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Market, Games and StrategyWeek 1 – Competition and Market StructuresIntroduction and Perfect Competition “Competition arises when firms fights for customers by offering them a better deal in terms of price, quality, range, reliability or associated services” – Lyons (2009)  Some firms may be force...

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Market, Games and Strategy Week 1 – Competition and Market Structures Introduction and Perfect Competition    

“Competition arises when firms fights for customers by offering them a better deal in terms of price, quality, range, reliability or associated services” – Lyons (2009) Some firms may be forced out of market if uncompetitive i.e., not offering the best in the eyes of consumers, or not selling at efficient levels/prices etc. Other firms may get high profits due to successful strategy Perfect Competition; - Competition between many firms - No barriers to entry/exit - Firms sell products price = marginal costs - Total welfare is maximised, i.e., allocative efficiency

Monopoly and Market Power 

A monopolist is able to set price above MC due to being the one dominant firm in the market, i.e., no competition; - Will want to profit maximise - Total welfare is not maximised therefore, deadweight welfare loss results, allocative inefficiency - May also lead to productive inefficiencies etc. due to monopolist complacency - In the graph below CS = ½*(V – V+C/2)*(V-C)/2, = 2*(2V – (V+C))/2*(-C_/2, = ½*(V-C)^2/2*(VC)/2, = (V-C)^2/8 - Profit = (V-C)^2/4 (simplified) - DWL = (V-C)^2/8, the same as CS in this case

 Market Power = the ability to raise prices above MC, i.e., they set the price, not the consumer  Between Perfect Competition and Monopoly, you have Imperfect Competition structures (which are very common), which includes Oligopoly

 Market Power is related to the number of firms in the market, but there are other factors too  A firm has a dominant position if it has the ability to behave independently of its competitors, customers, suppliers and ultimately the consumer, e.g., Google. It isn’t a monopoly, but it has significant power

 Government Intervention; - When competition is not possible e.g., because the market is a natural monopoly, regulation will be required, e.g., rail, telecoms

- When there is the potential for competition, competition policy is required Competition Policy  

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“The set of policies and laws which ensure that competition in the marketplace is not restricted in a way that is detrimental to society” – Motta (2004) EC and UK-CMA (Competition Act 1998); - Agreements (vertical and horizontal) - Abuse of dominance - Merger control - These laws are still broadly based on EU law following Brexit Described as a “referee” for free markets (Lyons 2009) so there is no foul play in offering the best deals for customers Policies include; - Preventing of cartel behaviour such as price fixing - Prevent abuse of dominant position - Regulating M&As to prevent loss of competition Market Investigations – distinctive UK policy; - Identify ways of fixing markets that aren’t working well, not just where there is illegal behaviour - Examples include BAA airports in 2009 Arguments that favour focus on CS in competition policy; - Gives consumers a voice - Balances lobbying power - In merger cases, it counteracts the information advantages of the merging parties - Simple test to use, effect on prices Arguments against solely focusing on CS; - Some consumers may have stake in business through investments - Maximisation of CS would result in P=MC, however due to presence of FC, the firms could make losses and would exit the market, reducing competition - Profits offer incentive to invest and stay in market Other factors include public policy, such as social, political, and environmental factors, or trade policies etc. “Economic effects” based approach, where the approach to business practises depends upon the impact on welfare

Week 2 – Market Definition SSNIP Test  

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Introduced by US DOJ in 1980s – stands for Small but Significant Non-transitory Increase in Prices, also known as Hypothetical Monopolist test Consider a hypothetical monopolist is the only seller of bananas; - Would it be profitable for this hypothetical monopolist to permanently raise prices 5-10% above the current level? - If YES, then there are no other close enough substitutes for bananas for the hypothetical monopolist to lose much demand when it raises price. Therefore, bananas should be considered a separate market - If NO, then it is because demand would be lost to a competitor, such as Kiwi fruits, thus bananas should not be considered a separate market - In stage two of the SSNIP test, you consider a hypothetical monopolist of banana + kiwi fruit sellers, and ask would it be profitable to raise prices 5-10% again - Perhaps now the answer would be yes because the other substitutes do not impose a significant restraint, and the product market definition would be bananas and kiwi fruit - However, if the answer is again no, then the test would continue with other substitutes added to the hypothetical monopolist e.g., apples, pears, chocolate until the hypothetical monopolist finds a 5-10% price increase profitable SSNIP can also be used to define the geographic market – e.g., would a hypothetical monopolist in Birmingham be able to raise prices, or would it lose sales to rivals in say Coventry or Wolves. Would one in the UK lose to competition overseas? In both product/geographic market tests; - Start with the narrowest product/geographic market - Is it profitable for the hypothetical monopolist to increase price? - If yes, you stop the test. If no, expand the market to include at least one good substitute and test again Substitutability – market definition considers two types; - Demand-side i.e., consumers switching - Supply-side, i.e., produces that are currently selling a different product, but may switch to say bananas due to the higher market price for them. This can widen the relevant market if they switch quickly Market definition can be critical as each banana seller’s market share will depend heavily on the market definition used; - Say if you consider whole foods as being in its own market and not the same as say Walmart, Tesco etc., then it would imply they have a huge market share. The results would be very different if you put them alongside Walmart and Tesco, who are much larger - Competition authorities view on a merger may crucially depend upon the market definition used

Cellophane Fallacy 

Problem with SSNIP test in non-merger cases; - Consider an abuse of dominance case - Say Chelsea are charging a price that’s too high for tickets, first you’d ask is Chelsea FC dominant? Is the market wide or narrow? - What products are substitutes for tickets to watch Chelsea play football? There are other teams you could go watch, but what if you support Chelsea and don’t want that? Cinema? TV?

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Would it be profitable for Chelsea to raise ticket prices 5-10% above the current level? If people switch to Cinema or TV, are you saying that these things are in the same market as Chelsea tickets? - The test would suggest so, but this doesn’t make sense - If Chelsea already charge very high prices, then this may suggest they already have a dominant/monopoly decision – if Chelsea were charging prices at P=MC then cinema tickets wouldn’t be considered a close substitute This problem is known as cellophane fallacy; - Du Pont case, involving a firm selling cellophane - Evidence of high cross-price elasticity between cellophane and other flexible wrapping materials, i.e., a rise in cellophane price leads to a rise in demand for other wrapping materials - US Supreme Court therefore defined the market as for all wrapping materials - However, this was criticised and argued that high XED was due to du Pont’s high market power; there was evidence that consumers were considering inferior substitutes because du Pont was pricing so high - In non-merger cases therefore, conducting the test at the current price level may lead to too wide a market definition and understates existing market power

Week 3 – Oligopoly & Cournot Competition Models of Oligopoly  

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Interdependence – each firm in oligopoly has to take account of the others, will be affected by rivals’ decisions (such as pricing) and vice versa (Game Theory) Two original models from 1838 and 1883; - Cournot model – firms decide output - Bertrand model – firms pick prices One-shot non-cooperative equilibrium; - Firms maximise their own profit assuming rivals will behave in the same way - Firms make their decisions as if they’re only playing the game once - The resulting equilibrium may then be repeated period after period

Cournot Model 

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Key assumptions; - Produce homogenous products - Have identical and constant AC and MC (no fixed costs) - Perfectly informed about the market, and so are its rivals - Simultaneously choose outputs Cournot Equilibrium; - Nash equilibrium – all firms are producing best replies, holding their rivals’ output fixed, no firm would want to change their output. E.g., in a market with two firms, each producing an output of 10 is at Nash equilibrium if firm 2 produces 10 and firm 1’s best response is to produce 10 as well - Consider a market with the demand function p = v-q, and q – q1+q2, with cC2 – firm 1 won’t sell below C1 in order to avoid a loss while firm 2 can price slightly below C1 and thus steal the market – the equilibrium comes to P2 being slightly below C1 but above C2 – firm 2 ends up being the single seller and makes a profit Product differentiation – can be vertical i.e., if all products are priced equally consumers agree that one product is better than the other, e.g., iPhone 13 vs 11. Horizontal has no universally accepted ranking such as Coca-Cola vs Pepsi. There can be experimental evidence such as blind tests – even split between Coke and Pepsi, however when told what they were drinking, majority preferred Coke. MRI scans showed brain activity associated with deep thinking – showing the impact of influence and advertising. With product differentiation therefore, even if P2>P1, firm 2 will still have some demand due to consumer preference – setting a lower price will steal some but not all of the market demand. In equilibrium, P>C. if the products are so distinct, then they may become independent of each other

Capacity Constraint; - Without constraint a firm can serve the whole market when undercutting rivals - However, with constraints then a firm may not be able to do this - Capacity choice + Price competition = quantity competition i.e., Cournot competition Search cost/Switching cost; - When there are search costs/switching costs then a firm may not be able to attract a lot of consumers by undercutting rivals - Diamond Paradox – no search cost = competitive price, positive search cost = monopoly price

Bertrand vs Cournot

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Suppose firms make output/capacity decisions as well as prices; - If it is more difficult to adjust the output/capacity, then there is Cournot competition - if output is a SR decision with respect to price and it is more difficult to adjust price, then there is Bertrand competition

Week 5 – Tacit collusion and Cartels What is Collusion?  

For economics – market outcome – high prices Two alternative forms; - Tacit collusion (mutual understanding that higher prices benefit all firms) – not illegal - Cartel – communication between firms with agreement to fix prices, share markets etc. – illegal

Theory of Collusion 

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Economic theory shows when collusions should occur, however not when it will occur; - Shows mechanism and conditions but this doesn’t mean firms will actually choose to - Doesn’t distinguish between tacit and cartel When could collusion occur; - Requires mutual understanding (repeating the one-shot equilibrium every period always remains a possibility) - Repeated interaction, trust Infinity repeated game; - Bertrand competition between 2 identical firms - Homogenous products - No capacity constraints - Constant MC of production equals c and no FC - Consumers perfectly informed - Bertrand paradox if this game is repeated only once In this game, firms would like to collude on higher price, e.g., monopoly price p>c; - Assume at equal prices demand is split 50/50 between firms - Therefore, colluding results in per period profits of monopoly profit/2 - However, if one firm cheats and sets its price marginally below the monopoly price, then it steals the entire market demand makes a profit similar to that of monopoly level Punishment – if a rival cheated on the agreement, then the firm could switch to one-shot Nash equilibrium forever and both firms lose profit Cheating results in a one-off increase in profits, followed by a loss from punishment forever more – it all depends how patient firms are Punishment strategy seems harsh as deviations could be made by mistake – an alternative strategy is tit-for-tat where you start by co-operating and then copy your rival’s strategy in the previous period

Cartels  

Usually last between 3-7 years but length differs depending on study Overcharges tend to be 10-20% but can be higher/lower

Week 6 – Tacit Collusion and Cartels

Factors affecting the likelihood of collusion 

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Three crucial factors; - Number of firms - Asymmetry between them - Market transparency Number of firms; - If as before, at equal prices firms split the demand equally then collusion results in per period profits of Profit/Number - However, if one deviates and sets its price marginally below the others then it steals the entire market demand and gets an immediate profit - But punishment leads to 0 profit later, as before One-off temptation to cheat – if two firms, then the incentive is half of all profit. If it is 3, then the incentive is 66% of total market profit – so the incentive to cheat gets larger, and so on The loss from punishment also goes down as the number of firms increases, therefore collusion becomes harder to sustain Symmetry; - We have assumed that firms shared the market equally, however this may not be the case - The smaller firm may have a greater incentive to cheat and take the larger firms market share - Loss from punishment is the same for both i.e., profit = 0, however the loss for the larger firm would be larger than the smaller firm due to their larger existing market share - Collusion is thus harder the more asymmetric firms are Transparency; - Last week we considered that if a firm made 0 profit, then it would know for sure its rival had cheated - In Bertrand Model, if a firm sells nothing, it knows the other has cheated and will start punishment - Now suppose there is a probability that industry demand is zero each period… - Assume firms observe only their own sales – monitoring is now imperfect – if I sell nothing either industry demand is zero, or a rival has cheated but you don’t know - Deviations become harder to detect and thus collusion becomes more difficult again - Collusion must at least temporarily breakdown when industry demand is low, otherwise deviations would go unpunished Coordination; - Firms need to know what they are colluding on – earlier models assume common knowledge was collusion on pmon - However, collusion on other prices will also be sustainable - Pmon could be a focal point - The coordination problem may be difficult under tacit collusion as communication could lead it being deemed a cartel

Fighting against Cartels 

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Penalties include; - Substantial fines, EC up to 10% of global turnover across all operations - Damages to 3rd parties - Jail sentences in UK & US Leniency programmes were introduced however in UK in 1978 and EC in 1996; - Complete immunity from fines given to first firm to report a cartel

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Example is Virgin and BA price fixing in 2000s – reported by Virgin, surcharges increased from £5 to £60 – Virgin got no punishment, but BA got fined £58.5m in the end and 4 employees almost went to jail Lysine cartel in 1990s – Mark Whitacre of ADM informed the FBI about it and then secretly filmed the meetings held by executives from companies involved The immunity provides a big incentive for firms to inform on their rivals in the cartel

Combating tacit collusion 

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Why is it not illegal to begin with; - Extremely difficult to prove prices are “too high” - Increased legal certainty – requires evidence of communication, parallel prices aren’t sufficient evidence Ways of combatting tacit collusion; - Dawn raids used to uncover hard evidence e.g., meeting minutes, emails - Try to prevent market conditions from arising - Merger policy

Week 7 – Horizontal Mergers – Unilateral Effects Unilateral effects under Cournot Competition    

Arise when firms are adopting individual profit maximising behaviour A post-merger increase in prices may result from moving to a new one-shot equilibrium – there is no need for the game to be repeated Possibility of unilateral effects depend on the nature of competition – e.g., Cournot or Bertrand Under Cournot Competition; - Consider competition between 3 identical firms - If two firms merge, they must jointly decide how much output to produce between them - To consider the effect this has on market outcomes we need to compare an equilibrium with 3 firms to one with 2 - Assuming that firms’ costs remain the same post-merger, we have seen earlier that the price under Cournot competition rises as the number of firms falls

 Cournot competition?

So, is the merger profitable under

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The profit difference comes to less than 0, so even if prices rise after the merger, the merger is not profitable when 3 firms become 2 – this is known as the merger paradox in Cournot competition This is because the merging parties reduce output below their combined earlier pre-merger level, however the outsider not involved in the merger can free ride on this and increase its own output The total output is lower than pre-merger, so the price increases, however the outsider is producing more and selling it at the new higher price, so it gains the most while the merging parties’ profits are lower as the price increase doesn’t compensate for the reduction in output If two firms become one, then there is no outsider and thus the merging firms’ profits increase – they become a monopoly anyway which is the most profitable scenario

Unilateral effects under Bertrand Competition   

Likewise, under the Bertrand Paradox only merger to monopoly may be profitable; - N>2 firms post-merger -> price = c However, when there is product differentiation, a merger will allow firms to raise prices to some extent Consider competition between fast food restaurants that supply differentiated products; - One-shot Nash equilibrium results in pi>c as all firms are producing best replies, holding their rivals’ prices fixed - If McDonald’s increases its price above pi, then BK and KFC would benefit from increased sales – there is an externality - Now consider McDonald’s and KFC decide to merge – decisions are made to maximise their joint profits - If McDonald’s again increases its price, some consumers will still switch to KFC and Burger King – however you wont care about people switching to KFC as they are still part of your company now. The merged party internalises part of the externality - There is therefore more incentive to increase prices for McDonald’s and KFC - The outsider, Burger King, may also have an incentive to increase prices as McDonald’s/KFC have – free ride again - Overall, prices increase, the merger is profitable, and consumer welfare falls

When are unilateral effects larger?   

If McDonald’s increases price on its own, many more may switch to Burger King than KFC if Burger King is considered a closer substitute If McDonald’s and BK merged therefore i...