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Econ 201Winter 2011

Market Failure:

Anti-Competitive Behavior

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Market Failure

• What do we mean?– Basic/key assumptions of the perfectly

competitive market are not met– As a result: perfect competitive market

outcomes are not met• May result in

– Economic inefficiency (deadweight loss) as gains from trade are not as large as possible

– Goods not produced at least cost (excess capacity)– Lower incentive for technological innovation – reducing

costs in the future, introducing new product developments/technology

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What is Market Failure

• First Problem: Not enough sellers (or buyers)– Monopoly

• Single seller -> no substitute– Too little output, too high a price, no incentive to innovate

– Few sellers -> oligopoly• If collude -> act just like a monopolist

– Price fixing, quantity supplied reduced/restricted

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What is Market Failure

• Second Problem: Externalities (both positive and negative)– Costs (or benefits) imposed on others who

were not directly involved in the market exchange

– Negative externality• Too much of the good will be produced, too much

of the externality (e.g., pollution) produced without government intervention

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What is Market Failure?

• Third problem: asymmetric information– Buyers and sellers don’t have the same

information about the product’s properties/qualities

• E.g., quality of a house, risk of default of a borrower

• Leads to asymmetric (different) incentives for parties involved in the transaction

– E.g., difference in incentives for real estate agent and buyer (principal agent problem)

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Government Regulationof Too Few Sellers

• Major problems with too few sellers– Anti-competitive behavior

• Price Discrimination– Charge multiple prices to same customer, or customers in

different markets, for same good– Goal: extract consumer surplus

• Collusion– Price fixing – setting p > mc– Market agreements/non-compete agreements

» Geographic or demographic markets

• Mergers/acquisitions– Reduce competition (horizontal mergers)– Extend market power up and down distribution chain

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Government Regulation

• Tools available– Statutory

• Prohibitive– E.g. Price fixing/restricting output, cartels, collusive behavior

• Fines, breakup (divestiture)

– Deregulation• Removing regulation

– Airlines, Banking

• Incentive mechanisms– Managed competition

– Incentive design

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Promoting Efficiency

• Goals of regulation– Promote Technological Innovation– Efficiency in Production– Efficiency in Allocation

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Efficiency in Production

• Produce Goods at Least Cost– Firms to operate at the minimum of their Long

Run Average Cost Curve

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Efficiency in Allocation

• Marginal value consumers place on last (marginal unit) produced to equal the resource “opportunity” costs– MV = MC at the marginal unit

Technological Innovation• Perfect Competition

– Incentive is the possibility of earning a short-run economic profit from having lower costs than competitors

• Besides output decision (mc(q) = p) only thing under firm’s control (or only strategy available)

• Monopolistic competition– Two forms:

• Lower costs (just like PC)• New product with different attributes

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Technological Innovation• Oligopolies

– Lower costs • Lead to higher profit• Increase in quota (?)• Less incentive than PC or MC

– Uncertainty as to whether investment in innovation will actually be successful and reduce costs

• Monopoly– Uncertain return on investment– Maybe to stave off alternative technologies

• “competitive fringe”, e.g. landline/wireless12

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Government Regulatory AgenciesAdministrative Agencies

• Federal Trade Commission (1914) Act– “empowered to pursue abuses of trade that could lessen competition”

• Department of Justice (DOJ)– Jointly charged with FTC for overseeing and enforcing antitrust policy– Established by the Judiciary Act of 1789 – 1870 Act: handle the legal business of the United States. – control over all criminal prosecutions and civil suits in which the United

States had an interest • Federal Communications Commission (FCC)

– established by the Communications Act of 1934 – charged with regulating all non-Federal Government use of the radio

spectrum (including radio and television broadcasting), and all interstate telecommunications (wire, satellite and cable) as well as all international communications that originate or terminate in the United States.

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What Happens in Different Markets?

• Monopoly/Oligopoly– Single-price monopolist/cartel (collusive)– Price Discrimination

• Block pricing – 2nd degree• Third degree: different prices for different WTP

– Income, sex, age, geography

• Monopolistic Competition– “branding” for market power

• advertising– Geographic pricing,

• e.g., Madison Park shell, CD grocery stores – Price points and product proliferation

• Perfect Competition– Compete by reducing costs

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Antitrust Blog

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Antitrust Blog

• RebeccaStop Following Follow Rebecca • Former Executives from Two Japanese

Airlines Indicted in Conspiracy to Fix Rates on Air Cargo Shipments...

• • Former Executives from Two Japanese

Airlines Indicted in Conspiracy... justice.gov • posted 14 days ago • Rebecca Thai, Attorney at Law 11 days ago •

Edit • Yes. The best source is the Department of Justice, Antitrust Division Web site.

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What’s the Goal of Regulation

• Standard of comparison for all market models (optimal) is Perfect Competition– Productive efficient

• Firms operate at min of LRAC or exit

– Technological innovate• Innovate or die

– Allocative efficient• Consumers value marginal unit at MV

– Equals firm’s cost of producing marginal unit

• No deadweight loss

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Monopoly

• Not Efficient in Production– Never operate at min of LRAC– Underutilized capacity and resources

• Not Technologically Innovative– No incentive to invest in/develop new

technology when you’re the only firm

• Not Efficient in Allocation– P (=MV) > MR = MC– Deadweight loss

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Monopolistic Competition

• Not Efficient in Production– Never operate at min of LRAC– Underutilized capacity and resources

• Technologically Innovative– Competition with other firms provides incentive

• Not Efficient in Allocation– P (=MV) > MR = MC– Deadweight loss (but not as great as Monopoly)

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How Has the Government Sought to Regulate Markets?

• Punishing Anti-Competitive Behavior– Pricing/market tactics

• Collusion– Price-fixing, restricting output

• Price Discrimination• Predatory Pricing

– Impose fines for AC tactics

• Preventing Anti-competitive Behavior– Mergers and Acquisitions

• Review by appropriate administrative agency

– Divestiture/breakups

• Regulating Natural Monopolies• Deregulation(sic) of Selected Industries

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Punishing AC Behavior

• Punishing firms for behaving like a monopoly– Sherman anti-trust Act (1890)

• “conspiring to fix prices or restrict output”

– Clayton Act (1914)• More sophisticated price discrimination• Tie-in sales – requiring the purchase of 2nd good• Stock purchases/acquisitions

– Robinson-Patman Amendment(1936)• 3rd degree price discrimination • Amendment to Clayton Act

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Reviewing Mergers

• Primarily aimed at preventing mergers or acquisitions that reduce competition– FCC regulates communications media

(newspapers, tv, telecomm, radio)– FTC and DOJ regulate the rest

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Where We’re Going

• How do we tell if a merger is anti-competitive?– Market Concentration

• CR4: market share for the 4 largest firms• Herfindahl Index (HHI): computed from the squares of the

market shares

• Strategic behavior (how do they behave in the market place)– Collusive: act together– Non-collusive: act separately and/or stratgeicially

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How do we tell?

• Market concentration refers to the size and distribution of firm market shares and the number of firms in the market.

• Economists use two measures of industry concentration:– Four-firm Concentration Ratio – The Herfindahl-Hirschman Index

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Four-Firm Concentration Ratio

• The four-firm concentration ratio (CR4) measures market concentration by adding the market shares of the four largest firms in an industry.– If CR4 > 60, then the market is likely to

be oligopolistic.

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Example

Firm Market Share

Nike 62%

New Balance 15.5%

Asics 10%

Adidas 4.3%

CR 4 = 62 15.5 10 4.3 91.8

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The Herfindahl-Hirschman Index

• The Herfindahl-Hirschman index (HHI) is found by summing the squares of the market shares of all firms in an industry.

– Advantages over the CR4 measure:• Captures changes in market shares• Uses data on all firms

HHI > 1800

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Example

Firm Market Share

Nike 62%

New Balance 15.5%

Asics 10%

Adidas 4.3%

HHI 622 15.52 102 4.32 4,202.74

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Example (cont’d)

Firm Market Share

Nike 22.95%

New Balance 22.95%

Asics 22.95%

Adidas 22.95%

What happens if market shares are evenly distributed?

HHI 22.952 22.952 22.952 22.952 2,106.81

CR 4 91.8

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How do they determine whether a merger reduces competition?

• Herfindahl-Hirschman Index or HHI, – measure of the size of firms in relationship to the

industry – Meant to be an indicator of the amount of competition– sum of the squares of the market shares of each

individual firm. • decreases in the Herfindahl index generally indicate a loss of

pricing power and an increase in competition, whereas increases imply the opposite

• DOJ guidelines– Mergers resulting in HHI > 1800 can be challenged

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Figure 12.11 Four-Firm Concentration Ratio (CR4) for Selected Industries in

1997

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Are All Mergers Equal?

• Conglomerate – Merger of firms in unrelated industries

• Vertical Merger– Merger of firms upstream/downstream from each other in

production stream• FCC: ownership of more than 1 media type• Microsoft

• Horizontal Mergers– Firms in the same industry

• Telecomm industry– AT&T divestiture– Verizon/GTE merger; RBOC mergers

• Would the HHI be a valid measure of competitiveness?