TOPIC 10:COMPETITIVE CONSTRAINT AND MARKET POWER Topic 10| Part 224 September 2013 Date ANTITRUST ECONOMICS 2013 David S. Evans University of Chicago, Global Economics Group Elisa Mariscal CIDE, Global Economics Group

2 Overview Part 1 Market Power Background Market Power and the Demand Side Market Power and the Supply Side Part 2 Role and Definition of Market Power Market Power Measurement Multi-Sided Platforms and Market Power

The Role and Definition of Market Power 3

4 Dominance and Market Power According to the Commission and the Courts “ Dominance has been defined under EC law as a position of economic strength enjoyed by an undertaking, which enables it to prevent effective competition from being maintained on a relevant market, by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of consumers.” “Guidance on the Commission’s Enforcement Priorities in Applying Article 82 EC Treaty” relying on ECJ in United Brands and Hoffman La Roche “… undertaking’s decisions are largely insensitive to the actions and reactions of competitors, customers and ultimately, consumers” Id. In modern practice before the Commission, dominance and market power are used interchangeably.

5 Monopoly and Market Power in the US “Market power is the ability of a firm or group of firms within a market to profitably charge prices above the competitive level for a sustained period of time.” US DOJ Merger guidelines and various US court decisions. The antitrust authorities and courts require that the excess over the competitive level be “substantial” or “significant” for there to be market power in the antitrust sense of the phrase. The antitrust authorities and courts also require that the ability to sustain price over the competitive level be more than temporary. In the US the terms “market power” and “monopoly power” are often used interchangeably.

6 Economic Definitions of Market Power Antitrust economists also typically view market power as the ability to raise price significantly above the competitive level for a sustained period of time. The competitive level is the price that would enable firms to earn a long-run risk adjusted competitive return on the capital invested in the business. Whether price is above the competitive level could be inferred from whether the risk-adjusted return is greater than the competitive level; there many are difficulties in calculating this. The competitive level is often approximated in practice by marginal (or incremental) cost because economic theory says that price equals marginal cost in perfectly competitive equilibrium. However, we know in theory and in fact that p=MC is often not the competitive equilibrium and p>MC is common in theory and fact.

Market Power Measurement 7

8 Market Share for the Market Power Thermometer Market power for a firm is often based on its share of sales in the relevant market Various numbers have been tossed out for what share demonstrates market power—from as low as 40% in the EC to 60% or more in the US roughly speaking. But as a matter of economics there is no “thermometer” or “benchmark” for market power in practice that can be used across all industries. No 98.6 o rule!

9 Market Shares as Measures of Market Power Cournot model with homogenous goods finds positive relationship between concentration and markup. (P – MCavg)/P = HHI/ , where P is the market price, MCavg is the weighted average marginal cost, and  is the market demand elasticity. Price-cost markup for industry equals HHI divided by demand elasticity and is therefore higher in more concentrated industries (P – MCi)/P = Si/  for firm i with share of total market of Si Markup is higher for firms with larger shares That result is not general though, since is requires homogenous products that are uncommon in practice and Cournot competition. There is no systematic economic theory or evidence showing a close relationship between market share and market power.

10 P>MC May Not Imply Significant Market Power A firm with fixed costs has to earn a large enough profit to offset its fixed cost (see examples from previous lecture). In a simple model where C=F+cQ the price-cost margin must be greater than the ratio of fixed cost to sales (F/pQ) for the firm to make a profit. Suppose fixed costs are 20% of revenue. Then the price-cost margin must be at least 20% and the firm must face a demand curve with an elasticity of less than 5 to operate profitably. Suppose fixed costs are 50% of revenue which could be the case for IP-related products like music and software. Then the price-cost margin must be at least 50% and the firm must face a demand curve with an elasticity of less than 2 to operate profitably.

11 The Impact of Investment and Risk Suppose firms in an industry must make significant investments and incur risk. They must expect a profit in excess of what they would get with marginal cost pricing to compensate for those risky investments. Entry into the industry will take place only up to the point where the price-cost margin for the firm is high enough to compensate for risks and capital investment. The analysis is similar to that of fixed cost. The larger the necessary risk premium the larger the price-cost margin and the smaller the elasticity of demand in a “competitive equilibrium”.

12 Difficulties in Using Profits to Assess Market Power Requires accurate measurement of incremental cost which may be hard to obtain from company data Need to assess which costs are fixed or variable and over what time period Operating margin (price-cost markup) Well-known biases in accounting profits resulting from R&D, advertising, and accounting conventions Difficult to measure risk ex post—everything looks easy after the fact! Risk-adjusted rate of return can be a measure of economic profits

13 Multiple Sources of Evidence are Best for Market Power assessment Demand substitution Supply substitution Entry barriers, and other factors General assessment of competitive constraints Price-cost margins Risk-adjusted rate of return But use with considerable care Direct measures of market power Best using alternative, plausible market definitions More useful for helping to understand competitive structure of industry, not useful for making firm statements on market power. Market shares Should have more confidence in a finding of market power—or lack of market power—when multiple sources of imperfect evidence point in the same direction.

Multi-Sided Platforms and Market Power 14

15 Special Issues for Multi-Sided Platforms Competition forces overall prices down Competitive equilibrium will ordinarily result in price exceeding marginal cost on one side Market power reflects the ability of a platform to elevate overall prices for various sides Substitution on one side has effect on the other side through demand interdependencies Possibility of both platform and non-platform substitutes Demand substitution takes place on both sides Critical mass and entry Platform competition Supply side must address special issues Maybe price is held constant on one side and issue is whether price could be elevated to the other side Ordinarily with strong demand interdependencies there are still cross effects that need to be considered Market power on one side might be of interest in special case

16 A One-Sided Perspective on Market Power Side A Before price increase Side A After price increase Price$8$9 Marginal Cost$4 Margin$4$5 Output500 Revenue$4,000$4,500 Operating Cost$2,000 Markup50%56% Is this an exercise of market power? Have consumers been harmed? Firm has 50% price-cost markup and it increases price by 13%. Significant increase in price by a firm with a high mark up. Looks like a firm with significant market power has exercised it and gotten more.

17 A Two-Sided Perspective on Market Power-Ex.1 Before Price IncreaseAfter Price Increase Side ASide BTotalSide ASide BTotal Price$8$2$10Price$9$1$10 Marginal Cost$4 $8Marginal Cost$4 $8 Margin$4($2)$2Margin$5($3)$2 Output500 Output500 Revenue$4,000$1,000$5,000Revenue$4,500$500$5,000 Cost$2,000 $4,000Cost$2,000 $4,000 Operating Margin$1,000Operating Margin$1,000 Markup50%-100%20%Markup56%-300%20% Fixed Cost$1,000Fixed Cost$1,000 Total Profit$0Total Profit$0 Firm increases price by 13% to Side A and decreases price by 50% to Side B with no change in total price or profits. Example assumes change in pricing structure doesn’t alter output. This example could arise if some exogenous event like the appearance of a competitor changes the relative demand elasticities of the two sides. How output, welfare, etc. change in actual practice would depend on what caused the change in the pricing structure and the precise demand interdependencies. Platform has an markup of 20% which is common and although Side A consumers paid more, Side B consumers paid less and overall price didn’t change nor did profits increase.

18 A Two-Sided Perspective on Market Power-Ex.2 Firm increases price by 13% to Side A and decreases price by 50% to Side B but with higher output and profit. Before Price IncreaseAfter Price Increase Side ASide BTotalSide ASide BTotal Price$8$2$10Price$9$1$10 Marginal Cost$4 $8 Marginal Cost $4 $8 Margin$4($2)$2Margin$5($3)$2 Output500 Output550 Revenue$4,000$1,000$5,000Revenue$4,950$550$5,500 Cost$2,000 $4,000Cost$2,200 $4,400 Operating Margin $1,000Operating Margin$1,100 Markup50%-100%20%Markup56%-300%20% Fixed Cost$1,000Fixed Cost$1,000 Total Profit$0Total Profit$100 Example assumes change in pricing structure increases output. This example could arise if the firm realized its pricing structure was not optimizing the value of the network. In this case the change in the pricing structure increases output on both sides and therefore increases welfare. Even though consumers on Side A are paying more they buy more because of value of interacting with more members on Side B. Platform also earns more profit.

19 Price-Cost Comparisons for Two-Sided Platforms The service received by both sides is a transaction Each side is paying a price for the same “transaction ” Straightforward when “units” are the same for both sides. Consider a platform that provides “transactions” of some sort such as payments. Total price is price paid by each side for the transaction Total incremental cost is cost of providing that transaction to both sides Price-cost margin is total price minus total incremental cost Unit is different (e.g. advertising and content use) Prices therefore can’t be added up (apples and oranges) Costs refer to the provision of different services Could still do revenue-weighted averages More complicated when

20 1-Sided Price-Cost Markup Formula Wrong for 2- Sided Platforms Price-Cost Margin is derived from profit-maximization conditions. Very different conditions for two-sided versus one sided models. This chart shows conditions for three leading two-sided models and then the standard result.

21 Analyzing Market Power for Platforms Market power is the ability to raise “total price”—reflecting a combination of the prices to the separate sides-- significantly above competitive level. Question is whether competitive constraints by other platforms or in some cases single-sided firms are sufficient to limit supracompetitive prices. Prices on either side by themselves can’t say anything about market power. Looking at subsidy side leads to false negatives of no market power while looking at money side leads to false positives of market power.

22 End of Part 2, Next Class Topic 11: Market Definition Part 1 Overview of Market Definition General Principles of Market Definition Hypothetical Monopolist Test Critical Loss Analysis Part 2 Overview of Issues in multisided platforms The Case of Additive Prices Newspaper Markets One-Sided Biases