1. Frank Cowell: Market Power & Misrepresentation MARKET POWER AND MISREPRESENTATION MICROECONOMICS Principles and Analysis Frank Cowell July 2015 1 Note: the detail in slides marked “ * ” can only be seen if you run the slideshow

2. Frank Cowell: Market Power & Misrepresentation Introduction  Presentation concerns trading behaviour  Context is an exchange economy usual focus is on simple price-taking but we will examine non-competitive behaviour  Use a standard modelling framework  Endow traders with different degrees of power captured in the trading rules  Extend this to a simple model of manipulation and design  Begin with a simple analysis of nonlinear prices July 2015 2

3. Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Nonlinear price systems July 2015 3

4. Frank Cowell: Market Power & Misrepresentation The setting  Consider an exchange economy  Suppose one agent has extended monopoly power  Can charge a fee for the right to access good 1 this can only work for goods where resale is difficult otherwise consumers can undermine the fee by bulk-buying and selling on the commodity to others sometimes public utilities fit this paradigm  Assume that any other trader acts as a price taker  Analyse this within the context of the Edgeworth box July 2015 4

5. Frank Cowell: Market Power & Misrepresentation The model  Two goods (1,2) and two traders (Alf, Bill)  Given resource distribution endowments of two goods are such that Bill owns all good 1 Alf: [R 1 a, R 2 a ] = [0, R 2 a ] Bill: [R 1 b, R 2 b ] = [R 1, R 2 b ] R 2 : = R 2 a + R 2 b  Trading outcomes described by allocation vector of consumptions Alf: [x 1 a, x 2 a ] Bill: [x 1 b, x 2 b ]  Use good 2 as numéraire price of good 1 is p := p 1 /p 2  Assume materials balance condition satisfied with equality x 1 a + x 1 b = R 1 x 2 a + x 2 b = R 2 permits use of the Edgeworth box diagram July 2015 5

6. Frank Cowell: Market Power & Misrepresentation Market power  Suppose Bill has the power to set the price p and the entry fee F  Then Bill can fix a budget constraint for Alf anywhere in the diagram subject to one important condition this has to do with the trading rules see below  Bill’s control over the budget constraint: p fixes the slope; F fixes the position  In effect Bill has the power to set a non-linear price system the pair (p, F) examine how this works: July 2015 6

7. Frank Cowell: Market Power & Misrepresentation x1x1 a x2x2 b x1x1 b x2x2 a 0a0a The “two-part” tariff  The endowment point  Price per unit F  Fixed charge p [R] July 2015 7 0b0b

8. Frank Cowell: Market Power & Misrepresentation x1x1 a x2x2 b x1x1 b x2x2 a 0a0a *Changing the budget constraint  Varying F  Varying p [R] July 2015 8 0b0b

9. Frank Cowell: Market Power & Misrepresentation Key condition  Bill nearly has total control over Alf  However, one thing remains in Alf’s power: Alf does not have to consume good 1 can just consume his endowment [R 1 a, R 2 a ]  This condition effectively constrains Bill’s action  Draw Alf’s indifference curve through the endowment point Alf’s reservation indifference curve cannot be forced to trade at an allocation with lower level of utility  This is the boundary of Bill’s attainable set  Begin with case where Bill considers goods perfect substitutes July 2015 9

10. Frank Cowell: Market Power & Misrepresentation Exploitation solution  a ’s indifference curves  Endowment point  b ’s constraint set  b ’s indifference curves  The solution  Entry fee and price F p  a’ s reservation indiff curve x1x1 a x2x2 b x1x1 b x2x2 a 0a0a [R] [x a ] July 2015 10 0b0b

11. Frank Cowell: Market Power & Misrepresentation Solution works in general case F p  Basic model as before  b ’s indifference curves  Solution as before x1x1 b x1x1 a x2x2 a x2x2 b 0a0a [R] [x a ] July 2015 11 0b0b

12. Frank Cowell: Market Power & Misrepresentation Full market power: the result  Bill has maximal power in market for good 1 can use a nonlinear pricing scheme sets price ratio and entry fee to market for good 1  Outcome is full exploitation trading partner is forced to reserve indifference curve solution allocation [x a ] is on indifference curve through [R]  But it is efficient at [x a ] MRS is is the same for both traders… … so it is on the contract curve  Solution applies for general form of Bill’s preferences July 2015 12

13. Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Power play in the Edgeworth box July 2015 13

14. Frank Cowell: Market Power & Misrepresentation Using the idea of market power  We’ve characterised market power in a simplified case Bill a had built-in monopolistic advantage also endowed with complete market power  Now use this model apply this to a number of trading stories again in a simplified world  Address some key questions How related to competitive outcomes? Under what circumstances will we get an efficient outcome? July 2015 14

15. Frank Cowell: Market Power & Misrepresentation Trading: alternative stories  A case with simplified property distribution Bill has all of commodity 1 Alf has all of commodity 2  Review the standard equilibrium concepts the core competitive equilibrium  Examine two polar cases 1. Bill has complete market power (can choose point in A’s acceptance set) 2. Alf has complete market power  Then consider limited market power Alf can act as a simple monopolist July 2015 15

16. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p* Trading and competition  a ’s indifference curves  b ’s indifference curves  The contract curve  Endowment point  Trades acceptable to a & b  The core  CE and prices [x*] July 2015 16

17. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] [x*] [x a ] Bill has total market power  Competitive equilibrium  b ’s opportunity set given market power  b’ s optimal allocation  A nonlinear schedule to implement it July 2015 17

18. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 a x2x2 b [x*] [xb] [xb] Alf has total market power  a ’s opportunity set given market power  a’ s optimal allocation  A nonlinear schedule to implement it x1x1 b x2x2 a [R] July 2015 18

19. Frank Cowell: Market Power & Misrepresentation Simple monopoly  The three stories have a common element characterise three points in the core all stories have efficient outcomes  Now a story with less than complete market power Alf can simply set the price Bill acts as price taker  Rework the diagram first map out Alf’s attainable allocations then characterise optimum conditional on this restricted-power model July 2015 19

20. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] Alf can set prices  b’ s reaction function  Endowment  a tries out alternative prices  a ’s attainable set  b ’s preferences July 2015 20

21. Frank Cowell: Market Power & Misrepresentation p 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] ^ ^ Monopoly trading  Competitive equilibrium  a ’s monopolistic optimum  a’ s total market power solution  a ’s preferences [x] [x b ] [x*]  Efficient allocations (contract curve)  MRS and prices at optimum July 2015 21

22. Frank Cowell: Market Power & Misrepresentation Summary of market power model  Suppose Alf has market power  Gets higher utility than in CE  Gets higher utility if has total market power than as simple monopolist  CE and total market power are efficient  Simple monopoly is inefficient price = Alf’s MRS price ≠ Bill’s MRS July 2015 22

23. Frank Cowell: Market Power & Misrepresentation Overview Market power Exchange and monopoly Misinformation Market Power and Misrepresentation Applying the simple monopoly model July 2015 23

24. Frank Cowell: Market Power & Misrepresentation Misrepresentation  The standard exchange model tells a simple story  But relies on strong informational assumption each trader has full information about the other’s preferences What happens if we drop this?  Use the same model as the market power example take the case where Alf owns good 2 Bill owns good 1  Start from case of perfect information  Then suppose that Alf misrepresents preferences Bill continues to reveals full information July 2015 24

25. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p ^ ^ [x] p* Misrepresentation and distortion  a ’s true ICs  b ’s true ICs  The contract curve  Endowment point & core  CE allocation and prices  a’ s false IC  Induced equilibrium with a’ s misrepresentation [x*] July 2015 25

26. Frank Cowell: Market Power & Misrepresentation Misrepresentation: outcome  The equilibrium has been seen before version with Alf’s misrepresented preferences same that for a simple monopolist  Opportunity to masquerade induces a distortion trader with informational advantage forces price in his favour in this case: price ratio = MRS a ≠ MRS b  Bilateral trading is manipulable by revealing false preferences Alf secures higher utility for himself  What if both can misrepresent? outcome is still likely to be inefficient… July 2015 26

27. Frank Cowell: Market Power & Misrepresentation 0b0b 0a0a x1x1 b x1x1 a x2x2 a x2x2 b [R] p ^ p* Misrepresentation and distortion (2)  True indifference curves  The contract curve & core  CE allocation and prices  a ’s false ICs  Outcome if a misrepresents [x*] ^ [x]  b’ s false IC  Outcome if both misrepresent ~ [x] July 2015 27

28. Frank Cowell: Market Power & Misrepresentation Application  Consider a model of international trade Alfaland exports good 2 Billestan exports good 1  Price ratio is terms of trade suppose one country can impose a tariff get inefficient (monopoly) outcome suppose other country retaliates with its own tariff outcome may still be inefficient  Same outcomes could arise if each country can misrepresent preferences of its citizens  Could design an efficient outcome if use nonlinear prices Alfaland demands payment F for access to market for good 2 or vice versa for Billestan and good 1 July 2015 28