Transport Economics and Management

Competition policy and regulation

Eric Pels apels@feweb.vu.nl

This lecture

Last time: market structures

Economic inefficiencies General description

This time: pricing, competition policy and regulation

European Commission

Learning objective: understand why competition policy exists, and be able to explain why competition policy is not always successful (or useful).

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Pricing

Perfect competition: P=MC, welfare maximized Monopoly: P>MC, profits maximized (not welfare) Oligopoly:

Cournot: P>MC, profits maximized, not welfare Bertrand: P=MC

Lets say were are a monopolist.

Set output where MR=MC. Price determined by inverse demand function. Can we get higher profits than this?
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Price discrimination

Conditions:

Market power Different groups of consumers (based on willingness-topay, demand elasticity etc.) segmentation. Resale not possible. Cost of discrimination may not exceed additional profits Markets should be transparent

Charge different (groups of) consumers different prices to maximize profits price discrimination.

First, second and third degree.

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First degree price discrimination

Perfect discrimination: each unit of output sold at different price. Price determined by inverse demand curve. What is the optimal output?

profits

MC

Q*
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Second-degree price discrimination Non-linear pricing: price depends on how much you buy. Fundamentals. Application (as in Mallard and Glaister)

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Second-degree price discrimination Consumer decides on how much to buy: Self selection constraints.

2 consumers; each spends ri to receive Xi benefitsi(Xi)-ri>0 benefits1(X1)-r1> benefits1(X2)-r2 benefits2(X2)-r2> benefits2(X1)-r1

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Second-degree price discrimination

Consider an individual demand function (for convenience, marginal cost are 0) Monopolists wants to supply X1 at a total price of A.

A X1 X

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Second-degree price discrimination

Now consider two individual demand functions Monopolist would like to supply X1 at A+B+C and X2 at A p

B A C X2 X1 X

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Second-degree price discrimination

But: if consumer 1 also purchases X2 at a price of A, he/she will get surplus B (self selection). If the monopolist would charge A+C for X1, consumer 1 get surplus B and the monopolist higher profits. Can the monopolist get higher profits? Make X2 unattractive for consumer 1. Offering less of X2 (loss for monopolist) allows for higher profits from X1.

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Second-degree price discrimination

p Extra profit (increase in C) B A C X2 Loss (reduction in A) X1 X p B Equilibrium: marginal benefit in reduction of X2 = marginal cost

A D X2 Consumer 2 pays A for X2

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C X1 X Consumer 1 pays A+D+C for X1

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Second-degree price discrimination

Examples?

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Third degree price discrimination

Set prices for different groups of consumers: examples?

p* p*

MC Q* Q
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MC Q* Q

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Segmentation based on willingness-to-pay and elasticity

Competition policy

Ensure markets functions as close as possible to perfect competition model European Commission:

5 pillars Subsidiarity: enforced by individual countries Commission intervenes in situations with more than 1 country

National: competition authority

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Anti-competitive behaviour Merger control
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Competition policy

EC competition policy
Encouraging competition

Subsidiarity
State-aid control

International cooperation

Competition policy: national

Subsidiarity National firms Does a firm have monopoly power?

Theory: P=MC/(1+1/p) Market definition: relevant markets

Market is allocation mechanism The ability of consumers to switch products following a change in relative prices Competitive constraint if third-party suppliers can switch production in the short term without significant additional investments (costless entry)
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Demand side substitution

Supply side substitution

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Demand side substitution

SSNIP (Small but Significant and Non-transitory Increase in Price)

US department of justice, 1982 smallest relevant market in which permanent increase in price is possible interview consumers

price increase of e.g. 5% Consumers do not switch to alternatives: no (or limited) change in demand Price increase profitable: regulation Consumers switch to alternatives: change in demand market is not relevant market for regulation, SSNIP test performed on larger basket of products

Does this make sense?

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Monopolist operates on elastic part of (inverse) demand curve!

Marginal revenues
Ped=- P Inverse demand ( a/b-1/b*Q ) Marginal revenues Ped=-b*a/(2b)/(a/2)=-1 MR positive if p<-1 Ped=0

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Monopoly
P
Marginal revenues Marginal costs

Pm

Average costs

Inverse demand

Qm
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Supply side substitution

SSS-test: can a third party enter the market?

What assets are needed to produce the relevant products? Can missing assets be acquired without the need for significant, irreversible new investments? Are companies able to divert production from supply-side substitutes to the relevant products, or are they contractually committed to continue production of existing products? Can unused plant capacity be brought into production at a reasonable cost? Will consumers regard their products as valid substitutes for the existing set of products?

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SSS

hypothetical example. airport A serves passenger airlines, airport B serves cargo airlines. airport B increases charges. Can airport A step in?

airport A must set attractive charge for cargo airlines

incentives for a change

airport has enough capacity to be an alternative of supply Airport is comparable in geographic catchment area Airport is alternative for cargo airlines cargo airlines must be able to easily switch demand

significant investments for specialized storage and warehouse facilities?

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Regulation of monopoly

Cost-based

Price should allow return on investment Most common form: Rate of return regulation

Limit the rate of return to capital: ROR=[pQ-wL-rK]/[pkK]

r=user cost of capital (depreciation), pk=purchase price of capital ROR of 0 is competitive rate of return (no excess profits) Regulated firm maximizes profits under the ROR-constraint

Problems with ROR:

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Fair ROR? Different methods (capital asset pricing, comparative earnings etc.: finance theory) Information assymetry Averch-Johnson effect: incentive to increase capital relative to labor to maximize profits (Gold plating)
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Regulation of monopoly - ROR

Example Carlton and Perloff (2005) P=100-Q Q=LK

Labor price: 168 Capital price (user cost of capital): 168 Cost of capital 1680

Interest rate 10%

ROR=(PQ-168L-168K)/(1680K)

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Regulation of monopoly - ROR

K
6 6 6 6 6 6

L
4 5 6 7 8 9

Q
24 30 36 42 48 54

price
76 70 64 58 52 46

revenues cost profits MR 1824 1680 144 2100 1848 252 2304 2016 288 2436 2184 252 2496 2352 144 2484 2520 -36 2016 2275 2436 2499 2464 2331
2176 2400 2496 2464 2304 2016 2304 2475 2484 2331 2016 1539 1516.5

MK
52 40 28 16 4 34 31 28 26 24 23

Welfare
432 702 936 1134 1296 1422

ROR
1.43 2.50 2.86 2.50 1.43

7 7 7 7 7 7
8 8 8 8 8 8 9 9 9 9 9 9 9.02

4 5 6 7 8 9
4 5 6 7 8 9 4 5 6 7 8 9 9.02

28 35 42 49 56 63
32 40 48 56 64 72 36 45 54 63 72 81 81.36

72 65 58 51 44 37
68 60 52 44 36 28 64 55 46 37 28 19 18.6

1848 2016 2184 2352 2520 2688

2016 2184 2352 2520 2688 2856

168 259 252 147 -56 -357

160 216 144 -56 -384 -840

44 30 16 2

32 28 26 24 22 21
30 27 24 22 21 20 28 25 23 21 20 19 19

560 871.5 1134 1347.5 1512 1627.5

672 1016 1296 1512 1664 1752 768 1135.5 1422 1627.5 1752 1795.5 1795.56

1.43 2.20 2.14 1.25

36 20 4

1.19 1.61 1.07

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2184 120 2352 123 2520 -36 2688 -357 2856 -840 3024 -1485 3030.7 -1514.2 TEM

28 10

0.79 0.81

Average ROR: 1.66

Regulation of monopoly - ROR

Inverse demand MR
Profit maximum Output and price at average ROR Welfare maximized

MC

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Regulation of monopoly

Price-cap (CPI-X) regulation Prices are allowed to increase by the consumer price index, minus expected efficiency savings x. Sets incentive for cost reduction and revenue generation Difficulty: firms have an incentive to undersupply quality (postpone investments) to reduce costs with little reduction in revenues

e.g. rolling stock of railway company

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Efficiency analysis, benchmarking

Determining X Cost minimization: minimize cost to produce given output level. Benchmarking: comparing business (performance metrics) to industry bests. Various tools

Frontier analysis

Cost frontier

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Regression - frontier
ln(C)=K+a*ln(X)+v ln(C)

Frontier Most efficient observation (firm) ln(X)

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Frontier analysis

Corrected OLS

Shift until all but one residuals are positive

add largest negative residual: ln(C)=K+a*ln(X)+v+max(v) = K+a*ln(X)+w

ln(C)=K+a*ln(X)+w C= eK*Xa*ew Efficiency coefficient: EC = CMIN/C

(eK*Xa*e0)/(eK*Xa*ew`) = ew Same output can be obtained at fraction EC of costs ln(C)=K+a*ln(X)+u+v, v has normal distribution, u is nonnegative error term
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Stochastic frontier:

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Alternative regulation methods

Sliding scale regulation

Tries to deal with information assymetry

Give incentive to release information

sliding scale: higher cost firms have higher regulated price benchmark for profits; profits exceeding benchmark split between firm and consumers Somewhere between CPI-X and cost-based

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Alternative methods

Yardstick competition

Regulator employs cost levels of identical firms to determine regulated price

Mean average (marginal) cost of firms

Investment regulation

Excess demand: extra capacity comes at higher cost. Price caps must allow higher charges.

Price monitoring
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Summary

International and national rules Does a company have monopoly power? Does regulation give proper incentives? Schiphol has strong position on market for provision of infrastructure for take-offs and landings for O&D passengers. Many airlines are very unlikely to leave Schiphol for other airports (GAP, 2010).

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Background slide 29: logarithms

alog(x)=q

aq=x (raise a to the power q to get x) ln(x)=elog(x) (raise e tot the power ln(x) to get x) eln(x)=x ln(ex)=x ln(xy)=ln(x)+ln(y) ln(xayb)=aln(x)+bln(y)

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