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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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Quiz (1)

• How will the price and quantity consumed change

when income increases?

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Increase in demand leads to higher prices and

greater sales

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Price

Quantity

Supply

10

5

12

Demand

X

Y

11

4

Excess demand

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Quiz (2)

• What is the price elasticity of demand?

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The percentage increase in quantity demanded from a one

per cent increase in some other price

Percentage increase in demand from one per cent increase

in price (ie, a negative number)

• What is the cross-price elasticity of

demand?

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Quiz (3)

• What is the price under perfect competition?

• Price=Marginal cost=Average cost

• How does the price under monopoly differ from

perfect competition?

•Monopoly price is higher

• Why is monopoly pricing inefficient?

•Allocative inefficiency

• Productive inefficiency

•Dynamic inefficiency

• What is market power?

•Ability profitably to raise prices above competitive level

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Outline for today

• Barriers to entry

• Game theory

› Static games

› Dynamic games

• Models of markets based on game theory

› Bertrand (price) competition

› Cournot (quantity) competition

• Applications of game theory

› Monopoly with entry deterrence

› Predatory pricing

› Collusion

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Barriers to entryThe key to enduring market power

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A single supplier can be perfectly competitive

• Perfectly contestable market

› One supplier

› Technology/knowhow for production

available to all

› Fixed, but no sunk costs

• Outcome

› Price=average costs

• But

› Fixed costs often sunk – no

‘hit and run’ entry

› New entrants may have higher

variable costs

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Barriers to entry allow incumbents to set prices above

the competitive level without entry occurring

• Some disagreement on exact definition• Something that allows the incumbents to earn above-normal

profits

• A cost of producing that must be borne by an entrant but not incumbents

• Additional profit earned as a sole consequence of being established in the industry

• Key is that barriers to entry allow firms to have market power

• As a practical matter – extent to which the threat of entry restricts market power depends upon:› Likelihood of entry

› Timeliness of entry

› Impact of entry on the incumbents

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There are three types of entry barriers

• Structural

› Economies of scale

› Sunk costs

• Strategic

• Legal/regulatory

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• Fixed (and not sunk) costs are not barriers to

entry on their own

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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

Co-operate Betray

Prisoner 2

Co-operate

Betray

•

• 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

Co-operate Betray

Prisoner 2

Co-operate 1 year No jail

1 year 3 years

Betray 3 years 2 years

No jail 2 years

• Equilibrium (betray, betray) is inferior for both players to

(co-operate, co-operate)

Dominant

strategy

Dominant

strategy

Equilibrium

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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

› Intersection of best response functions, ie 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

› 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

• Solve by backward induction

› If M don’t invest, then B should not invest

› If M invests, then B should also invest

› So, M should invest

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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 any split (eg, 50%/50%, or 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

• Player 1› 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?

• Player 2› How many rejected the offer?

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• Assume one shot game with perfectly rationale players

• Player 2 should

• accept any amount greater than 0

• Player 1 should

• offer smallest amount possible

• But, 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?

• Firm A and B supply imperfect substitutes

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

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PB

PA

Firm A b.r.

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Demand changes when rival sets higher price

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Price

Quantity

Demand (A)

Firm B increase

price

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Price competition

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

• Firm A and B supply imperfect substitutes

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

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PB

PAFirm A b.r.

Firm B b.r.

200

200 300

300

Nash equilibrium: the

intersection of best responses

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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

$99

$100

$100

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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

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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

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QT (seats per day)

QJ

(seats per

day) Firm T b.r.1000

500

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Demand changes when rival produces more

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Price

Quantity

Demand (T)

Firm J increases

output (seats)

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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

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QT (seats per day)

QJ

(seats per

day)

Firm J b.r.

Firm T b.r.Nash equilibrium: the

intersection of best responses

1000

500

500 1000

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Quantity competition: the Cournot model

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Firm 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 one additional

saleRevenue

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Cournot illustrated

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Price

Quantity

Marginal cost

Monopoly

output

Monopoly price

Demand

PC price

PC

output

Cournot (n=2)

Cournot

(n=2)Cournot

(n=3)

Cournot (n=3)

Price falls as the number of firms

increases

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Applications of Game

TheoryInsights into firm behaviour

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Example: Monopoly with entry deterrence

• A monopolist chooses to invest in either small or largeproductive capacity› Small capacity is just sufficient for sales at the pure monopoly

price

› Large capacity means the monopolist sets a lower price (closer to the competitive price)

› Without entry, small capacity is more profitable than large capacity

• An entrepreneur chooses to enter (incurring sunk costs) or not› If the incumbent has small capacity they share the market and

the entrant’s fixed costs are recouped

› If the incumbent has large capacity the entrant’s fixed costs are not recouped

• If entry occurs then the monopolist will receive:› Low profits if it has small capacity

› Even lower profits if it has large capacity

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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

Monopolist

Entrant Entrant

Small

capacity

Large

capacity

EnterDon’t

enterDon’t

enterEnter

(20, 20) (60, 0) (0, –20) (40, 0)(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

• Requires

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

› Recoupment 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?

› What if the regulator makes a mistake?

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Game theory - points to take away

• Strategic interaction – firms make decisions based on

what they expect will be reactions of others

• Best responses and Nash equilibrium

• Backward induction

• Importance of information

• Learning in repeated games

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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

Payoff from

always collude

Payoff from

compete today

Number of

periods from now

Pa

yo

ff p

er

pe

rio

d (

firm

1)

Assume firm 2

undertakes ‘grim

trigger’ collusive

strategy

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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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