2000 (more on that in two weeks!)

EU Commission findings The commission found that Microsoft had violated its dominant position in the PC OS market. Microsoft abused its market power by deliberately restricting interoperability between Windows PCs and non- Microsoft work group servers. This illegal conduct allowed Microsoft to acquire a dominant position in the market for work group server OS and risked eliminating competition in that market. This acted as a brake on innovation and harmed competition and consumers, leading to less choice and higher prices.

EU Commission penalties & remedies The Commission imposed a fine of € million. As regards interoperability, Microsoft is required, within 120 days, to disclose complete and accurate interface documentation which would allow non-Microsoft work group servers to achieve full interoperability with Windows PCs and servers. This will enable rival vendors to develop products that can compete on a level playing field in the work group server operating system market. The disclosed information will have to be updated each time Microsoft brings to the market new versions of its relevant products. To the extent that any of this interface information might be protected by intellectual property in the European Economic Area, Microsoft would be entitled to reasonable remuneration.