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Introduction to Competition

Economics

University of Sydney Law School

Competition Law 2016

Dr Luke Wainscoat

Senior Economist, HoustonKemp

© 2016

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Economics provides insights into competition law

• Competition and Consumer Act is based largely on

what economics tells us harms consumers

• Economics will help you understand cases and

judgments (to an extent…)

• You will not be examined directly on your

understanding of economics

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Economics is a language and set of analytical tools

• No single answer to each economic problem

› “economics is the only field in which two people can get a

Nobel Prize for saying exactly the opposite thing” Anon

› “Give me a one handed economist” Harry S Truman

• Different economic approaches

› Classical economics/price theory (Smith, 1766)

› Structure/conduct/performance (Chamberlain & Robinson,

1930’s)

› Game theory (von Neumann & Nash, 1930’s and 1940’s)

› Behavioural economics (1980’s but mostly 2000’s)

• You will learn methods for analysing problems and

language

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Outline

• Lecture 1:

› Demand and supply model

› Perfect competition vs. monopoly

› Economic welfare and market power

• Lecture 2:

› Game theory

› Price and quantity setting competition

› Other applied topics such as collusion and predatory pricing

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Demand and SupplyThe key to understanding firm conduct

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Demand - How much is one customer willing to

purchase?

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Price

Quantity

Demand

10 12

5

6 X

Y

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Price elasticity of demand• Percentage increase in demand from one per cent

increase in price (ie, a negative number)

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Price

Quantity

Demand

98 100

100

X

Y

101

Elasticity=-2

Elasticity=-0.5

(less elastic)

99.5

• Elasticities of demand and supply are usually higher in the

long run than in the short run

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Cross-price elasticity of demand

• The percentage increase in quantity demanded

from a one per cent increase in some other price

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Negative for complements

Positive for substitutes

Weetbix Milk

Weetbix Cornflakes

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Supply - How much is one firm willing to supply?

9

Price

Quantity

Supply

10

5

12

6

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Equilibrium is where demand is equal to supply

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Price

Quantity

Supply

10

5

12

Demand

Excess supply

Excess demand

7

6

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Increase in supply leads to lower prices and

greater sales

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Price

Quantity

Supply

10

5

12

Demand

X

Y

11

4

Excess supply

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Increase in demand leads to higher prices and

greater sales

12

Price

Quantity

Supply

10

5

12

Demand

X

Y

11

4

Excess demand

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Market demand is the sum of individual demands

13

Price

Quantity5 11

Market

demand

6

4

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What affects market demand for cereal?

• Price of product (move along demand curve)

• Price of substitutes (shift demand curve)

• Price of complements (shift)

• Income (shift)

• Tastes/technology (shift)

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Increase in price of substitute will lead to rise in

market demand

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Price

Quantity

Market

demand for

cereal

Price of

toast goes

up

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Market supply is the sum of individual supplies

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Price

Quantity

6

Market

supply for

cereal

Supply of

Cornflakes

Supply of

Weetbix

2 3 5

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Most significant recent change in the world economy

• Short run demand (and supply) for crude oil are inelastic

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Price

Quantity

Supply

Jan-2014 =

$110/barrel

Demand

Dec-2014 =

$50/barrel

~2% ↑ in 2014

~55% ↓ in 2014

Source: http://www.vox.com/2014/12/16/7401705/oil-prices-falling

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Most significant recent change in the world economy

• What expect to happen in long run?

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Price

Quantity

Supply

Jan-2014 =

$110/barrel

Demand

Dec-2014 =

$50/barrel

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But the oil price continued to fall…

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Source: http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=2y

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Supply exceeded demand for prolonged period

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Source: http://www.vox.com/2016/1/12/10755754/crude-oil-prices-falling

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Opportunity and sunk costs

• Opportunity cost

› Cost of doing something relative to next best alternative

• Sunk cost

› Already incurred and can never be recovered

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Total cost curve

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$

Quantity

Cost of

supplying

Weetbix

Fixed cost

Economies of

scale

Diseconomies of

scale

Variable

costs

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Average and marginal cost

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$

Quantity

Marginal cost

Average cost

Efficient scale of

production

Marginal cost less

than average

cost

Marginal cost more than average

cost

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Break

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Competition and

MonopolyAn introduction to market power

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Efficiency and welfare

• Economic welfare: consumer surplus + producer

surplus

• Consumer surplus: difference between valuation (ie,

willingness to pay) and actual price paid

• Producer surplus: difference between price received

and minimum willing to accept

• Economic welfare = ‘gains from trade’

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• Features:

› Many firms – individual firms are ‘price takers’

› Many consumers – individual consumers are ‘price takers’

› Homogeneous goods

› No barriers to entry

• Outcomes:

› Price=average cost

› Zero economic profit (revenue=opportunity cost)

› Firms operate at efficient scale

› Price=

What is perfect competition?

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Marginal revenue=Marginal costPrice=Marginal revenue =Marginal costPrice=Marginal revenue =Marginal cost

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Perfect competition illustrated

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Price

Quantity

Supply

Demand

PC

price

PC

output

Each firmThe market

Quantity

Average

cost

Marginal

cost

PC output

Demand

Price

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Supply curve for global iron ore

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Source: http://www.rba.gov.au/publications/smp/2015/feb/graphs/graph-a2.html

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Price of iron ore 2011-2016

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Source: http://www.indexmundi.com/commodities/?commodity=iron-ore&months=60

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Example – shifts in supply curve for iron ore

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Source: RBA Statement of Monetary Policy August 2014, Box B,

http://www.rba.gov.au/publications/smp/boxes/2014/aug/b.pdf

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Features of a monopoly

• A single firm which is a ‘price maker’

• The higher the price, the less it sells

• Barriers to entry prevent new suppliers entering

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Monopoly in practice

• Natural monopoly

› Privatised government businesses, e.g. electricity distribution

› Large sunk costs, e.g. airports

• Monopoly licensing: e.g. Tabcorp wagering

• Proprietary knowledge protected by

patent/copyright, e.g. drug companies, musicians

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Two elements to a monopolist’s marginal revenue

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Monopoly increases

output by one unit

Quantity sold increases

Price Revenue

Output

Price falls

Loss of revenue

from lower price

on existing sales

Additional revenue

from greater salesRevenue

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Output is lower and prices are higher under a monopoly

3535

$

Quantity

Marginal

cost

Output

(Monopoly)

Price

(Monopoly)

Demand

Marginal revenue

(monopoly)

Price (perfect

competition)

Output

(Perfect

competition)

Producer surplus

Consumer

surplus Dead weight loss

Richard A. Posner ‘the economic

theory of monopoly provides the only

sound basis for antitrust policy’

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Efficiency and welfare

• Allocative efficiency

• Productive efficiency

• Dynamic efficiency

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Market power

• Ability to profitably raise prices above competitive

level is called ‘market power’

› Non competitive outcomes

› Absence of competitive constraints

• The logic of the monopoly model…

› Marginal revenue < price

› Firms produce and sell less than in a competitive market

› There is deadweight loss / inefficiency

…holds for any firm with market power

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What do we do about market power?

• Some market power is good…

› Incentive to innovate

› 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 particular purposes (extend market power), s46

› If it is achieved through collusion or mergers (substantial

lessening of competition, s50)

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Preview of Lecture 2

• Game theory

› What do the monopoly and PC models leave out?

› A toolkit for analysing strategic interactions

› Examples of entry deterrence and collusion

• Models of price (Bertrand) and quantity (Cournot)

competition

• Other applied situations

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