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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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