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202 Part 1: Introduction

EC competition law whether the referrals included in the national law are subjective or
objective. Even if a private national law is applicable, it does not answer the question which
other national or foreign regulations may also be applicable or even executable.
1–7–117 As shown previously in Benetton International,168 European competition law is an important
part of the European and the local public order, especially as regards Arts 81 and 82 EC. The
arbitration tribunals have to adhere to the regulations and decisions of the European authorities,
irrespective of other possible jurisdictions that may exist in certain issues. A decision made by a
court of arbitration which is contrary to European competition law will have to be declared
void by the relevant higher national courts for breach of public policy. The decision of the
arbitration tribunal will neither be recorded nor executed.

G. Economic Principles of Competition Law

Literature. Bester, Theorie der Industrieökonomik, 3rd edn, 2004; Bishop/Walker, The Economics of
EC Competition Law: Concepts, Application and Measurement, 2nd edn, 2002; Bork, The Antitrust
Paradox: A Policy in War with Itself, 1978; Bühler/Jaeger, Einführung in die Industrieökonomik, 2002;
Cabral, Introduction to Industrial Organization, 2000; Carlton/Perloff, Modern Industrial Organization, 4th
edn, 2005; Church/Ware, Industrial Organization. A Strategic Approach, 2000; Cucinotta/Pardolesi/Van den
Bergh, Post-Chicago Developments in Antitrust Law, 2002; Davies/Lyons/Dixon/Geroski, Economics of
Industrial Organisation, 1989; Ellig, Dynamic Competition and Public Policy, 2001; Hayek, Competition
as a Discovery Procedure, in: Hayek, New Studies in Philosophy, Politics, Economics, and the History of
Ideas, 1978, 179–190 Hoppmann, Wirtschaftsordnung und Wettbewerb, 1988; Hylton, Antitrust Law:
Economic Theory and Common Law Evolution, 2003; Kaserman/Mayo, Government and Business: The
Economics of Antitrust and Regulation, 1995; Kerber, Wettbewerbspolitik, in: Bender et al., Vahlens
Kompendium der Wirtschaftstheorie und Wirtschaftspolitik, Vol.2, 9th edn, 2007, 369–434; Knieps,
Wettbewerbsökonomie. Regulierungstheorie, Industrieökonomie, Wettbewerbspolitik, 2nd edn, 2005;
Martin, Industrial Organization. A European Perspective, 2001; Metcalfe, Evolutionary Economics and
Creative Destruction, 1998; Monopolkommission, Hauptgutachten I–XVI, 1975–2004; Motta, Compe-
tition Policy: Theory and Practice, 2004; Neumann, Competition Policy: History, Theory and Practice,
2001; Neumann/Weigand, The International Handbook of Competition, 2004; Pepall/Richards/Norman,
Industrial Organization. Contemporary Theory and Practice, 2nd edn, 2002; Phlips, Competition Policy: A
Game Theoretic Perspective, 1995; Posner, Antitrust Law. An Economic Perspective, 2nd edn, 2001;
Scherer/Ross, Industrial Market Structure and Economic Performance, 3rd edn, 1990; Schmalensee/Willig,
Handbook of Industrial Organization, Vol.1 and 2, 1989; Schmidt, Wettbewerbspolitik und Kartellrecht,
8th edn, 2005; Schwalbe/Zimmer, Kartellrecht und Ökonomie, 2006; Schulz, Wettbewerbspolitik. Eine
Einführung aus industrieökonomischer Perspektive, 2003; Shy, Industrial Organization: Theory and
Applications, 6th edn, 2001; Utton, Market Dominance and Antitrust Policy, 2nd edn, 2003; Tirole, The
Theory of Industrial Organization, 15th edn, 2004; Van den Bergh/Camesasca, European Competition Law
and Economics. A Comparative Perspective, 2nd edn, 2006; Viscusi/Vernon/Harrington, Economics of
Regulation and Antitrust, 3rd edn, 2000; Waldman/Jensen, Industrial Organization: Theory and Practice,
2nd edn, 2001; Williamson, Antitrust Economics: Mergers, Contracting, and Strategic Behavior, 1987.

Contents

Para. Para.
I. Competition and competition 3. Competition policy in other European
policy: an introduction countries.............................................. 1–8–020
1. Market economy, competition, and 4. European competition policy............ 1–8–023
economic constitution........................... 1–8–001 5. Competition policy at the
2. Public and private restraints to international level................................. 1–8–030
competition, and natural monopolies...... 1–8–005 III. Competition economics: an
3. Competition policy.......................... 1–8–009 overview of theoretical concepts
II. History of competition policy 1. Classical economics.......................... 1–8–033
1. US antitrust policy........................... 1–8–013 2. Neoclassical microeconomics, market
2. Competition policy in Germany........ 1–8–017 forms, and welfare economics................ 1–8–035

168
cf. paras 67–72.

Kerber/Schwalbe
G. Economic Principles of Competition Law 203

3. Workable competition and empirical (b) Effects of perfect competition


industrial organisation (aa) Allocative efficiency............. 1–8–119
(a) Workable competition................ 1–8–043 (bb) Productive efficiency............ 1–8–121
(b) Structure-conduct-performance (cc) Dynamic efficiency.............. 1–8–122
paradigm.................................... 1–8–044 3. Monopoly
(c) Empirical industrial organisation... 1–8–046 (a) Assumptions and market
(d) Harvard School and the structural performance............................... 1–8–124
approach.................................... 1–8–048 (b) Effects of monopoly
(e) Policy implications and impact..... 1–8–051 (aa) Allocative efficiency............. 1–8–127
4. Efficiency-based concepts of (bb) Productive efficiency............ 1–8–128
competition (cc) Dynamic efficiency.............. 1–8–131
(a) Introduction............................... 1–8–053 (dd) Reallocation........................ 1–8–132
(b) The Chicago School................... 1–8–054 (c) Extensions of the monopoly
(c) Contestable markets.................... 1–8–060 model........................................ 1–8–133
(d) Transaction costs economics........ 1–8–062 (aa) Durable-goods monopolies. . . 1–8–134
(e) Policy implications and impact..... 1–8–064 (bb) Multi-product monopolies.... 1–8–136
5. Competition and innovation: (d) A dominant firm with a
Schumpeterian approaches and the competitive fringe....................... 1–8–138
Austrian School 4. Monopolistic competition................. 1–8–141
(a) Introduction............................... 1–8–066 5. Oligopoly
(b) Schumpeterian approaches: (a) Introduction............................... 1–8–143
dynamic competition as a process (b) The basic concepts of game theory 1–8–144
of innovation and imitation......... 1–8–069 (aa) Players, strategies, and pay-
(c) Competition as a discovery offs..................................... 1–8–147
procedure (Hayek)...................... 1–8–073 (bb) Nash equilibrium................. 1–8–148
(d) Ordoliberalism and Hoppmann’s (c) Equilibrium in oligopolistic
concept of freedom of competition 1–8–075 markets...................................... 1–8–150
(e) Evolutionary and innovation (aa) Price competition with
economics and competition homogeneous goods............. 1–8–151
theory: an outlook...................... 1–8–078 (bb) Quantity competition with
6. Recent theoretical developments and homogeneous goods............. 1–8–152
Post-Chicago economics (cc) Price competition with
(a) Introduction............................... 1–8–079 differentiated goods.............. 1–8–157
(b) Industrial organisation theory....... 1–8–080 (dd) Quantity competition with
(c) Institutional economics and the differentiated goods.............. 1–8–160
theory of the firm....................... 1–8–083 (d) Other models of oligopolistic
(d) Competition in networks: competition............................... 1–8–161
regulation and deregulation......... 1–8–086 (e) Efficiency in oligopolistic markets 1–8–164
(e) Empirical analyses....................... 1–8–087 6. The concept of market power
(f) Post-Chicago economics: a new (a) Market power and the price
consensus?.................................. 1–8–088 elasticities of demand and supply. . 1–8–167
(g) Critical assessment...................... 1–8–092 (b) Market power, market dominance,
IV. Competition policy: normative and efficient competition............. 1–8–180
and theoretical foundations 7. Assessment of market power—market
1. The aims of competition policy delineation........................................... 1–8–183
(a) Introduction............................... 1–8–093 (a) Measuring market power directly. 1–8–184
(b) Welfare-based objectives............. 1–8–094 (b) Market definition—indirect
(aa) Allocative efficiency............. 1–8–095 assessment of market power......... 1–8–188
(bb) Productive efficiency............ 1–8–096 (aa) A concept based on
(cc) Dynamic efficiency/ consumers’ needs................. 1–8–189
innovations.......................... 1–8–097 (bb) The hypothetical monopoly
(dd) Consumer welfare/ test..................................... 1–8–191
preventing redistributions due (cc) Demand-side substitution...... 1–8–194
to market power.................. 1–8–099 (dd) Supply-side substitution........ 1–8–199
(c) Other possible objectives of (ee) Simultaneous definition of the
competition policy...................... 1–8–103 relevant product and
(d) Conclusions............................... 1–8–108 geographical markets............ 1–8–203
2. Perfect competition.......................... 1–8–110 (ff) Market definition in the case
(a) Assumptions and market of differentiated goods.......... 1–8–204
performance............................... 1–8–111 (gg) Market definition in the case
of price discrimination.......... 1–8–205
(hh) Aftermarkets........................ 1–8–206

Kerber/Schwalbe
204 Part 1: Introduction

(ii) Innovation markets.............. 1–8–207 (b) Possible causes of variations in


(jj) The cellophane fallacy.......... 1–8–208 concentration............................. 1–8–322
(kk) Conclusions......................... 1–8–211 2. Effects of mergers: outline................ 1–8–323
(c) Empirical methods of market 3. Unilateral effects.............................. 1–8–326
definition................................... 1–8–213 (a) Price competition with
(aa) Price elasticity of demand, homogeneous goods................... 1–8–327
critical elasticities and critical (b) Quantity competition with
sales loss.............................. 1–8–214 homogeneous goods................... 1–8–329
(bb) Cross-price elasticities and (c) Price competition with
diversion ratios.................... 1–8–219 differentiated goods..................... 1–8–331
(cc) Price tests............................ 1–8–220 (d) Quantity competition with
(dd) Defining the relevant differentiated goods..................... 1–8–333
geographical market............. 1–8–226 (e) Detecting unilateral effects........... 1–8–335
(ee) Conclusions......................... 1–8–228 (aa) Merger simulations............... 1–8–336
8. Potential competition and barriers to (bb) Structural measures............... 1–8–342
entry................................................... 1–8–229 (cc) Conclusions......................... 1–8–345
(a) Potential competition.................. 1–8–230 4. Co-ordinated effects
(b) Barriers to entry......................... 1–8–231 (a) Introduction............................... 1–8–346
V. Horizontal Agreements and (b) Theoretical problems in the
Cartel prohibition assessment of co-ordinated effects. 1–8–347
1. Introduction.................................... 1–8–239 (c) The assessment of co-ordinated
2. The theory of collusion.................... 1–8–248 effects........................................ 1–8–351
(a) Game theoretic foundations......... 1–8–250 (d) Approaches to the review of co-
(b) Necessary conditions for the ordinated effects......................... 1–8–352
existence of a co-ordinated 5. Efficiency gains
equilibrium (a) Effects of efficiency gains............. 1–8–357
(aa) Repeated interactions........... 1–8–256 (b) Types of efficiency gains............. 1–8–360
(bb) The discount factor.............. 1–8–257 (aa) Gains from rationalisation and
(cc) A credible punishment increasing returns to scale..... 1–8–361
mechanism.......................... 1–8–258 (bb) Economies of scope............. 1–8–363
(dd) Market transparency............. 1–8–260 (cc) Advantages in input markets. 1–8–364
(c) Mechanisms to achieve a co- (dd) Better access to capital.......... 1–8–365
ordinated equilibrium.................. 1–8–262 (ee) Reducing slack and X-
(aa) Explicit agreements.............. 1–8–263 inefficiencies........................ 1–8–366
(bb) Information exchange and (ff) Improved transmission of
price leadership.................... 1–8–265 know-how.......................... 1–8–367
(cc) Pricing rules........................ 1–8–268 (gg) Technological progress......... 1–8–368
(dd) Other mechanisms to achieve (c) Calculating efficiency gains.......... 1–8–371
co-ordination...................... 1–8–272 6. Takeover of a failing firm................. 1–8–374
(d) Conditions relating to the stability 7. Assessment of the overall effects of a
of equilibrium............................ 1–8–274 merger................................................ 1–8–375
(aa) Criteria relating to the firms. 1–8–275 8. Policy conclusions
(bb) Criteria relating to the market 1–8–282 (a) Market dominance versus
3. Agreements on prices, quantities, and significant impediment to effective
market division: Policy conclusions........ 1–8–294 competition............................... 1–8–376
(a) Preventing illegal agreements....... 1–8–295 (b) The guidelines for the assessment
(b) Disclosing illegal agreements........ 1–8–297 of horizontal mergers.................. 1–8–377
4. Agreements on joint research and VII. Vertical agreements and vertical
development mergers
(a) Introduction............................... 1–8–299 1. Introduction.................................... 1–8–380
(b) Effets of collaborative research..... 1–8–301 2. Efficiency advantages of vertical
(aa) Potential advantages............. 1–8–302 agreements
(bb) Anti-competitive effects........ 1–8–308 (a) Co-ordination as a precondition
(c) Policy conclusions...................... 1–8–311 for efficiency in the value chain... 1–8–386
5. Other horizontal agreements............. 1–8–313 (b) Free-riding problems between
VI. Horizontal mergers and merger dealers and producers.................. 1–8–389
control (c) Transaction-specific investments
1. Concentration: Causes and and hold-up problems................. 1–8–394
measurement (d) Investments for the development
(a) Measurement of concentration..... 1–8–319 of new markets........................... 1–8–397

Kerber/Schwalbe
G. Economic Principles of Competition Law 205

(e) Economies of scale, indivisibilities (d) Tying and bundling.................... 1–8–498


and variety................................. 1–8–399 (e) Essential facilities........................ 1–8–503
(f) Double marginalisation................ 1–8–401 (f) Other predatory practices............ 1–8–506
(g) Learning, communication and 4. Implications on competition policy.... 1–8–507
complementary knowledge.......... 1–8–405 IX. Natural monopolies and
(h) Conclusions............................... 1–8–406 regulation
3. Potential anti-competitive effects of 1. Economic foundations of natural
vertical agreements monopolies.......................................... 1–8–508
(a) Competition between 2. The necessity of regulating natural
manufacturers............................. 1–8–407 monopolies.......................................... 1–8–511
(aa) Strategic use of vertical 3. Methods of regulation
restraints for impeding (a) Ramsey prices............................ 1–8–517
competition between (b) Peak-load pricing........................ 1–8–520
manufacturers...................... 1–8–408 (c) Non-linear pricing and two-part
(bb) Vertical restraints to facilitate tariffs......................................... 1–8–521
oligopolistic co-ordination (d) Regulating access prices.............. 1–8–522
between manufacturers......... 1–8–412 (e) Incentive mechanisms................. 1–8–524
(cc) Commitment problems of (f) Cost-based regulation and rate-of-
manufacturers with market return-based regulation................ 1–8–527
power................................. 1–8–415 (g) Price-cap regulation.................... 1–8–528
(b) Foreclosure and leverage effects 4. Deregulation.................................... 1–8–529
(aa) Introduction........................ 1–8–419
(bb) Foreclosure effects of X. Institutional foundations of
exclusive agreements............ 1–8–420 competition policy
(cc) Foreclosure and leverage 1. Introduction.................................... 1–8–530
effects of vertical mergers...... 1–8–424 2. State failure in competition policy:
(c) Competition between retailers..... 1–8–431 some fundamental problems
(d) Conclusions............................... 1–8–436 (a) Political economy problems......... 1–8–532
4. Policy conclusions for vertical (b) Problems of knowledge and
agreements and vertical mergers predictability of competition
(a) General principles....................... 1–8–437 processes.................................... 1–8–534
(b) Vertical mergers......................... 1–8–446 (c) Costs of competition policy......... 1–8–536
(c) Resale price maintenance............ 1–8–448 3. Rules versus discretion in competition
(d) Exclusive agreements.................. 1–8–450 policy
(e) Other vertical agreements............ 1–8–452 (a) Basic considerations.................... 1–8–537
5. Economic analysis of European (b) Per se rules and the rule of reason:
competition policy on vertical agreements an economic analysis................... 1–8–539
(a) Introduction............................... 1–8–453 (c) Specific problem I: obligations,
(b) The aim of market integration and commitments, and the control of
the problem of parallel trade........ 1–8–454 behaviour.................................. 1–8–544
(c) Block exemption regulation on (d) Specific problem II: industrial
vertical agreements...................... 1–8–456 policy and political decision-
(d) Block exemption regulation on making...................................... 1–8–546
vertical agreements in the motor 4. Enforcement of competition law
vehicle sector............................. 1–8–458 (a) Institutional options.................... 1–8–550
(b) Public competition authorities..... 1–8–551
VIII. Predatory behaviour and (c) Private enforcement.................... 1–8–556
prohibiting of abuse of market power (d) Economic analysis of sanctions in
by a dominant firm competition law......................... 1–8–560
1. Introduction.................................... 1–8–460 (e) Conclusions............................... 1–8–561
2. Exploitative abuses 5. Jurisdictional problems and
(a) Excessive prices.......................... 1–8–465 international competition policy
(b) Price discrimination.................... 1–8–467 (a) The problem of cross-border
3. Predatory behaviour effects of restrictions of
(a) Introduction............................... 1–8–479 competition and the limits of the
(b) Predatory pricing effects doctrine........................... 1–8–562
(aa) The basic idea..................... 1–8–480 (b) Main remedies for international
(bb) Conditions.......................... 1–8–482 competition problems................. 1–8–565
(cc) More recent theories of (c) Application I: competition law in
predatory pricing................. 1–8–485 the EU...................................... 1–8–572
(dd) Detecting predatory pricing. . 1–8–491 (d) Application II: competition policy
(c) Price discrimination.................... 1–8–496 at the global level....................... 1–8–574

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206 Part 1: Introduction

I. Competition and competition policy: an introduction


Literature. Böhm, Das Problem der privaten Macht, in: Böhm, Reden und Schriften, 1960, 25–45;
Böhm, Privatrechtsgesellschaft und Marktwirtschaft, ORDO 17, 1966, 75–151; Cooter/Ulen, Law &
Economics, 4th edn, 2004; Downs, Economic Theory of Democracy, 1957; Edwards, Big Business and the
Policy of Competition, 1956; Eucken, The Foundations of Economics: History and Theory in the Analysis
of Economic Reality, 1950; Fritsch/Wein/Ewers, Marktversagen und Wirtschaftspolitik, 6th edn, 2005;
Hayek, Law, Legislation and Liberty, Vol.1: Rules and Order, 1973; Hoppmann, Zum Problem einer
wirtschaftspolitisch praktikablen Definition des Wettbewerbs, in Schneider, Grundlagen der Wettbe-
werbspolitik, 1968, 9–49; Leach, A Course in Public Economics, 2004; Mestmäcker, The Role of Com-
petition in the Liberal Society, in Koslowski, The Social Market Economy. Theory and Ethics of the
Economic Order, 1998, 329–350; Mueller, Public Choice III, 2003; Mussler, Die Wirtschaftsverfassung der
Europäischen Gemeinschaft im Wandel, 1998; Posner, Economic Analysis of Law, 6th edn, 2003; Fur-
ubotn/Richter, Institutions in Economic Theory: The Contribution of the New Institutional Economics,
2nd edn, 2005; Smith, The Wealth of Nations, 1776/1937; Streit, Economic Order, Private Law and Public
Policy. The Freiburg School of Law and Economics in Perspective, Journal of Institutional and Theoretical
Economics 148, 1992, 675–704.
1–8–001 1. Market economy, competition, and economic constitution. Competition among
firms as well as among consumers on all markets of an economy is a necessary precondition for
the functioning of market economies. Without competition markets cannot fulfil their fun-
damental tasks of co-ordinating supply and demand and of allocating resources to their most
productive use. Moreover, without competition no incentives would exist for the develop-
ment of new products and production technologies, i.e. for technological progress. Therefore,
competition is fundamental to the effectiveness of the market economy as a self-regulating
system. Classical authors such as Adam Smith, David Ricardo and John Stuart Mill viewed the
market economy as a self-regulating system, driven by competition and free prices. The market
economy directs the self-interested activities of individuals for the benefit of the whole of
society without requiring any central planning. This phenomenon is also known as the
‘‘invisible hand’’ of the market or as ‘‘spontaneous order’’.1 Although the decisions of all
members of the society as suppliers and consumers of goods, services and production factors are
guided by self-interest, competition implies that every actor contributes to a state of welfare
which is as high as possible for everyone. Furthermore, through its role of limiting power,
competition protects from the manifold negative effects of market dominance.2 Competition is
also of the utmost importance in the political realm as it follows from the fundamental civil
liberties in a democratic constitutional state.3 Such a political system is characterised by
competition among parties for voters in political markets.4
1–8–002 How can market competition be described? Phenomologically, competition can be
described as a process of rivalry driven by profit-seeking in which firms try to improve their
products and services or to offer them at lower prices in order to induce consumers to conclude
contracts. In this competitive process suppliers can use many different factors such as price,
service, advertising, and product design or product quality. Buying firms in down-stream
markets and, ultimately, consumers, decide which of the offered services or products meet their
preferences or needs best. Each buying decision initiates a feedback loop because suppliers learn
about their relative success, which is shown by the extent of their profits (or losses). Com-
petition also takes place among firms as buyers in upstream markets for scarce products and
technologies. Although a generally accepted definition of the term ‘‘competition’’ has yet to be
found, Section III will show that in the economic literature several different theoretical
concepts have been developed for the analysis of market competition.
1–8–003 From an economic point of view an appropriate institutional framework is necessary to
ensure the proper functioning of markets. The legal system, in particular, provides the
institutional preconditions for the working of markets and competition. Private property
rights, freedom of contract as well as entrepreneurial freedom and free market entry (i.e.
economic freedom) are basic legal premises; economic agents should have the right to decide
freely on the production of goods and services, their transactions as suppliers and consumers,
and to pursue innovative activities through the development of new goods and technologies.5

1
See Smith, 1776/1937; Hayek, 1973.
2
See Eucken, 1952; Böhm, 1960; Edwards, 1956, 4; Scherer/Ross, 1990, 18.
3
See Hoppmann, 1968; Mestmäcker, 1998.
4
See Downs, 1957; Mueller, 2003.
5
For the freedom to innovate as a part of freedom of competition, see Hoppmann, 1968, 241.

Kerber/Schwalbe
G. Economic Principles of Competition Law 207

In the 18th and 19th century, the classical liberal authors referred to above had drawn attention
to these institutional preconditions for the functioning of markets and competition. A sys-
tematic analysis of the necessary institutional framework for market was, however, first made
by the German approach of Ordoliberalism (the Freiburg School of Law and Economics).6 In
Germany, the necessary legal framework for a market economy has also been called the
‘‘economic constitution’’ (‘‘Wirtschaftsverfassung’’) or according to Walter Eucken ‘‘compe-
tition order’’ (‘‘Wettbewerbsordnung’’).7 Internationally, this necessary institutional framework
has been analysed since the 1960s by the New Institutional Economics and the more inter-
disciplinary approach of Law and Economics.8
This institutional framework for markets contains more legal rules than just the most basic 1–8–004
private property rights and freedom of contract. Real-world markets almost never correspond
with the ideal concept of perfect markets because more or less serious market imperfections
often impede the perfect functioning of markets. The economic theory of market failure helps
to analyse such market failures and attempts to derive suitable policy solutions. In many cases
such problems can be solved or at least mitigated by introducing additional mandatory rules
(regulation) into the institutional framework. Typical examples of market failures are infor-
mation problems, which may require consumer protection regulations (e.g. the legal rules
against unfair competition common in Continental legal systems or regulating unfair contract
terms in the UK), negative external effects (environmental problems, leading to environmental
regulations) or public goods which are not supplied by private agents (e.g. national security).
Also, in areas such as labour policy (labour regulations), innovation policy (patent laws), or
financial markets (banking regulations), economic analysis helps to detect problems of market
failure which can be alleviated through appropriate regulation. In addition, questions of dis-
tribution can also be addressed in order to correct socially unacceptable market results (social
and educational policy). However, the most important aspect here is that the smooth working
of market competition is generally not achieved. Economic theory and empirical studies
demonstrate that there can be a number of restraints of competition that may cause market
failure. As a result, competition policy is generally seen as necessary. However, the problems
and dangers of public policy and regulation, i.e. state failure, must also be taken into account; in
order to reach appropriate policy conclusions both market failures and state failures must be
balanced against each other.9
2. Public and private restraints of competition and natural monopolies. All societies 1–8–005
have the following general problem in relation to the enforcement of competition: on the one
hand, all economic agents, in their role as suppliers of goods, would like to produce and sell
their products without any competitive pressure at the highest prices possible. However, the
same economic agents, acting as consumers, want competition amongst suppliers because
competition increases consumer welfare. Therefore, all firms would like to avoid competition
for themselves but want, simultaneously, to benefit from the competition of other firms. From
the perspective of game theory, this can be analysed as a ‘‘prisoner’s dilemma’’ situation: for
each individual agent it is rational to restrict competition, yet from the perspective of society as
a whole it is rational that as many products and services as possible are supplied under con-
ditions of competition. In the light of the large incentives to avoid competitive pressure, it is
not surprising that firms and whole industries have developed business practices to restrict
competition.
Public and private restraints of competition can be distinguished. In the case of public 1–8–006
restraints of competition, competition is restricted or distorted through measures by the
Government, or, more generally, the state:
(1) Through a protectionist international trade policy (such as customs tariffs or other import
restrictions), which harms domestic consumers, in particular through excessive prices as
domestic industries are protected from foreign competitors. Therefore, a policy of free
trade, which abolishes restraints on international trade, is viewed as making an important
contribution to ensuring domestic competition (open domestic markets).
(2) In many countries certain sectors of the economy (e.g. telecommunication, mail services,
energy) have (or had) state monopolies or private firms that have been granted monopoly
rights. In either case, competition can be entirely eliminated in these industries.
(3) State subsidies may also impede competition. Though competition is not eliminated

6
See Eucken, 1950; Streit, 1992.
7
On the concept of ‘‘economic constitution’’, see Böhm, 1966, and Mussler, 1998.
8
See Furubotn/Richter, 2005; Posner, 2003; Cooter/Ulen, 2004.
9
For the theory of market failure, see Fritsch/Wein/Ewers, 2005, and Leach, 2004.

Kerber/Schwalbe
208 Part 1: Introduction

completely, distortions of competition between subsidised and non-subsidised firms may


arise. The firms with the highest subsidies, rather than the most efficient, might prevail in
the market.
(4) Competition can also be restricted by public barriers to entry. Entry into particular
markets can be restricted quantitatively (e.g. licences) or through high minimum stan-
dards (e.g. minimum qualifications in professional services). Though there are cases in
which such regulations (as well as some subsidies) can be defended due to market failure
problems, they often tend to be abused for the protection of established firms against
market entrants.
1–8–007 Private restraints of competition are characterised by the direct attempts by firms to restrain
competition on markets through a number of business strategies:
(1) Co-ordination of behaviour: By forming cartels or by co-ordinating their behaviour (e.g.
through price-fixing agreements) competing firms can restrict competition amongst
themselves (horizontal agreements). Thus, consumers must pay higher prices or receive
worse goods and services. Contractual relations between firms operating at different
economic levels (vertical agreements) can also restrict competition.
(2) Mergers and acquisitions: Mergers and acquisitions eliminate competition between the
merging firms and can increase market concentration substantially; this can change market
structures in such a way that restraints of competition due to oligopolistic co-ordination
or the emergence of a monopoly are more likely.
(3) Predatory behaviour: Dominant firms may hamper competition by exploiting consumers
through setting excessive prices or by impeding rivals, e.g. through predatory pricing or
other strategies. As a consequence, strategies based on unfair behaviour rather than
superior performance might determine market success.
1–8–008 Natural monopolies: It may be most efficient if one firm only produces and offers a good or
service due to technological conditions such as increasing economies of scale or network
advantages. In the economic literature such cases are described as natural monopolies. The
crucial point is that such monopolies are neither based on public interventions (such as public
monopolies or the grant of monopoly rights) nor on private anti-competitive behaviour (as, e.g
mergers), but on purely technological grounds.
1–8–009 3. Competition policy. Competition policy encompasses all legal rules and public mea-
sures that counter restraints of competition and help to implement and safeguard effective
competition. Competition policy usually refers only to policy regulating private restraints of
competition, i.e. anti-competitive agreements, mergers, and predatory behaviour. The current
legal rules for this kind of competition policy are the Act Against Restraints of Competition
(‘‘Gesetz gegen Wettbewerbsbeschränkungen’’, GWB) in Germany and on the European level,
Arts 81 and 82 EC as well as the Merger Regulation. US antitrust policy and UK competition
policy also focuses on these private restraints of competition, as does this chapter on the
economic foundations of competition policy. However, a broader concept of competition
policy could include the following two additional policy issues as well.
1–8–010 Since, in the case of natural monopolies, it is impossible to implement competition, it might
be necessary for the State to regulate these monopolies. An assessment is required of whether
certain economic sectors which have often been operated by public monopolies fulfil the
criteria of natural monopolies or whether more competition could be introduced through
deregulation. A number of procedures have been developed over the last decades for the
proper regulation of natural monopolies. These issues are dealt with in a special field of
competition economics known as the regulation of natural monopolies. A brief introduction to
the theory of natural monopolies and the most important forms of regulation is set out below.
1–8–011 A broad concept of competition policy also encompasses all types of economic policies
which introduce and promote more competition in specific sectors, as, e.g. policies for lib-
eralisation, deregulation and privatisation. Therefore, policy measures against public restraints
of competition have also come under the focus of competition policy. In particular, European
competition policy distinguishes itself from all other competition policies by claiming not only
to fight against private restraints of competition but also against public restrictions. By pursuing
a policy against public monopolies, the grant of monopoly rights and State aid (Arts 86 and 87
EC), the Commission also tries to fight against restraints of competition caused by Member
State policies. This issue is, however, not dealt with in this chapter.
1–8–012 Beyond that, it should always be borne in mind that competition laws represent only a small
fraction of the entire set of legal rules under which competition takes place in markets. Since,
from an economic perspective, all kinds of market failures are a problem, interdependencies
between competition policy and other areas of economic policy, which address other types of

Kerber/Schwalbe
G. Economic Principles of Competition Law 209

market failure and also may pursue other policy objectives, should not be ignored and must be
considered appropriately. Some links to other policy and legal fields are obvious, e.g. the
solving of incentive problems in relation to innovations (intellectual property rights) as well as
information problems for consumers (consumer law).

II. History of competition policy


Literature. Audretsch, Divergent Views in Antitrust Economics, Antitrust Bull. 33, 1988, 135–160;
Baker, A Preface to Post-Chicago Antitrust, in Cucinotta/Pardolesi/Van den Bergh, Post-Chicago
Developments in Antitrust Law, 2002, 60–75; Basedow, Weltkartellrecht: Ausgangslage und Ziele,
Methoden und Grenzen der internationalen Vereinheitlichung des Rechts der Wettbewerbsbes-
chränkungen, 1998; Biondi/Eckhout/Flynn, The Law of State Aid in the European Union, 2004; Budzinski,
The International Competition Network: Prospects and Limits on the Road Towards International
Competition Governance, Competition and Change 8, 2004, 223–242; Cook/Kerse, E.C. Merger Control,
4th edn, 2005; Connor, Global Antitrust Prosecutions of Modern International Cartels, Journal of Industry,
Competition and Trade 4, 2004, 239–267; Demsetz, How Many Cheers for Antitrust’s 100 Years?,
Economic Inquiry 30, 1992, 207–217; Dı́az, The Reform of European Merger Control: Quid Novi Sub
Sole?, World Competition 27, 2004, 177–199; Duijm, Die Wettbewerbspolitik der EG gegenüber verti-
kalen Wettbewerbsbeschränkungen, 1997; Ehlermann, The Modernization of EC Antitrust Policy: A Legal
and Cultural Revolution, Common Market Law Review 37 (3), 2000, 537–590; Ehlermann, European
Competition Law Annual 1999: Selected Issues in the Field of State Aid, 2001; Emmerich, Kartellrecht, 9th
edn, 2001; Fikentscher/Immenga, Draft International Antitrust Code: Kommentierter Entwurf eines inter-
nationalen Wettbewerbsrechts, 1995; Fornalczyk, The Enforcement of Competition Policy in Candidate
Countries, Intereconomics, 2002, 52–58; Furse, The Role of Competition Policy: A Survey, ECLRev.
1996, 250–258; Geradin/Damien, The Liberalization of State Monopolies in the European Union and
Beyond, 1999; Gerber, Law and Competition in Twentieth Century Europe: Protecting Promotheus, 1998;
Gieseke, Die Untersagung von Parallelimport-Beschränkungen durch EG-Kommission und EuGH, 1994;
Goodman, Steady as She Goes: The Enterprise Act 2002 Charts a Familiar Course for UK Merger Control,
ECLRev. 24, 2003, 331–346; Goyder, EC Competition Law, 4th edn, 2003; Hildebrand, The Role of
Economic Analysis in the EC Competition Rules, 2nd edn, 2002; Hovenkamp, Federal Antitrust Policy:
The Law of Competition and its Practice, 1999; Immenga/Mestmäcker, Gesetz gegen Wettbewerbsbes-
chränkungen: Kommentar, 3th edn, 2001; Ioannis/Reiner, State Aid Control in the European Union—
Rationale, Stylised Facts and Determining Factors, Intereconomics 36, 2001, 289–297; Kartte/Holtschneider,
Konzeptionelle Ansätze und Anwendungsprinzipien im Gesetz gegen Wettbewerbsbeschränkungen—zur
Geschichte des GWB, in Cox/Jens/Markert, Handbuch des Wettbewerbs, 1981, 193–223; Kerber, Die
europäische Fusionskontrollpraxis und die Wettbewerbskonzeption der EG: zwei Analysen zur
Entwicklung des europäischen Wettbewerbsrechts, 1994; Kovacic/Shapiro, Antitrust Policy: A Century of
Economic and Legal Thinking, Journal of Economic Perspectives 14, 2000, 43–60; Kühn, Germany, in
Graham/Richardson, Global Competition Policy, 1997, 115–149; Lenaerts, Modernisation of the Appli-
cation and Enforcement of European Competition Law—An Introductory Overview, in Stuyck/Gilliams,
Modernisation of European Competition Law, 2002, 11–40; Lévy, EU Merger Control: From Birth to
Adolescence, World Competition 26(2), 2003, 195–218; Lin/Raj/Sandfort/Slottje, The US Antitrust Sys-
tem and Recent Trends in Antitrust Enforcement, Journal of Economic Surveys 14, 2000, 255–306; Lyons,
Reform of European Merger Policy, Review of International Economics 12, 2004, 246–261; Maher,
Alignment of Competition Laws in the European Community, Yearbook of European Law 16, 1996, 223–
242; Martin, Competition Policies in Europe, 1998; Möschel, Recht der Wettbewerbsbeschränkungen,
1983; Murach-Brand, Antitrust auf deutsch. Der Einfluß der amerikanischen Alliierten auf das Gesetz
gegen Wettbewerbsbeschränkung (GWB) nach 1945, 2004; Neumann, Competition Policy in the Federal
Republic of Germany, in Mussati, Mergers, Markets and Public Policy, 1995, 95–131; Ortwein, Das
Bundeskartellamt: Eine Politische Ökonomie deutscher Wettbewerbspolitik, 1998; Parmentier, Reform of
French Competition Law: Adoption of a Mandatory Pre-Merger Control Regime, ECLRev. 23, 2002,
99–106; Pelkmans, European Integration: Methods and Economic Analysis, 2nd edn, 2001, 67–199; Peritz,
Competition Policy in America: 1888–1992, 2nd edn, 2001; Quigley/Collins, EC State Aids: Law and
Policy, 2002; Rodger/MacCulloch, Competition Law and Policy in the EC and UK, 2004; Scherer, Com-
petition Policies for an Integrated World Economy, 1994; Schmidt, The New ECMR: ‘‘Significant
impediment’’ or ‘‘significant improvement’’?, Common Market Law Review 41, 2004, 1555–1582;
Schmidt/Binder, Wettbewerbspolitik im internationalen Vergleich: die Erfassung wettbewerbsbes-
chränkender Strategien in Deutschland, England, Frankreich, den USA und der EG, 1996; Schmidt/
Schmidt, Europäische Wettbewerbspolitik, 1997; Schoneveld, Cartel Sanctions and International Competi-
tion Policy: Cross-Border Cooperation and Appropriate Forums for Cooperation, World Competition 26,
2003, 433–471; Sierra, Article 86: Exclusive Rights and Other Anti-competitive State Measures, in Faull/

Kerber/Schwalbe
210 Part 1: Introduction

Nikpay, EC Law of Competition, 1999, 273–332; Streit/Mussler, Wettbewerb der Systeme und das Bin-
nenmarktprogramm der Europäischen Union, in Gerken, Europa zwischen Ordnungswettbewerb und
Harmonisierung. Europäische Ordnungspolitik im Zeichen der Subsidiarität, 1995, 75–107; Sullivan/
Grimes, The Law of Antitrust: An Integrated Handbook, 2000; Symeonidis, The Evolution of UK Cartel
Policy, in Martin, Competition Policies in Europe, 1998, 55–73; Thill-Tayara/Joseph/Schiller, Develop-
ments in French Competition Law, ECLRev. 18, 1997, 113–117; Thorelli, The Federal Antitrust Policy.
Origination of an American Tradition, 1955; Utton, Fifty Years of UK Competition Policy, Review of
Industrial Organization 16, 2000, 267–285; Vedder, Spontaneous Harmonisation of National (Competition)
Laws in the Wake of the Modernisation of EC Competition Law, Competition Law Review 1, 2004, 5–
21; Venit, Brave New World: The Modernization and Decentralization of Enforcement under Articles 81
and 82 of the EC Treaty, Common Market Law Review 40, 2003, 545–580; Whish, Competition Law,
5th edn, 2003; Zimmer, Significant Impediment to Effective Competition. Das neue Untersagungskriter-
ium der EU-Fusionskontrollverordnung, ZWeR 2, 2004, 250–267.
1–8–013 1. US antitrust policy. In the second half of the 19th century the US economy experi-
enced rapid development which led to very considerable restructurings of firms and industries.
In order to reduce costs through economies of scale and scope, and as a measure to improve the
control of markets, large corporate trusts were founded. They often pursued predatory business
practices against competitors (price wars and other predatory strategies). Farmers and small
business, in particular, were able to win political support against such restraints of competition.
Although some types of regulations against monopolies had already existed in Europe for a long
time, the newly developing US antitrust law was the first modern competition law and became
a model for competition policy in other countries.10
1–8–014 In 1890 the Sherman Act was passed, establishing the prohibition of horizontal and vertical
agreements that restrict competition (restraints of trade; s.1). This led, e.g. to a per se prohi-
bition of horizontal price-fixing agreements and vertical price-fixing. Furthermore, the
Sherman Act prohibited the monopolisation of markets (s.2). On the basis of this law, several
major trusts, such as Standard Oil and American Tobacco, which dominated the US market,
had already been broken up by the time of the First World War. In 1914 this competition
legislation was extended by the Clayton Act, which introduced merger control and established
the Federal Trade Commission (FTC) as an independent authority against unfair business
practices. Together with the US Department of Justice (DOJ), the FTC is responsible for the
application of the US antitrust laws. These legal rules were supplemented by the Robinson-
Patman Act (1936), which mainly addresses price discrimination at the expense of small
businesses, and by the Celler-Kefauver Act (1950) and Hart-Scott-Rodino Act (1976), both of
which amended the review of mergers and acquisitions. From the early stages of the antitrust
legislation far reaching sanction mechanisms, which included high fines as well as criminal law
penalties, were established in order to ensure effective enforcement.11 In addition, civil claims
for compensation through high awards of damages (treble damage) were introduced.
1–8–015 While the period before the First World War was characterised by the vigorous develop-
ment and application of US antitrust policy, the period between the two World Wars was
marked by a much more modest enforcement of these antitrust laws. Partly as a result of the
Great Depression in the 1930s, even anti-competitive agreements were approved. The sub-
sequent period until the 1970s, however, saw a very intensive application of antitrust laws.
Influenced by the Structure-Conduct-Performance paradigm and the Harvard School,12 the
emergence and private control of market dominance was perceived as the central danger for
competition, especially through mergers and increasing market concentration. This approach
led to very restrictive merger control in the 1960s, under which mergers with relatively small
market shares were prohibited, and to per se prohibitions of, e.g. tying and bundling practices
as well as exclusive agreements in vertical relationships.
1–8–016 This restrictive competition policy changed dramatically in the 1980s following the harsh
criticism by the Chicago School, which claimed that such an interventionist competition
policy went too far. The ensuing emphasis on efficiency gains realised through mergers and
vertical agreements led to a turning point of antitrust policy. During the Reagan Adminis-
tration, in particular, a far less restrictive control of mergers was pursued, and per se prohi-
bitions of vertical agreements were increasingly replaced by a rule of reason approach (e.g.
through the Supreme Court decision on GTE-Sylvania in 1977 on vertical agreements on non-
price parameters). A number of new guidelines by the US Department of Justice for the US

10
For the historical development of US antitrust laws, see Thorelli, 1955, and Peritz, 2001.
11
For a recent review of the US antitrust law, see Hovenkamp, 1999, and Sullivan/Grimes, 2000.
12
See Section III.3.

Kerber/Schwalbe
G. Economic Principles of Competition Law 211

antitrust authorities reflected this development. Since the 1990s, no serious changes in US
antitrust policy have occurred. However, spectacular cases, such as the controversial Microsoft
case, and the increased prosecution of cartels together with sharper sanction rules (e.g. leniency
programs) illustrate that, in the aftermath of the tendency to laissez-faire in the 1980s, a more
differentiated enforcement of antitrust laws has been pursued—also influenced by new theo-
retical developments (Post-Chicago Economics).13
2. Competition policy in Germany. The dynamic economic developments in the 1–8–017
second half of the nineteenth century led to entirely different implications for competition
policy in Germany as compared with the US. In 1897, the German Reichsgericht decided in
the Sächsischen Holzstoff-Fabrikanten (Saxon Wood Pulp Manufacturers) case that cartel agreements
were allowed under the principle of freedom of contract. This approach was based on the
assessment that even price cartels need not always be seen as economically negative because
they may help to control market instabilities caused by price wars. Consequently, a vast number
of cartels emerged in Germany which dominated much of the German economy until the
1930s. Although legal rules (‘‘Kartellverordnung’’) against the abuse of the economic power of
cartels were enacted in 1923, they proved to be ineffective. After the seizure of power by the
National Socialists in 1933 a law for mandatory cartelisation (‘‘Zwangskartellgesetz’’) was
passed. Based on this legislation, the Nazi government could force firms to enter cartels. This
led to the complete elimination of market competition and paved the way for the centrally
planned war economy.14
After the Second World War, the Allied Forces issued de-cartelisation and de-concentration 1–8–018
laws in order to break up the excessive concentration of economic power. However, it was not
until 1958, after a long and controversial debate, that the first modern German competition
law, the Act Against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen,
GWB), was passed. This represented a fundamental change in the enforcement of competition
in Germany. Influenced by US antitrust policy as well as by the Ordo-liberal concepts of the
Freiburg School, which was vehement in its demands for a law against restraints of compe-
tition, the GWB introduced a general prohibition of cartels (with exemptions) and the control
of the abuse of market power by dominant firms. The Federal Cartel Office (‘‘Bundeskar-
tellamt’’) enforces the GWB. The most important amendment of the GWB (until 1989) was
the second amendment of 1973, which introduced merger control and prohibited vertical
price-fixing agreements per se. The sixth and seventh amendments of 1998 and 2005 were
intended primarily to achieve a greater consistency between German competition law and the
European competition rules.15
Despite the distinct cartel tradition that had prevailed in Germany, a reasonably strict 1–8–019
competition policy has been established and enforced since the Second World War. This is
mainly due to the broad political support for competition policy, to the important role of the
academic and public discussion on competition policy and to the successful performance of the
politically independent Bundeskartellamt. Although the theoretical basis of the German
competition policy has changed over time (from strict Ordo-liberal principles to Kantzenbach’s
market structure-oriented approach, criticised, in turn, by Hoppmann’s evolutionary concept
of the ‘‘freedom to compete’’), in retrospect, a substantial continuity of the development and
differentiated enforcement of German competition law can be observed. As regards
the objectives of competition policy, German competition law has not only pursued economic
objectives but also the protection of economic freedom, thereby limiting the relevance
accorded to the objective of economic efficiency. Overall, German competition law was the
most differentiated and strictest law in Europe until the 1990s and, for a long time, has strongly
influenced European competition law. However, apart from the problematic issue of minis-
terial authorisation in merger control, it is unsatisfactory that, for decades, whole industries had
been exempted from the application of German competition law; this situation has only
changed as a result of European competition law. Since the 1990s, German competition law
has suffered a remarkable loss of importance (except for the review of mergers and acquisitions)

13
For the development of the US antitrust policy under the impact of changing economic schools of
thought, see Audretsch, 1988; Demsetz, 1992; Kovacic/Shapiro, 2000; Lin/Raj/Sandfort/Slottje, 2001; Baker,
2002.
14
See Gerber, 1998, 69–153; Ortwein, 1998, 17–58.
15
For the German cartel law, see, e.g. Emmerich, 2001; Immenga/Mestmäcker, 2001.

Kerber/Schwalbe
212 Part 1: Introduction

due to the increasing dominance of European competition law, which can now be applied by
the Bundeskartellamt.16
1–8–020 3. Competition policy in other European countries. For a long time only a few
European countries had competition policies.17 Only after the Second World War were
competition laws introduced in the United Kingdom. In particular, the Restrictive Trade
Practices Act (1956) was important. However, it did not prohibit anti-competitive agreements
in general because they could only be prosecuted if they violated the public interest. It thus
corresponded to a control of abuse of market dominance. This Act was supplemented by the
Resale Prices Act (1964), which prohibited vertical price-fixing agreements, and by the
Monopolies and Mergers Act (1965 as codified in 1973: the Fair Trading Act) which intro-
duced merger control. The system was not particularly effective. First, the application of the
competition laws suffered from the uncertainty created by the ambiguous ‘‘public interest’’
objective. In combination with the political decision process and industrial policy objectives,
there was considerable scope, especially in merger control, to deviate from the recommen-
dations made by the Office for Fair Trading and the Monopolies and Merger Commission.
Secondly, the competition laws had only minimal sanction and implementation mechanisms,
raising doubts concerning its effectiveness. The situation changed fundamentally with the
introduction of the Competition Act in 1998, which adapted competition law extensively to
the European rules. In 2002 this reform was continued by the Enterprise Act concerning the
review of mergers. It replaced the ‘‘public interest’’ criterion with a pure competition test, and
restricted very considerably the circumstances requiring political involvement in decisions.18
1–8–021 In France, after the Second World War only isolated regulations against anti-competitive
business practices existed within the so-called pricing regulation. Although there was a broad
set of competition rules (extended by the introduction of merger control in 1977), the principle
of competition was barely enforced within the generally strongly interventionist French
economic policy. In 1986 entirely new competition legislation was enacted that partly followed
the European competition law approach. It encompassed a prohibition on horizontal and
vertical agreements (with exemptions), merger control, and the prohibition of abuses by
market dominant firms. An important feature is that the advantages and disadvantages of
restraints of competition can be balanced (‘‘bilan économique’’), not only in the case of
exemptions but also in merger reviews.19 Thus, in French merger control industrial policy
concerns, such as international competitiveness, can be taken into consideration.
1–8–022 The developments of competition laws in other European countries has been very different.
Before the Second World War only a few European states had enacted competition laws, e.g.
Sweden (1925), Norway (1926), and Denmark (1937). After the Second World War only a
few countries passed competition laws and these often proved to be ineffective (e.g. the first
Austrian anti-cartel law (1951) and the Swiss ‘‘Federal law on cartels and similar organisations’’
(‘‘Bundesgesetz über die Kartelle und ähnliche Organisationen’’; 1962)). The Netherlands,
Belgium, Finland and Ireland enacted competition laws in the 1950s, other countries followed
later. In 1990, Italy was the last of the old EU Member States to pass its own competition law.
Since the mid-1980s, however, a rapid spreading of competition laws has taken place in
Europe. It is characterised by the increasing convergence of the national competition rules with
the European rules, the decentralised application of the European competition rules and the
commitment of the new EU Member States and Accession Countries to adopt European
competition law.20
1–8–023 4. European competition policy. The implementation and enforcement of the principle
of competition in the Internal Market became a key strategy for European economic inte-
gration. From 1951 the ECSC (‘‘European Coal and Steel Community’’) had competition
rules; Art.65 (the prohibition of cartels) and Art.66 (merger and abuse control), which,
however, proved ineffective due to continual state interventions in these sectors.21 Article 3f

16
See Kartte/Holtschneider, 1981; Möschel, 1983; Neumann, 1995; Kühn, 1997; Murach-Brand, 2004;
Schmidt, 2005, 168–188.
17
For an overview, see Martin, 1998; Schmidt/Binder, 1996.
18
See Symeonidis, 1998; Utton, 2000; Whish, 2003; Goodman, 2003; Rodger/MacCulloch, 2004; Schmidt,
2005, 189–198.
19
See Schmidt, 2005, 199–207; Thill-Tayara/Joseph/ Schiller, 1997; Parmentier, 2002.
20
See Maher, 1996; Gerber, 1998, 153–207, 335–342; Fornalczyk, 2002; Goyder, 2003, 16–22; Vedder,
2004; Schmidt, 2005, 208–228.
21
For the competition rules in the ECSC, see Gerber, 1998, 335–342; Goyder, 2003, 16–22.

Kerber/Schwalbe
G. Economic Principles of Competition Law 213

(now Art.3g EC) of the Treaty of Rome (1957), establishing the European Economic
Community (EEC), provided that the Community should implement a system which ensures
undistorted competition. Therefore, a general prohibition of anti-competitive agreements
(with exemptions) (Art.85; now Art.81 EC), and a prohibition of the abuse of market dom-
inance (Art.86; now Art.82 EC) were included. However, merger control was only introduced
in 1989. The Commission (DG Competition) is the competition authority that enforces these
competition rules and can, thus, apply a number of effective sanction and enforcement
instruments. The Decisions of the Commission are reviewed by the CFI, and, ultimately, by
the ECJ.
Despite the early establishment of European competition law, until the early 1980s the 1–8–024
development of the European competition policy had proceeded slowly. This was the result of
the incremental enforcement of European competition rules, which were applied, step-by-
step, to additional areas.22 Except for some developments concerning the regulation of the
abuse of market dominance, the Commission was active mainly in relation to horizontal and
vertical agreements. After some important decisions of the ECJ, many horizontal and vertical
agreements were judged as infringing Art.81(1) EC. This drew attention to the conditions for
exemptions in Art.81(3) EC. From an early stage, European competition policy embraced the
objective of market integration in addition to safeguarding competition. This has led to a very
restrictive approach towards vertical distribution systems with territorial restrictions in order to
protect cross-border trade within the EU and to prevent the division of national markets.23
Since the 1980s the application and development of European competition policy has been 1–8–025
gaining new momentum. A broad interpretation of Art.81(1) EC resulted in the extensive need
for exemptions under Art.81(3) EC from the general prohibition on anti-competitive agree-
ments, which in turn led to the introduction of the instrument of the block exemption for
several kinds of horizontal and vertical agreements. The Commission issued a number of
specific block exemption regulations concerning such agreements. The process of the com-
pletion of the internal market since the mid-1980s, was also of particular importance because it
led to new developments in European competition policy. Since the transformation from
national to European markets would result in the restructuring of firms and industries within
the EU, the introduction of merger control was seen as necessary in order to safeguard
competition in the newly emerging European markets. Since the enactment of the ECMR (in
1989) European competition policy has encompassed all important instruments of a modern
competition policy.24 Therefore, from the beginning of the 1990s, European competition law
became a serious rival to the established national competition policies of the Member States.
Important progress has also been made under the policy against restraints of competition by 1–8–026
the Member States, which has been developed step by step since the 1980s—with ever-
increasing impact. First, the efforts of the ECJ (the Cassis-de-Dijon judgment) and the Com-
mission (the internal market programme) to enforce the four basic freedoms of the EC-Treaty
(free movement of persons, goods, services and capital) has had an impact: the reduction of
impediments to mobility across national borders has removed entry barriers to national markets,
leading to the increasing development of the internal market (through market integration
through the mutual recognition or harmonisation of national regulations).25 Secondly, the
Commission has increasingly applied Art.86 EC against public monopolies and special
monopoly rights granted by Member States. This has led to a remarkable increase in dereg-
ulation in the Member States.26 Thirdly, the Commission has succeeded in enforcing an
increasingly strict and effective control of state aids (subsidies) to firms in order to prevent
distortions of competition (Art.87 et seq. EC).27 Although these policies are not without their
problems (including from an economic view), they have contributed much to the enforcement
of competition in the EU. Therefore, European competition policy has developed a successful
policy against public state restraints of competition which does not exist in other competition
policy regimes.

22
For the evolution of the European competition legislation, see Gerber, 1998, 342–391; Goyder, 2003,
22–55.
23
See Gieseke, 1994; Duijm, 1997; Goyder, 2003, 179–181.
24
For the European merger control, see Cook/Kerse, 2005; Lévy, 2003; Goyder, 2003, 335–397.
25
See Streit/Mussler, 1995; Pelkmans, 2001, 67–199.
26
See Schmidt/Schmidt, 1997; Sierra 1999; Gerardin/Damien, 1999.
27
See Ioannis/Reiner, 2001; Ehlermann, 2001; Quigley/Collins, 2002; Biondi/Eckhout/Flynn, 2004.

Kerber/Schwalbe
214 Part 1: Introduction

1–8–027 The objectives and theoretical foundations of European competition policy against private
restraints of competition have not remained unchanged.28 Initially, they were strongly influ-
enced by German competition law with its additional concern for the protection of economic
freedom, e.g. in regard to the application of Art.81 EC. To date, the central objectives of
European competition law have been the promotion of effective competition and of economic
integration. The promotion of small and medium-sized enterprises, international competi-
tiveness and other industrial policy objectives such as technological progress can play a role in
special cases. The fear, however, that European competition policy might be subjected to
industrial policy objectives has proved unfounded in practice; the application of European
competition law has been nearly exclusively competition-based. However, the meaning of the
objective of ‘‘effective competition’’ has changed over time. Initially based upon the market
structure-oriented approach of the Harvard School and the Structure-Conduct-Performance
paradigm, it has since been much influenced by Chicago and Post-Chicago Economics.
Therefore, economic efficiency (primarily in the form of the consumer welfare standard) has
gained much more significance. However, technological progress and other advantages of
competition, however, are also seen as important aspects of ‘‘effective competition’’.29
1–8–028 Theoretically, this development has been accompanied by an increasing move away from
the long prevailing market structure-oriented approach and towards a more case-by-case
analysis. The latter refers primarily to the specific economic effects in the particular case, and is
influenced largely by game-theoretical industrial economics and empirical methods of case
analysis (the ‘‘More economic approach’’). As a consequence, the Commission has reformed
the BERs by adopting a more efficiency-oriented approach and introduced the possibility of
taking into account efficiency gains in the recently reformed ECMR 2004.30 Whether the
concept of market dominance, which for decades has dominated European competition policy
in relation to the control of abusive behaviour and merger control, will become less relevant as
a result of the new assessment criterion ‘‘Significant Impediment to Effective Competition’’
(SIEC test) in merger control, remains an open question so far.31
1–8–029 Important reforms of European competition policy have also been made in relation to
procedural issues. The new ‘‘modernisation’’ Regulation 1/2003 introduced significant
changes; the former system of notification and approval and the exclusive right of the Com-
mission to grant exemptions under Art.81(3) EC were abolished. Furthermore, NCAs and
national courts now have this right. This is part of the policy of the Commission to achieve a
more decentralised application of European competition law, in particular through the NCAs
and National courts.32 The broad interpretation of the requirement that inter-state trade is
affected, actually or potentially (as the criterion for the applicability of European competition
law), and the supremacy of European competition law has led to national competition laws
increasingly losing their relevance. In the long run, European competition law might become
the only important competition law in Europe.33
1–8–030 5. Competition policy at the international level. Since the beginning of the 1990s
there has been a broad spreading of competition policies all over the world, especially into
countries which did not have any competition regulations. Apart from in the USA, detailed
competition policies existed in only a few non-European countries, e.g. Canada, Japan,
Australia and New Zealand. In the last 20 years the number of states with competition laws has
increased rapidly, particularly among newly industrialised and developing countries. This
development is a consequence of liberalisation and market-oriented reforms, which took place
in many countries in the 1990’s. It also signifies the growing awareness of the relevance of
competition and of the necessity for rules against restraints of competition.34
1–8–031 International or even global markets have emerged through the process of ‘‘globalisation’’.
International cartels and mega-mergers have led to a considerable increase of international

28
For analyses of the conceptional foundations of the European competition policy, see Kerber, 1994,
171–233; Gerber, 1998, 334; Hildebrand, 2002.
29
For the objectives of the European competition law, see Furse, 1996; Bishop/Walker, 2002, 3–6; Motta,
2004, 13–17; Goyder, 2003, 8–15.
30
See Diaz, 2004, and Lyons, 2004.
31
See Zimmer, 2004; Schmidt, 2004.
32
See Venit, 2003; Lenaerts, 2002; Ehlermann, 2000.
33
For the problems of centralism and dececentralism of competition policy in the EU, see Section X.5.
loc. cit.).
34
See Scherer, 1994; Basedow, 1998.

Kerber/Schwalbe
G. Economic Principles of Competition Law 215

restraints of competition.35 The attempts of national competition policies to solve these


competition problems by the extra-territorial application of domestic competition laws (based
on the effects doctrine) or by bilateral collaboration with other national competition authorities
have been of only limited success. Enforcement problems and conflicts have emerged, as well as
high administrative costs due to multiple proceedings, especially in international merger cases.
Therefore, it is not surprising that since the 1990s a new discussion on the necessity, suitability
and potential designs of an international competition policy has developed.36 Whilst the efforts
to establish mandatory rules within the framework of the WTO failed, in 2001 the ‘‘Inter-
national Competition Network’’ (ICN) was founded as a voluntary and informal global net-
work of competition authorities with the aim of improving and spreading competition rules
and associated administrative and enforcement practices.37

III. Competition economics: an overview of theoretical concepts


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See Connor, 2004.
36
See Fikentscher/Immenga, 1995; Basedow, 1998; Section X.5.
37
See Schoneveld, 2003; Budzinski, 2004.

Kerber/Schwalbe
216 Part 1: Introduction

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G. Economic Principles of Competition Law 217

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Notions of what competition is, how it can be analysed theoretically and what policy 1–8–032
conclusions can be drawn (the normative perspective) have changed significantly since
economists began to analyse these topics more than 200 years ago. This section is a short
overview of the history of competition economics, as far as it is still important for the
understanding of the current debate. Most of today’s terms and concepts, basic patterns of
argumentation and controversies in competition theory and policy are much easier to
understand if one knows the theoretical background and the most important debates in the
past. To date, debate has been shaped by a small number of basic concepts of competition each
with specific theoretical and normative notions.38
1. Classical economics. In the period of classical liberalism in the eighteenth and nine- 1–8–033
teenth century, e.g. in Adam Smith’s ‘‘Wealth of Nations’’ (1776),39 competition was seen as
playing a central role in society. Based upon the deistic notion of a ‘‘natural order’’, Smith
assumed that the ‘‘invisible hand’’ of competition induces each individual agent to advance the
common interest through pursuing his or her self-interest. Competition forces firms to charge
low prices in order to attract demand, thereby increasing social welfare. In classical economics,
competition was seen as a system of powers that start to take effect as soon as the current market
prices differ from the ‘‘natural’’ prices. Increasing or declining prices signal changed scarcities
and simultaneously provide incentives to producers and customers to eliminate disequilibria on
the markets by adjusting production, capacities and consumption. ‘‘It was the conception of

38
For a broad overview of the history of competition economics, see McNulty, 1968; Heuss, 1980; C.W.
Neumann, 1982; Auerbach, 1988; Ruffner, 1990; Burton, 1994; Mantzavinos, 1994; Hildebrand, 2002, 105–
169.
39
Central figures of classical economics are Adam Smith (1723–1790), David Ricardo (1772–1823), and
John Stuart Mill (1806–1873).

Kerber/Schwalbe
218 Part 1: Introduction

competition as an ordering force which dominated classical economics’’.40 Therefore, the


classical concept of competition can be compared with a cybernetic system. The character of
competition as a process was emphasised in particular.41
1–8–034 The dichotomy between competitive markets on the one hand and monopolies on the other
also has its roots in classical economics. Whereas Smith defined the ‘‘natural price’’ clearly as a
competitive price that covered the costs (‘‘. . . what is sufficient to pay the rent of the land, the
wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it
to the market. . .’’),42 the monopoly price was characterised only vaguely as ‘‘the highest that
can be got’’.43 Since monopolies were seen as being caused primarily through public privileges,
classical economics demanded policies against public restraints of competition. However, the
following famous quotation from Smith shows that he also knew about the relevance of private
restraints of competition:

‘‘People of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public or in some contrivance to raise prices’’.
He was sceptical, however, about the possibilities of fighting against them: ‘‘It is impossible
indeed to prevent such meetings, by any law which either could be executed, or would be
consistent with liberty and justice. However, though the law cannot hinder people of the
same trade from sometimes assembling together, it ought to do nothing to facilitate such
assemblies; much less to render them necessary’’.44
1–8–035 2. Neoclassical microeconomics, market forms, and welfare economics. By the
1930s the essential parts of microeconomic theory had been developed. The most important
element has been the rigorous formulation of the model of perfect competition with the
increasing use of analysis by mathematical models. This development, linked with the names of
Cournot, Dupuit, Launhardt, Jevons, Marshall, Walras, Arrow and Debreu has continued to
date. With the increased use of mathematical analyses of markets the concept of competition
changed. In contrast to classical economics, the notion of competition as a competitive and
dynamic process vanished, and competition was increasingly seen as a state of equilibrium with
a number of desirable properties. Competition was defined as ‘‘perfect’’ if firms had no
influence on prices and were therefore ‘‘powerless’’. In this model of ‘‘perfect competition’’
profit maximising firms would supply quantities at prices that are equal to marginal costs (i.e.
the additional costs of producing one additional unit). Supernormal profits cannot be made
because market access is free. Monopolies were defined as the other extreme: As the only
supplier of a good, a monopolist can charge a monopoly price which is considerably higher
than marginal costs, leading to a monopoly profit. The contrast between these basic char-
acteristics of competition and monopoly shapes the discussion of competition policy to this
day: firms with market power can influence prices, set prices above marginal costs, and
therefore can reap supernormal profits due to this market power. From this perspective, it was
considered appropriate to measure market power as the relation between price and marginal
costs (Lerner).45
1–8–036 In the model of perfect competition a large number of very restrictive assumptions are made
which are hardly ever fulfilled in real markets. First, it is assumed that on both sides of the
market there are very many, very small, producers and customers, so that none of them is able
to influence prices by changing the quantity supplied or demanded. If this is the case, the
market price is the result of the equilibration of supply and demand, and cannot be changed by
the market participants. They can merely adapt their supplied or demanded quantities to this
price (as a price taker). Secondly, the goods supplied by the firms must be complete substitutes
(homogeneous goods), and all market participants must have perfect information about all
relevant features such as the product quality and the price (market transparency). If all these
conditions are fulfilled, a market is called ‘‘perfect’’. Furthermore, neither transaction costs
(costs for the negotiation and enforcement of contracts) nor economies of scale (i.e. costs per
unit, which decline with growing output) may exist. Of particular importance in the model of
perfect competition is that the preferences of the customers, the products and the production
technologies are assumed as exogenously given, i.e. the development of new products and

40
McNulty, 1968, 643.
41
See Smith, 1776/1937; Hayek, 1973.
42
Smith, 1776/1937, 55.
43
Smith, 1776/1937, 61.
44
Smith, 1776/1937, 128.
45
See Lerner, 1934; Section IV.6.(a).

Kerber/Schwalbe
G. Economic Principles of Competition Law 219

production methods (product and process innovations) is excluded. Finally, it is assumed that
the market participants react with infinite speed and that no positive and negative externalities
exist.46
This analysis can be extended to the simultaneous analysis of all markets in an economy 1–8–037
(general equilibrium analysis). A first general equilibrium model was developed by Walras in
1881; in the 1950s the Nobel prize winners Arrow and Debreu presented the rigorous
mathematical formulation of general equilibrium theory.47 The outstanding importance of the
model of perfect competition in economic theory can be understood through general equi-
librium theory. In this theory it was shown that, in an economy in which the conditions of the
model of perfect competition are fulfilled on all (goods and factor) markets, the aim of efficient
allocation is achieved by the purely decentralised decisions of profit- and/or utility-maximising
firms and households. Efficient allocation of resources means that it is not possible through a
different use of the resources to increase the utility of any person in the economy without
reducing the utility of at least one other person. This normative criterion has been called the
Pareto criterion. The nowadays widely-used term ‘‘economic efficiency’’ is identical with the
term ‘‘efficient allocation’’ in economic theory. However, in economics there always has been
a broad consensus that the conditions of perfect competition are almost never fulfilled on real
markets, i.e. that considerable market imperfections are present in most markets.
By 1838 Cournot had shown that prices decrease with the number of firms in the market. 1–8–038
Starting from this insight, various market types were developed for a more precise and dif-
ferentiated analysis of market competition. The number of firms on both sides of the market
became the most important determinant for the characterisation of these market forms:
monopoly, oligopoly, and perfect competition were the most important ones in which many,
very small, customers face either one, few or many firms on the supply side. Similarly, markets
were defined as having a large number of small suppliers facing only one or a few buyers
(monopsony, oligopsony), or as having only one or few participants existing on both sides of
the market (bilateral monopoly or oligopoly). Therefore, perfect competition can be compared
with a number of other market forms which do not have its ideal properties. Microeconomic
price theory primarily asked what prices and quantities would emerge in each of these market
forms through the profit maximising behaviour of the firms.
In the monopoly model it was shown that a profit-maximising monopolist can increase the 1–8–039
price above marginal costs by reducing the supply. As a consequence, supernormal profits can
be reaped (monopoly profits). Cournot had shown that a monopolist maximises his profits by
supplying a quantity at which the additional revenue of a unit sold (marginal revenue) is equal
to the marginal costs. The critical point is that, in a monopoly, the quantity supplied is smaller
and the price higher than in a market with perfect competition.48
In the case of oligopoly markets, which often exist in reality, the analysis proved to be much 1–8–040
more complex. Early on it was recognised that strategic interactions can emerge between few
suppliers, i.e. in oligopolies, competitive actions of one firm can have such a strong effect on
the other firms that mutual reactions are probable. The analysis of these oligopolistic inter-
dependences was further complicated by the existence of the expectations of the firms about
the reactions of their competitors. As a consequence, the microeconomic analysis of oligopolies
has turned out to be a very complex problem. Only recently has modern game theory provided
the appropriate mathematical methods for analysing such problems of strategic interactions.
Despite a broad range of different oligopoly models, with different results in terms of prices and
quantities, it could be shown that, in most cases, oligopolies lead to prices above marginal costs
and to quantities smaller than in the case of perfect competition. Therefore, oligopoly firms are
also often able to make supernormal profits (oligopoly profits), although usually smaller ones
than those that could be made by a monopolist.49
In the 1930s the consequences of other market imperfections, such as economies of scale or 1–8–041
differentiated goods, were analysed, leading to the theories of monopolistic or imperfect
competition.50 The theory of monopolistic competition proved that, on markets with differ-
entiated goods, small and medium-sized firms can also have some (although limited) scope for
setting prices, and therefore some market power.
The result of these theoretical developments was the (somewhat dissappointing) insight that 1–8–042

46
See Section IV.2.
47
See Walras, 1954; Debreu, 1959.
48
See Section IV.3.
49
See Section IV.5.
50
See Chamberlin, 1933; Robinson, 1933; Section IV.4.

Kerber/Schwalbe
220 Part 1: Introduction

real markets are almost always characterised by a number of market imperfections. Therefore,
deviations between prices and marginal costs exist in most real markets. Most firms seem to
have some market power as defined above—even though to different extents. This ubiquity of
deviations from the conditions for perfect competition, suggesting the existence of market
failures, prompted the question: what is the usefulness of this model of perfect competition as a
normative point of reference? Most well-known, for example, is the critique of Demsetz, who
denounced this concept of perfect market competition as a ‘‘nirvana approach’’.51
1–8–043 3. Workable competition and empirical industrial organisation
(a) Workable competition. At the end of the 1930s the dissatisfaction with the abstract
microeconomic theory and the model of perfect competition, which was considered to be
much too unrealistic, led to the development of new approaches in the USA. Mason and Bain
developed the Empirical Industrial Organisation approach, which was the first systematic
attempt in economics to analyse markets and industries empirically. The theoretical basis of this
quantitative approach was the so-called Structure-Conduct-Performance paradigm (S-C-P
paradigm).52 A second new approach was introduced by John Maurice Clark with his article
‘‘Toward a Concept of Workable Competition’’ in 1940. Due to the ubiquity of irreducible
market imperfections, he pleaded for the rejection of the model of perfect competition.
Instead, he proposed to focus on investigating those market conditions which lead to
‘‘workable’’ competition processes (workable competition). From this perspective, competi-
tion should fulfil a number of essential functions—despite all the imperfections that exist on real
markets: ‘‘. . . to formulate concepts of the most desirable forms of competition, selected from
those that are practically possible, within the limits set by conditions we cannot escape’’.53 From
this emerged the normative question: what market outcomes or functions should competition
produce or fulfil? The normative perspective of Clark is expressed by the title of one of his
other articles: ‘‘What do we want competition to do for us?’’54 This new pragmatic approach of
workable competition was very compatible with the new S-C-P paradigm of Empirical
Industrial Organisation. Linking both approaches led to the policy question, what kinds of
market structure lead to those market outcomes which are seen as most desirable from the view
of workable competition? The following section discusses the (strongly interwoven) approa-
ches of the S-C-P paradigm, Empirical Industrial Organisation and the structural approach of
the Harvard School (which emerged from the workable competition tradition) which domi-
nated competition policies until the late 1970s in the USA and the beginning of the 1990s in
Europe.
1–8–044 (b) Structure-conduct-performance paradigm. Compared with the market forms in
neoclassical price theory, the S-C-P paradigm offers a much broader and more open frame-
work for the analysis of market competition (see Figure III–1, below). Market structure
encompasses all the characteristics of markets which firms view as not capable of change and
hence as constant—at least in the short and medium term. Besides the number and market
shares of suppliers and buyers, which had already been taken into account in traditional price
theory, important additional features are the size of barriers to market entry and exit, the extent
of market transparency and product heterogeneity, the existence of economies of scale and
scope as well as personal and financial links between the firms. Market conduct encompasses
not only price and quantity policies but all action parameters which are important for com-
petition, particularly product and process innovations, product quality, service and advertising.
In addition to market prices and quantities sold, market performance also includes the size of
profits in the market, technological progress (innovations), quality and variety of products as
well as the effects on allocative and productive efficiency. The S-C-P paradigm also
acknowledged the importance of macroeconomic developments (growth, business cycle) and
of the general institutional framework for the analysis of competition in markets and industries.
1–8–045 In the beginning, the S-C-P paradigm was based upon the clear causal hypothesis that
market structures influence the behaviour (conduct) of the competing firms, which, in turn,
leads to a certain market performance. This linear causal hypothesis was criticised from an early
stage. Attention was drawn to feedback effects from market conduct and performance to

51
See Demsetz, 1976.
52
See Mason, 1939; Bain; 1956, Bain, 1968.
53
Clark, 1940, 242.
54
Clark, 1954; for a survey on the workability concepts that were developed in the 1950s, see Sosnick,
1958.

Kerber/Schwalbe
G. Economic Principles of Competition Law 221

market structure, and a partial endogeneity of market structures suggested.55 However, the
causal hypothesis that market structure is the most important determinant for the extent of
effective competition (and therefore for market performance) has been the dominant theo-
retical basis for a market structure-oriented competition policy to date.
Figure III–1: Structure-conduct-performance paradigm56

(c) Empirical industrial organisation. The primary task of Empirical Industrial Orga- 1–8–046
nisation theory was the investigation of relations between market structure and market per-
formance within the theoretical framework of the S-C-P paradigm. The quantitative empirical
methods used were mostly statistical correlation analyses. The most important question
researched was the impact of firm concentration. Many empirical studies were, in particular,
made of the problem of whether an increasing (seller) firm concentration has negative effects
on competition, i.e. whether an increasing firm concentration would lead to higher profits due
to higher market power. This hypothesis, which would be confirmed through a positive
correlation between firm concentration and the profits of the firms, was derived from
microeconomic price theory. A reduction of the number of suppliers can lead to a higher
probability of market power and therefore to supernormal profits (concentration-collusion
doctrine). In the 1950s this hypothesis was differentiated by Bain through the inclusion of the
size of entry barriers as an additional explanatory variable for the profits. This led to the
proposition that a high firm concentration has a positive influence on profits if there are,
simultaneously, high barriers to market entry; otherwise, the profits of the incumbent firms
would be eroded by the entry of new competitors.57 Apart from this particular correlation
between firm concentration and profits, a great number of additional hypotheses concerning
correlations between market structure variables and market performance criteria have been
analysed within Empirical Industrial Organisation theory since the 1950s.58
The aim of this research by Empirical Industrial Organisation theorists was to make a 1–8–047
contribution to the policy question; which market structures influence, positively or nega-
tively, competition and market performance? Although the S-C-P paradigm was regarded as
successful until the 1980s, in the 1970s many doubts had been raised about its efficacy. The
overall results of the empirical studies showed that general correlations between market
structures and market performance are difficult to prove. The empirical results were incon-
clusive, for example, in relation to the central proposition that a positive correlation exists
between firm concentration and profits: although a weak positive correlation could be shown

55
See Sosnick, 1958, 387; for the later criticism by the Chicago School and in Germany, see, e.g.
Hoppmann, 1970.
56
This figure follows Kerber, 2007, 379; for other versions see Bain, 1968, 7–11; Scherer/Ross, 1990, 5;
Carlton/Perloff, 2005, 4; Schmidt, 2005, 60.
57
See Bain, 1956.
58
See Schmalensee, 1989; Scherer/Ross, 1990, 411–447.

Kerber/Schwalbe
222 Part 1: Introduction

in many empirical studies, the variance of the results of these studies was so large that this
correlation could not be regarded as a statistically confirmed empirical hypothesis:
‘‘The relation, if any, between seller concentration and profitability is weak statistically, and
the estimated concentration effect is usually small. The estimated relation is unstable over
time and space and vanishes in many multivariate studies’’.59

However, as regards other relations, clearer results could be obtained.60 Nevertheless, the
prevailing opinion today is that the expectations which were raised by the Empirical Industrial
Organisation research programme and the S-C-P paradigm, have not been fulfilled
sufficiently.61
1–8–048 (d) The Harvard School and the structural approach. In the 1950s and 1960s the
‘‘structural approach’’ of the Harvard School became dominant in the USA; in Germany, this
approach was called ‘‘funktionsfähiger Wettbewerb’’.62 It was developed on the basis of the
pragmatic approaches of workable competition, the S-C-P paradigm, and the Empirical
Industrial Organisation.
1–8–049 At the normative level, the central characteristic of this approach is that competition policy
should pursue a bundle of aims (multi-goal approach), which, ultimately, are the results of
political decisions. This bundle of aims can consist of economic aims, such as allocative effi-
ciency or technical progress, and industrial policy-related aims such as the international
competitiveness of domestic firms or the support of small and medium-sized firms. Further-
more, the aim of integration (as in European competition policy) can be taken into account as
well as aims such as restricting economic power, the protection of freedom of competition and
considerations of fairness. In Germany, Kantzenbach’s approach of ‘‘funktionsfähiger Wett-
bewerb’’ can be seen as a variant of this general approach. He suggested a number of desirable
functions of competition, e.g. static functions, such as allocative efficiency and (some kind of)
fair distribution and the dynamic functions of technical progress and flexible adaptation.63 From
the legal perspective, the normative openness of the concept of the Harvard School has some
appeal, because this leaves scope for the legislator (and the courts) to decide on the aims of
competition policy. In economics, however, this openness was criticised because of the risk of
arbitrariness with regard to the aims of competition policy. Economists in favour of this
concept focussed mainly on allocative efficiency, technical progress and the avoidance of
redistributions through market power.
1–8–050 At the theoretical level, the concept of the Harvard School was based both upon the
theoretical insights of microeconomics and the empirical results of Empirical Industrial
Organisation about the relations between market structure and market performance. In gen-
eral, the Harvard School was sceptical about the workability of markets; in particular, they
presumed that markets are vulnerable to restraints of competition and market power. There-
fore, an active public policy for the maintainance of competition was considered as necessary.
In their analyses of the effects of market structures and business behaviours, many scholars of
the Harvard School were convinced that firms strive primarily to build up or defend market
power. This attitude was described as the market power doctrine. As a consequence, mergers
that increase seller concentration and other business behaviours (e.g. vertical restraints) were
assessed with considerable scepticism.
1–8–051 (e) Policy implications and impact. The main policy strategy of the Harvard School
approach was that competition policy should focus primarily on maintaining competitive
market structures (structural policy approach). From that perspective, the S-C-P paradigm,
with its search for the optimal market structures, seemed a suitable theoretical framework. In
particular, the control of firm concentration (and therefore merger policy) was viewed as most
important for maintaining competitive market structures. This implied not only the control of
horizontal concentration (concentration-collusion doctrine), but also the control of vertical and
conglomerate mergers, both of which might also lead to anti-competitive effects under certain
conditions. Policy conclusions also included a prohibition of horizontal cartels (with some

59
Schmalensee, 1989, 976.
60
See Ravenscraft, 1983; Schmalensee, 1989, 981; Scherer/Ross, 1990, 426–446.
61
See Carlton/Perloff, 2005, 244; Knieps, 2005, 133.
62
See Kaysen/Turner, 1959; Kantzenbach/Kallfass, 1981; Scherer/Ross, 1990; Shepherd, 1997; Hildebrand,
2002, 126–136.
63
See Kantzenbach, 1967; Herdzina, 1999, 32.

Kerber/Schwalbe
G. Economic Principles of Competition Law 223

exemptions) and that vertical restraints be assessed as potentially anti-competitive because they
might increase market power (inhospitality doctrine).64
Despite widespread criticism, which is set out below in greater detail, the impact of the 1–8–052
structural approach of the Harvard School or the ‘‘funktionsfähiger Wettbewerb’’ in Germany
and Europe can hardly be overestimated. This approach dominated US antitrust policy until
the late 1970s. Since the 1960s it has also been very influential in German and European
competition policy and did not become less important until the emergence of the ‘‘more
economic approach’’ in the late 1990s. In particular, the implementation of restrictive merger
control is a consequence of this approach. Although most economists and many legal scholars
are now rather critical of this approach, the most basic categorical terms in today’s competition
policies, such as the distinction between market structure and market behaviour and the crucial
significance of market structures and market shares (as well as the delineation of relevant
markets) stem from the structural approach of the Harvard School.
The term ‘‘effective competition’’ (used by the Harvard School and also as a kind of
synonym for the German term ‘‘funktionsfähiger Wettbewerb’’), which has been of central
importance for European competition policy to date, is linked with this concept.
4. Efficiency-based concepts of competition
(a) Introduction. In the 1970s and 1980s new approaches to competition policy emerged, 1–8–053
which were quickly successful in the U.S.A. and, after a certain time-lag, have also had a
considerable impact in Europe. These new approaches were, in part, a critical reaction to the
restrictive US antitrust policy in the 1960s, which was dominated by the Harvard School. The
Chicago School, in particular, was at the forefront of this criticism, but the new approaches of
transaction costs economics and contestable markets also supported it through a number of
important new lines of reasoning. Apart from their criticism of the policy conclusions of the
Harvard School, these approaches have in common that they are based upon microeconomic
theory (postulating again the importance of the model of perfect competition) and pursue the
aim of efficient allocation. Therefore, the market power doctrine of the Harvard School was
challenged by the so-called efficiency doctrine. This counter-movement is also characterised by
a much greater trust in the general functioning of markets. This leads to the conclusion that
competition policy should not be too restrictive in order to avoid impeding efficient market
structures and business behaviours.
(b) The Chicago School. Stigler, Demsetz, Posner and Bork are the most well-known 1–8–054
representatives of the Chicago School in the realm of competition policy.65 The normative
notion of the Harvard School, that competition policy should pursue a bundle of different
aims, was vehemently criticised as being too vague, controversial and impractical. By contrast,
the Chicago School required that competition policy should pursue the aim of economic
efficiency only, which is defined, in neoclassical welfare economics, as the sole assessment
criterion.66
From this perspective, only the effects on total economic welfare are decisive in the 1–8–055
assessment of mergers and horizontal or vertical agreements. Cartels and firms with market
power can also present problems for the Chicago School, but not because consumers are
damaged through excessive prices and too small quantities. Rather, the problem is that market
power leads to distorted prices and quantities, and such an inefficient allocation implies a loss of
total welfare. Therefore, the problem is not the redistributive effects from consumers to
producers (through market power), but allocative inefficiencies (dead-weight losses) caused by
an artificial reduction of the supplied quantities. From the perspective of this total welfare
standard, pure redistributions are regarded as neutral and, therefore, need not be included into
the competitive assessment. Only the impact on total welfare is important.67
At the theoretical level, the Chicago School emphasises the importance of microeconomic 1–8–056
theory and the model of perfect competition. Although Chicagoan economists accept that
competition is a dynamic competitive process, and that many of the assumptions of the model
of perfect competition do not hold on real markets, they nevertheless believe that this model
has sufficient explanatory power to be used for the analysis and assessment of competition on

64
See Shepherd, 1997, 360.
65
See Posner, 1976, 2nd edn, 2001; 1979; Bork, 1978; Stigler, 1968; Demsetz, 1976; Brozen, 1982;
Easterbrook, 1984; for important critical literature see Lande, 1985; High, 1985; Schmidt/Rittaler, 1986;
Adams/Brock, 1991.
66
See Bork, 1978, 7.
67
See Section IV.1.

Kerber/Schwalbe
224 Part 1: Introduction

real markets.68 The Chicago School also challenged the S-C-P paradigm as a theoretical basis of
competition policy. They attacked Empirical Industrial Organisation on the grounds of the
ambiguousness of its empirical results. However, more importantly, the Chicago School
denounced the market power doctrine of the Harvard School by arguing that the primary
motivation of firms for mergers and many other business behaviours is the increase of efficiency
and not the extension or safeguarding of their market power. This approach contains an
implicit evolutionary (Darwinist) notion that on competitive markets only efficient market
structures and behaviours can survive in the long run (survivor-argument, the survival of the
fittest). Firms without an efficient size, or firms which agree to inefficient vertical agreements,
would suffer competitive disadvantages and would therefore have to leave the market sooner or
later. The policy implication of this survival of the fittest argument is that a general assumption
in favour of the efficiency of all kinds of market behaviours can be made, as long as these firms
remain in markets that are competitive.69
1–8–057 This different theoretical perspective became clearly apparent in the debate on mergers and
firm concentration. The Chicago School vehemently opposed the position of the Harvard
School: the main reason for mergers and increasing firm concentration is not the pursuit of
market power but the realisation of efficiency benefits, especially economies of scale. Since
increasing profits can also be a consequence of a better utilisation of economies of scale, this
conclusion from the efficiency doctrine would even be compatible with a positive correlation
between firm concentration and profits. Therefore, a too restrictive merger policy can impede
efficient firm sizes.
1–8–058 A conflict is also possible between the realisation of economies of scale (productive effi-
ciency) and the negative allocative effects of firms with market power. Williamson’s trade off-
model analysed this conflict for the first time. According to this analysis, a merger should be
permitted if the welfare advantages of the merger (in terms of an increase of productive
efficiency through economies of scale or synergy effects) exceed the allocative welfare losses
which arise from the increase of market power through the merger. In this analysis both the
efficiency and market power effects of mergers are considered, but only in relation to the total
welfare standard. However, redistributions of welfare (consumer rent) from consumers to
producers as a result of market power are not taken into account.70 These trade-offs between
efficiency benefits and the disadvantages of restraints of competition and market power have
become an increasingly important issue in competition policy. They are not only a concern in
the debate about an efficiency defence in merger control, but also in other realms of European
competition policy (e.g. cartel exemptions).
1–8–059 Other important differences between the Harvard and the Chicago School have emerged in
relation to market entry and oligopoly issues. Bain (as a representative of the Harvard School)
distinguished three different kinds of structural market entry barriers (absolute cost economies,
product differentiation and economies of scale), behind which incumbent firms can reap
supernormal profits without being challenged by new competitors. The Chicago School,
however, disputed the anti-competitive character of these market entry barriers and argued that
in private markets no serious entry barriers would exist. As a consequence, firms with market
power are not a serious problem because in the long run their market power will be eroded by
the entries of new competitors, especially if the incumbent firms try to exploit their market
power by raising prices. For the Chicago School the most important problems in relation to
market entry are caused by public entry barriers erected by the Government.71 In addition, the
Chicago School considers that there is only a small risk that oligopolists are able to raise prices
by collusion. Their reasoning uses Stigler’s oligopoly theory, which analyses the specific
conditions that are necessary for the successful co-ordination of market conduct. As a con-
sequence, the Chicago School generally cannot see much danger in oligopolistic market
structures and firms with market power, especially in the medium and long run.72
1–8–060 (c) Contestable markets. The theory of contestable markets, which was developed at
the beginning of the 1980s, analysed for the first time under what precise conditions

68
See Reder, 1982.
69
For this implicit evolutionary reasoning see Alchian, 1950; Stigler, 1958; Bork, 1978, 192; Demsetz,
1976, 374: ‘‘If the theory of competition tells us anything about industry structure, it is that an industry that
has persisted for a long period of time in the absence of legal restrictions on entry fundamentally reflects
underlying cost conditions’’; for criticism of this survivor’s fallacy see Vanberg, 1994, 29.
70
See Williamson, 1968; Farrell/Shapiro, 1990.
71
See Demsetz, 1982.
72
See Stigler, 1964; Posner, 1979, 932; Brozen, 1982, 130.

Kerber/Schwalbe
G. Economic Principles of Competition Law 225

potential competition can limit the market power of incumbent firms. It analyses the effects
of potential competition within neoclassical microeconomics and defines, exactly, the condi-
tions of perfect potential competition.73 A market is perfectly contestable if both market entry
and exit are free. Therefore, it is necessary that market entry requires no irreversible invest-
ments, i.e. that no sunk costs arise. For example, if a retailer enters a market by renting sales
space (with a short period of notice) and buying standard shelving which can easily be resold,
virtually no sunk costs arise from his market entry. Using all of the assumptions of the model of
perfect competition, the theory of contestable markets shows that in this case the incumbent
firms cannot raise their prices above the level of average costs. This is true even in the case of an
oligopoly of two or three sellers, because if the oligopolists charge prices above the average
costs a so-called ‘‘hit-and-run-entry’’ by potential competitors is possible. A ‘‘hit-and-run-
entry’’ implies that potential competitors enter into the market, undercut slightly the prices of
the incumbent firms, reap profits and can then leave the market quickly and without costs if the
incumbent firms reduce their prices to the level of average costs. Therefore, prices above
average costs are not in a stable equilibrium. As a consequence, the desirable outcome of
perfect competition, i.e. prices at the level of average costs, zero profits for firms and efficient
allocation, can also be achieved if the assumption of an atomistic structure of firms is not met.
Under the conditions of perfect contestability, even oligopolistic firms, which can be found on
many real markets, would behave as firms under the conditions of perfect competition.
The implications for competition policy are that on perfectly contestable markets prices are 1–8–061
independent of the level of firm concentration, because potential competition can substitute
completely actual competition. However, the conditions of perfectly contestable markets with
entirely free market entry and exit almost never exist in real markets. Even if there are only
small sunk costs, the perfect contestability of a market is not the case and private entry barriers
can arise. This was shown by the theory of strategic barriers to market entry. Nevertheless, the
merit of the theory of contestable markets was the precise analysis of the well-known argument
of potential competition. This analysis led to the systematic integration of potential compe-
tition into industrial economics as well as into the set of established criteria for the competitive
assessment of mergers and business behaviours in the practice of competition policy.74
(d) Transaction costs economics. The transaction cost approach, developed by Wil- 1–8–062
liamson in the 1970s, was the first approach of the new institutional economics to be applied
successfully to competition policy issues. It supported the efficiency doctrine of the Chicago
School. In 1937 Coase had argued that the size of transaction costs in the firm and on the
market determines whether activities are performed by the firms themselves or bought from
the market (‘‘make-or-buy decisions’’, leading to co-ordination by hierarchy or market).75
Transaction costs are all kinds of costs that arise from the search for transaction partners and the
negotiation and completion of transactions. By focusing primarily on production costs, tra-
ditional microeconomics neglected this type of costs.76 On the basis of this reasoning about
transaction costs Williamson developed a new theory of the firm (governance approach).77
In his analysis of transaction problems Williamson used the behavioural assumptions of 1–8–063
bounded rationality and opportunism, i.e. that the transaction partners might provide wrong or
biased information and might not abide by contractual agreements. Due to the presence of
uncertainty, the transaction partners are not able to negotiate in relation to all future con-
tingencies (imperfect contracts). This might lead to serious transaction problems with poten-
tially high costs. A particular problem arises if one of the partners (e.g. a supplier) must invest in
highly specific assets to carry out a transaction for a particular customer (transaction-specific
investments). Here, a unilateral dependence can emerge, which leads to the danger of
opportunism, i.e. the independent party might exploit the dependent transaction partner, e.g.
by forcing him to price reductions (hold-up problem). In these cases, vertical integration can be
a solution for such transaction problems which would reduce transaction costs. Williamson was
able to show that vertical mergers and a number of vertical agreements, which were viewed as
potentially anti-competitive, might also be explained by the motivation to reduce transaction
costs and hence to increase efficiency.78
(e) Policy implications and impact. These efficiency-oriented approaches led to a 1–8–064

73
See Baumol/Panzar/Willig, 1982.
74
See Spence, 1983; Shepherd, 1984; Fehl, 1985.
75
See Coase, 1937.
76
See Furubotn/Richter, 2005, 47–78.
77
See Williamson 1975, 1985; Hart, 1995; Erlei/Leschke/Sauerland, 1999, 175–228.
78
See Williamson, 1987; Kirchner, 1992; Joskow, 1991, 2002.

Kerber/Schwalbe
226 Part 1: Introduction

profound change of US antitrust policy, which had previously been dominated by the struc-
tural approach of the Harvard School. Horizontal mergers and high levels of firm concentration
were considered as much less critical due to the assumed efficiency advantages of large firms.
Therefore, a less restrictive policy in relation to horizontal mergers was adopted. Since vertical
and conglomerate mergers were considered as generally unproblematic, their control was not
seen as necessary. However, agreements on prices and quantities were viewed as the major
problem, because they do not imply any efficiency benefits. Other forms of horizontal
agreements (e.g. R&D joint ventures) with potential efficiency advantages should be exempted
from the general prohibition of cartels. An about-turn was indicated for vertical agreements in
particular. Following the approaches of the Chicago School and transaction costs economics,
many vertical agreements were considered likely to raise efficiency, leading to the conclusion
that they be, in general, permitted, or at least to a broad application of a rule of reason which
could take into account their efficiency benefits.79
1–8–065 In the 1970s and 1980s the Chicago School had a significant influence on US antitrust
policy, especially in relation to the policy of the Antitrust Division of the US Department of
Justice under the Reagan administration. Also, the Supreme Court (as the supreme authority in
the US system of antitrust law) started to use some of the central arguments of the Chicago
School. As a consequence, the application of US antitrust policy became considerably less
restrictive. Although the opinions of the Chicago School could not prevail completely, the
framework of arguments used in competition policy discussions today reflects, to a great extent,
this development. This applies, in particular, to the focus on the aim of economic efficiency,
the importance of potential competition, economies of scale and other efficiency advantages as
well as the necessity of balancing anti-competitive market power effects and positive efficiency
advantages. The general greater trust in the self-regulating forces of markets is also a con-
sequence of these efficiency-oriented approaches.80 Their impact on competition policies in
Europe, however, which did not take place until the 1990s, was much weaker and was
influenced ultimately by the newer developments of Post-Chicago economics.81
5. Competition and innovation: Schumpeterian approaches and the Austrian
School
1–8–066 (a) Introduction. It is an undisputed empirical fact that technological progress (i.e. new
products and production methods) is the most important determinant for long-term economic
growth.82 There is also a broad consensus that the innovation and diffusion of new products and
technologies is one of the essential functions of competition. However, economists have always
had difficulties in explaining the development and diffusion of innovations using their usual
analytical instruments. Therefore, a satisfactory integration of innovation into competition
economics has not taken place yet. This can also be seen in the practice of competition policy;
up to now, the impact of restraints of competition on technological progress has not been
sufficiently taken into account. The difficulty of integrating innovations into standard
microeconomic theory arises from the specific character of innovation activities. Due to the
importance of human creativity, and to very considerable uncertainty, they cannot simply be
modelled as a production process with an input of resources for research and development
leading to a specific quantity of innovative output: The analysis of innovation processes has
proved to be very complex.83 In addition, economic theory has focussed primarily on static
equilibrium models in which the development of new products and production methods was
excluded: Both the model of perfect competition and general equilibrium theory (including
the notion of efficient allocation) presuppose a set of existing products and technologies, and
therefore do not take into account at all the dimension of technological progress.
1–8–067 Consequently, in microeconomic theory competition and technological progress are treated
separately. A broad consensus exists that under the premises of the model of perfect compe-
tition there are no incentives for innovation. Complete market transparency would imply an
immediate imitation by the other firms of every successful innovation. Thus, no profits can be
made by developing new products and technologies. This perspective suggests the public good
character of innovations, because the innovator cannot exclude other firms from using the new
knowledge. Using market failure theory this would imply an under-investment in research and
development (R&D). As a consequence, R&D must either be subsidised (public technology

79
See Bork, 1978; Posner, 1979.
80
See Buxbaum, 1989; Kovacic/Shapiro, 2000; Baker, 2002.
81
See Van den Bergh, 2002; Hildebrand, 2002, 158–169.
82
See Solow, 1957.
83
For the research in innovation economics, see generally Freeman, 1994; Dosi, 2000; Rogers, 2003.

Kerber/Schwalbe
G. Economic Principles of Competition Law 227

policy) or (temporary) exclusive rights such as over the use of innovations have to be granted to
the innovators (intellectual property rights: patents and copyrights) in order to facilitate the
amortisation of R&D investments. Here, a fundamental conflict seems to arise: To create
sufficient incentives for innovation in the market it may be necessary to restrict competition by
granting a temporary monopoly through patents and copyrights.84 This conflict is what makes
the interface between competition law and the law of intellectual property rights so difficult.
On the face of it, competition and innovation seem to be in conflict. However, this conflict 1–8–068
is not necessary: on the one hand, innovation research shows that the process of appropriating
the benefits of innovations operates very differently under real market conditions. Depending
on the extent that information remains secret and a number of other imitation barriers, there
can be considerable incentives for innovations in real markets without the protection by patents
or copyrights.85 On the other hand, the generation and distribution of innovations and new
knowledge can also be integrated into the concept of competition. Such an integration of
competition and technological progress can be found in the Schumpeterian concept of
dynamic competition and in Hayekian and Austrian market process theory.
(b) Schumpeterian approaches: dynamic competition as a process of innovation 1–8–069
and imitation. In 1911 Schumpeter published his famous book ‘‘Theory of Economic
Development’’, which remains today the main starting-point for innovation economics.86 In
his theory he stressed that technological progress is the central endogenous driving force for
economic development. Of particularly importance are entrepreneurs, who introduce new
products and production methods (innovations), as well as imitators, who spread these inno-
vations (diffusion). Hence, the new innovations displaced the established products and pro-
duction technologies (creative destruction). For Schumpeter, the most important function of
competition was the creation and diffusion of new products and (cost-cutting) process inno-
vations, and not price competition. Theoretically, his approach was radical. He claimed that the
process of economic development, which is driven by innovations, generally cannot be ana-
lysed appropriately by applying neoclassical microeconomics with its equilibrium concept
(including the theory of perfect competition). He suggested, rather, that the analysis of eco-
nomic development required a fundamentally different theoretical paradigm. This critical
stance in relation to mainstream economic theory was also the root of evolutionary economics,
which has spread widely in the last 25 years and which views the process of economic
development as an evolutionary process.87
Starting from Schumpeter’s basic propositions, both Clark (as a continuation of his workable 1–8–070
competition approach) and German authors like Arndt, Heuss and Hoppmann, developed the
theory of dynamic competition in the 1950s and 1960s. Competition was viewed as a dynamic
process of innovation and imitation. In this competitive process some firms advanced with
competitive actions (innovations), while the other firms followed them by imitation or even
overtook them with new and better innovations. In this way a never-ending, competitive
process arises, as it can be observed on many real markets.88 Clark’s move away from a static
notion of competition became apparent with his argument for a notion of effective compe-
tition which also integrated Schumpeter’s dimension of innovation. Part of this dynamic
competition concept is Heuss’ theory of market phases, according to which whole industries
pass through different phases (development, expansion, maturity, stagnation and decline)
during their life cycle. As a consequence, markets are not given exogenously but emerge and
change in the course of an industry life cycle. Therefore, both the markets and the market
structures are an endogenous result of dynamic, innovative competition processes.89
From a normative point of view, the approach of dynamic competition focuses mainly— 1–8–071
apart from the aim of efficient allocation—on the generation and diffusion of innovations
(dynamic efficiency). This is also an inherent part of the term ‘‘effective competition’’, as it is
used in European competition policy.90 In this context, the possibility of a conflict between the
two aims of ‘‘efficient allocation’’ (static efficiency) and ‘‘technological progress’’ (dynamic

84
See Arrow, 1962; von Weizsäcker, 1980, 1981; Scherer/Ross, 1990, 613–660.
85
See Hippel, 1982; Dosi, 1988; Scherer/Ross, 1990, 627–630.
86
See Schumpeter, 1934.
87
See Röpke, 1977; Witt, 1987; Andersen, 1993; Nelson, 1995; Metcalfe, 1998; Nelson/Winter, 2002.
88
See Arndt, 1952; Heuss, 1965; Heuss, 1980; Hoppmann, 1977, 1988; however, also in the US, these
basic Schumpeterian ideas were applied: see Downie, 1958; Clark, 1961; Ellig/Lin, 2001; Peritz, 2002.
89
See Heuss, 1965; Klepper, 1996.
90
See also the dynamic competition functions (technological progress and adaptation flexibility) sug-
gested by Kantzenbach, 1967.

Kerber/Schwalbe
228 Part 1: Introduction

efficiency), needs to be discussed. Since, in the dynamic competition approach, the innovators
need sufficient incentives to innovate, the exploitation of temporary market power, which can
arise from the competitive lead of innovators, should not be seen as a problem. Even temporary
monopoly profits should be accepted in order to give the innovating firms enough incentives
for their innovative activities. Granting patents can support this, but the granting of intellectual
property rights is not considered to be the only (or even main) means of solving this incentive
problem. It is, however, important that such positions of market power arising as a result of
innovations should be temporary only. It is an inherent part of the dynamic competition
approach that competitors should erode this market power by imitation and/or overtaking the
innovator through new and better innovations. The implications for competition policy are
that only permanent positions of market power are a problem, and that, in particular, predatory
behaviour of dominant innovating firms against the competition of rival firms (or new entrants)
which try to catch up with imitations or new innovations should be controlled through
competition policy.91 In general, dynamic competition theory stresses the necessity of certain
deviations from the model of perfect competition in order to provide fertile conditions for
innovation and therefore for high, dynamic, efficiency.
1–8–072 Empirical Industrial Organisation economists carried out much research into the question
whether there is an optimal firm size, or an optimal degree of firm concentration, for the
achievement of a high rate of innovation. Schumpeter developed the notion that large firms
with market power might be particularly well-qualified to advance technological progress
(Schumpeter-hypotheses). The results of many empirical studies on this issue seem to show that
both very high and very low firm concentrations tended to have negative effects on innovation
activities; however, no optimal market structure or optimal firm size for innovations could be
identified. Rather, the empirical evidence suggests that the conditions for a high level of
dynamic efficiency depend on a large number of factors which also vary within the different
phases of innovation processes and as between different technologies and industries.92
1–8–073 (c) Competition as a discovery procedure (Hayek). Austrian market process theory,
which is based on Hayek and—to a lesser extent—on Kirzner (and other ‘‘Austrian econo-
mists’’), proposed a slightly different way to integrate innovation, in terms of new knowledge,
into the concept of competition.93 The starting-point of Hayek’s approach is the insight that
the individual members of a society do not have perfect knowledge of all relevant facts. Rather,
they have only bounded and subjective knowledge on which they must base their economic
decisions (the knowledge problem). It cannot be assumed—as it is in the model of perfect
competition—that firms as suppliers know the preferences of consumers, which products best
satisfy these preferences and what the best (i.e. most cost-efficient) production technologies are.
From the perspective of Hayek, the opposite applies; the main function of competition is to
find out which products and production methods are best. Due to the knowledge problem,
these facts cannot be known ex ante. For Hayek, competition is a process of trial and error in
which success or failure on the market helps to identify which of the different solutions of the
competing firms are (relatively) the best. Thus, competition can be characterised as an
experimentation process in which the firms, as suppliers, test their solutions on the market and
learn from the market feedback. Therefore, Hayek characterised competition as a ‘‘discovery
procedure’’ in which new knowledge is generated which would not exist without competi-
tion. One feature of these knowledge-generating processes of market competition is that the
outcome cannot be predicted in detail. Hence, Hayek’s contention was that the traditional
neoclassical concept of competition (as shown in the model of perfect competition) is entirely
flawed, because it starts with the assumption that there is no knowledge problem and therefore
ignores the search for new and better knowledge as being the main function of competition.94
1–8–074 The basic tenets of ‘‘Austrian Economics’’ and the Austrian market process theory where
developed mainly by Kirzner in the 1970s. In contrast to equilibrium-oriented micro-
economics, Kirzner stressed the process character of competition. His main focus was on the
activities of ‘‘alert’’ entrepreneurs, those who find and exploit previously undetected profit
opportunities and thus drive the market process. As a consequence, initial ignorance is reduced
by these entrepreneurs. In contrast to the Schumpeterian approach of dynamic competition,
which emphasises the disequilibrating character of entrepreneurs (creative destruction), Kirzner

91
See C.W. Neumann, 1983.
92
See Scherer/Ross, 1990, 613–660; Elßer, 1993; Dosi, 1988; Audretsch, 1996, 2004.
93
See Hayek, 1957, 1973; Kirzner, 1973, 1992, 1997; they see themselves in the tradition of Austrian
Economics (Menger, Böhm-Bawerk, v Mises); see Vaughn, 1994.
94
See Hayek, 1952; Hayek, 1973; Streit/Wegner, 1992; Harper, 1996; Kirzner, 1997; Kerber, 1997.

Kerber/Schwalbe
G. Economic Principles of Competition Law 229

assumes that these entrepreneurial activities drive the market to an equilibrium, because—with
constant exogenous conditions—all profit opportunities are gradually discovered by the
entrepreneurs. However, the ‘‘radical subjectivists’’ (another group of Austrian economists)
disputed such a tendency to equilibrium and pointed out that creative entrepreneurs can also
generate new possibilities and would not just discover existing opportunities. As regards
competition policy, Kirzner pleaded mainly for a laissez-faire approach; only the emergence of
resource monopolies could be seen as problematic.95
(d) Ordoliberalism and Hoppmann’s concept of freedom of competition. In 1–8–075
parallel to the research of Hayek in the 1940s and 1950s was the development of the Ordo-
liberal approach of the Freiburg School of Law and Economics. This institutional economics
approach emphasised the great importance of competition in a market economy and had great
influence on the development of German and European competition policy. Ordoliberalism
made no contribution to competition theory, but instead developed a unique approach to
identifying the most appropriate form of competition policy. At least five arguments and
associated principles had a long-term impact and remain important today:96 first, the Ordo-
liberal economists and legal scholars not only considered efficient allocation to be an aim of
competition policy, but also the protection of individual freedom from economic power. This
led to the principle of protecting economic freedom from restraints of competition. This is still
very important in German and European competition law, but is not often understood outside
Germany.97 Secondly, the Ordoliberals were convinced that the State must pursue an active
competition policy in order to overcome the inherent tendencies for restraints of competition
and monopolisation in market economies. Thirdly, they suggested the concept of ‘‘as-if-
competition’’ (‘‘Als-ob-Wettbewerb’’), which implied that firms with market power should
behave as if there was sufficient competition. This became an important principle in the
application in German and European competition law of the prohibition against abuse by
dominant firms. Fourthly, the concept of an independent competition authority, which should
be free from direct political influences, is based on Ordoliberal ideas.98 Fifthly, they argued that
competition policy decisions should be based as far as possible on general rules in order to avoid
interventionism. This is a consequence of their main proposition that a market economy needs
a stable institutional framework which ensures the functioning of markets. Additional inter-
ventionist measures into the markets, however, should be avoided.
On the basis of these Ordoliberal ideas and the approach of dynamic competition, Hopp- 1–8–076
mann developed his concept of freedom of competition in the late 1960s and the 1970s. The
critical role, (which the Chicago School had fulfilled in the USA in relation to the Harvard
School), was played in Germany by Hoppmann with regard to the German variant of the
concept of workable competition (Kantzenbach) and the S-C-P paradigm.99 On the normative
level, he criticised vehemently the view that competition is primarily an instrument to achieve
economic aims. Instead, he considered individual freedom as the most important aim. Since the
pursuit of this aim would also lead to the positive economic effects of competition, he con-
cluded that the protection of freedom of competition should be the central aim of competition
policy. Freedom of competition means, on the one hand the (entrepreneurial) freedom of firms
to decide freely their actions (in the parallel process of competition) and, on the other hand, the
freedom of buyers and sellers to decide freely with whom to deal (the exchange process). At the
theoretical level, Hoppmann challenged the S-C-P paradigm with its causal hypothesis from
market structure to market performance. Using the dynamic competition approach, he argued
that market structures are not exogenously given but emerge endogenously through the
competitive process. Hoppmann did not see market power as a great problem because of the
effectiveness of potential competition in open markets (similar to the Chicago School). He was
also very sceptical of a market structure-oriented competition policy, because nobody knows
which are the optimal market structures. This leads to the risk of interventionism through
merger policy. Instead, he preferred a competition policy which would limit itself to per se
rules. They should prohibit generally all kinds of business behaviours that restrict the freedom

95
See Kirzner, 1973, 1992; for the ‘‘radical subjectivists’’ see Lachmann, 1976; Littlechild, 1986.
96
For ordoliberal competition policy see Eucken, 1950; Gerber, 1998, 232–265; Möschel, 1989; Hildeb-
rand, 2002, 158–162.
97
See Gerber, 1998, 250–255; Hildebrand, 2002, 160–162; Murach-Brand, 2004, 102–106, 115–124.
98
See Eucken, 1949, 68.
99
See Hoppmann, 1968; Hoppmann, 1970; Hoppmann, 1972; Hoppmann, 1977; Hoppmann, 1988; Clap-
ham, 1981; Herdzina, 1999.

Kerber/Schwalbe
230 Part 1: Introduction

of competition (market behaviour-oriented competition policy). This can be seen as the


application of the Ordoliberal and Hayekian concept of ‘‘rule of law’’ to competition policy.
1–8–077 Hoppmann’s approach was criticised because of the difficulty of how to define freedom of
competition. There was considerable scepticism concerning whether the control of market
behaviour can be sufficient for the protection of competition.100 However, Hoppmann’s
insistence on the significance of economic freedom for competition, especially in relation to
innovations, of a stable institutional framework for competitive processes and of the danger of
an interventionist competition policy are valuable contributions to the debates on competition
policy. In Germany, the controversy between Hoppmann and Kantzenbach (as the German
representative of the structural approach) in the late 1960s and 1970s had a significance similar
to that between the Harvard and Chicago Schools in the USA. The critical role of Hoppmann
is one of the reasons why the arguments of the Chicago School spread so slowly within
German and, (to a lesser extent), European competition policy.
1–8–078 (e) Evolutionary and innovation economics and competition theory: an out-
look. Based upon the analysis of serious weaknesses in the static neoclassical concept of
competition, the Schumpeterian and Austrian approaches have provided important starting-
points for the development of a notion of competition which integrates both dynamic com-
petition and the search for new knowledge and innovations. These approaches are not yet
elaborated sufficiently for their practical application in competition policy decisions to be a
serious theoretical alternative. However, they can provide a number of valuable theoretical and
empirical insights about the determinants of innovation processes, which, so far, have barely
been considered in competition policy. These insights could be used to develop additional
criteria for the competitive assessment in concrete cases.101 Beyond that, an evolutionary
concept of competition could be developed through the stronger integration of Austrian
market process theory, Schumpeterian theories of dynamic competition, evolutionary inno-
vation economics102 and the resource- and knowledge-based theory of the firm.103 Innovation
activities in markets could be understood as competitive processes of experimentation (Hayek),
and modelled as variation-selection processes of new problem-solving hypotheses (product and
process innovations) which are tested and selected in the market. Analysis of how market
structures, legal rules and institutional frameworks can influence and channel these knowledge-
generating processes of competition could be carried out. For example, to test the hypothesis
that a larger number of heterogeneous competitors, and therefore a higher degree of diversity,
has a positive influence on the generation of new knowledge in processes of competition. The
reason is that more parallel experimentation can lead to a broader range of different innovative
problem solving hypotheses that are tested in the market, and therefore to more experiences
from which firms can learn mutually.104
6. Recent theoretical developments and Post-Chicago economics
1–8–079 (a) Introduction. From at least the beginning of the 1990s, the vehement debate between
representatives of the old Harvard School and the Chicago School has ceased to play a
dominant role. In US antitrust policy many of the arguments of the Chicago School are well-
established. In Europe the efficiency-oriented approaches have gained significant influence,
although after a long time lag. Nevertheless, the Chicago School has not been able to prevail
completely. The main reason was certain new developments in the theory of Industrial
Organisation; in particular, new applications of game theory and new insights concerning the
impact of market structures and business behaviours. These insights suggest a much more
differentiated assessment of potentially anti-competitive market structures and behaviours than
the policy recommendations of the Chicago School. In some respects, they also reinforce some
of the old sceptical positions of the Harvard School. These new developments have been
labelled Post-Chicago Economics. In addition, important new topics have been theoretically
analysed, e.g. the problem of natural monopolies (network industries) and their regulation.
1–8–080 (b) Industrial organisation theory. Traditional microeconomic theory had used math-
ematical equilibrium models for determining the prices and quantities which arise in different
market structures if sellers and buyers maximise profits. Following the emergence of game
theory105 in the 1970s the theoretical approaches known as Industrial Organisation experienced

100
See Clapham, 1981.
101
For a broad overview, see also Grupp, 1998; Münter, 1999; Audretsch, 2004.
102
See Nelson/Winter, 1982; Saviotti, 1996; Dosi, 2000.
103
See Barney, 1991; Foss/Montgomery, 1995; Conner/Prahalad, 1996.
104
See Röpke, 1977; Metcalfe, 1989; Kerber, 1997; Kerber/Saam, 2001; see Section V.4.(b)(bb).
105
See Section IV.5.(b).

Kerber/Schwalbe
G. Economic Principles of Competition Law 231

rapid progress. With the help of game theory, different types of markets can be analysed much
more precisely than by using traditional price theory.106 However, the game-theoretic foun-
dation of Industrial Organisation does not break with the development of neoclassical
microeconomics (including the general equilibrium theory), because both are based upon the
assumptions of the optimising behaviour of market participants and the equilibrium concept.
However, game theory has enabled the theoretical Industrial Organisation approach to advance
the analysis of markets in several directions because it allows for the analysis of more complex
market structures. These models can analyse problems in which firms interact repeatedly and
decide sequentially or simultaneously on their action parameters, while taking into account the
reactions of their competitors. In addition, situations in which the market participants have
only incomplete or asymmetric information can, and have been analysed. The most important
methodological instrument for the analysis of these strategic interaction situations is the concept
of the Nash equilibrium. Such an equilibrium exists if none of the firms (players) can improve
its situation through a unilateral change of behaviour, given that the behaviour of the other
players is assumed as constant.107
Game theory is particularly suitable for the analysis of market structures in which—as in 1–8–081
oligopolies—complex interactions between several firms take place. Game-theory-based ana-
lyses provided important insights, in particular, for the investigation of co-ordinated behaviour,
both in cases of price cartels and oligopolies, which can be applied directly in competition
policy.108 For example, the well-known problem of the potential instability of cartels could be
reconstructed as a familiar type of game: the ‘‘prisoners’ dilemma’’ describes very well the
fundamental conflict between the individual and collective rationality of cartel members. Each
of the cartel firms can increase its profits by cheating behaviour (through secret price reduc-
tions), but the high cartel price can only be stable if all members of the cartel stick to the
collective agreement. Game theory can analyse these problems more precisely, in particular,
which conditions have positive or negative effects on the stability of cartels (or collusive
behaviour in oligopolies). Another important field for the application of game theory in
Industrial Organisation is the analysis of strategic barriers to market entry. The analysis of
interactions between incumbent firms and potential entrants has shown that, under certain
assumptions, incumbent firms are able to erect strategic barriers to market entry, and thus can
limit the effectiveness of potential competition. Therefore, contrary to the position of the
Chicago School, private barriers to market entry are possible.109 It also could be proved that
firms (with market power) might be able to raise the costs of competitors systematically, e.g. by
exclusive marketing agreements (‘‘raising rivals’ costs’’).110
Modern competition policy is based substantially upon these game-theory approaches of 1–8–082
Industrial Organisation. The ‘‘more economic approach’’, which has been introduced by
European competition policy in recent years, strives for a greater application of Industrial
Organisation theory in the practice of competition policy. This theoretical approach therefore
plays a central role in the following sections about the economic foundations of competition
law.
(c) Institutional economics and the theory of the firm. Williamson’s transaction costs 1–8–083
theory was not only the first approach of the new institutional economics, but also the first
theory of the firm which was used in relation to competition problems. Institutional economics
has been one of the highest growth sub-disciplines in economics since the 1960s. Apart from
transaction costs economics, other important approaches of institutional economics theories are
the German Ordnungsökonomik, based mainly on Ordoliberalism and the Freiburg school
(Eucken, Böhm, Hayek), New Political Economy (public choice) and Constitutional Eco-
nomics, which analyse political and public institutions, law and economics, (including the
property rights approach and contract theory), and principal-agent theory, which deals with the
problem of asymmetric information between principals and agents. The main areas of research
of these approaches are the analysis of the incentives of institutional arrangements, their eco-
nomic effects and the optimal design of incentive mechanisms.111

106
See Martin, 2001a; Tirole, 2004; Carlton/Perloff, 2005.
107
See Section IV.5.(b).
108
See Section IV.5 and V.2.
109
See Section IV.8.
110
See Salop/Scheffman, 1987.
111
For a broad survey on institutional economics see Furubotn/Richter, 2005; Erlei/Leschke/Sauerland,
1999; for particular approaches see Mueller, 2003 (new political economics); Posner, 2003, and Cooter/Ulen,
2004 (law and economics); Eucken, 1950 (ordoliberalism).

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232 Part 1: Introduction

1–8–084 In a similar fashion to transaction costs economics, both economic contract theory and
principal-agent theory can contribute considerably to our understanding of the economic
rationale of horizontal and vertical agreements, e.g. in the case of information asymmetries
between firms. They can help us assess to what extent such agreements are primarily efficiency-
enhancing or anti-competitive. These approaches are also applied increasingly to competition
issues, particularly in combination with models of Industrial Organisation.112 For example, the
new phenomenon of networks of firms has been analysed using these theories. Networks of
firms are a difficult topic from the perspective of competition policy, because they are some
kind of intermediate case between horizontal and vertical agreements on the one hand and
mergers on the other.113 The analysis of networks of firms is very close to that of other
institutional theories of the firm, which understand firms, for example, as a nexus of contracts
between capital owners, employees, banks, suppliers and customers.114 However, besides these
incentive-based theories of the firm, knowledge-based (or resource-oriented) theories of the
firm might also be helpful for the analysis of competition issues, particularly in relation to
innovation issues and for the assessment of R&D joint ventures. Their primary focus is on the
knowledge resources and capabilities of firms.115
1–8–085 Since the 1990s the institutional design of competition policy has also been analysed from
the perspective of institutional economics. The discussion of fundamental institutional ques-
tions has a long tradition, especially in the German approach of Ordnungsökonomik and in the
public choice approach. Since state failure, due to knowledge problems and political influences
(through lobbying and rent seeking activities) on competition policy decisions, cannot
be excluded, the question of what kind of institutional design helps to overcome or reduce the
extent of state failure accordingly arises. Important issues here are whether the competition
authorities should be politically independent agencies and whether the application of com-
petition law should be more oriented towards rules (rule of law) or whether a more discre-
tionary approach of case-by-case decisions (with the danger of interventionism) should be
pursued. Furthermore, the law and economics approach to the economic analysis of legal rules
is becoming more important for competition law. Important examples of this are the economic
analysis of sanctions and of leniency programs for the detection of cartels. Another important
issue concerns the comparative institutional analysis of private litigation for breaches of
competition laws (private damages) with the public enforcement approach of competition
authorities as regards the issue of the efficiency of competition law enforcement. The insti-
tutional economics research programme also provides a wide variety of fruitful insights and
analytical instruments for the improvement of the procedural rules and of the institutional
design of competition law.116
1–8–086 (d) Competition in networks: regulation and deregulation. Since the end of the
nineteenth century, in many industrial countries whole industries had been organised as state
monopolies or were highly regulated by public authorities, leading to the impossibility of
competition, e.g. the postal system, telecommunication, energy, and water supply as well as the
railway system and air traffic. In general, this was justified by the special conditions in these
sectors, which would make competition impossible. In the 1960s economists started to analyse,
systematically, under which conditions competition cannot be introduced and what regulations
might be appropriate for unavoidable monopolies. An important result of this research was that,
in many of these monopolised or highly regulated sectors, the introduction of competition was
considered to be possible to a much larger extent than had been thought, with the implication
for a policy of deregulation. The theory of natural monopolies showed that the subadditivity of
costs is a suitable criterion for assessing whether more than one competitor can exist on a
market, and the theory of regulation analysed a set of alternative options for regulating these
natural monopolies. Most of the natural monopolies, e.g. telecommunication, railways, and
energy, are so-called network industries, because in these sectors the specific economic pro-
blems of network externalities arise (network economics). The most important competition
problems in network industries are the regulation of prices and other parameters, competition
for networks, the access to networks for competitors (including the level of the access fees) and
also the appropriate institutional design of regulatory agencies.117

112
For the economic rationale of vertical agreements see Section VII.2.
113
See Buxbaum, 1994; Kirchner, 1996.
114
See Hart, 1995; Holmström/Tirole, 1989; Erlei/Leschke/Sauerland, 1999, 69–228.
115
See Montgomery, 1995; Langlois/Robertson, 1995.
116
See Sections X.2 and X.4.
117
See Laffont/Tirole, 1993; Borrmann/Finsinger, 1999; Section IX.

Kerber/Schwalbe
G. Economic Principles of Competition Law 233

(e) Empirical analyses. Although the traditional research programme of Empirical 1–8–087
Industrial Organisation theorists, which was based on the S-C-P paradigm, is no longer
considered as very promising, there have been new developments in relation to empirical
studies. The research questions, statistical methods and the databases of the empirical studies
have evolved greatly. New empirical methods have been developed for competition policy
issues and, in particular, empirical studies are now also used in competition cases, e.g. for the
competitive assessment of mergers. Furthermore, market power can be identified both directly
and indirectly through empirical methods. The indirect diagnosis of market power implies the
delineation of relevant markets and the measuring of the market shares. Quantitative empirical
methods can help find the correct market definition. Important methods include econometric
analysis, which allows the determination of demand price elasticity and cross price elasticity,
correlation analysis of price developments of different products (shock analysis), empirical
analyses of trade flows and transport costs as well as comparative analyses of the correlation
between firm concentration and prices on different markets. In addition, simulation analyses of
the probable effects of mergers on market prices and quantities (merger simulation) can be
conducted under certain conditions. However, such empirical analyses are only possible in a
limited number of cases, mainly due to lack of data. Also, their economic interpretation is not
easy and must be very carefully made. Nevertheless, a broad consensus exists that the additional
possibilities for empirical studies should be used for competitive assessments in appropriate
concrete cases. These empirical methods represent important progress which will become more
important in the future.118
(f) Post-Chicago economics: a new consensus? In many areas of competition policy 1–8–088
there remain a large number of open and controversial questions, and the academic
debate about the most appropriate competition policy will continue. However, the debate
today about competition policy is much less dominated by two clearly distinguished factions,
with their own approaches and distinct policy positions, as this was the case between the
Harvard and Chicago Schools. Rather, there seems to be a new consensus about basic questions
and methods, which has been termed ‘‘post-Chicago Economics’’. This consensus does not
deny that there remain followers and opponents of a more or less restrictive competition
policy, or that there are still considerable differences over competition policy issues between
the US and Europe. However, these differences seem to concern, in the main, certain issues
rather than basic theoretical and normative issues. The following is a brief summary of the main
characteristics of this Post-Chicago economics.119
At the normative level, the orientation towards welfare economics, with its central aims of 1–8–089
allocative and productive efficiency, has been adopted from the Chicago School. This implies
the acceptance of an efficiency defence in merger policy. However, industrial economists do
not agree on the question of whether competition policy should pursue the total welfare
standard or the consumer welfare standard. The former maximises the sum of the surplus of
producers and consumers (and therefore ignores redistributions from consumers to producers
caused by market power), whereas the latter focuses solely on changes in the consumers’
surplus. Most Post-Chicago economists would see no problem in also including effects on
innovations (dynamic efficiency) in addition to the effects on static efficiency, even if this
aspect is most often neglected. The consideration of other aims of competition policy is,
however, fiercely disputed. In contrast to the Chicago School, many (particularly European)
representatives of Post-Chicago economics would accept that the decision on the aims of
competition policy is ultimately a political one, such as the market-integration aim of European
competition policy.120
The main focus of Post-Chicago economics is at the theoretical level. A broad consensus 1–8–090
exists that the theoretical basis of competition policy should be the theoretical Industrial
Organisation with its mathematical models based on game-theory. Although competition
policy is still based on microeconomic theory, as postulated by the Chicago School, the various
theoretical developments of the Industrial Organisation approach showed that the propositions
and policy recommendations of the Chicago School are too general and need much stronger
differentiation. The following examples show how Post-Chicago economics has led to policy
conclusions which differ from those of the Chicago School:121

118
See Bishop/Walker, 2002, 315–456; Hofer/Williams/Wu, 2005; Sections IV.7 und VI.3.(e).
119
See Sullivan, 1995; Baker, 1999, 2002; Jacquemin, 1999; Kovacic/Shapiro, 2000; Hovenkamp, 2001;
Carlton, 2003; current textbooks are also characterised by this approach, see, e.g. Motta, 2004.
120
See Aiginger/McCabe/Mueller/Weiss, 2001; Aiginger/Mueller/Weiss, 1998.
121
See Baker, 1999; Baker, 2002.

Kerber/Schwalbe
234 Part 1: Introduction

(1) Since private barriers to market entry can exist, this issue must be investigated in case
analyses.
(2) Certain practices can facilitate the co-ordination of behaviour between oligopolists,
implying that collusive pricing behaviour and price cartels can be stable, even in the long
term.
(3) Practices that aim at excluding competitors from markets (exclusionary practices) or
raising their costs (raising rivals’ costs), as well as anti-competitive pricing behaviour,
(predatory pricing) can be rational strategies, which must be prevented through com-
petition policy.
(4) Even vertical agreements and vertical mergers can lead to significant restraints of com-
petition under certain conditions.
(5) The theory of unilateral (non-co-ordinated) effects shows that horizontal mergers with
even relatively small market shares can lead to price increases.
However, certain core arguments of the Chicago School have also been reinforced, e.g. the
efficiency advantages that follow from many vertical agreements. Although Post-Chicago
economics proceeds mainly from the theoretical and normative basis of the Chicago School, it
recognises to a far greater extent problems which arise through private restraints of competi-
tion. Today, most Post-Chicago economists, despite all kinds of specific disagreements, see a
much greater necessity for an active competition policy of the state for the protection of
competition than did the Chicago School. Another important characteristic of Post-Chicago
economics is the development and application of empirical methods for the analysis of specific
competition cases. Better availability of data (e.g. scanner data), the rapid progress in computer
technology and improved econometric methods have contributed to this development. As a
consequence, simple cause-effect-relationships, as suggested in the S-C-P paradigm, are being
replaced increasingly by the empirical analysis of more complex theoretical models.122
1–8–091 Within the framework of Post-Chicago economics a new approach concerning the form of
the application of competition law in specific cases has tended to emerge, which already
partially influences the practice of competition policy. The theoretical analyses of Post-Chicago
economics often lead to the problem that no clear conclusions about the competitive effects of
certain market structures or business behaviours can be drawn because they depend on specific
assumptions. In addition, there are often simultaneously both positive (welfare-increasing) and
negative (welfare-reducing) effects; this leads to trade-off problems between them. Two
conclusions follow for the practice of competition policy:
(1) Due to the need for more differentiation, per se-rules, which allow or prohibit business
behaviours generally, seem to be less appropriate. A ‘‘rule of reason’’ strategy seems to be
more advantageous because it allows a more differentiated assessment in individual cases.
(2) The simultaneous existence of both positive and negative effects requires the solving of
the trade-off problem through a more precise quantification of these effects. The
development of quantitative methods for empirical studies in competition cases fits such
an approach. One example is the attempt to predict the price and quantity effects of
mergers through the method of merger simulation.
These developments lead to the tendency to carry out more case-specific analyses of the
positive and negative welfare effects in competition cases. This also increases the influence of
economic experts in competition law proceedings.123
1–8–092 (g) Critical assessment. In a brief critical assessment of the latest developments con-
cerning the economic foundations of competition law the following points can be made. A
very positive development is that the theoretical and the empirical basis of competition law and
its application have both been improved significantly. The debates on competition policy have
also been much improved by the fact that they are less dominated by the controversy between
two schools with fundamentally opposing approaches. Today’s discussions focus much more on
different opinions on specific issues. Although this makes the discussions more complex, they
are indeed becoming more fruitful. Of particular importance is that, in addition to the
Industrial Organisation approach, other economic approaches such as institutional economics
in particular are also increasingly used in competition policy. The so far insufficient attempts to
argue for a better consideration of theories of the firm and of the manifold insights of inno-
vation economics should be extended. However, the complex and differentiated nature of
discussions also shows that the knowledge of economists about the determinants of competition
and the effects of market structure and business behaviours is still limited. Empirical evidence is

122
See Joskow/Waterson, 2004.
123
See Posner, 1999; Hovenkamp, 2002.

Kerber/Schwalbe
G. Economic Principles of Competition Law 235

often still fragmentary and not always robust. Some theoretical models do not permit the
derivation of general conclusions because of their very restrictive assumptions. Another pro-
blem is that the attempts to achieve differentiation and quantification also carry new risks:
There is a tendency that competition policy decisions, e.g. in merger control, are made solely
on the basis of predicted price and quantity effects. This leads to the risk of overestimating the
capabilities to predict successfully such effects and of using too short a time horizon. It also
implies the danger that other important dimensions of competition, e.g. competition for new
products, higher quality, better service or new distribution channels, are not taken into account
adequately because they are much more difficult to quantify. From this perspective, it seems
particularly desirable that the Schumpeterian innovation dimension (or, alternatively, Hayek’s
‘‘competition as a discovery procedure’’) receives more attention both in theoretical discussions
and in the practice of competition policy. A final critical remark is that more economic analyses
in individual competition cases can reduce the predictability of competition law decisions—
with the possible consequence of increasing legal uncertainty.

IV. Competition policy: normative and theoretical foundations


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1. The aims of competition policy
1–8–093 (a) Introduction. The current debate on competition policy, as well as its practice in
various countries, covers a variety of possible objectives. These include effective competition;
social welfare; consumer welfare; international competitiveness; the protection of small and
middle-sized companies; integrating the European market; guaranteeing economic freedom,
fairness, and justice; the protection from economic power and other social and political
objectives. These aims are only partially economic in nature, in the narrow sense of the word.
The next section contains a brief introduction to these objectives, and briefly assesses their
adequacy, from an economic point of view.
1–8–094 (b) Welfare-based objectives. From the normative point of view, the main purpose of
economic policy consists in maximising the welfare of a society (welfare economics). In this
context, the term ‘‘welfare’’ means that the needs of the members of society be satisfied as far as
possible. Total welfare may be increased either by employing existing resources more effi-
ciently, given the existing products and technology (static efficiency), and/or by means of
technological progress (dynamic efficiency). From the economic perspective, competition
policy should ensure, by means of suitable competition law, that competition augments welfare
through the promotion of both static and dynamic efficiency. For this purpose, criteria for the
assessment of allocative efficiency, production efficiency and dynamic efficiency (innovations)
have been developed.
1–8–095 (aa) Allocative efficiency. Allocative efficiency is ensured if the existing resources within
an economy (e.g. the factors of production, or the goods) are employed in such a way that,
given the products and the production processes, society’s economic needs are satisfied opti-
mally. Such an efficient allocation will be reached if no individual can be made better off
without making anyone else worse off, either by employing the given factors of production in a
different way or by reallocating the goods produced. If it is possible to make an agent better off
only at the expense of another agent’s welfare, then the underlying allocation is Pareto-
efficient, or Pareto-optimal.124 Put another way, an allocation is inefficient if a different use of
resources, i.e. a reallocation, can improve the situation of all members of society, or at least

124
Named after the Italian economist and sociologist Vilfredo Pareto (1848–1923).

Kerber/Schwalbe
G. Economic Principles of Competition Law 239

make one individual better off, without making another person worse off. Note that the
concept of Pareto-efficiency does not consider the distribution of goods among the members of
society—even an extremely unequal distribution that is regarded as unfair could be Pareto-
efficient.
(bb) Productive efficiency. Production efficiency refers to the use of inputs and factors 1–8–096
of production in the production of goods. A single firm produces efficiently if, given the
existing technology, each output is produced with the least possible amount of input factors or
if, vice versa, the largest possible output is produced with the existing inputs. In the case of
individual production efficiency, this is usually ensured by the assumption of profit max-
imisation. However, this is not always the case, since the firm’s internal organisation structure
must also be taken into consideration. In order to produce efficiently, the firm’s decision
makers must be given the correct incentives to pursue the firm’s aim of profit maximisation,
rather than their own personal goals, which might differ from those of the firm (e.g. luxurious
office equipment or expensive company cars). The economic literature has labelled such
inefficiencies as X-inefficiencies.125 Production efficiency may also refer to the distribution of
production between firms. In the case of increasing returns to scale, i.e. if producing a larger
quantity incurs a lower per-unit cost than producing a smaller quantity, efficiency might be
enhanced by two firms jointly producing the good in question. The same argument applies in
the presence of economies of scope, e.g. if a single firm can produce two goods with fewer
inputs than can two separate firms. In these cases, the allocation of production between two
firms will waste resources. Within the economy as a whole, production costs are minimised if,
in each case, the best technology is being used to produce one or more goods.
(cc) Dynamic efficiency/innovations. Whilst both allocative and production efficiency 1–8–097
refer to a given standard of knowledge, technology, and a given set of possible products, the
criterion of dynamic efficiency encompasses the progress in knowledge (e.g. know-how), as
well as the development and introduction of new goods and production technologies (both
product innovation and process innovation). One possible definition of dynamic efficiency
would be to say that the economic process is dynamically efficient if these changes take place
over time at the rate which is socially optimal. This is the case when the additional cost
incurred by a further investment in research and development (R&D) equals the additional
expected revenue from the innovation.126 However, research on innovation suggests that,
because of the considerable amount of uncertainty associated with the search for new
knowledge, and especially with respect to investment in R&D, it is very difficult to tell
whether or not economic process develops in a way which is dynamically efficient. The
expected returns from R&D are hard to anticipate, and, more often than not, research leads to
entirely unexpected results. The branch of evolutionary innovation research based on
Schumpeter denies the possibility that, in the case of the highly complex phenomenon of
innovation processes and technological progress, efficiency can be defined in a way similar to
that employed in relation to the optimal use of resources where products and technologies are a
given. In this sense, the criterion of innovation lies outside the range of both production and
allocative efficiency. Economic theory has still not succeeded in integrating innovation into the
theory of general equilibrium.127
This assessment criterion is of paramount importance, since technological progress is one of 1–8–098
the core determinants of the increase of a society’s welfare. At the same time, however, this
criterion is hard to apply. The reason is that, on the one hand, it is not easy to derive a clear and
workable criterion to assess the optimal extent of innovative activity. However, this does not
mean that, say, an increase in R&D expenditure could not be used as an indicator of a higher
degree of dynamic efficiency. On the other hand, particular problems arise concerning the
adoption of new technologies which may be imitated easily. Here, the protection of com-
petition through, e.g. patents may be necessary in order to create sufficient incentives to invest
in R&D.
(dd) Consumer welfare/ preventing redistribution due to market power. For quite 1–8–099
a period of time the main reason for combating restrictions on competition was not the ensuing
loss in efficiency, but rather the redistribution of economic surplus. More precisely, that

125
Leibenstein, 1966; Section IV.3.(b)(bb).
126
There are a number of theoretical models that show that, in certain circumstances, investments in
R&D exceed the amount that would be optimal for society as a whole; e.g. models of patent races by
Reinganum, 1989.
127
Compare Section III.5. Therefore, the term ‘‘dynamic efficiency’’ does not enjoy the same status in
economic theory as the concepts of production and allocation efficiency.

Kerber/Schwalbe
240 Part 1: Introduction

economic surplus was taken away from the consumers, thus increasing the surplus gained by
the powerful firms. The main problem associated with monopolies was, according to this view,
that a monopoly would exploit consumers by charging high prices. In this sense, competition,
and thus competition policy, were important instruments for the protection of consumers, who
are less powerful, from the economic power and exploitation of large firms or cartels. When
firms agree to form a cartel and jointly raise prices, this will not only incur economic ineffi-
ciencies but, moreover, also involve a redistribution of economic surplus from consumers to
producers. Up until now, debate on competition policy and competition law has relied on the
principle that a firm’s profits from competition should be based on benefits for consumers. That
is, one should prevent profits stemming from market power on the part of the firms (or from
state-aided restrictions to competition such as subsidies). The competition debate in Germany
has drawn on Ordoliberal ideas, and thus developed the term ‘‘competition the merits’’.128
Most concepts of competition contain the aim of the prevention of redistributions induced by
market power and restrictions. This reflects both the aim of preventing the exploitation of
consumers as well as the idea that a firm’s profits should be due to a better performance.
1–8–100 The recent debate also deals with the issue of whether or not competition policies should, in
their political assessment, take into account the redistributions through market power, e.g. in
merger control. This issue manifests itself in the conflict between the Total Welfare Standard
on the one hand, and the Consumer Welfare Standard on the other. The former is concerned
only with maximising total welfare, i.e. the sum of producer and consumer surplus, in a single
market.129 The distribution of welfare within that market plays no role. In contrast, the latter
concept is concerned with consumer surplus, which increases if and only if prices fall, per-
formance being equal. The difference between the two is best explained by an example.
Suppose a merger results in both an increase in market power and a cost reduction at the same
time (i.e. there is an increase in productive efficiency). The Total Welfare Standard would
check whether the loss in allocative efficiency arising from increased market power over-
compensates the cost reductions induced by the merger. If this were the case, the merger
would be prohibited. Otherwise, it would be approved. This is the well-known Williamson
trade-off between a merger’s negative effects arising from increased market power and its
positive effects on productive efficiency.130 This concept ignores the redistributive effect
resulting from a price increase due to enhanced market power. The Consumer Welfare
Standard, by contrast, takes this effect into consideration, since it is concerned solely with
consumer surplus. The merger would be approved if the efficiency gains of the merger would
be large enough to result in a price cut, and thus raise consumer surplus, despite the augmented
market power. As a consequence, netting-off the efficiency gains and losses of a merger is not
an issue for the Consumer Welfare Standard, but it is for the criterion of Total Welfare. From
the point of view of welfare economics, the Total Welfare Standard corresponds to the so-
called Kaldor-Hicks criterion, which allows for a netting-off because of the hypothetical
possibility that consumers are compensated by producers. The Consumer Welfare Standard, by
contrast, insists that conduct that restricts competition must never harm consumers.131
1–8–101 The recent economic debate presents the following arguments in favour of the Total
Welfare Standard.132 Consideration of consumer surplus and producer surplus at the same time
allows for more welfare- enhancing developments, as compared with the consideration of
consumer surplus only. Further, a larger producer surplus implies a larger dividend payout,
which in turn benefits shareholders, and thus consumers. On the other hand, arguments in
favour of the consumer welfare standard include the presumption that, in contrast to the
producers, consumers face difficulties when trying to assert their interests in the political
process. This is why there is a need for institutional protection as provided by the Consumer
Welfare Standard. Furthermore, the consideration of consumer surplus only makes it harder for

128
Böhm, 1933; Eucken, 1952; Vanberg, 1998.
129
Further, one may include the additional welfare effects accruing to other markets into consideration.
Crampton, 1994, differentiates between total social surplus (defined by the sum of consumer and producer
surplus in the markets directly affected by the merger) and the total welfare that takes into account
additional effects on other markets.
130
Williamson, 1968; Farrell/Shapiro, 1990; Section VI.5.
131
From the economic point of view one could say that restraints of competition may never result in the
consumers being worse off, which corresponds to a direct application of the Pareto criterion, cf. Schäfer/
Ott, 2000, 23–53, with respect to these welfare economic criteria.
132
Besanko/Spulber, 1993; Neven/Röller, 2000; Lyons, 2002; Motta, 2004, 20. Lande, 1991, and Crampton,
1994, provide a good survey on the anterior US-American discussion.

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G. Economic Principles of Competition Law 241

firms to exploit their information advantage over competition authorities with respect to
alleged efficiency gains. Moreover, the Consumer Welfare Standard is easier to implement
since, in many cases, it suffices to check whether prices fall or not.
The decision on the aims of competition policy, and thus the assessment standard, is of a 1–8–102
normative nature. Nowadays, most economists are concerned primarily with the issue of the
augmentation of total welfare, and therefore ignore the distributive aspect, or relegate it to tax
or social policy. Therefore, the Total Welfare Standard is considered to be more appropriate.
Questions of distribution are assigned to other areas of politics, not to competition policy.133 In
contrast, under the Consumer Welfare Standard, the distribution of welfare is inherent within
the framework of competition law. The traditional competition policy debate considered the
prevention of redistribution due to market power to be a central objective of competition
policy. All in all, however, this issue has not been analysed sufficiently, independent of its
normative content. Different countries provide different answers to the normative question of
which of the two welfare standards should be employed. Whilst Europe and the US tend to
rely on the consumer welfare standard, other countries like Canada, Australia and New
Zealand take producer surplus into consideration also.134
(c) Other possible objectives of competition policy. Economic freedom. Competition 1–8–103
policy may be assigned the task of protecting the economic freedom (or freedom of compe-
tition) of individuals. This is primarily the case in the German competition regulations.
Competition allows consumers to choose between different suppliers (freedom of the exchange
process). Similarily, freedom of competition also encompasses the freedom of firms to decide
their action parameters (freedom in the parallel process). Economic freedom in both these
senses may be restricted by the market power of firms.135 The protection of economic freedom
has been a principal aim of many competition laws. There remains a need in research to
adequately and integrate in an interdisciplinary way the aim of economic freedom (which is
emphasised, above all, by jurisprudence) with an economic analysis of restrictions of compe-
tition. Furthermore, there is a need to find a way to resolve trade-offs between economic
freedom on the one hand, and efficiency on the other.
Fairness and justice. Competition laws often contain the direction that competition should 1–8–104
take place in some kind of fair manner. It is not only from an economic perspective that it is
hard to define what, exactly, this means. For one thing, a redistribution resulting from
restricted competition and market power may be considered unfair. Nevertheless, this is already
covered by the concept of consumer welfare. Secondly, one would prefer competition to rely
on fair means. Practices like, e.g. predatory pricing, might be considered unfair. This aspect will
be dealt with in the context of the abuse of a dominant position, and the prohibition of abuse
on the part of dominant firms.136 A third aspect concerns the issue of whether competing firms
face equal starting conditions (the ‘‘Level Playing Field’’), or if distortions exist, e.g. subsidies.
From a normative point of view, questions of fairness and justice may well play a major role in
society. However, it might not be expedient to consider these aspects—except for the dis-
tribution through market power—within the framework of competition policy.
Protecting small and medium-sized firms. To date, the protecton of small and medium-sized 1–8–105
firms is a separate concern, especially with respect to large firms’ market power. Although,
from an economic point of view, the formation of firms and the existence of small and
medium-sized firms is deemed beneficial with regard to economic development, in particular
with respect to innovation and new jobs, it is hard to find convincing reasons why competition
policy should protect these firms beyond the scope of the general protection of competitors
from others’ market power. It is true, however, that small and medium-sized firms rarely get
the chance to restrict competition. Therefore, they should remain unhindered by red tape as far
as possible, particularly with respect to co-operation.
International Competitiveness. The aim of promoting the international competitiveness of 1–8–106
domestic industries, e.g. through creating/strengthening ‘‘National Champions’’, is often
mentioned in debates on competition policy, and arises in practice. It is argued that otherwise
anti-competitive mergers or agreements (like co-operation on R&D or even export cartels)
should be approved for this purpose. The justification seems to be the argument that, from the
point of view of industrial policy and politics, the well-directed promotion of single, national

133
This argument implicitly assumes the amount of economic surplus to be independent of a possible
redistribution effected at a later stage.
134
Crampton, 1994; Lyons, 2002; Motta, 2004, 20; Van den Bergh/Camesasca, 2006, 35–45.
135
Hoppmann, 1968, 1988; Mestmäcker, 1980; Herdzina, 1999.
136
cf. Section VIII.3.

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242 Part 1: Introduction

firms, in particular through allowing or sustaining restrictions to competition, may give them a
lead over foreign competitors, which in turn increases domestic welfare (strategic trade policy).
For decades, however, experience of such policies has been predominantly negative. Indeed, to
the contrary, maintaining competition has proved to be the best way of promoting interna-
tional competitiveness.137 From a normative point of view, such policy is problematic since it is
based on the idea of raising domestic welfare at the expense of foreign welfare (‘‘Beggar-my-
Neighbour’’ policy).
1–8–107 Economic integration. This is the special aim of European competition policy; the abolition of
obstacles preventing the completion of the common market. In principle, there is no conflict
between the promotion of a single market on the one hand, and the general aim of welfare
maximisation on the other. However, if the objective of a European single market is supposed
to include the requirement that such a market should display equal prices, or that there should
be no absolute territorial protection, (e.g. exclusive dealing contracts), i.e. that so called parallel
trade should always be possible, then it is possible that the aim of integration might be at odds
with that of economic efficiency (if only to a very limited extent).138 This is why the inte-
gration of a single market is listed as a separate goal of European competition policy, in addition
to the economic objectives.
1–8–108 (d) Conclusions. The decision as to the aims of competition policy and competition law
is a normative, and therefore political, decision. An economic perspective can, however,
provide the basis for recommendations with respect to the suitability of certain goals. For
instance, some of the concepts described, e.g. the concept of effective competition, explicitly
rely on a bundle of multiple aims, whereas others reject this idea in favour of a single goal, like
the Chicago School emphasis on total welfare. Economic experience shows that considerable
problems may arise if one tries to achieve several aims at the same time, and they differ too
widely. Economics suggests that focussing on certain criteria has been shown to be appropriate.
These criteria see competition primarily as a means to create the highest possible welfare, either
by advancing allocative and productive efficiency, or by promoting innovations (dynamic
efficiency). Although there is controversy between the concepts of consumer welfare and total
welfare standards on the other, there are many arguments in favour of taking into consideration
systematically and explicitly the redistributions effected by the use of market power on the part
of the firms. Whether or not additional objectives should be incorporated should be considered
carefully. If possible, this should be avoided. Furthermore, one would have to specify the
relationship between the separate goals more precisely, e.g. economic freedom or fairness
versus economic objectives. There exists a considerable need for further research (especially of
the interdisciplinary kind) in this area.139
1–8–109 Together with integration of the single market, the predominant aim of European com-
petition policy consists in securing effective competition. For instance, the Guidelines for the
assessment of horizontal mergers of 2004 state that:

‘‘Effective competition is advantageous for consumers, for example in terms of low prices,
high quality products, a large selection of goods and services, and innovation’’.140
The objective of effective competition coincides with the criteria of allocative and pro-
ductive efficiency, innovation (dynamic efficiency) and consumer welfare. Consequently, these
will serve as criteria for assessing competition policy. However, this does not exclude the
possibility of trade-offs occurring between the various dimensions of a given objective. Above
all, it is well known that trade-offs may arise between efficiency in production and allocation
(Williamson Trade-off), and between static efficiency (both allocative and productive) and
dynamic efficiency (innovation). Furthermore, conflicts may arise between raising total welfare
on the one hand, and consumer welfare on the other
1–8–110 2. Perfect competition. Up to now, the economic goals of competition law, policy and
competition have been described in a general and abstract fashion only. The next section
describes the economic foundations which help to explain how competition can contribute to
achieving the aims mentioned so far.141 It covers the market structures of perfect competition,
monopoly, monopolistic competition, and oligopoly.

137
Krugman, 1989; Monopolkommission, 2005, 75–84; Section X.3.(d).
138
Bishop/Walker, 2002, 3–6.
139
Kerber, 2007.
140
European commission, 2004, 5, text number 8.
141
Sections 2 to 8 are based on Schwalbe/Zimmer, 2006.

Kerber/Schwalbe
G. Economic Principles of Competition Law 243

(a) Assumptions and market performance. The way in which perfect competition 1–8–111
works is best explained by the example of a market for a homogeneous good (see figure IV–1,
below). It is assumed that each firm and each consumer’s influence on the market is negligible
(perfect or polypolistic competition). In this case, a single market participant cannot affect the
market price through its supply or demand decision. Therefore, the agents act as price takers.
Consumer demand is described by a demand function (NN’) that indicates the quantity
demanded at each given price. The demand curve is usually downward sloping, since con-
sumers will demand less when the price is high. The area below the demand curve indicates the
consumers’ willingness to pay for a certain quantity of the good. Supply is characterised by the
supply function (A‘A). It shows the quantity supplied at each given price. A firm will increase
its supply if the price covers the cost of production. That is, the supply curve corresponds to the
additional cost of producing one more unit, the so called marginal cost. The area below the
supply curve indicates (variable) production cost. The curve is upward sloping since supply
increases with price. The market equilibrium is indicated by the intersection of the demand
(NN‘) and supply (AA‘) curve.
Figure IV–1: Market equilibrium with perfect competition

On the vertical axis, the intersection of supply and demand curves indicates the equilibrium 1–8–112
price pk. On the horizontal axis, the intersection indicates the quantity traded at this price, i.e.
the equilibrium quantity xk. In equilibrium, consumers demand exactly the same quantity as
supplied by the firms, and the market clears. The total expenses incurred by consumers cor-
respond to the area pkb xk 0 (equilibrium price pk ! equilibrium quantity xk), whereas their
willingness to pay for the equilibrium quantity corresponds to the entire area below the
demand curve a b xk 0. There is thus a positive difference between the consumers’ total
willingness to pay for the equilibrium quantity on the one hand, and their actual expenses on
the other. This difference is referred to as consumer surplus. It is indicated by the area abp. A
similar consideration applies to the firms: Their revenue corresponds to the area pkb xk 0
(equilibrium price pk ! equilibrium quantity xk), while their total (long-run) cost of pro-
duction is given by the entire area below the supply curve. Again, there is a positive difference
between the two, which is referred to as producer surplus.142 This corresponds to the area pkbd.
The sum of consumer and producer surplus (abd) is called economic surplus. It comprises the
sum of all gains from trade, and is often used as a measure of economic welfare in a market.

142
In the long run, producer surplus equals the firm’s profit. In the short run, producer surplus and profit
differ by the amount of fixed costs, which are not part of marginal cost in this case.

Kerber/Schwalbe
244 Part 1: Introduction

1–8–113 At any other than the equilibrium price, the economic surplus is lower: If the price exceeds
the equilibrium price pk, supply will exceed demand in this market. If this were the case, some
firms would be willing to lower their price in order to be able to sell their quantity produced.
As long as the price exceeds marginal cost, undercutting this price will be profitable. For this
reason, a price reduction would be expected in this market. On the other hand, if the market
price falls short of the equilibrium price, demand will exceed supply. In this case, competition
between consumers would induce an increase in price. This is because some consumers would
be willing to pay a higher price in order to attain the good, to the extent their willingness to
pay exceeds the prevailing price. The equilibrium price will clear supply and demand, such that
all possible gains from trade will be realised. That is, in equilibrium, price equals marginal cost,
and the resulting allocation is efficient.
1–8–114 If we consider not a single market, but the economy as a whole, then this condition must
hold for all markets simultaneously in order to extract the entire economic surplus. The
question arises if, and in what circumstances, a market economy can arrive at a state where an
efficient allocation is realised in each market. This is the pivotal question posed by general
equilibrium theory. It was answered in general form only in the 1950s, by the works of Arrow,
Debreu, and McKenzie.143 Existence of such an equilibrium requires quite a few rather
restrictive conditions to be met. In reality, only very few markets, if any, fulfil these conditions.
In this context, it must be emphasised that general equilibrium theory is not supposed to offer a
realistic description of an existing market economy. Neither should it be understood in that
way. Instead, it is an ideal conception of economic theory that is used, above all, to explain the
functioning of a market economy, and especially the role of prices with respect to allocations.
1–8–115 The basic assumptions necessary for a general equilibrium to exist are as follows: First, all
firms and consumers act as price takers, i.e. each firm and each consumer presumes that its own
supply or demand decision does not affect the market price. This assumption makes sense when
there is a ‘‘large’’ number of firms/consumers that supply/demand the product in question,
such that each firm/consumer supplies/demands only a very small fraction of the total quantity.
Further, it is assumed that all market participants have complete information concerning all
relevant issues such as prices, market conditions, the quality of the goods, where to purchase,
etc. The reason is that, when information is asymmetric as between buyers and sellers, or if
information about relevant facts is incomplete, then it could be that competition will not
produce a result that is socially desirable in that market.144 The existence of incomplete or
asymmetric information often implies that transactions cannot be performed without incurring
a cost as implicitly presumed in general equilibrium theory. The market participants face
transaction costs that may lead to an inefficient allocation when they conduct business and
enforce their claims.
1–8–116 Moreover, it is assumed that there are no public goods, i.e. goods that are characterised by
there being no rivalry in consumption, and that people cannot be excluded from the use of the
good (non-excludability). An example would be state defence or the legal system. Since public
goods are non-excludable, each individual can consume the good without having to effect any
payment. As a consequence, too little will be supplied of the good. A similar problem occurs
when there are external effects. External effects occur whenever the activities of any one
market participant directly (i.e. not through market transactions) affect others. Such effects can
be either positive or negative. An example would be environmental pollution. Here, too, the
problem of non-excludability is an issue, and an inefficient allocation results. In addition, it is
assumed that a larger size of a firm is not advantageous, i.e. that there are no economies of scale.
The reason is that, with increasing returns, both average and marginal costs will fall when more
output is produced. The more a firm produces, the more cost savings it can make. Its profits
will go up with increasing output. In the long run, such a firm would squeeze out all other
suppliers from the market, and it would no longer act as a price taker.145 The same argument
holds in the case of economies of scope, i.e. when it is more efficient to produce several goods
in one firm than across diverse, specialised firms.
1–8–117 If just one of these conditions is not met, then either the existence of a general equilibrium is
no longer guaranteed, or the equilibrium is not Pareto efficient. Such a case is referred to as
market failure. Economic theory has been concerned with the issue of the causes of market
failure for quite a long time. It has also analysed the question of what results to expect in a

143
Arrow/Debreu, 1954; Debreu, 1959; McKenzie, 1959.
144
Asymmetric information may prevent that all gains from trade be realised, as shown, e.g. in the model
by Akerlof, 1970.
145
In the extreme, this could induce a natural monopoly, cf. Section IX.1.

Kerber/Schwalbe
G. Economic Principles of Competition Law 245

market where, e.g. transactions are not costless, or where there are problems concerning
information, or if production exhibits increasing returns to scale.
Finally, the static nature of general equilibrium theory constitutes a severe restriction. This 1–8–118
means that innovative changes, e.g. with respect to technology or the number of different
goods in the economy, cannot be taken into consideration. The behaviour of firms and
consumers is analysed in the given set-up, and the focus is entirely on equilibrium states.
Adaptation processes to equilibrium play no role—the model is static and atemporal. The basic
general equilibrium model systematically disregards changes in the general conditions, i.e.
dynamic aspects like market entry and exit, innovation, technological progress, or the design of
new products. Needless to say, this poses a very severe restriction with regard to dynamic
efficiency, which explicitly focuses on such changes in the general conditions.146
(b) Effects of perfect competition
(aa) Allocative efficiency. Despite its numerous and rather restrictive assumptions, the 1–8–119
model of perfect competition presents a central point of reference. This is because a compe-
titive equilibrium displays a number of desirable qualities. These are summarised by the two
fundamental theorems of welfare economics. The first welfare theorem states that the allocation
resulting in a general equilibrium is Pareto efficient. All gains from trade are realised, such that
it is not possible to make any one individual better off without making someone else worse off.
General equilibrium theory assumes a given number of firms, an assumption that is often not 1–8–120
suitable for describing long-run developments in a market. Therefore, an alternative model,
namely the one of long-run equilibrium, assumes that the number of firms in a market is
potentially infinite, and that firms will enter a market if there are profits to be made. It is
assumed that firms have access to the most efficient production technology. However, if firms
incur losses, they will exit from the market. A long-run competitive equilibrium is char-
acterised as being where supply and demand are cleared, firms maximise profits, and there is no
market entry or exit. The latter condition implies that the firms neither make profits nor incur
losses.147 Since economic costs, namely the opportunity costs, already include the imputed
employer’s salary, the zero-profit condition implies that each firm realises normal profits.
Further, the long-run equilibrium maximises economic surplus, i.e. it is Pareto efficient.
(bb) Productive efficiency. The model of general equilibrium implies productive effi- 1–8–121
ciency. In the short run, however, the number of firms is fixed, and there is no market entry or
exit. As a consequence, positive profits are possible in equilibrium. In the long run, in contrast,
these profits will be diminished by market entry. A state will be reached where all firms
produce at minimum average cost. It is assumed that firms entering the market have access to
the most efficient technology, and that there are no barriers to entry or to exit. The entry of
additional firms will raise the quantity supplied, and thus lower the price (assuming demand
remains unchanged). Inefficient firms will be forced to exit from the market until, eventually, a
state is reached in which all firms employ the most efficient technology and produce at
minimum average cost, i.e. where each firm has reached its optimal size. Recent empirical
studies also confirm such a relationship between productivity and market entry and exit.148
(cc) Dynamic efficiency. The model of general equilibrium, being static and atemporal 1–8–122
in nature, is unable to deal with the dynamic aspects of the economic process. Indeed, equi-
librium can be considered as the result of an adaptation process (that is not modelled).
However, the theory contributes very little to explaining the competitive process over time.
Although attempts have been made to devise an intertemporal modelling of general equili-
brium theory by endowing the goods with a time index, the theory remains a static one.
Despite these modifications, all market participants’ decisions are made once and for all, and
remain valid for the entire future. Similarly, the theory of long-run equilibrium relies on the
concept of equilibrium, despite its consideration of market entry and exit. Although firms can
enter or exit the market, no innovation takes place, no new goods are introduced to the market
and no new technologies are developed. Thus, in this model too, no process (or progress) takes
place. Instead, a state is considered where no changes occur.
However it can be analysed if, and to what extent, firms invest in R&D under perfect 1–8–123
competition. In practice, it is useful to distinguish between process innovations and product
innovations. The former is concerned with new and cheaper production processes, while the

146
There are extensions to general equilibrium theory that take intertemporal aspects into consideration.
These include, e.g., the models of overlapping generations c.f. Geanakoplos/Polemarchakis, 1991. However,
these approaches do not constitute dynamic models in the sense mentioned either.
147
Mas-Colell/Whinston/Green, 1995, 337–337.
148
Disney/Haskel/Heden, 2003; Olley/Pakes, 1996.

Kerber/Schwalbe
246 Part 1: Introduction

latter refers to novel or improved products. There is a strong incentive to invest in, say, process
innovation in order to be able to produce at a lower cost than one’s competitors. This is
because the firm would be able to realise larger profits, at least for some time. Alternatively, the
firm could try to attain a monopoly position by undercutting its competitors’ prices.149 In the
case of a product innovation the firm will be in a monopoly position, realising the corre-
sponding profits, for as long as the innovation is protected by a patent. With respect to dynamic
efficiency, the firms’ competition parameter is, therefore, the investment in R&D, not the
price. This is true, above all, of markets that are characterised by rapid technological change.
However, with perfect competition, firms do not make profits and, as a consequence, they
often lack the necessary means to invest in risky research projects.150 This leads to the con-
clusion that perfect competition is not well qualified for the promotion of the dynamic effi-
ciency of the economic and competitive process.
3. Monopoly
1–8–124 (a) Assumptions and market performance. Whilst the model of general equilibrium is
based on the assumption that individual firms act as price takers, since their influence is
negligible with respect to the entire market, this assumption is not adequate if a firm is of
considerable size relative to the market. In fact, a monopolist as the sole supplier of a good faces
the entire market demand. By definition, a pure monopoly faces neither actual or potential
competition. Thus, it is able to select any point on the demand curve by setting the corre-
sponding price or by supplying the respective quantity. A monopolist has the option either to
pick a certain price for its product, in which case consumers will buy the quantity determined
by their demand function at this price, or to produce a certain quantity, when the resulting
market price will be such that this quantity can just be sold.151 In contrast to a perfectly
competitive market, a monopolist is able to affect the market price either directly (i.e. by price),
or indirectly (through the quantity produced).152 For instance, it can raise the price by reducing
the quantity. The question arises at what price the monopolist should charge, or what quantity
should it produce, in order to maximise profits?
1–8–125 If the monopolist increases slightly the quantity produced, this will result in a decrease in
price, since the demand function is downward sloping. Though a larger quantity can be sold,
this also incurs additional costs. However, the lower price does not apply just to the additional
(marginal) unit produced, but also to all other units that have already been produced, the so-
called infra marginal units.153 On the other hand, the monopolist will also sell more. The
resulting change in revenue, referred to as the marginal revenue, is determined by the lower
price of all units combined with the increased quantity. This change in revenue depends on the
shape of the demand curve. However, the monopolist also incurs the marginal cost associated
with the additional quantity produced. The latter is determined by the firm’s technology. A
quantity increase will be profitable if the ensuing marginal revenue exceeds the marginal cost,
such that profits will go up. Therefore, maximum profit is reached when a quantity is produced
such that marginal revenue equals marginal cost. As the monopolist takes the effect of its
quantity on the price into consideration, it will keep the quantity short in order to prevent a
low price. For a monopoly, the principle that ‘‘marginal revenue equals marginal cost’’ thus
yields a higher price and a lower quantity, as compared with perfect competition. In the
resulting equilibrium, the price exceeds the marginal cost of production. The resulting allo-

149
The literature distinguishes between drastic and non-drastic innovations: a drastic innovation allows
the firm to set so low a price that it achieves at least a temporary monopoly position. Non-drastic
innovations give the firm an advantage over its competitors, but the ensuing cost reduction does not suffice
to attain a monopoly position.
150
Also, for small firms, it is often impossible, or at least difficult, to fund these investments on the capital
market. This is due to asymmetric information on the risks entailed by the investment.
151
In what follows, we assume that the monopolist produces but one good. The conduct of multi-
product monopolies will briefly be referred to in Section IV.3.(c)(bb).
152
Up to now, the focus of the discussion was on the market price. An anologous argument also holds
for other competition parameters. For instance, if the price of a good remains unchanged but the quality
deteriorates, this may be interpreted as an increase in price, applying the concept of a ‘‘qualitiy adjusted
price’’: The consumer will now get an inferior product at the same price as before. Put differently, the
consumer will have to pay a higher price for a quality equivalent to the previous one. An analogous
characterisation holds for other competition parameters such as services. cf. Rosen, 1974.
153
Here it is assumed that the monopolist charges the same price to all consumers, i.e. that there is no
price discrimination. Price discrimination, or price differentiation, will be dealt with in section VIII.2.(b).

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G. Economic Principles of Competition Law 247

cation will be inefficient since the potential gains from trade are not exhausted. Figure IV–2,
below, depicts the difference between monopoly and perfect competition.
Figure IV–2: A monopolistic market

The line NN‘ depicts the downward sloping demand curve, while AA‘ represents the upward 1–8–126
sloping marginal-cost curve. The line GG‘ is the marginal-revenue curve, which lies below the
demand curve since, if quantity is increased, the price of all units will fall, including the infra
marginal ones. In a perfectly competitive market, the equilibrium price-quantity combination
is pk, xk, where price equals marginal cost. A monopolist, by contrast, picks a price such that
marginal cost equals marginal revenue. The resulting price-quantity combination is given by
pm, xm, which results in a higher price and smaller quantity. The difference in the results from
perfect competition and monopoly depends on the shape of the demand curve or, more
precisely, the price elasticity of demand. This concept measures the degree to which demand
falls when the price goes up. In the case of a horizontal demand curve, i.e. a perfectly elastic
one, even the smallest price increase reduces demand to zero. In case of a vertical demand
curve, on the other hand, demand is completely inelastic. An example would be the demand
for vitally important drugs. In this case, the monopolist may, in principle, keep raising its price
until he has acquired the consumers’ entire income. It follows that the result in a monopolistic
market depends crucially on the demand function.154
(b) Effects of monopoly
(aa) Allocative efficiency. The figure shows that a monopolist will supply less and charge 1–8–127
a higher price as compared with supply under perfect competition. The economic surplus in
the monopolistic market is given by the area aced, whereas under perfect competition, total
surplus is given by abd. The welfare loss induced by monopoly corresponds to the area cbe. If
the price elasticity of demand is small, i.e. if the demand curve is steep, then there will be a
considerable difference between the monopoly price and the perfectly competitive one.
Although, for the same reason, the quantity supplied by the monopolist will differ only slightly
from that supplied in a perfectly competitive market. These effects counteract each other.
Therefore, it is not possible to derive a one-to-one relationship between the price elasticity of
demand and the extent of the welfare loss. Empirical studies have estimated the welfare loss

154
The concept of the price elasticity of demand is also dealt with in Section IV.6.(a).

Kerber/Schwalbe
248 Part 1: Introduction

resulting from monopoly to be about 0.1 per cent of GDP,155 however, more recent studies
have shown that such welfare losses may be considerable, taking up to 7 per cent of GDP.156
1–8–128 (bb) Productive efficiency. In the framework of the long-run equilibrium model,
competition, be it actual or potential, forces firms to employ the most efficient technology, and
not to waste resources when pursuing their goal of profit maximisation. That is, efficiency of a
single firm as well as of the entire economy is ensured. However, if there is no competitive
pressure, as in the case of a pure monopoly, a firm might not be forced to operate efficiently.
The ‘‘quiet life’’ enjoyed by the monopolist may induce X-inefficiencies such as, e.g. the
choice of an inferior production technology. Such inefficiencies result from the fact that in
many firms ownership is responded from control. As a consequence, the management tends to
pursue their own goals, rather than those of the firm. In this case, the managers have insuf-
ficient incentives to use the most efficient technology.157 Such problems are likely to occur
when the management possesses an informational advantage over the owners of the firm,
which they can use to promote their own goals. Furthermore, the pursuit of their own interests
may prevent managers from maximising profits. Thus, the welfare loss resulting from mono-
poly is even larger in the presence of X-inefficiencies.158 However, the literature on industrial
organisation has little to say about the relationship between the internal organisation of a firm
and its market conduct, which is of major importance with respect to productive efficiency.159
1–8–129 A further source of inefficiency is the expenses a monopolist spends on securing its position.
This problem of so-called rent seeking was first identified by Tullock and Posner.160 Where
these expenses are of no social value, and the monopolist’s maximal willingness to spend on
securing its position corresponds to the entire monopoly profit, then this profit would present a
measure of the waste of productive resources. Then, in most cases, the conditions for rent
seeking to occur do not hold. Therefore, the inefficiencies induced by rent seeking need to be
reassessed.161
1–8–130 Alchian and Demsetz even point out a positive relationship between monopoly and the
possible degree of production efficiency. They state that a firm may have reached a monopoly
position for the very reason that it has been more efficient than its competitors.162 If this were
the case, there would be a trade off between allocative efficiency on the one hand, and
productive efficiency on the other. It is possible that the allocative inefficiency caused by a
monopoly falls short of the additional productive efficiency. This issue is discussed further in
the context of efficiency gains and merger control below
1–8–131 (cc) Dynamic efficiency. The conjecture that there may be a positive relationship
between monopolies or large firms and dynamic efficiency or innovation and technological
progress dates back to Schumpeter.163 The main argument supporting this hypothesis is that
only a monopoly realises sufficient profits to be able to afford the often risky and expensive
investments in R&D that are necessary to develop and market new products, or to invent cost
reducing innovative technologies. Without sufficiently large profits such investments would be
impossible. However, as a counter-argument, a monopolist has hardly any incentive to invest,
as compared to a firm under perfect competition. The reason is that, while a firm in a perfectly
competitive market is able to drastically increase its profits by succeeding in a process or
product innovation, a monopolist earns monopoly profits even without any innovation. In the
case of successful R&D the monopolist would only be able to appropriate additional profits,
namely the difference between its previous monopoly profit and the one resulting from the
new technology.164 Thus, the difference lies first of all in the initial conditions: a firm under
perfect competition will realise considerable gains from a successful innovation, whereas a

155
Harberger, 1954. This number being so low results from some specific assumptions made by Harberger
such as a specific demand function.
156
Cowling/Mueller, 1978; Jenny/Weber, 1983. Scherer/Ross, 1990 are sceptical with restpect to these
results. According to them, the welfare loss amounts to 1–2% of GDP, compare Scherer/Ross, 1990, 661–
667.
157
Leibenstein, 1966. A survey on X-inefficiencies is given by Frantz, 1988.
158
Button/Weyman-Jones, 1992; Nickell, 1996.
159
Hart, 1983; Scharfstein 1988; Schmidt, K.M., 1997.
160
Posner, 1975; Tullock, 1967.
161
Fudenberg/Tirole, 1987.
162
Alchian/Demsetz, 1972.
163
Schumpeter, 1950; Schumpeter, 1952; Section III.5.(b).
164
This effect has first been described by Arrow. It is referred to as ‘‘replacement effect’’ since the
monopolist replaces itself, cf. Arrow, 1962.

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G. Economic Principles of Competition Law 249

monopolist will receive only a mark-up on its monopoly profit. It follows that, in most cases, a
monopolist has a lesser incentive to invest in R&D than a firm under perfect competition.165
However, this conclusion does not necessarily hold when the monopoly is threatened by the
entry of a potential competitor into the market. In this case, an innovation on the part of the
monopolist might serve to render market entry less attractive for potential competitors.166
(dd) Reallocation. A monopoly will sometimes cause a considerable loss in economic 1–8–132
welfare. Moreover, it uses its market power to appropriate part of the consumers’ surplus. In a
perfectly competitive market, consumer surplus is indicated by the area abpk in figure IV-2. In a
monopolistic market, by contrast, consumer surplus is reduced to the area acpm. The area pmcfpk,
which forms part of the consumer surplus in a perfectly competitive market, goes to the
monopolist. Producer surplus under perfect competition consists of the area pkbd, but corre-
sponds to pmced in the case of a monopoly. Obviously, in a monopolistic market, producer
surplus is larger than in a perfectly competitive one. However, this effect is of no importance
with respect to efficiency considerations since it is only a reallocation of surplus. Efficiency
considerations take into account only the total economic surplus, not its distribution. With
regard to the distribution of the economic surplus, a normative statement is required, since one
has to weigh the profits and losses of firms and consumers, respectively. As stated above,
competition policy has required that consumers be protected from being thus exploited by a
monopolist.167
(c) Extensions of the monopoly model. The basic theory of monopoly as presented 1–8–133
above has been extended in several respects. Below is an outline of some of the most important
modifications, such as, e.g. the durable-goods monopoly and multi-product monopoly.
(aa) Durable-goods monopoly. A monopoly producing a good that is not immediately 1–8–134
consumed but that lasts over several periods, like a car or a fridge, will lead to results which
differ from those of a monopoly producing non-durable goods. This hypothesis dates back to
Coase and is known as the so-called Coase-Conjecture.168 Suppose that consumers differ in
their willingness to pay for the durable good. In this case, the monopolist might at first charge a
high price and sell to those customers with the highest willingness to pay, and then successively
lower the price in each time-period and sell to those with a lower willingness to pay. Over
time, all consumers will be served. The monopolist might thus try to effect intertemporal price
discrimination. But the consumers with a high willingness to pay will anticipate this policy. As
a consequence, they will defer purchase until the price has decreased. This implies that the
monopolist competes with itself through its supply in future periods. In the limit, i.e. if the
good has an infinite durability, the monopolist faces a perfectly elastic demand, and will act like
a firm under perfect competition, such that the resulting allocation will be efficient. The Coase
conjecture implies that durable-goods monopolies are less harmful to welfare than monopolies
producing non-durable goods.
As a caveat, the assumptions underlying the Coase conjecture are very restrictive. In real life, 1–8–135
these assumptions will rarely be met. To start with, the durability of a good is not infinite, and
the monopolist will not cut its price very quickly. Furthermore, consumers often incur a loss in
utility from delaying the purchase. What is more, there are strategies available to the mono-
polist which prevent it from competing with itself, or at least mitigate the problem. Suppose
the monopolist decides to rent the good for one period at a time, rather than selling it. The
durable good would thus be broken down into several non-durable goods, and the monopoly
price would be charged in each period. Alternatively, the monopoly may offer leasing contracts
to its customers.169 In order to shorten the durability of a good, the monopolist might also
employ the strategy of ‘‘built-in wear-out’’.170 Besides, it may escape the Coase conjecture by
building up a reputation for maintaining a high price,171 or by restricting capacity in order to
make it clear that it is unable to produce a sufficient quantity in the future.172 This variety of

165
Tirole, 2001, 392.
166
Section IV.8.(b).
167
Lande, 1991, 71–84.
168
Coase, 1972; Bulow, 1982; Stokey, 1981; Gul/Sonnenschein/Wilson, 1986.
169
Here, some problems may arise because consumers tend to treat a rented good with less care, as
compared with his own property. This so-called ‘‘moral hazard problem’’ has to be taken account of in the
hire contract. Similar problems arise in the case of leasing, cf. Hart/Tirole, 1988.
170
Bulow, 1986.
171
Ausubel/Deneckere, 1989.
172
As an example, artists often destroy their original printing plates in order to signal that there is only a
limited number of copies available that cannot be increased.

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250 Part 1: Introduction

strategies shows that also a durable-goods monopolist will in general, bring about allocative
inefficiencies.
1–8–136 (bb) Multi-product monopolies. If a monopoly produces several goods instead of just
one considerable consequences with respect to its conduct may result.173 In this context, the
correlation between these goods is of major importance. If the monopolist produces substitutes
it will compete with itself when cutting the price for any one of these goods. In order to avoid
this, the monopolist will charge a higher price for both goods, compared with two separate
monopolists. In contrast, if the goods are complements, i.e. if the goods are consumed together,
then the monopolist will be able to stimulate demand for one good by cutting the price of the
other. In the extreme, it is possible that a good will be supplied at a price below marginal cost.
Therefore, prices below marginal cost are not necessarily an indicator of predatory pricing, but
may result entirely from profit maximising calculations.
1–8–137 Apart from these extensions of the basic model, numerous further dimensions of mono-
polistic behaviour have been analysed in the economic literature, e.g. advertising, the choice of
quality, and the product range. The literature shows that in these cases also monopolistic
conduct will induce inefficient results in the market.
1–8–138 (d) A dominant firm with a competitive fringe. The model of a dominant firm with a
competitive fringe is closely related to the monopoly model.174 Due to its size, a dominant firm
is able to supply the largest part of the market. Like a monopoly, such a firm does not act as a
price taker, but is able to set a price, or choose a quantity, respectively. Besides the dominant
firm, however, there are several small firms acting as price takers, as in the model of perfect
competition. These firms are referred to as the competitive fringe. There are several possible
reasons for the existence of such a dominant firm: for example, it may possess better technology
than the other firms, or have enjoyed a protected monopoly position for a longer period of
time in a market that has only recently been opened to competition.
1–8–139 When the dominant firm charges a certain price for its product, the fringe firms will take this
price as given, and choose their respective quantities according to their marginal cost function
(i.e. their supply function). Thus, each price fixed by the dominant firm automatically
determines the corresponding total quantity supplied by the competitive fringe. The higher the
price fixed by the dominant firm, the larger the quantity supplied by the competitive fringe.
Therefore, at any given price, a corresponding fraction of demand supplied by the competitive
fringe. The dominant firm will include this consideration into its pricing policy. It subtracts the
quantity supplied by the competitive fringe from the total demand. This yields the remaining
demand for the dominant firm, i.e. the residual demand. With respect to the residual demand,
the dominant firm is thus a monopolist.
1–8–140 It follows that the dominant firm’s conduct is described by the monopoly model, with the
difference that residual demand replaces total demand. The quantity supplied will be such that
marginal revenue (with respect to residual demand) equals marginal cost. As in the case of
monopoly, the resulting allocation depends on the price elasticity of demand. The more elastic
the demand, the smaller the difference between the price charged by the dominant firm and the
one which would result in a competitive market. However, in addition, the supply of the
competitive fringe has to be taken into consideration. In this respect, the concept of the price
elasticity of supply is important. This is a measure of the percentage change in supply induced
by a 1 per cent increase in price. If the supply curve is rather flat, even a small increase in price
will induce a considerable increase in supply by the competitive fringe. This would be the case
if, e.g. marginal costs do not rise sharply as a result of the increase in quantity, (e.g. if there is
idle capacity). Thus, the dominant firm’s pricing possibilities are restricted from two sides: on
the one hand, by the reaction of consumers as measured by the price elasticity of demand, and
on the other hand, by the supply reaction of the competitive fringe indicated by the price
elasticity of supply.175 The more elastic the demand, and the supply of the competitive fringe,
the smaller the range of possible prices for the dominant firm. The effects on efficiency are
similar to those in the case of monopoly, but they are somewhat mitigated by the existence of
the competitive fringe. Both allocative and productive inefficiencies are likely to arise. It is
conceivable, however, that there will be more innovation, since this allows the dominant firm
to prevent fringe firms from threatening its dominant position.
1–8–141 4. Monopolistic competition. The model of monopolistic competition was developed
by Chamberlain in 1938. It combines the approach of the long-run equilibrium under perfect

173
Bester, 2004, 29–31; Tirole, 2003, 69–72.
174
z.B. Carlton/Perloff, 2005, 110–120; Stigler, 1965.
175
Landes/Posner, 1981.

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G. Economic Principles of Competition Law 251

competition with monopoly.176 Firms are assured to produce horizontally differentiated


goods177 and each firm produces one version only of the good and faces a downward sloping
demand curve. In general, the model is based on the assumption of there being a representative
consumer who has preferences over the goods produced by the firms, and whose utility
increases when there is a wider range of products.178 It is assumed that the firms maximise
profits. However, such a firm also faces competition since, as in the model of long-run
equilibrium, additional firms will enter the market if positive profits can be made. The
newcomers will then produce new varieties of the good as demanded by the representative
consumer. This implies a reduction in the demand for the established firms’ products. This
process will continue until the number of firms in the market is such that no firm makes any
more profits. An equilibrium under monopolistic competition is reached if, and only if price
equals average cost. The number of different varieties of the good (and thus the number of
firms in the market) is thus determined endogenously, i.e. within the model.
Since it is assumed that the firms also incur fixed costs, average cost differs from marginal 1–8–142
cost, such that the equilibrium price exceeds marginal cost. That is, monopolistic competition
leads to an inefficient allocation. Moreover, one can show that each firm does not produce at
its minimum average cost, i.e. firm size is sub-optimal. An interesting question is whether
monopolistic competition between differentiated goods supplies too large (or to narrow) a
range of varieties, as compared with the social optimum. The answer depends on the mag-
nitude of the fixed costs: if fixed costs are high, even the products for which there is a high
willingness to pay will not be produced, not even if the price exceeds marginal cost. The reason
is that the high fixed costs would cause the firm to make losses. On the other hand, a new firm
entering the market will compete with the established firms, and thus take away demand from
them. However, the newly entrants do not take this into account. As a consequence, too many
varieties will be produced. Depending on the relative magnitude of these effects, there will be
either too few or too many varieties of the good.179 With respect to dynamic efficiency, the
result is similar to the one under perfect competition: whilst there are strong incentives to
innovate, the firms lack the means for investing in research because their profits are too low.
5. Oligopoly
(a) Introduction. Until now, the concern has been with market structures characterised 1–8–143
by either a large number of competing firms, or a single, very large one. However, from the
viewpoint of competition policy, the markets which are most interesting are those where the
products are supplied by a small number of firms, i.e. oligopolistic markets.180 Apart from a
potential competitive fringe, each firm is of significant size with respect to the size of the entire
market. Therefore, a price reduction or a quantity increase on the part of one firm has a
considerable effect on the other firms in the market. For instance, a price cut will induce other
firms’ customers to switch to the one with the lower price. As a result, these firms will lose
revenue, and possibly also profits. One would expect them to react by reducing their prices
also. Therefore, profit-maximising pricing and supply policies in the presence of such a stra-
tegic interdependence have to be analysed, where a firm’s profits are determined not only by its
own decisions but also by those of its competitors. Thus, a firm is able to make a rational
decision only if it explicitly takes into account the strategic interdependence. Needless to say,
this is true for all firms in the market. That is, each firm is aware of this interdependence, and
will take it into consideration when deciding on price, quantity, quality, etc. Owing to the
extreme complexity underlying a firm’s decision problem, oligopolistic competition has only

176
Chamberlin, 1933; Dixit/Stiglitz 1977; Spence 1976a; Spence 1976b; Hart, 1985.
177
Economic theory distinguishes vertically and horizontally differentiated goods. Horizontal differ-
entiation means that there are several versions of a good, such that some consumers prefer one version
while others have a preference for the other. This is because, in the case of horizontal differentiation, the
various versions of the good are supposed to supply the various tastes of consumers (e.g. cars of the same
class manufactured by different producers, or of different colour). In the case of vertically differentiated
goods, however, all consumers prefer one version to the other. This is because the goods differ with respect
to certain characteristics, or components (cars with or without navigation device). The problem of dif-
ferentiated goods is discussed in Beath/Katsoulacos, 1991.
178
A further approach to model markets with differentiated goods was devised by Hotelling, 1929. Here,
the consumers differ in their preferences concerning certain versions of the good. This type of models is
referred to as ‘‘address models’’. Such models are discussed in the context of oligopolistic competition, cf.
Section IV.5.(c)(cc).
179
Dixit/Stiglitz, 1977; Koenker/Perry, 1981.
180
Friedman, 1983, Vives, 1999.

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252 Part 1: Introduction

been capable of satisfactory analysis once researchers had a suitable tool to analyse rational
behaviour in situations of strategic interdependence. This tool is the theory of games developed
by the mathematician John von Neumann and the economist Oskar Morgenstern. They
presented the theory in 1944 in their book ‘‘The Theory of Games and Economic Beha-
viour’’.181 Since then, games theory has been advanced to a great extend by John Nash, John
Harsanyi, and Reinhardt Selten.182 The theoretical overview presented below introduces
briefly the game-theoretic concepts necessary to analyse oligopolistic markets.183
1–8–144 (b) The basic concepts of game theory. Game theory has become the essential ana-
lytical tool in industrial organisation.184 The impressive advance in economic theory achieved
during the past 25 or 30 years is mainly due to this method. Numerous new concepts and
models have been developed which provide a better understanding of market processes in the
presence of imperfect competition. Set out below is an introduction to the basic terms of game
theory, illustrated by their application to a simple, stylised, oligopoly situation.
1–8–145 In game theory, any situation involving strategic decision making is considered as a game.
The term has been established for historical reasons as the first studies analysing strategic
decision making dealt with parlour games such as chess, poker, etc. The theory is divided into
co-operative and non-co-operative game theory. Co-operative game theory is based on the
assumption that the decision-makers, e.g. the oligopolists in a market, are able to make binding
agreements, i.e. conclude contracts that can be enforced by some exogenously given
mechanism (e.g. severe contract penalties that can be enforced by a court). In contrast, non-co-
operative game theory assumes that agents are unable to engage in binding agreements.
1–8–146 With respect to oligopoly theory, non-co-operative games are rather more important than
co-operative ones. The reason is that, in most cases, oligopolists are unable to make binding
agreements. For instance, an agreement on fixing prices or quantities would infringe com-
petition law and be unenforceable. This means that an unenforceable agreement requires that
each oligopolist must have an incentive to stick to it, and not to deviate. Thus, e.g. a price-
fixing cartel agreement must be such that it is in each firm’s own interest to stick to it. If this is
the case, the agreement is self-enforcing, or incentive-compatible.
1–8–147 (aa) Players, strategies, and pay-offs. In order to describe a non-co-operative game,
the first step is to identify the persons involved in the strategic decision making situation, i.e.
the ‘‘players’’. Secondly, each player’s set of possible actions must be determined, i.e. his
strategies. Finally, one must specify the outcomes induced by the various strategies. In game
theory, these components of a game are referred to as the set of players, the players’ strategy
sets, and their pay-off functions, respectively. For instance, consider an oligopolistic market
with price competition. In this setting, the set of players corresponds to the oligopolists, their
strategy sets are those given by all conceivable prices, and each player’s pay-off function
specifies the firm’s profit for every strategy combination, i.e. for every combination of prices set
by all firms. Consider an oligopoly of three firms, A, B, and C, which are engaged in price
competition. In this case, firm A’s pay-off function indicates the firm’s profit, which depends
on the prices set by the three firms A, B, and C.185 Put differently, the pay-off function links
each player’s strategy with the outcomes resulting from the strategic interaction. For instance,
when there is price competition in a market for a homogeneous good, one would expect that
consumers will tend to buy from the firm with the lowest price. As a consequence, the firm
with the highest price will be unable to sell its product, and thus make little or no profit.
Consumers will buy from the other firms. The profits made by any one firm thus depend on
the strategies of all the firms in the market, and the pay-off function reflects the strategic
interdependence between the players.
1–8–148 (bb) Nash equilibrium. However, the description of a game does not imply anything

181
von Neumann/Morgenstern, 1944.
182
In 1995, they won the Nobel prize for their contributions. Important works include Harsanyi, 1967,
Nash, 1950, Nash, 1951, Selten, 1965, 1975.
183
Section III.6.(b).
184
Systematic expositions of game theory can be found in Eichberger, 1998, Friedman, 1991, Fudenberg/
Tirole 1991, Gibbons, 1992, Holler/Illing, 2003, Osborne/Rubinstein, 1994. An introduction is provided by
Dixit/Nalebuff, 1995.
185
In general, strategies in the game-theoretic sense are more complex than just relating to a price or a
quantity. In game theory, a strategy prescribes a complete plan of action for every conceivable contingency
that may arise in the course of the strategic interaction. Such a plan takes into account the player’s
information, i.e. his knowledge about the other players. Examples of such complex strategies will be
discussed in the context of co-ordinated effects in Section V.2.(a).

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G. Economic Principles of Competition Law 253

about the outcome that will actually prevail, or the strategies the players will actually choose. A
general statement on the outcome of a game is given by a so-called ‘‘solution concept’’. The
principal solution concept for non-co-operative games is the Nash equilibrium.186 A Nash
equilibrium is a strategy combination such that no player has any incentive to deviate uni-
laterally from his strategy. That is, in a Nash equilibrium, the players’ strategies are mutually
best responses. The equilibrium is thus incentive-compatible. An illustration of the idea
underlying the Nash equilibrium concept is the following simple situation of strategic decision
making. Suppose there are two players, A and B, and each of them has three different strategies
available: player A may choose one out of the strategies 1, 2, and 3, while player 2 may choose
from a, b, and c. The outcomes resulting from the nine possible strategy combinations are
summarised in a so-called pay-off matrix. Each cell of the matrix contains two numbers: the
first one indicates player A’s pay-off, and the second one indicates player B’s pay-off, given the
corresponding strategy combination. Player A chooses the row of the matrix, while player B
chooses the column.

B
a b c
1 32,32 41,30 48,24
A 2 30,42 40,40 50,36
3 24,48 36,50 48,48

The Nash equilibrium of this game consists in the strategy combination 1, a. Given these 1–8–149
strategies, no player can gain by deviating unilaterally. At any other strategy combination,
either A or B would like to change his strategy. To see this, consider the strategy combination
3, c. Here, player A would prefer to switch to his strategy 2, provided that player B sticks to c,
since this would increase his pay-off from 48 to 50. The example shows that players pursuing
their own self-interests may end up with an outcome that is not optimal for either of them. The
strategy profiles 2, b or 3, c both yield higher pay-offs to both players, when compared with the
Nash equilibrium. However, these strategy combinations do not constitute a Nash equilibrium,
since each player has an incentive to deviate. Thus, individual rationality and collective
rationality may differ, as can be seen in the prisoners’ dilemma presented above. This game
exhibits one Nash equilibrium only. However, there are also games with multiple equilibria, or
none at all. In these cases, either it is not possible to derive an unambiguous prediction with
respect to the outcome, or a prediction cannot be made.187
(c) Equilibrium in oligopolistic markets. The concept of Nash equilibrium is useful to 1–8–150
analyse the market outcome in an oligopoly.188 The most relevant aspect of oligopolistic
competition is that of the firms’ competition parameters, i.e. their strategies. Price competition
is distinguished from quantity competition. This is because in certain industries, the quantity,
once decided upon, is hard to adjust later on, e.g. when there are capacity constraints. The
price, in contrast, can be adjusted easily to changing market conditions, such that the quantity
produced is sold. These industries are characterised by quantity competition, which is also
referred to as Cournot competition.189 On the other hand, in some industries it is impossible to
adjust the price at short notice, e.g. when comprehensive catalogues have been printed, as in
mail-order business. In these cases, the quantity can often be adjusted at short notice, e.g. by
buying from other producers. In these industries, the price is the relevant competition para-
meter. The reason is that pricing matters to the firms since a mistake will produce bad results
that are hard to correct. Such industries are characterised by price competition, which is also

186
Named after the winner of the Nobel Prize in economics, John Nash.
187
In general, most oligopoly models posess a unique Nash equilibrium under fairly plausible
assumptions.
188
In what follows, we will introduce only the basic models of oligopoly. Extensive theoretical analyses
of this market structure are supplied by Vives, 1999. Similarly to oligopoly or monopoly, one can analyse
markets where the market power is possessed by the consumers, e.g. oligopsony or monopsony,
respectively.
189
Named after the French philosopher, mathematician, and economist Antoine Augustin Cournot (1801–
1877) who, in 1838, was the first to submit such a model. (Cournot, 1838.)

Kerber/Schwalbe
254 Part 1: Introduction

called Bertrand competition.190 In contrast to the case of monopoly, the competition parameter
is of great importance to the market outcome. In what follows, it is assumed that firms are
unable to form agreements on their conduct, on collusion, or otherwise. Further, it is assumed
that there is no market entry. The firms in the market act competitively, given the market
structure, and take the strategic interdependence of their decisions into account. Conditions for
co-ordination will be discussed further below.
1–8–151 (aa) Price competition with homogeneous goods. Suppose that the firms in the
market produce a homogeneous good, that they are not subject to capacity constraints, pro-
duce at equal, constant marginal cost, and compete on prices. In this case, the Nash equilibrium
implies the same price and quantity as in a perfectly competitive market.191 In the Bertrand
model with homogeneous goods, each firm charges a price equal to its marginal (or average)
cost in Nash equilibrium.192 The reason is as follows. Consider a market with two firms. If one
of them charges a price below its marginal cost, i.e. below the price resulting from perfect
competition, this firm, though it will attract the entire market demand, will incur a loss. The
lower price is thus not worthwhile. On the other hand, charging a higher price does not pay
either, since the firm is unable to sell anything because all consumers buy from its competitor.
In other words, no firm has any incentive to deviate from its strategy, and this price forms a
Nash equilibrium. What if both firms fix equal prices that exceed marginal cost? In this case
they realise positive profits, but their strategies do not form a Nash equilibrium. The reason is
that each firm would like to undercut its competitor by a small amount, and thus attract the
entire market demand. This would increase its profits considerably: The price reduction is
small, such that per-unit profit remains almost unchanged, but the firm captures the entire
market demand. If this happens, the other firm will sell nothing, and thus face an incentive to
cut its own price in turn. As a result, the Nash equilibrium yields the same result as perfect
competition, with respect both to price and quantity. Competition between the firms is so
strong because of the way consumers react to a price change: a small price cut on the part of
one firm enables that firm to capture the entire market, whereas a price increase causes it to lose
all demand.
1–8–152 (bb) Quantity competition with homogeneous goods. Similarly, we can analyse
quantity competition with homogeneous goods, i.e. the Cournot model. An example is a
duopoly in which firms produce with equal and constant marginal cost. They decide the
quantity to be produced and supplied in the market. The ensuing price will be such that the
quantity produced will be sold. The firms have to take into consideration the fact that a larger
quantity will lead to a lower price, i.e. that the demand curve is downward-sloping.
1–8–153 The Nash equilibrium in this model is best explained by a comparison with monopoly. A
monopolist takes into account the price change resulting from an increased supply. As a
consequence, it supplies a smaller quantity and charges a higher price, as compared with perfect
competition. In the Cournot model, there is a similar relationship between price and quantity:
each firm is aware that by increasing its supply the market price will fall. However, if one firm
expands its quantity, this will affect not only its own price, but also that of its competitor, who
has not altered its price. The latter will lose revenue: it will sell the same quantity as before, but
at a lower price. The other firm, however, does not take this effect into account when deciding
on its supply. That is, part of the effect of a price change is not taken into consideration when
the firm increases its quantity.
1–8–154 How will a firm react to a quantity increase on the part of its competitor? If it responds by
increasing its own supply, this will result in a further price fall in the market. To avoid this, the
firm responds by cutting its own production and supply. However, this quantity reduction is
smaller than the quantity increase effected by the first firm. Similarly, if one of the firms reduces
its quantity, the price will go up, and the other firm will respond by expanding production. To
summarise, the firms’ reactions with respect to quantity changes run in opposite directions. The
quantities supplied in a Cournot duopoly are known as strategic substitutes. In equilibrium, a

190
Named after the French mathematician Joseph Louis François Bertrand (1822–1900) who published his
criticism of Cournot’s model in 1883. (Bertrand, 1883.)
191
There are numerous models analysing the outcome of oligopolistic competition in the presence of
capacity constraints. It turns out that the existence of Nash equilibrium cannot be ensured under this
assumption. However, a mixed-strategy equilibrium exists, as shown by Davidson/Deneckere, 1986, Kreps/
Scheinkman, 1983, Levitan/Shubik, 1972, and Osborne/Pitchik, 1986.
192
As marginal cost is assumed to be constant, and there are no fixed costs, marginal cost equals average
cost. These costs refer to the economic costs rather than the accounting costs. The economic costs include
the imputed employer’s salary and the market specific returns on investment.

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firm’s expansion of supply would yield additional revenue, but this would be counteracted by
the loss resulting from a lower price, and the higher cost of producing the larger quantity.
In a market with quantity competition, the Nash equilibrium is given by a combination of 1–8–155
supply quantities such that no firm faces any incentive to change its quantity, given the supply
decisions of the other firms. In total, the firms produce a larger quantity than a monopolist,
since each firm considers only a part of the price effect it induces. However, this quantity is
smaller than the one produced under perfect competition, because the price effects resulting
from quantity expansion are taken into account, at least to some extent. Thus, the market
outcome of oligopolistic competition with a homogeneous good lies in between those implied
by perfect competition and monopoly. The argument shows that the firms’ competition
parameter determines, to a significant degree, the market outcome. Whilst price competition
results in the same outcome as perfect competition, a Cournot oligopoly supplies a smaller
quantity at a higher price. This is because demand reacts differently in each case: with price
competition, a small price change induces a large increase or decrease in demand. It follows that
competition is extremely fierce and, as a consequence, the same outcome occurs as under
perfect competition. If the firms compete on quantities, on the other hand, demand reactions
will be moderate. Although reducing supply raises the price to some degree, demand is
somewhat diminished but a firm does not lose its entire demand. Thus, with quantity com-
petition, demand is much more inelastic than with price competition. Therefore, there is less
competitive pressure in a Cournot market, implying higher prices and profits for the firms.193
However, the market outcome also depends on the number of firms in the market. If there 1–8–156
are not only two but, say four identical firms in the market, then the effect of a quantity
expansion on the part of one firm will affect this firm by only 25 per cent. That is, 75 per cent
of the effect concerns the other three firms and will not be taken into account by the first firm.
As a result, the firm supplies a larger quantity, since it is hardly affected by the corresponding
price reduction. The larger the number of firms in the market, the smaller is the fraction of the
price effect pertaining to the firm which expands its supply. One might expect that increasing
the number of firms in the market will result in a larger total supply. Indeed, it can be shown
that, if the number of firms is very large, the outcome will correspond to the one under perfect
competition.194 Conversely, reducing the number of firms causes the quantity to shrink. In the
limit, with only one firm, it equals the quantity supplied by a monopolist. Increasing con-
centration thus implies decreasing quantities and increasing prices.
(cc) Price competition with differentiated goods. In many markets, the assumption 1–8–157
that the firms sell homogenous goods is incorrect. Most goods, albeit similar, differ in some
respects, i.e. they are not perfectly homogeneous. The analysis needs therefore to be extended
to oligopolistic markets with differentiated goods.195 In the Bertrand model with homogeneous
goods, the extreme price elasticity of demand produced an outcome corresponding to that
under perfect competition. In the case of differentiated goods, demand is more inelastic, since
consumers differ in their preferences regarding the different variants of the good.196 Therefore,
a consumer is less inclined to substitute his preferred brand for another—differentiated goods
are therefore incomplete substitutes. If one of the firms raises its price, not all of its customers
will switch to other goods, but only those whose preferences for the good in question are the
least pronounced, i.e. the marginal consumers. Each firm has a certain share of regular cus-
tomers who will buy the product even if its price goes up. Of course, the number of marginal
consumers depends on the magnitude of the price rise—the larger the increase in price, the
more consumers will switch to substitute goods. Since demand is less price elastic, the firms are
able to charge a price that exceeds the competitive price without immediately losing all of their
customers.
In these circumstances, if one firm raises the price of its product, some of its customers will 1–8–158

193
The model has been extended to allow for a two-stage decision process where, in a fist step, the firms
choose their quantities or, respectively, their capacities, and decide about the price in a second step. As a
result, under certain conditions, this model yields the same outcome as the Cournot model, as shown by
Kreps/Scheinkman, 1983.
194
Carlton/Perloff, 2005, 169–170; Novshek, 1980; Novshek, 1985; Ushio, 1985.
195
In what follows, attention is limited to the case of horizontal differentiation. Models of oligopoly
with vertically differentiated products are analysed in Tirole, 2003, 296–298.
196
Whilst the model of monopolistic competition is based on the assumption that consumers have a
preference for consuming as many different goods as possible, it is assumed here that consumers are
interested in the characteristics of a good, and that they want to consume the good that best matches their
preferences.

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switch to a substitute, so the demand for the substitute will go up. The firm producing the
substitute will then be able to sell a larger quantity. Owing to the increase in demand, it will
now raise the price of its product as well. This price increase will be smaller than the one
effected by the first firm.197 For a price reduction, the argument runs along similar lines: if one
of the firms reduces its price, this firm will be only be able to induce a few consumers to switch
to its product. Many consumers will still buy the relatively more expensive goods produced by
the firm’s competitors. However, since the competitors’ demand is somewhat diminished, they
will respond by cutting their own prices in order to compensate for the loss in demand.
However, this price reduction will be less than the one effected by the first firm. This is because
they too have a number of regular customers who are unwilling to switch to an incomplete
substitute, even if it is slightly cheaper. Thus, the oligopolists’ reactions with respect to price
run in the same direction: If one of the firms raises its price, the others will follow suit. The
same applies in the case of a price cut on the part of any one firm. For this reason, in a Bertrand
model with differentiated goods, prices are considered as strategic complements.198
1–8–159 In the context of a price setting oligopoly with differentiated goods, the Nash equilibrium is
a list of prices such that no firm has an incentive to either raise or cut its price as long as the
others stick to their prices. Equilibrium prices exceed the price under perfect competition,
since the goods are only imperfect substitutes. The amount by which the price differs from the
competitive one depends on the degree to which consumers consider the goods to be sub-
stitutes: in the case of perfect substitutes, the outcome is equal to the one in the original
Bertrand model, i.e. the competitive price. Prices rise in line with increasing differentiation. In
the limit, i.e. when the goods are not considered to be substitutes at all, each firm is in a
monopoly position, and charges the corresponding price. This leads to the conclusion that the
higher a firm’s price, the higher are the other firms’ prices, whereas a higher degree of
substitutability implies lower prices.
1–8–160 (dd) Quantity competition with differentiated goods. There is only a small difference
between quantity competition with differentiated goods and with a homogeneous good. The
size of this difference depends on the degree of differentiation: with closer substitutes, the
market outcome resembles more closely the one with a homogeneous good.199 With a greater
degree of differentiation, i.e. when the goods are considered weaker substitutes, the firms are
more independent and thus set a higher price and supply a smaller quantity. In the extreme case
of the absolute independence of the goods, each firm is a monopolist with respect to its product
charges the monopoly price, and supplies the corresponding quantity.
1–8–161 (d) Other models of oligopolistic competition. The models considered so far assume
implicitly that the firms decide simultaneously, i.e. without observing their opponents’ price or
quantity choice. However, it may be the case that one firm is the first to set its price or
quantity, and that the others choose their strategies after observing the first firm’s choice.200 The
cause of such price or quantity leadership may be that a firm has made a successful innovation
and thus was the first to enter the market, while the other firms, as followers, are able to act
only after the leader has chosen its strategy.201
1–8–162 A price-leading firm takes into account its competitors’ reactions in calculating its price,
whilst the competitors have to take the leader’s price as given. It is obvious that, in the case of a
homogeneous good, it does not matter if the firms’ prices are set simultaneously or sequentially.
In either case, the outcome will be the same as under perfect competition. Things are different
in the case of differentiated goods. Here, the price leader must be aware that the follower will
undercut its price by a small amount in order to secure himself a larger share of demand.202 The
leader anticipates the follower’s reaction, and therefore sets a higher price in the first place, as

197
Even if these firms do not change their pricing policies in any way, their profits will rise: they sell a
larger quantity at the same price. Yet, the firm could further increase its profit by slightly raising the price of
its product, cf. Shy, 2001a, 139–142.
198
We will later see that this has positive effects on the firms’ incentive to merge (Section VI.3.(c)). The
concepts of strategic substitutes and complements are discussed in Bulow/Geanakoplos/Klemperer, 1985.
199
Shy, 2001a, 137–139.
200
The first model of oligopoly with sequential decisions is due to von Stackelberg, 1934.
201
Church/Ware, 2000, 472.
202
This corresponds to the model of a dominant firm with a competitive fringe whith the difference that
the firms comprising the fringe assume that they do not face any options with respect to price-setting, and
thus supply the quantity appropriate to the given price. Here, in contrast, the price follower sets a price for
the product, too. Models of sequential pricing decisions are discussed in Shy, 2001a, 139–142; Tirole, 2003,
330–333.

Kerber/Schwalbe
G. Economic Principles of Competition Law 257

compared to the one resulting from simultaneous price setting. However, the higher price set
by the leader enables the followers to raise their prices too, which in turn benefits the demand
for the leader’s product. The higher price leads to less competition (as compared with the case
of simultaneous price setting) and thus to increased profits. Here, the price leader earns lower
profits than the follower, since the latter is always able to undercut the price set by the former.
This model shows that it is in the interests of all firms to accept that one of them act as a price
leader, since then the profits for all firms will go up.
The model of sequential quantity competition dates back to the German economist 1–8–163
Heinrich von Stackelberg. In this model, one firm is able to commit to a certain quantity
supplied. The other firms will then react to that quantity. The Stackelberg leader, being the
first to move, anticipates the followers’ reactions to any quantity produced by himself, and takes
these reactions into account. As in the Cournot model, quantities are strategic substitutes. This
implies that, if the leader expands its quantity supplied, the followers will react by reducing
their supply in order to prevent a further fall in price. Anticipating this, the Stackelberg leader
supplies a larger quantity as in the Cournot-Nash equilibrium, and realises higher profits. The
Stackelberg followers supply less, and realise lower profits, as compared with the Cournot-
Nash equilibrium with simultaneous quantity competition.203
(e) Efficiency in oligopolistic markets. The various models of oligopoly described 1–8–164
above show that, except in the extreme case of Bertrand competition with a homogeneous
good, oligopoly induces conditions that deviate from an efficient allocation. Each of these
models implies prices that exceed marginal costs, and a smaller quantity than in a perfectly
competitive market. It follows that consumer surplus is reduced and, what is more, a loss in
social welfare ensues. However, since these models assume that the firms compete with each
other (if only in a limited way), they are forced to operate efficiently in order not to be at a
disadvantage, as compared with their competitors.
As regards dynamic efficiency, however, oligopoly may well be superior to both monopoly 1–8–165
and perfect competition. Competition within oligopoly induces each firm to try to achieve an
advantage over its competitors by a product on process innovation. A perfectly competitive
firm, though facing incentives to engage in R&D, usually lacks sufficient funds. In contrast, an
oligopolist, making profits, is provided with sufficient means for R&D. Furthermore, oligo-
polistic firms have better access to the capital market to raise funds. Moreover, these firms are
more likely to be able to appropriate the returns from their investment. Oligopolistic com-
petition by means of innovation may thus contribute to dynamic efficiency. However, the
results derived from both empirical and theoretical studies are ambiguous. As a consequence,
opinion is divided in the economics literature. There is no clear-cut conclusion on the
interaction between market structure, measured by the number of firms in the industry, and
innovative activity. There is a trend, however, to consider oligopoly as the market structure
that is most suited to promote dynamic efficiency.204 Results from other fields of economic
theory confirm this, e.g. the theory of economic growth.205
To conclude, none of the existing market structures is able to achieve all efficiency goals. 1–8–166
Perfect competition, while superior with respect to allocative and production efficiency, is
probably not dynamically efficient. Oligopoly, though producing allocative inefficiencies, is
presumbed to be characterised by efficient production. With respect to dynamic efficiency, the
prevailing opinion tends to regard oligopoly as the market structure most likely to bring about
innovation and technological progress. Monopoly, by contrast, will not achieve either allo-
cative or productive efficiency. With regard to dynamic efficiency, both theoretical and
empirical studies show that monopoly does not exhibit any advantages over other market
structures.
6. The concept of market power
(a) Market power and the price elasticities of demand and supply. Inefficiencies will 1–8–167
occur if the price of a good exceeds its marginal cost. In the first place, this applies to allocative
efficiency, but it is also true with respect to production since, especially in the case of
monopoly, X-inefficiencies tend to arise. A firm that is able to raise its price above the
competitive level faces a broad scope for price-setting. Economic theory labels this scope as

203
A good exposition of the von Stackelberg model is provided by Pepall/Richards/Norman, 2002, 270–275.
204
‘‘Both theoretical and empirical research on the link between market structure and innovation is not
conclusive, even though a ‘middle ground’ environment, where there exists some competition but also
high enough market power coming from the innovative activities, might be the most conducive to R&D
output’’ Motta, 2004, 57. Also compare Scherer/Ross 1990, 613–660.
205
Aghion/Bloom/Blundell/Griffith/Howitt, 2002.

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258 Part 1: Introduction

market power. That is, economics defines market power by reference to a firm’s ability to raise
its price above marginal cost.206 This includes the case of a firm that keeps its price constant but
reduces the quality of its product, and thus the cost of production. In this case, too, the price
will exceed marginal cost.207
1–8–168 This definition of market power allows for a simple measure, the so-called Lerner Index.208
According to this index, a firm’s market power is determined by the difference between the
price of a good i from the marginal cost of producing this good in relation to the price.209 If the
price of a good i is denoted by pi and marginal cost by c0i the Lerner index is given by:
pi # c 0i
L¼ :
pi
1–8–169 It is obvious that a firm has no market power when price equals marginal cost. The larger
the difference between price and marginal cost, the larger is the firm’s market power, and the
more severe is the ensuing inefficiency. In the case of perfect competition, where each firm acts
as a price taker, supply is such that the price equals marginal cost. It follows that a perfectly
competitive firm possesses no market power. The resulting allocation is efficient. In the case of
a monopoly that produces only one good i the Lerner index is:
pm # c 0 1
L ¼ i m i ¼ n;
pi !i
where pmi denotes the price charged by the profit-maximising monopolist,210 and !ni indicates
the price elasticity of demand (n) for good i.
1–8–170 The price elasticity of demand is determined by the demand function, which in turn
depends not only of the price of a good i but also on the prices of other goods which are
possible substitutes or complements. The shape of the demand curve depends on the pre-
ferences, the income and the number of consumers in the market. When the price of good i
goes up, consumers’ demand for this good is reduced. The change in demand for good i
induced by a price increase is described as follows. Let pi denote the price of good i, and !pi the
change in this price. For instance, suppose pi equals 10 Euros, and the change in price amounts
to 50 cents. Then, the price will increase by !pi/pi = 0.05, i.e. by 5 per cent. Further, let xi
denote the quantity demanded at the price pi, and !xi the change in demand due to a 5 per
cent price increase. As an example, suppose at a price of 10 Euros the quantity demanded is
1,000, and after a 5 per cent price increase the quantity demanded falls to 900 units. That is,
demand changes by !xi/xi percent, i.e. #100/1000 which equals #0.1, or #10 per cent. The
price elasticity of demand, denoted by !ni , indicates the percentage change in demand for good
i resulting from a percentage change in the price of this good. Formally, the elasticity is given
by:
!xi !pi !xi pi
!in ¼ = ¼ :
xi pi !pi xi
In the example, the price elasticity is:

206
This definition of market power is generally accepted in temporary economic theory. ‘‘A firm has
market power if it finds it profitable to raise price above marginal cost.’’ Church/Ware, 2000, 29. ‘‘Market
power may be defined as the ability to set prices above cost, especially above incremental or marginal cost,
that is, the cost of producing an extra unit.’’ Cabral, 2000, 6. ‘‘Since the lowest possible price a firm can
profitably charge is the price which equals the marginal cost of production, market power is usually defined
as the difference between the prices charged by a firm and its marginal costs of production.’’ Motta, 2004,
40f.
207
However, it has to be kept in mind that the price is, in general, easy to observe, whereas the quality
of a good is hard to determine. But this does not imply any consequence with respect to the applicability of
the definition. Approaches are provided by the method of ‘‘hedonic prices’’, cf. Rosen, 1974.
208
Named after the economist Abba Lerner (1903–1982). The index bearing his name can be found in
Lerner, 1934.
209
What follows is primarily meant to describe the concepts underlying the Lerner index. For this
reason, the focus is on the case where each firm produces just one good. In the case of multi-product firms,
situations may arise that cannot be captured by this simple form of the Lerner index (Schmalensee, 1982).
210
This follows from the monopolist’s maximising its profit. It is assumed that the monopolist does not
engage in price discrimination. cf. Section VIII.2.(b).

Kerber/Schwalbe
G. Economic Principles of Competition Law 259

#0:1
!in ¼ ¼ #2:
0:05
Since a price increase usually induces demand to fall, the elasticity will be negative. Thus, for 1–8–171
simplicity, economic theory works with the absolute value of elasticity, i.e. with the corre-
sponding positive number. In the example above, the elasticity equals 2. That is, a 5 per cent
price increase reduces demand by twice as much, i.e. 10 per cent. The concept of the price
elasticity of demand comprises all of the consumers’ possibilities to avoid the price increase.
These include switching to substitutes, as well as reducing the demand for the good in
question, maybe even to zero, i.e. dispensing with consumption of the good (or of a substitute)
altogether.
Two cases are distinguished with respect to the absolute value of elasticity: First, it may 1–8–172
range between 0 and 1, and secondly, it may be larger than 1. In the first case, demand is said to
be inelastic. That is, a 1 per cent price increase reduces demand by less than 1 per cent. In the
second case, if the elasticity exceeds 1 in absolute value, a 1 per cent price rise implies a demand
reduction of more than 1 per cent. The corresponding part of the demand curve is said to be
elastic. There is one point on the curve where a 1 per cent price induces an equal per cent
change in demand. At this point, demand is unit elastic. If the demand curve is very flat, even a
small price rise will produce a considerable reduction in demand. On the other hand, if the
demand curve is very steep, even a significant price rise will hardly affect demand, i.e. demand
will be inelastic. In order for demand to be elastic, it is not necessarily the case that a large
number of consumers switches to substitutes or reduces demand. In many cases, it suffices that a
relatively small number of consumers does this. What matters are the marginal consumers, i.e.
those that switch to other goods.
In general, the price elasticity in not constant, but changes along the demand curve. That is, 1–8–173
demand for a certain good tends to be more elastic at higher prices and more inelastic if prices
are low. When the price is low, a 1 per cent price increase hardly affects demand. At a high
price, however, a 1 per cent price rise will result in a considerable absolute increase in price and
therefore in a significant reduction in demand. Furthermore, the price elasticity of demand
varies with the time horizon under consideration. It depends to a great extent on whether one
considers the long run or the short run. For example, consider the price of oil. In the short run,
demand is inelastic since buyers find it hard to reduce their consumption of petrol, fuel oil, etc.
In the long run, however, people tend to respond by switching to cars with lower petrol
consumption, heating with gas, etc. such that the long-run elasticity significantly exceeds the
short-run elasticity.
If demand is inelastic, i.e. smaller than 1, this will imply that a 1 per cent price rise increases 1–8–174
the firm’s revenue. In the case of elastic demand, in contrast, revenue will decrease. A priori,
the concept of elasticity is therefore able to predict the change in revenue, but not the change
in profits. However, the following argument establishes a relationship between the price
elasticity of demand and profits: if a firm raises its price, it will sell less, and thus reduce its
quantity and save on production costs. That is, in the case of inelastic demand, a price increase
induces both revenue and profits to go up.211 Although this implies that a firm facing an
inelastic demand will raise its price until the elastic part of demand is reached. It follows that a
monopolist will always set a price on the elastic part of the demand curve.212
For instance, if the elasticity at the monopoly price equals 2, the monopolist will receive a 1–8–175
mark-up on marginal cost of 50 per cent. The Lerner index shows that even a monopolist does
not possess any significant market power if demand is very elastic. In this case, if the monopolist
charges a higher price, it would lose a large share of its demand. In the limit, i.e. if demand is
infinitely elastic, market power will vanish completely.213 Large market shares do thus not
necessarily imply the existence of market power. In most cases, market power is significant only
if demand is not very elastic.
The Lerner index also captures the market power of a Cournot oligopolist in the case of a 1–8–176
homogeneous good. Denote the Nash-equilibrium price by pc. The per cent deviation of the
market price pc from marginal cost is

211
However, even in the case of elastic demand, profits may rise in response to a price increase, namely
when the costs associated with the reduced quantity supplied fall by a larger amount than the revenues.
Compare Section IV.7.(c)(aa) (critical elasticities).
212
This statement does not only apply to monopoly but also to any firm maximising its profit.
213
This corresponds with the situation of a firm under perfect competition, that also faces a completely
elastic demand.

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260 Part 1: Introduction

pc # c 0i si
Li ¼ ¼ n;
pc !
where si denotes the market share held by the oligopolist i, and !n denotes the price elasticity of
demand. This formula differs from the one used in a pure monopoly since, in the case of
oligopoly, one has to take each firm’s market share into account. Thus, the market power faced
by a Cournot oligopolist depends on the price elasticity of demand, weighted by its market
share. It follows that the degree of concentration in a market plays a major role in determining
market power. The larger the firms’ market shares, the larger is the mark-up of price over
marginal cost, and the greater is their market power. The Lerner index also depends on
differences in the firms’ costs. A firm with lower marginal costs is able to realise a higher mark-
up and to capture a larger share of the market. The formula would also apply if the firms were
able to co-ordinate their behaviour and to act collectively as a monopolist. In this case,
however, one has to use the monopoly price, and the market shares refer to the smaller
quantity produced in monopoly.214
1–8–177 In general market structures, by contrast with monopoly or Cournot oligopoly, a distinction
is required as between the market demand, and the demand faced by a single firm i.e. the
residual demand. Thus, it is possible that market demand is very inelastic with respect to price,
but that the demand faced by a single firm, i.e. its residual demand, is very elastic. As an
example, consider the market for a medication which is essential to some patients, e.g. insulin.
Insulin is supplied by several firms using identical substances. The market demand for insulin
will hardly react to price changes. If, however, only one firm raises its price in order to increase
its profits, many customers will switch to the other suppliers. That is, a firm’s residual demand is
very elastic and, as a consequence, its market power is negligible even though market demand
is inelastic. What matters with respect to the existence of market power is thus the price
elasticity of a firm’s residual demand.215
1–8–178 If there are other firms in the market apart from the monopoly or oligopoly, e.g. a com-
petitive fringe, or if new firms may enter the market, the concept of market power has to take
into account the behaviour of these actual or potential competitors. Similar to the price
elasticity of demand, the price elasticity of supply accounts for the quantity supplied by actual
or potential competitors.216 The elasticity of supply is determined by several factors. For
instance, the other firms’ capacities play a major role. These firms can expand their supply only
if there is sufficient idle capacity, or if additional capacity can be built at short notice.
Otherwise, these firms would not be able to expand output even in the case of a dramatic price
increase—the price elasticity of supply would be zero, or at least very small. Barriers to entry
are also important. Absolute barriers to entry, e.g. a patent, prevent new firms from entering
the market, and the price elasticity of supply is small. The time horizon also plays a major role.
In the short-run, supply reacts to a small extend only, since reorganising the production process
takes time, and market entry occurs only after a certain time lag for preparation. A long-run
analysis will therefore show a more noticeable reaction in supply. The Lerner index in the case
of further competitors or market entry is given by
pi # c 0i si
Li ¼ ¼ n ;
pi !i þ ð1 # si Þ!ia
where !ai denotes the price elasticity of supply. This elasticity is weighted with all firms’ market
shares, except the one of the firm under consideration.217 This is analogous to the case of
oligopoly, where the expression !ni + (1 # si)!ai denotes the price elasticity of the residual
demand facing a firm i. The index shows that a firm’s market power is inversely related to the
price elasticities of supply and demand. That is, a firm’s market power is restricted from two
sides: On the one hand, the consumers avoid a price increase by switching to other brands, and
on the other, actual or potential competitors adjust their quantities supplied. It follows that a
firm’s market power may reduce to zero even if demand is very inelastic. This is the case if
supply is very price elastic. A firm’s market power will be greater if there are fewer substitutes
available to consumers, and if supply is less elastic.
1–8–179 These considerations can be applied to differentiated goods, using the same formula as

214
Co-ordination in oligopoly is discussed in Section V.2.
215
The difference between aggregate and residual demand is explained in Carlton/Perloff, 2005, 66–69.
216
Carlton/Perloff, 1999, 66.
217
Carlton/Perloff, 1999, 68, explain how this is derived.

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G. Economic Principles of Competition Law 261

above. The question of which goods have to be taken into account is not of major importance
since the price elasticity of demand and the market share move in the same direction:218 if only
a few very close substitutes are taken into consideration, a firm’s market share will be quite
large. But demand will also be quite elastic, since consumers face a multitude of possible
substitutes. While a large market share implies significant market power, a large elasticity of
demand implies little market power. On the other hand, if both close and distant substitutes are
taken into account, then each firm’s market share will be small, but demand will also be very
inelastic, since there are but a few substitutes available to consumers. A similar argument applies
to the price elasticity of supply. It will be large if only close substitutes are considered, and small
if a wider range of substitutes is taken into account.
(b) Market power, market dominance and efficient competition. The Lerner index 1–8–180
is a clear concept well-founded in economic theory. In principle, it may be applied to all
market forms. The Lerner index shows that the market power of a firm, or a group of firms, is
constrained both by the number of substitutes available to consumers on the demand side, and
the behaviour of actual or potential competitors on the supply side of the market. Both
demand-side and supply-side substitution provide competitive contrains on a firm’s market
power. Furthermore, the Lerner index allows the distinguishing of various degrees of market
power. As a consequence, it is possible to determine if, and how, a firm’s market power will be
affected by, e.g. a merger, or if any one firm has more or less market power than another. It is
important to note that the measurement of market power by the mark-up of price over
marginal cost is based on a long-run analysis where all costs are variable, i.e. where there are no
fixed costs. In the short run, price may exceed marginal cost if there are fixed costs which must
be covered by a price corresponding to average cost.
However, the use of the difference between price and marginal cost to determine market 1–8–181
power is best suited to capture allocative inefficiencies. Furthermore, under certain restrictions,
the Lerner index may serve as an indicator of productive inefficiencies.219 However, it is a static
concept that cannot be used to detect dynamic inefficiencies. A certain degree of market power
is necessary to ensure dynamic efficiency where the firms compete on product or process
innovations, and not on prices or quantities. Such competition works only if the firms investing
in R&D are able to reap the gains from their investments. This can be achieved by patent
protection that provides a firm with market power for the duration of the patent. Furthermore,
the analyses of various market structures point out that dynamic efficiency is more likely to be
expected in oligopolistic markets. To conclude, it is not necessarily advisable to rule out any
degree of market power altogether, i.e. any mark-up of price over marginal cost, especially
where dynamic efficiency is concerned. Indeed, a certain degree of market power may be
essential in order to bring about dynamic efficiency. Restricting attention to prices would
exclude the aspect of competition by means of innovation. Therefore, from the point of view
of a reasonable economic policy, the aim of competition policy should not be to reach perfect
competition. Instead, one should aim for effective competition as this is better suited to achieve
the economic goals of allocative, productive, and dynamic efficiency. Furthermore, it is more
likely to prevent a reallocation of economic surplus due to market power from arising (con-
sumer welfare standard).
How to define effective competition i.e. the degree of market power that is acceptable, 1–8–182
depends also on whether the focus is on the long run or on the short run. By attributing much
importance to the short-run effects of market power, the allocative aspects are assigned a
greater weight as compared to a long-run analysis. This is why the concept of effective
competition is, among other things, determined by normative considerations. To define the
concept of effective competition precisely requires that its practicability has to be taken into
account. For example, a small degree of market power cannot be detected. In order to be
noticed, the degree of market power has to exceed a certain threshold. As a consequence,
effective competition exists if a certain degree of market power is not exceeded. This degree is
also determined by normative considerations. The critical degree of market power will differ
across markets. In markets where innovation is the major competitive parameter, one tends to
accept a larger degree of market power since the firms compete for the market, not in the
market. In contrast, a smaller degree of market power will be acceptable in mature markets
where major innovations are not to be expected.220 A similar argument holds for industries

218
Baker/Bresnahan, 1988, 286; Hausman/Leonard/Zona, 1992, 896; Landes/Posner, 1981, 962.
219
Thus, a small difference between price and marginal cost in the case of monopoly might possibly
indicate excessive marginal costs, i.e. inefficiency in production.
220
Office of Fair Trading, 2002, 43–51; Geroski, 2003.

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262 Part 1: Introduction

characterised by large fixed costs, which will be covered only if the price exceeds marginal cost.
Furthermore, such a concept of effective competition opens up the possibility of establishing a
relationship between the economic term ‘‘market power’’ and the legal term ‘‘market dom-
inance’’. As effective competition, in the sense outlined above, is constrained only if a firm’s
market power exceeds a certain threshold, one can interpret this degree of market power as
market dominance.221 However, it has to be kept in mind that market power is not necessarily
bad. For instance, when a firm has reached a dominant position by introducing a cost reducing
technology, this is a normal by-product of effective competition, and does not require any kind
of interference on the part of the competition authorities. Only if market power is achieved by
using methods that are incompatible with competition on the merits, or if a dominant position
is being abused in order to exclude competitors, measures have to be taken to restore effective
competition. From an economic point of view, one has to distinguish between market power
and the abuse of a dominant position.
1–8–183 7. Assessment of market power—market delineation. In order to be able to tell if
effective competition exists in a market, or if it is constrained, or if a merger threatens to
constrain it, it has to be determined whether a significant degree of market power prevails, will
emerge or be enhanced. In this context, it is important to distinguish between a retrospective
analysis, i.e. investigating whether market power exists, and a prospective assessment to
whether market power will arise or is being extended. A retrospective analysis has to be applied
in case of an abuse of a dominant position. Here, it has to be ascertained first if a firm has a
dominant position, i.e. if there is a significant degree of market power. Only then has it to be
considered whether or not this dominant position is being abused. The prospective analysis is
used primarily in merger control since, in these cases, the focus concerns future changes in
market power. Failure to make a clear distinction between a retrospective and a prospective
analysis may result in incorrect assessments of market power and market dominance, especially
with respect to defining the relevant market.
1–8–184 (a) Measuring market power directly. In order to determine the alleged market power
held by a firm, or a group of firms, one may calculate the Lerner index, or the elasticity of the
corresponding residual demand, and thus try to determine the prevailing degree of market
power.222 Looking at the percentage deviation of price from marginal cost, the price is the
easiest factor to observe.223 Determining the marginal cost, however, presents several con-
siderable difficulties. First of all, marginal cost is primarily a theoretical concept which is
difficult to determine even if one knows the technical conditions underlying production.224
Although it is sometimes possible to observe the variable costs of production, these reflect an
accounting measure only. They do not reflect the opportunity cost necessary for an eco-
nomically correct assessment. Moreover, firms that possess a significant degree of market power
may have inflated costs due to X-inefficiencies. If this is the case, even if marginal costs were
calculated, one would not be able to infer the degree of market power. If the components of
the Lerner index cannot be observed, a firm’s profitability may be used to derive conclusions
with respect to its market power. For this purpose, a number of techniques and methods have
been developed in recent years. However, because of several severe conceptual problems, these
methods can serve as an indication only of a firm’s market power.225

221
Bishop/Walker, 2002, 184. This does certainly not imply that the the economic concept of significant
market power and the legal concept of market dominance should be considered as equivalent. The legal
term ‘‘market dominance’’ encompasses further aspects besides the economic one, like, e.g. the protection
of liberty rights of third parties, which are at most indirectly taken into account by the economic concept of
market power.
222
Bresnahan, 1989.
223
In the case of consumer goods, the average price could be detected by scanner data. With other
goods, however, this is more difficult since, in many cases, there are no sufficient data available, or there
does not exist a market price as such because the price is determined by negotiations between buyers and
sellers. If the price is observed during a period where a dominant firm attempts to squeeze out competitors
by predatory pricing, such a price will lead to false conclusions with regard to the determination of market
power.
224
Motta, 2004, 116.
225
Office of Fair Trading, 2003b.

Kerber/Schwalbe
G. Economic Principles of Competition Law 263

Since price equals cost in the case of perfect competition, one might determine the degree of 1–8–185
market power by calculating the price in a perfectly competitive market.226 In certain cir-
cumstances, this could be achieved by means of a comparison of two separate but similar
markets. This could be done by considering a different geographical market, or a different
product market, which corresponds to the original one in every respect and where it is evident
that efficient competition prevails. If the price prevailing in the comparable market differs
significantly and permanently from the one in the market under consideration, this would be
evidence for the existence of market power. In practice, however, such a comparable market is
often hard to find. The features in which the two markets differ have to be clearly spelled out
and accounted for by mark-ups or discounts. In most cases, however, it is not obvious how to
determine these corrective factors. For this reason, price comparisons have to be applied with
caution.227
Another way to determine market power directly is by calculating the price elasticity of 1–8–186
residual demand.228 The residual demand depends not only on the consumers’ reactions but also
on the supply decisions on the part of actual and potential competitors. However, calculating
supply-side substitution is often problematic.229 Therefore, it is usually difficult to assess market
power directly. Obtaining an acceptable estimate of the residual demand function requires a
comprehensive econometric analysis. This in turn requires sufficient data over long periods of
time. In addition, the conditions in the market under consideration have to be relatively stable
since changes in products or in consumer preferences affect the data, and thus the result of the
analysis. If, however, these conditions are satisfied, such an analysis will yield a precise eva-
luation of a firm’s market power.230
To sum up, direct determination of a firm’s market power is typically a difficult task. While 1–8–187
there are some methods which could, in principle, enable this to be done, e.g. estimating the
elasticity of the residual demand function, these methods are intricate and can be applied only
under very specific conditions. This is why, in most cases, one has to resort to indirect methods
of assessing market power.
(b) Market definition—indirect assessment of market power. The indirect deter- 1–8–188
mination of market power is based on conclusions drawn from a firm’s market share. Similarly,
anticipated changes in market shares resulting from a merger are taken as an indication of a
change in the firm’s market power, e.g. the emergence of a dominant position. Using market
shares as an indicator of market power requires that the relevant market be defined such that
the market shares reflect as precisely as possible a firm’s market power or its degree of market
dominance. For conceptual reasons, an exact reflection is impossible, since even in the case of
large market shares, a firm’s market power may be small if, e.g. demand is very price elastic.
The indirect method of assessing market power thus consists of three steps: First, the relevant
market has to be defined. Then, the firms’ market shares have to be determined. Finally, the
market shares have to be interpreted, taking into account the competitive conditions prevailing
in the market in order to establish whether a dominant position exists, or if it is strengthened or
being abused.231 In addition to market shares as a measure of concentration and as an indicator
of market power, further aspects must be considered in assessing the competitive situation in
the market. For instance, if there is considerable buyer power, a firm may be unable to raise its
price significantly above the competitive price even if its market share is large. The threat of
potential competition plays a similar role. From an economic point of view, defining the

226
‘‘One would simply identify the competitive price level and then compare it with the observed price
level. If the observed price level were significantly above the competitive price level then the firm can be
deemed to hold a dominant position (i.e. the ability to charge prices significantly in excess of the com-
petitive level).’’ Office of Fair Trading, 2001, 17.
227
Schmidt, I., 2005, 152–154.
228
Baker/Bresnahan, 1988; Scheffman, 1992; Werden, 1998.
229
cf. Section IV.7.(b)(dd) and the references stated there.
230
The methods to determine market power directly discussed up until now refer to the case where
market power already exists. With regard to the prospective question of whether or not a merger will give
rise to market power (or enhance it), empirical methods have been developed in order to derive direct
inferences on the change in the market power possessed by the firms in question. These methods are
presented in Section VI.3.(e)(aa) on merger control in the context of co-ordinated and unilateral effects.
231
‘‘. . . that the analysis does not end when the market has been defined and that simple-minded
measures of market power or concentration, like simple-minded binary treatments of market definition, are
unlikely to be adequate substitutes for a full analysis.’’ Fisher, 1987, 28.

Kerber/Schwalbe
264 Part 1: Introduction

relevant market is but a tool, a device, and an intermediate step on the way to the final goal of
assessing and evaluating market power.232
1–8–189 (aa) A concept based on consumers’ needs. To define the relevant market, legal
practice has relied on several criteria. Goods are assigned to the same market if they are
considered as interchangeable, or as substitutes, with respect to their function, their char-
acteristics, their price level and their intended use. However, the usefulness of such criteria as
means to reach a satisfactory market definition which is supposed to yield precise answers to the
questions of market power or dominance, is to be considered doubtful for several reasons.233
1–8–190 For one thing, consideration of the good’s functional substitutability avoids the central
problem posed by market power, which depends on the elasticities of supply and demand. To
constrain a firm’s market power, it is often sufficient that only a few customers switch to other
products if a price increases; in general, it is not necessary for the goods to be interchangeable,
either completely or to a large extent, in order to constrain market power. As a consequence,
this approach will result in a narrow definition of the relevant market.234 Similarly, the criterion
of physical characteristics, which assigns products to different markets when their characteristics
differ widely, often produces a market definition that is not sensible from an economic point of
view. This is because a product does not necessarily have to exhibit the same physical char-
acteristics as another to be considered as a substitute. For instance, bus and railway travel are
close substitutes for many consumers, although they differ widely in their physical character-
istics. Therefore, defining the relevant market on the basis of similarities in the physical
characteristics of the goods may imply a very narrow market definition. In certain cases,
these characteristics are of no importance in relation to a consumer’s decision to buy.235 When
assigning two products to different markets because of their distinct characteristics, the focus
should be on the influence of these characteristics on the goods’ substitutability. Similarly, a
difference in the price levels of the goods does not necessarily imply that the goods belong
to different markets. Suppose two goods differ in their quality, e.g. their product life. Then, an
expensive but high quality product might well serve as a close substitute for a product of
inferior quality that lasts half as long, but costs half as much.236 Here, too, is a danger of defining
the market too narrowly, and thus of overestimating market power. It is true that these
concepts help to decide on the range of products to be considered as substitutes. However, they
do not answer the decisive question concerning market power, and the restrictions imposed on
market power by substitute goods.
1–8–191 (bb) The hypothetical monopoly test. Since the beginning of the 1980s, economic
theory has proposed a concept especially designed for merger control in order to define the
relevant market on the basis of market power. Bearing in mind that market shares are but
imperfect indicators of market power, a market should be defined in such a way which
maximises the explanatory power of market shares with respect to market power.237 This
concept was first introduced in the US horizontal merger guidelines. It is referred to as the
concept of an antitrust market.238 The idea underlying this concept is as follows. Market shares
are useful indicators of market power only if, at the very least, a firm possessing a 100 per cent
share would be able to exercise market power. Put differently: if even a monopolist does not
possess market power, i.e. is unable to raise the price above the competitive level, then a firm
with a market share smaller than 100 per cent will be much less able to do so. That is, there will
be no possibility of raising the price.239 If this is the case, market shares are no indication of

232
Bishop/Walker, 2002, 83; Werden, 1983, 516; Werden, 1992, 197.
233
‘‘The delineation of the relevant market, where a firm may enjoy a dominant position, will serve as
an example to illustrate how outdated economic concepts still survive in legal textbooks as the ‘legal’
approach. Modern industrial organisation offers new concepts that overcome the current subjective eva-
luations of product characteristics as a method to define the relevant market.’’ Van den Bergh, 1996, 76.
234
Camesasca/Van den Bergh, 2002, 158.
235
Bishop, 1997, 482.
236
‘‘Products constitute a bundle of characteristics, including price and quality. Higher priced, higher
quality products often are close substitutes for lower quality, lower priced goods, the quality differences just
making up for the differences in price.’’ Simons/Williams, 1993, 854.
237
‘‘Thus, market delineation in the Guidelines is a tool used to construct market shares that are as
meaningful as possible.’’ Werden, 1983, 577.
238
Werden, 1992; Bishop/Walker, 2002, 82–92; Church/Ware, 2000, 602–612; Geroski/Griffith, 2003;
Kauper, 1997; Massey, 2000; Werden, 1983; Werden, 1992; Werden, 1993.
239
‘‘We can only answer the question of whether, for instance, a 70 per cent share of a ‘market’ is likely
to give a firm market power if that ‘market’ is an economically meaningful market.’’ Bishop 1997, 481.

Kerber/Schwalbe
G. Economic Principles of Competition Law 265

market power. The relevant antitrust product market thus comprises all goods that constrain a
monopolist’s market power, and the relevant geographical market consists of all regions that
restrict it. If some of these products or regions were not included in the market, a price increase
would cause consumers to switch to these goods or regions, thus constraining the exercise of
market power. This argument was further developed into the hypothetical monopoly test. This
test is employed today in most legal systems as a conceptual framework for market definition.240
The hypothetical monopoly test asks the question: would a hypothetical, profit-maximising 1–8–192
monopolist, (i.e. a firm operating as the sole supplier of a good), raise the price of this good?241
If this were the case, the hypothetical monopolist would possess market power, and the firms’
market shares would allow for inferences (albeit imperfect) to be drawn with respect to their
market power. In contrast, if a price increase on the part of the hypothetical monopolist would
not raise its profit, then its market power will obviously be constrained. These constraints are
formed either by consumers’ switching to other products, or by supply reactions by actual or
potential competitions. In this case, the firms’ market shares will not serve as a useful indicator
of market power. However, a small degree of market power is not necessarily problematic,
from an economic point of view. It poses a problem only if it exceeds a certain level. The
problem is to determine an appropriate degree of market power to serve as a benchmark, i.e. a
certain level of price increase for a certain length of time.242 A drastic increase in price that is
effective for a couple of weeks only, until consumers decide to switch products or new firms
enter the market, is perhaps less harmful than a moderate price increase that lasts for several
years.243 A normative decision must be made as to the extent and duration of a price increase
that is to be considered acceptable without requiring competition policy intervention. The
limit is usually set at a 5–10 per cent price increase for about a year. When this limit is
exceeded, the existing market power is not to be tolerated.244 In this case, the relevant market
definition is such that the firms’ market shares are fit to serve as an indicator of market power.
Thus, the condition for defining the relevant market is as follows: The relevant market includes
the regions and products for which a profit maximising hypothetical monopolist would be able
to effect a small but significant non-transitory increase in price. Therefore, this test is known as
the SSNIP test.245 In this context, ‘‘non-transitory’’ means for about one year at least, and
‘‘small but significant’’ means in the range of at least 5 to 10 per cent.246
In merger control the SSNIP test is applied as follows. One begins with a candidate market 1–8–193
that includes only the goods produced by the merging firms. Then, it is asked whether or not
the merged firm would effect a small but significant increase in price, provided that the firm is
maximising profits. If this is the case, the relevant market will be adequately defined. Then, the
firms’ market shares can be determined and interpreted. However, if the merged firm is not
able to profitably effect such a price increase, then the market will be too small to serve as the
relevant market. In this case, the hypothetical monopolist is constrained by competition, i.e. by
consumers’ switching to other goods, and/or by the reactions on the part of other suppliers.
Here, a distinction has to be made between the definition of the relevant product market and
the relevant geographical market. In the context of defining the relevant product market, more
products must be added to the candidate market, while more regions must be added when

240
Bishop/Walker, 2002, 88.
241
This applies also in the case of multiple products.
242
‘‘Only if the magnitude and duration of the price increase exceed certain significance thresholds
should the product and area be deemed to constitute a market.’’ Werden 1983, 542.
243
Geroski/Griffith, 2003, 8.
244
In the case of a small increase in price there is a risk that a merger is not considered as a horizontal one
since the firms seem to belong to different relevant markets. (Werden, 1983, 539.)
245
Here it is assumed that a profit maximising firm would raise the price by at least 5–10 per cent.
Sometimes it is said that a price increase by 5–10 per cent would be profitable. The difference is that, while
a price raise by 5 per cent may well be profitable, but a profit maximising firm will raise the price by, say, 3
per cent only. From an economic point of view, the former test is better since it focusses on what the firm
will actually do. (Baumann/Godek, 1995.)
246
Here, deviations from these limits are possible, depending on different configurations. Such devia-
tions should not be taken too literally since, in some cases, higher or lower limits make sense (Werden, 1993,
534–536).
Further, note that these limits only reveal facts concerning the relevant market. Therefore, they should
not automatically be seen as a tolerance limit with respect to price increases resulting from a merger
(Werden, 1993, 536 et seq.). Moreover, the definition of the relevant market may change, e.g. because of
technological innovations such as the internet.

Kerber/Schwalbe
266 Part 1: Introduction

defining the relevant geographical market.247 The test is then repeated until a hypothetical
profit maximising monopolist would effect such a price increase.248 The relevant market thus
consists of the smallest product and geographical market satisfying this condition. Only if the
relevant market is defined accordingly will the prevailing competitive constraints on the
exercise of market power be captured, and only then will the firms’ market shares be useful
indicators of market power.249 Whether a hypothetical profit-maximising monopolist will
effect a small but significant, non-transitory increase in price depends mainly on the reactions of
buyers and sellers.
1–8–194 (cc) Demand-side substitution. All reactions on the part of consumers to a price
increase are covered by the price elasticity of demand.250 In the case of inelastic demand, a small
but significant increase in price results in a minor reduction in demand only. In this case the
hypothetical monopolist will be able to realise higher profits. This will be the case if there are
not sufficient substitute goods available to consumers.251 On the other hand, if demand is very
elastic, a price increase will not raise profits since even a small increase in price will lead to a
major reduction in demand.252 Here, the consumers can switch to substitute products or other
regions if the price goes up.253
1–8–195 If it turns out that the hypothetical monopolist faces a very elastic demand, the relevant
market will have to be extended by including further products and a wider region. The
extension should first of all comprise such products and regions that form the closest substitutes,
since these are the main factors that prevent the execise of market power. Adding these goods
and regions to the candidate market reduces the competitive constraints.
1–8–196 To find out what are the closest substitutes to be included in the candidate market, the
concept of the cross-price elasticity of demand may be useful. This elasticity specifies the per
cent change in the demand for good i due to a 1 per cent increase in the price of another good
j. A significant cross-price elasticity indicates that the goods under consideration serve as close
substitutes. Likewise, a cross-price elasticity of zero means that the goods are independent of
each other. If the cross-price elasticity is negative, the goods will be complements, i.e. an
increase in the price of one good will also induce a reduction in the demand for the other.
However, it has to be pointed out, that the cross-price elasticity between two goods A and B
says little about whether or not a good constrains a firm’s market power. For instance, even
where the cross-price elasticity is small, market power may not exist when there are many
substitute goods available to consumers. Thus, products with a small cross-price elasticity may
well belong to the same relevant market. Then again, a large absolute value of the cross-price
elasticity may be compatible with considerable market power. That is, even products with large
cross-price elasticities do not pose competitive constraints.254 This is the case if, e.g. the
quantities sold of the two goods differ widely. Suppose that, within a year, 1,000,000 units of
good A are sold, but only 1,000 units of good B. Then, assuming the cross-price elasticity to be
25, a 5 per cent increase in the price of good A increases the demand for good B by 1,250. But
this corresponds to a reduction in the demand for good A of only 0.125 per cent. If the price of
good A prior to the price rise is 1 Euro, such that profits amount to 1,000,000 Euro, after the
price increase profits will rise to 1,048,687, despite the reduction in demand. This shows that
neither high nor low cross-price elasticities reveal much about market power. Even if all the

247
In rare cases, it might be necessary to define the relevant market with regard to a relevant time-
period. We will not further elaborate on this aspect here. The definition of the relevant product and
geographical markets should be carried out simultaneously. Otherwise, one runs the risk of too narrow a
definition. (Compare Section IV.7.(b)(ee)).
248
A precise describtion of this algorythmic procedure is given by Werden, 2002a.
249
‘‘Moreover, it cannot be stressed enough that defining relevant markets on a basis that does not apply
the conceptual framework of the hypothetical monopolist test will, almost by definition, not take into
account the main competitive constraints posed by demand-side and supply-side substitution and in
consequence, any market shares will be unable, except purely by chance, to capture the nature of the
competitive constraints in the industry under investigation.’’ Bishop/Walker, 2002, 86.
250
i.e. switching to other products as well as to other geographical markets.
251
In this context, the degree of product differentiation in the market is of importance. The closer the
substitutes, the higher will be the elasticity, as explained in Section IV.6.(a).
252
There is no consideration of the quantity where increase lowers the monopolist’s costs to such an
extent that a price rise will be profitable even if demand falls considerably. (Section IV.7.(c)(aa))
253
The buyers’ options to switch to other products are determined by the prices, the physical char-
acteristics, the quality, and other characteristics unrelated to price.
254
Church/Ware, 2000, 605f.

Kerber/Schwalbe
G. Economic Principles of Competition Law 267

cross-price elasticities are known, this will not allow sufficient inferences to be made with
respect to market power, since it is decisive whether the expenditures on the good amount to a
large proportion of the consumer’s budgets.255 The price elasticity of demand contains all this
information since it is composed of the cross-price elasticities in relation to all other goods,
taking into account the weight of the other goods in the consumers’ budgets.256
Price elasticity of demand is of major importance to the hypothetical monopolist’s decision 1–8–197
for or against a price rise, whereas cross-price elasticities play only a minor role. They matter
only in so far as they affect the own-price elasticity. This is why the customary use of cross-
price elasticities with regard to market definition is misplaced.257 The concept is of interest only
in so far as it contributes to identifying the closest substitutes relevant for the hypothetical
monopoly test.258 For this purpose, further criteria may be employed besides the cross-price
elasticities. These are, e.g. exchangeability, physical characteristics, or the intended use. Fur-
thermore, the price level may offer a clue as to which of the products should be considered as
close substitutes. However, none of these criteria is well qualified to resolve questions of
market definition.259
In order to constrain the market power of a hypothetical monopolist by demand-side 1–8–198
substitution it is in most cases not necessary that a large fraction of consumers, or at least 50 per
cent, switch to substitute goods. It suffices that a sufficient number of consumers does so. Even
if there are large groups of consumers that cannot substitute the good this does not auto-
matically imply market power. What matters are the marginal consumers, since they determine
the price elasticity of demand.
(dd) Supply-side substitution. The market power of a hypothetical monopolist may also 1–8–199
be constrained by supply-side substitution.260 A price increase on the part of the hypothetical
monopolist makes it attractive to other firms to supply the product also, and thus raise their
profits as a result of the increased price. In principle, the good may be supplied by firms which
are already operating in other geographical or product markets and which are sufficiently
flexible to adjust or to divert their supply. In the case of differentiated goods, supply-side
substitution can be carried out by repositioning existing goods through a modification of some
of their characteristics. Additional supply may be provided by firms that are able to enter the
market only after investing in, e.g. production facilities. This latter case is one of market entry
rather than supply-side substitution. The difference between supply-side substitution and
market entry consists in the time a firm needs to enter the market. If a firm is able to react very
quickly to a price increase, say within a few months, the market power of the hypothetical
monopolist will be constrained in a way similar to that of demand-side substitution.261 A further
difference between supply-side substitution and market entry is that the former prevails when a
firm is able to enter the market without first incurring considerable fixed costs, i.e. when it has
the option of ‘‘uncommitted entry’’, and is in a position to react quickly to current price
increases. However, if considerable fixed costs have to be sunk to enter the market, this is called
‘‘committed entry’’ that occurs only after a considerable length of time. Thus, its profitability
depends on the expected market outcome after entry has taken place. Therefore, the hypo-
thetical monopoly test should include supply-side substitution when defining the market
whereas market entry or potential competition should be taken into account when assessing
competition, i.e. after having defined the relevant market.262
In order to constrain the hypothetical monopolist’s market power by supply-side sub- 1–8–200
stitution, a firm has to possess all the production facilities and technological know how needed
to produce a substitute good. It must also have or be able to procure the necessary distribution
channels and marketing measures. The reorganisation of production must take place rapidly
and at little cost. Furthermore, the capacities needed to produce and to supply the substitute
good must not be constrained by long-term contracts. A firm will reorganise its supply only if it

255
Werden, 1998, 401.
256
Church/Ware, 2000, 606.
257
Scheffman, 1992, 903; Simons/Williams, 1993, 828; Van den Bergh 1996, 83; Werden 1998, 401f,.
258
Motta, 2004, 107; Simons/Williams, 1993, 828.
259
Van den Bergh, 1996, 83.
260
Padilla, 2001.
261
‘‘The difference between a supply side substitute (i.e. a rival producer producing a me-too product to
compete with the hypothetical monopolist) and an entrant is that the former is able to enter and compete
with the hypothetical monopolist within a year. That is entry is in effect distinguished from intra-market
rivalry by the time-period in which it occurs.’’ Geroski/Griffith, 2003, 12.
262
Bishop, 1997, 483, Padilla, 2001, 25–27.

Kerber/Schwalbe
268 Part 1: Introduction

may expect higher profits as a consequence.263 If any one of these condition is not satisfied, the
firm will not be able to prevent a price increase through supply-side substitution.
1–8–201 To ascertain whether a price increase effected by a hypothetical monopolist will be followed
by supply-side substitution, one has to verify that the necessary conditions hold. More pre-
cisely, are the production facilities, know how, distribution systems, spare capacities, etc.
available? Further, one has to examine which firms are likely to effect a supply-side sub-
stitution, and to what extent.264 If effective supply-side substitution is to be expected, the
question arises as to how to take this into consideration with respect to the definition of the
relevant market. There are two possibilities. First, all the goods produced be the firms that
would reorganise their production are included in the relevant market, i.e. the relevant product
market or geographical market is enlarged.265 For instance, shoes of different size are
not substitute goods from a consumer’s point of view. Thus, restricting attention to demand-
side substitution alone would imply a multitude of relevant markets. However, most shoe
manufacturers are able to adjust their production to different sizes at short notice. It follows
from such a supply-side substitution that the relevant market is the market for shoes. A similar
argument holds for other goods between which there is no demand-side substitution, but
where the difference refers only to size or colour, and firms are able to readjust production
quickly without any difficulties.266 A broader market definition, however, requires that all or at
least most of the firms effect such supply-side substitution. If this is not the case, the relevant
market should be defined with respect to demand-side substitution. Only then should the firms
producing substitute goods be considered as market participants, and the capacities employed to
produce substitutes have to be taken into account when calculating the market shares. For
example, suppose that firms that normally produce hub-caps were able quickly and without
difficulties to reorganise their production process to producing bumpers, should the price of
bumpers go up. However, it would not make sense to include both hub-caps and bumpers in
the relevant market. Instead, considering demand only, the relevant market is the market for
bumpers. However, the hub-cap producers’ market shares should now include the capacities
they used in bumper production.267 In general, both methods will produce the same result, or
at least a similar one, with regard to the firms’ market shares.268
1–8–202 Taking the supply-side substitution into account, either in defining the relevant market or in
calculating the market shares, requires that supply be quantifiable. But in most cases, this is
difficult or even impossible, since it depends on determining which firms are to be considered
as potential suppliers of a substitute good. In order to do this, however, information about their
technologies, know how, etc. would be necessary. More often than not, this information is not
available.269 Therefore, it is often impossible to rely on a quantitative analysis of the supply-side
substitution, either in defining the relevant market or in calculating the market shares. Instead,
as for market entry, the supply-side substitution will be taken into consideration only after the
relevant market has been defined. It has to be borne in mind that the market shares, having
been calculated without consideration of supply-side substitution, tend to overestimate the
firms’ market power. Therefore, a cautious interpretation is required.270
1–8–203 (ee) Simultaneous definition of the relevant product and geographical market. In
defining the relevant product or geographical markets a sequential definition of first the
relevant product market and then the relevant geographical market usually yields market shares
that are an inadequate indicator of a firm’s market power since they tend to overrate the latter.
Defining the relevant product market first means that consumers’ reactions are taken into
account only with respect to their switching to other products. Taken on their own, however,
these reactions may not suffice to prevent a profitable price increase. That is, the relevant
product market is rather narrow. Now, defining the relevant geographical market as a second
step, the consumers’ switching to other regions, taken alone, may also not suffice to prevent a
price increase. Thus, the relevant geographical market is also rather narrowly defined. In

263
Padilla, 2001, 4.
264
Padilla, 2001, 18–25.
265
In what follows, the focus is entirely on supply-side substitution with respect to the relevant procuct
market. With regard to the relevant geographical market, the argument is analogous.
266
Office of Fair Trading, 2001, 10.
267
In the literature, this method is referred to as ‘‘share-measurement approach’’. (Werden, 1983, 519–
521; Werden, 1984, 657–659).
268
Werden, 1984, 659.
269
Padilla, 2001, 26 et seq.
270
Bishop/Walker, 2002, 95.

Kerber/Schwalbe
G. Economic Principles of Competition Law 269

contrast, under a simultaneous definition of the relevant product and geographical markets, the
consumers’ reactions taken together might suffice to render a price increase unprofitable, and
the relevant market will be broader.271 This difference in the result depends primarily on
whether or not the consumers who switch to other products are identical to those who buy in
other regions.272
(ff) Market definition in the case of differentiated goods. Markets with differentiated 1–8–204
goods pose an additional conceptual problem with respect to market definition. In general, not
all differentiated goods will serve equally well as substitutes for a certain product. Instead, there
will be closer and poorer substitutes. In this case, the market shares of firms producing poor
substitutes are less significant than those of firms producing closer substitutes. This may turn out
to be problematic, especially with respect to merger cases. If two firms that produce close
substitutes merge, the effect on competition will be considerable. By contrast, if the merging
firms operate in the same product market but produce poor substitutes, the merger will hardly
affect competition, even if they have equal market shares.273 Therefore, information about the
strength of competition between the differentiated goods is vitally important. In such cases,
market shares have to be interpreted cautiously.274 In the past, this problem has been evaded by
specifying sub-markets within the differentiated goods market. However, this procedure is
rejected under the hypothetical-monopoly test.275 On the other hand, firms producing goods of
different degrees of substitutability will induce different effects on competition which are not
captured by the firms’ market shares. In such cases, one might define a sub-market within the
relevant market in order to take into account only the suppliers of close substitutes. On the one
hand, this would allow the problem of ‘‘localised competition’’ to be analysed in this way. On
the other hand, however, important constraints imposed by demand-side substitution would
remain unconsidered.276 It follows that the effects of the loss in ‘‘localised competition’’ should
not be captured by forming sub-markets, but rather by assessing the competitive conditions in
the relevant market. Adjusting or weighting market shares is rather arbitrary and is thus not a
satisfactory solution.277 For these reasons, the aspects of market definition and market shares
should be given less weight in the analysis of markets with differentiated products. Instead, the
focus should be on a direct analysis of the competition constraining effects induced, e.g. by a
merger.278
(gg) Market definition in the case of price discrimination. Some markets are char- 1–8–205
acterised by several groups of consumers who differ in various respects, e.g. their willingness to
pay for a good. This enables a firm to price discriminate between groups that face different
substitution possibilities. If a hypothetical monopolist is able to raise the price of its product by
5 to 10 per cent over a considerable length of time, the relevant market will comprise not only
the relevant product and geographical market but also the corresponding group of con-
sumers.279 In order for price discrimination to be feasible, a number of conditions have to be
satisfied. For instance, arbitrage between different groups of consumers must be precluded, or
else this would undermine any attempt to price discriminate. Furthermore, the hypothetical

271
With respect to interdependence of the relevant product and geographical markets, cf. Werden, 1983,
552–555.
272
Camesasca/van den Bergh, 2002, 163; Van den Bergh, 1996, 84–85.
273
Baker/Coscelli, 1999; Baker/Wu, 1998, 277; Maisel, 1983, 52; Werden 1993, 524; Werden, 1997, 369.
The effects of mergers in markets with differentiated products are analysed in Sections VII.3.(c) and (d).
274
Baker/Wu, 1998, 278.
275
‘‘There is no place for submarkets within this basic analytical framework. If a firm’s market power is
effectively limited by the existence of substitute products to which a significant number of customers would
turn should the firm raise prices above competitive levels, then those products should be included in the
relevant product market. Market shares computed in any smaller market will provide misleading inferences
as to the firm’s control over prices and output.’’ Maisel, 1983, 50. Similar arguments are put forward by
Simon/Williams, 1993, 816f; Werden, 1983, 574f.
276
Maisel, 1983, 52; Glick/Cameron/Mangum, 1997, 128 et seq.
277
Maisel, 1983, 53.
278
‘‘But it is ultimately not the best way to approach unilateral competitive effects because market
definition is generally not very helpful as a first step in assessing the potential loss of localized competition. I
have argued elsewhere that antitrust doctrine can be expected to this situation by giving a greater role to
direct evidence of harm to competition in evaluating mergers among sellers of differentiated products.’’
Baker, J., 2002, 218.
279
Frankena, 2001, 375, Geroski/Griffith, 2003, 9, Pitofsky, 1990, 848f., Werden, 1983, 529; Werden,
1984, 662

Kerber/Schwalbe
270 Part 1: Introduction

monopolist has to be able to identify the various groups of consumers. These conditions,
especially the ability to identify different consumer groups, are hard to verify. However, when
price discrimination is a well-established practice with respect to the product in question, this
provides strong evidence that a hypothetical monopolist will also price discriminate. The
relevant market must then be defined by taking into consideration different groups of con-
sumers that are subject to price discrimination.280
1–8–206 (hh) Aftermarkets. Specific problems with respect to market definition may arise in the
case of products that are used only in combination with another product, e.g. spare parts for
cars or toner cartridges for printers. Generally speaking, this is the case when a primary product
like, e.g. a car or a printer is bought first, and the consumer needs secondary products later to
be used together with the primary product. Without the secondary products the primary
product will be of little use, or none at all. The primary and secondary products thus form a
system that works properly only if both products are combined. Often, the technical specifi-
cations of the two products are such that, after purchasing the primary product, the consumer is
very restricted in his choice of substitutes for the secondary one. For example, once having
purchased a certain printer, the toner cartridges have to be compatible with this printer.
Consumers are said to be locked-in. In many cases, the producers of the primary good are at
the same time the sole suppliers of the compatible secondary good. Defining the relevant
market by the market for the secondary product only, the so-called aftermarket, will usually
imply very significant market shares, and thus the existence of market power.281 However, even
a 100 per cent market share in the aftermarket does not provide clear evidence of market
power. This would be the case only if the supplier of the secondary product were able to take
advantage of the consumers’ lock-in and raise the price of the secondary product significantly
above the competitive price. Nevertheless, consumers will take this into account when buying
the primary product, especially when the price of the secondary product amounts to a large
fraction of the total price of the system, or if the secondary product has to be replaced
frequently. Thus, an increase in the price of the secondary product will produce a reduction in
the demand for the corresponding primary product, provided that consumers have a suffi-
ciently wide range of substitutes. Therefore, it is not advisable to analyse the aftermarkets in
isolation, independently of the market for the primary good. The supplier of a primary good
will not raise the price of the secondary one if consumers take this price into account when
purchasing the primary product, and switch to another primary product as a consequence. In
such a case, the market for the secondary product does not constitute a relevant market.
Instead, the relevant market is the market for the system, i.e. primary and secondary products
combined. Alternatively, if consumers do not have sufficient substitutes for the primary good
from which to choose, the supplier of the system has an incentive to raise significantly the price
of the secondary product. In this case, the aftermarket is to be defined as the relevant market.282
1–8–207 (ii) Innovation markets. In the context of dynamic efficiency it has seen proposed that
special innovation markets be defined as separate relevant markets.283 The term ‘‘innovation
market’’ refers to a market for research and development rather than a market for goods. An
innovation market comprises all R&D activities that refer to the development of new products
or processes, as well as to close substitutes for these R&D activities. The latter includes such
R&D activities, technologies, and products that restrict the use of market power with respect
to the research and development under consideration. This type of market power may occur,
e.g. if, as the result of a merger, the firm uses one research laboratory only instead of two. This
will result in a decline in the rate of technical progress. The concept of an innovation market
could be better able to capture these effects on the incentives to innovate, and could provide a
more suitable framework for the analysis of questions concerning competition with respect to
products to be developed as compared to the usual methods of market definition. However,
this proposal has been severely criticised on several grounds.284 First of all, it is argued that there
is only a weak relationship between the degree of concentration, R&D expenditure and
innovation in a market. This means that no unambiguous conclusions can be drawn regarding

280
Maisel, 1983, 55–57. However, when there is price discrimination, defining the relevant market may
turn out to be difficult in practice. (Hausman/Leonard/Vellturo, 1996.)
281
Bishop/Walker, 2002, 123–125, 205–209; Klein, 1998; Motta, 2004, 111–113; Shapiro, 1995; Shapiro/
Teece, 1994.
282
A more precise analysis of abusive conduct is given in Sections VIII.2 and VIII.3.
283
Gilbert/Sunshine, 1995a.
284
Carlton, 1995, Eiszner, 1998, Hay, 1995, Hoerner, 1995, Rapp, 1995. A reply to this criticism is given
by Gilbert/Sunshine, 1995b. Davis, 2003, provides a survey on the debate.

Kerber/Schwalbe
G. Economic Principles of Competition Law 271

the effects of changes in R&D activities on the rate of innovation. This is why the concept of
innovation markets should be avoided, if possible. Instead, one should favour an analysis of the
actual and potential competition in the respective product markets. If no suitable product
market can be defined, since the products are not yet developed, the concept of an innovation
market might turn out to be useful. But then the market shares have to be interpreted with
caution. Innovations are primarily motivated by the aspiration of securing a patent. Therefore,
substantial competition is to be expected even in the case of only a few market participants with
large market shares.285
(jj) The cellophane fallacy. Another important aspect to be considered with respect to 1–8–208
market definition is the kind of competitive problem to be analysed by indirectly measuring
market power. For instance, when two firms merge, it is necessary to determine whether the
merger will create or strengthen market power. The analysis is prospective, and the starting-
point is usually the prevailing price. The question is whether a hypothetical profit maximising
monopolist would raise the price by a small but significant amount. This test determines the
products and geographical regions that restrict the hypothetical monopolist’s market power.
However, things are different when the task is to figure out if a firm already possesses sig-
nificant market power, e.g. when the abuse of a dominant position is suspected. In such a case,
the question whether market power would emerge, or be strengthened, i.e. the future com-
petitive conditions, is not the issue. Instead, the crucial point is the existing market power, i.e.
the present market conditions. In these cases, the analysis has to be retrospective. In such a
situation, applying the hypothetical monopoly test blindly gives rise to the danger of too broad
a market definition, and thus an underestimatiion of a firm’s market power.
The literature refers to this error as the Cellophane fallacy. It goes back to a US Supreme 1–8–209
Court’s decision in the Dupont case. Dupont, being the sole supplier of cellophane, argued that
cellophane alone did not constitute a relevant market, since there were close substitutes
available, such as tin foil or waxed paper, and other flexible packaging materials. As a con-
sequence, the court defined the relevant market to be so extensive as to include all flexible
packaging materials, and ruled that Dupont did not possess any market power because of its
small market share. However, the prevailing view is that, due to this broad definition of the
relevant market, Dupont’s market power was not recognised.286 It is conceivable that Dupont,
as a monopolistic supplier of cellophane, had already raised the price of this product, since a
monopolist will always set a price in the elastic range of the demand curve. A further increase in
price would cause consumers to switch to substitute goods, thereby reducing profits. The
reason is that, if a profitable price increase had been possible, the monopolist would probably
have already raised the price. By setting such an inflated price, the monopolist itself has created
competition from substitute goods. This is because, at such a high price, consumers consider
goods as substitutes that they would not have taken into consideration at a lower price. If
cellophane is very expensive, tin foil will become an interesting alternative. That is, products
that are substitutes at the monopoly price are not necessarily substitutes at the competitive
price.
However, to assess if market power exists, i.e. if a firm has already raised its price above the 1–8–210
competitive level, the starting-point for defining the market must not be the prevailing price,
but the price that would prevail under effective competition.287 Note that the cellophane fallacy
is not just a problem with regard to the hypothetical monopoly test, as is often alleged. Rather,
it may also occur with other methods of defining the market. For example, the fallacy may arise
when employing methods that rely on the functional exchangeability in the estimation of a
reasonable consumer, but then take into account the prevailing price instead of the competitive
one. Indeed, a similar method gave rise to the erroneous market definition in the Dupont case.
In general, it is not possible to define the relevant market independently of the prevailing
competitive problem. If the issue is the creation or strengthening of market power, then the
prevailing price will be the starting-point, and all products serving as substitutes at this price
will be included in the relevant market.288 If the issue is behaviour where market power already
exists, the products included in the relevant market will be those that serve as substitutes at the
competitive price.
(kk) Conclusions. A methodically correct application of the hypothetical monopoly test 1–8–211

285
Bishop/Walker, 2002, 122–123, Church/Ware, 2000, 727–728, Office of Fair Trading, 2002, 132–135.
286
Stocking/Mueller, 1955.
287
Bishop/Walker, 2002, 98–104; Office of Fair Trading, 2001; Werden, 2000.
288
This would also be the correct approach if market power was to be created or enforced by abusive
conduct.

Kerber/Schwalbe
272 Part 1: Introduction

whether market power exists is equivalent to the direct identification of market power directly.
The reason is that, if it were possible to determine the competitive price, market power would
immediately be verifiable, and it would not be necessary to define the relevant market. If,
however, market power can only be measured indirectly, then, from an economic point of
view, the basic concept of the hypothetical monopoly test should be adhered to as far as
possible.289 For this purpose, the following procedure has been proposed: The definition of the
relevant market has to be compatible with the principle of demand and supply-side substitu-
tion, and the goods have to serve as substitutes at least at the prevailing price, or else the goods
will not be considered substitutes at a lower price either. Further criteria may be taken into
consideration, such as functional interchangeability or physical characteristics. Then, the effects
of differences in these properties on the consumers’ switching behaviour must be taken into
account, if possible by conducting empirical studies.290 In this context, the analysis of price
concentration is an important method.291 These considerations may also be taken into account
when it is suspected that the merging firms already possess considerable market power, e.g. by
co-ordinating their behaviour.
1–8–212 It is important to note that the hypothetical monopoly test primarily provides a conceptual
framework for dealing with the question of market definition on the basis of economic
considerations. The focus is on the competitive constraints posed by demand and supply-side
substitution that constrain market power. The relevant market is defined conceptually in such a
way that the firms’ market shares reflect their respective market power as precisely as possible.
This is the case when the relevant market comprises all products and geographical regions that
pose constraints on a firm’s market power, and at the same time excludes all products and
geographical areas that do not constrain it. Since the hypothetical monopoly test is quantita-
tively framed, it is often erroneously interpreted as an empirical method. However, this
interpretation ignores the fundamental difference between the hypothetical monopoly test as a
concept on the one hand and the implementation of this concept on the other, where the latter
may be carried out by empirical methods. In any case, quantitative methods are a priori
independent of the concept used to define the relevant market. What matters is not the
quantitative formulation of the hypothetical monopoly test but rather the economics based
approach to defining the relevant market, and assessing market power.292
1–8–213 (c) Empirical methods of market definition. This section contains a brief outline of
the empirical methods and concepts that are most relevant to market definition.293 First, it
describes those methods that enable the direct implementation of the hypothetical monopoly
test. Then it outlines briefly the most important methods which use price tests in order to
determine the products to be included in the relevant market.294
1–8–214 (aa) Price elasticity of demand, critical elasticities and critical sales loss. Whether
or not a profit maximising monopolist will effect a small but significant increase in price
depends on the price elasticity of demand, or of residual demand, as the case may be, and on its
cost structure. This is why information on the price elasticity of demand has to be available in
order to implement the hypothetical monopoly test directly. If demand is very elastic, a
hypothetical monopolist will often not possess market power in the market under considera-
tion. Further products and geographical areas will have to be added to this market until the

289
‘‘But despite those difficulties it raises, the cellophane fallacy does not imply that a new theoretical
framework to defining relevant markets is required. On the contrary, the framework embodied in the
SSNIP test, with its focus on competitive constraints, continues to provide the correct theoretical fra-
mework.’’ Office of Fair Trading, 2001, 29.
290
Office of Fair Trading, 2001, 20–30.
291
Section IV.7.(c)(cc).
292
‘‘It is important to recognise that although the test is formulated in a quantitative way (i.e. it considers
the profitability of a 5–10 per cent price rise across all products in the set), the value of the test lies in its role
as a conceptual framework within which to view evidence of competition between products, rather than as
a formal econometric test to be rigorously applied in all cases.’’ Office of Fair Trading, 2001, 10, c.f. also
Werden, 1983, 571.
293
Bishop/Walker, 2002, 317–454, Lexecon, 2003, Office of Fair Trading, 1999.
294
Only the best known and most common methods are devised here. We do not go into the details of
some of the very complex econometric models like causality analysis, cointegration, etc. This is done by
Bishop/Walker, 2002, and the literature cited there.

Kerber/Schwalbe
G. Economic Principles of Competition Law 273

price elasticity has reached a sufficiently low value such that a 5 per cent increase in price will
maximise profits.295
In the literature, a number of methods have been proposed to estimate demand functions 1–8–215
and residual demand functions.296 The elasticity of the estimated function can then be deter-
mined easily. The empirical methods used to estimate demand functions are based on a so-
called regression analysis.297 The demand for a product is considered as a function of other,
independent variables such as the price of the good, the prices of substitutes and complements,
etc. The shape of the curve is then estimated by econometric methods. Furthermore, it is
important to choose a suitable time horizon for the analysis since, e.g. in the case of durable
goods, in the short run, demand will react to a lesser degree than in the long run. Estimation of
the residual demand further requires that the reactions of potential competitors be taken into
account. By means of statistical tests one may determine the robustness of the estimated
demand function. However, a regression analysis requires long time series of data that should
be derived preferably under stable conditions of supply and demand to determine the shape of
the demand curve precisely. The econometric methods used for such estimations are usually
rather complex. They require a considerable amount of time, and, in most cases, can only be
carried out by econometricians.
However, information on the elasticity of demand on its own is not sufficient in order to 1–8–216
find out whether or not a hypothetical monopolist will profit from a price increase. In addition,
information on the firm’s costs, or rather its profit margin, i.e. the difference between price and
marginal cost is necessary. This information is then combined in order to find out whether or
not a significant increase in price will be profitable. Recently, competition policy has often
used the concepts of critical elasticity and critical sales loss,298 as complementary to the analysis
of demand. The critical elasticity of demand indicates the maximal value of the price elasticity
of demand such that a hypothetical monopolist will increase the price by at least 5 per cent. If
the actual elasticity exceeds this value, such a price increase will be unprofitable, and the
relevant market definition will have to be broader. The critical sales loss is the maximal value
by which the quantity sold by a hypothetical profit maximising monopolist may decrease such
that it will raise the price by, e.g. 5 per cent. If the sales loss exceeds this value, a 5 per cent
increase in price will not be profitable and a broader market definition will be expedient. If the
sales loss falls short of this critical value, a 5 per cent price increase will be profitable, and the
relevant market will be defined.
Both the critical elasticity and the critical sales loss usually depend on the price increase 1–8–217
under consideration, the profit margin, and the presumed shape of the demand curve. The
larger the assumed increase in price, the smaller is the critical elasticity, since major price
increases are profitable only if demand is inelastic. Analogously, the critical sales loss increases as
the price rises: in the case of a 10 per cent price increase, a larger sales loss is compatible with
profit maximisation than in the case of a 5 per cent price increase. This is because, in the former
case, there is a larger per-unit profit. A similar relationship exists between the profit margin and
the critical elasticity, or the critical sales loss, respectively. If the profit margin is large, the
consumers’ reactions will affect profits considerably. This is why the critical elasticity is smaller
in the case of a larger profit margin. Similarly, in the case of high profit margins, the adverse
effect of a sales loss on profits is considerably more pronounced than in the case of low profit
margins. Therefore, the critical sales loss decreases with increasing profit margins. The effects of
the shape of the demand curve on the critical elasticity and the critical sales loss are usually not
significant when the price increase is small.299 As a second step, the critical elasticity and the

295
With respect to the question of what products to add to the candidate market, cross-price elasticities
and diversion ratios can offer clues.
296
Baker, J./Bresnahan, 1988, Baker, J./Bresnahan, 1992, Froeb/Werden, 1991, Scheffman, 1992. Demand
systems are also estimated, primarily in the context of the quantitative analysis of effects arising from
mergers. These systems will be presented in Section VI.3.(e)(aa). They can also be applied to questions of
market delineation.
297
Fundamental presentations of regression analysis are given by, e.g. Gujarati, 1995, Hübler, 1989, or
Greene, 1993. An introduction within the framework of competition analysis is presented by Bishop/Walker,
2002, 327–350.
298
‘‘Over the last decade, critical elasticity and critical loss analyses have become standard analytical
tools; they are now used in the investigation and litigation phase of most merger cases.’’ Werden, 2002b, 14–
15. Danger/Frech III, 2001; Langenfeld/Li, 2001; O’Brian/Wickelgreen, 2003; Werden, 1998; Werden, 2002c;
Werden/Froeb, 2002.
299
Werden, 1998, 389–390.

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critical sales loss are compared with the actual elasticity of demand and the actual expected sales
loss, respectively. The actual elasticity is estimated either by econometric estimates or by
approximation on the basis of, e.g. consumer surveys. If the critical elasticity exceeds the actual
one significantly, there is a high probability that this is the relevant market. The extent of the
sales loss may as well be determined by econometric estimates, or by other methods such as,
e.g. diversion ratios or shock analyses.300 The main contribution of the concepts of critical
elasticity and critical sales loss is to provide a benchmark for measuring consumers’ actual
conduct.
1–8–218 With regard to critical elasticities and critical sales loss, a number of issues must be taken into
account. For one thing, the profit margin made by a hypothetical monopolist has to be
determined, which might give rise to difficulties.301 The profit margin, i.e. the difference
between price and marginal, or average variable cost that is often used to approximate the
former, is higher when fixed costs form a large part of total costs. A high profit margin,
however, implies the critical sales loss to be low. Thus, even a small sales loss will render any
price increase unprofitable, and the market has to be extended.302 Further problems associated
with using the critical elasticity or the critical sales loss may arise if consumers differ significantly
in their price elasticities of demand, if marginal costs (or average variable cost) differ widely
across production plants or if there is a considerable amount of avoidable fixed costs. Including
differentiated goods in a relevant market requires that the substitution possibilities be taken into
account.303 Moreover, as with any method relying on the prevailing market price, the danger of
the cellophane fallacy arises. If the prevailing price is already inflated because of existing market
power, the critical elasticity and the critical sales loss will be underestimated, and the market
definition will be too broad.304
1–8–219 (bb) Cross-price elasticities and diversion ratios. In the course of the algorithmic
procedure used to define a market by means of the hypothetical monopoly test, further
products and geographical areas are added to a candidate market until the relevant market is
defined. As a first step, the candidate market is extended to the closest substitutes for the
products in this market. In order to determine these products, the concepts of cross-price
elasticity and diversion ratios may be useful. The cross-price elasticity, however, brings with it
the danger that a product that is consumed in a very small quantity only, i.e. a product that is
not a close substitute, displays a high cross-price elasticity. However, in many cases a high
cross-price elasticity may be expected between two products that belong to the same market.
Alternatively, the degree of substitutability between two products can be measured by the so
called diversion ratio. The diversion ratio between two products, 1 and 2, is defined by the
ratio of the cross-price elasticity of good 1 to a change in the price of good 2 together with the
price elasticity of demand of good 1. It indicates the size of the proportion of demand switching
from product 1 to product 2 when the price of product 1 rises. For instance, a diversion ratio of
0.75 between products 1 and 2 means that 75 per cent of the total reduction in demand for
good 1 shift to good 2. The remaining 25 per cent shift to other products. In this case, good 2 is
the closest substitute, and it should be the next one to be included in the candidate market.305
1–8–220 (cc) Price tests. These empirical methods allow a direct implementation of the hypo-
thetical monopoly test with respect to the relevant product market. However, a direct
implementation may cause problems, e.g. when there are no data available, the quality of the
data is insufficient or the time frame is not long enough for an exact quantitative analysis. In
such cases, there are a number of other empirical methods to determine at least indirectly the
products that impose competitive constraints on market power and which should therefore be
included in the same market. Most of these methods are based primarily on the development of
the prices of various potential substitutes as, e.g. price-correlation analysis, stationarity analysis
and shock analysis. With regard to the relevant geographical market, data concerning the trade

300
Section IV.7.(b)(bb); Section IV.7.(b)(cc).
301
This problem has already been dealt with in Section IV.7.(a).
302
Danger/Frech III, 2001, 339; Langenfeld/Li, 2001, 303.
303
Regarding the analysis of the critical loss in demand with differentiated goods, O’Brian/Wickelgreen,
2003 is a good reference.
304
However, if the price elasticity of demand increases with the price when there is no market power,
the reverse of Cellophane fallacy might occur: The critical elasticity will be determined at the lower,
competitive price, but not at the higher price a hypothetical monopolist would charge. In this case, the
market definition will be too narrow, and market power will be overestimated. (Froeb/Werden, 1992.)
305
Baker/Coscelli, 1999; Bishop/Walker, 2002, 371–375; Shapiro, 1996.

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G. Economic Principles of Competition Law 275

flows between the respective areas provide helpful information, as well as data on prices and the
development of these prices.306
Price-correlation analysis is based on the observation that the prices of two goods 1 and 2 1–8–221
that are close substitutes will develop in the same manner over time. When the price of good 1
increases, some consumers will switch to good 2. As a result, the demand for the substitute
good 2 will increase, which in turn will cause the price of good 2 to rise as well. Further, some
suppliers of good 2 will switch to producing good 1, which again tends to reduce its price.
Both effects imply that there is a positive correlation between the two price movements.307
This correlation is an indicator of the closeness of the relationship between the price changes of
the two products. It is measured by the correlation coefficient that lies between –1 and +1. A
correlation coefficient close to 1 means that both goods’ prices behave almost identically. Note
that what matters here is not the absolute magnitude of the prices but rather whether or not the
prices develop in the same way. Differences in the absolute magnitude of the respective prices
may be due to (either actual or perceived) differences in quality, such as trade marks and non-
branded products. Moreover, it could be that a product by itself constitutes a relevant market
even if the correlation coefficient is high, i.e. if there is a close substitute available. This is the
case when the competitive pressure posed by the substitute does not suffice to prevent market
power. Thus, a high correlation coefficient is necessary, but not sufficient, for the inclusion of
both goods in the relevant market.308
To determine the value of the correlation coefficient (0.5, 0.7, or 0.9) which guarantees a 1–8–222
substitution possibility sufficiently close in order to include the products in the same market,
so-called benchmarking is employed.309 Benchmarking considers the correlation coefficient of
the time series of the prices of the respective products, where there is no doubt that these
products belong to the same relevant market (e.g. two brands of carbonated mineral water). If
the correlation coefficient of two goods exceeds this value, then the products are considered as
belonging to the same relevant market. In this context, the problem of spurious correlation
may arise. Consider an input factor that is essential for the production of two unrelated goods.
An increase in the price of this input will cause the prices of the two goods to respond in the
same way. Thus, the goods seem to be substitutes, whereas in fact they are not. To avoid this
problem, one must take care to eliminate those price effects resulting from commonly used
input factors. Likewise, prices have to be adjusted by deducting seasonal fluctuations and
general price trends. Another difficulty is that there might be a time lag before the price of a
good reacts. Thus, the price correlation will seem to be negligible, although the products are in
fact close substitutes, and the long-run correlation is significant.310 It follows from these
arguments that the results of a price-correlation analysis have to be interpreted with caution.
However, a low correlation coefficient will, in most cases, imply that the two goods do not
belong to the same relevant market. That is, this method is better suited to refute a hypothesis
than to prove it.
A related concept is that of stationarity analysis, where the development of the price ratio of 1–8–223
two products, or the price ratio of a product in two different geographical areas, is observed
over a period of time.311 When the price ratio remains static, i.e. when it is equal to a constant
value, or when it returns to this long-run value after an exogenous disturbance, it is likely that
both goods belong to the same relevant market. If the price of one good rises, the price ratio
will change, and consumers will switch to the good that is now relatively cheaper. However,
this will increase the demand for the relatively cheaper good, which in turn will cause its price
to increase. As a consequence, the price ratio will return to its original value. The faster this
happens, the more likely it is that both goods belong to the same relevant market. This analysis
may be extended in order to determine whether several products belong to the same relevant
market. For this purpose, the price ratios are determined with respect to a reference price. The
next step is to check if all these price ratios remain static over time. If this is the case, there is a

306
Note that these so-called price tests do not answer the fundamental question of competitive con-
straints to market power. This should always be kept in mind when applying them.
307
The first application of price-correlation analysis to the definition of the relevant market was sug-
gested by Stigler/Sherwin, 1965. cf. Bishop/Walker, 2002, 378–403; Lexecon, 2003, 5–8; Office of Fair Trading,
1999, 53–55.
308
Bishop/Walker, 2002, 382.
309
Bishop/Walker, 2002, 392–394; Lexecon, 2003, 7.
310
Sometimes this can already be ascertained by graphically depicting the price series, Office of Fair
Trading, 1999, 55.
311
Lexecon, 2003, 9–13.

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high probability that the goods belong to the same relevant market. The stationarity analysis
avoids some of the problems related to a price-correlation analysis. First, the effect of a
common cost factor is automatically eliminated in the formation of the price ratio. Secondly,
time lags in the price adjustment process are taken into consideration. This is why, in most
cases, a stationarity analysis offers more reliable results than the analysis of the price correlation.
1–8–224 Another method to determine whether two goods belong to the same relevant market is the
so-called shock analysis.312 In most cases, this analysis is easy to carry out since only few data are
necessary. Where a market has been subject to sudden and unexpected fluctuations in demand
or supply, these are referred to as shocks. On the basis of the evolution of the prices after the
shock, one attempts to infer information on whether or not the goods belong to the same
relevant market. Such a shock would typically be, e.g. the introduction of a new product by a
competitor, a strike, or the introduction of a new technology. For example, if a novel product
is introduced at a low price, one would expect products in the same relevant market to react to
the shock in a similar fashion. If, however, only the prices of some established products react
while others do not, then this difference in conduct implies that the latter goods are not in the
relevant market.
1–8–225 Shock analyses are also useful for defining the relevant geographical market. For instance, if
the question is whether the relevant geographical market contains several countries, one would
observe the price variations of the product in the various countries after one product has been
subject to a shock, e.g. a significant rise in consumption tax or in the exchange rate. If, after
some time, the price ratio approaches the pre-shock level in two countries, this will indicate
that the relevant market comprises both countries. Otherwise, i.e. if the shock has altered the
price ratio permanently, the countries probably form separate geographical markets.
1–8–226 (dd) Defining the relevant geographical market. A further method of defining the
relevant geographical market results from the analysis of trade flows and transport costs. This
test is also known as the Elzinga-Hogarty Test. It is the first empirical method employed to
define the relevant market.313 The test is based on the definition of two criteria from which
inferences can be drawn with respect to the degree of ‘‘openness’’ to imports and exports of a
certain region. If the trade flows are such that a large proportion of domestic consumption is
covered by imports, then foreign firms are able to export their goods to the region under
consideration, and thus constrain the domestic firms’ market power. On the other hand, if
imports are not considerable, but a large proportion of production is being exported, this
implies that the relevant market is larger than the region under consideration. Evidently,
transport costs are not high enough to prevent exports. The criteria referred to above measure
these two effects. One of them is called LIFO (little in from outside). It is defined by the
proportion of total consumption in the region covered by domestic production. When this
factor is large (close to one), little is imported. The other measure is called LOFI (little out from
inside). It is defined by the ratio of production remaining in the region and total production in
this region. If this ratio is high, exports from the region are low. A separate relevant geo-
graphical market is assumed if both measures exceed 0.7, or their average exceeds 0.9. The
results of the Elzinga-Hogarty test provide evidence for the correct definition of the relevant
geographical market. Note, however, that the test does not answer the central question
concerning market power, namely whether a hypothetical monopolist would be able to sig-
nificantly raise the price in the region under consideration. In this sense, the test should be
interpreted as follows: if imports into the region are considerable, i.e. if the LIFO is low, it may
be assumed that this region does not constitute a relevant geographical market.
1–8–227 In some cases, data on transport costs allow for the hypothetical monopoly test to be carried
out in order to define the relevant geographical market. The question is whether an increase in
the price in a certain region will offer an incentive for producers from other regions to supply
the good in the region with the higher price. In such a case, these suppliers constrain the
market power of the domestic firm. At the original price it was probably not worthwhile for
producers from other regions supplying the area in question because of high transport costs.
After a price rise, however, this may well be worthwhile. To ascertain this, information on
transport costs is indispensable. In order to define the relevant geographical market, a number
of econometric methods have been developed in recent years, in addition to the analyses of
trade flows and transport costs. These methods focus primarily on the evolution of prices in

312
Bishop/Walker, 2002, 323–326; Lexecon, 2003, 34–36.
313
Elzinga/Hogarty, 1973. A clear presentation of this test is provided by Bishop/Walker, 2002, 404–418,
while Werden, 1981, supplies critical comments.

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G. Economic Principles of Competition Law 277

different regions.314 Therefore, these methods in principle correspond to those used to define
the relevant product market, i.e. correlation and stationarity analysis. However, the methods
have to be modified to be applicable to the definition of the relevant geographical market.
(ee) Conclusions. In recent years a number of empirical methods have been developed to 1–8–228
carry out market definition within the framework of the hypothetical monopoly test, either by
a direct implementation through estimating elasticities, or by indirect methods such as various
price tests. This is due primarily to a better availability of data (e.g. scanner data), the devel-
opment of computer technology and the corresponding advances in econometric methods.
These methods differ in their complexity, and in their data requirements. Some methods, like
the estimation of elasticities of residual demand functions, require elaborate econometric
analyses and place stringent demands on both the quantity and the quality of the data. Such
methods can only be conducted by specialists. Other methods, such as shock analysis, are easy
to implement and often require few data. Note that different methodological approaches may
be applied to the same problem, and affect the results. Therefore, an empirical analysis must set
out the methods used, the underlying assumptions, and the data employed, in order for the
results to be reproducible. An objective debate on which are the suitable methods and the most
sensible assumptions may then follow. Even with few data, an empirical analysis should be
conducted whenever possible in order to make sure that the market definition derived from
theoretical considerations does not (at least not obviously) run counter to the empirical facts.
There may, of course, be cases where sufficient data are not available, or where the time
horizon does not allow for an empirical analysis. However, this does not challenge the concept
of the hypothetical monopoly test as such. In order to define a market according to economic
principles the constraints on market power posed by supply and demand-side substitution have
to be identified, which is achieved by the hypothetical monopoly test.
8. Potential competition and barriers to entry. The model of long-run equilibrium has 1–8–229
shown that free market entry and exit are indispensable preconditions for the restriction of
market power, and for achieving allocative and productive efficiency. If some firms in the
market possess market power and make positive profits, this will induce other firms to enter the
market. If market entry and exit are free, market structures displaying imperfect competition,
such as monopoly or oligopoly, where considerable profits are earned, will be transformed into
competitive markets.315 Conversely, market power can persist in the long run only if market
entry is restricted. For this reason, the analysis of market entry and exit is essential to the analysis
and assessment of market power.
(a) Potential competition. The theory of contestable markets has drawn attention to the 1–8–230
fact that, under certain conditions, market power will be constrained not only if entry actually
takes place. Instead, potential competition, i.e. the threat of market entry on the part of other
firms, suffices to force even a monopolist to act like a firm under perfect competition.316 This
theory is based on a number of rather restrictive assumptions. First, all firms, established as well
as the newcomers, are assumed to have access to the same technology, and there are no sunk
costs .317 Secondly, it is assumed that firms can enter the market without any time lag, that they
can produce any technically feasible quantity and that they can exit from the market imme-
diately without incurring any cost. Finally, the period required by the established firm to adjust
its price must exceed the period required by the other firms to be able to exit from the market.
If these conditions are satisfied, a market will be contestable. In this case, even a monopolist
with a market share of 100 per cent has to charge the competitive price. At a higher price, and
therefore ensuing higher profits, another firm will enter the market immediately, undercut the
monopoly price by a small amount, earn positive profits and then quit the market just before
the established firm is able to react.318 The mere threat of such a ‘‘hit-and-run entry’’ to a
contestable market suffices to induce the same outcome as perfect competition. The number of

314
Haldrup, 2003.
315
The theory of monopolistic competition, however, has shown that, under certain conditions, more
firms will enter the market than would be socially optimal. A similar result holds for Cournot oligopoly.
Mas-Colell/Whinston/Green, 1995, 408.
316
The theory of contestable markets was developed by Baumol/Panzar/Willig, cf. as well Baumol/
Panzar/Willig, 1982; Section III.4.(c); Spence, 1983; Baumol/Willig, 1986.
317
The sunk cost is defined by the fraction of fixed costs that could not be recovered even if the firm
closed down, e.g. expenses on advertising campaigns.
318
In the case of technologies displaying increasing returns to scale, the welfare-maximising outcome
(price equals marginal cost) will not prevail in a contestable market. However, at least the second best
outcome (price equals average cost) wil result.

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278 Part 1: Introduction

firms in the market, and thus their market shares, are irrelevant if the market is contestable.
However, this model is not robust since even a small change in any of the assumptions will
drastically alter the results. If a firm incurs even a small sunk cost on entering the market, such
as, e.g. promotional expenses, and the established firm is able to adjust its price quickly, as is
almost always the case in reality, potential competition will no longer be effective: if a new firm
enters the market, it has to sink costs. Since the established firm reacts immediately to the new
entrant’s lower price, the latter will not make positive profits, and thus not enter the market in
the first place. The combination of sunk costs and the time it takes the established firm to react
is of major importance: the higher the sunk costs incurred by the newcomer, the slower must
the established firm be to react in order for a newcomer to be able to cover these costs and
make positive profits in this market. Despite this fundamental weakness of the model, it has
drawn attention to the roles of potential competition and sunk costs in relation to market entry.
If market entry (and exit) do not incur high sunk costs, the possibility of such uncommitted
entry will have a greater effect on the established firm’s conduct, compared with the case where
only committed entry is possible, i.e. that considerable sunk costs have to be incurred.
1–8–231 (b) Barriers to entry. The theory of contestable markets has shown that even where high
profits prevail in a market this does not necessarily imply market entry. In the example above,
the combination of sunk costs and the quickness of reaction on the part of the established firm
presents a barrier to entry. The concept of a barrier to entry is one of the most disputed in
industrial organisation theory, and numerous definitions have been proposed. The first of these
dates back to Bain, who defined the height of a market barrier by the extent to which the
established firm is able to raise the price of its product above the competitive level without
inducing market entry.319 According to Stigler, in contrast, a barrier to entry exists if a new
entrant incurs costs that are not incurred by the established firm.320 Von Weizsäcker extends
this definition by explicitly considering welfare effects such that a barrier to entry exists only if
it implies a decrease in welfare.321 Gilbert defines a barrier to entry by the additional profit
made by a firm as a result of being the first in the market; the rent to incumbency.322 While
Bain’s definition focuses on the incumbents’ profits, Stigler and von Weizsäcker emphasise the
cost differences faced by established firms and newcomers. Gilbert noted the established firm’s
first mover advantage. The more recent debate on potential competition and barriers to entry
has identified three fundamental aspects that are of importance for competition policy with
respect to the assessment of market entry: first, the role of the sunk costs incurred by a
newcomer, secondly, as emphasised by modern industrial organisation theory, the role of
expected profits that are affected by the mode of competition after market entry has taken
place, and thirdly, the strategic interaction between incumbents and newcomers.
1–8–232 These considerations give rise to a distinction between absolute and strategic barriers to
entry.323 Absolute barriers to entry grant the incumbent firm an absolute cost advantage over
the newcomers. Absolute barriers include most of the barriers imposed by the government,
legal barriers such as state monopolies, licences, e.g. for taxis, landing rights at airports, or
patent protection. Likewise, the exclusive access to better inputs, or the control of an essential
facility may pose an absolute barrier to entry.324 Strategic barriers to entry are divided into those
that arise from a first-mover’s advantage, those resulting from abusive conduct, and those that
are due to vertical constraints. In general, strategic barriers to entry serve the purpose of
rendering market entry unprofitable, either by raising the newcomer’s costs or by reducing its
revenue.
1–8–233 A firm which is established in a market has often incurred considerable sunk costs, e.g. of
initial investments, promotion, or investment in R&D. On the other hand, it enjoys increasing
returns to scale due to its quantity produced, or learning-curve effects, that serve as barriers to
entry. This is the case if, e.g. the minimal optimal plant size of a firm is only reached at a
quantity that supplies a significant proportion of the market.325 A new entrant supplying a
correspondingly huge quantity would make the price fall to such a low level that no profits

319
Bain, 1956.
320
Stigler, 1968; Baumol/Willig, 1981.
321
von Weizsäcker, 1980.
322
Gilbert, 1989.
323
This distinction is dealt with by Harbord/Hoehn, 1994. In the literature, other classifications are
employed as well, e.g. governmental, structural, and strategic barriers to entry. (Schmidt, I., 2005, 69–73.)
324
Essential facilities are discussed in Section VIII.3.(e), and also in Section IX.3.(d).
325
In the extreme, the optimal plant size might be so large that a single firm suffices to supply the entire
market at minimal average cost. This case of natural monopoly is analysed in Section IX.1.

Kerber/Schwalbe
G. Economic Principles of Competition Law 279

would be realised. If the firm entered with a small, sub-optimal, quantity, it would incur higher
costs than the established firm, and again be unable to make any profits. This situation is prone
to arise where there are considerable sunk costs. The incumbent may even amplify these effects
by behaving strategically, e.g. by installing excess capacity,326 by endogenous sunk costs327 such
as R&D expenditure, or by strategic excess production in order to achieve learning-curve
effects in a shorter time. All these strategies will raise the newcomer’s costs.
Barriers to entry may also be present in markets with network effects. Network effects occur 1–8–234
in industries where the utility of a good increases with the number of users. A distinction can
be made between physical networks, such as the telephone network, and virtual networks
existing between complements, e.g. computer operating systems and user software.328 Network
effects lead to economies of scale in consumption, rather than in production. As more users are
connected to a telephone network each of them has a larger number of potential partners to
communicate with. The more consumers use a certain operating system for their computers,
the more software will be developed for this system. Such network industries tend to be
supplied by only a few firms, or even a single one, since they are characterised by feed-back
loops: if there are already many consumers connected to a physical network, more and more
other consumers will also choose this network. Or, if many consumers have installed a certain
operating system on their computers, there will be a lot of software available for this operating
system, and a new consumer will also decide to install this system. The problem facing a firm
that plans to enter the market is to attract a large number of customers for its product quickly in
order to capsize the market. However, this is sometimes impossible, even if the newcomer
actually supplies a superior product, especially when the so-called installed basis, i.e. the
number of consumers using the established product, is very large. As a consequence, entering a
market that is characterised by network effects may turn out to be difficult.329
The established firm gains benefits from product differentiation which are not available to 1–8–235
the newcomer. For example, advertising expenditure is likely to exhibit returns to scale since a
television advert may be broadcasted in a certain region as well as nationwide. Since a firm
determines its own advertising expenditures, these constitute endogenous sunk costs that may
be applied strategically, and pose a barrier to entry. Furthermore, advertising helps the
established firm build up goodwill on the part of consumers, and thus reduce the newcomer’s
revenues.330 In order to attract customers, the newcomer has to conquer this goodwill by
spending more on advertising, or setting a lower price, both of which will incur additional
costs. There is also the problem of so-called switching costs.331 Switching from one supplier to
another incurs a cost for the consumers, e.g. switching from the operating system which they
are used to, to another that they do not know how to handle, or switching from one bank to
another. These customers are subject to a lock-in, similar to that in network industries. A new
firm will first have to overcome this lock-in effect in order to be able to enter the market.
Firms use these switching costs strategically by increasing the installed customer base, or by
endogenously altering these switching costs, as in frequent-flyer programmes. Another option
is product proliferation by supplying a vast range of differentiated goods, as, e.g. in the case of
cornflakes. This will not leave a sufficient share of the market for the newcomer to be able to
make profits. Needless to say, an established firm will employ such strategies only if the costs
incurred by preventing other firms from entering the market do not exceed the profit which
they would lose were entry to take place, in which case competition will be intensified.
It is sometimes argued that the acquisition of capital is not a barrier to entry. However, this 1–8–236
view is rather doubtful. On the one hand, it is argued that a certain amount of capital be
necessary in order to be able to enter certain markets, but this holds as well for other markets
like, e.g. professional sports, which require specific talents.332 On the other hand, established
firms may attempt to hinder the potential entrants’ access to the capital market, such that a
barrier to entry is created. As yet, there is no unanimous conclusion. However, many firms

326
Dixit, 1980.
327
Sutton, 1991.
328
Economides, 1996; Shy, 2001b.
329
cf. Farell/Saloner, 1985; Katz/Shapiro, 1985; Katz/Shapiro, 1986; Laffont/Rey/Tirole, 1998.
330
Baldoni/Masson, 1984. On the other hand, such a firm would not be willing to engage in price
competition after entry, since it would lose a large amount of profits from its regular customers. In this case,
advertising would not pose a barrier to entry, since the established firm would not ract agressively. It
follows that the effect depends on the relative strength of the two effects. (Schmalensee, 1983.)
331
Klemperer, 1987a; Klemperer, 1987b; Office of Fair Trading, 2003a.
332
Bork, 1978

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280 Part 1: Introduction

consider restrictions to accessing the capital market as a barrier to entry. Therefore, they should
be taken into account.333
1–8–237 The abuse of a dominant position, in particular, limit pricing and predatory pricing, can
create barriers to entry. A firm that practices limit pricing sets a very low price in order to deter
entry, while predatory pricing aims at squeezing actual competitors out of the market through
strategic price-cutting. However, such prices may also well serve as a signal to potential
competitors, indicating that market entry is unprofitable. In this sense, such prices pose a barrier
to entry. Further, bundling and tying strategies can be employed as strategic instruments to
deter entry. These strategies will be analysed in detail in the section on abusive behaviour.
Vertical agreements, such as exclusive dealing contracts, can be used as a strategy to raise the
entry cost for potential entrants, and thus render entry unprofitable. Refusal to supply may
close a market and thus form a barrier to entry as may vertical mergers.
1–8–238 Empirical investigations reveal a close relation between the height of the barrier to entry on
the one hand, and concentration and profitability on the other. This is true with respect to
economies of scale as well as expenditure on advertising and R&D. Indeed, Sutton has shown
in two extensive studies that there is a close correlation between endogenous sunk costs,
advertising and R&D, and the level of concentration in a market.334 High endogenous sunk
costs imply a large optimal plant size, and thus a higher degree of concentration. This in turn is
linked empirically to low entry and exit rates. The existence of state-controlled barriers to
entry, or similar absolute barriers (e.g. patents, licences, essential facilities), is easy to ascertain.
Measures to determine the existence and the extent of barriers to entry have been derived from
empirical investigations. These include the ratio of expenditure on advertising or R&D to
revenue, the minimal optimal plant size determined by engineering data, and the rates of entry
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1–8–239 1. Introduction. A horizontal agreement is understood as any kind of co-ordination
between firms competing directly with each other. Well-known examples are (open or tacit)
collusion on prices, or agreements to increase prices (price cartels), as well as agreements to
divide the market such as between a French firm and a German firm that each will stop
exporting into the other country such that direct competition between these firms is excluded
(agreements on market division). Competitors may also agree on the quantities produced, or
on investment in new capacity, in order to affect the price by restricting output or capacities
(quantity cartels). Instead of colluding on prices directly, firms may agree discounts, payment
conditions, or the extent of guarantees (discount and condition cartels). In each case, buyers
face a wall of sellers that they can overcome only if there are independent suppliers outside the
cartel.

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Apart from cartels, there is a variety of other means for competitors to co-ordinate their 1–8–240
conduct, such as co-operation agreements, joint ventures, or strategic alliances, across a broad
spectrum of the most diverse phenomena. Thus, there are forms of organisation that focus on
co-ordinating prices, or on dividing the market, as cartels do. Firms often co-operate in order
to save costs or to develop new products or innovations, which would be impossible for a
single firm to do on its own. Agreements on joint research and development, rationalisation,
specialisation, or standardisation are further important examples. Co-operation on the part of
small or medium-sized firms, e.g. by forming buying syndicates, may well compensate for the
disadvantages these firms face as compared with larger competitors. Co-operation may also
occur where several firms create a joint venture. In this case, however, it may be difficult to
draw the line between a co-operative and a concentrative joint venture.
After all, any competition parameter available to the firms is potentially the subject of co- 1–8–241
ordination, and may reduce competition between the firms, or exclude it altogether. Some of
these horizontal agreements may, however, affect welfare positively, e.g. when they increase
the efficiency of production, or promote technological progress. Co-ordination among
competitors can take on a variety of different forms:
(1) Legally binding contracts. If firms co-operate, it stands to reason to that this co-operation be 1–8–242
based on a legal contract that is enforceable in court. This is the established practice for
co-operation on R&D, agreements on specialisation, and many other forms of co-
operation. In principle, firms could be free to contract to fix prices or quantities by setting
up a legally binding cartel agreement. This would solve the cartel members’ central
problem: making sure that all firms stick to the agreement since, in the case of a breach of
contract, adherence will be enforced by court (e.g. by imposing severe fines). In this case,
competition between firms would be constrained by a cartel contract.
(2) Collusion without legal enforcement. However, since cartel agreements with respect to prices, 1–8–243
quantities, and market division are illegal—for good reasons—competitors try to co-
ordinate their conduct without entering into a legally enforceable contract. For instance,
the managers of competing firms could meet regularly and co-ordinate their pricing
policies or, in the case of procurement bidding, e.g. for a public tender, co-ordinate their
bids in order to restrict competition. In principle, such constraints on competition may
lead to higher prices in a way similar to a contract. Nevertheless, since each competitor
has a strong incentive to offer lower prices secretly to potential customers in order to gain
additional orders, each cartel member cannot rely on the other members abiding by the
agreement. As a consequence, non-legal coordination must solve the problems of
supervising and enforcing the agreement.
(3) Co-ordination without explicit agreement. Apart from explicit and concious agreements, it is 1–8–244
possible for competitors to find themselves colluding without ever communicating
explicitly, or without even being aware of it. This is referred to as tacit collusion, or
conscious parallelism in economics. For instance, suppose that, over the years, an implicit
practice has emerged in an industry to raise prices every spring, with the market leader
determining the extent of the price increase and the others following (price leadership),
even though this conduct has never been explicitly agreed upon. In fact, such co-
ordination constrains price competition. However, the question arises as to whether
competition law can (or should) actually combat such conduct. This is because, in most
cases co-ordination is hard to distinguish from cases where competitors merely react in
the same way to exogenous shocks. For example, if wages or input prices in an industry
go up by a certain percentage, the firms’ independent maximisation of their respective
profits will produce a parallel price adjustment on the part of all competitors. From an
economic point of view, however, this is not to be considered as anti-competive.
In competition policy there is long-standing agreement on the negative effects and the anti- 1–8–245
competitive character of price co-ordination and price cartels. All approaches of competition
theory rank them among so-called hardcore cartels which restrict competition directly. The
same is true with respect to agreements on market division and on quantity restrictions. Such
practices lead to market power and give rise to excessive prices, inefficient quantities, a re-
allocation of economic surplus from consumers to producers, as well as reduced incentives to
produce efficiently. Because of these allocative and productive inefficiencies, hardcore cartels
reduce both total welfare and consumer surplus due to higher prices and/or inferior services.
Likewise, there will be reduced incentives to develop cost saving production processes and to
invent new products. For these reasons, most competition laws generally prohibit such hor-
izontal agreements (per se prohibition)—regardless of whether they result from a contractual
agreement or just from the firms’ informal co-ordination of their conduct. For the practice of

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competition law, the most important problem is how to proceed successfully against infrin-
gements of the prohibition.
1–8–246 The task of competition policy to assess other horizontal agreements, e.g. co-operation on
R&D, is much more difficult. On the one hand, such co-operation has an adverse effect by
restricting competition between direct competitors. On the other hand, however, it also
induces beneficial effects on economic welfare. Even though opinions have been divided with
respect to horizontal agreements, there is still a broad consensus in competition policy on the
usefulness of conducting differentiated assessments and treatments. The difficulty consists in
deciding if, and under what conditions, the positive effects of an agreement on innovation and
efficiency exceed the negative effects of constrained competition. As a consequence, in many
competition laws these considerations have given rise to the combination of a general cartel
prohibition, with more or less extensive exemption rules and, concerning the exemptions, to
the practice of either explicitly or implicitly weighing the disadvantages of constraining
competition against the economic advantages of such horizontal agreements.
1–8–247 This section is organised as follows; first, there is a description of how cartels work. As
legally binding cartel agreements are prohibited, there is an analysis of the main problem facing
price cartels, namely, how to make the members stick to the agreement? The conditions for
this to be achieved are discussed. The problem arises since each firm faces a strong incentive to
cheat (the inherent instability of cartels). This subject is dealt with extensively since it is of
major importance not only with respect to cartels but also with regard to the analysis of co-
ordinated behaviour in oligopoly. This also links to the later discussion of whether a merger
may give rise to so-called co-ordinated effects. The economic theory of cartels is then used to
analyse how to proceed against horizontal agreements which produce no noteworthy beneficial
effects on efficiency. The issues of how to deal with the practices used to sustain the stability of
a cartel, and what measures to employ to detect illegal cartels more easily are also dealt with.
The much-discussed topic of leniency programs is then examined. Finally, those horizontal
agreements which could be exempted from the prohibition of cartels are identified.
1–8–248 2. The theory of collusion. The analysis of different market structures above has shown
that a monopolistic supplier is able to earn higher profits than suppliers in markets where
competition prevails and where firms compete on prices, quantities, or innovation.336 For this
reason, firms in such a market have a strong incentive to escape the pressure of competition, or
to constrain it, in order to enjoy higher profits that are not justified by attractive prices or by
improved quality. The firms could achieve this aim either by charging higher prices, or by
supplying smaller quantities, or by dividing the market. Such anti-competitive conduct implies
significant reductions in productive, allocative, and often also in dynamic efficiency, which are
similar to the case of monopoly.
1–8–249 In general, however, agreements between firms aiming at constraining competition, or at
excluding it altogether, are illegal. Thus, the firms cannot simply negotiate a legally enforceable
contract about anti-competitive conduct. Instead, if the firms agree to restrict competition it
has to be in their self-interests to adhere to the arrangement. In other words, the agreement has
to be self-enforcing, or incentive-compatible.337 This is why it is necessary to analyse if, and
under what conditions, firms are able to constrain or exclude competition by means of a self-
enforcing agreement.
1–8–250 (a) Game theoretic foundations. Oligopoly theory points out that firms often have an
incentive to deviate from an agreement to restrict competition. Therefore, it seems that one
should not have to worry about such an agreement lasting for a long time. The underlying
strategic problem can be explained using a simple example with two firms. When the firms
compete on prices, each of them could make a profit of 85 million euros. However, if the firms
constrain competition and set the monopoly price, each firm’s profit will be 100 million euros.
But then again, if one of the firms sticks to the monopoly price while the other one charges a
lower price, the former will make a profit of only 60 million euros. This is because it will lose a
large share of its demand to the competitor charging the lower price. This firm will earn a
profit of 130 million euros. The set of players in this game consists of the firms A and B. Their
respective strategy sets each consists of two possible prices, a high price ph and a low price pe.
Their respective profits are described by the pay-off matrix below.

336
The following section is based on Schwalbe/Zimmer, 2006.
337
Telser, 1980.

Kerber/Schwalbe
G. Economic Principles of Competition Law 287

B
ph pe

A ph 100, 100 60, 130


pe 130, 60 85, 85

The strategy combination where both firms charge the high price does not form a Nash 1–8–251
equilibrium: if firm A sets the high price, firm B should respond by choosing the low price and
thus realise a profit of 130 rather than 100. An analogous argument holds for firm B. Thus, each
firm faces an incentive to deviate from the high-price strategy, and charge the low price
instead. The unique Nash equilibrium of this game is the strategy combination where each firm
sets the low price. Starting from this strategy combination, neither firm could gain by switching
to the high price since this would induce its profit to fall from 85 to 60. Therefore, neither firm
has an incentive to deviate from the low-price strategy. As the firms are unable to commit to
the high-price strategy, e.g. by an enforceable contract, the firms’ individual self-interest
induces them to deviate from the high-price strategy and thus realise a higher profit. While
both firms would like to restrict competition by employing the high-price strategy, this
situation would not be stable, since neither firm would stick to the agreement. This is why, in
the past, it was sometimes believed that it was not necessary to prohibit cartels explicitly since
the fact that cartel agreements are not legally enforceable would be sufficient to deter them.
Such agreements would collapse because they were inherently contradictory. In what follows,
it will be seen that, contrary to this belief, there is a variety of measures to design agreements in
ways which makes them self-enforcing. That is, the partners have an incentive to adhere to the
agreement even in the absence of the threat of legal prosecution. Then, the inability to enforce
the cartel agreements does not suffice to deter them from concluding the agreement.
In order to explain how such an incentive-compatible agreement works, it is necessary to 1–8–252
develop the example above by assuming that the firms make decisions about their competition
parameters, such as prices and quantities, not once and for all, but repeatedly over time, as
competition between the firms stretches over time. The temporal aspect affects fundamentally
the strategic situation faced by the firms. When interaction takes place repeatedly, each firm
will react to the past behaviour of its competitors. That is, a firm can affect the future conduct
of its competitors by its present actions. Obviously, a repeated game displays a wider range of
strategic possibilities, and a greater degree of complexity, as compared with a one-shot game.
Despite this, a repeated game can be described in an analogous manner. Now, the players A
and B are endowed with larger strategy sets and different pay-off functions. In a repeated game,
a strategy of a firm is a plan prescribing a certain pricing behaviour for each time-period,
depending on the prices set by all firms in all past periods. In particular, a strategy may prescribe
a certain reaction to the others’ actions in the preceding period. For instance, a possible
reaction would be to reward desirable actions and to punish objectionable ones. Note that, in
this context, a punishment is not a monetary fee determined by contract. Instead, punishment
is achieved by altering one’s behaviour, e.g. by switching to an aggressive pricing policy. As an
example, consider the following strategy:
‘‘In the first period, start by setting the monopoly price, i.e. the price that maximises the
joint profits of all firms in the market. If all other firms in the market do the same, then set
the same price again in the next period. Continue in this manner as long as all firms keep
charging the monopoly price in each period. But, if in any period any one firm charges a
price other than the monopoly price, then respond by setting the (lower) competitive price
in all subsequent periods’’.
This is the so-called trigger strategy. It rewards ‘‘good’’ behaviour (i.e. co-operation) on the
part of the other oligopolists, and at the same time punishes any deviation from the monopoly
price by an aggressive pricing policy.338 In the repeated game, the pay-off functions must also

338
In game theory there are also other strategies inducing the same outcome, like, e.g. the Tit-for-Tat
strategy, that in each period reacts to the action taken by the opponent in the previous period. (Axelrod,
1984.) Friedman, 1971, was the first to analyse the trigger strategy with respect to the existence of a co-
ordinated equilibrium, also, cf. Porter, 1983.

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288 Part 1: Introduction

be adjusted to repeated interaction since a pay-off is not realised once only, as a firm receives a
profit in every period. However, the value of future profits is usually different from that of
present profits, from today’s point of view. This is accounted for by using the present value of
the sum of the future profits.
1–8–253 The new game consisting of a repetition of the one-shot game is thus a game in itself, if
somewhat more complex. It follows that the concept of Nash equilibrium in the repeated game
relies on the same basic considerations: A Nash equilibrium of a repeated game is a strategy
combination with the property that no player has any incentive to deviate from his strategy,
provided that the other players also stick to their strategies. As this holds for all players, a Nash
equilibrium is characterised by no player having an incentive to deviate from his strategy.
Obviously, the strategy combination where all firms set the low price in each period is also a
Nash equilibrium of the repeated game: if all firms always charge the low price, a firm could
only lose out by setting the high price since, in this case, it would lose all its demand to the
other firms. As a matter of fact, the strategies consisting of the repetition in each period of the
Nash-equilibrium strategies of the one-shot game, the so-called short-run Nash equilibrium,
always constitute an equilibrium of the repeated game. At this stage, it is expedient to dis-
tinguish between a game that goes on for a fixed, pre-specified number of periods, and one that
goes on indefinitely, i.e. one where the players do not know when the last period will be. In
the former case, one can show that the unique Nash equilibrium consists in repeating the short-
run equilibrium in every period.339 Therefore, what follows focuses on the case that there is no
last round that is known to the players, i.e. potentially the game could go on for ever.340 In this
case, under certain conditions, additional Nash equilibria may occur which allow for outcomes
that are not achievable in the one-shot game. More precisely, the strategy of each firm setting
the high price in each period might occur in a Nash equilibrium. This can be achieved, e.g. by
the above mentioned trigger strategy, provided that future profits matter to the firms, i.e. that
they are not discounted too heavily. It is true that a firm could increase its short-run profit by
deviating from the monopoly price and thus attract a large share of market demand. In the long
run, however, this firm would forfeit its share of the monopoly profit since the other firms
would switch to the low price forever after, as prescribed by the trigger strategy. If a firm takes
these future losses into account, the short-run gain from deviating will be more than eclipsed
by the lasting loss of its share of the monopoly profit.
1–8–254 Game theory has derived a number of statements (the so-called folk theorems) that show
that, in a repeated game, any combination of pay-offs can be achieved where each player gets at
least the pay-off he would receive in the short-run equilibrium, depending on the players’
valuation of future pay-offs.341 Thus, in general, a repeated game exhibits an infinite number of
Nash equilibria, amongst them the one that prescribes joint monopolistic behaviour on the part
of all oligopolists. We will refer to Nash equilibria that involve some degree of co-ordination
(up to joint profit maximisation) as co-ordinated equilibria. Accordingly, the generally unique
Nash equilibrium of the one-shot game is referred to as the non-co-ordinated equilibrium.
With repeated interaction, behaviour patterns may occur that cannot be observed in equili-
brium in the case of a single interaction. As a caveat, the folk theorems merely serve to prove
the existence of co-ordinated equilibria. With respect to many central questions concerning
competition policy, however, what matters is not only the existence of such an equilibrium.
Rather, the question is how the firms manage to choose one of the several possible equilibria,
how they arrive at co-ordinating on the chosen equilibrium, and what conditions have to be
satisfied in order for such an equilibrium to be stable in the long run.342
1–8–255 The first step here is to take a closer look at the conditions stated in the folk theorems as
necessary for the existence of a co-ordinated equilibrium in an oligopolistic market. These are
repeated interaction between the firms, a large enough discount factor, the existence of a

339
However, when the one-shot game exhibits multiple Nash equilibria with different pay-offs, co-
operation can be achieved even with a finite number of repetitions. (Benoit/Krishna, 1985.) Further,
incomplete information can help to achieve co-operation in some periods. (Kreps/Milgrom/Wilson/Roberts,
1982, and Radner, 1980.)
340
Of course, this does not mean that such a game is actually played infinitely often. It suffices to assume
that in each period there is a chance of playing another round.
341
Auman/Shapley, 1994; Friedman, 1990; Fudenb erg/Maskin, 1986; Fudenberg/Levine/Maskin, 1994;
Häckner, 1988; Kaneko, 1982; Rubinstein, 1979. A survey on the different variants is provided by Friedman,
2000.
342
These aspects were already pointed out by Stigler in his classic article on oligopoly theory (Stigler,
1964); cf. also Salop, 1986.

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G. Economic Principles of Competition Law 289

credible punishment mechanism, and market transparency. The second step is to establish how
the firms agree to co-ordinate on one of the multiple equilibria of a repeated game. There is a
broad spectrum of different methods, ranging from direct communication to spontaneous co-
ordination resulting from market observation. Direct communication means that the firms
agree to fix prices, quantities, capacities, or a division of the market. Besides these explicit cartel
agreements, there is a multitude of instruments such as applying a certain pricing rule, or
announcing future behaviour patterns in advance. Finally, co-ordination may arise sponta-
neously, without any sort of communication between the firms, be it direct or indirect.
Economically speaking, it does not matter whether the oligopolists co-ordinate their strategies
by means of independent actions, agreement, or by other means. The reason is that, since
agreements are not legally enforceable, the strategic problem (to cheat or not to cheat) is
exactly the same in each case. The third step requires taking a closer look at the conditions that
help to sustain a co-ordinated equilibrium over a longer period of time. These conditions
include firm-specific factors such as the number of firms in the market, their symmetry with
respect to costs, their array of products, their capacities, their stock of inventory as well as their
organisational structures. On the other hand, there are criteria referring to the market, e.g. the
price elasticity of demand, substitutability of the goods produced by the firms, existence of
multi-market contacts and buyer power.
(b) Necessary conditions for the existence of a co-ordinated equilibrium
(aa) Repeated interactions. The considerations outlined above have made it clear that a 1–8–256
co-ordinated equilibrium can exist only if the firms interact repeatedly. Only then do the firms
have the option to co-ordinate their behaviour with respect to their competition parameters.
Furthermore, there must be no exogenously-fixed last round of play. That is, in each period
there is a chance that interaction will go on for another period. Market requirements follow
directly, as well as the conditions to be met by the firms. For one thing, it will be difficult to
achieve co-ordination if one or more firms are expected to exit from the market in the near
future. In such a situation, there would be a strong incentive for these firms to deviate from the
co-ordinated action in order to secure higher profits before leaving the market. As they will
exit the market after deviating, they do not have to fear any punishment. If the firms know that
one of them will exit the market in the near future, the others will anticipate this. As a
consequence, co-ordinated behaviour will no longer constitute an equilibrium. A similar
situation tends to arise in markets that are becoming obsolete because of technological pro-
gress.343 Here, too, there is an incentive for the firms to deviate from co-ordination and pocket
the profits. Since all the firms in the market know about the development, a co-ordinated
equilibrium would not to be expected.344 Similarly, when firms interact only intermittently, or
with long time lags between the interactions (e.g. travel agents offering package holidays,
where catalogues are printed biannually and supply has to be planned up to two years in
advance), then punishment of cheating can be carried out only after a long delay. In such cases,
action and reaction are separated in time, which renders co-ordination unlikely.345 Such
markets are far less susceptible to co-ordinated behaviour as compared with markets where
interaction is frequent and regular.
(bb) The discount factor. The folk theorems imply that the existence of a co-ordinated 1–8–257
equilibrium is ensured only if the discount factor is large enough. This means that the firms
attach great importance to the future. The discount factor depends primarily on the interest
rate. If a firm has free access to the capital market, then the interest rate underlying the discount
factor will correspond to the market interest rate.346 Thus, the value of future returns will
decrease in times of high interest rates. It follows that co-ordinated behaviour will be unli-
kely.347 Further, firms facing high risks, e.g. firms dependent on the success of a newly
developed product, have to pay higher interest rates on the capital market than firms that do
not face such risks. Therefore, the former’s discount factor will be higher than that of less risky

343
Such problems may also occur in markets for scarce resources. An empirical investigation of the
OPEC cartel showed that the scarcity of oil storage played a major role with respect to the deviating
behaviour on the part of some of the cartel members (Griffin/Xiong, 1997). A more general investigation of
cartel stability in the presence of scarce resources is provided by Thomas, 1992.
344
A similar phenomenon occurs in the presence of business fluctuations. Here, co-ordination tends to
be dissolved in periods of cyclical downturn, cf. Section V.3.(c)(bb).
345
Scherer/Ross, 1990, 268–273; Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 19–21.
346
The discount factor will drop, however, if a firm expects the interaction to be continued with less
than certainty. Further, the discount factor will be influenced by the firm’s risk preference.
347
The question of co-ordinated behaviour with interest-rate fluctuation is dealt with by Dal Bo, 2002.

Kerber/Schwalbe
290 Part 1: Introduction

firms. A similar argument applies to firms that depend on the quick realisation of profits, e.g. in
order to meet an urgent obligation. In either case, the firms will put more weight on present
returns than on future ones. It follows that the incentive to deviate from co-ordination is
stronger in this case. If the firms differ in their discount factors because of different time
preferences on the part of the owners or managers, or if the firms display different attitudes
towards the risk of a deviation being detected, then it may be the case that no co-ordinated
equilibrium exists.348
1–8–258 (cc) A credible punishment mechanism. The condition that suitable punishment
mechanisms must be available is closely related to the importance of repeated interactions and
future profits, and is indispensable for the existence of a co-ordinated equilibrium. Such
measures will usually consist in aggressive competition on the part of the firms reacting to
cheating by another firm.349 For instance, a drastic price cut, i.e. a price war, is a form of
punishment. Another possible sanction would be to dump a large quantity of the good on the
market in order to reduce the price. What matters here is that the punishment follows quickly
after the deviation, which implies frequent interactions. Furthermore, the punishment has to be
effective, which is the case only if future returns are highly valued. Finally, the punishment
must be credible, i.e. it must be in the punishers’ self interest to carry out the punishment. As
an example, the threat to increase the quantity produced to such an extend that the deviator’s
profit be minimised would in general not be credible since carrying out the threat would run
counter to the punishing firms’ self interest. In this case, a firm deviating from the co-ordinated
equilibrium can depend on the others’ not carrying out their threat. Therefore, empty threats
are not effective in deterring a firm from deviating. As a consequence, in order to qualify as an
effective punishment, the prices or quantities supplied must be such that a firm pursuing its
long-run goals would actually choose them as a reply to a deviation.350 For instance, if it is
observed that a firm deviates from the co-ordinated equilibrium by supplying a larger quantity,
or by charging a lower price, then it must be advantageous for its competitors to carry out the
punishment. This will not be the case if a firm loses out by carrying out the punishment.351
Thus, if a credible punishment mechanism does not exist, a firm will be able to deviate without
having to fear any loss in profits. In such a situation, a profit maximising firm will always
deviate from the co-ordinated situation. As the competitors will anticipate this, the firms will
not reach a co-ordinated equilibrium in the first place. Therefore, the existence of a credible
punishment mechanism is essential for a co-ordinated equilibrium to be feasible at all.
1–8–259 The more effective the credible punishment mechanism, i.e. the larger the loss in profits
incurred by the deviating firm as a result of the aggressive behaviour on the part of the other
firms, the easier it is to ensure the existence of a co-ordinated equilibrium. However, if there
are only limited punishment possibilities available, it is to be expected that co-ordination will
not reach its full potential. Instead, the firms will be able to achieve an outcome that is indeed
more profitable than that without any co-ordination at all, but which is still inferior to the
monopolistic one. In such an equilibrium, the total profit made by the firms falls short of the
(maximum possible) monopoly pay-off. It follows that the incentive to deviate is also reduced,
and a milder punishment suffices to prevent the firms from deviating.352 A punishment
mechanism which is mentioned often in the literature is the return to normal competitive
behaviour as described by the short-run Nash equilibrium. Yet this is often not sufficient to
deter firms from deviating from the co-ordinated equilibrium. That is, such a punishment
allows only incomplete co-ordination. Game theory has demonstrated that there are other,
more efficient, punishment mechanisms to sustain a co-ordinated equilibrium than the return
to the short-run equilibrium.353
1–8–260 (dd) Market transparency. The existence of a co-ordinated equilibrium depends on the
implicit assumption that the firms be able to observe all the relevant parameters, such as prices,

348
Co-ordination when the firms differ in their discount rates has been analysed by Harrington, 1989a.
349
Motta, 2004, 139.
350
The equilibrium concept used here is the one of sub-game-perfect Nash equilibrium due to Selten,
1975. The concept considers only those strategies that induce rational behaviour at each point in time. This
excludes the use of empty threats.
351
If the punishment makes both firms worse off, they could engage in renegotiations and thus prevent
the punishment from being executed. In this case, the Nash equilibrium is not renegotiation proof.
(Aghion/Dewatripont/Rey, 1994; Benoit/Krishna, 1993; Farrell/Maskin, 1989; Bergin/MacLeod, 1993;
McCutcheon, 1997.)
352
Church/Ware, 2000, 334; Stigler, 1964.
353
Abreu, 1986; Abreu, 1988; Häckner, 1996; Lambson, 1987; Lambson, 1994; Lambson, 1995.

Kerber/Schwalbe
G. Economic Principles of Competition Law 291

costs, capacities, etc. of their opponents (subject to certain cases of partial transparency discussed
below). If this is the case, any deviation from the co-ordinated equilibrium will be detected
immediately. The deviating firm will then be identified and punished accordingly. In many
cases, however, these detection possibilities are limited. For example, if a firm is in a position to
offer secret discounts to its customers, this firm could attempt to increase its profit by such
secret cheating.354 The same is true if the price is determined by negotiations between the firm
and the customer. If the probability of a secret discount being detected increases with the
number of customers getting the discount, then a market with a large number of consumers is
more susceptible to co-ordinated behaviour. A similar argument applies where a firm is unable
to put a large quantity on the market without this being noticed by the other firms. Markets
characterised by quality competition offer the possibility of deviating from the co-ordinated
equilibrium by modifying the quality of the good produced. Such markets are less transparent
since differences in quality are harder to detect than differences in price. This in turn increases
the incentive to deviate. In such cases, the other firms can only attempt to draw conclusions
from the development of their own sales or profits. Obviously, this will yield but imperfect
information. To summarise, market transparency with respect to prices and quantities supplied
is an important factor that promotes the existence of a co-ordinated equilibrium.355
However, market transparency is not indispensable for co-ordinated behaviour on the part 1–8–261
of the firms. Even where the market is not entirely transparent, under certain conditions co-
ordination may be achieved, at least temporarily. Here, co-operation is from time to time
interrupted by a phase of severe price competition. Suppose the firms observe a price
reduction, but are unable to tell whether it results from a decline in demand or from a firm’s
deviation. There, temporary co-ordination can be achieved by the following rule: when the
price falls below a certain threshold, each firm acts competitively for some period of time, and
then returns to the higher co-ordinated price.356 Such behaviour has been confirmed
empirically in a number of cases.357
(c) Mechanisms to achieve a co-ordinated equilibrium. Suppose the conditions with 1–8–262
respect to repeated interaction, the discount factor, the punishment mechanism and—with
some restraints—market transparency are all satisfied. Then, a co-ordinated equilibrium will
exist. There remains, however, the problem that there is not only one equilibrium but infi-
nitely many, as pointed out by the folk theorems. Thus the question arises: how do the firms
select one of these?358 Until now, game theory has contributed little to solving this problem.359
Recently, however, a number of attempts to solve the problem of equilibrium selection in
repeated games has emerged.360
(aa) Explicit agreements. In practice, firms can choose from a variety of methods and 1–8–263
instruments in order to co-ordinate on one of the many equilibria. The simplest possible
method would be an explicit agreement between the firms on the prices to be charged, the
quantities supplied, the capacities, or the division of the market, either geographically or with
respect to market shares, i.e. a price cartel, a quota cartel, or a cartel with respect to territories
or market shares. Even explicit agreements suffer from a host of problems resulting from
asymmetries between the firms. Thus, a firm’s preferred price depends on its cost structure: a
firm operating with high fixed costs prefers a smaller quantity and a higher price, as compared
to a firm with low fixed costs. In a joint-profit maximum, the firms with low marginal costs
would have to supply a larger share of the quantity produced. In the extreme case, a firm
incurring very high costs would have to discontinue production and receive a payment from
the other firms instead. Dividing the quantity produced equally across all firms does not
maximise the overall profit. Moreover, if the firms produce differentiated goods, they will have
to agree not only on one price but rather on a vector of prices. In this case, the stability of a

354
Experimental investigations confirm that such discounts tend to prevent a co-ordinated equilibrium
from being reached, e.g. Feinberg/Snyder, 2003.
355
For this reason, it is important for a firm to ascertain market transparency.
356
Green/Porter, 1984; Abreu/Pearce/Stacchetti, 1986; Athey/Bagwell, 2001. With respect to the folk
theorem with private information, cf. Abreu/Pearce/Stacchetti, 1990; Fudenberg/Maskin, 1986; Fudenberg/
Levine/Maskin, 1994; Matsushima, 2000; Matsushima, 2001b; Kandori, 2002.
357
Ellison, 1994; Levenstein, 1997.
358
Tirole refers to this as ‘‘an embarrassment of riches’’ and concludes: ‘‘Somehow the firms must
coordinate on a ‘focal equilibrium’ in order for the equilibrium to remain attractive’’. Tirole, 2003, 247.
359
Section VI.4.(b) and the literature cited there.
360
These approaches stem from evolutionary game theory and experimental economics, respectively.
(Section VI.4.(b)).

Kerber/Schwalbe
292 Part 1: Introduction

cartel may be threatened by the firms’ using other competition parameters to deviate from the
explicit agreement, such as advertising, quality, or innovation. These factors would also have to
be incorporated in the agreement.
1–8–264 Furthermore, explicit agreements on prices, quantities, etc. are illegal in almost all legal
systems, and for good reasons too. Such agreements induce a reallocation of economic surplus
to the benefit of the firms. Further, they cause all sorts of allocative, productive, and dynamic
inefficiencies analogous to monopoly. However, there is always a possibility of such agree-
ments being discovered, since they invariably leave behind verifiable traces such as written
statements, meetings, telephone calls, emails, etc. However, if the cartel members possess
private information on, e.g. demand and cost structures which the competition authorities are
unable to observe, then the firms will be able to act in a way as to keep up some sort of bogus
competition. Then, a cartel will be hard to detect.361 These considerations give rise to the
conjecture that cartels are more likely to occur when the firms are characterised by similar cost
structures, and produce only a limited range of differentiated goods. In a market with few firms,
each of which supplies a large share of the market, negotiations concerning prices, quantities,
etc. tend to be less complex, leave fewer traces, and there are fewer accomplices to the illegal
activity.362 Empirical investigations of cartels have shown that in 80 per cent of the cases the
number of firms involved was less than 10. Further, in 76 per cent of the cases considered, the
market shares of the four largest firms made up more than 50 per cent, and the firms produced a
homogeneous good.363 Similar conclusions have been derived form a study on hardcore cartels
that were detected in the USA in the years 1995–2002. Most of these cartels consisted of 10 or
fewer members, there was a high degree of market concentration, and often other instruments
were employed besides the price, e.g. exclusive territory agreements. While product homo-
geneity was not a decisive factor, it did facilitate the formation of cartels.364
1–8–265 (bb) Information exchanges and price leadership. Explicit cartel agreements being
illegal, firms might try to resort to other methods and instruments in order to facilitate co-
ordination on a certain equilibrium, to provide incentives to stick to it, and to increase market
transparency.365 These measures are known as ‘‘facilitating practices’’.366 In this context, the
public announcement of future prices, e.g. by giving a speech, has become a major instrument
for attaining co-ordination. Game theory shows that non-committal and non-verifiable
statements that do not incur any costs, so-called ‘‘cheap talk’’, helps the selection of an
equilibrium in the case of multiple equilibria. The chosen equilibrium is then established as a
‘‘focal point’’.367 The public announcement of the intention to increase the price in the near
future enables the other firms to react by publicly announcing their pricing policies in turn in
order to facilitate co-ordination. Announcing price cuts in situations characterised by low
demand signal that the firm does not intend to gain additional profits by deviating from the co-
operative equilibrium. Instead, it allows the other firms to cut their prices in time, too.
However, public price or quantity announcements are not to be considered as entirely anti-
competitive. Indeed, such announcements benefit consumers since they enhance market
transparency, and thus offer a more reliable basis for planning. However, this is not true for
announcements of prices or quantities made exclusively to the firm’s competitors. Such private
announcements do not yield any efficiency gains for consumers. They serve the sole purpose of
facilitating collusion.368
1–8–266 Similarly, the exchange of information on past and present prices and quantities produced
serves the same purpose, especially when the market is not entirely transparent. In this case,
deviations from the co-ordinated equilibrium will be hard to detect, which threatens the
stability of the co-operation. Detecting such deviations is easier when there is verifiable
information on the prices charged (past as well as present), the quantities produced, or the

361
This statement is referred to in the literature as non-differentiability theorem (Phlips, 1995, 124–148;
Cyrenne, 1999).
362
But, in the case of explicit negotiations, the problem may arise that a deviation and the ensuing
punishment involve the incentive to renegotiate on the part of the firms. (Abreu/Pearce/Stacchetti, 1993;
Driffill/Schulz, 1995; Farrell/Maskin, 1989.)
363
Hay/Kelley, 1974.
364
Kolasky, 2002.
365
Stennek, 1997, shows that the firms have an interest in creating institutions to serve these purposes.
366
Grillo, 2002; Salop, 1986.
367
Farrell/Gibbons, 1989; Farrell/Rabin, 1996. Experimental results can be found in Cason, 1995; Harstad/
Martin/Norman, 1997.
368
Kühn, 2001; Blair/Romano, 2002.

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G. Economic Principles of Competition Law 293

firms’ capacities. In this case, the deviating firm will be identified easily, and will be punished
accordingly. In order to ensure market transparency, the firms will be interested in exchanging
information via price reporting points, or trade and industry associations.369 With respect to
information exchange, special problems arise in the case of auctions, where the bids submitted
by a firm reveal information about its intended conduct (code bidding). As an example, during
the German radio spectrum auctions in 1999, Mannesmann placed a low bid of 20 million DM
for one-half of the spectrum, and an even lower one for the other half, namely 18.18 million
DM. Given the rule that each new bid must exceed the preceding one by at least 10 per cent,
the other bidder, T-Mobile, interpreted this behaviour as follows. Since 18.18 million plus 10
per cent roughly yields 20 million, T-Mobile placed a bid of 20 million for the other half. After
that, neither bidder placed another bid, and the auction terminated.370
While the mere announcement of an intended price may also serve to test the competitors’ 1–8–267
reactions, a price leader sets a price that is taken as given by the other firms.371 In the short run,
however, it is not in a firm’s interest to act as a price leader: If the leader sets a high price, the
other firms will undercut this price and thus attract a larger share of demand, and realise larger
profits. That is, each firm would prefer to act as a price follower and thus benefit from higher
profits, as compared to the leader.372 With repeated interactions, however, it may turn out to be
advantageous for the firms to establish one of them as a price leader in order to solve the
coordination problem.373 Thus, an equilibrium with a price leader can be achieved by the
following strategies.374 A price increase by a firm will be followed by the others as long as their
profits go up. If a firm does not follow the price increase, it will announce this. If all firms agree
on the price increase, the higher price will apply for the next period. In contrast, if a price cut is
announced, all firms follow the price cut for as long as the new price does not fall below the
price which arises with no co-ordination whatsoever. If any one firm deviates from this rule, all
firms will charge the low competitive price in the next period. These strategies form a co-
ordinated equilibrium since no firm has an incentive to deviate by charging a slightly lower
price, provided that the other firms adhere to their strategies. If a firm deviates, then the non-
co-ordinated equilibrium will emerge immediately, together with the corresponding lower
profits. However, the model does not determine how to select the firm to which the leadership
role is to be assigned. In recent years it has been demonstrated that differences between the
firms play a major role with respect to the selection of the price leader. Thus, in the presence of
uncertainty with respect to demand, the firm possessing the best information will act as a price
leader.375
(cc) Pricing rules. Pricing rules are a further possibility for achieving co-ordinated 1–8–268
behaviour. As a multiplicity of rules are used, the following depicts only the most prevalent
ones.376 These are meet-the-competition clauses, most-favoured-customer clauses, and the
rules of delivered price and basing-point pricing in relation to geographical markets. A price
guarantee promises to grant to the buyer of a product a discount if he happens to find the
identical product being offered by another seller at a lower price. In most cases, the amount of
the discount corresponds to the price difference. Sometimes, the customer is allowed to return

369
Howe, 1973; Kirby, 1988; Logan, 1988. It has to be pointed out, however, that a firm will be
unwilling to exchange information if this gives rise to a considerable advantage on the part of a competitor.
Clarke, 1983; Gal-Or, 1985; Vives, 1984. This depends on the competition parameters employed, among
other things. Kühn/Vives, 1995; Raith, 1996a.
370
Klemperer, 2000.
371
Sleuwaegen, 1986.
372
This is not necessarily true when the firms differ. Thus, a firm incurring low marginal cost may well
be predestined to the leader position (Ono, 1982). Alternatively, larger firms may come into (Deneckere/
Kovenock, 1988). If there is uncertainty with respect to demand, the firm possessing better information
(Eckard, 1982) will become the leader, or the one displaying the highest risk preference (Holthausen, 1979).
Further, a higher degree of consumer loyalty may predestine a firm to become the price leader (Deneckere/
Kovenock/Lee, 1992).
373
A survey on the various industries where price leadership was observed is given by Scherer/Ross, 1990,
250–261.
374
This corresponds to the model developed by MacLeod, 1985. The depiction of strategies follows
Schulz, 2003, 81–83.
375
Rotemberg/Saloner, 1990; Amir/Grilo/Jin, 1999; Amir/Stepanova, 2000; Pastine/Pastine, 2004; van
Damme/Hurkens, 2004.
376
‘‘The variety of collusive pricing arrangements in industry is limited only by the bounds of human
ingenuity.’’ Scherer/Ross, 1990, 235.

Kerber/Schwalbe
294 Part 1: Introduction

the good (meet-or-release clause).377 The purpose of such clauses is to increase market trans-
parency. The firm using such pricing rule will be informed by its customers of the other firms’
prices, at least in cases where another firm charges a lower price. In this way, a firm’s customers
are being used as a source of information on the competitors’ pricing policies. In addition, pure
price guarantees which exclude the option of returning the good enable the firm to initiate a
price increase without fear of losing customers to a competitor that has not raised its price.378
The competitor, in turn, will want to follow the price rise without any delay, since it can
hardly profit from a lower price.379 A price guarantee constitutes a credible and effective
punishment mechanism, because the firm is, in practice, committed to this rule by its
announcement. Any price cut on the part of a competitor will be detected immediately, and
will be imitated, such that a competitor is unable to gain any advantage. If all firms in the
market stick to this rule, no additional profits can be gained by deviating from the co-ordinated
equilibrium. This reduces the incentive to deviate from a co-ordinated equilibrium with
excessive prices. Despite being seemingly customer friendly, price guarantees have a high
potential to restrict competition.380 While the primary purpose of information exchanges, price
announcements, and price leadership is to facilitate co-ordination on a certain equilibrium,
price guarantees modify the incentives to deviate from a co-ordinated equilibrium.
1–8–269 Whilst price guarantees refer to the prices charged by the firm’s competitors, most-
favoured-customer clauses concern the price set by the firm itself. Such clauses protect the
customers from the firm either setting a lower price in the future, or charging a lower price to
other buyers. The former is known as a retroactive clause, while the latter is referred to as a
contemporaneous clause. In general, such clauses are valid for a certain period of time. They
serve as an instrument to facilitate collusion by affecting the firms’ incentives to deviate from
the equilibrium by cutting their prices, similar to the case of price guarantees. If a firm using a
most-favoured-customer clause tried to deviate by a price cut, it would have to pay a penalty,
namely by granting a discount to its customers that have paid the higher price. On the other
hand, however, such a clause reduces both the incentives and the possibilities of a firm to
punish any deviation on the part of a firm that does not use a most-favoured-customer clause.
The reason is that, if the punishing firm responds by cutting its own price, it will incur a
considerable loss by having to compensate all its past customers. Although, if many firms in the
market employ such a pricing rule, this will stabilise a co-ordinated equilibrium by lowering
the incentive to deviate from the high price. On the other hand, most-favoured-customer
clauses may increase efficiency by reducing uncertainty about future price increases faced by
consumers. This in turn will cause the consumer to carry out the purchase quickly, and reduces
search costs. Most of the research in the field of most-favoured-customer clauses tends to
sustain the opinion that the competition-restricting effects dominate.381 However, further
research is still needed.
1–8–270 There are also pricing rules pertaining to geographical aspects: when firms operate in dif-
ferent regions, i.e. when they produce geographically differentiated products, co-ordination
problems will arise. This is because there is not just one price to be fixed but a whole system of
prices. Moreover, the firms find it difficult to observe their competitors’ prices, which creates
opportunities to deviate from a co-ordinated equilibrium. The usual pricing policy to be
expected when there is competition would be FOB (Free on Board) pricing. That is, the buyer
pays the factory price plus transport costs. The final price faced by the buyer, i.e. factory price
plus transport costs, cannot be observed by other firms, e.g. because of secret discounts on
transport cosst.382 Various pricing rules are available to the firms in order to enhance market
transparency and thus facilitate collusion. These include the various specifications of delivered
pricing, such as uniform delivered prices, or basing-point pricing. With uniform delivered
prices all customers pay the same price, independent of their respective locations. This increases
market transparency since a firm’s deviation from this price will be observed easily by the other
firms. What is more, such deviation is not profitable since the firm has to charge the same price

377
Belton, 1987; Chen, 1995; Edlin, 1997; Holt/Scheffman, 1987; Salop, 1986; Schnitzer, 1994.
378
However, this implies that consumers do not incur any cost when claiming the discount. Hviid/
Shaffer, 1999.
379
Phlips, 1995, 90.
380
The efficacy of such clauses has been confirmed by both empirical and psychological studies.
Chatterjee/Heath/Basuroy, 2003; Hess/Gerstner, 1991; Arbatskaya/Hviid/Shaffer, 1999.
381
Besanko/Lyon, 1993; Cooper, 1986; Neilson/Winter, 1993.
382
Carlton/Perloff, 2005, 383.

Kerber/Schwalbe
G. Economic Principles of Competition Law 295

to all its customers.383 Another type of delivered pricing is zone pricing, where customers
located in a zone all pay the same price.384
A further pricing system often employed in practice is that of basing-point pricing. Econ- 1–8–271
omists have been studying this system intensely for quite a long time. There are many argu-
ments as to why basing-point pricing facilitates co-ordination.385 The firms employing basing-
point pricing agree on one or more locations that do not necessarily correspond to one of their
production plants, and that may be entirely notional.386 If the basing-point is unique, the price
paid by consumers is the factory price plus transport costs starting from the basing point. In the
case of multiple basing-points, each consumer pays the factory price plus transport costs from
the basing-point such that the total price is minimised. This is not necessarily the basing-point
closest to the consumer, because the factory prices may differ. Each consumer thus pays the
same price for the product, no matter what firm he buys from.387 The prices charged at the
basing-points are known to all consumers and all firms. Likewise, the costs of transport, usually
by railway or ship, are publicly available. This system enables each firm to determine the total
price charged to consumers at any location. Thus, any deviation from the pricing system will be
discovered easily. As basing-point pricing interconnects firms from distant locations, a devia-
tion on the part of a firm affects a larger number of firms than would be the case where factory
prices are charged. Of course, this larger number of firms will also take part in punishing the
deviator and, consequently, the incentive to deviate is reduced.388
(dd) Other mechanisms to achieve co-ordination. In addition to these means of co- 1–8–272
ordination, the literature lists a multitude of further methods. For instance, a joint promotion
agency,389 premium systems, cross licensing,390 or debts391 may help to achieve co-ordination,
and thus higher prices and profits. Apart from these horizontal mechanisms, vertical agreements
may be employed by the firms in order to co-ordinate their behaviour. Examples are exclusive-
dealing agreements, exclusive territories, etc.392
Spontaneous co-ordination. Even if the firms do not employ any such facilitating practices, one 1–8–273
cannot be sure that spontaneous co-ordination will not arise between them. In this situation,
co-ordination comes about spontaneously, without any agreement whatsoever, and without
the employment of any instruments to co-ordinate their behaviours. This may result from
analysis of the market, when each firm concludes independently that a higher price would be
appropriate, e.g. the monopoly price. However, it is quite unlikely for a co-ordinated equi-
librium to emerge without any sort of communication, direct or indirect. This has also been
confirmed by a series of experimental studies.393
(d) Conditions relating to the stability of equilibrium. Even if the firms have 1–8–274
achieved coordination, either by an explicit cartel agreement, by using facilitating practices, or
spontaneously, a number of conditions are important with respect to the stability of the co-
ordinated equilibrium. These are factors relating to the firms, and those relating to the market
or markets served by the firms. Whilst the following conditions are not necessary to achieve
co-ordination, a co-ordinated equilibrium will be easier to attain the greater the extent that
these conditions are satisfied. A priori, however, co-ordination may occur even if these
conditions do not hold, or if they hold only in parts.
(aa) Criteria relating to the firms. The number of firms in the market. In principle, co- 1–8–275
ordination may occur even when the number of firms is large. However, it will be harder to
achieve. The reason is that it is usually easier to establish co-ordination when the number of
partners is small, all the more so if there are no explicit negotiations, i.e. if co-ordination has to
be reached by other means. Furthermore, a comparison of the possible gains and losses incurred

383
Edlin, 1997 points out that this can be achieved by a most-favoured-customer clause.
384
Peeters/Thisse, 1996.
385
Carlton, 1983; Gilligan, 1993; Levy/Reitzes, 1993; Machlup, 1949; Stigler, 1949; Thisse/Vives, 1992.
386
Usually the FOB system is employed when transport cost accounts for a large share of total cost, such
as steel, coal, or cement.
387
‘‘(The) basing point method of pricing makes it possible for any number of sellers, no matter where
they are located and without any communication with each other, to quote identical delivered prices for
any quantity of the product in standardized qualities and specifications.’’ Machlup, 1949, 7.
388
Scherer/Ross, 1990, 506; Church/Ware, 2000, 353.
389
Bernheim/Whinston, 1985.
390
Eswaran, 1994.
391
Buduru/Colonescu, 2002.
392
Section VII.
393
Section VI.4.(b).

Kerber/Schwalbe
296 Part 1: Introduction

by a deviation reveals that a small number of firms is essential for co-ordination to be stable.
Consider an oligopoly with price competition and a large number of firms. If the firms co-
ordinate their prices, each of the many firms will receive only a small fraction of the monopoly
profit. On the other hand, if a firm deviated from the monopoly price by slightly undercutting
it, this firm would immediately secure for itself a large share of the market, and thus sig-
nificantly increase its profits, provided that it has sufficient capacities. The incentive to deviate
is therefore considerable in such a situation. Even a severe punishment may not suffice to deter
the firms from deviating. This is not the case when there are only a few firms operating in the
market. Consider a duopoly, where each firm receives half the monopoly profit in a co-
ordinated equilibrium. Deviating is now less attractive since the deviator would lose half the
monopoly profit during the punishment phase. Furthermore, with fewer firms it is easier to
detect deviations. If there is a large number of small firms producing differentiated products,
each firm’s pricing decision will have only a small impact on the demand of the other firms. As
a consequence, deviations will be harder to detect. However, if there are only a few, large
firms, a firm’s deviation will have a large impact on the other firms’ demand. The deviation
would be discovered immediately, and the deviating firm would be identified and punished.
1–8–276 Symmetry. The degree of the symmetry of the firms is another important aspect which affects
co-ordinated behaviour. This refers to all aspects of the firm, such as its technology, its cost
structure, the product range, market shares, and the form of organisation. Symmetry facilitates
co-ordination since similar firms have similar conceptions of a co-ordinated equilibrium.
1–8–277 (1) Technology and costs. If the firms differ with respect to their technologies, and thus their
cost structures, they will have different conceptions of the price to be charged, or the
quantity to be supplied. A firm operating with lower marginal cost will prefer a lower
price and a larger quantity than one with higher marginal cost. Therefore, there is no
unique price that induces an obvious co-ordinated equilibrium.394 These differences may
be taken into account by explicit agreements, allocating a larger supply quantity to the
more efficient firms than to the less efficient ones, and specifying side-payments between
the firms.395 However, this is usually not possible without resorting to explicit negotia-
tions.396 Moreover, different cost structures imply different incentives to deviate from a
co-ordinated equilibrium, and different options for punishing deviating behaviour.397 In
particular, a low-cost firm gains more from deviating than a high-cost one, and is also
harder to punish by the latter. The reason is that, in order to punish a low-cost firm, the
high-cost firm would have to set a price equal to the efficient firm’s cost. But then the
inefficient firm would incur a considerable loss. The threat of punishment is thus not
credible. When there is little room for punishment, the incentive to deviate from the co-
ordinated equilibrium will be strong. The severity of the punishment carried out by the
high-cost firm is decisive to the determination of the level of co-ordination that may be
obtained. Indeed, the low-cost firm’s incentive to deviate could be reduced by assigning it
a larger share of the market, or the profit. But then the possibilities for co-ordination will
be restricted by the fact that market shares are supposed to reflect the cost differences
between the firms.398
1–8–278 (2) The product range. If the product ranges offered by the firms differ such that some firms
supply a wider range of products than others, then their incentives to deviate from a
coordinated equilibrium will differ as well.399 Suppose a firm producing a large number of
differentiated goods considers cutting the price of one of its products. This would entice
customers away from the other goods supplied by the firm, thus incurring a loss in
revenue. On the other hand, the price cut will fail to attract sufficiently many new
customers that have hitherto purchased from other firms. As a consequence, it is in the
firm’s interest to charge high prices for all its differentiated goods. What is more, if a firm
intends to punish a deviation on the part of another firm, the former will incur con-

394
If the firms were symmetric, however, there would be a unique price, i.e. a ‘‘focal point’’.
395
Such side-payments may consist in monetary transfers but also, if the firms operate in different
markets, in making concessions with respect to another market. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003;
Osborne/Pitchik, 1983; Schmalensee, 1987.
396
Experimental studies have confirmed that co-operation is more likely to be observed when cost
structures are symmetric (Mason/Philips/Nowell, 1992).
397
Bae, 1987; Harrington, 1991a; Rothschild, 1999; Verboven, 1997.
398
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 39. The question of profit allocation in oligopoly is dealt
with by Collie, 2004; and Osborne/Pitchik, 1983.
399
Kühn, 2004.

Kerber/Schwalbe
G. Economic Principles of Competition Law 297

siderable losses. That is, its ability to punish deviations is limited. But this means that a
firm producing only a limited range of products faces a strong incentive to deviate: On
the one hand, the price cut will attract much additional demand to the firm, and on the
other hand, a firm offering a wide array of products will have little room for punishment.
As a result, asymmetries between the firms makes co-ordination harder to achieve.
(3) Excess capacities and inventory stock. When the firms possess large production capacities that 1–8–279
are not fully employed, this will affect a co-ordinated equilibrium by facilitating devia-
tions. A firm may cut its price and still be able to supply the increased demand. This is
why the traditional view of the role of excess capacities was that they limited the pos-
sibility of co-ordination. Historical developments in the 1920s and 1930s seemed to back
up this notion, since the European chemical industry, while having significant excess
capacities, suffered severe price wars.400 However, subsequent investigations revealed that
those price wars did not arise from the excess capacities but rather from a severe slump in
demand.401 The firms had built up their excess capacities in the 1920, at a time when co-
ordination of the firms’ behaviour was prevalent. This implied that there was a positive
correlation between excess capacity and co-ordinated behaviour. The theory shows that,
while a firm holding excess capacity has an increased incentive to deviate, excess capacity
can also be used to punish a deviation.402 Suppose a firm has limited capacity which is
already fully employed. Such a firm is unable to punish another firm for deviating, as the
punishment requires a lower price and a larger quantity supplied. This provides a strong
incentive for competitors to drop out of the co-ordinated equilibrium. Empirical studies
have also confirmed this correlation. This gives rise to the conjecture that the role of
excess capacity as a punishment device dominates the effect on the incentive to deviate.403
It follows that different capacities on the part of the firms tend to aggravate co-ordinated
behaviour. A firm that is subject to a tight capacity constraint cannot gain from deviating.
The same is true if output expansions lead to a sharp increase in marginal cost. On the
other hand, firms with large, idle capacities will gain from deviating, since they face no
limits on producing large quantities. Deviating will be especially rewarding if it cannot be
punished by the other firms because of their capacity constraints. Some recently published
works have confirmed this view.404 An analogous argument applies to inventory stock.
On the one hand, a large inventory stock makes deviation more attractive, but on the
other hand, it facilitates the punishment of a deviating firm. Investigations of this problem
suggest that, as in the case of capacities, the role of inventory stock as a punishment device
prevails.405
(4) The form of organisation. Symmetry between firms relates also to their form of organisation, 1–8–280
and thus their legal structures. Different legal structures, such as business partnerships and
public companies, imply different behaviour patterns in the market. The main reason is
that different organisational structures create distinct incentives for the management, e.g.
the separation of ownership from control in a public company as compared with a
business partnership. As a result, firms vary in their objectives and their behaviour. As yet
there are but few economic studies concerning the effects of legal structures on market
conduct with regard to co-ordination. These, however, indicate that asymmetries in the
structures of organisation tend to impede co-ordination.406
All in all, these considerations suggest that symmetry, with regard to the aspects men-
tioned above, is of major importance. The obstacles to sustaining co-ordination rise with
the degree of heterogeneity. For instance, a firm with significantly lower costs than the
average has a strong incentive to act as a ‘‘maverick’’, and prevent co-operation. Such a
firm would be willing to co-operate only under conditions which cannot be granted by
the other firms.407 The same reasoning applies to firms that, due to their organisational

400
Phlips, 1995, 153.
401
Church/Ware, 2000, 346. The effects of a recession on co-ordination is discussed in Section
V.3.(c)(bb).
402
Brock/Scheinkman, 1985; Benoit/Krishna, 1987; Davidson/Deneckere, 1990; Loury, 1990; Osborne/
Pitchik, 1987.
403
Investigating the American aluminium producing industry, Rosenbaum, 1989 concluded that there is a
positive correlation between excess capacities and larger profit margins.
404
Compte/Jenny/Rey, 2002; Lambson, 1994.
405
Matsumura, 1999; Rotemberg/Saloner, 1989.
406
Lambertini/Trombetta, 2002; Neubauer, 1999; Spagnolo, 2004; Vroom/Riuz-Aliseda, 2002.
407
Baker, 2002; Kolasky, 2002.

Kerber/Schwalbe
298 Part 1: Introduction

structure, heavily discount future returns, or that face a stronger incentive to act com-
petitively because of their size, their capacity, or their product range.
1–8–281 Structural Links Structural links between the firms may also facilitate co-ordination. These
include mutual share holdings,408 joint shareholdings in third parties, strategic alliances, research
co-operations, or other horizontal arrangements.409 Structural links facilitate the exchange of
information on prices, quantities, and capacities, which makes co-ordination easier to achieve.
Furthermore, deviations will be detected more easily. What is more, the incentive to compete
is diminished, e.g. by mutual share holdings. If a firm aimed at reducing a competitor’s profits
through aggressive competition, this would adversely affect its own profits when it holds shares
in the other firm. For these reasons, co-ordination becomes more attractive.
1–8–282 (bb) Criteria relating to the market. Market entry. Another important condition for a co-
ordinated equilibrium is the existence of barriers to market entry. If co-ordination enables the
firms in a market to realise high profits, when there are no barriers to entry, new firms will
enter the market in order to obtain a share in these profits. This may be effected in two
different ways. First, the new firm could skim the market by undercutting the prevailing,
excessive price. This will disturb the co-ordinated equilibrium, and co-ordination will disin-
tegrate. Alternatively, the newcomer may join the existing co-ordinated equilibrium by
charging the prevailing excessive price for its product, or by adapting its quantity produced to
the co-ordinated equilibrium.410 In either case, increasing the number of firms which must co-
ordinate their behaviour leads to a reduction in each firm’s share in total profit. This makes it
hard to sustain a co-operative equilibrium, since the incentive to deviate becomes stronger
with an increasing number of firms.411 The mere threat of market entry may suffice to prevent
co-ordination from even arising. What matters here is the established firms’ swiftness in
detecting a deviation, and ability to punish it. The speed of market entry is also important. If
the time lag between deviation and punishment is small, new firms would have to be able to
enter the market quickly in order to prevent co-ordination.412 A similar problem occurs when
there are other firms besides the oligopolists which do not participate in the co-ordination, but
act as free-riders, profiting from the increased price.413 The market outcome will converge to
the competitive one if the competitive fringe is able to adjust its production quickly, because
this enables it to even out the supply reduction resulting from co-operation on the part of the
oligopolists.414 However, if the fringe firms face capacity constraints, expanding production on
short notice will not be feasible. In this case, co-ordination in the oligopoly is possible, if only
temporarily, until the fringe firms have adjusted their capacities. Several theoretical models of
co-ordinated behaviour and free market entry have shown that co-ordination cannot be
entirely stifled, even if entering the market incurs only very low costs, provided that the
established firms are able to credibly threaten potential newcomers with aggressive competition
if they should enter the market.415 It follows that, even in the absence of barriers to entry, one
cannot be sure that a co-ordinated equilibrium may not exist. If there are significant barriers to
entry, though, this will facilitate co-ordination considerably. This is not necessarily true in
markets characterised by strong network effects. In such markets, firms compete primarily for
the market, rather than in the market. In these markets, the incentive to deviate is particularly
strong since the deviator can secure a large share of the market. Furthermore, it is to be
expected that its position will persist for some time because of lock-in effects.416 In such
markets co-ordination is very unlikely, regardless of barriers to entry.
1–8–283 The price elasticity of demand. A monopolist’s profit is determined to a large extent by the price
elasticity of demand. Ceteris paribus the profit will be larger when demand is less elastic. The
same is true in the case of oligopoly: The potential profit gained from co-ordination is higher
when demand is less elastic. That is, if demand is inelastic, co-ordination will be more prof-
itable than in the case of elastic demand. With elastic demand, even a small price increase
induces a drastic fall in demand. The high potential profits in the case of inelastic demand thus
provide incentives for the firms to devise methods and devices which enable them to co-

408
cf. Gilo/Spiegel, 2003; Malueg, 1992; Parker/Röller, 1997; Reynolds/Snapp, 1986.
409
Sections V.4. and V.5.
410
In this case, the other firms would also have to adjust their quantities supplied.
411
Section V.3.(c)(aa).
412
Simpson, 1997.
413
Selten, 1973; d’Aspermont/Gabszewicz/Jacquemin/Weymark, 1983; Donsimoni, 1985.
414
Knieps, 2005, 123–125; Carlton/Perloff, 2005, 148.
415
Friedman/Thisse, 1994; Harrington, 1989b; Harrington, 1991b; Stenbacka, 1990; Vasconcelos, 2004.
416
Section IV.8.(b).

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G. Economic Principles of Competition Law 299

ordinate their behaviour, or even risk a direct agreement. Moreover, the reduction in con-
sumer surplus is larger when demand is inelastic.417 However, the price elasticity of demand has
no effect on the existence of a co-ordinated equilibrium when there is price competition. The
reason is that elasticity, or the shape of the demand function, affect both the incentive to
deviate from the co-ordinated equilibrium as well as the effectiveness of the ensuing punish-
ment: When demand is inelastic, a firm may reap considerable additional profits by effecting a
small price cut. The firm will attract the entire market demand, as it remains almost unaffected
by the price cut. However, the ensuing punishment will result in it incurring a considerable
loss, as compared to the high profit resulting from co-ordination.418
Typical transactions. When typical transactions are frequent and their volume is small relative 1–8–284
to the market, sustaining co-ordination will be easier, since the punishment can be effected
shortly after a deviation. If, however, transactions take place infrequently, or if their volume is
large relative to the market, e.g. bulk orders, then the incentive to deviate from co-ordination
will be stronger419: Since a deviation cannot be punished immediately, but only after a lapse of
time. Owing to discounting, the punishment will become less important. Moreover, a firm that
undercuts its competitors will secure itself a profitable bulk order. Despite the punishment, this
is a strong incentive to deviate from the co-ordinated equilibrium.
Homogeneous and differentiated products. The homogeneity of the products is often considered 1–8–285
a major condition for co-ordination to be possible. According to this view, co-ordination is
hard to sustain with differentiated products. At this stage one must distinguish between vertical
and horizontal differentiation.420 In the case of vertical differentiation, a firm that produces
better quality is in a situation similar to that of a low-cost firm: in either case, consumers are
willing to pay a premium.421 If this premium exceeds the cost difference between the qualities,
the high-quality firm will receive a larger mark-up than the ones producing lower quality.
Therefore, the low-quality firms are constrained in their ability to punish a deviation on the
part of a high-quality firm. This is why a high-quality producer faces a stronger incentive to
deviate from a co-ordinated equilibrium, similar to a low-cost firm. The larger the difference in
qualities, the harder it becomes to achieve co-ordination. When the difference is large, the
high-quality firm has an advantage anyway, which further reduces its interest in co-ordination.
When qualities become more alike, this advantage disappears, and the interest in co-ordination
increases.422 To counteract this effect, the firm in question might be assigned a larger market
share, although this requires explicit agreements. As a consequence, vertical differentiation
yields only limited room for co-ordination.423 Horizontal differentiation, in contrast, exists
where each firm has a number of customers with a preference for its branded product. If
another firm cuts its price, only a few customers will switch to that brand. It follows that the
firm will gain very little from lowering its price, since this will not attract much additional
demand. If the goods were homogeneous, a firm would be able to attract a significant share of
demand by a price cut. These arguments suggest that co-ordination is easier to achieve when
there is horizontal differentiation. Although then, with differentiated goods, it is also harder to
punish a deviating firm. Unlike with homogeneous goods, in spite of the punishment, a
deviating firm will not lose all its customers at once. Instead, a considerable share of demand
may be left with the deviating firm. The other firms’ ability to effect a punishment is thus
limited. It may be concluded that co-ordination becomes more difficult. The ambiguous result
implies that it is not, a priori, possible to say whether co-ordination is more or less likely to
occur in the case of differentiated goods.424 As pointed out in the literature, a number of
problems may arise with differentiated goods that do not occur when products are homo-
geneous. For instance, it may be that the demand for a firm’s product goes up because of a
change in consumer preferences. This happens without the firm having any hand in the matter.

417
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 50.
418
In the case of quantity competition, however, numerical studies show a positive correlation between
the price elasticity of demand and the occurrence of a co-ordinated equilibrium (Collie, 2004). In this case,
the curvature of the demand function also affects co-ordination (Lambertini, 1996).
419
Snyder, 1998.
420
Section IV, n.175.
421
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 46.
422
Häckner, 1994.
423
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 46.
424
Chang, 1991, Häckner, 1996; Osterdal, 2003.

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That is, the demand for a product may vary, and such variations cannot be observed by the
other firms.425 The firms have to resort to assessing their competitors’ behaviour on the basis of
their own quantities sold. However, this is harder to do when the goods are differentiated. As a
result, in the case of differentiated goods, co-ordination is difficult to achieve.426 Further
problems result from the fact that, with differentiated goods, co-ordination is not about fixing
one price only, but rather a whole system of prices. The problem is thus much more complex.
1–8–286 Buyer power. Market power on the part of consumers is adverse to co-ordination since it
presents a countervailing power, either in the form of a large buyer, or a pool of small and
medium-sized buyers. As previously mentioned, bulk orders and/or large time lags between
orders challenge the existence of a co-ordinated equilibrium since the incentive to deviate is
strong in such situations. Buyers can now pool their purchases by forming a buying syndicate in
order to be able to place bulk orders, with longer time intervals in between. This will tempt
suppliers to deviate from the co-ordinated equilibrium by lowering their prices.427 They could
do this, e.g. by procurement auctions in order to make co-ordination difficult. Alternatively,
powerful buyers may encourage market entry by guaranteeing the corresponding demand. This
would destroy co-ordination. Large buyers may even threaten to start producing the good
themselves. This will be a credible threat if the buyer has sufficient market power. In this case,
the oligopolists will not be able to charge excessive prices.428
1–8–287 Multi-market contacts. The firms’ interaction in several markets also helps to make coordi-
nation possible. In this context, it does not matter whether there are different product markets
or different geographical markets. The fact that multi-market contacts facilitate collusion was
recognised very early on, but only in recent years has a closer analysis taken place.429 The
incentive to deviate is stronger with multi-market contacts because a firm may deviate
simultaneously in all markets, and thus gain short-run profits in each of these markets. On the
other hand, the range of punishment possibilities is also enlarged. A priori, it is not quite clear
whether or not multi-market contacts help to sustain a co-ordinated equilibrium. The answer
may be affirmative when the incentives to deviate differ across markets. Suppose there are two
firms, each operating in two distinct markets. Further, suppose that one firm has a large share in
the first market but only a small one in the secondly, while the reverse holds for the other firm.
In total, however, the two firms’ market shares are balanced. The asymmetry in each market
prevents a co-ordinated equilibrium from being reached in a single market. However, if both
markets are taken together, co-ordination will be possible. While the gains from co-ordination,
and the potential losses from being punished, differ substantially in each single market, they will
be balanced when both markets are considered together. In this sense, multi-market contacts
facilitate co-ordination, provided that there is a certain asymmetry between the firms in each
market. Such asymmetries may consist in different market shares, but also in the firms’ cost
structures, the number of firms in the market, their reaction times, and the development of
demand in the various markets.430
1–8–288 Growing markets. The incentive to deviate from a co-ordinated equilibrium is reduced when
the resulting increase in profit is small, relative to the loss resulting from future punishments. In
a growing market, this is indeed the case: The present profits are insignificant in comparison
with potential future profits, which renders cheating unattractive.431 Therefore, co-ordinated
behaviour is more likely to occur in a growing market. This is true only if the number of firms
in the market remains constant over time. In general, the profit opportunities in a growing
market tend to attract market entry, which in turn reduces the probability of co-ordination.
More recent studies focusing on growing markets and market entry indicate unanimously that,
despite the increasing number of firms, co-ordination is not seriously impeded.432 However,
studies on this subject are still in their infancy, and further research is needed.
1–8–289 Innovations. Growing markets may also indicate strong tendencies towards innovation, either
with respect to new products or to new production technologies. When a firm succeeds in

425
In the case of geographical differentiation, it may be that demand develops differently in different
regions.
426
Raith, 1996b.
427
Stigler, 1964; Lustgarten, 1975; Kerber, 1989, 263–277; Snyder, 1996.
428
Scherer/Ross, 1990, 517–532.
429
Edwards, 1955; Bernheim/Whinston, 1990; Matsushima, 2001a; Spagnolo, 1999; Thomas, 1999; Parker/
Röller, 1997.
430
Bernheim/Whinston, 1990.
431
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 26.
432
Capuano, 2002.

Kerber/Schwalbe
G. Economic Principles of Competition Law 301

creating a new product, or one of better quality, it will be less inclined to hold on to a co-
ordinated equilibrium. This is because the new, vertically-differentiated product enables the
firm to realise higher profits. Such a firm will turn into a ‘‘maverick firm’’ as a result of the
product innovation. The ensuing asymmetry impedes co-ordination. A related issue arises in
the case of process innovations. A non-drastic process innovation grants the innovating firm a
cost advantage over its competitors. As demonstrated above, such a firm is likely to deviate
from a co-ordinated equilibrium. If the innovation is drastic, the other firms may have to
consider exiting the market since they are unable to compete with the superior technology of
the innovating firm.433 Future returns are of little value to such firms, which tends to make co-
ordination more difficult.434
Fluctuations in economic activity. If a market is liable to substantial fluctuations in economic 1–8–290
activity, co-ordination will be harder to sustain than in a stable or steadily growing market. For
one thing, the fluctuations require the prices to be adjusted constantly to the volatile economic
situation. Furthermore, the incentive to deviate from a co-ordinated equilibrium keeps
varying. For instance, suppose the economy is on the brink of a down turn. The firms will now
face a stronger incentive to deviate: while huge profits will be reaped today when demand is
still high, the punishment will come into effect only later, when demand has slumped. Then
the punishment will have no bite. In the presence of immense technological progress, the
market positions held by the firms keep changing, and new products will be introduced
frequently. This effect also impedes co-ordination.
In recent years, the effects of fluctuations in demand and business cycles on the stability of a 1–8–291
co-ordinated equilibrium have been analysed in more detail in the economic literature.435 In
order to sustain co-ordination, the short-run increase in profits gained by the deviation have to
fall short of the persistent losses which will be incurred by the firm being punished. Now, if
demand fluctuates with economic activity, such incentives and costs will vary over time. To
ensure co-ordination, the co-ordinated prices and quantities will have to be adjusted con-
stantly. Suppose there is an equal probability of demand being either ‘‘high’’ or ‘‘low’’ in each
time-period. The firms will then expect the average demand in each period. In a period of high
demand, deviating is more attractive since it is more profitable than during a recession. What is
more, the firms expect demand to be lower in the next period, since they expect the average
demand. As a consequence, the punishment due in that period will lose much of its deterrence
power. A co-ordinated equilibrium can be sustained in both demand situations if future profits
are only marginally discounted. In order to minimise the incentive to deviate, the firms will
aim at reducing the fluctuations in profits as far as possible, by adjusting their prices accordingly
over time. This is because the incentive to deviate is strong when the profit is above average.
For this reason, the price will have to be high during a recession, and low in a boom.436 Recent
analyses revealed that this is especially true when the firms are well informed about the
development of demand. If their information is insufficient, however, a fixed price turns out to
be the better strategy, even if demand tends to fluctuate.437 An empirical study of the cement
industry in 1947 to 1981 revealed counter-cyclical behaviour on the part of prices, although
the quantities developed in a pro-cyclical manner. Similar results were derived from analysing
the development of prices in the railway and automobile industries.438
If the fluctuations in demand are not merely random but follow the business cycle, different 1–8–292
conclusions will prevail, provided that the firms are aware of the business cycle.439 When
demand goes up, profits tend to increase as well. It follows that deviations from the co-
ordinated equilibrium are unprofitable since the ensuing punishment is more powerful. When
demand decreases, however, cheating becomes more attractive. Profits will fall as a result of the
reduction in demand, and the punishment will therefore have a smaller impact.440 In this
model, a deviation from co-ordinated behaviour is more likely to occur at the beginning of a

433
Section IV n.147.
434
Ivaldi/Jullien/Rey/Seabright/Tirole, 2003, 32.
435
Bagwell/Staiger, 1997; Haltiwanger/Harrington, 1991; Kandori, 1991; Rotemberg/Saloner, 1986; Staiger/
Wolak, 1992.
436
The model has also been extended to allow for the possibility of the firms going bankrupt. In general,
this makes it harder to sustain a co-ordinated equilibrium (Eswaran, 1997).
437
Hanazono/Yang, 2002.
438
c.f. Bresnahan, 1981; Porter 1983.
439
Haltiwanger/Harrington, 1991.
440
However, it has to be presupposed that the firms have sufficient capacities. In the case of small
capacities, it may be that deviating pays even when demand is on the increase (Fabra, 2003).

Kerber/Schwalbe
302 Part 1: Introduction

recession. While the first model deals with the link between co-ordination and demand, the
second one analyses the link between co-ordination and changes in demand. However, it is
well-established that a co-ordinated equilibrium will be destabilised if it is to be expected that
demand tomorrow will be less than today. Extensions of these models have analysed the effects
of the business cycle on co-ordination. It has been shown that, during a cyclical upswing where
substantial growth today indicates substantial growth tomorrow (i.e. in case of a positive
correlation of growth rates), the development of prices is pro-cyclical. That is, co-ordinated
behaviour is more likely to be observed in a boom than during a recession. This is also in line
with the result in markets with steadily increasing demand. In contrast, when substantial
growth today indicates reduced growth tomorrow, i.e. if growth rates are negatively correlated,
then the development of prices will be anti-cyclical. Co-operative behaviour will then be more
likely during a recession.441
1–8–293 The ‘‘ideal’’ market which satisfies all conditions for co-ordination would be a stable and
transparent market with high barriers to entry, where there are only a few firms that are very
similar and which produce a homogeneous good. Furthermore, interaction takes place
repeatedly, transactions occur frequently, there is a credible punishment mechanism and there
are many small buyers whose demand is inelastic. If the firms have mechanisms available to co-
ordinate their behaviour, and exchange information, than it is to be expected that a co-
ordinated equilibrium will occur in this market. A market that comes close to this is the petrol
market.
1–8–294 3. Agreements on prices, quantities and market division: policy conclusions. Since
co-ordination constrains competition it will have negative effects on the efficiency of allocation
and production. Co-ordination also results in the reallocation of economic surplus from the
consumers to the firms. These effects do not depend on the way in which co-ordination is
achieved, e.g. through an explicit cartel agreement, or by employing facilitating practices such
as information exchange price leadership, or certain pricing rules. From the viewpoint of
competition policy, it makes sense to take actions that prevent co-ordinated behaviour from
arising or, if co-ordination already exists, to introduce measures to increase competition. It
follows directly from this analysis that competition policy must prohibit agreements which are
intended to limit or exclude competition between firms. The prohibition should apply to all
competition parameters which the firms might choose to agree upon.
1–8–295 (a) Preventing illegal agreements. As described above, co-ordination between firms
may well arise even if they do not communicate explicitly. This will be the case, e.g. if there
are facilitating practices available to the firms that enable them to co-ordinate their behaviour,
and thus constrain competition. Such practices may help to bring about market transparency,
which is a major precondition for a co-ordinated equilibrium. This is why competition policy
should scrutinise all measures that promote market transparency and do not benefit consumers.
The main types are market information systems or price registration offices, and also the private
exchange of information between the firms. Further devices to facilitate collusion are pricing
rules, e.g. basing-point pricing or uniform delivered prices. Here, the option of a per-se
prohibition might be considered. Similar arguments apply to facilitating practices such as price
guarantees or most-favoured customer clauses that aim to reduce a firm’s incentive to deviate
from the co-ordinated equilibrium. In particular, price guarantees should be prohibited.
Despite their seeming to strengthen competition, such guarantees actually do the opposite.442
Co-ordination may also arise in bidding markets, either in the form of a bidding cartel or by
code-bidding. Here, the possibility of co-ordinated behaviour on the part of the bidders could
be reduced by specifying the rules of the auction accordingly.443
1–8–296 The number of firms in the market is of major importance with respect to co-ordinated
behaviour. The same holds for other aspects such as, e.g. symmetry, or. Therefore, if the
number of firms in the market declines, or if other aspects change as a result of a merger, it will
be necessary to examine if the merger opens up new avenues for co-ordination that did not
exist before. It follows that preventing co-ordinated behaviour is one of the most important
tasks faced by merger control. This aspect of competition policy will be analysed in more detail
in the section on co-ordinated effects.
1–8–297 (b) Disclosing illegal agreements. While such prohibition measures focus on prevent-
ing co-ordination from arising, or from being strengthened, other methods are required when
co-ordination already exists. Such measures could aim at the discovery of a possible agreement

441
Bagwell/Staiger, 1997.
442
Edlin, 1997, Motta, 2004, 158, Sargent, 1993.
443
Klemperer, 2000.

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G. Economic Principles of Competition Law 303

or co-ordination on the part of the firms when such an agreement is suspected. In this case, a
‘‘dawn raid’’ is more likely to provide the necessary information. In addition, one could
provide incentives to the firms to deviate from the co-ordinated equilibrium. Leniency pro-
grams, which have been discussed extensively in recent years, are based on this idea. A firm
participating in an explicit agreement is granted exemption from punishment, either com-
pletely or to a large extent, if it informs the competition authority of the agreement. This
undermines the trust between the firms that participate in the agreement, and increases the
incentive to deviate.444 However, in order for this policy to be effective, it is essential that a
firm is granted exemption, or a reduced penalty, even if the competition authority’s investi-
gation has already been initiated.445 Furthermore, the programmes should be transparent and
grant the firms legal security, as well as the highest possible degree of confidentiality.446 These
programmes have been a great success in the USA as well as in Europe, where a number of
cartels have been disclosed by means of leniency programmes. Such programs have thus proved
to be a powerful instrument in fighting cartels.
By contrast, if co-ordination has not been initiated by an explicit agreement, it is usually 1–8–298
hard to ascertain if competition is actually being restricted. Parallel changes in prices, high
prices and stable market shares may indicate co-ordinated behaviour, but these factors can also
be due to other causes. Furthermore, investigating the firms is useless since co-ordination
cannot be traced if it arises spontaneously. Neither do leniency programs have any bite. Thus,
competition policy has only limited means available to detect co-ordination that is not based on
an explicit agreement. It can merely prohibit certain facilitating practices, or ensure conditions
that impede co-ordination.
4. Agreements on joint research and development
(a) Introduction. The following section considers the assessment of research and dev- 1–8–299
elopment (R&D) agreements between competing firms from a competition policy perspective.
Although such collaborations may restrict competition in innovation as well as in product
markets, they may also have positive effects on efficiency and innovations. Consequently,
under certain conditions it might be reasonable to exempt these co-operation agreements from
a general ban on anti-competitive agreements instead of prohibiting R&D agreements per se.
However, this subject must be discussed in the broader context of the manifold forms which
co-operation between firms can take, and of national technology policies.
Since the 1980s many different forms of co-operation between firms have emerged. Some of 1–8–300
these co-operation agreements are characterised as strategic alliances and joint ventures.447
Many concern collaboration which aims at the generation and exchange of novel knowledge
about new technologies and products. R&D agreements comprise agreements concerning the
co-ordination and bundling of R&D activities of the member firms, which activities often take
the form of a joint corporation (corporate joint venture). Such research agreements take place
at the horizontal level between direct competitors, vertically between producers and their
clients or suppliers or within the broader framework of a wide-ranging network between firms
offering distinct technologies and products. Furthermore, universities and publicly funded
research laboratories may also participate in research consortia. Governmental research and
technology policy may also contribute to such research networks by providing financial sup-
port. From such a technology policy perspective, the joint research activities of firms are often
appraised positively and are strongly supported.448 However, the assessment of R&D agree-
ments also depends on the design and implementation of intellectual property rights, parti-
cularly patents and copyrights.
(b) Effects of collaborative research. The following discussion of the potential 1–8–301
advantages and disadvantages of collaborative research between rivals considers primarily their
welfare effects. Nevertheless, advantages and disadvantages for the firms themselves must also
be included. In particular, three different theoretical concepts in the relevant literature on the
analysis of joint research are considered; namely, industrial organisation models, transaction cost
rationales, and the resource-based theory of the firm.449

444
Spagnolo, 2004b.
445
Motta/Polo, 2003; Motchenkova, 2004; Ellis/Wilson, 2004; Aubert/Rey/Kovacic, 2003.
446
Motchenkova, 2004, Motta, 2004, 193–202.
447
See Hagedoorn/Link/Vonortas, 2000.
448
Since research and technology policy is often linked to the objective of improving the international
competitiveness of domestic firms, such a focus on industrial policy goals may lead to tensions with
competition policy.
449
See Caloghirou/Ioannides/Vonortas, 2003.

Kerber/Schwalbe
304 Part 1: Introduction

1–8–302 (aa) Potential advantages. A central argument which has been developed in the
industrial organisation literature concerns the potential efficiency improvements resulting from
a research agreement through the internalisation of technological spillovers in innovations
(positive externalities). The difficulties faced by innovating firms due to their insufficient
appropriation of innovation benefits because of knowledge diffusion to other firms has already
been noted. In particular, rivals may benefit from such externally produced knowledge and
free-ride on their competitors’ research efforts. The extent of positive technological extern-
alities in the generation of new knowledge by rival firms acting together brings with it the
danger that there are too few incentives for firms to invest in R&D activities (under-
investment). Such market failure can lead to a loss of welfare. Dynamic competition concepts
highlight the problem of very fast imitation, with consequently insufficient profits for the
innovator. If two competing firms decide to pool their research efforts instead of sustaining
independent research projects, technological spillovers between them no longer affect their
innovation incentives negatively. By contrast, incentives for R&D investment thrive as
compared to non-co-operative research.
1–8–303 Although such spillovers are widespread in relation to the generation of new knowledge, the
extent and rate of knowledge diffusion differs depending on the specific market conditions.
Insights gained by innovation economics highlight that the exploitation of external knowledge
requires that significant time and knowledge resources be spent.450 Consequently, imitation
might only succeed following a delay, or might fail. Therefore, firms may possess sufficient
incentives to innovate anyway. Furthermore, incentives for a firm to invest in its own R&D
activities may exist on the grounds that, without possessing sufficient knowledge capabilities,
firms cannot successfully utilise external knowledge (absorptive capacity).451 In particular, no
major incentive problems are caused by spillover effects as regards new implicit knowledge
(tacit knowledge)—i.e. knowledge that cannot be communicated, since it exists in the form of
certain skills and competences only. Moreover, an R&D joint venture internalises any spillover
effects as between the research partners; any spillovers which exist outside the research coalition
are unaffected. Complete internalisation of spillovers thus requires that all competitors join a
single (monopoly-like) research joint venture. However, the scarce empirical literature on
knowledge spillovers suggests that their importance for collaborative research has been con-
siderably overestimated.452
1–8–304 Through their hybrid form of organisation—being neither a form of pure hierarchical co-
ordination nor pure market co-ordination—research agreements may also have advantages
from a transaction cost perspective.453 In particular, if firms possessing complementary resources
pool their research efforts, or if one firm must undertake additional specific investments, hold-
up problems may arise due to opportunistic behaviour in the light of the great uncertainties
over demand, technology or regulation. If a merger or acquisition does not seem feasible for
whatever reasons, a cleverly designed R&D joint venture can mitigate such transaction cost
problems and, thus, is transaction cost efficient. If new knowledge is neither tangible nor
sufficiently protected through intellectual property rights, selling such knowledge in the market
may not be possible.454 However, substantial transaction cost problems may also occur within
research consortia: negotiations on the joint exploitation of innovations and on the distribution
of the innovation profits might be difficult. Moreover, there is the risk that research partners
may contribute too little or pocket too great a share of the jointly-produced knowledge. Thus,
greater mutual controls become necessary in order to solve internal free-riding problems. As a
consequence, and in particular from a transaction cost and a principal/agent perspective, the
question arises as to what organisational form is best suited to accomplish joint R&D activities.
Complex contractual agreements may well be needed in order to implement an R&D
partnership.
1–8–305 Joint research may also reduce R&D costs.455 A central argument in favour of research
agreements is the avoidance of cost duplication which would otherwise arise due to the parallel
development of new products and technologies. In addition, joint research allows better
exploitation of economies of scale in R&D activities and the distribution of fixed R&D costs
between several research partners. A further advantage of research co-operation is access to the

450
See Nelson/Winter, 1982, 124; Levin/Klevorick/Nelson/Winter, 1987.
451
See Cohen/Levinthal, 1989.
452
See Hernan/Marin/Siotis, 2003; Fritsch/Franke, 2004.
453
See Williamson, 1985, 1996; Menard, 1996.
454
See Arrow, 1962.
455
See Katz/Ordover, 1990; Shapiro/Willig, 1990; Hagedoorn/Link/Vonortas, 2000.

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greater financial resources where two or more firms intend to realise a large R&D project.
R&D coalitions may also allow for better risk diversification where there is great uncertainty
about the likely technological and economic success of a research project.
Joint research can also lead to efficiency advantages if the collaborating firms possess 1–8–306
complementary technologies or research resources. Such co-operation can enable the imple-
mentation of a specific research project, speed up project execution or reduce R&D costs as the
result of synergies realised. In particular, the resource-based theory of the firm, which primarily
emphasises the knowledge and capabilities of a firm, refers to the increased relevance in today’s
innovation processes of combining complementary knowledge. This, in turn, implies that
R&D collaboration and innovation networks play a significantly more important role than in
former times.456 Like dynamic theories of competition, these concepts depict the ongoing
development of the knowledge and skills of firms as the central measure to achieve durable
competitive advantages. Joint research efforts can stimulate the generation of new knowledge
and allow for mutual learning among the firms within the research partnership (organisational
learning), i.e. research coalitions can play a crucial role in the diffusion and implementation of
novel knowledge.457
The strategic management literature points to the strategic relevance of R&D partnerships 1–8–307
through which firms can secure strategic access to knowledge, skills and technologies which
they do not possess. In this context, an investment in an R&D joint venture can be seen as
buying an option on technologies which have not yet been part of the firm’s research portfolio.
This option then can either be used or dropped at a future point, depending on further
developments (strategic flexibility).458 Another strategic problem is caused by network spil-
lovers which occur when the successful implementation of a technology depends on its degree
of diffusion (critical mass effects) or on the simultaneous development of complementary
technologies or products. R&D partnerships may mitigate problems arising through such
network spillovers.
(bb) Anti-competitive effects. Joint R&D activities restrict innovation competition 1–8–308
among the participating firms, as they conduct their innovation activities jointly or at least co-
ordinate them ex ante. Therefore, it is often argued that, due to this reduction of competitive
pressure, less is invested in R&D activities and research processes are slowed down. According
to a dynamic concept of competition, which is characterised as a process of rivalry among firms
competing for new innovations and thus for profits from advances in competition, considerable
incentives exist to invest in new products and technologies. Such investments are meant to
allow for the reaping of the profits of competitive advantage or the avoidance of large losses
when rivals suddenly launch new and better products, driving out rival products. In general,
increased competitive pressure therefore leads to higher investments in R&D activities and,
thus accelerates innovation processes. Situations may arise during which firms compete for a
patent and only the firm which innovates first and gains the patent will reap all the profits
(‘‘winner-takes-it-all’’ race). If no spillover effects occur, i.e. if the patents are perfect, then
such a patent race may cause excessive investments in R&D activities from a total welfare
perspective (overinvestment hypothesis). If there are spillovers, then a direct link exists
between the extent of these effects and R&D investments. It could be shown that, in the case
of low spillovers, the competitive threat dominates and leads to greater R&D efforts. Moderate
spillover effects may help to mitigate the overinvestment problem. However, if spillover effects
are very large, private incentives to invest in R&D activities decrease so much that they
overcompensate the effect of competitive pressure and, thus the extent and rate of innovation
activities decreases. In the case of differentiated products, both spillover effects and competitive
threat effects are less relevant due to limited substitutability.459 After all, R&D collaborations
may lead to strong reductions in research investments and in the rate of progress, as competitive
pressure is reduced or even eliminated entirely, especially in the case of limited spillover effects.
Although a research partnership may be beneficial from the perspective of the firms involved, it
can lead to negative effects on dynamic efficiency and therefore on total welfare.460
Another group of arguments refers to links with other markets. Closely related to the above 1–8–309
rationale concerning the reduction of competitive threat are models which show that, espe-
cially in the light of fierce competition on product markets, R&D partnerships can reduce the

456
See Richardson, 1972; Kogut, 1988; Hagedoorn/Link/Vonortas, 2000.
457
See Pavitt, 1988; Hamel, 1991; Dodgson, 1991; Teece, 1992; Glaister, 1996.
458
See Pindyck, 1991.
459
See De Bondt/Slaets/Cassiman, 1992.
460
See Dasgupta/Stiglitz, 1980; Ordover/Willig, 1985; Beath/Katsoulacos/Ulph, 1989; Katz/Ordover, 1990.

Kerber/Schwalbe
306 Part 1: Introduction

rate of cost-saving process innovations. Due to intensive price competition in highly com-
petitive product markets, the advantages of increased productive efficiency must be handed
over to consumers rapidly.461 Furthermore, R&D joint ventures can also be used to build or
secure dominant market positions, e.g. by involving co-operation with small, innovative firms
which could endanger another’s market position or by using R&D partnerships as barriers to
entry for non-participating firms. Many authors see the main danger as being that anti-com-
petitive effects cannot be limited to the R&D stage but extend to the entire value chain and
other markets.462 First of all, it is clear that, after the joint development of a product, there are
also incentives to produce and distribute the product jointly. However, such an extension of
the co-operation would restrict competition in the product market, in particular, taking into
account the empirical fact that R&D joint ventures are often created by large firms in highly
concentrated industries.463 In addition, it is often difficult to distinguish clearly between the
R&D and the production levels. Furthermore, R&D collaborations lead to the joint profit
interests of co-operating firms, e.g. through the creation of joint undertakings, which dampen
the incentives to compete fiercely in the subsequent product markets. In particular, close co-
operation offers a multitude of opportunities to communicate, for mutual monitoring and the
enforcement of co-operation agreements in order to allow for and stabilise oligopolistic co-
ordination of behaviour. However, co-operation in R&D does not only entail the risk among
participating firms of extending anti-competitive effects to other stages of the value chain: the
literature also points to the risk that an abundance of opportunities emerge for the co-ordi-
nation of interests and the restriction of competition due to a network of R&D partnerships
amongst large firms which engage in many markets (‘‘multi-market and multi-project con-
tact’’). This is true for existing markets as well as for markets which are created through
innovations.464
1–8–310 Another central problem caused by joint R&D, which is alluded to by many authors
(although hardly yet analysed systematically), is the reduction of the number of independent,
research paths pursued in parallel. That is, the diversity of the search for innovative problem
solutions is reduced. Joint research requires an ex ante-agreement between rivals on which
research path to choose. If sufficient knowledge is available about which path will lead to the
best solution, then such an agreement makes sense in order to avoid unnecessary duplication of
costs. However, as a matter of fact, many innovation processes are characterised by substantial
uncertainty as to their likely results. In such a case, it may be beneficial to pursue several
research paths in parallel, since then the probability of finding superior solutions increases.
Innovation economics emphasises the necessity of the continuous generation of a variety of
different innovative hypotheses on problem solutions, as these hypotheses can then be tried,
selected and diffused in markets (trial and error-process). This also follows directly from
evolutionary concepts of competition which, along the lines of the basic ideas of Schumpeter
and, particularly, Hayek, understand competition as a process of parallel experimentation with
new solutions (competition as a discovery procedure). From this perspective, an R&D joint
venture may lead to the premature abandonment of an as-yet-untried research path, which, in
turn, could decrease the odds of finding good innovative solutions in the context of uncer-
tainty. Therefore, a research partnership might lead to negative effects on the development of
product and process innovations. Besides, this aspect of the finding of a better solution
(selection effect) also highlights the complementary effect, i.e. new complementary knowledge
is created through many independent sources and firms mutually benefit from this com-
plementary knowledge base. This positive effect on welfare, induced by the increased chances
of finding a better innovative solution through additional, parallel research efforts, is not usually
considered in the industrial organisation literature and would have to be assessed against the
potential negative effects due to possible cost duplication through parallel trials.465
1–8–311 (c) Policy conclusions. Theoretical and empirical research on the effects of joint R&D
activities among rivals highlights the considerable ambiguity of the effects R&D partnerships

461
See Katz, 1986; Katz/Ordover, 1990; Kline, 2000; Vonortas, 1994.
462
See Katz, 1986, 542; Jorde/Teece, 1990; Katz/Ordover, 1990, 145; Shapiro/Willig, 1990; Martin, 1995;
Vonortas, 2000; Rabassa, 2004; for the stabilisation of the co-ordination of behaviour see above Section V.2.
463
See Scott, 1988; Miotti/Sachwald, 2003; Hernan/Marin/Sioti, 2003.
464
See Scott, 1993; Vonortas, 2000; Caloghirou/Ioannides/Vonortas, 2003, 560.
465
See Metcalfe, 1989, 1995; Mowery, 1995; Kerber, 1997; Kerber/Saam, 2001; Aigner/Kerber, 2006.
Section III.5; especially for selection and complementary effects see Cohen/Malerba, 2001; for the reduction
of the probability of finding a successful innovation through a reduction of research paths see also Carlton/
Perloff, 2005, 540; Neumann, 2000, 161.

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G. Economic Principles of Competition Law 307

have on total welfare. First of all, it must be acknowledged that, due to new technological and
market developments, the relevance of temporary co-operation between firms concerning
research and development has risen significantly. The positive effects on static and dynamic
efficiency, however, can only partially be ascribed to the internalisation of spillovers. Rather,
such positive impacts arise mainly from synergy effects, stemming from co-operation between
firms which possess different, complementary, knowledge resources and from cost savings and
risk diversification. Therefore, R&D coalitions have a remarkable potential for the realisation
of positive welfare effects. In general, this is also true for co-operation between direct com-
petitors or—equally important—between established firms and potential rivals. Nevertheless,
such horizontal agreements on R&D co-operation may also bring considerable risks. In par-
ticular co-operation in R&D activities between large rivals may lessen competitive threat and,
thus, may lead to a reduction of innovations or a slow down in the rate of technological
progress. Furthermore, in the light of uncertainty as to which are the right research paths and
on the likely future results of technological research, there is the problem that the diversity of
research paths pursued is drastically reduced by R&D partnerships. Thus, the probability of
finding a particularly promising innovative solution falls and the effectiveness of competition as
a discovery procedure is impaired. In particular, the risk that co-operation does not remain
restricted to R&D activities but is extended to additional levels of the value chain and to other
markets is relevant, since in such a case the anti-competitive effects may outweigh the potential
positive impact on efficiency and technological progress.
These considerations have some clear implications for competition policy. The dangers of 1–8–312
reduced competitive pressure and research diversity, as well as of co-ordinated conduct on
product markets triggered by co-operation in R&D efforts, is likely to be the greater the larger
the market shares of the co-operating firms and/or the higher the concentration of the market.
Therefore, market share thresholds are useful, i.e. below which R&D partnerships can usually
be deemed as unproblematic and, thus, exempted. Above these thresholds the competition
authorities should employ a rule of reason approach in order to weigh the potential positive
and negative effects against each other. Since R&D activities are characterised by high degrees
of uncertainty, reliable (quantitative) predictions about the advantages and the risks of R&D
coalitions are hard to reach. This problem is particularly important in the case of research
directed to as yet non-existent product markets. Although US antitrust policy has tried to solve
these problems by introducing the so-called Innovation Market Analysis, competition policy
remains very limited because of the high level of uncertainty about the mechanisms and results
of innovation processes.466 The main prerequisite is that it should be ensured that firms par-
ticipating in R&D collaboration do not extend their co-operation to other areas. Contractual
agreements on the joint production and marketing of the results of R&D should therefore be
reviewed thoroughly. In particular, significant anti-competitive effects can be caused through
ancillary restraints in contracts, e.g. on the geographic division of markets or the use of patents.
For example, if the exploitation of a joint patent by rival firms is governed by a unit fee instead
of a quantity-independent fixed payment, such an agreement will lead to higher product prices,
because the marginal costs of production have been increased.467
5. Other horizontal agreements. Technologies can be the subject of horizontal agree- 1–8–313
ments concerning licences and patents and also standard setting. If two different firms possess
patents on particular technologies, they can agree to grant mutual licences for the use of their
patents (cross-licensing), or to bring their patents into a patent pool in order to exploit these
patents as a package (patent pooling). Depending on the circumstances, such agreements could
either primarily restrict competition or increase static and dynamic efficiency. If the patented
technologies are substitutes, then cross-licensing or patent pooling may restrict competition
between the firms, leading to higher prices of those products which depend on these tech-
nologies as their inputs. Thus, oligopolistic co-ordination among competitors in product
markets can be alleviated by such cross-licensing of patents.468 However, if complementarities
exist between the patented technologies, then externalities arising between complementary
goods are internalised, and both cross-licensing and patent pooling lead to decreasing costs and
increasing efficiency. Bargaining on bundles of complementary patents may also reduce
transaction costs.469
Many technological areas such as television and video technologies, CDs and DVDs are 1–8–314

466
See Gilbert/Sunshine, 1995; Section IV.7.(b)(ii).
467
See Motta, 2004, 205.
468
See Eswaran, 1994.
469
See Merges, 2001.

Kerber/Schwalbe
308 Part 1: Introduction

characterised by significant network effects. In the medium and long run, these network effects
may allow for the survival of only a few or even just one technological standard in a market.
There is often fierce competition to be the first standard to gain a large market share and thus to
prevail in the long run. From an economic perspective, the problem is that it is difficult to
predict whether competition for the market will choose the best standard. Furthermore, in the
long run, network effects and additional dynamic economies of scale can render it very difficult
for a well-established standard to be replaced by a new and better standard in the future (lock-in
effect).470 In such cases, it could be beneficial if rivals agreed on a common standard before-
hand. Such an agreement would restrict competition for standards but might bring advantages
as well: the market for particular new products could develop faster and cheaper, since the
future standard would be known earlier as compared with the absence of any such agree-
ment.471 However, it is unclear whether negotiations on standards would lead to the most
efficient standard or whether other criteria, such as the market and bargaining power of
established firms or even political concerns (so far as those of governments or regulatory
authorities involved) play a decisive role. Therefore, from a policy perspective, such agree-
ments on standard setting should be treated cautiously, and should be reviewed critically to
ensure that no additional restrictions on competition evolve.
1–8–315 Specialisation agreements between firms are an important kind of co-operation agreement.
For example, two rival firms which offer a broad range of products, e.g. an assortment of
screws, could agree that, rather than each of them producing all the sorts of screws which they
offer, each firm restricts itself to the production of only a part of the assortment and the firms
mutually supply each other. Hence, both firms would compete in the product market by
offering the whole range of screws, yet they would specialise in the production of these
particular sorts of screws. If there are economies of scales, then production costs would decrease
and productive efficiency would rise. These advantages in efficiency are nevertheless to be
balanced against the restrictions in price competition triggered by the agreement on supply
prices as between the firms. Since it is not certain that at least part of the efficiency advantages
will accrue to consumers, and that these agreements will not be abused in order to increase
prices, it is necessary to safeguard competition in the market. Therefore, the size of market
shares of the firms involved becomes a relevant assessment criterion.
1–8–316 If one generalises this concept, the question arises whether small and medium-sized firms
should be exempted from a ban on anti-competitive agreements per se. Often, SMEs have
disadvantages as compared to large firms, e.g. because they cannot fully exploit economies of
scales and other advantages caused by synergies. Since, in addition, smaller firms usually cannot
gain significant market power through horizontal co-operation, a generous exemption of
various kinds of co-operation agreements among small- and medium-sized firms would seem
reasonable. Nevertheless, the market shares of the co-operating firms should be taken into
account, because a cartel of SMEs can represent significant market shares.
1–8–317 Joint buying agreements are a special kind of such co-operation agreements. Here, SMEs in
the main, e.g. retailers, agree on joint purchasing in order to achieve lower purchase prices. It
has been empirically proven that by buying larger quantities lower purchase prices can be
realised, e.g. due to higher rebates. These additional rebates are, in part, caused by lower costs
to the supplier due to the delivery of these larger quantities to customers. Thus, such joint
sourcing improves product efficiency. However, the realisation of lower prices often results
from the greater bargaining power of customers when they buy larger quantities. In this case,
mere redistribution takes place between suppliers and customers. This raises the question
whether the buyers can restrict competition through such joint buying and, thus, possess
problematic buying power.472 Therefore, joint purchasing might also raise competition policy
concerns. As long as the members of such a joint buying venture are SMEs and its market share
remains relatively limited, these firms can gain the opportunity to achieve similarly advanta-
geous purchase prices like their larger rivals without seriously endangering competition.
1–8–318 Structural crisis cartels, and export and import cartels represent types of horizontal agree-
ments which should be viewed very critically as regards their potential exemption from the
general prohibition of cartels. If there is a long-lasting crisis with structural overcapacities in an
industry, e.g. due to a long-term decrease in demand, which leads to a tendency for heavy price
decreases, the question is whether the necessary structural adjustments in such industries should

470
See Arthur, 1989.
471
See Shapiro, 2001.
472
For the problem of market dominance of buyers see Lademann, 1986; Kerber, 1989; Scherer/Ross,
1990, 517–536.

Kerber/Schwalbe
G. Economic Principles of Competition Law 309

be left to competition or whether the firms should found a structural crisis cartel. The firms in
the cartel might agree to cutback these overcapacities and simultaneously prevent additional
price decreases by restricting price competition until the restructuring process is accomplished.
Although such a solution seems reasonable at first sight, the experience with these agreements
has been very negative. In most cases the firms do not succeed in actually reducing the
overcapacities which are least productive. Furthermore, the elimination of competition often
prolongs structural adjustment, especially if public subsidies are paid in order to sustain
employment. From an economic perspective, export and import cartels of domestic firms must
be rejected entirely, because they aim primarily at a mere restriction of price competition and
impede competition on international markets.473

VI. Horizontal mergers and merger control


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the Antitrust Laws, New York University Law Review 77, 2002, 135–203; Bendor/Mookherjee/Ray,
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Enough, ECLRev. 17, 1996, 3–5; Bishop/Lofaro, A Legal and Economic Consensus? The Theory and
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The Economics of EC Competition Law, 2002; Bork, The Antitrust Paradox, 1976; Bühler/Jaeger, Ein-
führung in die Industrieökonomik, 2002; Compte/Jenny/Rey, Capacity Constraints, Mergers and Collusion,
E. Econ. Rev. 46, 2002, 1–29; Crooke/Froeb/Tschantz/Werden, Effects of Assumed Demand Form on
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Dobson/Waterson, Countervailing Power and Consumer Prices, Economic Journal 107, 1997, 418–430;
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Werden, A Robust Test for Consumer Welfare Enhancing Mergers among Sellers of a Homogeneous
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Firm Defence, OECD Journal of Competition Law and Policy 1, 1999, 119–139; Hosken/O’Brian/
Scheffman/Vita, Demand System Estimation and its Application to Horizontal Merger Analysis, 2002,
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Oligopolies, Bonn University Discussion Paper 12/2001; Ivaldi/Jullien/Rey/Seabright/Tirole, The Eco-
nomics of Unilateral Effects, Interim Report for D-G Competition, 2003a; Ivaldi/Jullien/Rey/Seabright/
Tirole, The Economics of Tacit Collusion, Interim Report for D-G Competition, 2003b; Jacquemin/Slade,
Cartels, Collusion, and Horizontal Merger, in Schmalensee/Willig, Handbook of Industrial Organization,
Vol.1, 1989, 415–473; Kleinert/Klodt, Megafusionen, 2001; Kühn, The Coordinated Effects of Mergers in
Differentiated Products Markets, CEPR Discussion Paper No.4769, 2004; Kühn/Motta, The Economics of
Joint Dominance and the Coordinated Effects of Merger, 2000, mimeo; de la Mano, For the Customer’s
Sake: The Competitive Effects of Efficiencies in European Merger Control, Enterprise Papers No.11,
2002; Mason/Weeds, The Failing Firm Defence: Merger Policy and Entry, CEPR Discussion Paper
No.3664, 2002; Monopolkommission, IV. Hauptgutachten: Fortschritte bei der Konzentrationserfassung,
1982; Monopolkommission, XII. Hauptgutachten: Marktöffnung umfassend verwirklichen, 1998; Mono-
polkommission, XV. Hauptgutachten: Wettbewerbspolitik im Schatten ‘‘Nationaler Champions’’, 2004;
Motta, Competition Policy, 2004; Muren/Pyddoke, Coordination and Monitoring in Tacit Collusion,
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473
See Victor, 1992; Schultz, 2002; for the assessment of export and import cartels from the perspective of
the protection of competition on international markets see Section X.5.

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310 Part 1: Introduction

Standard in a Political Economy of Merger Control, CEPR Discussion Paper No.2620, 2000; Neven/
Seabright, Synergies and Dynamic Efficiencies in Merger Analysis, Interim Report to D-G ECFIN 2003;
Piesch, Statistische Konzentrationsmaße, 1975; RBB Economics, The Emperor’s New Clothes?—the Role of
Merger Simulation Models, 2004; Röller/Stennek/Verboven, Efficiency Gains from Mergers, European
Economy, Reports and Studies 5, 2001, 31–128; Salant/Switzer/Reynolds, Losses Due to Merger: The
Effects of an Exogenous Change in Industry Structure on Cournot-Nash Equilibrium, Quarterly Journal of
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58, 1968, 18–36.
1. Concentration: Causes and measurement
1–8–319 (a) Measurement of concentration. As described above, in the course of defining the
relevant market, the firms that supply the goods traded in that market are identified. The
concentration of firms in the market is determined by their number and their relative sizes in
terms of market shares. To measure the concentration, a number of statistical indices are
employed, e.g. the so-called concentration ratio (CR).474 The concentration ratio in a market is
calculated by adding the market shares of the largest firms in the market ranked in order of
market shares. Often, these ratios refer to the 6, 10, 25, and 50 largest firms, e.g. in the German
Monopoly Commission’s report.475 For instance, a concentration ratio CR6 = 60 per cent
indicates that the six largest firms in the market possess a market share of 60 per cent in total.
However, concentration ratios do not consider the relative sizes of the firms. Thus, a con-
centration ratio of CR6 = 60 per cent may indicate that the six largest firms hold a market share
of 10 per cent each. However, it may also mean that the largest firm has a market share of 55
per cent, while the following five largest firms possess a share of only 1 per cent each. As the
situations just described differ widely, assigning the same number to both of them seems
unsatisfactory. For this reason, the Herfindahl-Hirschman index (HHI), in which the relative
sizes of the firms are taken into consideration, is used in addition to the concentration ratio.
The HHI is defined by the sum of the squared market shares of all firms in the market. In
general, this number is multiplied by 10,000 in order to avoid extremely small numbers.
Formally, the HHI is defined by
X n
HHI ¼ 10000 s2i ðsi : Market share held by firm i; i ¼ 1; :::; nÞ:
i¼1

474
cf. Schmidt, 2005, 138–141; Piesch, Statistische Konzentrationsmaße, 1975; Monopolkommission, 1998.
475
cf. Monopolkommission, 2004.

Kerber/Schwalbe
G. Economic Principles of Competition Law 311

The maximum value of the HHI is 10,000, which is the case for a monopoly with a 100 per 1–8–320
cent market share. In a market with a large number of small firms, the HHI is close to 0. In the
example above, the HHI would be 640 in the first case and 3,070 in the secondly, asssuming
that the other firms possess a 1 per cent market share each. This shows that the market is much
more concentrated in the second case, compared with an equal distribution of market shares
between the six largest firms. The squaring of the market shares enhances the significance of
their size. In recent years, the HHI has been established as the major measure of concentration,
in the USA as well as in Europe. In the US, a value smaller than 1,000 is considered as a ‘‘low
degree of concentration’’, while values between 1,000 and 1,800 (or 2,000 in the EU) are
termed a ‘‘medium level of concentration’’, and higher values indicate a ‘‘highly concentrated
market’’.476
Besides the absolute measures of concentration ratios and the HHI, the literature employs a 1–8–321
number of other measures that are used primarily to determine the inequality of the dis-
tribution of market shares. These are disparity ratios which indicate the size of the fraction by
which the value of a concentration ratio results from the inequality of market shares. Suppose
the concentration ratio with respect to the three largest firms out of 100 is 10 per cent. If all
firms were of equal size, the concentration rate would be CR3 = 3 per cent. Therefore, of the
actual value of the concentration ratio (10 per cent), 70 per cent results from the inequality of
the market shares. The disparity ratio would then be DR3 = 70 per cent. The HHI can also
produce relative concentration measures, e.g. the often- employed variation coefficient. This is
the ratio of the standard deviation of the market shares to their arithmetic mean. A large
variation coefficient indicates a high degree of inequality in the market shares, i.e., if all market
shares were equal, the variation coefficient would be 0. Other measures of disparity that are
often employed include the Gini coefficient, which measures the deviation between an equal
distribution and the actual one, and the Linda-Index, which allows for the separation of a
dominant group of firms from competitors that posses relatively small market shares.477
(b) Possible causes of variations in concentration. Variations in the level of con- 1–8–322
centration of firms over time may result from a variety of causes. Major determinants of the
development of concentration are market entry and exit, which depend, amongst other things,
on the strength of the existing barriers to entry and exit. The concentration in a market is also
affected by different rates of the internal growth of the firms. A higher growth rate of a firm’s
market share may indicate a higher degree of efficiency or of productivity, but it may also result
from the firm’s impeding of its competitors. A major cause of increasing concentration is the
external growth of firms as a result of horizontal mergers. Unlike internal growth due to
increased productivity, external growth is a particularly problematic cause of increasing con-
centration, since a merger eliminates direct competition between the merging firms.478
2. Effects of mergers: outline. The analysis of the various market structures above 1–8–323
pointed out the correlation between the degree of concentration in a market and the firms’
market power: the smaller the number of firms in the market, i.e. the higher the degree of
concentration, the more likely are the firms to possess market power.479 This correlation
indicates a major incentive for the achievement of external growth: a merger secures a larger
market share, which in turn helps the firms to obtain market power, or to extend existing
market power, as the case may be. This provides the firms with a wider scope to behave
independently of their competitors and their customers, which enables them to charge higher
prices and realise higher profits. Another incitement to merge is to avoid unnecessary dupli-
cation of, e.g. administration such as accounting or data processing departments. Furthermore,
merger may lead to the employment of better production technologies which will save on
production costs, and thus raise the profit margin. Such efficiency gains may counteract the
detrimental effects of mergers due to increased market power.
The theory of industrial organisation distinguishes between two general classes of effects that 1–8–324
impair competition as a result of a merger. These are closely related to the equilibrium concepts

476
cf. Europäische Kommission, Leitlinien zur Bewertung horizontaler Zusammenschlüsse gemäß der
Ratsverordnung über die Kontrolle von Unternehmenszusammenschlüssen, in: ABl EG 2004 C No.31, 7,
US DOJ/FTC, 1997, 1.51; Neven/Nuttall/Seabright, 1993, 58.
477
cf. Piesch, 1975.
478
cf. Monopolkommission, IV. Hauptgutachten 1980/81, Kap. IV.
479
There is a tendency towards this correlation to hold, however, there may be substantial competition
between the firms even in a market with a very high degree of concentration. e.g. in the case of price
competition with a homogeneous good, the outcome is the same as under perfect competition. Sections 2–
5 are based on Schwalbe/Zimmer 2006.

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for oligopolistic markets, namely the non-co-ordinated equilibrium and the co-ordinated
equilibrium.480 A merger affects both the number of firms in the market as well as their
structures, since the merged firms possess a larger capital stock, a different cost function, etc. As
a consequence, the firms will most probably adjust their behaviour. Put differently: the stra-
tegies hitherto employed will no longer form a Nash equilibrium post-merger. Two different
situations may arise after the merger: first, a new Nash equilibrium may emerge in the market
now characterised by a smaller number of firms, new cost structures and market shares, etc.
without any co-ordination. This new Nash equilibrium is characterised by new prices and
quantities, but the firms continue to act competitively within the oligopolistic market. They
take into account their strategic interdependence, but co-ordination will not take place. While
the oligopolists adapt to the altered situation, the difference in the market outcome results
entirely from the oligopolists’ individual decisions. Competition between the merged firms
being eliminated, and the competition in the market being lessened as a consequence of the
reduced number of firms in the market, price increases and output reductions are to be
expected, and thus a loss in welfare. These changes in prices and quantities supplied are referred
to as unilateral or non-co-ordinated effects of a merger. These effects are likely to occur in any
case of merger in an oligopolistic market.
1–8–325 Secondly, the merger may result in a regime switch with respect to competition between the
firms: before the merger, there was no co-ordination of behaviour. After the merger, however,
opportunities may arise that enable the firms to co-ordinate their behaviour. Furthermore the
post-merger situation may be such that it facilitates or stabilises existing co-ordination, or
renders co-ordination more effective. This may eliminate or at least drastically reduce com-
petition. The resulting price increase and quantity reduction exceed the unilateral effects. Such
effects resulting from a regime switch in the structure of competition are referred to as the co-
ordinated effects of a merger. On the other hand, a merger may yield efficiency gains that allow
the firms to, e.g. produce at a lower cost, or enable them to develop new and better products
through integrating their respective R&D departments. The next section takes a closer look at
the possible effects of a merger.
1–8–326 3. Unilateral effects. What follows is a more detailed analysis of the effects of a merger,
starting with an oligopolsitic market. The focus here is on unilateral effects. The analysis of the
ways in which a merger affects the market outcome assumes that there is no co-ordination
between the firms, either before or after the merger. It is therefore a comparison of the non-
co-ordinated Nash equilibrium outcomes before and after the merger. The unilateral effects
depend on the competition parameters (i.e. prices or quantities) employed by the firms, and on
the degree of homogeneity of the goods produced.
1–8–327 (a) Price competition with homogeneous goods. In an oligopolistic market where the
firms produce a homogeneous good and compete on price, the short-run non-co-ordinated
Nash equilibrium is characterised by the price being equal to marginal cost. The extremely
intense competitive pressure results in an outcome the same as that under perfect competi-
tion.481 In this situation, a merger of two firms will not affect the market outcome, even if the
merging firms possess large market shares, provided that the merger does not result in a
monopoly position on the part of the merged firm.482 The merger will also have no adverse
effects on competition between the remaining firms. The market price will remain unaffected
by the merger. The same is true for the quantity produced. The argument applies even if the
merged firm possesses so large a market share that it obtains what would be, on the face of it, a
dominant position. Furthermore, even significant increases in the market share do not imply
any harmful consequences.
1–8–328 Whilst this results from an extreme theoretical case, such outcomes resembling the Bertrand
equilibrium may actually occur in bidding markets.483 In such markets, even a small number of
firms is often sufficient to exercise considerable competitive pressure. As a consequence, the
outcome is likely to be competitive. This is especially true in markets where substantial bulk
orders are placed, relative to the entire market volume. In this situation, what matters is not a
firm’s market share but rather its ability to submit competitive bids.484
1–8–329 (b) Quantity competition with homogeneous goods. If the relevant competition
parameter is the quantity produced, or the production capacity, the outcome will differ from

480
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a and 2003b.
481
cf. Section IV.5.(c)(aa).
482
cf. Bühler/Jäger, 2002, 135.
483
cf. Bishop/Bishop, 1996, 3.
484
cf. Bishop/Walker, 2002, 54.

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the one under price competition. The short-run, or non-coordinated Cournot-Nash equili-
brium is characterised by the firms’ supplying a smaller quantity at a higher price, compared
with perfect competition.485 Now, if two firms merge in this situation, competition between
them will be eliminated. Prior to the merger, neither firm considered the effects of its supply
decision on the other’s profits, since they affected the other firm only. This is why pre-merger
the firms supply a larger quantity, since the resulting reductions in the other firm’s revenues and
profits were not taken into account. Post-merger, however, these negative external effects are
internalised, as any decision made by the firm will affect itself, rather than another firm. It
follows that the merged firm reduces its output, as compared with the situation prior to the
merger, and thus induces an increased market price.
However, the unilateral reduction in the quantity supplied, and the resulting increase in 1–8–330
price, are not the only effects caused by the merger. The other firms that do not participate in
the merger will respond by adjusting their quantities supplied, too. If, prior to the merger, a
Cournot-Nash equilibrium had prevailed in the market, then the quantities produced by the
firms were mutually best responses. After the merger, however, the quantity produced by the
merged firm declines, and the market price goes up. Therefore, the quantities produced by the
other firms pre-merger are no longer the best responses in the post- merger situation. As a
result of the increased price, the other firms will expand their production, since the quantity
produced before would be too small at this price.486 Of course, the merged firm anticipates the
other firms’ reactions. As a consequence, it chooses the quantity that is the best response to the
other firms’ quantities supplied, after having taken into account their reaction. The total effect
of a merger in a market with quantity competition and a homogeneous good thus consists of a
reduction in the quantity produced by the merged firm and an expansion in the quantity
produced by the other firms. That is, the effects of the merger are not merely unilateral, but all
firms in the market will adjust their quantities supplied. Therefore, in order to be able to
determine the total effect, one must consider not only the effects resulting from the adjustment
made by the merged firm, but also the reactions on the part of the other firms in the market.
Limiting one’s attention to the adjustment made by the merged firm only would result in an
overestimation of the effect of the merger. The reason is that the quantity increase on the part
of the other firms counteracts the output reduction effected by the merged firm. In general,
however, the other firms’ output increase will not suffice to compensate the quantity reduction
on the part of the merged firm. The reason is that,while the competitors profit from the price
increase by expanding their production, this expansion will not be large enough to counter-
balance the initial price increase. They profit from a larger quantity as well as a higher price.487
As a result, the total quantity supplied will be less than before the merger, and the price will
increase, such that consumer surplus as well as total welfare will decline as a result of a
merger.488 Only if the merger produces considerable synergy effects which reduce costs, might
consumer surplus may be increased due to falling prices.489
(c) Price competition with differentiated goods. Whilst price competition with 1–8–331
homogeneous goods induces the same outcome as perfect competition, this is not the case with
differentiated goods. Here, the firms charge prices which are above the competitive level. The
reason is that, if a firm raises its price, it will not lose all its customers immediately, but maintain
the part of them that are willing to pay a higher price for their preferred product.490 Obviously,
in a market with differentiated goods, the effects of a merger will depend on the degree of
substitutability of the goods produced by the merging firms.491 If the majority of consumers
consider the goods as rather poor substitutes, then the competitive constraints one firm exerts
on the other will tend to be insignificant. In this case, if a firm raises its price, this will not
induce any noticeable demand-side substitution. Thus, competition between suppliers of

485
cf. Section IV.5.(c)(bb).
486
As the quantities supplied in a Cournot model are strategic substitutes, a quantity reduction on the
part of one firm will cause the other firms to expand their quantities.
487
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, 40.
488
If the merging firms are ‘‘small’’ in comparison with the other firms in the market, the increase in the
quantities supplied by the other firms may overcompensate the reduction in the quantity supplied by the
merged firm, such that the net effect may be positive. But then, mergers between small firms are generally
considered as innocuous; cf. Motta, 2004, 234.
489
Here, the reduction in the merged firm’s costs has to be so large that the mark-up on the merged
firm’s profits exceeds the sum of the mark-ups gained by all other firms; cf. Farell/Shapiro, 1990.
490
cf. Section IV.5.(c)(cc).
491
As before, in what follows we will consider a merger of two firms only.

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remote substitutes is only weak, since their products are relatively independent of each other.
Here, a merger would hardly affect the market outcome. Things are different when the
majority of consumers consider the goods as being close substitutes. In this case, competition
between the firms is much keener. If a firm raises its price, a large number of its customers will
switch to the substitute good. On the other hand, by cutting its price a firm will be able to
entice away a large fraction of the competitor’s customers. This is because most consumers
consider the products as almost identical.492 Therefore, each firm’s ability to exercise market
power is restricted.
1–8–332 A merger of two firms producing close substitutes eliminates competition between them.
Prior to the merger, if a firm raised its price, its opponent would reap the larger part of the
benefit. After the merger, however, the producer of the substitute good is integrated in the firm
itself. Now, consumers that switch to that substitute no longer buy from the competitor, but
continue to purchase it from the same firm. The elimination of the competitive barrier will
induce the merged firm to increase the prices of both its products. It may be that a few customers
will switch to other goods, but a considerable share of the demand will remain with the merged
firm. This renders a price increase profitable, which was not the case prior to the merger when
competition was fierce. The effects on competition therefore depend to a large extent on the
degree of substitutability between the goods. If the goods are close substitutes, the competitors
will restrict each other’s market power. On the contrary, if the goods are only poor substitutes, a
firm’s market power will scarcely be constrained by a distant competitor. If the producers of
close substitutes merge, a high degree of competitive pressure will be eliminated. The effects on
competition, and also on prices and quantities supplied, will be considerable. In the case of poor
substitutes, the competitive pressure one firm exerts on the other is not very pronounced
anyway. In this case, a significant increase in price is not to be expected. The market outcome
will also depend on whether or not the goods produced by the non-merging firms are con-
sidered as close substitutes to the merged firm’s product. In the case of poor substitutes, the price
increase effected by the merged firm will be more significant as compared to the case of closer
substitutes. As in the case of quantity competition, the merged firm’s change in behaviour is not
the only effect of the merger, since the competitors will also react to the price increase. The
price increase effected by the merged firm will induce its competitors to raise their prices also.
This is because the increase in price makes consumers switch to substitute goods, such that
demand for the competitors’ products rises.493 The price charged by the competitors before this
rise in demand is now no longer optimal, it is too low. A profit-maximising firm will raise the
price of its product but only to a certain extent in order to prevent demand from decreasing.
Thus, the firm will profit both from a higher price charged and from a larger quantity supplied.
The increase in the competitors’ demand, and the price increment, depend on how close the
substitutes are, i.e. to what degree the goods produced by the merged firm are substitutes for the
goods produced by its competitors. The merged firm anticipates the price increase on the part of
its competitors, and takes this into account in its own pricing policy. As a consequence, the
merged firm will increase its price even further, by a small amount. If the predicted effects of the
merger were based on the price increase effected by the merged firm only, disregarding the
competitors’ reactions, the total effect will be underestimated.494 In the new situation, the prices
of all goods will have increased in the Bertrand-Nash equilibrium. The magnitude of the price
increase differs across firms, and depends on the substitutability of their products as compared to
those produced by the merged firm. Since all prices have gone up, although to different degrees,
a merger will, ceteris paribus, reduce both consumer surplus and total welfare.
1–8–333 (d) Quantity competition with differentiated goods. When the competition para-
meter in a market with differentiated goods is the quantity produced, or the capacity, rather
than the price, the effects of a merger will be similar to those of quantity competition with a
homogeneous good. The main difference is that, in the former case, the goods are only poor
substitutes. If a firm cuts down on its quantity supplied, this will mostly affect the price of the
good itself, and those of close substitutes. Poorer substitutes will not be affected by the
reduction in supply of the good in question. This is why a merger of firms that produce distant
substitutes will not have any noticeable effect on the market outcome. However, if the

492
In Section IV.6.(a) we explained that the marginal consumers are pivotal with regard to the possibility
of a price increase. If the number of customers that switch to other suppliers is sufficiently large, a price
increase will become unprofitable.
493
As prices are strategic complements, a price increase on the part of a firm will induce the other firms
to raise their prices as well.
494
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, 52.

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G. Economic Principles of Competition Law 315

merging firms produce close substitutes, the merged firm will reduce the quantities supplied of
both products, in order to raise their prices. Now, firms producing weaker substitutes will face
an increase in demand, and they will react by expanding their production, to a certain extent.
These effects will be of lesser significance the lower the degree of substitutability. Note,
however, that in the case of incomplete substitutes, smaller quantities would have been pro-
duced even before the merger, and prices would have been higher, as compared to the case of a
homogeneous good (i.e. when all goods are perfect substitutes). In the former case, there is a
lesser degree of strategic interdependence, and thus a more pronounced tendency towards
monopolistic behaviour, associated with smaller quantities and higher prices.
The analysis of unilateral effects has shown that the merged firm will, ceteris paribus, produce 1–8–334
a smaller quantity and charge a higher price than the participating firms had before the merger.
Although the other oligopolists will respond by increasing their quantities as well, the total
effect will be an increase in the price level in the market under consideration, always assuming
that the merger does not induce any efficiency gains. In comparing the effects of a merger as
between the cases of quantity competition and price competition, it appears that, in the former
case, the reactions on the part of the merged firm and its competitors counter each other: A
quantity reduction on the part of the merged firm, and the ensuing price increase, will be partly
compensated for by the competitors expanding their quantities. In the case of price compe-
tition, by contrast, the effects mutually enforce each other: the price increase on the part of the
merged firm induces its competitors to raise their prices also. This difference affects the
incentives of the merging firms: with quantity competition, it may be the case that after the
merger, the profit realised by the merged firm is less than the sum of the firms’ pre-merger
profits. This may be the case when the efficiency gains resulting from the merger are insuf-
ficient.495 With price competition, however, this is impossible, since a merger is always
profitable.496 Furthermore, the different effects arising from quantity and price competition do
not allow any conclusions to be drawn with respect to the extent of the price increase and the
change in welfare. First, the original price level in a market with quantity competition is
different from the one resulting from price competition: competitive pressure is less significant
in the case of quantity competition, and higher prices will result, in comparison with price
competition. Secondly, in the presence of quantity competition, the extent of the price
increase induced by the reduction in the merged firm’s supply exceeds the extent of the price
increase in the case of price competition. In the former case, the output expansion on the part
of the merged firm will be mitigated by the competitors’ output reductions. In the latter case,
by contrast, the competitors will react by raising their prices too, thus reinforcing the effect.497
Therefore, there is no general rule as to the effects of a merger being more or less severe in the
case of price competition as compared to quantity competition.498
(e) Detecting unilateral effects. As with the determination of market power, unilateral 1–8–335
effects may be calculated either by identifying directly the unilateral effects of a merger, or by
pursuing an indirect, structural approach based on market definition, calculation of the firms’
market shares, and the change in concentration due to the merger. These methods are
described briefly below.
(aa) Merger simulations. For several years, simulation models have been used to deter- 1–8–336
mine directly the effects of a merger on prices, quantities, and welfare. In particular, mergers of
firms producing differentiated products have been analysed in this way.499 With simulation
models, the effects of a merger are estimated directly, employing data on the demand for the
products and a model of consumer behaviour, as well as an appropriate oligopoly model. The
method proceeds in several stages. First, a demand system is determined, i.e. a formal model of
consumer behaviour. To this end, econometricians have developed a number of models, which
vary in their degree of complexity. The best-known systems are the linear one, the log-linear

495
cf. Salant/Switzer/Reynolds, 1983.
496
cf. Davidson/Deneckere, 1985.
497
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, 53.
498
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, 53.
499
cf. Epstein/Rubinfeld, 2002; Werden/Froeb, 1996; Werden, 1997a, Werden, 1997b, Werden/Froeb, 2002.

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316 Part 1: Introduction

one, as well as the Logit, AIDS, and NIDS demand systems.500 The Antitrust Logit Model
(ALM) is often used in practical applications of merger control. The advantage of this model is
that only two elasticities have to be estimated. Thus, estimations giving a picture of the
magnitude of the effects of a merger can be made with comparatively small effort.501
1–8–337 The next step in simulating a merger consists in calibrating the demand system, i.e. speci-
fying the parameters underlying the demand system in such a way that the empirically
determined or estimated elasticities give rise to such prices and market shares of the respective
products which correspond precisely to those prevailing in the market prior to the merger. The
supply side is modelled by employing a model of oligopoly that fits as closely as possible to
competition observed in the market. Next, the market shares, prices, and the model of oli-
gopolistic interaction are used to estimate the firms’ marginal costs. Profit maximisation implies
that marginal revenue equals marginal cost for each firm, and marginal revenue can be
determined through the prices, elasticities and the market shares. It is then possible to draw
conclusions with respect to the firms’ marginal costs.502 The result is an empirically based model
of the market. The final step of simulating the merger consists in calculating the equilibrium in
the situation post-merger, taking into account the empirical data. These simulation models are
based on the assumption that the firms do not co-ordinate their behaviour after the merger, i.e.
that there will be no co-ordinated effects. Then, the prices and quantities which are predicted
to occur after the merger are compared with those prevailing prior to the merger. The
difference yields an estimate of the unilateral effects.
1–8–338 Benefits of simulation models. Simulation models provide a prediction of the effects of a merger
based on empirical data and testable theories. Furthermore, the assumptions underlying the
simulation model are clearly stated. As a consequence, the main data, assumptions, and con-
ditions with respect to the outcome may be identified, and the possible causes of differences in
the estimates of unilateral effects can be determined. In principle, the simulation may be
conducted under diverse assumptions. Thus, a lower limit on the magnitude of the unilateral
effects can be derived. The results of the simulation may be replicated, and the precision of the
prediction is indicated by calculating the standard error. The question of market definition
plays but a minor role in simulation models. Not including a certain firm or product in the
model just means that the price of this product is treated as a constant. In a Bertrand model
with differentiated goods, however, a merger always induces all prices to go up; those set by the
merged firm as well as those fixed by its competitors. Now, if a firm or product is not included

500
However, not every model is suited for an analysis of the effects on competition. While the linear and
log-linear systems are relatively easy to apply, their results are often implausible, from an economic point of
view. For instance, in the case of linear demand systems, negative cross-price elasticities may arise between
substitute goods, although this is typical of complementary goods. Furthermore, the log-linear demand
system assumes the elasticities to be constant, which runs counter to empirical results. Moreover, the
outcomes may be contradictory to economic theory. Therefore, the AIDS (‘‘Almost Ideal Demand Sys-
tem’’) and the logit demand system have been proposed as alternatives. The AIDS demand system has the
benefits of being compatible with utility maximisation on the part of the consumers, and of taking into
account variable elasticities. Estimating demand by means of the AIDS model requires a large number of
parameters to be determined, i.e. prices, price elasticities, and cross-price elasticities. The same holds in the
cases of the linear and log-linear models. This implies that a huge quantity of suitable data has to be
available. The various econometric demand systems are discussed by Hosken/O’Brian/Scheffman/Vita, 2002;
Bishop/Walker, 2002, 362–377.
501
Another essential property of the model is the so-called independence of irrelevant alternatives. This
means that the demand for, say, goods A, B, and C does not depend on whether or not another good D is
available. This property implies that, in such a market, all goods are equally close substitutes for each other.
Further, an increase in the price of good A will induce a demand substitution that is proportional to the
respective market shares of the goods B, C, and D. This is an obvious limitation of the model’s applicability.
cf. Motta, 2004, 130. Indeed, it is possible to extend the model in order to capture different degrees of
substitutability. This is done by means of so-called ‘‘nested logit’’ models. But this places more restrictive
demands on the necessary data. In these models, a consumer’s decision-making process is assumed to consist
of several stages. First, the consumer will decide whether or not to buy a computer in the first place.
Secondly, he will decide on the kind of product to be purchased, e.g. a laptop, a desktop, or a hand-held
computer. The brand will then be determined as a third step. It is also possible to consider more than three
steps, but then the models will become increasingly complex; cf. Bishop/Walker, 2002, 354; Hausman/
Leonard/Zona, 1994.
502
However, this gives rise to a mere estimate of marginal cost in one point. Therefore, an assumption
has to be made with regard to the shape of the curve. In general, constant marginal costs are assumed.

Kerber/Schwalbe
G. Economic Principles of Competition Law 317

in the simulation model, the price of this product will remain unchanged in the model. As a
consequence, the predicted price increase will be underestimated, and the unilateral effect will
seem smaller than it would be.503
Another advantage of simulation models is that potential efficiency gains can be directly 1–8–339
integrated into the model. In principle, the net effect of a merger is determined by considering
the unilateral effects on the one hand, and the efficiency gains on the other. This could be done
by modifying the merged firm’s marginal cost accordingly, taking into account the predicted
efficiency gains.504 Alternatively, simulation models can be used to estimate the magnitude of
the potential efficiency gains that would be necessary to outweigh at least the price increase
induced by the unilateral effects. The net effect of a merger will be positive only if the
efficiency gains reach this level. In a similar manner, simulation models may be used to estimate
the effects of various remedies, such as the sale of certain divisions of the firm. This procedure
reveals the remedy that yields the best possible impact on the market outcome.
Drawbacks of simulation models. Since simulations are based on a stylised model of a market 1–8–340
they cannot possibly take all aspects of reality into account. Thus, it may be the case that some
important aspects are excluded from consideration.505 Possible candidates are, first of all,
dynamic aspects such as the repositioning of products, investments, or market entry. Fur-
thermore, the underlying demand system has a huge impact on the predicted price increase.
The unilateral effect of a merger depends critically on the assumed demand system.506 More-
over, a simulation requires adequate data and observations concerning demand and firm
behaviour to be available. For instance, in case of a merger on the producer or wholesale level,
only the final prices paid by consumers are observable. Inferences with respect to wholesale
prices can be made within a limited range of possibilities only.
Interpreting a simulation model and its results requires adequate data to be available. Also, 1–8–341
the underlying demand system should reflect the actual situation as closely as possible, or at least
there must be no obvious contradiction between the model and reality. If this cannot be
guaranteed, conservative assumptions (e.g. a logit demand system) may help to avoid an
overestimation of the unilateral effects. Similarly, the assumed oligopoly model should cor-
respond to the actual competitive situation. For example, it is not a good idea to assume
quantity competition when the firms actually compete on price. However, if the assumptions
are sustained by observations and empirical data, simulation models provide at least a rough
estimate of the unilateral effects of a merger to be expected in the near future.
(bb) Structural measures. The method most often used by merger control in order to 1–8–342
predict the effects of a merger is a structural approach which determines the firms’ market
shares on the basis of the definition of the relevant market. As a second step, the expected
effects of the merger are estimated. An increase in concentration is an important indicator of
increasing market power, and of a firm’s creating or strengthening a dominant position.
Concentration can be measured, e.g. by the level of the Herfindahl-Hirschman index (HHI),
and the increase in concentration change in the HHI induced by the merger. This approach is
justified by the fact that, in the Cournot model, there is a direct relation between market power
and concentration, where market power is measured by the Lerner index which indicates the
mark-up (i.e. the difference between price and marginal cost) over price ratio, and con-
centration is measured by the HHI. The average weighted mark-up in this market is then
determined by weighting the individual firms’ mark-ups Li with their market shares si and
adding them up:
p # c 01 p # c 02 p # c 0n
s1 L1 þ s2 L2 þ ::: þ sn Ln ¼ s1 þ s2 þ ::: þ sn :
p p p

503
In contrast, if market shares are taken into consideration, as in the definition of the relevant market,
disregarding a product will cause an increase in the market share. Market power will then be overestimated;
cf. Bishop/Walker, 2002, 366.
504
This implies that it is possible to quantify the efficiency gains. cf. Section VI.5.(c).
505
Criticisms of simulation models can be found in RBB Economics, 2004.
506
Thus, in the case of a linear demand system, the demand function is only slightly curved. As a
consequence, the price increase induced by a merger will be small. In the cases of a log-linear or AIDS
demand systems, the curvature is more pronounced. Therefore, these models predict a more considerable
increase in price. Similar problems arise with respect to the estimated elasticities: The smaller the degree of
elasticity, the more substantial is the predicted increase in price; cf. Crooke/Froeb/Tschantz/Werden, 1999.

Kerber/Schwalbe
318 Part 1: Introduction

Since (p # c0i) / p = si / !n, this is equal to


s21 s22 s2n X n
s2i HHI
þ þ ::: þ ¼ ¼ ;
! n !n !n !
i¼1 n
!n

where !n " denotes the price elasticity of demand. This expression shows that a larger average
weighted mark-up implies a larger value of the HHI.507 However, this relation does not hold
for all market structures. Even in the case of high concentration, this does not necessarily imply
the existence of market power. For instance, in a market characterised by price competition
with a homogeneous product, and also in bidding markets, a firm’s market share is entirely
independent of its market power. From the point of view of economic theory, it is almost
impossible to derive generally accepted limits on concentration or on the HHI such that
considerable market power and an impediment of competition may be expected when this
limit is exceeded. What is more, empirical studies show that, even in oligopolies with few firms
and large market shares, fierce competition may be observed, as there are in markets with
comparatively many firms where there is hardly any competitive pressure to speak of. It follows
that the well-established criterion of market shares which dominates merger control is not in
fact specific enough. Other market conditions have to be taken into account in addition to
market shares. These include potential market entry or potential competition, and the existence
of buyer power.
1–8–343 Nevertheless, in the context of the structural analysis of the effects resulting from mergers,
certain ranges of the HHI have emerged, based on experience, according to which mergers are
classified. It is assumed that a merger will not induce adverse effects on competition if the
participating firms possess only small market shares, and operate in a market characterised by a
low degree of concentration. Thus, both the US ‘‘Horizontal Merger Guidelines’’ and the
European Guidelines for the assessment of horizontal mergers are based on the assumption that
a merger will be innocuous if the post-merger HHI is less than 1,000. In case of a merger
which results in the HHI lying between 1,000 and 2,000, the change in the index has to be
taken into consideration, the so-called delta. The delta is determined as follows: before the
merger, the squared market shares of the merging firms, say 1 and 2, in the HHI are s21 + s22 .
After the merger, however, their squared market shares become (s1 + s2)2 = s21 + s22 + 2s1s2.
The change, i.e. the delta, is thus 2s1s2. It is assumed here that the merged firm’s market share
equals the sum of the two market shares before the merger. Furthermore, the other firms’
market shares remain unaffected by the merger. The analysis of unilateral effects has shown that
this assumption is usually not quite correct. However, it may well be used as a first approx-
imation.508 If the delta is less than 250 or if, even in the case of the HHI exceeding 2,000, the
delta is less than 150, then there will be no objections to the merger, unless special conditions
apply, e.g. one of the merging firms possesses a market share of 50 per cent, or if it is a merger
of particularly innovative firms, if it involves an especially competitive maverick or a firm that
has just entered the market. Also, where there are mutual shareholdings between the firms, or
the merger is likely to give rise to co-ordinated behaviour, competition policy may want to
raise objections to the merger, even with small values of the HHI and the delta.509 If either the
HHI or the delta (or both) exceed the thresholds indicated above, a more detailed analysis will
be advisable. Further information on the market will be taken taken into consideration, e.g.
institutional specifics in the market, documents (such as business plans) and files of the firms, as
well as statements on the part of the firms’ customers with respect to the merger. These
thresholds have been developed as normative benchmarks in the course of competition
authorities’ practice. However, they have no reliable theoretical foundation or empirical basis.
1–8–344 As a caveat, in most cases, a structural analysis cannot be used to quantify the effects of a
merger on prices and quantities. That is, in general it is not possible to predict what the
consequences of a certain shift in the firms’ market shares might be with respect to the market
outcome. It follows that the effects of efficiency gains cannot easily be included in the analysis.
Another weakness of the structural approach concerns differentiated goods. With differentiated
goods, the magnitude of the unilateral effects depends primarily on the kind of substitutes the
merging firms produce, i.e. whether they sell close substitutes or rather incomplete ones. This

507
cf. Church/Ware, 2000, 239.
508
In Section VI.3.(b) we have seen that, due to the merger, the market share of the merged firm will be
smaller than the sum of the firms’ pre-merger market shares. Moreover, the other firms’ market shares will
increase. Therefore, the change in the HHI will be overestimated.
509
cf. European Commission, 2004, 7.

Kerber/Schwalbe
G. Economic Principles of Competition Law 319

determines the competitive pressure between them. Consider a merger of two firms that
produce only substitutes, as opposed to a merger of two firms that produce close substitutes.
Even if the change in the HHI is the same in both cases, the unilateral effects induced by the
former will be far less considerable. Therefore, with differentiated goods, both market shares
and concentration measures based on market shares provide but a poor estimate of the firms’
market power. The applicability of a structural analysis is thus limited.510 One could attempt to
capture this problem of ‘‘local competition’’ by means of the concept of sub-markets. But this
incurs a variety of problems, as already described.
(cc) Conclusions. The pros and cons of both methods, the direct estimation of the effects 1–8–345
of a merger by means of simulation models and the indirect, structural approach, give rise to the
conclusion that neither is able, on its own, to provide a complete estimation of the market
situation, or a reliable prediction of the effects of a merger. Since, however, both approaches
display different benefits and drawbacks, they are not to be considered as alternatives but rather
as complementary methods. Whilst simulation models allow for quantified estimates, they
abstract from many facts some of which may be important. Furthermore, some restrictive
assumptions have to be made with respect to the behaviour of firms and consumers. By
contrast, the structural approach is better able to consider the specific details prevailing in a
market. However, its focusing on the level and the change of concentration measured by the
market shares may lead to an incorrect estimation of the effects of a merger, especially in the
case of differentiated goods. Therefore, from an economic point of view, both methods should
be applied together in order to arrive at a well-founded estimation of unilateral effects.
4. Co-ordinated effects
(a) Introduction. Whilst unilateral effects account for the changes in prices and quantities 1–8–346
in the market after the merger, the nature of competition between the firms remains
unchanged: there will be no co-ordination of behaviour even after the merger, i.e. the firms
continue to act non-co-operatively. However, a merger may trigger a fundamental change in
the nature of competition in the market. Put differently, it may offer to the firms opportunities
to co-ordinate their behaviour, or to stabilise existing co-ordination and thus to establish a co-
ordinated equilibrium which could not have been reached without the merger having taken
place.511 A co-ordinated equilibrium is characterised by competition between the firms being
virtually eliminated, and the outcome corresponds to the monopolistic one. The changes in
prices and quantities, and thus in consumer surplus and welfare induced by such a regime
switch, are referred to as co-ordinated effects.
(b) Theoretical problems in the assessment of co-ordinated effects. The theory of 1–8–347
industrial organisation has been addressing the analysis of co-ordinated equilibrium for some
time. Numerous models have been developed which analyse the effects of various factors on
such equilibria. However, these models deal primarily with the existence of co-ordinated
equilibria.512 The folk theorems show that, under the appropriate conditions, there is not only
one such equilibrium, but many. In general, there is an infinite number of co-ordinated
equilibria.513 The proof of existence is based on comparing the short-run profit a firm can get
from deviating from the co-ordinated equilibrium with the permanent loss resulting from the
ensuing punishment. This gives rise to a condition relating to the discount factor of the firm,
i.e. the factor with which future returns are evaluated.514 If this condition is satisfied, co-
ordinated equilibria will exist. A mere statement concerning their existence, however, is of
little interest with respect to co-ordinated effects. The issue is the changes induced by a merger,
and above all, whether the merger is likely to give rise to co-ordination which would not have
been possible, or not completely possible without the merger.515
Game theory analyses this question as follows. First, it checks whether, prior to the merger, 1–8–348
co-ordination is impossible, or only partly possible. This will probably be the case if the firms
display a large degree of asymmetry, or if there is no effective or credible punishment
mechanism available or if a maverick firm is preventing co-ordination.516 In this case, the
conditions for the existence of a co-ordinated equilibrium are not satisfied. Now, if the merger,

510
A similar problem arises with regard to the definition of the relevant market in the case of differ-
entiated goods. cf. Section IV.7.(b)(ff).
511
cf. Motta, 2004, 251; Bishop/Lofaro, 2004, 217.
512
cf., e.g. Jacquemin/Slade, 1989, 379.
513
cf. Tirole, 2003, 253; Friedman, 2000.
514
cf. e.g. Bühler/Jaeger, 2002, 119; Shapiro, 1989, 361.
515
cf. Motta, 2004, 251; Bishop/Lofaro, 2004, 217; Ivaldi/Jullien/Rey/Seabright/Tirole, 2003b, 63.
516
cf. Section V.2.(d)(aa); Baker, 2002.

Kerber/Schwalbe
320 Part 1: Introduction

e.g. increases the firms’ symmetry, establishes a credible punishment mechanism or eliminates a
maverick it could be that the conditions for co-ordination will be satisfied after the merger. In
either case, post-merger there will exist co-ordinated equilibria which have not existed pre-
merger. The few theoretical works addressing the co-ordinated effects of a merger are also
based on these considerations.517 The reasoning is as follows: Suppose the conditions for the
existence of co-ordinated equilibria become less restrictive after the merger, i.e. easier to satisfy,
e.g. due to increased symmetry on the part of the firms. Then, co-ordinated effects become
more likely to occur. The approach is thus based on a comparison between the sets of equilibria
before and after the merger. If, post-merger, there exist co-ordinated equilibria which have not
existed before, co-ordinated effects become possible. However, this does not imply that the
firms will necessarily co-ordinate on such an equilibrium after the merger. It merely says that,
due to the merger, co-ordination becomes a feasible option.518 This may be dissatisfying from
the theoretical point of view, but in the context of merger control it is not necessary to predict
that a merger will actually induce co-ordination. To prohibit a merger, it usually suffices that
the possibility of co-ordination arises, or that the conditions for co-ordination are enhanced.
However, the effects induced by a merger will often tend towards opposite directions, i.e.
some effects will facilitate collusion, while others will impair it. This makes it hard to say
whether or not the merger will increase the probability of co-ordination. Indeed, whilst the
number of firms in the market will be reduced by the merger, their asymmetry might be
increased. The market may become more transparent, but product differentiation might be
enhanced. The variety of factors relevant to a consideration of co-ordinated effects gives rise to
a wide spectrum of possible combinations. In this case, the first step would have to be to
identify the factors that are particularly relevant for co-ordination in the industry, weight them,
and determine how the merger will change them. But from the economic point of view, even
if the merger increases the probability of co-ordination, it cannot be verified that the condition
stated in the Guidelines, that a merger must increase the probability of co-ordination, or
stabilise existing co-ordination or make it more effective, is met. At best, one may be able to
conclude that (additional) co-ordinated equilibria will exist after the merger.519
1–8–349 However, in practice the approach outlined above will not be applicable in most cases. In
order to check whether or not the conditions for the existence of a co-ordinated equilibrium
are satisfied, information on a number of factors is required. This is not usually readily available.
One would first have to calculate the profits to be gained by the firms when they co-ordinate
their behaviour. Then, the profits gained by a firm that deviates from the co-ordinated
equilibrium have to be computed. Finally, the profits during the punishment phase have to be
determined. It may seem a good idea to estimate these profits by means of a simulation model,
but this will be difficult in practice. The existence of a co-ordinated equilibrium further
depends on the discount factor which indicates a firm’s valuation of future profits. The dis-
count factor in turn depends not only on the prevailing interest rate, but also on other aspects
such as, e.g. the firm’s risk and time preferences. It follows that the discount rate is not easy to
determine, either. As a direct consequence, another problem arises with respect to an analysis
based on these concepts: it is impossible to say, e.g. what degree of asymmetry between the
firms would be sufficient to make co-ordination possible, or to prevent it. Likewise, the
magnitude a potentially credible punishment must have in order to deter the firms from
deviating from the co-ordination is unknown. Furthermore, it is difficult to determine whether
a certain firm acts as a maverick, and if co-ordination could be reached without this firm.
Similar problems arise in determining the other factors that affect the possibility of co-ordinated
behaviour. In general, therefore, it is not possible to derive an unambiguous conclusion as to
whether or not the conditions for co-ordination are satisfied in any given market. At best, one
can say pragmatically that co-ordination is unlikely to occur in a market that does not satisfy
any of the main conditions for a co-ordinated equilibrium, whereas it is more likely to occur in
a market where all, or at least some, of the conditions apply.
1–8–350 It is nevertheless conceivable that the conditions required by the theory on the existence of
co-ordinated equilibria are satisfied prior to the merger. In this case, a merger will leave the set

517
The works to be mentioned in this context are Davidson/Deneckere, 1984; Kühn/Motta, 2000; Vas-
concelos, 2001; Compte/Jenny/Rey, 2002 and Kühn 2004. ‘‘Previous research has done very little to provide
theoretical or empirical underpinnings for dealing with the issue of coordinated effects of mergers.’’ Kühn,
2004, 4.
518
cf. Jacquemin/Slade, 1989, 379; Bishop/Lofaro, 2004, 217; Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a,
26; Ivaldi/Jullien/Rey/Seabright/Tirole, 2003b, 64.
519
cf. Kühn, 2001, 8; Kühn, 2004, 3.

Kerber/Schwalbe
G. Economic Principles of Competition Law 321

of equilibria virtually unchanged. In this situation, one can infer only that a co-ordinated
equilibrium is a possible outcome, as much before the merger as afterwards. Traditional game
theory cannot predict whether or not co-ordinated behaviour becomes more likely, more
effective or more stable as a consequence of a merger. The reason is that traditional game
theory allows only for a comparison of the respective sets of equilibria. It does not tell us which
of the equilibria the players will choose, if any, or how they arrive at their decisions.520 In order
to be able to prove that co-ordination will become ‘‘more probable, more effective, and more
stable’’ as a result of a merger, further research is required into how individuals select equilibria.
In recent years, a number of approaches have been developed in this area. For instance,
bargaining theory has shown that not every equilibrium in the set can be a potential result of a
negotiation process.521 However, this theory presumes that there are explicit agreements
between the agents. Therefore, it is better suited to answer the question of how the members of
a cartel arrive at an agreement on a certain price, or certain quotas, and is less useful when it
comes to predicting co-ordinated effects. Another line of research aims at reducing the number
of possible equilibria by introducing additional requirements with regard to plausibility. Such
refinements of the Nash equilibrium reject a number of equilibria on grounds of their lack of
plausibility. In the case of co-ordination, however, the number of equilibria remains con-
siderable even after applying such refinements.522 Better approaches have been developed by
evolutionary game theory and experimental economics. Evolutionary game theory is based on
the assumption of bounded rationality on the part of the players. The players are assumed to
interact repeatedly, to learn from their mistakes, and to modify their behaviour accordingly.523
This approach uses dynamic models to analyse what equilibria the process will arrive at.524 In
experimental economics, laboratory experiments are conducted in order to find out how, e.g.
individuals behave in a computer simulation of an oligopolistic market, and under which
conditions co-ordinated behaviour will arise.525 Research in these areas has only just begun.
However, a number of promising results have already been derived. Some of the experimental
studies suggest that, when there is no communication between the players, co-ordinated
behaviour will arise only if the number of players is small, i.e. if there are at most two or three
players involved.526
(c) The assessment of co-ordinated effects. It has already been pointed out that, for 1–8–351
conceptual reasons, it is difficult to predict whether or not a merger will give rise to co-
ordinated effects, or if they will become more likely as a result of the merger. If the analysis of
market conditions indicates that co-ordinated effects cannot be excluded, it will at least be
possible to derive an upper bound on the extent of the co-ordinated effects. In order to do this,
one could use a version of the simulation approach in which it is assumed that the firms will co-
ordinate their behaviour completely after the merger. This would yield a worst-case scenario,
i.e. the maximal extent of co-ordinated effects. It is also possible to determine the magnitude of
efficiency gains necessary to counterbalance these effects. However, this method at best
determines the range of the potential co-ordinated effects. For conceptual reasons, with the
methods presently available it is not possible to predict the occurrence and the extent of co-
ordinated effects in quantitative terms.
(d) Approaches to the review of co-ordinated effects. To summarise, the propositions 1–8–352
which economic theory is able to make with respect to co-ordinated effects are rather
unspecific, and their extent is limited. Furthermore, it cannot provide robust propositions with
respect to the probability, the stability, and the effectivness of co-ordination. Therefore, in
order to decide whether co-ordinated effects will occur after the merger, it is first necessary to

520
If there is only one equilibrium before the merger as well as after it, as in the case of co-ordinated
effects, this unique equilibrium suggests itself as the outcome of the game. In what follows, are outlined
some approaches to solve the problem of equilibrium selection in the case of multiple equilibria.
521
cf. Binmore/Osborne/Rubinstein, 1992.
522
Examples of such refinements are, e.g. Pareto dominance or renegotiation proofness; cf. Farell/
Maskin, 1989, 327. Van Damme, 1992, gives a general treatise on refinements of the Nash equilibrium.
523
Schwalbe 2002 provides an introduction to the theory of evolutionary games. Surveys of this area of
research are provided by Vega-Redondo, 1996; Weibull, 1995; Samuleson, 1997.
524
The outcome of an evolutionary model depends on the kind of boundedly rational behaviour under
consideration. Thus, imitation often induces an outcome that is analogous to that of perfect competition,
cf. Vega-Redondo, 1996, 157 and Thijssen, 2003. In contrast, learning may induce a co-operative outcome.
cf. Bendor/Mookherjee/Ray, 2001.
525
Huck/Norman/Oechssler, 2001, supply a survey of the various outcomes of oligopoly experiments.
526
cf. Huck/Normann/Oechsler, 2001; Muren/Pyddoke, 2004.

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322 Part 1: Introduction

check whether the conditions for co-ordination are satisfied. Necessary conditions for co-
ordinated behaviour are the frequency of interaction between firms, market transparency, the
existence of a credible punishment mechanism, and the value of the discount rate or of the
interest rate. If, in addition to these conditions, others also hold, such as a small number of
symmetric firms, high barriers to entry, inelastic demand, product homogeneity, multi-market
contacts, no buyer power and stable market conditions, then co-ordination is possible in this
market.527 Otherwise, i.e. in the case of a shrinking market, or one that is subject to fluctua-
tions, when the firms interact only infrequently and transactions are characterised by infrequent
bulk orders, and there are no barriers to entry, co-ordination is not to be expected in that
market.
1–8–353 Changes in these conditions which result from the merger, e.g. in the firms’ symmetry, are
not important with respect to the occurrence of co-ordinated effects. They may safely be
ignored.528 The reason is that, in general, it is impossible to say what thresholds with regard to
the parameters of the key conditions must be met in order to either ascertain or refute the
existence of co-ordinated equilibria. These conditions are the degree of symmetry of the firms,
the number of firms in the market, the frequency of interaction, the discount rate, the degree
of market transparency, etc. It may be the case that, even if all conditions for a co-ordinated
equilibrium are improved by the merger, co-ordination remains impossible, namely when the
condition for the existence of a co-ordinated equilibrium is not satisfied. Likewise, the con-
dition for its existence may remain valid even if most requirements are weakened as a result of
the merger. As long as there is no yardstick for measuring these changes, knowledge of their
existence is of little use.
1–8–354 Therefore, the next step should be to examine whether there are mechanisms which help
the firms to co-ordinate their behaviour. To date, such facilitating practices have often been
considered merely as additional criteria in the analysis of co-ordinated effects. In the future,
however, these practices should receive more attention. The possibility of co-ordinated
behaviour will exist only if the firms are able to co-ordinate on a certain equilibrium, or if their
means to do so are improved. This also holds if complete co-ordination is feasible even before a
merger. The following points should be taken into consideration: If co-ordinated behaviour
has been observed in the past, e.g. a cartel agreement, then the former price may serve as a focal
point which helps the firms to reach a co-ordinated equilibrium. Alternatively, the structure of
prices, the quota or the division of the market may serve as a focal point. Furthermore, if there
is an established price leader, or if the merger creates a price leader, the price set by this firm
will serve as a signal for the other firms, and co-ordination will be achieved. Moreover, a
merger may improve the channels of information exchange. The existence of pricing rules such
as basing-point systems or price guarantees on the part of some of the firms may indicate that
there are co-ordination devices available. A merger may render such devices more effective,
e.g. if it involves a firm that has hitherto not adhered to the pricing rule. The role of the various
facilitating practices with regard to co-ordination have as yet not been analysed systematically
in the literature. There is thus considerable need for further research.
1–8–355 To conclude, under certain conditions, a merger may trigger co-ordinated effects that are
much more substantial than the unilateral ones. However, theory cannot provide a well-
founded prediction concerning the changes produced by a merger, i.e. with respect to the
probability, the stability, and the effectiveness of co-ordination. For reasons of practicality, the
analysis has to focus on the market conditions for co-ordinated behaviour, and the devices and
mechanisms of co-ordination. If the conditions are satisfied, but there are no co-ordination
devices available, experimental studies suggest that a merger will be problematic only if two out

527
cf. Section V.2.(c).
528
This statement is in sharp conflict with what is usually stated in the economic literature, namely that
the assessment of potential co-ordinated effects should focus on the changes effected by the merger. The
reason is that many statements made in the literature lack sufficient theoretical foundations. Thus, game
theory cannot give rise to a statement like this: ‘‘In general, the greater the degree of symmetry, the greater
the likelihood of a merger giving rise to coordinated effects. Conversely, where a merger increases the
degree of asymmetry between firms, it is more unlikely that the transaction will give rise to coordinated
effects’’. (Bishop/Lofaro 2004, 218). This is because game theory is concerned with the existence of
equilibria, and their properties. It says nothing about whether or not an equilibrium will be reached, or
with what probability, or which of the possible equilibria is more likely than another. Stretching inter-
pretation any further is beyond the scope of a well-founded economic analysis.

Kerber/Schwalbe
G. Economic Principles of Competition Law 323

of three firms merge.529 However, if there are effective co-ordination devices available in the
market, then co-ordinated effects may also occur in markets with more than three firms.
These considerations indicate that a merger may cause a substantial impediment to com- 1–8–356
petition, and a loss in welfare. However, the previous studies of both unilateral and co-
ordinated effects are based on the assumption that there is no market entry. More precisely, it
has been assumed that the price increase induced by the merger, and the resulting rise in the
established firms’ profits, do not entice other firms to enter the market. That is, there is no
supply-side substitution. It is assumed that there are barriers to entry which cannot be over-
come by potential newcomers. However, this assumption is not always justified. If it is to be
expected that, in the near future, a significant amount of supply-side substitution or market
entry will take place, then the additional quantity supplied will compensate the potentially
detrimental effects of the merger. In this case, either there will be no price increase at all, or it
will be only transitory. But this requires that the effects produced by the merger be effective
enough to provoke market entry even in the absence of barriers.530 However, the estimation of
the extent of potential market entry raises considerable practical difficulties, even more so than
in the case of supply-side substitution.531 In contrast, if there are either absolute or strategic
barriers to entry, market entry will be unlikely to occur. Possible barriers to entry are legal
regulations, patents, sunk costs, etc. A similar situation arises when the market is characterised
by extensive network effects. In this case, market entry will occur only if the newcomer
succeeds in rapidly establishing an installed base. But this will be an exceptional case, especially
if consumers face considerable switching costs. Other factors like buyer power contribute to
reducing the adverse effects of a merger. By strategically restricting their demand, or by taking
up production of the good themselves, the buyers may prevent a price increase. In most cases,
however, buyer power will not be strong enough to fully compensate for the merger’s negative
effects.
5. Efficiency gains
(a) Effects of efficiency gains. Besides the unilateral and co-ordinated effects produced 1–8–357
by a merger and which impede competition and thus reduce consumer surplus and welfare, a
merger may well have positive effects, too. For example, if the merged firm is able to produce
more cheaply than the two firms did pre-merger, so-called efficiency gains will emerge.
Efficiency gains comprise all improvements, synergies, innovations, and cost savings which
result from a merger.532 These effects tend to increase welfare and, under certain conditions,
consumer surplus. The impact of efficiency gains is illustrated in the diagram below.

529
cf. Huck/Normann/Oechssler, 2001, 9.
530
Froeb/Werden, 1998 analyse market entry induced by a merger. They conclude that, in the case of
price competition, market entry will render an otherwise profitable merger unprofitable. This effect is even
stronger in the case of quantity competition. When there are no barriers to entry, firms will merge only if
they expect efficiency gains to arise.
531
cf. Section IV.7.(b)(dd) and Section IV.8.
532
e.g. the US Merger Guidelines, US DOJ/FTC, 1997, x4, Abs.2.

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324 Part 1: Introduction

Figure VI–1: Efficiency gains induced by a merger

1–8–358 Figure VI–1 displays an inverse demand function (NN’) and the corresponding marginal
revenue curve (GG’). Suppose that the total quantity produced by the firms in a Cournot
oligopoly is given by yd. The resulting market price is pd. Consumer surplus is depicted by the
area adpd, while producer surplus is indicated by the area pddgc0. The total economic surplus is
then given by the area adgc0, and the resulting welfare loss amounts to dgi. Now, if the duopolists
merge to form a monopoly, profit maximisation requires that marginal revenue equals marginal
cost, which gives rise to the quantity produced xm and the market price pm. In comparison with
the duopoly outcome, the quantity is less and the price is increased. Consumer surplus has
fallen to pmab, while producer surplus has risen to pmbfc0. In total, however, economic welfare
has declined, and the welfare loss is now indicated by bfi.533
1–8–359 Now suppose that the merger induces the firm’s marginal cost to fall to the level c1. Then,
profit maximisation results in the quantity ye. This quantity exceeds the one produced by the
original duopoly before the merger. As a consequence, the resulting price has fallen from pd to
pe. It is important to note that this lower price results from the monopolist’s profit max-
imisation. That is, it is in the firm’s own self-interest to lower the price. It would hurt itself, and
gain less profit, by not passing on the cost reduction to the consumers. Compared with the
duopoly situation, both consumers and producers are made better off by the cost reduction.
Consumer and producer surplus have risen to aepe and peehc1, respectively. The resulting
situation is thus advantageous to all. In this example, the effects of the merger are entirely
beneficial. From the economic point of view, the merger is desirable, in the framework of
comparative statics.534 In the case of a smaller cost reduction, it could be that producer surplus
only increases, while consumer surplus declines. While total welfare has risen, only the pro-
ducers profit from the increase. Depending on the welfare standard under consideration,
assessments of the merger will yield different results. According to the total welfare standard,
the merger should be cleared. The opposite holds when the consumer welfare standard is
applied, since consumer surplus is reduced.535
1–8–360 (b) Types of efficiency gains. Efficiency gains can therefore compensate for the detri-
mental effects of a merger such as increased market power, raised prices, and welfare losses.
There are different types of efficiency gains, which are distinguished by criteria based on the

533
Williamson, 1968, was the first to point out the welfare augmenting effects of efficiency gains.
534
However, it has to be pointed out that an analysis based on comparative statics does not capture the
long-run dynamic effects ensuing from efficiency gains.
535
The various welfare standards are discussed by Neven/Röller, 2000, as well as in Section IV.1.(b)(dd),
and the literature stated there.

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G. Economic Principles of Competition Law 325

concept of a production function.536 Examples include rationalisation, economies of scale,


economies of scope, technological progress, better buying conditions and the reduction of X-
inefficiencies. This classification of efficiency gains according to aspects of production theory is
further differentiated into the following categories. On the one hand, there are gains that are
not invoked by a change in the production function, i.e. by the technological opportunities of
the merging firms. These are so-called technological efficiencies. On the other hand, there are
gains caused by a change in the production opportunities, the so-called synergy effects. A
further distinction is made between static and dynamic efficiencies, depending on whether they
produce a one-off improvement of the production options or if they promote technological
progress itself, by constantly modifying the economic framework through new products and
processes. What follows is a brief outline of the different types of efficiency gains.
(aa) Gains from rationalisation and increasing returns to scale. Gains from ratio- 1–8–361
nalisation typically arise when the merging firms are able to realise cost reductions by shifting
production from one firm to the other. This will be the case if, prior to the merger, the firms
did not produce at the minimum of their respective average costs. After the merger, production
is then divided in such a way that both firms produce at the minimum of their average costs. As
a result, they can produce the same quantity as before at a lower cost. Such rationalisation gains
produce real cost savings that are desirable from the economic point of view. Increasing returns
to scale exist when the average cost of production declines with increasing output. There are
short-run and long-run returns to scale. In the short-run, the capital stock is fixed. In the long-
run, by contrast, returns to scale are realised by the firms’ investment decisions, i.e. by altering
their capital stock and their production possibilities. For instance, the firms may realise short-
run returns to scale by avoiding unnecessary duplication of certain fixed factors. Typical
examples are accounting, electronic data processing, the human-resources department or the
purchasing department. Prior to the merger, both firms have these departments. They incur
costs that do not usually depend on the quantity produced, i.e. fixed costs. After the merger,
the firms may end the duplication, and thus reduce their fixed costs. This in turn will cause
average costs to decline. Long-run returns to scale typically accrue from the firms’ specialising
in production in their respective plants. Prior to the merger, each firm produced several goods.
After the merger, each good will be produced in one specialised production plant only.
Furthermore, some technologies require a certain minimum quantity to be produced in order
to work efficiently. While a single firm does not reach this quantity, the merged firm will be
able to realise efficiency gains by employing the new technology. In addition, increasing
returns may result from volumetric effects, and from cost savings due to a reduction in standby,
or spare machines.537
If efficiency gains produce a reduction in the firm’s fixed costs, this will not affect its pricing 1–8–362
decision, since a profit maximising firm chooses its quantity produced, or its price, in such a
way that marginal revenue equals marginal cost. The fixed costs are, however, independent of
the quantity produced. They do not contribute to marginal cost, but only the latter is relevant
with respect to the pricing decision. Whilst a reduction in the fixed costs produces an increase
in producer surplus, consumers will not profit from the cost reduction. Thus, the rise in welfare
will benefit the firms only.538 For efficiency gains to produce a price cut, the variable costs have
to be reduced. However, efficiencies that lower variable costs but leave the production options
unchanged will not produce a lower price. One can show that, in the case of quantity
competition with a homogeneous good, efficiency gains that shift production without
improving the production options will not lead the market price to fall.539 This result indicates
that, in order to effect a price decrease, the production options of the merged firm will have to
improve, or its costs must be less than the sum of the pre-merger costs of both firms. Such
synergy effects may arise, e.g. when the firms own complementary patents that allow them to
produce with a new, lower-priced technology after the merger. If synergy effects are obtained
due to a merger, these should be assigned a weight greater than that of mere technological
efficiency gains. A special class of synergy effects which is often observed are so-called
economies of scope.
(bb) Economies of scope. Economies of scope exist when a single firm is able to pro- 1–8–363
duce several goods at a lower cost than if each of the goods were produced by a separate firm.

536
cf. Röller/Stennek/Verboven, 2001.
537
cf. Röller/Stennek/Verboven, 2001, 44; Neven/Seabright, 2003, 6.
538
In the long-run, however, a reduction in the fixed costs might facilitate market entry, thus inducing
favourable effects on competition.
539
cf. Farell/Shapiro, 1990, 2001.

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326 Part 1: Introduction

For instance, suppose a certain input is used in the production of several goods. Then, the firm
might be able to achieve a price discount by ordering a larger quantity of the input. Moreover,
exchanging know-how and knowledge is much easier within a firm than as between two
independent ones. Even if the merger gives rise to economies of scope, it is not certain that the
firm’s costs will actually decline. This would, however, be necessary in order to produce a price
cut, and thus a rise in consumer surplus. To ensure that the firm’s cost is reduced as a
consequence of the merger, the post-merger cost function must possess the property of sub-
additivity. That is, the technology must be such that it is cheaper for a single firm to produce all
the goods on its own, as compared to dividing production between several firms.540 However,
the case of a sub-additive cost function results in a natural monopoly, provided that sub-
additivity extends to a larger scale of output.541 It follows that, in order to produce price cuts
and the ensuing rise in consumer surplus, the merger will have to create a firm with a sub-
additive cost function, i.e. a natural monopoly. But then, because of its better technology, the
monopolist will drive the other firms out of the market. However, this does not justify the
argument that it creates an efficiency offence, since the production of the goods on the part of
one firm is the economically most efficient way to supply these goods. However, in order to
prevent the monopolist from utilising its market power, regulation is needed. The cost of such
regulation will have to be taken into account in assessing the efficiency gains.
1–8–364 (cc) Advantages in input markets. Efficiency gains can also be realised when the
merged firm, being larger, is able to purchase larger input quantities, and thus obtain better
conditions, such as quantity discounts. If the supplier operates with decreasing average cost, this
will be a real cost reduction. Furthermore, the merged firm will be endowed with a higher
degree of bargaining power which will enable it to enforce better conditions. However, a mere
reallocation is not desirable, i.e. there must be a reduction in real costs. Two cases must be
distinguished: first, a situation where the input market is not endowed with considerable
market power, and secondly, a situation where just a few, or even just one, powerful firms
operate in the input market. If the procurement market is competitive, an increase in the
merged firms’ market power will tend to diminish welfare. In contrast, if the procurement
market exhibits a certain degree of market power, then the merger will establish a counter-
vailing power, which will be able to enforce better conditions against its powerful oppo-
nents.542 However, it is not certain that the improved conditions will be passed on to the
consumers. This depends on whether or not the merged firm possesses a certain degree of
market power on the output market itself. In the absence of market power on the part of the
merged firm, it is to be expected that competition will compel the firm to pass on the efficiency
gains to the consumers, e.g. by offering them better terms and conditions. In contrast, if the
merged firm has market power in the output market, it will not necessarily pass on its efficiency
gains. This depends on the relative magnitudes of two opposing effects, namely, if the effect of
the increase in market power in the output market outweighs the efficiency gains in the
procurement market.543
1–8–365 (dd) Better access to capital. A merger may also provide the merged firm with better
access to capital. This is the case if capital markets are incomplete, e.g. because of asymmetric
information. Because of information asymmetries, e.g. with respect to risk and possible returns,
it may be that smaller or expanding firms face difficulties in procuring the necessary capital.
Now, if two small firms merge they will improve their access to capital and reduce the
corresponding costs. However, some of the literature is rather sceptical as regards this
argument.544
1–8–366 (ee) Reducing slack and X-inefficiencies. Another argument in favour of the con-
sideration of efficiency gains in merger control is that the market for external control will work
better, thus reducing ‘‘managerial slack’’. The disregarding of efficiency gains in merger control
will render take-overs more difficult. As a consequence, management inefficiencies are more
likely to occur, since the market for external control between firms operates less efficiently. But
then again, the literature is sceptical about the relationship between competition and X-
inefficiencies.545 While there are some works on the relationships between financial infor-

540
cf. Stennek/Verboven, 2001, 149.
541
cf. Section IX.1.
542
cf. Dobson/Waterson, 1997; von Ungern-Sternberg, 1996.
543
cf. de la Mano, 2002, 66; Röller/Stennek/Verboven, 2001, 46.
544
cf. de la Mano, 2002, 66.
545
cf. de la Mano, 2002, 68; Motta, 2004, 240.

Kerber/Schwalbe
G. Economic Principles of Competition Law 327

mational, and strategic aspects, it has not been possible to derive an unequivocal conclusion.546
Likewise, theoretical works which analyse the effects of mergers on the internal efficiency of
firms, arising from a change in the intensity of competition, remain lacking.
(ff) Improved transmission of know-how. Suppose that a firm is less efficient than 1–8–367
another, either in the field of internal organisation, management or the technology employed.
Then, a merger might induce efficiency gains, since the formerly inferior partner could profit
from the other firm’s superior structure of organisation of from its more efficient management
techniques. In general, however, these efficiencies cannot be realised without the firms’
merging, since factors such as a firm’s reputation, certain forms of human capital, the com-
munication structure, the interaction structure, etc. are intangible assets that are not tradable.
That is, the superior firm can impart its knowledge only if the firms merge. Intangible assets
such as the internal communication structure, or certain abilities on the part of the manage-
ment, may increase the efficiency of the merged firms considerably. However, these intangible
assets may be difficult to quantify, or even to verify.
(gg) Technological progress. Another way to save costs is to avoid duplicating the firms’ 1–8–368
R&D activities. On the one hand, the merger produces a reduction in the fixed costs. But this
will usually not affect the firm’s pricing policy. On the other hand, a reduction in expenditure
on R&D is likely to be beneficial when the firms were involved in a patent race prior to the
merger, where the amount spent on R&D was inefficiently high. However, it is also possible
that it is economically efficient for each firm to have its own research department. This will be
the case if the probability of making a certain invention is increased. Typically, this is the case
when the costs of R&D remain within reasonable limits. The assessment of a merger should
thus take into account the pre-merger situation in order to be able to assess whether or not a
reduction in R&D expenditure is desirable. Efficiency gains will also occur if, prior to the
merger, the firms were conducting complementary research programs. After the merger, the
complementary research outcomes will be combined in order to develop new or improved
products, or superior production processes. The same holds when the firms possess com-
plementary patents. After the merger the cost of production could be reduced when the patents
relate to production. In other cases, novel products may be launched. As a result, efficiency
gains may also arise in markets different from the market where the merger has taken place.
Further efficiency gains may arise when the incentives to conduct R&D are increased by the 1–8–369
merger. If it is hard to keep innovations secret, or if the possibility of patent protection is
limited, a firm will not be able to reap the entire benefit from its innovation. This will reduce
the incentives to engage in R&D. Thus, research activity will be insufficient, due to these
externalities. A merger will then internalise these externalities, and thus increase research
activity.547 However, there are no empirical results as to whether or not a larger firm tends to
invest more in R&D than several smaller ones. Economic theory suggests that the amount of
R&D expenditure depends on the probability of success or the riskiness of a research project.
If there is a high probability of success, and little risk involved, then R&D expenditures
resemble an ordinary investment, and a larger firm will invest more. Where there is only a small
probability of success but a high risk involved, a larger firm will rather utilise its market power
than risk its capital by investing in such research projects.548
To summarise, a merger may give rise to considerable efficiency gains and substantial 1–8–370
economic benefits. Cost reductions due to synergy effects may result in lower prices to be paid
by consumers, and increased research activity will result in new and improved products being
developed which increase economic welfare considerably. However, empirical studies cannot
as yet provide a clear-cut picture concerning the extent of efficiency gains resulting from a
merger. Indeed, substantial efficiency gains have been asserted in particular cases. Yet a large
number of mergers have to be considered as a failure from the operational point of view—
more than 60 per cent of the mergers involving major firms fail. This suggests that even the
firms participating in the merger tend to overestimate the extent of potential efficiency gains.
At the same time, there is a systematic bias to underestimating the costs induced by the merger,
e.g. costs arising because of conflicting corporate cultures.549 However, efficiency gains, real or
presumed, counteract the detrimental effects induced by a merger, namely unilateral and co-
ordinated effects. This raises the question of whether or not the economic benefits resulting

546
cf. Röller/Stennek/Verboven, 2001, 49.
547
cf. Section V.4.(b)(aa).
548
cf. Röller/Stennek/Verboven, 2001, 46.
549
Surveys of empirical investigations are provided by Kleinert/Klodt, 2000, and by Röller/Stennek/
Verboven, 2001, 58–72.

Kerber/Schwalbe
328 Part 1: Introduction

from the efficiency gains realised could have been achieved without the merger, or by other
measures less harmful to competition. For instance, one could argue that gains from rationa-
lisation may also be obtained through internal growth and, therefore, that a merger is not
necessary. Similar arguments apply to other efficiencies that do not affect the merging firms’
production options. The less efficient firm, or the one with the slower growth rate, will lose
market share over time, or disappear altogether. Thus, the economic benefits will be realised
without the merger, but this will perhaps take a litttle longer.550 Efficiency gains resulting from
increased buyer power may also be realised by a retailer co-operative or by joint purchasing.
Likewise, R&D departments could be integrated through R&D co-operation, which would be
much less harmful to competition.551 As a consequence, the argument that efficiency gains may
outweigh the detrimental effect of limited competition should be taken into account only if
these gains are merger-specific, i.e. if they cannot be attained through other means that are less
detrimental to competition.
1–8–371 (c) Calculating efficiency gains. The main problem with quantifying efficiency gains is
that the information necessary to estimate the extent of these beneficial effects is in the hands of
the merging firms. There is thus asymmetric information between the competition authorities
on the one hand and the firms on the other. Often, the information is difficult to verify. The
firms have an incentive to take advantage of their better information and report exaggerated
assertions of the magnitude of the efficiency gains to the competition authority. As a con-
sequence, the probability that the merger will be cleared is increased. While this problem
cannot be avoided entirely, it might be mitigated by requiring the firms to provide verifiable
and quantifiable information on the expected efficiency gains. Moreover, it must be ensured
that the efficiency gains arise within a short time, and with high degree of probability. The
reason is that the adverse effects of the merger due to unilateral effects should be compensated
from the outset. This will raise difficulties especially in the case of efficiency gains in R&D,
which are of particular importance. In general, it will not be feasible to provide well-founded
probabilities of successful innovation or improvements, and to determine the time frame
necessary to realise these innovations.
1–8–372 If welfare is measured by consumer surplus, it will be desirable to determine the magnitude
of the efficiency gains necessary to make sure that the price will at least not increase as a result
of the merger and the ensuing unilateral effects. Attempts to do so have been made in relation
to both markets for a homogeneous good, and for differentiated goods.552 For instance, con-
sider a market for a homogeneous good, and suppose that the firms engage in quantity
competition. Now suppose that two firms merge, their respective market shares being 10 per
cent and 20 per cent. Further, assume that the price elasticity of demand is equal to 2. In this
situation, in order to ensure compensation, marginal cost will have to decline by 7.3 per cent. If
each of the merging firms had a market share of 20 per cent, and the elasticity of demand were
equal to 3, a cost reduction of more than 7 per cent would be necessary. In general, in the case
of small market shares and very elastic demand, a 5 per cent reduction in marginal cost will be
required to achieve compensation. However, in the case of a low elasticity, e.g. an elasticity of
1, exceptional cost reductions of more than 20 per cent will be necessary, even if market shares
are comparatively small. In a market with price competition and differentiated goods, the
estimation of the necessary efficiency gains is based on the firms’ profit margins and the
diversion ratios between the products.553 A small diversion ratio indicates that there is only a
minor degree of competition between the products. This is the case when, e.g. the reduction in
the demand for a product is scattered over a large number of other products. In contrast, a large
diversion ratio indicates that there is keen competition between the products. In this case, a
large share of the demand reduction goes to the other firm. A merger will thus limit com-
petition considerably. For instance, if the profit margin is 50 per cent, and the diversion ratio is
0.2, then a cost reduction of 25 per cent will be necessary to compensate for the detrimental
effects of a merger on economic welfare. With a 40 per cent profit margin and a diversion
ration of 0.1, the costs would have to be reduced by about 7.5 per cent in order to compensate
for the welfare loss. Generally speaking, markets for differentiated goods and close substitutes
tend to require drastic cost reductions in order to prevent a price increase being produced by
unilateral effects. This assessment of the necessary efficiency gains is then compared to the
efficiency gains quoted by the firms. Further, the estimate must be weighed against the det-

550
cf. Neven/Seabright, 2003, 7.
551
cf. Section V.4.
552
cf. Froeb/Werden, 1998; Werden, 1996.
553
cf. Section IV.7.(c)(bb).

Kerber/Schwalbe
G. Economic Principles of Competition Law 329

rimental effects of the merger. If even the merging firms expect the efficiency gains to be
insufficient to compensate for the adverse effects, then, in all probability, the detrimental effects
will dominate.554 Otherwise, the efficiency gains will possibly suffice to compensate for the
negative effects, or even to induce a price fall.
However, efficiency gains may also be harmful, namely if they enhance the conditions for 1–8–373
co-ordinated effects. Thus, efficiency gains may reduce existing asymmetries between the
firms, e.g. if, prior to the merger, the merging firms were using an inferior technology, in
comparison with their competitors. While such a merger enables the firms to catch up with
their competitors, and thus raise welfare (ignoring unilateral effects), it may also facilitate co-
ordination by reducing asymmetries. This possibility must be taken into account when assessing
efficiency gains. A further detrimental effect of efficiency gains may arise in the context of
economies of scope under certain, albeit restrictive, conditions.555 A substantial level of effi-
ciency gains may enable the merged firm to produce at a cost so low that competitors will be
driven out of the market, and thus the merged firm will obtain a monopoly position. This may
be the case when, e.g. the merger creates a firm that operates with a sub-additive cost
function.556
6. Takeover of a failing firm. A special problem arises where a merger involves a firm 1–8–374
that is persistently facing financial difficulties, and which will probably exit from the market in
the near future.557 It is argued that, in this situation, the merger will not affect the market
structure, since the number of firms will remain unchanged. The relevant situations to be
considered are first, the situation before the merger but after the failing firm has quit the
market, and secondly, the situation after the merger. If the production capacity of the failing
firm disappears, this will adversely affect competition since the overall production capacity will
be reduced. As a result, supply will decrease, while prices will go up. Now, a takeover of the
failing firm will ensure that the production capacities will be maintained. This will cause keener
competition, a larger quantity supplied, and lower prices, as compared to the situation with no
merger. However, this implies that there is no other potential buyer willing to take over the
firm. If there are other interested buyers outside the relevant market, these should be favoured.
The reason is that the capacities will remain in the market, but they will be controlled by an
independent competitor. This is why a takeover of a failing firm should be approved only if the
failing firm is likely to exit from the market in the near future, such that its production
capacities vanish from the market, and there are no other firms willing to effect the takeover.
Note, however, that the takeover of a failing firm could enhance the possibilities of co-
ordinated effects, even if all the above-mentioned conditions are met. For example, if the firm
taking over the failing firm gains capacity that equals its competitors’ capacities, asymmetries in
the market are reduced, which facilitates co-ordination.
7. Assessment of the overall effects of a merger. In order to predict the overall impact 1–8–375
of a merger on the market outcome and on competition, it must first be determined whether
significant unilateral or co-ordinated effects are likely to arise. At the same time, potential
efficiency gains have to be identified which may possibly compensate for the adverse effects on
competition, or even outweigh them. The larger the extent of unilateral and co-ordinated
effects, the more significant the efficiency gains will have to be in order to be compensatory. As
a first step, the assessment of the overall effect of a merger requires the determination of the
extent of the individual effects produced directly by the merger, i.e. quantifying them, and then
calculating the net effect. If it is assumed that the merger produces only unilateral effects, and
not co-ordinated ones, simulation models will provide a proper framework for the analysis. For
this purpose, the efficiency gains will have to be quantified. This, however, will usually be
unfeasible. Alternatively, one might derive lower bounds on efficiency gains. One can be sure
that the detrimental effects of the merger will be compensated even without quantifying the
efficiency gains exactly if the expected efficiency gains are substantial, while there are only
minor unilateral effects. The situation is more difficult when co-ordinated effects are to be
expected. Since these are hard to quantify, compensation will be possible at best if the effi-
ciencies compensate the co-ordinated effects even in a worst-case scenario.

554
However, this requires a robust and well-founded estimation of the unilateral effects.
555
cf. Section V.4.(b)(bb).
556
cf. Motta, 2004, 261 et seq.
557
cf. Hewitt, 1999, 119–139; Mason/Weeds, 2002.

Kerber/Schwalbe
330 Part 1: Introduction

8. Policy conclusions
1–8–376 (a) Market dominance versus significant impediment to effective competi-
tion. The analysis of unilateral effects indicates that such effects of a merger must be expected
in any event. The magnitude of these effects is determined by the merging firms’ market shares,
but also depends on whether the goods produced by the firms are close or distant substitutes. In
general, however, a merger will tend to limit competition, induce an increase in prices and a
reduction of the quantity supplied, and losses in both consumer surplus and in economic
welfare, provided that there are no efficiency gains, and that there is no market entry that might
compensate these effects. In the past, the detrimental effects of a merger were assessed primarily
by checking whether they were likely to create, or to strengthen, a dominant position. Market
dominance could occur either in the form of single market dominance, or in the form of
collective dominance. The latter more or less corresponds to co-ordinated behaviour on the
part of the firms, or a co-ordinated equilibrium. However, unilateral effects may arise, and thus
a significant impediment to competition, even if the merger produces neither single nor
collective dominance, and does not strengthen it, either. Whether or not protection aginst such
unilateral effects is incomplete depends on the definition of the term market dominance, or
rather its extent. This problem arises only if the concept is defined very narrowly, e.g. if a
dominant firm is understood as the largest firm in the market, and there is no competition
restricting its behaviour.558 However, if market dominance is interpreted in a way such that it
applies when firms possess the economic power to affect competition significantly, either with
or without co-ordination, the concept of market dominance will also include unilateral effects.
From the economic point of view, it is irrelevant whether or not a firm dominates the market.
Instead, it is of prime importance whether the merger will cause a significant impediment to
competition, by inducing either unilateral or co-ordinated effects, as the case may be.
Therefore, the transition from the criterion of market dominance to one that focuses on the
effects of the merger with respect to competition is to be appreciated. There is no doubt that
the SIEC test (Substantial Impediment of Effective Competition) introduced in 2004 is the
clearer concept in comparison with the market-dominance test. The reason is that the SIEC
test focuses on the problem that is pivotal to merger control, namely preventing a substantial
impediment of effective competition.559
1–8–377 (b) The Guidelines for the assessment of horizontal mergers. The Guidelines for the
assessment of horizontal mergers published by the Commission in 2004 encompass all the
aspects as identified by the theory of industrial organisation as relevant to the assessment of
effects induced by mergers on prices and quantities supplied. Except for some minor details, the
Guidelines are based on economically correct considerations, approaches and criteria. How-
ever, there is a risk of ignoring systematically all effects which do not refer to either prices or
quantities supplied. Such effects concern, e.g. the effectiveness of competition in promoting
innovations. This process generates, selects and spreads innovation, or extends the variety of
products supplied.
1–8–378 For reasons of economy alone, it is not practical to analyse all conceivable effects in detail.
Therefore, it makes sense to employ general approaches in order to separate innocuous mergers
from those that may be harmful to competition. The Guidelines do this by indicating bounds
on the HHI. Thus, mergers of small firms are flatly considered as inoffensive, and mergers of
medium-sized firms are investigated only under certain, additional conditions, while large
mergers are to be investigated regularly.560 However, as the bounds on the HHI are based on
the firms’ market shares, it is essential, in order to reflect their market power as precisely as
possible, that the market definition is economically sound, i.e. that it is based on the hypo-
thetical monopoly test.
1–8–379 The section on unilateral effects (paras 24–38) basically reflects the current state of economic
theory.561 The same is true with respect to co-ordinated effects, but, as indicated, there remain
some shortcomings on the part of economic theory. Therefore, it is generally difficult, if not
impossible, to make well-founded theoretical predictions of whether a merger is likely to give
rise to co-ordinated behaviour, or even to render it possible. Neither can anything be said
about the extent of such effects. The Guidelines thus contain an extensive survey of the
conditions for co-ordination, which correspond to the state of economic knowledge. How-
ever, there is little to be found on the effects of a merger on these conditions, and on a potential

558
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, 55.
559
cf. Schwalbe, 2004, 997.
560
cf. European Commission, 2004, paras 14–21.
561
cf. Ivaldi/Jullien/Rey/Seabright/Tirole, 2003a, Motta, 2004, Europe Economics, 2001.

Kerber/Schwalbe
G. Economic Principles of Competition Law 331

increase in the probability of co-ordination, or its effectiveness or stability.562 In this context,


the propositions concerning pricing rules and information exchanges are of importance.563 The
propositions on efficiency gains also reflect the present state of economic research. These
should be taken into consideration in the assessment of a merger. The required conditions are
reasonable from the economic point of view, namely that the efficiency gains must be merger
specific and substantial, benefit the consumers, be verifiable and quantifiable, and occur shortly
after the merger. The problem is, however, that there is almost no instance of efficiency gains
that satisfies all conditions simultaneously.564 For this reason, it will be in exceptional cases only
that a merger that is otherwise considered harmful will be cleared on the grounds of efficiency
gains. This raises the question whether, analogous to the bounds on the HHI, efficiency gains
should only be assessed using general rules, and not separately in each individual case.565 A
further problem is that no explicit statements are made with respect to the time horizon under
consideration, neither with regard to the effects on prices and quantities, nor the efficiency
gains to be taken into account.

VII. Vertical agreements and vertical mergers


Literature: Aghion/Bolton, Contracts as Barrier to Entry, Am. Econ. Rev. 77, 1987, 388–401; Barney,
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cf. European Commission, 2004, para.42.
563
cf. European Commission, 2004, paras 47 and 51.
564
cf. Schwalbe, 2005, 82.
565
cf. Schwalbe, 2005, 86–92; Bork, 1976, 117–133.

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1. Introduction. Goods are not usually produced and sold directly to consumers by one 1–8–380
firm only. Instead, a number of firms operating at several levels of production and distribution
stages are involved. Producers of primary materials, energy, machinery, and intermediate
products supply their goods and services to the manufacturers of consumer goods, who sell
them via wholesale and retail dealers to consumers. Firms at all levels in these vertical value
chains contribute to the overall offering to consumers. Figure VII–1 shows three levels of
production in stylised form: the suppliers of intermediate products, the manufacturers of
consumer goods, and the distributors (dealers, retailers) selling these products to consumers. At
each of these levels the firms compete with each other, on the one hand as suppliers to the
down-stream market and on the other hand as buyers of goods and services from the up-stream
market. On each market at the different levels of the value chain the questions can be asked;
how effective is competition and are there impediments to competition? It is important to
differentiate between competition between different manufacturers’ brands (‘‘inter-brand
competition’’) and competition between dealers each selling the same brand to consumers
(‘‘intra-brand competition’’). These markets are also linked vertically via supply-demand-
relationships, which implies that they influence each other.
Figure VII–1: Horizontal and vertical relations between firms at different stages of
the value chain

This section analyses the extent to which mergers and contracts between firms at different 1–8–381
vertical levels, i.e. vertical mergers and agreements, can lead to restraints of competition, and
how they should be assessed from a competition law perspective, in particular, as regards the
prohibition of agreements and their exemption (Art.81 EC), and under merger policy. Most of
these vertical agreements concern forms of distribution between manufacturers and dealers. For
example, an exclusive distribution agreement commits a manufacturer to sell products through
a single retailer only. These arrangements often provide territorial exclusivity for the retailer.
Exclusive purchasing agreements commit the retailers to buy certain products from one
manufacturer only. Selective distribution systems require that the retailers fulfil a number of
qualitative requirements for the distribution of the products of a manufacturer (e.g. exclusive

Kerber/Schwalbe
334 Part 1: Introduction

fashion shops). In distribution-related franchise systems the franchiser offers an entire dis-
tribution system (with various services but also extensive obligations) to the franchisees.
Vertical resale price maintenance implies that the manufacturer determines the resale price of
retailers to their customers. In addition to these types of contractual arrangements, there are also
a large number of other vertical agreements between firms at different levels of the value chain.
1–8–382 Theoretically, a vertical agreement exists where two firms at different stages of a value chain
(like, e.g. M1 and D1) have concluded a contract which restricts the behaviour of at least one of
the firms. In the case of resale price maintenance such a restraint is obvious: the retailer no
longer has the right to decide freely on his resale prices in competition with other retailers (e.g.
the resale price maintenance for books in Germany). Exclusive distribution and purchasing
agreements restrict the scope for freedom of choice as between dealers or manufacturers.
Franchise systems, as the ‘‘densest’’ contractual arrangements, often have the effect that the
franchisees have little scope for their own decisions. These restrictions on freedom of decision
through vertical contracts are expressed by the widely used term ‘‘vertical restraints’’. From this
perspective, a vertical merger is the extreme form of a vertical commitment, in which one firm
gives up its freedom to make decisions. Therefore, it is not surprising that, from an economic
point of view, the effects of vertical mergers and vertical restraints are, to a certain extent,
similar. This justifies their simultaneous economic analysis.
1–8–383 Theoretically, the following main types of vertical agreements can be distinguished:
(1) Vertical merger: Two firms at vertically linked levels of a value chain merge (vertical
integration).
(2) Price fixing: This includes resale price maintenance, but also variants such as minimum
prices or maximum prices; another possibility is recommended prices for retailers.
(3) Quantity fixing: The determination of maximum or minimum quantities for buyers.
(4) Tie-ins: The sale of one product is made dependent on the purchase of another product.
(5) Exclusivity clauses: Manufacturers can distribute through one dealer only (exclusive deal-
ing/distribution) or dealers can purchase from one manufacturer only (exclusive pur-
chasing). Exclusive distribution by a dealer often relates to a geographically delineated
territory (exclusive territory) or to a particular group of customers. An important question
is, whether and to what extent trade between these territories remains possible in spite of
exclusive dealing with territorial exclusivity (the parallel trade/imports issue).
(6) Non-linear pricing: If the price of a manufacturer differs in relation to quantities sold, then
some kind of non-linear pricing exists. This includes rebate systems based upon sold
quantity or sales figures. Another form concerns two-part tariffs consisting of a fixed fee F
and a price per unit p—as, e.g. used for charging phone calls.
1–8–384 Since vertical agreements refer to contractual relationships between sellers and buyers within
a value chain, and not to the co-ordination of competition parameters among firms which
compete directly (such as horizontal agreements), the question can be raised; why are these
vertical agreements relevant at all for competition policy? The simple answer is that vertical
agreements can impede effective competition substantially, but can also produce a number of
efficiency gains. As a result of these possible positive and negative effects, there has been much
controversy about their competitive assessment. While the Harvard School was suspicious
about vertical agreements (and vertical mergers) because of their suitability for the creation and
safeguarding of market power, the Chicago School stressed the many efficiency advantages,
leading to the support for liberalisation.566 As will be shown below, the analyses of Post-
Chicago economics have led to a more differentiated assessment.
1–8–385 This section is arranged as follows: section 2 presents the numerous efficiency gains that
might be reaped through vertical agreements. It will be shown that agreements are often
necessary to solve co-ordination problems within the value chain and to avoid horizontal and
vertical externalities which would lead to sub-optimal outcomes. These advantages imply,
primarily, improvements of productive and allocative efficiency. In section 3 the possible anti-
competitive effects of vertical agreements on competition between manufacturers and on
competition between distributors are analysed. Can vertical agreements and vertical mergers
lead to foreclosure effects? What is the significance of ‘‘intra-brand competition’’ between
retailers as compared to ‘‘inter-brand competition’’ between the manufacturers? An important
result of the economic analysis is that the extent of the anti-competitive effects of vertical
agreements depends largely on the market power of the firms. The conclusions for competition
policy from this analysis of the advantages and disadvantages of vertical agreements are discussed
in section 4. This encompasses both general conclusions as well as specific recommendations

566
See Bork, 1966, 1978, 288; Posner, 1976; 1981.

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G. Economic Principles of Competition Law 335

with regard to common types of vertical agreements. In the final section 5, the treatment of
vertical agreements by European competition policy (including BERs) is assessed briefly from
an economic point of view.567
2. Efficiency advantages of vertical agreements
(a) Co-ordination as a precondition for efficiency in the value chain. Since, in a 1–8–386
value chain, a number of independent firms offer a composite product (including services) to
consumers, it is necessary for them to co-ordinate their various activities. Otherwise, it would
not be possible to adapt the entire offering optimally to the preferences of the consumers, to
realise cost-efficient production, and to achieve an optimal ratio of price and benefits for
customers.568 The total performance of the value chain includes the product itself as well as all
appropriate services. For example, in fulfilling the preferences of a certain group of consumers,
a luxury good must not only satisfy very high standards in relation to quality, design, and
advertising: appropriate levels of consultancy services and attractive business premises are also
necessary. Vertical agreements, e.g. a vertical distribution system, can help to improve the
vertical co-ordination of the activities of all the firms involved and thus help to achieve
optimisation of the total performance of the value chain. In particular, a very close form of co-
ordination as between suppliers and manufacturers is often necessary for solving problems of
technical compatibility.
From an economic point of view, the goods and services of the firms within a value chain 1–8–387
are complements. Economic theory maintains that the independent maximisation of profits of
firms which produce complementary products can lead to sub-optimal results. If each firm at
the different levels of a vertical production chain maximises its profits without considering the
effects on the other firms, the overall result is sub-optimal. If a firm sets a higher price for its
product this not only has consequences for its own demand but also for the demand of the
other firms, because the final good becomes more expensive. Whilst firms producing substitute
goods are interested that their competitors demand a higher price as they receive more demand,
the situation is reversed in the case of complementary goods: now the firms are interested in the
lower prices of the other firms, because this reduces the price of the entire product and
therefore increases demand.569 This economic reasoning is not only important for vertical
production chains, but also for all kinds of complementary products such as computers and
software.
Consequently, the profit-maximising behaviour of a firm in a value chain may have negative 1–8–388
effects on the other firms. From the perspective of economics these negative effects are
externalities,570 which occur in vertical production chains as horizontal externalities, e.g.
between retailer D1, D2 and D3, as well as vertical externalities between firms at different levels
of production stages, e.g. between the supplier S2 and the manufacturer M2. In the following, it
will be shown that such externalities may cause inefficiencies, which can be reduced or even
avoided by vertical agreements (internalisation of externalities).
(b) Free-riding problems between dealers and producers. The most well-known 1–8–389
example of possible inefficiencies caused by horizontal externalities is the free-riding problem
which arises in relation to pre-sale services, especially the consultancy/advisory services pro-
vided by retailers. If consumers get information from a specialised retailer with a high service
level and afterwards buy the product from a retailer offering less service but at lower prices, the
cheaper retailer can ‘‘free ride’’ on the better service provided by the first retailer. Such
consultancy services of the specialised retailer have a positive effect on the dealer without these
services, but the specialised retailer is not compensated for them. This will lead to a reduction
in the provision of such services by the specialised retailer. The consumers might be able to
acquire the product more cheaply, but without the appropriate level of information and
consultancy services. As a consequence, a loss in efficiency might arise, which must be assessed
negatively in terms of overall welfare.571
Chicago School economists argued that vertical agreements, in particular, might be used as 1–8–390
an instrument to reduce this inefficiency. The easiest way to solve this problem is through

567
For a general overview about economic effects of vertical agreements and mergers see Blair/Kaser-
man, 1983; Katz, 1989; Perry, 1989; Scherer/Ross, 1990, 541–569; Dobson/Waterson, 1996; Rey/Caballero-
Sanz, 1996; Bishop/Walker, 2002, 153–171; Motta, 2004, 302–398; Carlton/Perloff, 2005, 395–438; Knieps,
2005, 151–169.
568
See Riordan/Salop, 1995, 523; Rey/Caballero-Sanz, 1996, 11–16.
569
See Bishop/Walker, 2002, 156.
570
See Tirole, 2003, 173.
571
See Telser, 1960.

Kerber/Schwalbe
336 Part 1: Introduction

vertical integration between the manufacturer and the dealer in order to control the level of
service to the consumer. In general, it is possible to commit the dealer to a minimum level of
service through a selective distribution system. However, this requires the verifiability of
compliance through the contract clauses imposed by the manufacturer (the problem of
incomplete contracts). Another option is that the producer determines a (minimum) resale
price of the retailer (vertical price fixing). In this case, the dealer with a high level of presale
services could not be undercut by dealers with a lower level of service. Furthermore, an
exclusive distribution agreement (with territorial protection) can be used to make it very
difficult for consumers to change to another dealer; this can lead to higher incentives for the
dealers to offer an adequate level of services.
1–8–391 Although these examples of horizontal externalities and their internalisation via vertical
agreements appear plausible, deeper analysis leads to a much more differentiated result.572 This
free-riding problem can only arise in relation to a part of the retailing services. After-sales
services, such as the advantages of buying in an attractive shop or the offer of consumer credit,
are not threatened by free-riding. These other advantages of specialist dealers can be com-
pensated through higher prices. Furthermore, consumers have to consider any additional time
and costs, for example in driving to the cheaper discount shop; hence, the problem of free-
riding is, in reality, limited to products with relatively high prices. There may be other ways to
achieve a higher level of service, in particular, through direct remuneration of those dealers
who provide better services (e.g. special rebates), or through the provision of more information
(e.g. via the internet) by the manufacturer himself. Finally, it should be remembered that whilst
vertical agreements can solve free-riding problems they may also lead to other inefficiencies.573
It can be shown that under certain conditions vertical agreements can lead to an inefficiently
high level of pre-sale services, if consumers differ systematically in their need for advisory
services. Vertical price fixing may lead dealers to invest more in services in order to generate
additional demand. However, those consumers who already know the product well do not
benefit from these services, i.e. the dealer invests too much in attracting additional marginal
consumers at the expense of the infra-marginal (regular) consumers.574
1–8–392 Since consumers often do not know the quality of the products, dealers can fulfil an implicit
quality certification function through their decisions as to which products they include in their
range. In this case, the dealer transfers its good reputation for selling only high-quality products
to the products of the manufacturers, by including them in its range. On the basis of this
reasoning it can be argued that free-riding between dealers can occur as regards this quality
certification function.575 When consumers know that dealer D3 has a good reputation as regards
the quality of products in its range has stocked a specific product, other dealers can also offer
this product. In this case they profit from the quality signal generated by D3 without incurring
their own costs. This form of free-riding may raise problems when the quality-signalling dealer
cannot redeem its costs for this quality certification, because competitors offer the same product
more cheaply. Consequently, these certification services might not be offered any more. Such
inefficiencies might be avoided through price-fixing or through a selective distribution system
which may exclude discounters. Other solutions, however, can be lower supply prices for
dealers with quality certification in order to remunerate them for additional performance
which also benefits the manufacturer. Note, however, that this free-riding behaviour can only
occur in the case of relatively expensive products. In addition, a dealer-based quality certifi-
cation is only of importance for products that do not have much of an own-reputation.
Therefore, products of strong manufacturers’ brands are not affected. Besides that, dealers with
a quality certification function are in most cases able to appropriate sufficiently the advantages
of their reputation through higher prices.
1–8–393 Free-riding problems can also emerge between producers. If a manufacturer trains the staff
of his dealers on advisory and selling activities as well as after-sale services, e.g. repair services,
or offers other services like financial support, e.g. for the interior equipment of the shop, then
the dealers might also use these services for the products of other manufacturers. Consequently,
a free-riding problem between competing producers can occur. One solution may be exclusive
purchasing agreements or other special contract clauses of which prohibit the use of these
investments for other products.576

572
See Scherer/Ross, 1990, 551–552; Boyd, 1996; Carlton/Perloff, 2005, 418–424; Motta, 2004, 313–321.
573
See Chapter VII.3.
574
See Scherer/Ross, 1990, 552; Motta, 2004, 315.
575
See Marvel/McCafferty, 1984; Scherer/Ross, 1990, 552–554.
576
See Marvel, 1982; Besanko/Perry, 1991, 1993.

Kerber/Schwalbe
G. Economic Principles of Competition Law 337

(c) Transaction-specific investments and hold-up problems. Transaction cost eco- 1–8–394
nomics (such as Williamson) showed that a firm can become dependent on another firm, at
least to a certain extent, if it makes an investment that has an economic value only in relation to
a specific transaction with the other firm (transaction-specific investments). Here, the
dependent firm can lose the surplus (quasi-rents) from these investments due to its weak
bargaining position after the investment (the hold-up problem). Inefficiencies can occur if firms
anticipate this danger and refuse to invest in such transaction-specific assets (under-invest-
ment).577 These transaction problems can arise in vertical value chains in manifold ways: for
example, suppliers often need specialised machinery or particular investments in research and
training, which are only valuable as regards one buyer; or the supplying firm sets up its factory
close to the location of its main buyer (site-specific assets). In these cases of transaction-specific
investments, the buyer can take advantage of this unilateral commitment by the supplier, e.g.
by forcing the supplier to accept lower prices. Similar situations can occur when a manufacturer
invests specifically for a particular dealer, e.g. by training the staff or by supplying facilities free
of charge. If, after these investments, the dealer stops buying from this manufacturer (e.g he
stocks other products), then the manufacturer loses the benefits from his transaction-specific
investments. However, the reverse situation can also apply: a dealer makes transaction-specific
investments by training his employees for selling and repairing the products of a particular
manufacturer. Take, for example, authorised distributors in the car industry, which have to
make large specific investments for a particular car manufacturer. If the latter terminates the
contract with the dealer, he will lose the value of his transaction-specific investments to a large
extent.
Such transaction problems can be solved with vertical restraints. In serious cases, a vertical 1–8–395
merger, e.g. the acquisition of a supplier by the manufacturer, can be an option to solve the
under-investment problem generated from such a potential hold-up. Empirical studies confirm
that an increasing specificity leads to a higher probability of vertical integration, as, for example,
in relation to suppliers in the car or aviation industries.578 Exclusive distribution or purchasing
agreements are other possible solutions to this problem. A particular example can be seen with
restaurants and pubs where breweries often provide the (mostly built-in) furniture in return for
a long-term exclusive purchasing agreement with the tenants. These contracts stipulate prices
for beverages which are higher than the market prices, in order to compensate the breweries
for their transaction-specific investment. These agreements can have advantages for both
parties, and thus can be efficient. However, the length of the commitment in the exclusive
purchasing agreements, as well as any other effects on competition must be considered care-
fully, especially with regard to free market access. In the case of the transaction-specific
investments of a dealer for a particular manufacturer, exclusive distribution agreements might
be a way to reduce these hold up-problems. This applies also to the investments of a dealer for
the development of new markets (as will be shown below).
If hold up-problems are to be solved through vertical restraints it is vital to consider that, 1–8–396
first, these restrictions might lead to other inefficiencies (e.g. excessive prices in the case of
exclusive distribution), and, secondly, that other options might exist. For example, if both of
the contracting parties have invested transaction-specifically, then a mutual commitment will
emerge, which in general will protect the investments of both firms (Williamson described this
as ‘‘using hostages to support exchange’’).579 The hold up-problem can also be solved if the
buyer, for whom the transaction-specific investment is made, bears its costs instead of the
supplier. However, other vertical restraints must then ensure that the supplier uses these
investments only for this buyer.
(d) Investments for the development of new markets. If a manufacturer wants to sell 1–8–397
its product in a new market, the distributing retailer must sometimes invest heavily, e.g. in
advertising, in order to make the product with its characteristics and advantages known to
consumers. These investments for the development of a market are mostly sunk cost and hence
irreversible. A retailer will only make such investments if they are profitable. One option is that
the manufacturer bears the costs of the market development, because, in the long run, these
costs can be covered by his higher sales. If, however, the manufacturer is not able or willing to
make these investments, or if he wants to give greater incentives to the retailer to encourage
successful market development, the manufacturer might grant him the right of exclusive dis-

577
See Williamson, 1975, 1985, 1989; Klein/Crawford/Alchian, 1978; Joskow, 2002; Section III.4.(d).
578
See Monteverde/Teece, 1982; Masten, 1984; Joskow, 1988; 1991, 2002; Carlton/Perloff, 2005, 400–403,
433–435.
579
See Williamson, 1983.

Kerber/Schwalbe
338 Part 1: Introduction

tribution in this new market. Thus, the retailer can amortise its investment through a higher
resale price, because it is protected from intra-brand competition from other retailers. These
exclusive distribution agreements can solve both the retailer’s hold up-problem, due to its
specific investments, and the free-riding problems with other dealers in relation to the
advantages from this market development. However, it is important to consider that, due to the
monopoly position of the sole distributor (within his exclusive territory), significant efficiency
losses might occur.
1–8–398 Closely related to this problem are other possible vertical externalities between manu-
facturers and distributors.580 For example, the demand for the manufacturers’ products depends
also on the sales efforts of the retailers: the larger the advertising by the retailer, the higher will
be the sales of the manufacturers. Again, exclusive distribution agreements may prompt the
retailer to enhance his sales efforts. However, these externalities could also be solved if the
manufacturer pays a share of the advertising costs directly or gives special rebates to those
retailers which advertise.
1–8–399 (e) Economies of scale, indivisibilities, and variety. Where there are economies of
scale in the distribution of products, certain kinds of vertical restraints can produce efficiency
gains. For instance, it might be efficient that the manufacturer limits the number of retailers
(quantitatively-limited selective distribution) or fixes a minimum quantity of delivery to save
distribution costs. This might be true, in particular, if the products are perishable or their
continuous availability for retail is important for consumers. For many brands, (with their
reputation of high quality) it is very important that they are offered in the same, high quality
way in different regions. In particular, franchise systems, which offer services under a single
brand name which signals uniform quality, often need extensive vertical restraints to ensure
such uniformity of service and quality. Therefore, selective distribution systems, which require
retailers and service providers to fulfil predefined uniform quality standards, might be necessary
to provide consumers with uniform services of high quality. Since the image of a brand is not
divisible, this problem, as well as the problem of economies of scale, can be seen as being
rooted in the problem of indivisibilities (as one of the potential causes of market failure).581
1–8–400 The question of whether too many retailers might lead to excessive distribution costs has
been discussed with regard to vertical integration. In general, a vertically-integrated firm will
have fewer points of sale as compared with the number of independent retailers which would
emerge in the case of free market entry. Integrated firms take into account that each additional
selling point reduces the sales of the established selling points. Independent retailers, however,
would not consider these externalities. Therefore, vertical integration may lead to a reduction
in distribution costs due to fewer selling points (the prevention of duplicated fix costs) and thus
may result in lower prices for consumers. However, this thinning out of selling points may also
imply a reduction of consumer welfare, because consumers must bear higher search and
transport costs, or their welfare is reduced due to a more limited choice of retailers. There is a
controversial discussion in the literature about whether, from the consumers’ perspective, the
advantages of lower prices outweigh the disadvantages resulting from fewer selling points and a
reduction of variety in retailing. In fact, this problem is similar to the well-known trade-off
concerning product differentiation: a higher number of differentiated products results in a lesser
realisation of economies of scale and therefore higher costs and prices, whereas greater product
standardisation leads to lower prices but also to a poorer fulfilment of heterogeneous consumer
preferences. Thus, the efficient solution depends on consumer preferences for variety in
retailing.582
1–8–401 (f) Double marginalisation. Positive welfare effects may result from vertical agreements
even where—contrary to the previous examples—the firms possess market power. In the well-
known case of ‘‘double marginalisation’’, the firms as suppliers possess market power on the
up-stream and the down-stream markets, e.g. on the manufacturing as well as on the retailing
level. In the simplest case, it is assumed that a monopolistic supplier at the manufacturing level
sells at monopoly prices to retailers who are also monopolists to consumers (chain of mono-
polies). This can occur, if the retailers have exclusive distribution in particular regions and are
therefore regional monopolists. The model of monopoly pricing shows that a monopolist can
reap supernormal profits because it offers a significantly lower quantity than in the case of
perfect competition, and hence can achieve higher prices. To maximise monopoly profit, it
will supply that quantity, which leads to an equalisation of marginal costs and marginal revenue.

580
See Rey/Caballero-Sanz, 1996, 11.
581
See the guidelines of the Commission on vertical restraints, European Commission, 1999, C 270/27.
582
See Mathewson/Winter, 1983; Perry/Groff, 1985; Kühn/Vives, 1999; Motta, 2004, 324.

Kerber/Schwalbe
G. Economic Principles of Competition Law 339

In the case of two monopolies in the up-stream and down-stream market, the monopoly price
set by the manufacturer is the purchasing price of the retailers, who will—by applying the same
rationale for determining their own monopoly price—reduce further the quantity offered to
consumers with the consequence of even higher prices for consumers. This double monopoly
pricing due to double marginalisation implies particularly high inefficiencies and, as a result,
large welfare losses.583
Vertical agreements can reduce these welfare losses significantly. For example, the merging 1–8–402
of the two monopolists into a vertically-integrated firm would not only increase total welfare
but also the welfare of all actors. The single monopoly pricing of an integrated monopolist
would result in, first, a lower price and a larger quantity for consumers, thus increasing the
consumer surplus; and, secondly, the monopoly profit of the integrated firm would be larger
than the sum of the profits of the two non-integrated monopolists. Therefore, total welfare will
also increase. However, it should be borne in mind that the vertically-integrated monopoly still
leads to inefficiencies, but that the extent of the inefficiencies would be reduced through
vertical integration. The additional inefficiency through double marginalisation can be inter-
preted as a consequence of vertical externalities, since each of the two independent monopolists
does not take into account the negative effects of his monopoly pricing on the profit of the
other monopolist on the up- or down-stream market. Therefore, it is possible to understand
vertical integration as a form of internalisation of these vertical externalities. Welfare losses due
to double marginalisation may occur not only in the case of a chain of monopolies but in all
cases where firms at successive stages of a value chain possess market power, e.g. in the case of a
chain of oligopolies. In these cases vertical mergers can lead to higher allocative efficiency by
reducing the inefficiencies due to market power. This argument can also be applied to the
sellers of complementary products, even if they do not sell at different levels of a value chain.
The problem of double marginalisation can also be solved through other vertical agree- 1–8–403
ments, e.g. resale price maintenance. If the monopolist at the production level is able to impose
on the monopolistic retailer his sales price to consumers (or at least fix a price ceiling), then
only single monopoly pricing would occur—with the same results as in the case of vertical
integration. The same effect can be achieved if the manufacturer obliges the retailer to sell a
defined (minimum) quantity, because this forces the retailer to adopt a certain (low) price level.
The problem can also be solved by the manufacturer through non-linear pricing for the
retailers, which consists of a fixed fee F and a purchasing price per unit pe which is equal to the
producer’s marginal costs. In this case, the retailer would set his monopoly price by equating his
marginal costs (i.e. the purchasing price pe) with the marginal revenue (derived from the
demand curve). Therefore, the monopolistic retailer would offer the same quantity as a ver-
tically integrated monopolist. In that case, the monopolistic manufacturer can reap his
monopoly profits through the setting of an appropriately high fixed fee F. If the retaile