L2 Market CompetitionPolicy

Lecture notes session 2
Market definition
Assessing and measuring market power
Competition policy
Stockholm School of Economics
Matilda Orth
Research Institute of Industrial Economics (IFN), Stockholm
matilda.orth@gmail.se
March 28, 2018
Matilda Orth () IO: Market power March 28, 2018 1 / 51

Overview
Part 1: Market definition
Part 2: Assessing and measuring market power
Part 3: Competition policy

Market definition
How to define a market?
Define a set of products that constraint each other’s pricing (or

quality, service, innovation etc)
If a firm has products that face close substitutes, it is difficult to

increase prices above its rivals’ prices
Firms facing many substitutes have limited market power (abilities to

raise prices above marginal cost)

Market definition: Examples
Sparkling water, still water, soft drinks, juice, milk...
Airline industry
◮ Flights to/from all airports in a city
◮ Primary vs secondary airports
◮ Rule out alternative transportation modes
(Future) challenges
◮ online-offline markets: Amazon and Alibaba versus local specialized
stores?
◮ New, complex markets develop fast: Google search?

Market definition: Examples
Electricity firm
1 Consumers no choice of heating - monopoly power
2 If consumers can easily switch to alternative energy sources (coal, gas),
it is difficult to profitably raise price as many consumers will switch
The relevant market is:
1 electricity
2 energy (electricity, coal, gas)
Although monopolist on electricity, the firm may have limited market

power

Market definition
Define the relevant...

1 product market
2 geographic market
Demand substitution and supply substitution limit firms’ market

power
Practitioners
◮ How much substitution is enough?
◮ When does product differentiation imply market power?

Market definition: EC guidelines (1997)
”A relevant product market comprises all those products and/or

services which are regarded as interchangeable or substitutable by the
consumer, by reason of the products’ characteristics, their prices and
their intended use.”
”The relevant geographic market comprises the area in which the

undertakings concerned are involved in the supply and demand of
products or services, in which the conditions of competition are
sufficiently homogeneous and which can be distinguished from
neighbouring areas because the conditions of competition are
appreciably different in those area.”

Market definition
Demand substitution
◮ To what extent do consumers substitute to other products following a
price increase? cross price elasticity of demand
Distinguish between if few or many consumers switch after a price

increase
Firms are constraint if many consumers switch

Market definition
Supply substitution
◮ What are rivals responses to a price increase, i.e., to what extent do
rival firms (other products/other geographical areas) supply (produce)
following a price increase? fixed costs to change the production function (?)
EC guidelines [small change in relative prices implies:]

◮ (i) fast (short-term)
◮ (ii) without significant costs or risks
◮ (iii) not potential entrants

Market definition Peter Davis, UK competition authority.
Assessment of market definition:

1 Qualitative evidence
2 Price
3 Natural experiments
4 Estimation of price elasticities
5 Hypothetical Monopolist Test
⋆ SSNIP-test = Small and Significant Nontransitory increase in Price
Used in mergers and corporate acquisition.

Market definition
(1) Qualitative evidence

◮ Plausible substitutes based on product characteristics, intended use etc.
◮ Facts, consumer tastes (surveys)
(2) Price analysis

◮ Correlations and co-movements: prices of substitutes should move
together similar product follow similar price movements over time. Subject to the
same supply and demand shocks.
◮ The law of one price (perfect substitutes): price levels of substitute
goods should be similar

Market definition
(3) Natural experiments

◮ Need cross-price elasticities
◮ What is the reaction in rivals’ prices after a price shock to the product
under review?
◮ Exogenous shock, i.e., not determined by market conditions affecting
consumers and firms
⋆ Price experiment
⋆ Regressing prices on market structure (entry)

Market definition
(4) Estimation of substitution effects

◮ Revealed preferences: Demand estimation
⋆ Know consumer choices, explain them given consumer characteristics
◮ Stated preferences: Survey evidence
⋆ Ask consumers what to do under different choice sets

(5) Hypothetical Monopolist Test
Determine the set of products/geographical areas that impose

constraints on each other’s ability to exploit market power. Often
focus on price.
SSNIP-test = Small and Significant Nontransitory increase in Price
◮ Consider a hypothetical monopolist: would it be profitable to raise
prices by 5-10 percent?
◮ Examines pricing constraints from outside the used market definition
(product/geographic area)
◮ A hypothetical monopolist will not have market power if there is
enough demand or supply substitutability from products (areas) outside
the candidate market

SSNIP-test
Davis and Garcés, Figure 4.12

◮ Start with the narrowest possible market – apply repeatedly
Requires information about demand elasticities
Relies on ”competitive price” but monopoly implies high elasticity of

substitution and thus a wider market (concern using observed
substitution). Merger cases.

Overview
Part 2: Assessing and measuring market power

Assessing and measuring market power
cross price elasticities are really important for the firms.
Many policy concerns relate to concentration of an industry and the

intensity of competition
Why do the number of firms differ across markets?
The number of firms influences price and quantities, but is also

endogenously determined
Number of firms is different between markets, why is it so different? It is also endogenous

Example
Consider 2 industries and 2 firms operating in each

◮ Industry A: Firm 1 has 95% market share Firm 2 has 5% market share
◮ Industry B: Firm 1 has 50% market share Firm 2 has 50% market share
Same number of firms but A looks more like a monopoly than B
Need concentration measures, not enough with the number of firms

Concentration measures
◮ (1) The m-firm concentration ratio
◮ (2) Herfindahl index [Herfindahl-Hirschman index]

(1) The m-firm concentration ratio
Degree of concentration in the industry

◮ Define firm i’s market share as αi = qqi
◮ Sort firms by decreasing market share
◮ Sum the market share of a particular m number of firms in the market
Cm = Σm
i =1 αi
this is just adding up market shares...
If Cm close to 1 the industry is fairly concentrated
Screening device for Competition Authorities and regulators
EU legislation: if α1 = 0.40 a firm is denoted ”a dominant firm”
Rests heavily on definition of the relevant market

(1) The m-firm concentration ratio: Examples
Example I
◮ Industry A: C4 =0.8
⋆ firm 1 60%; firm 2 10%; firm 3-4 5% each
◮ Industry B: C4 =0.8
⋆ firm 1-4 20% each
◮ Cannot distinguish firm sizes when the largest firms have high joint
market shares. Not informative about concentration among top firms.
Example II
◮ Industry C: C4 = 1 we cannot tell anything about the distribution of the top firms.
100 [ it seems a terrible indicator if equal splits give C =1]
⋆ firm 1-3 3
% each
◮ Industry D: C4 = 0.985
⋆ firm 1-2 49% each; firm 3-10 0.25% each
◮ An industry equally shared by 3 firms [C] more concentrated than an
industry dominated by only two firms [D]

(2) Herfindahl index [Herfindahl-Hirschman index]
The sum of squared market shares: HHIm = Σni=1 α2i
Capture two factors affecting concentration:

◮ (1) number of firms
◮ (2) dispersion in market shares, i.e., the distribution of output among
the firms
Squaring the market shares increases HHIm to a large value for

industries with unequal distribution of market shares

(2) Herfindahl index [Herfindahl-Hirschman index]
Monopoly: HHIm = 1
Perfect competition: lim HHIm = 0 as n → ∞
If we use market shares in percentages: HHI ∈ 1 to 1002 = 10 000

Example II
◮ Industry C: C4 = 1; HHIm = 3, 333
100
⋆ firm 1-3 3
% each
◮ Industry D: C4 = 0.985; HHIm = 4, 802
⋆ firm 1-2 49% each; firm 3-10 0.25% each
Industry D is now ’more concentrated’ than industry C

Link between market concentration and market power? Homogenous
vs differentiated products

Monopoly
How can we measure market power? What are firms’ abilities to price
above marginal cost?
◮ Consider a general inverse demand function P(q)
◮ Marginal cost c
Monopolist’s profit
π = P(q)q − cq
First order condition

∂π ∂P(q)
= q + P(q) − c = 0
∂q ∂q

Monopoly
Elasticity of demand
∂q P
η=−
∂P q
Inverse elasticity of demand
1 ∂P q
=−
η ∂q P
Re-write the F.O.C. to obtain the Lerner index (markup)

okey this is markup
P −c 1
=
P η
Having an estimate of the price elasticity, η, we can obtain the

markup P−c
P without observing the marginal cost c

Implications of Cournot competition
Consider a general inverse demand function P(q)

Different marginal costs Ci (qi ) = ci qi
Firm i ’s profit
πi = P(q)qi − Ci (qi )
First order condition
∂πi ∂P(q) ∂Ci (qi )
= qi + P(q) − =0
∂qi ∂q ∂qi
c_i or marginal cost

Inverse elasticity of demand
1 ∂P(q) q
=−
η ∂q P
Use the F.O.C. and re-write

◮ Multiply by Pq Pq
◮ Let αi = qqi denote the market share of firm i
P(q) − ci αi
=
P(q) η
Interpretation: Firms have more market power if...

◮ Market share is high
◮ Demand elasticity is low

With constant marginal cost ci , we have
P − ci αi
Li = =
P η
Summing equilibrium profits we get
n
(
(P − ni=1 αi ci )q
P
X
(P − ci )αi q = Pq Pn 2
i =1
q_i η i =1 αi
◮ Bottom equation comes from Lerner index equation

cournot case
Equating them we get
degree of market degree of
(P − ni=1 αi ci )
Pn
α2
P
HHI concentration index
power = i =1 i =
P η η
Average Lerner index is proportional to the Herfindahl index
In Cournot with homogenous products there is a direct relationship
between market concentration (HHI) and market power (average
markup given by the Lerner index)
Estimation of market power: conduct
Can we find an expression that is derived from economic theory and

that we can take to the data to estimate and thus obtain a measure
of market power?
Assume homogenous products

Nest several different degrees of competition into one model
∂P(q)
MR(λ) = λq + P(q)
∂q
Conduct parameter λ: Measures the degree of market power in the

industry
◮ If λ = 0 perfect competition
◮ If 0 < λ < 1 oligopoly
◮ If λ = 1 monopoly

Use in FOC to get:
P − ci ∂P(q) q λ
L = =− λ=
P ∂q P η
If firms are identical, λ = n1 , the conduct parameter corresponds to n

identical firms
Examples:
◮ λ = 0.2 corresponds to 5 identical firms
◮ λ = 0.1 corresponds to 10 identical firms

If we have access to information about costs, λ can be expressed in

the following way:
P − ci
Lη = η=λ
P
Conduct parameter λ equals the adjusted Lerner index, i.e., the

elasticity adjusted Lerner index
The pricing rule

ηci
P=
η−λ
Given data on prices, quantities and costs we can estimate how

competitive a market is (value of λ)

Genesove and Mullin RJE (1998)
Main idea: determine the degree of market power in the US sugar

industry
◮ Sugar is a homogenous product
To obtain λ (θ in GM), we need the demand elasticity and cost

information
Model + Data

Main idea: determine the degree of market power in the US sugar

industry
Model
Constant marginal cost: Simple production technology where raw

sugar transformed at a fixed, and known, coefficient into refined sugar
c = c0 + k ∗ PRAW
Demand specification:
ln(Q) = γ0 + γ1 ln(P) + ǫ

Data
◮ prices, quantities
◮ What else do we need?
How can we take the model to the data?
Empirical workshop 1: Testing Static Oligopoly Models in an

application to the coffee market

Overview
Part 3: Competition policy

Competition policy and regulation
Competition Policy aims at ensuring that competition in the

marketplace is not restricted in a way that is detrimental to society
Regulation
◮ Government intervention to limit the exercise of market power,
intervenes on market structure
⋆ price, investments, entry, products . . .
◮ Inefficiency associated with the exercise of market power
Antitrust laws
◮ Limit the acquisition, protection, and extension of market power
◮ Make certain kinds of behavior illegal
Competition policy: ex-post; Regulation: ex-ante

Competition policy
Market failure, dominant positions might persist, due to:

◮ sunk costs industries
◮ lock-in effects and switching costs
◮ network effects
Without monitoring firms can resort to actions that increase profits

but harm society, such as
◮ Collusion
◮ Mergers
◮ Predatory behavior
◮ Exclusionary behavior

Objectives of competition policy
Welfare (Total Surplus): W = CS + PS

◮ If welfare enhancing: a presumption on economic grounds that the
behavior is desirable and should be legal
◮ Measurement
◮ Key idea: Dynamic welfare
⋆ High-dimensional and complex problem
⋆ Potential entrants (entry/exit)
⋆ Evolution of industries over time under alternative policies

Objectives of competition policy
Hints regarding consumer surplus: theory vs practice

◮ EU competition law
⋆ Article 101(3) allows agreements that allows ”consumers a fair share
of the resulting benefit”
⋆ Merger regulation: efficiency defence ”provided that it is to
consumers’ advantage”
Welfare captures the whole economy

◮ Firm profits (link to consumers/employees/owners)
◮ Innovation, R&D, introduce new products

Other objectives of competition policy
Promote market integration

◮ Do we still have national markets?
◮ No price discrimination across countries in EU (but might increase
welfare)
Defence of smaller firms (SMEs)

◮ EU 2020 goals on growth, innovation, employment etc.
◮ Entry induces industry dynamics
◮ They may be less efficient (subsidies, tax exemptions etc)

Other objectives of competition policy
Fairness and equity

◮ Guarantee a level playing field for all firms in the market: same ex ante
opportunities in the market
Social, political, environmental reasons

◮ Avoid firms/individuals to own a large share of resources
Strategic reasons (trade and industrial policies)

Competition laws: The US
1890: Sherman Act

◮ 1) Price agreements
◮ 2) Monopolisation
1914: Clayton Act - mergers, price discrimination
Department of Justice (DoJ), Federal Trade Commission (FTC)

Competition laws: The EU
Paris Treaty (1951): predecessor of current EU Competition Law

◮ Art. 65: prohibits agreements that distort trade
◮ Art. 66: prohibits abuse of dominant position
◮ Art. 66: concentrations
Treaty of Rome (1957): articles 81, 82

Merger Regulation (1989)
Directorate-General for Competition (DG-Comp)

Competition laws: The EU
Objectives
◮ Competition as an intermediate objective (towards the primary
objective: to help economic progress and welfare of European citizens)
◮ European integration (elimination of national discriminations in the
economic system)
Now: Single digital market (e-commerce)
Economic analysis vs integration

The EU competition law
Article 102: Abuse of dominant position
Firms that have a dominant market share and abuse that position
”Abuse of dominant position”
Mergers, acquisitions and joint ventures [Merger regulation 2004]
◮ Market dominance must exist
◮ But not sufficient: Dominant firm must use its dominance

Example: Google
EC Antitrust case: Abuse of dominant position

1 Restricting third-party websites from displaying search ad:s from
Google competitors.
⋆ Google places ads on third-party websites, require them to not take ads
from competitors, reserve prominent place for Google’s ads, approval
from Google when changing ads from rivals
2 Abusing the dominance of its Android mobile operating system by

requiring manufacturers of devices to pre-install Google’s services, e.g.,
Chrome internet browser and Maps. This is claimed to prevent
manufacturers from selling mobile devices running on competing
operating systems.
3 Favoring its own comparison shopping service in its general search
result
Poor google. EC just wants money ;(

The EU competition law
Article 101: Horizontal and vertical agreements

Cartels and restrictive vertical agreements
◮ Prohibited are ”all agreements between undertakings, decisions by
associations of undertakings and concerted practices which may affect
trade between Member States and which have as their object or effect
the prevention, restriction or distortion of competition within the
common market.”

Recent developments at the DG-comp 2015/2016
Summary in Review of Industrial Organization

(I) Merger case: Alstom/General Electric (GE)
◮ Acquisition of the energy business of Alstom by GE
◮ Heavy duty gas turbines (HDGTs)
◮ Tender process – bidding markets
(II) Antitrust enforcement Article 101 decision:
◮ Container shipping – information exchange in pricing

Qualitative evidence
◮ Organization of tenders and tender-processes
◮ What theoretical model should we rely on for the empirical work?
What model will describe the reality/data in the best possible way?
Quantitative evidence
◮ What data to collect?
⋆ Bidding data, identity of firms, tender specifications, expected
revenues, costs, margins

Quantitative analysis
◮ Participation analysis: how/when did the merging parties participate in
the same tenders? Submitted bids and what was the outcome (winning
bid)? Participation will tell us about closeness of competition. Found
that GE and Alstom were close competitors on bids.
◮ Win/loss analysis: Outcome in tenders where Alstom and GE met?
Alstom successful when met GE – competitive pressure
◮ Econometric analysis on winning probabilities and margins: Alstom
outcome with/without facing competition from GE, number of bidders

LOL MY FIRST CASE STUDY IN BOCCONI
Conclusion: Alstom and GE close competitors, impose significant

competitive constraints on each other. Efficiencies not sufficient to
offset the competitive harm to consumers.
Outcome: reduce competition, approved subject to divestiture.

Replicate Alstom’s role in the market as independent firm.
Maintain competition: Short- medium run (price competition,

product variety); Long-run (upgrade products and invest in R&D)

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Lecture notes session 2

Stockholm School of Economics

March 28, 2018

Matilda Orth () IO: Market power March 28, 2018 1 / 51

Part 1: Market definition

Part 2: Assessing and measuring market power

Part 3: Competition policy

Matilda Orth () IO: Market power March 28, 2018 2 / 51

How to define a market?

Define a set of products that constraint each other’s pricing (or

If a firm has products that face close substitutes, it is difficult to

Firms facing many substitutes have limited market power (abilities to

Matilda Orth () IO: Market power March 28, 2018 3 / 51

Sparkling water, still water, soft drinks, juice, milk...

Matilda Orth () IO: Market power March 28, 2018 4 / 51

Although monopolist on electricity, the firm may have limited market

Matilda Orth () IO: Market power March 28, 2018 5 / 51

Define the relevant...

Demand substitution and supply substitution limit firms’ market

Matilda Orth () IO: Market power March 28, 2018 6 / 51

”A relevant product market comprises all those products and/or

”The relevant geographic market comprises the area in which the

Matilda Orth () IO: Market power March 28, 2018 7 / 51

Distinguish between if few or many consumers switch after a price

Firms are constraint if many consumers switch

Matilda Orth () IO: Market power March 28, 2018 8 / 51

EC guidelines [small change in relative prices implies:]

Matilda Orth () IO: Market power March 28, 2018 9 / 51

Assessment of market definition:

Matilda Orth () IO: Market power March 28, 2018 10 / 51

(1) Qualitative evidence

(2) Price analysis

Matilda Orth () IO: Market power March 28, 2018 11 / 51

(3) Natural experiments

Matilda Orth () IO: Market power March 28, 2018 12 / 51

(4) Estimation of substitution effects

Matilda Orth () IO: Market power March 28, 2018 13 / 51

Determine the set of products/geographical areas that impose

Matilda Orth () IO: Market power March 28, 2018 14 / 51

Davis and Garcés, Figure 4.12

Requires information about demand elasticities

Relies on ”competitive price” but monopoly implies high elasticity of

Matilda Orth () IO: Market power March 28, 2018 15 / 51

Part 2: Assessing and measuring market power

Matilda Orth () IO: Market power March 28, 2018 16 / 51

Many policy concerns relate to concentration of an industry and the

Why do the number of firms differ across markets?

The number of firms influences price and quantities, but is also

Matilda Orth () IO: Market power March 28, 2018 17 / 51

Consider 2 industries and 2 firms operating in each

Same number of firms but A looks more like a monopoly than B

Need concentration measures, not enough with the number of firms

Matilda Orth () IO: Market power March 28, 2018 18 / 51

Degree of concentration in the industry

If Cm close to 1 the industry is fairly concentrated

Screening device for Competition Authorities and regulators

EU legislation: if α1 = 0.40 a firm is denoted ”a dominant firm”

Rests heavily on definition of the relevant market

Matilda Orth () IO: Market power March 28, 2018 19 / 51

Matilda Orth () IO: Market power March 28, 2018 20 / 51

The sum of squared market shares: HHIm = Σni=1 α2i

Capture two factors affecting concentration:

Squaring the market shares increases HHIm to a large value for

Matilda Orth () IO: Market power March 28, 2018 21 / 51