1. TOPIC 10:COMPETITIVE CONSTRAINTS AND MARKET POWER Topic 10| Part 112 September 2013 Date ANTITRUST ECONOMICS 2013 David S. Evans University of Chicago, Global Economics Group Elisa Mariscal CIDE, Global Economics Group

2. 2 Overview Part 1 Competitive Constraints and Market Power 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

3. Competitive Constraints and Market Power 3

4. 4 Definitions of Market Power “ Significant” required because almost all firms have some degree of short- run market power as a result of product differentiation and location. No consensus on what “ significant” means Competitive level often taken as p=MC Ability of a firm to raise prices significantly above the competitive level Market power not always manifested in price Firms compete on many dimensions besides price Ability of a firm to take actions that a competitive firm couldn’t do that significantly harm consumers such as impose contractual restraints, prevent entry, and so forth.

5. 5 Market Power and the Ability to Do Harm The degree to which a firm has market power could tell us the extent to which it is able to engage in practices that harm competition and consumers.

6. 6 Market Power Provides a Screen Firms that pass the screen have enough market power that they could do bad things. They then need a closer look.

7. 7 The Quest for the Market Power Thermometer Courts and authorities would like a “market power thermometer”. If market share or mark-up is “too high” then conclude that there is significant market power say courts. But there is no “thermometer” or “benchmark” for market power in practice that can be used across all industries. No 98.6 o rule!

8. 8 Monopoly, Perfect Competition, and Market Power QCQC QMQM PMPM PCPC Supply = MC Demand MR Q P Monopoly price significantly above competitive levels And significantly above marginal cost Textbook description of competitive industry but need to be careful in using in practice.

9. 9 Definition of Competitive Level But price must be greater than marginal cost if there are fixed costs In fact for long-run equilibrium P>ATC for firms to remain in business in competition Price equal to marginal cost is typically used. The “you know it when you see it” definition leads to debate Provides some flexibility in assessing market power Could also use “prices that would emerge in a competitive industry” to accommodate diversity of industries. This is the “if it looks like a duck, quacks like a duck it must be a duck” definition of monopoly But … not everyone sees the duck … Could also use structural and behavioral proxies to assess the degree of market power.

10. 10 Market Power in Antitrust and Mergers Does the firm have the ability to engage in anticompetitive actions (e.g. a firm couldn’t “force” consumers to take a tied product if it has no power). Has the firm’s actions increased its market power (e.g. will behavior such as exclusive dealing increase monopoly power). Also there is a view that firms with market power shouldn’t be allowed to compete “as hard” as firms without (special obligations). Monopolization and abuse of dominance Will the merger result in the combined firms having significantly more market power than the firms had separately. The merger inquiry does not care much whether either firm had market power to start with. Merger analysis

11. 11 Level Versus Changes in Market Power MergerUnilateral Conduct Level Background information that may affect concern over the change Can the firm impose anticompetitive constraints? Change Will the merger increase market power of merged firms? Do the anticompetitive constraints increase market power and thereby harm consumers? Why we care about market power?

12. 12 Market Power and Competitive Constraints Market power is a measure of the extent to which “competitive constraints” limit the ability of a firm to dictate prices or other competitive conditions An inquiry should make sure that simple approaches to assessing market power don’t obscure consideration of the full spectrum of competitive constraints since that is what market power is supposed to summarize The source of competitive constraints come from demand side and from the supply side.

13. 13 Competitive Constraints Can Limit Market Power DemandSupply Substitutes in demand based on products and geography Product repositioning Consumer switching costsElasticity of supply Two-sided platform constraints resulting from loss of complementary sales/indirect network effects Barriers to entry including scale economies, network effects, regulation Innovation and feature competition

14. Market Power and the Demand Side 14

15. 15 Demand Substitution and Economic Concepts Market power is limited if consumers can turn to alternative products if price exceeds competitive levels. Own-price elasticity of demand which measures the percent change in sales for the company resulting from a 1% change in price. The higher the elasticity the less the ability to raise prices. Cross-elasticity of demand with other products measures the extent to which an increase in price results in substitution to other products. The higher the elasticity the more substitutable the product. Diversion ratio is the portion of lost sales that are diverted to competing product with small increase in price; this is a function of cross-elasticity. Own-price, cross-elasticity, and diversion ratios are all mathematically related and yield same answers

16. 16 “Marginal” not “Average” Consumers Matter Market equilibrium result in prices set where consumers are almost indifferent between buying the subject product over an alternative product If there are many of these marginal consumers then a price increase will result in much lost sales; if there are few of these marginal consumers then a price increase will not result in much lost sales. The average consumer will typically value the subject product more than the marginal consumer and therefore be less likely to switch. But there could still be significant lost sales if there are many marginal consumers. In US Whole Foods acquisition of Wild Oats the question was whether there were many marginal consumers of “premium natural organic supermarkets” who would switch to a regular supermarket if prices increased.

17. 17 Demand-Side Substitution and the Marginal Consumer A,B, C, D are at “the margin” of buying or not buying beer F is an “average consumer” of beer (from O to C) O G is not a consumer of beer at current prices The “average” consumer may not switch to a substitute product in response to a small price increase; the producer needs to worry about what consumers “at the margin” between buying and not buying the product, will do. G DC F B A

18. 18 Price-Cost Margin and Demand Elasticity Elasticity of demand Markup 1.2580.0% 1.5066.7% 1.7557.1% 2.0050.0% 2.5040.0% 3.0033.3% 3.5028.6% 4.0025.0% 5.0020.0% Notes: Elasticity of demand for a profit maximizing firm has to be greater than 1.0 (in absolute value); so demand is relatively more inelastic as it is closer to 1.0 and relative more elastic as it is farther than 1.0 Elasticity of demand for product x (for single-sided firm): Price – Cost mark-up (“Lerner condition” for product x: e x = dq x /q x dp x /p x m x = p x – c x = 1 p x e x

19. 19 Markups and Fixed Costs Fixed costs as a percent of revenue Minimum elasticity of demand Minimum Markup 80.0%1.2580.0% 66.7%1.5066.7% 57.1%1.7557.1% 50.0%2.0050.0% 40.0%2.5040.0% 33.3%3.0033.3% 28.6%3.5028.6% 25.0%4.0025.0% 20.0%5.0020.0% Percent markup must be greater than or equal to fixed costs as a proportion of sales for a firm to cover its costs and make a profit m x ≥ F p x x Example based on constant marginal costs and linear demand.

20. 20 Practical Assessment of Demand Substitution Do customers switch between products? Interchangeability Who do company executives in internal business documents say they compete with? Company records on competitors What do company sales reports say about who they won business from or lost business to (many B2B companies collect records systematically)? Win-loss Reports What do customers say in response to a survey question about which if any product they would switch to if prices increased? Customer surveys What do econometric studies of historical prices and sales imply about cross- elasticities of demand? Statistical estimates Is there a situation where one can compare sales before and after a price increase or between two locations with different prices? Natural experiments

21. 21 Special Factors on Demand-Side Buyer power: Large customers can discipline market power Two-sided platforms Price increase on one side reduces customers available to other side which makes price increase more expensive (more details next week). Price discrimination: is ability to engage in price discrimination evidence of market power? In theory yes, because p>MC; if practice, no because price discrimination common among firms in competitive industries.

22. Market Power and the Supply Side 22

23. 23 Supply Substitution Can new firms get in quickly when prices go up? New Entry Could current rivals expand production easily by switching production lines from other products? Expansion Could current rivals make their products more competitive by adding or changing features? Product repositioning

24. 24 Elasticity of Supply and Competitive Fringe Market demand elasticity Fringe supply elasticity Share of dominant firm Dominant firm demand elasticity Markup 3.000.2540%7.8812.7% 3.000.5040%8.2512.1% 3.000.7540%8.6311.6% 3.000.2560%5.1719.4% 3.000.5060%5.3318.8% 3.000.7560%5.5018.2% 3.000.2580%3.8126.2% 3.000.5080%3.8825.8% 3.000.7580%3.9425.4% where: S x is the share of the dominant firm, e f is the elasticity of demand of the fringe, and, e M is the elasticity of demand of the market e x = e M + (1 – s x )e f s x

25. 25 Barriers to Entry Debate Any advantage existing firms have that enable them to raise price above short-run competitive level. Corresponds to what many competition authorities and courts use Bain Costs that new firms bear that existing firms don’t Helps to emphasize that firms must incur investments to enter and expand and realize a return from that. Not really a barrier if entrant must incur these same investments. Stigler

26. 26 Bain-Type Barriers to Entry Can additional firms fit into the market? Scale economies Chicken and egg problems/critical mass; Demand-side scale economies that may limit number of efficient firms Network effects Discourages entrants because of high risk incumbent will lower prices and firm will lose sunk costs Sunk costs Can consumers readily switch? Switching costs Incumbents may have significant brand assets Advertising/brand value Patents, copyrights, trademarks, business secrets that limit entry Intellectual property Access to unique facilities or sources of supply; locational advantages Special assets Licenses, regulatory approvals; regulation-induced fixed costs Legal/regulatory barriers

27. 27 Dynamic Competition Threat of entry encourages firms to innovate and keep prices low Limit pricing models have firms keeping prices just low enough to deter entry More sophisticated theories of dynamic competition focus on innovation rather than pricing

28. 28 End of Part 1, next week Part 2 Part 1 Competitive Constraints and Market Power 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