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Introduction to Competition

Economics

University of Sydney Law School

Competition Law 2015

Dr Luke Wainscoat

Senior Economist, HoustonKemp

© 2015

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Previous lecture

• Demand and supply model

› Complements and substitutes

› Elasticities

› Marginal cost

› Economies and diseconomies of scale

• Perfect competition vs monopoly

› Number of firms

› Barriers to entry

› Homogeneity of product

• Economic welfare and efficiency:

› Consumer and producer surplus

› Deadweight loss

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Efficiency and welfare

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Price

Quantity

Marginal cost /

Supply

Monopoly

output

Monopoly

price

Demand

PC price

PC

output

Producer surplus

Dead weight loss Consumer

surplus

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Efficiency and welfare

• Allocative efficiency

• Productive efficiency

• Dynamic efficiency

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Market power

• Ability to profitably raise price above perfect

competitive level is called ‘market power’

• The logic of the monopoly model…

› Firms produce and sell less than in a competitive market

› There is deadweight loss / inefficiency

…holds for any firm with market power

• Market power is a form of ‘market failure’

› The privately optimal decision ≠ the socially optimal decision

› In this case: private pricing decision does not maximise

welfare

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What do we do about market power?

• Some market power is good…

› Incentive to innovate/differentiate

› And so it is not illegal to have or use market power

• But ‘substantial’ market power can be bad

› Regulation is sometimes used when there is significant and

enduring market power (eg electricity distribution)

› If used for the purpose of deterring or preventing entry or

substantially damaging a competitor (s46)

› If it is achieved through collusion or mergers (substantial

lessening of competition, s50)

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Outline for today

• In PC/monopoly there is no strategic interaction…

• Game theory:

› Static games

› Dynamic games

• Models of markets based on game theory:

› Bertrand (price) competition

› Cournot (quantity) competition

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Game TheoryA tool for analysing strategic interactions

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Game Theory

• Key features of interactive decision-making:

› Who are the decision-makers?

› In what order do they make decisions?

› What actions are available?

› What are their motives or preferences over outcomes?

• A game is a formal representation of this, with elements:

› Players

› Timing:

Simultaneous or sequential actions

One-shot or repeated game

› Actions (can be discrete or continuous)

› Payoffs

› Strategies (“if she does this, I do that…”)

› Equilibrium or equilibria

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Static games

• A one-shot, simultaneous action game

• Represented by the ‘normal form’ matrix.

• Example: Prisoners’ Dilemma

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Prisoner 1

Betray Co-operate

Prisoner 2

Betray

Co-operate

•

• What will be the outcome (equilibrium)?

2 years

2 years

3 years

No jail

No jail

3 years

1 year

1 year

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Static games – equilibrium concepts

• Dominant strategy equilibrium:

› Is there a “dominant strategy” that yields a higher payoff

regardless of the other player’s action?

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Prisoner 1

Betray Co-operate

Prisoner 2

Betray 2 years 3 years

2 years No jail

Co-operate No jail 1 year

3 years 1 year

• The dominant strategy equilibrium (betray, betray) is inferior

for both players to the alternative (co-operate, co-operate)

Dominant

strategy

Dominant

strategy

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Nash equilibrium: another solution concept

• There is not always a dominant strategy equilibrium

• Define a “best response” function as the optimal

choice given your rival’s action

• Nash equilibrium:

› The intersection of best response functions

› i.e. all players are playing their best responses

› Given their rivals’ actions, in a Nash equilibrium no player has

an incentive to change their own action

› Note a DSE is automatically a Nash equilibrium as well

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Example of Nash equilibrium

• A ‘co-ordination game’ of development of new technology› Assume two firms: a TV manufacturer and a broadcaster

› There are costs to both of investing in HDTV technology which will only be recouped if the other also invests

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TV manufacturer

Invest Don’t invest

Broadcaster

Invest 100 20

100 – 50

Don’t invest – 50 20

20 20

• Nash equilibria: (invest, invest) & (don’t invest, don’t

invest)

• What would happen if the game were sequential?

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Sequential games

• Backward induction

• Represent sequential games and repeated games in

the “extensive form”

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M

B B

Invest Don’t

invest

InvestDon’t

investDon’t

investInvest

(100, 100) (–50, 20) (20, –50) (20, 20)(M, B) =

InvestDon’t

invest

Invest

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Ultimatum game

• A one-shot sequential game

• There is a pile of chocolate to be divided amongst 2

players

• Player 1 proposes a split (e.g. 50:50, 80:20, 90:10)

• Player 2 accepts or rejects the offer

› If player 2 accepts, the chocolate is divided as proposed

› If player 2 rejects, neither player receives any chocolate

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Ultimatum game - results

• How many rejected the offer?

• How many offered 50% to the other player?

• How many offered less than 50% to the other player?

• How many offered more than 50% to the other

player?

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• Assume one shot game with perfectly rationale players

• Backward induction

• Player 2 should accept any amount greater than 0

• Player 1 should offer smallest amount possible

• Outcomes often different to theory because repeated

game, fairness etc

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Break

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Models of oligopolyExamining firm conduct when there are few

players

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Price competition

• When firms compete on price, what is the optimal strategy and how competitive will the market be?

• Assume imperfect substitutes

• ‘Best responses’: the higher your rival’s price, the higher your own:

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PA

PQFirm Q b.r.

Firm A b.r.

200

200 300

300

Nash equilibrium: the

intersection of best responses

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Demand increases when rival sets higher price

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Price

Quantity

Demand (Firm Q)

Firm A increase

price

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Price competition (continued)

• Perfect substitutes: “Bertrand competition”

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PT

PJ

J b.r.T b.r.

MCJ

MCT

45° line

• Best response: price just below your competitor (but not < MC)

• Nash equilibrium: P=MC, zero profit

• Are just two firms sufficient to generate a perfectly competitive market?

Nash equilibrium: the

intersection of best responses

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Quantity competition: the Cournot model

• Firms set quantities and let the market determine a

price

• Can represent setting of capacities followed by

capacity-constrained price-setting

• Cournot quantity ‘best responses’:

› Firms choose quantity such that Marginal Revenue = MC

› MR can be broken down into

Additional revenue from one additional sale, which depends on

the price (and therefore quantity sold)

Loss of revenue from lower price on existing sales, which depends

upon how much the increase in the firm’s output alters the price

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Demand falls when rival produces more

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Price

Quantity

Demand (Firm J)

Firm T increases

output

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Quantity competition: the Cournot model

• The best response to 0 is the monopoly quantity (e.g. 500)

• The best response to the PC quantity (e.g. 1000) is 0

• The Nash equilibrium sees P > MC, with the price-cost margin

decreasing as the number of firms increases

• For n=1 and n=∞ Cournot produces the monopoly and PC models

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QT

QJ

Firm J b.r.

Firm T b.r.Nash equilibrium: the

intersection of best responses

1000

500

500 1000

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Cournot illustrated

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Price

Quantity

Marginal cost

Monopoly

output

Monopoly price

Demand

MR

(n=1)

PC price

PC

output

Cournot P (n=2)

Cournot

Q (n=2)Cournot

Q (n=3)

Cournot P (n=3)

…as n ↑

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Applications of Game

TheoryInsights into firm behaviour

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Example: Monopoly with entry deterrence

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• An example of ‘strategic commitment’

• The threat of entry can discipline a monopolist into

more competitive pricing; a ‘contestable market’

Monopolist

Entrant Entrant

Small

capacity

Large

capacity

EnterDon’t

enterDon’t

enterEnter

(20, 20) (60, 0) (0, –20) (40, 0)Profits for (M, E) =

EnterDon’t

enter

Large

capacity

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Predatory pricing

• A firm ‘predator’ sets a low price for sufficient period

such that rival (or rivals) exit

• Typically involves

› Loss of profit by predator when set low prices initially; and

› Phase where predator is able to set higher prices when faces

less competition – need market power

• What is the difference between predation prices

and competitive prices?

› Risk of stifling competition

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Predatory pricing theories

• Reputation models

› Incumbent make a loss fighting entrants in order to

discourage others

• Deep pocket theory

› Small firm’s borrowing is restricted

• Signalling

› Incumbent signals that it has very low costs

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Repeated prisoners dilemma (RPD) and collusion

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Firm 1

Compete Collude

Firm 2

Compete 5 1

5 14

Collude 14 10

1 10

14

10

5

1 2 3

Nash eqm in one

shot game

Firm 1 payoff from

always collude

Firm 1 payoff from

compete today

Number of

periods from now

Pa

yo

ff p

er

pe

rio

d (

firm

1)

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According to this RPD model, firms are more likely

to collude when..

• They are patient

• Frequent interactions between firms

› Benefit of cheating is small

• Cheating is easy to detect

• Fewer firms

•Necessary conditions for collusion:› Agree on collusive outcome

› Monitor collusion and punish cheaters

› Prevent entry (or accommodate)

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How can we stop collusion?

• Market outcomes of collusion and competition look

the same

• No competition authority has detected collusion by

examining market outcomes alone

• Leniency programs in combination with large fines

and are very effective:

› Create a strong incentive to apply for leniency

› “unquestionably, the single greatest investigative tool

available to anti-cartel enforcers” Scott D. Hammond

U.S. Department of Justice

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