Competition Policy--Theory and Practice

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Contents

PrefaceWhat competition policy is, and why we need it xCompetition policy and regulation xObjective of this book, and how to use it xi

1 Competition Policy: History, Objectives and the Law 11.1 Introduction 11.2 Brief history of competition policy 1

1.2.1 Anti-trust law in the United States 1The events leading to the Sherman Act 1The Sherman Act and its early enforcement 3The Clayton Act and the Federal Trade Commission Act 3The inter-war period 4Until the mid-70s: the activism in anti-trust case law 5From Sylvania onwards: Chicago School and the Reagan years 5Recent events 6

1.2.2 Competition laws in the European Union 61.2.2.1 Competition law in Germany 61.2.2.2 Competition law in the United Kingdom 71.2.2.3 Competition law in the European Communities 8

1.3 Objectives of competition policy, and other public policies 111.3.1 Objectives of competition policy 12

1.3.1.1 Welfare (total surplus) 121.3.1.2 Consumer welfare (consumer surplus) 13

Consumer v. total welfare standard in different jurisdictions 13Consumer v. total welfare standard for economists 13

1.3.1.3 Defence of smaller firms 151.3.1.4 Promoting market integration 151.3.1.5 Economic freedom 161.3.1.6 Fighting inflation 161.3.1.7 Fairness and equity 16

1.3.2 Other public policy factors affecting competition 181.3.2.1 Social reasons 181.3.2.2 Political reasons 181.3.2.3 Environmental reasons 191.3.2.4 Strategic reasons: industrial and trade policies 19

1.3.3 Competition policy: a definition 201.4 The main features of European Competition Law 21

1.4.1 Article 81: horizontal and vertical agreements 211.4.2 Article 82: abuse of a dominant position 23

Dominance 23Abuse of dominance 24

1.4.3 Mergers 241.5 Exercises 26

2 Market Power and Welfare: Introduction 272.1 Overview of the chapter 272.2 Allocative efficiency 28


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2.2.1 Market power: A definition 282.2.2 The allocative inefficiency of a monopoly 29

A simple graphical analysis 29The determinants of the deadweight loss 29

2.2.3 Rent-seeking activities 302.3 Productive efficiency 31

2.3.1 Additional welfare loss from productive inefficiency 31

2.3.2 Why is a monopolist less efficient? 312.3.2.1 Monopoly and managerial slack 322.3.2.2 Empirical evidence on individual firms' productivity 32

Competition and efficiency: Schmidt's model* 332.3.2.3 A Darwinian mechanism: competition selects efficient firms 33

2.3.3 Number of firms and welfare 352.3.4 Conclusions 352.3.5 Competition and productive efficiency* 35

2.3.5.1 Competition and selection of firms: An example* 352.3.5.2 Too many firms in the industry* 37

2.4 Dynamic efficiency 38

2.4.1 The lower incentives to innovate of a monopolist 382.4.2 Incentives to invest in R&D 392.4.3 Models of competition and innovation* 40

2.4.3.1 Monopoly gives fewer incentives to innovate: an example* 40Monopoly 40Comparison between monopoly and duopoly 41

2.4.3.2 R&D and competition** 412.4.3.3 Appropriability and R&D* 43

Duopoly under price competition 43Patent (no spillovers) 44Conclusions 44

2.5 Public policies and incentives to innovate 442.5.1 Ex-ante v. ex-post: property rights protection 452.5.2 Essential facilities 462.5.3 Price controls and structural remedies 482.5.4 Internal vs. external growth 49

2.6 Monopoly: will the market fix it all? 492.6.1 Durable good monopolist 49

Some instruments solve (or alleviate) the commitment problem 50Conclusions 51

2.6.2 Contestable markets 512.6.3 Monopoly and free entry 53

Monopolies might exist under free entry 53Persistence of concentration when (endogenous) sunk costs exists 532.6.3.1 Concentration under free entry* 53

A simple example* 53Finiteness property in vertical differentiation models* 54

2.6.3.2 Switching costs 55The competitiveness of switching cost markets 56Conclusions 57

2.6.3.3 Network effects 572.6.3.4 A model of (physical) networks* 60


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Two types of equilibria 61Price discrimination to exclude entry in a network industry 61

2.6.3.5 Exclusionary practices 622.7 Summary, and policy conclusions 622.8 Exercises 632.9 Solutions of exercises 66

Exercise 2.1 66

Exercise 2.4 67Exercise 2.5 67Exercise 2.6 67Solution of exercise 2.8 68Solution of exercise 2.9 68Solution of exercise 2.10 68Exercise 2.14 69Exercise 2.16 69Exercise 2.17 70Exercise 2.18 71

3 Market definition, and the assessment of market power 723.1 Introduction 723.2 Market definition 72

3.2.1 Product market definition 733.2.1.1 The SSNIP (or hypothetical monopolist) test 73

Demand and supply substitutability 73Supply substitutability v. entry that constrains market power 74

3.2.1.2 A problem in non-merger cases: the cellophane fallacy 753.2.1.3 Implementing the SSNIP test 75

Own-price elasticity 76Cross-price elasticities 76

Price correlation tests 77Price differences 78Characteristics and usage of products, and consumer preferences 78Temporal markets, seasonal markets, multiple markets 79After-markets (or secondary markets) 79Consistency of market definitions over time 81

3.2.2 Geographic market definition 813.2.2.1 The role of imports (shipment tests) 813.2.2.2 Transportation costs 823.2.2.3 Other characteristics 82

3.3 The assessment of market power 83

3.3.1 Traditional approach: (indirect) assessment of market power 843.3.1.1 The central role of market shares 843.3.1.2 Which thresholds for market shares 843.3.1.3 Measuring market shares and assessing relative strengths 853.3.1.4 Ease and likelihood of entry 863.3.1.5 Buyers' power 873.3.1.6 Market power, market shares and concentration* 88

3.3.2 Econometric techniques: (direct) assessment of market power* 893.3.2.1 Elasticity of residual demand* 89

Estimation of the residual demand elasticity** 91


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Residual demand elasticity in merger analysis 923.3.2.2 Logit models** 92

The logit demand model 92Independence of Irrelevant Alternatives and nested logit models 94Simulating effects of a merger with logit models 95

3.4 Exercises 973.4.1 Solutions to exercises 98

Solution of exercise 3.7 98

4 Collusion and horizontal agreements 994.1 Introduction 99

4.1.1 What is collusion? 100...first, a warning 100Defining collusion in economic theory 100What are the main ingredients of collusion? 100Which collusive price? 101Coordination: The difference between tacit and overt collusion 101

4.2 Factors that facilitate collusion 102

4.2.1 Structural factors 103Concentration 103Entry 104Cross-ownership and other links among competitors 104Regularity and frequency of the orders 104Buyer power 104Demand elasticity 105Evolution of demand 105Product homogeneity 105Symmetry 106Multi-market contacts 106

Inventories and excess capacities 1074.2.2 Price transparency and exchange of information 1084.2.2.1 Observability of firms' actions 108

Information exchange, I:Data on past or current prices and quantities 109

4.2.2.2 Coordination issues: The role of communication 109Information exchange, II: Announcements of future prices 110Private announcements 110An example of private announcements:

Communication in auctions 111Public announcements 112

4.2.3 Pricing rules and contracts 112Most-favoured nation and meeting-competition clauses 112Resale price maintenance 113Other pricing practices that increase observability 114

4.2.4 Analysis of collusion: conclusions 1144.2.5 Factors that facilitate collusion* 114

4.2.5.1 Conditions for collusion to arise* 1154.2.5.2 The basic model to analyse facilitating factors* 115

Concentration 116Regular orders facilitate collusion 117


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Demand elasticity 117Collusion and the evolution of demand 117Symmetry helps collusion 118Multi-market contacts 118

4.2.5.3 A problem with supergames: multiple equilibria* 1194.3 Advanced material** 120

4.3.1 Credibility of punishment and optimal penal codes** 120

An example of optimal punishments 120Nash reversal trigger strategies 120

4.3.2 Cartels and renegotiation** 123Costly renegotiation 124Discussion 125

4.3.3 The Green-Porter (1983) model** 1254.3.4 Symmetry and collusion** 127

4.3.4.1 Discussion and implications 1304.3.4.2 Proofs 130

Proof of Lemma 4.1 130Proof of Lemma 4.3 131

Proof of Proposition 4.1 1324.4 Practice: What should be legal, and what illegal? 1334.4.1 Standards of proof: market data v. hard evidence 133

Too lenient with the firms? 1374.4.2 Ex-ante competition policies against collusion 137

Black list of facilitating practices 138Auction design to avoid bid-rigging 138Merger analysis 139

4.4.3 Ex-post competition policies against collusion 139Surprise inspections (Dawn raids) 139Leniency programmes 139

Leniency programmes** 141Solution 141Implementing the optimal policy 144Fine reductions only before the inquiry is opened 144

4.5 Joint-Ventures and other horizontal agreements 1454.5.1 Joint-ventures 1454.5.2 Research joint-ventures 146

4.5.2.1 Treatment of research joint-ventures in US and EU law 1474.5.3 Other forms of co-operation regarding technology 148

4.5.3.1 Cross-licensing and patent pooling 1484.5.3.2 Co-operative standard-setting 148

4.5.4 Co-operative R&D* 150Competition in both stages 150Last stage: quantity competition 150Extensions and discussion 152

4.6 A case of parallel behaviour: Wood pulp 152A brief description of the industry 152The Commission Decision 153(1) Concertation within KEA 154(2) Concertation within Fides 154(3) Parallel behaviour 155


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(i) The system of price announcements 155(ii) The near-simultaneity of the announcements 156(iii) Parallelism of announced prices 156The Court's conclusions, and a discussion 157

4.7 Exercises 1584.7.1 Solution of exercises 162


Solution of exercise 4.2 162Solution of exercise 4.5 163Solution of exercise 4.7 163Solution of exercise 4.10 163Solution of exercise 4.11 164Solution of exercise 4.12 164Solution of exercise 4.13 165Solution of exercise 4.16 165Solution of exercise 4.17 165Solution of exercise 4.18 166Solution of exercise 4.19 166


5 Horizontal mergers 1685.1 Introduction 1685.2 Unilateral effects 169

5.2.1 Absent efficiencies, a merger increases market power 1695.2.2 Variables which affect unilateral market power 170

Concentration 170Market shares and capacities 170Entry 171Demand variables 171

Buyer power 171Failing firm defence 1715.2.3 Efficiency gains 172

The effect of efficiency gains on outsiders' profits 172The nature of efficiency gains, and their assessment. 173Asymmetric information 174Balancing efficiency and market power considerations 175

5.2.4 Modelling unilateral effects of mergers* 1755.2.4.1 Unilateral effects of mergers, absent efficiency gains* 175

Pre-merger 176The effect on insiders' profits 178

The effect on outsiders' profits 178The effect on total welfare 1795.3 Pro-collusive effects 179

5.3.1 Factors which affect collusion (reminder) 180Efficiency gains and pro-collusive effects 180

5.4 A more general model** 1815.4.1 The model 1815.4.2 Unilateral effects, without efficiency gains 182

5.4.2.1 Merger effects, and market power 1825.4.2.2 The welfare effects of a merger 183


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5.4.3 Efficiency gains from mergers 185The merger effect on consumer surplus. 186The impact of the merger on producer surplus. 186The net welfare effect of mergers 187

5.4.4 Efficiency offence: When the merger leads to the exit of the outsiders 1885.4.5 Proofs 189

Proof of Lemma 5.4 189

Proof of Lemma 5.6 1905.5 Merger remedies 191

5.5.1 Divestitures 1915.5.1.1 Problems with divestitures 1925.5.2 Behavioural remedies 193

5.5.2.1 Problems with behavioural remedies 1945.6 Merger policy in the European Union 195

5.6.1 Dominance test 1955.6.1.1 Joint dominance 195

5.6.2 The treatment of efficiency gains 1965.6.2.1 Efficiency offence? 197

5.6.3 Conclusions 1985.7 Case studies 1995.7.1 How to proceed in merger cases 199

Unilateral effects 199Pro-collusive effects 200

5.7.2 Nestl/Perrier 200Product market definition 200Geographic market 201Single-firm dominance 202Unilateral effects 202Joint firm dominance (pro-collusive effects) 204

Conclusions 2045.7.3 ABB/Daimler-Benz 205Product market definition 205Geographic market 205Market shares and concentration 206Joint dominance, or the coordinated effects of the merger 206Efficiency gains 208Conclusions 209

5.8 Exercises 2095.8.1 Solutions to exercises 212


Solution of exercise 5.2 212Solution of exercise 5.3 213Solution of exercise 5.4 213Solution of exercise 5.5 214Solution of exercise 5.6 214Solution of exercise 5.7 216Solution of exercise 5.8 216

6 Vertical restraints and vertical mergers 2176.1 What are vertical restraints? 217


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Most favoured nation clause and anti-discrimination laws 247Conclusions 2486.2.5.1 Vertical restraints and the commitment problem* 248

Observable contracts: A benchmark 249Unobservable contracts 249How to restore market power 249Vertical mergers and exclusive dealing

when a substitute input exists 2506.2.6 Conclusions 251

6.3 Inter-brand competition 2516.3.1 Strategic effects of vertical restraints 252

6.3.1.1 Strategic use of vertical restraints* 253Two-part tariff with price competition 253Vertical integration 254Exclusive territories 255Competition reduces the risk that vertical restraints lower welfare 256The results are not robust: Strategic substitutes 257The model 257

6.3.2 Vertical restraints as collusive devices 2596.3.2.1 RPM might facilitate collusion 2596.3.2.2 Common agency 259

Common retailer and RPM help collusion** 260No RPM (price choices delegated to the common retailer) 260RPM and common agency 261

6.4 Anti-competitive effects: leverage and foreclosure 2616.4.1 Anti-competitive effects: Exclusive dealing 262

Post-chicago models 2636.4.1.1 Exclusive dealing and entry deterrence* 265

Exclusive dealing: Chicago arguments* 265

Contracts as a barrier to entry* 266No contract 266Exclusivity contract 266Naked exclusion* 267Simultaneous non-discriminatory offers 267Simultaneous discriminatory offers 267Sequential offers 268Conclusions 268

6.4.2 Exclusionary effects of vertical mergers 2686.4.2.1 Exclusionary effects of vertical mergers* 270

One monopoly profit only* 270

Recent theories: Is there foreclosure from vertical mergers?* 270Unobservable offers. 271Downstream firms have market power. Efficient foreclosure 271Upstream firm is not a monopolist: possible

anti-competitive foreclosure 2716.5 Conclusions and policy implications 272

Balancing exclusionary and efficiency effectsof vertical mergers and vertical restraints 273

6.6 Cases 2736.6.1 General Electric/Honeywell 274


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The product markets 274Horizontal, conglomerate, vertical aspects of the merger 275The ingredients of GE's dominance 276Is it dominance? Other factors to take into account 278Conglomerate aspects: extending dominance 279Will the merger hurt consumers? 280Foreclosure through vertical integration: engine starters 281

Conclusions 2826.6.2 Ice-cream 282

A brief introduction to the industry 283The definition of the relevant market 284Market power, and the relative importance of exclusive agreements 285The foreclosing effects of the exclusivity clauses 286Efficiency effects of the exclusive agreements 287

6.7 Exercises 2886.7.1 Solutions of exercises 292

Solution of Exercise 6.1 292Solution of Exercise 6.2 292

Solution of Exercise 6.3 292Solution of Exercise 6.4 293Solution of Exercise 6.5 295Solution of Exercise 6.6 295Solution of Exercise 6.7 295Solution of Exercise 6.8 296Solution of Exercise 6.9 296Solution of Exercise 6.10 297

7 Predation, monopolisation, and other abusive practices 2987.1 Introduction 298

7.2 Predatory pricing 2997.2.1 Predation: search for a theory 2997.2.2 Recent theories of predatory pricing 301

7.2.2.1 Reputation models 3027.2.2.2 Signaling models 303

Predation for mergers 304Other signaling models 304

7.2.2.3 Predation in imperfect financial markets 3057.2.3 Models of predatory pricing* 306

7.2.3.1 Selten's chain-store paradox* 3067.2.3.2 A reputation model of predation** 307

Separating equilibrium. 307Semi-separating equilibrium. 308Comment 309

7.2.3.3 Milgrom and Roberts' limit pricing model** 310Separating equilibrium 311Pooling equilibrium 312Conclusion 312

7.2.3.4 Predation to merge** 313Separating equilibrium 313

7.2.3.5 Deep pocket predation* 314


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Product pre-announcements in network industries 3537.3.3.1 Interoperability choices in asymmetric networks* 353

Tipping to the firm with the large installed base 355Tipping to the entrant 355The choice of interoperability 356

7.3.4 Refusal to supply and exclusive contracts (reminder) 3577.3.5 Raising rivals' costs 357

7.4 Price discrimination 358The two main ingredients of price discrimination 3587.4.1 Welfare effects of price discrimination 359

7.4.1.1 First-degree (perfect) price discrimination 3597.4.1.2 Quantity discounts 3597.4.1.3 Price discrimination between countries 3607.4.1.4 Dynamic effects of price discrimination: incentives to invest 3617.4.1.5 Does market power matter? 3627.4.1.6 Price discrimination as a monopolisation device 362

Selective discounts and fidelity rebates 363Price transparency 363

7.4.1.7 Anti-dumping 3647.4.2 Price discrimination* 3657.4.2.1 Third-degree price discrimination)* 365

Price discrimination 3657.4.2.2 Quantity discounts: Two-part tariffs as price discrimination* 367

Non-discrimination 367Quantity discounts (two-part tariff) 367Quantity discounts and uniform pricing: a comparison 368

7.4.2.3 Price discrimination and investments* 368Uniform pricing 368Price discrimination 369

7.4.2.4 Price discrimination and market power* 369 Uniform pricing 369Price discrimination 370The effect on investments 371

7.4.2.5 Price discrimination under entry* 371Price discrimination 371Uniform pricing 371

7.5 US v. Microsoft 3727.5.1 A short description of the case 372

Middleware 3737.5.2 Monopolisation 374

7.5.2.1 Monopoly power 3747.5.2.2 Anti-competitive conduct 375Licenses issued to OEMs 375Integration of IE and Windows 376Agreements with IAPs 377Java 378

7.5.2.3 Causation 3797.5.3 Attempted monopolisation 3797.5.4 Tying 3797.5.5 Remedies 380


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7.5.6 Conclusions 3817.5.7 The District Court judgment on remedies 381

7.6 Exercises 3827.7 Solutions of exercises 385

Solution of exercise 7.1 385Solution of exercise 7.2 386Solution of exercise 7.3 387

Solution of exercise 7.4 387Solution of exercise 7.5 387Solution of exercise 7.6 388Solution of exercise 7.7 389Solution of exercise 7.8 389

8 A Toolkit: Game Theory and Imperfect Competition Models 3908.1 Introduction 3908.2 Monopoly 390

8.2.1 Single-product monopoly 390A specific functions example 391

8.2.2 Multi-product monopoly 3928.2.2.1 Independent demand and cost functions 3928.2.2.2 Interdependent demands 392

A dynamic interpretation of demand interdependence 394Intertemporal complementarity: Introductory price offers 394Intertemporal substitutability: Durable goods 395

8.2.2.3 Interdependent costs: Economies (or diseconomies) of scope 395An intertemporal example: learning-by-doing 396

8.2.3 Nash equilibrium 3978.2.3.1 The prisoners' dilemma 3988.2.3.2 Coordination games and equilibrium selection 398

Pareto dominance as an equilibrium selection device 399Elimination of weakly dominated strategies 3998.2.3.3 Mixed strategies 399

Mixed strategies 4008.2.4 Dynamic games, and sub-game perfect Nash equilibrium 400

8.2.4.1 Backward induction 4018.3 Oligopoly I: Market competition in static games 402

8.3.1 Product market competition with homogenous goods 4028.3.1.1 Price competition (Bertrand model) 403

Bertrand under cost asymmetric firms 404Large asymmetries 405

Small asymmetries 405Bertrand under capacity constraints 4058.3.1.2 Quantity competition (Cournot model) 406

Cournot with cost asymmetries 407Cournot with n firms 408

8.3.1.3 Joint-profit maximisation 4088.3.1.4 Benchmark models of product competition: A comparison 409

8.3.2 Product market competition with (exogenously) differentiated goods 4098.3.2.1 A linear demand model of differentiated goods 409

Quantity competition 411


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Equilibrium comparison 412Strategic substitutes v. strategic complements 412Stability of the equilibrium 413Joint-profit maximisation 414Price competition 415Joint-profit maximisation 416Repeated product market interaction 416

8.3.2.2 Finite horizon 4168.3.2.3 Infinite horizon 417

8.4 Oligopoly II: Dynamic games 4178.4.1 Strategic investments 418

8.4.1.1 Quantity competition (strategic substitutes) 418Accommodation 419Entry deterrence 419

8.4.1.2 Price competition (strategic complements) 420Accommodation 420Entry deterrence 420Discussion and interpretation 421

Examples of strategic investments 4218.5 Appendix 421

Endnotes 422

Bibliography 472

Case ReferencesEuropean cases: Decisions of the Commission of the European Communities 493European cases: Decisions of the Court of First Instance

and the European Court of Justice 495

European treaties 497European legislation and guidelines 497UK cases and MMC Reports 497UK legislation and guidelines 497US cases 497US legislation and guidelines 499

Index of Tables 500Index of Figures 501Tables 502Figures 521


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Upstream firm(manufacturer)

Downstream firm(retailer)

Consumers


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467/659

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!"#$% /(/( Strategic effect of a shock that reduces firm 1's costs

Strategic substitutes Strategic complements

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Index of Figures

Figure 2.1. Welfare loss from monopoly

Figure 2.2. Possible additional loss from rent seeking activities

Figure 2.3. Additional loss from productive inefficiency

Figure 2.4. Welfare W c as a function of the number of firms n ( ; c = .5; g = 4)

Figure 4.1. Incentive Constraints along collusive and punishment paths

Figure 4.2. Conditions for collusion: Nash reversal )( cn! v. two-phase )(!

punishment strategies

Figure 4.3. Game tree, at t = 2

Figure 4.4. Equilibrium solutions for given policy parameters

Figure 5.1. Effects of a merger absent efficiency gains: Strategic complements

Figure 5.2. Effects of a merger absent efficiency gains: Strategic substitutes

Figure 5.3. Effects of a merger with efficiency gains

Figure 5.4. Levels of efficiency gains and exclusion of competitors

Figure 5.5. Study of functions used in Lemma 7

Figure 6.1. Double marginalisation

Figure 6.2. Horizontal externality

Figure 6.3. Competing vertical chains

Figure 6.4. Tariffs as strategic device: Strategic complements

Figure 6.5. Tariffs as strategic device: Strategic substitutes

Figure 6.6. The "Chicago School" critique to foreclosure


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Figure 6.7. Segal-Whinston: sequential offers

Figure 7.1. State game at time t, chain-store paradox game

Figure 7.2. Deep pocket predation, with T = K = 1

Figure 7.3. Time line: a (financial) long purse model of predation

Figure 7.4. Time line: Bolton-Scharfstein's model

Figure 7.5. Entry-deterring investment

Figure 7.6. Strategic effect of bundling

Figure 7.7. Welfare under perfect price competition

Figure 8.1. Extensive form of the game

Figure 8.2. Extensive form of a quality game

Figure 8.3. Reaction functions in the Cournot model

Figure 8.4. Toughness of product market competition: Bertrand (B), Cournot (C), and joint-profits maximization (M)

Figure 8.5. Reaction functions under price competition

Figure 8.6. (a) Stable Nash Equilibrium; (b) Unstable Nash Equilibrium

Figure 8.7. Effects of a shock (s > 0) that reduces firm 1's marginal cost: Strategicsubstitutes

Figure 8.8. Effects of a shock (s > 0) that reduces firm 1's marginal cost: Strategiccomplements


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Competition Policy--Theory and Practice

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Transcript of Competition Policy--Theory and Practice