Economics of Competition Policy

Massimo Motta

Master in Competition and Market Regulation

Barcelona GSE
January-Feruary 2009

1
 Outline of the lectures
Massimo Motta:
1. Introductory elements
2. Cartels and horizontal agreements
3. Horizontal mergers
4. Vertical restraints and vertical mergers
5. Price discrimination
- A brief introduction to abusive practices
(this topic will be then developed by Jorge Padilla
in the second part of the course)

2
 Methodological note: in these lectures I will try to
explain relatively sophisticated economic concepts
by relying on very simple models and intuitions.
I will also occasionally refer to relevant cases.

Textbook:

Motta, Massimo
Competition Policy.
Cambridge U.P., 2004

3
 1) Introductory elements

a) Introductory remarks (why do we need

Competition Policy?)
b) Market power and welfare
c) Market power and market definition

4
 1a) Competition Policy: Introduction

What is Competition Policy?

Free entry does not solve all the problems
Objectives of competition policy

5
 What is competition policy?
Definition: Competition Policy aims at ensuring that
competition in the marketplace is not restricted in a
way that is detrimental to society
Why do we need a competition policy?
Market failure also in markets without natural
monopoly features. Even if entry is possible,
dominant positions might persist, due to:
• sunk costs industries (see below)
• lock-in effects and switching costs
• network effects (see below)
6
 What is competition policy, II
We need competition policy also because:

Un-monitored, firms may resort to actions that

increase their profits, but harm society, such as:

• Collusion
• Mergers which lessen competition
• Predatory behaviour
• Exclusionary behaviour

7
 Will the market fix it all?
Contestable market theory: does free entry eliminate all
concerns about market power of incumbents?

Persistence of dominance under free entry

• Endogenous sunk costs industries: finiteness property
• Network externalities (definition, direct and indirect,
coordination effects, interoperability) and two-sided
markets
• Switching costs (definition, natural v. artificial,
competitiveness of switching cost markets)
• Predatory and exclusionary practices

8
 Contestable markets
Assume an incumbent I and a potential entrant E are
equally efficient and produce homogenous goods.
Cost of production is F+cq
Baumol et al (1982): at equilibrium I will not set
monopoly price, but price equal to average costs
(AC: p=c+F/q).
This is because if the price was higher than AC,
profits would attract entry, in turn lowering prices
(‘hit and run’ strategy).

9
 Contestable markets: discussion
The theory of contestable markets would have strong
implications: if entry is free, we should not care
about monopolists, as efficient outcome is reached.
Critique: the theory hinges on two strong assumptions:
• Unrealistic timing of the game (I cannot change price
as E enters the market)
• No fixed sunk costs of entry (hit-and-run strategy not
profitable for E if some costs are non-recoverable)
But the theory has the merit to stress the role of free
entry in limiting market power: crucial insights for
merger analysis.

10
 A game theoretic version of the discussion
Contestable market game.
2) Firms I and E simultaneously set prices
3) E (as efficient as I) decides whether to pay F or not.
At the equilibrium, I sets pI=AC and E does not enter.
Proof.
At the last stage. If at stage 1) AC<pE<pI, firm E enters; if at
stage 1) pE<AC, or pI≤pE, firm E does not enter.
At stage 1), the only equilibrium is pI=AC=pE. Equilibrium: easy
to check that neither firm has an incentive to deviate.
Uniqueness: any other price would bring about a deviation
(e.g., if pI>AC, then E would undercut and get all demand)

11
 A game theoretic version , cont’d
When fixed sunk costs exist.
2) E decides whether to pay F or not.
3) Active firms simultaneously set prices
At the equilibrium, I sets pI=pM and E does not enter.
Proof.
At the last stage. If at stage 1) firm E entered, then standard
Bertrand game: pI=pE=c; if at stage 1) firm E did not enter,
firm I can set monopoly price pM.
At stage 1), the only equilibrium is that firm E does not enter: if it
did enter, it would get profits –F (zero Bertrand profits, but it
has to pay the sunk costs). It if does not enter, it gets zero
profits, which is better than negative.
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Finiteness Property (endogenous sunk costs)

Consider the following model (a very simplified

version of Shaked-Sutton’s (1982)
There exist n firms each with a product of quality uk
(labelled so that u1>u2>…>un) and a price pk
There exists a continuum of consumers with identical
tastes but different incomes t. t is uniformly
distributed with density S (S=size of the market)
on a support [a,b], with a>0.
Consumers buy one unit of the good (the market is
covered), and have utility U(t,k)=uk (t-pk)
13
 The game
1. Firms decide on entry (fixed cost ε>0)
2. They decide on quality of the good
3. They decide prices and sell (zero marginal costs)

Proposition: If b<2a, only one firm will enter the

industry at equilibrium (whatever S)

(As income becomes less concentrated, more firms can

enter; e.g., if 2a<b<4a, two firms will enter at
equilibrium. Generally, the number of firms which co-
exist at equilibrium is finite even as S goes to infinity)

14
 Proof of the proposition
We show that two firms cannot co-exist at equilibrium.
Firms’ demand is derived by finding the consumer
indifferent between the two qualities:
From: u1 (t-p1)≥ u2 (t-p2), we obtain:
u1 p1 − u2 p2
t ≥ t12 ( p1 , p2 , u1 , u2 ) =
u1 − u2

All consumers with income t≥t12 will buy 1, all others

will buy 2. Therefore:
q1 = S (b − t12 ); q2 = S (t12 − a ).

15
 Proof (cont’d)
Profits can be written as:
 u p −u p  u p −u p 
Π1 = S  b − 1 1 2 2  p1 ; Π 2 = S  1 1 2 2 − a  p2
 u1 − u2   u1 − u2 

By setting dΠi/dpi=0 we obtain the best reply functions:

b( u1 − u2 ) + u2 p2 a( u1 − u2 ) + 2u2 p2
R1 : p1 = ; R2 : p1 = ;
2u1 u1

Equilibrium prices are given by:

( 2b − a )( u1 − u2 ) ( b − 2a )( u1 − u2 )
p =
*
1 ; p =
*
2
3u1 3u2
Therefore, if b<2a there exists no equilibrium with positive p2,
and firm 2 will not enter the industry (whatever S).
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 Equilibrium, when b>2a
p1
R2

R1

p1E
E

p2
0 p2 E

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 No equilibrium, when b<2a
p1 When a increases, 2’s best reply
R2’(a’>a)
function shifts upwards and the
R2 equilibrium should involve a
negative price of firm 2.

R1

p2
0

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 Generalisation
The finiteness property holds if the cost of producing
a higher quality does not fall upon variable costs
It holds across a number of different specifications
(see e.g., Shaked-Sutton, 1987)
Sutton (1991) puts the result to an empirical test. It
shows that in advertising-intensive industries as S
increases the industry does not become fragmented
(when S increases, firms have incentive to increase
Ad, which in turn raises fixed costs and limit the
number of firms in the market).

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 Network effects: miscoordination
Assume that consumers value a network good i as:
Ui=vi (n)-pi,
Where vi (n) is valuation if n consumers buy good i.
vi (n) is non-decreasing and concave, with vi (1)=0
and vi (z) = vi (z+j) for any j>0 (all externalities
exhausted at size z)
There are an incumbent I and an “entrant” E, with
cE<cI. Networks of equal quality (vI=vE) if of same
size. No need to assume fixed cost of entry.
There are z ‘old’ consumers (they do not buy again),
and z ‘new’ consumers.
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 The game
1. Firms I and E set (uniform) prices, pI and pE
2. The z ‘new’ buyers decide btw. network I and E
Assume the two networks are incompatible.
This game admits two types of equilibria:
• “Entry” equilibria, where buyers buy from the
efficient “entrant”
• Miscoordination equilibria, where the inefficient
incumbent remains a monopolist

21
 2nd stage: Buyers’ equilibria
If pE≤pI≤v(z). There are two equilibria:
1) Miscoordination: all new consumers buy from
I. Each buyer receives v(z)-pI≥0. If one deviated,
he would get v(1)-pE≤0: no incentive to deviate.
2) “Entry”: all new consumers buy from E. Each
buyer receives v(z)-pE≥. If one deviated, he would
get v(z)-pI≤v(z)-pE.
If pI<pE (and pI≤v(z)), there is only a miscoordination
equilibrium. (All buyers buying from E cannot be
an equilibrium: a deviant buyer would get v(z)-
pI>v(z)-pE and disrupt the equilibrium.) 22
 Entry equilibria
There is an entry equilibrium where (pI,pE)=(cI,cI),
and all z new consumers join E’s network
whenever pE≤pI.
Proof.
A consumer would have no incentive to deviate. At
(candidate) equilibrium, its surplus is v(z)-cI. By
deviating and buying from I, it also gets v(z)-cI.
Firm I has no incentive to deviate: zero profits also if
it raises price (at the chosen continuation
equilibria), negative profits if reduces it.
Firm E neither: zero profits if it raises price, lower
profits if it reduces it. 23
 Miscoordination equilibria
There is a miscoordination equilibrium where I sets
monopoly price pI=v(z), and all z new consumers
join I’s network even when pE<pI.
Proof.
Suppose the entrant sets a price as low as cE. A
consumer would have no incentive to deviate. At
(candidate) equilibrium, its surplus is 0. By
deviating and buying from E, it gets v(1)-cE<0.
Firm I has no incentive to deviate (zero profits if it
raises price, lower profits if reduces it).
Firm E neither (at the appropriate continuation eq’a).
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 Welfare implications
In this case (networks externalities do not increase
above the critical threshold), the miscoordination
equilibrium leads to lower welfare (productive
inefficiency).
However, in a model where network externalities are
continuously increasing, welfare of old consumers
matter as well. Entry may have an adverse effect,
as old consumers are worse off relative to a
situation where all buyers buy from the incumbent
(limit case: old consumers are ‘stranded’).

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 Full interoperability
If the two networks were perfectly compatible with
each other, the entry equilibrium where
(pI,pE)=(cI,cI), and all z new consumers join E’s
network is the unique one.
Proof.
Suppose there exists an equilibrium where all new
buyers buy from I at a price pI≥cI. Then firm E
could set a price pE≤cI and it would attract all
buyers (a deviant buyer would prefer to buy from
E and get v(z)-pE>v(z)-pI – recall networks are
fully compatible!). 26
 Exclusion in network markets
Incumbents can use their customer basis to exclude
more efficient entrants. For instance:
• By using price discrimination the incumbent can
exclude more easily (Karlinger and Motta 2006)
• Making a network incompatible with other
networks, may lead consumers not to buy the latter
• Since coordination of consumers play important
role, incumbent may manipulate expectations so as
to deter entry

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 Two-sided markets
Consumers on a side of the market care about the number of
buyers on the other side of the same platform, and
(possibly) vice versa.
Examples: Credit cards, discos, newspapers and TVs,
shopping malls etc.
Market failures are possible: below-cost price on one side to
get one side on board, with the other side being attracted as
well
However, incumbent platforms may also benefit from
miscoordination and ‘asymmetric pricing’ and exclude
more efficient entrant platforms (Motta and Vasconcelos,
2008).

28
 A model of two-sided markets
A consumer on side i values a platform k as:
Ui=vi (bjk+Njk)-pik,
Where vi is externality from the other group j, bjk is
the established base of k, Njk is new consumers.
vi (n) is non-decreasing and concave, with vi (0)=0.
There are an incumbent I and an “entrant” E, with
cE<cI. E has no customer base: bjE=bjE=0. No fixed
cost of entry.
On each side, there are N ‘old’ consumers (they do
not buy again), and N ‘new’ consumers.
29
 The game
1. Firms I and E set (uniform) prices, piI and piK
2. The N ‘new’ buyers decide btw. network I and E
Assume the two platforms are incompatible.
This game admits two types of equilibria:
• “Entry” equilibria, where buyers buy from the
efficient “entrant”
• Miscoordination equilibria, where the inefficient
incumbent remains a monopolist

30
 2nd stage: Buyers’ equilibria
If pE≤pI≤v(2N). There are two equilibria:
1) Miscoordination: all N side-i consumers buy from
I. Each buyer receives v(2N)-pI≥0. If one deviated,
one would get v(0)-pE≤0: no incentive to deviate.
2) “Entry”: all N side-I consumers buy from E. Each
buyer receives v(N)-pE≥. If one deviated, one would
get v(N)-pI≤v(N)-pE.
If pI<pE (and pI≤v(2N)), there is only a miscoordination
equilibrium. (All buyers buying from E cannot be an
equilibrium: a deviant buyer would get v(N)-pI>v(N)-
pE and disrupt the equilibrium.)
31
 Entry equilibria
There is an entry equilibrium where (pI,pE)=(cI,cI),
and all N new consumers join E’s network
whenever pE≤pI.
Proof.
A consumer would have no incentive to deviate. At
(candidate) equilibrium, its surplus is v(N)-cI. By
deviating and buying from I, it also gets v(N)-cI.
Firm I has no incentive to deviate: zero profits also if
it raises price (at the chosen continuation
equilibria), negative profits if reduces it.
Firm E neither: zero profits if it raises price, lower
profits if it reduces it. 32
 Miscoordination equilibria
There is a miscoordination equilibrium where I sets
monopoly price pI=v(2N), and all N new
consumers join I’s network even when pE<pI.
Proof.
Suppose the entrant sets a price as low as cE. A
consumer would have no incentive to deviate. At
(candidate) equilibrium, its surplus is 0. By
deviating and buying from E, it gets v(0)-cE<0.
Firm I has no incentive to deviate (zero profits if it
raises price, lower profits if reduces it).
Firm E neither (at the appropriate continuation eq’a).
33
 Negative prices in 2-sided markets
Suppose now there is a monopolist, and that the market
does not exist yet (bIi=0). As before, Ui=vi (Njk)-pik.
Under uniform pricing, there is a market failure eq’m.
Proof. The lowest price I can make is p=cI. At candidate
equilibrium, UI=0. By deviating and buying from I,
given that nobody buys on side j, side i’s utility is
Ui=vi (0)-cI<0.
Under asymmetric prices, firm I can disrupt a market
failure eq’m by setting, e.g., piI=-ε, pjI= vj (N). Side-i
consumers would all buy, as Ui=vi (0)-(-ε)>0. Hence,
side-j’s utility would be: Uj=vj (N)-pjI (=0). A side is
‘subsidised’ to have both sides ‘on board’.
34
 Possible objectives of Comp. Law
Economic Welfare (Total Surplus)
Definition: W=CS+PS (+ …)
If price falls, welfare rises
Size of the pie, not how slices are distributed
Dynamic aspects important (future W matters)
Consumer Surplus
CS v. W: lobbying arguments; who owns the
firms?; If price equals marginal cost, who pays the
fixed costs?; Who innovates and invests?
Anyhow: usually, W and CS move together
35
 Other possible objectives
Defence of smaller firms
Promoting market integration
Protection of economic freedom
Fighting inflation
Fairness and equity

Public policy considerations affecting competition

Social, political, environmental reasons
Strategic reasons (trade and industrial policies)

36
 1b) Market power, competition, and welfare

1. Allocative efficiency
2. Productive efficiency
3. Dynamic efficiency
4. Public policies, and incentives to innovate

37
 1. Allocative efficiency
Definition of market power: the ability of a firm to
profitably raise price above marginal costs
A matter of degree, not of existence
The deadweight loss (see Figure 2.1)
Inverse relationship between market power and
welfare
An additional loss of monopoly: rent-seeking
activities (see Figure 2.2)

38
Figure 2.1. Welfare loss from monopoly

p
O

pm R

pc S c
T

O′
qm qc q
39
 2. Productive efficiency
Additional welfare loss if monopolist has higher costs
(see Figure 2.3)
“Quiet life” and managerial slack
Principal-agent models: market competition helps,
but too fierce competition may decrease efficiency
Nickell et al.: individual firms’ productivity higher
in competitive industries
Darwinian arguments: competition selects more
efficient firms
Olley-Pakes, Disney et al.: industry productivity
mostly increases through entry/exit
40
Figure 2.3. Additional loss from productive inefficiency

p
O

p′m R′
pm R

V W
pc′ c′

Z S c
pc
T′ T
O′
qm′ qm qc′ qc q
41
 Productive efficiency, II
Number of firms and welfare: trade-off between
allocative and productive efficiency
As number of firms increases, market power
decreases, but also welfare

Important: defending competition, not competitors!

(else, inefficiencies, and fixed cost duplications)

42
 3. Dynamic efficiency
U-shaped relationship between market power and
welfare: trade-off between appropriability and
competition in R&D investment
Lower incentives to innovate of a monopolist:
innovation introduced if additional profits higher
than costs
Appropriability matters: no (little) innovations if no
patent protection, compulsory licensing etc...

43
4. Public policies and incentives to innovate
Ex ante (incentives) v. ex post (diffusion): IPR
protection guarantees market power
Essential facilities (EF) doctrine
Necessary, non-reproducible inputs
Ex.: airport slots, port installations, local loop…
EC accept EF doctrine, but ECJ: Bronner case
Important to preserve incentives to innovate!
Apply EF doctrine only when owner has not
invested to create the facility

44
1c) Market power and market definition

Market definition is only an intermediary objective

Modern econometric tools allow in some cases to

assess market power directly: if so, defining the
market is not needed; if not, two steps in the
analysis:

i. Market definition (product and geographic)

ii. Market power assessment
45
 i. Market definition
Product Market: the set of products “substitutes enough” to
each other (in the sense of exercising a competitive
constraint on each other, not of ‘resembling’ each other).
a) Demand sustitutability and supply substitutability(*)
b) How to find this set?
SSNIP (Small Significant Non-transitory Increase in
Prices) test: could a hypothetical monopolist selling
products X profitably raise prices by 5-10%?
If yes, X is the product market
If no, apply SSNIP test again with X and Y, etc...

(*) Entry may also be considered at the market power stage of investigation if
not as likely and easy.
46
 Market definition, II
How to implement this ‘thought experiment’?
Own-price elasticities, cross-price elasticities, price
correlation tests
NO: Price differences and product characteristics

A problem with this test: raise prices relative to what?

Merger cases: current prices
Art.82 cases: competitive price? (more difficult to check;
also, cellophane fallacy – from Du Pont case where it was
find that high cross elasticity of demand was compatible with
cellophane and other flexible wrapping materials to be in the
same market)

Geographic definition: SSNIP test, transport costs

47
 Market definition, III
Temporal markets: restaurants and bars may be in the same
market for lunch meals, not for dinner meals
Seasonal markets: oranges and bananas may be in the same
market only for some months of the year
Multiple markets: markets may be defined differently
according to the starting point (e.g., trains, buses, planes)
After-markets: secondary products (e.g. spare parts) may be
in the same market as primary ones depending on: 1.
price of secondary product relative to primary; 2.
probability of replacement; 3. sophisticated buyers.
(Examples: Kodak, Kyocera, Hugin)
Consistency of market definitions over time.
48
 ii. Assessment of market power
The traditional approach
Central role of market shares
Which thresholds for market shares?
Measurement and relative strengths (reserves,
capacities, persistence of shares)
Ease and likelihood of entry
Buyers’ power

Econometric techniques
Estimation of residual demand elasticity
Logit models
49
 2. Cartels and horizontal agreements
a. Cartels
a. Economics of collusion
b. Practice
c. Woodpulp
b. Horizontal agreements
a. Joint-ventures
b. Cross-licensing
c. Patent pools

50
 2a. Cartels
Antitrust laws prohibit agreements aimed at fixing
prices, sharing markets etc.
Rationale: such agreements allow firms to exercise
market power they would not have otherwise
Collusion may take different forms, and laws may
differ as to what is collusion and what is evidence
required to prove it

Plan: what is collusion, what helps firms to sustain it,

what actions can be taken to fight it
51
 Collusion, I: “enforcing collusion”
Collusion refers to a situation where firms set prices
which are higher than some competitive benchmark (or
prices close enough to monopoly situation)
For economists, collusion is an outcome

What ingredients are necessary to enforce collusion?

Timely detection of deviations from collusive actions
Credible mechanism for the punishment of deviations
Threat of punishment prevents firms from deviating

Examples (explicit agreement not necessary)

52
 Collusion, II: Coordination
Which collusive price? The problem of coordination

Tacit collusion: costly experimentation to coordinate on

a collusive outcome, risk of triggering price wars
Explicit collusion: firms coordinate on collusive
outcome and avoid problems due to shock adjustments
(Market sharing schemes: possible to adjust to cost
and demand shocks without triggering price wars)

Firms will try to talk in order to coordinate!

53
 Collusion, III: formalisation
Firms meet in the marketplace for an infinite
number of periods (or with uncertain final date)
Collusion if following Incentive Compatibility
Constraint (IC) holds for each firm:
Πc+ δVc > Πd+ δVp
Or:
δ > (Πd- Πc)/(Vc-Vp)
(RHS is called critical discount factor)

Formalisation: see SEPARATE SET OF SLIDES.

54
 Factors that facilitate collusion
I. Structural factors
Concentration
Entry
Cross-ownership and other links with competitors
Regularity and frequency of orders
Buyers’ power
Evolution of demand
Symmetry
Multi-market contacts

55
 Facilitating factors, II
II. Price transparency and exchange of information
Observability of firms’ actions facilitate
enforcement
– Green and Porter’s model
– Exchange of information on past/current data

Coordination and the role of communication

– Focal points
– Exchange of information on future prices and outputs
(private v. public announcements)

Examples: ATP and collusion in auctions

56
 Facilitating factors, III
III. Pricing rules and contracts
Most-Favoured Nation clause (ambiguous effect)

Meeting-Competition clauses (helps collusion, by

eliciting information on rivals and discouraging
deviations in the first place)

Resale price maintenance (enhances cartel stability

by eliminating variation in retail prices)

Uniform delivered pricing; basing point pricing

57
 PRACTICE: How to detect and fight
collusion?
For economists, collusion as an outcome
Both tacit and explicit agreements may sustain collusion
So, why not inferring collusion from market data?

Inferring collusion from data. Problems, I: price levels

Price data availability (list v. effective prices)
Difficult to estimate ‘monopoly price’ and marginal
costs
Where to set the threshold level?
A dangerous principle: firms guilty because able to set a
high price…(market power not a problem per se)
58
 Standards of proof, II: data
Inferring collusion from data. Problems, II: evolution of prices
Price parallelism: not a proof of collusion (common shocks)
Which legal certainty if firms are found guilty for
independent business practices?
‘Parallelism plus’ not convincing either, unless there is proof of
coordination on facilitating factors (eg., RPM, info exchange)
Periods of ‘price wars’ not sufficient condition for collusion
either (new capacity, new competitors, demand shocks…)

Conclusion
Econometric tests as complementary evidence, not proof of
collusion (results sensitive to different techniques used)

59
 Standards of proof, III: hard evidence
Hard evidence only (of communication on prices and/or
coordination on facilitating practices) as proof
(focus on observable elements verifiable in courts, to
preserve legal certainty: fax, e-mail, phone calls, video etc.)

Too lenient with the firms?

(Since collusion can be reached tacitly, focusing on ‘hard
evidence’ amounts to permitting collusion?)
Not necessarily: firms will try to coordinate to avoid costly
market experimentation and will leave ‘traces’
More active policies can be used, ex ante and ex post

60
 Ex ante policies to fight collusion
Black list of facilitating practices might deter collusion
and free resources for cartel detection
– Private announcements of future prices/outputs
– Exchange of disaggregate current/past information
– Meeting competition, RPM and other clauses, if adopted by
coordination
– Cross-ownership among competitors not to be allowed
– Merger control (joint dominance)

Deterrence of collusion
- more severe fines; administrative penalties and directors’
disqualification, criminal sanctions
- higher probability of discovery
61
 Ex post policies to fight collusion
Surprise inspections

Leniency programmes
The US and EU experience:
Leniency must be clear and certain (not
discretionary)
Leniency should be extended to firms that report
after an investigation has started

62
 A Case: Wood pulp (ECJ, 1993)
1984: the EC finds that 40 wood pulp producers and 3
trade associations infringed article 85 of the Treaty
(now art. 81) by concerting on prices
1993: the ECJ annulled a large part of the EC Decision
(both on procedural and substantial grounds)
Three accusations made by the EC:
1) Price concertation with KEA (a US export cartel)
2) Price concertation within Fides (a trade-association)
3) Parallel behaviour.
1) and 2) concern a subset of firms/years and are
supported by clear hard evidence; 3) more interesting
63
 Parallel behaviour in Wood pulp
Parallel behaviour consisted of:
(i) a system of quarterly price announcements
(ii) (quasi-) simultaneity of price announcements
(iii) the fact that announced prices were identical
EC: this parallel behaviour is proof of collusion
ECJ: “parallel conduct cannot be regarded as furnishing
proof of concertation unless concertation constitutes
the only plausible explanation for such conduct”
Also: “[article 81] does not deprive economic operators
of the right to adapt themselves intelligently to the
existing and anticipated conduct of their competitors”
64
 Analysis of parallel behaviour, I
ECJ commissions an experts’ study of the industry, and
finds that parallel behaviour in this case might be due to
normal oligopolistic interdependence among firms:
(i) System of quarterly price announcements
ECJ finds that the practice of announcing quarterly prices
beforehand had been requested by buyers, who wanted
to estimate their costs (wood pulp accounts for 50-75%
of costs of a paper manufacturer) and fix the prices of
their downstream products.
(All prices quoted in US dollars also welcome by
buyers; not necessarily a practice to enhance collusion.)
65
 Analysis of parallel behaviour, II
(ii) Near-simultaneity of price announcements. According
to the EC, it can only be explained by concertation.
ECJ finds that there is a possible innocent explanation for
immediate diffusion of price information:
1. Each buyer is in contact with several suppliers (for
diversification) and may have incentive to reveal prices
2. Most wood pulp producers are also paper
manufacturers, and (again because of diversification)
purchase some of their inputs from upstream rivals
3. There are common agents who work for several
wood pulp producers
66
 Analysis of parallel behaviour, III
(iii) Parallelism of announced prices.
EC: very similar prices are proof of concertation; very
high prices in some years and low prices in others
(punishment phase) also indicate collusion
ECJ: 1. average price evolution compatible with
evolution of world demand and supply (e.g., storage
subsidy schemes in Sweden, excess capacity in North
America)
2. Similarity of prices across producers is compatible
with oligopolistic behaviour (ECJ refers to kinked-
demand curve story; but tacit collusion may also
explain parallelism) 67
 2b. Other horizontal agreements: JVs
Joint-Ventures: as for mergers, trade-off between
market power and efficiency
A special case: Research Joint-Ventures
Because of spillovers and non-rivalry, R&D
unlikely to attain socially optimal levels
RJV may promote R&D by sharing costs and
avoiding duplications, but:
R&D may fall absent competition, and…
collusion may extend to marketing and production
Only RJV on basic research should be allowed
68
Co-operative R&D (d’Aspremont-Jacquemin ‘88)

Homogeneous goods, demand: p=a-Q.

Marginal costs: ci=C-xi-sxi, with i=1,2.
with xi=investment, 0≤s≤1 is spillover rate.
R&D costs gxi2/2, with g>4/3 (for stability and SOC).
Game:
6. Firms choose R&D levels, xi, with i=1,2.
7. Firms choose output levels, qi, with i=1,2.
– Version (a) R&D set non-cooperatively;
– Version (b) R&D set cooperatively (R&D J.V.)
Firms always compete downstream.
69
 Version (a): competition in R&D
Last stage first. Each firm’s problem is:
Maxqi Πi(qi,qj)=[a-qi-qj-ci(xi, xj)]qi, given xi,xj, for i,j=1,2.
From FOCs, we obtain the Cournot outputs as:
qic=[a-C+xi (2-s)+xj(2s-1)]/3, and by substitution:
Π i =[a-C+xi (2-s)+xj(2s-1)]2/9.

First stage. Each firm’s problem is Maxxi Πi (xi,xj)- gxi2/2.

From FOCs, and imposing symmetry:
xc=[2(a-C)(2-s)]/[9g-4-2s+2s2], and:
qc= =[3(a-C)g]/[9g-4-2s+2s2].
70
 Cooperation in R&D (version b); comparisons
Last stage is the same as before.
First stage. Firms Maxxi,xj Πi (xi,xj)+ Πj (xi,xj)-gxi2/2-xj2/2.
From FOC:
xJV=[2(a-C)(1+s)]/[9g-2(1+s)2], and:
qJV =[3(a-C)g]/[9g-2(1+s)2].

Comparisons:
xJV > xC, qJV > qC, πJV > π C, WJV > WC, iff s>1/2.
If s large enough, firms know they appropriate little of
their investments in R&D, resulting in lower R&D.
Under R&D cooperation, the spillover is internalised.
71
 Cross-licensing
Cross-licensing: when two firms allow each other to
use their technology.
When technologies are complementary, cross-
licensing may be indispensable. Suppose that two
firms have ‘blocking’ (i.e., essential) patents.
Then, production or new innovation requires both
patents.
Also, an agreement whereby two rivals set
cooperatively the licensing fees for complementary
technologies allows internalisation of the Cournot
effect (see below) and results in lower fees.

72
 Patent pooling
When patents are complementary, better to have a single
owner of all patents (“Cournot effect”: better a
multiproduct monopolist than two independent
monopolists when products are complementary).
Patent pool: firm or organisation which owns the patent
rights and licenses them to third parties as a package.
If patents are complementary (a fortiori if essential),
this will keep royalties down (best if two-part
pricing).
Patent pooling may also save on transaction costs (rather
than having to negotiate with multiple parties, a firm
has to deal with one party only).
73
 A simple model of patent pooling
Suppose n manufacturers face a market demand Q=1-p
and need two complementary technologies owned by
firm A and B, who separately license them at royalty
rate wA and wB. (After, we look at patent pooling.)
2. Patent holders simultaneously set wA and wB.
3. The n firms compete in prices with cost c+wA+wB.
2nd stage. Bertrand comp.: p= c+wA+wB.
1st stage. Patent holders maxwi Πi=wi(1-c-wA-wB).
From FOCs and symmetry:
w*=(1-c)/3; p*=(2+c)/3; Π*= (1-c)2/9.
74
 Patent pool
1. Patent-holders set wi, wj to maximise joint profits.
2. As before.
2nd stage. Bertrand comp.: p= c+wA+wB.
1st stage. Patent holders maxwi,wj Πi=(wi+wi)(1-c-wi-
wj).
From FOCs and symmetry:
wp=(1-c)/4; pp=(1+c)/2; Πp= (1-c)2/8.

Clearly, patent poling Pareto-dominates the situation

where licenses are set independently: royalty fees
and prices are lower, profits are higher. 75
 3. Horizontal Mergers
a. Single-firm dominance (unilateral effects)
Merger increases market power
Efficiency gains
b. Joint dominance (pro-collusive - or
coordinated - effects)
c. How to proceed: A "check-list”
d. EU Merger Regulation
e. Merger remedies in the EU
f. A case: Airtours/First Choice

76
 Why modelling mergers is difficult
Brief explanation of what happens with homogenous
goods and cournot competition (salant, switzer,
reynolds, QJE 1981) – see separate slides

Need of asset-based model

• Product differentiation (Motta, 2004)
• Homogenous goods with capacity constraints
(Perry-Porter, 1985)

77
Horizontal mergers: unilateral effects

(One-shot Nash equilibrium before and after

the merger.)

If there are no efficiency gains, merging firms

increase prices:

→ consumer and total surplus decrease.

Intuitions.

78
Unilateral effects: A model*
n n  n 2 γ  n 2 
U = v ∑ q1 −  ∑ qi +  ∑ qi   + y (1)
i =1 2(1 + γ ) i =1 n  i =1  

γ ∈ [ 0, ∞ ) is degree of substitution.
1  n 
Whence: pi = v −  nqi + γ ∑ q 
j  (2)
1 + γ  j =1 

By inversion, direct demand functions:

1 γ
qi = v − pi (1 + γ ) + p j 
n

n
∑ (3)
n j =1 

79
Properties of demand function

- Both price and quantity competition can

be studied

- Aggregate demand does not depend on

γ and n.

Firms have identical technologies: C ( qi ) = cqi ,

with c<v.

80
The effects of a merger
1. Equilibrium with all single - product firms
2. Equilibrium with a multi - product firm with m
products.
Lemma 1 The merger increases prices and
decreases consumer surplus.
Lemma 2 A merger always benefits the merging
firms.
The result holds unless one assumes
(i) quantity competition,
(ii) homogenous goods and
(iii) no efficiency gains.
81
 RO
p1
RI′

pI M RI

pB B

pB pO p3

Figure 5.1. Effects of a merger absent efficiency gains: Strategic complements

82
 q1
RO

qc C

qI
π
1 M
π
1′ RI′ RI
qc qO q3

Figure 5.2. Effects of a merger absent efficiency gains: Strategic substitutes

83
Lemma 3 The merger increases outsiders'
profits.

This result does not depend on whether

firms compete on prices or quantities.

Lemma 4 The merger increases producer

surplus.

Lemma 5 The merger reduces net welfare.

84
Efficiency gains
If savings from the merger are large enough, they will
outweigh the increase in market power and result in lower
prices.
Assessment of efficiency gains.
• Distinction between cost savings that will affect variable
production costs (and prices), and cost savings that affect
fixed costs.
•Efficiencies from technical rationalisation are easier to
demonstrate.
•Efficiencies should be merger-specific.
• Sinergies, not mere reallocation of production
•Independent studies to try and evaluate
efficiency considerations.

85
Efficiency gains from mergers*

A merger creates a larger firm. Possible cost

savings: the merged entity has unit cost ec,
with e ≤ 1.

The lower e, the higher the efficiency gains.

Lemma 6 The merger is beneficial to

consumers if and only if it involves enough
efficiency gains, i.e. if and only if: e ≤ e .

86
 Synergies v. reallocation of output
Farrell-Shapiro: mere reallocation of production not enough to
increase consumer surplus.
Example. Simple Cournot model with two firms, having cost
c1=0 and c2<1/2. Demand p=1-Q.
Absent merger: q1=(1+c2)/3; q2=(1-2c2)/3;p=(1+c2)/3;
PS=(2-c2+5c22)/9; W=(8-8c2+11c22)/18.
Merger: qm=1/2; pm=1/2; PSm=1/4; Wm=3/8.
The merger always raises prices (pm>p for c2<1/2), and thus
decreases consumer surplus. However, it increases W (due to
the increase in profits) if c2>5/22.
Note: here consumer welfare standard may lead to different
conclusions than a welfare standard.

87
 RO
p1
RI′
(e =
1)

M RI
pI
RIe

pB B

pB pO p3
Figure 5.3. Effects of a merger with efficiency gains
88
Lemma 7 A merger always benefits the merging
firms.
Lemma 8 The merger increases outsiders'
profits if efficiency gains are small enough, i.e. if
e>e:
Only if there are important efficiency gains
will the outsiders lose from the merger.
Lemma 9 The merger always increases
producer surplus.
Lemma 10 The merger improves net welfare if it
involves enough efficiency gains, i.e. if e ≤ e .
89
Horizontal mergers: pro-collusive effects

The merger might create the structural conditions for

the firms to (tacitly or explicitly) collude.

Two main reasons.

Reduced number of firms.

More symmetric distribution of assets.

90
How to proceed in horizontal mergers: a check-list
3. Unilateral effects
Market definition:
Product and geographic market
Market power:
Market shares and distribution of capacities;
demand elasticities; elasticity of supply of rivals;
potential entrants; switching costs; buyer
power…
If possible, econometric analysis.
Efficiency gains
91
Two possible outcomes:

1. The merger enables firms to significantly raise

→ prices beyond the current level.

Prohibition or remedies.

2. Might collusion arise after the merger?

92
 Joint dominance

Number of firms and concentration

Distribution of market shares and capacities
Potential entrants (and switching costs)
Buyers' power
Observability of other firms' behaviour (exchange
of information, competition clauses, resale
price maintenance)
Frequency of market transactions and magnitude
of orders….

93
 EU Merger Policy
Preventive authorisation system (originally MTF, but
recent re-organisation)

One-stop shop for mergers (subsidiarity principle)

Reasonably quick and effective, with certain time horizon

94
The EU Merger Regulation 4064/89 was source of
inefficient biases.

1) Restricting attention to mergers which create

dominance implies that some welfare detrimental
mergers might be approved.

(Joint dominance to cover unilateral effects: not a good

approach. Airtours judgment.)

2) Failure to consider efficiency gains might result in

beneficial mergers being blocked by the EU authorities.

95
 New Merger Regulation
Compromise between “dominance” and “SLC” test.
It prohibits mergers that “would significantly impede effective
competition, in the common market or in a substantial part
of it, in particular as a result of the creation or strengthening
of a dominant position”.
Merger guidelines clarify DG-COMP’s approach to mergers.
(They also include an efficiency defence.)

96
 Merger remedies in the EU
Merger remedies increasingly important in the EU
and US
Structural remedies : they include divestiture of an
entire ongoing business or partial divestiture
(possibly a mix and match of assets of the different
firms involved.
Non-structural remedies : engagements not to abuse
of certain assets available to them, including
compulsory licensing or access to property rights.

97
 Airtours/First Choice
EC prohibited the merger in 2000.
CFI annulled decision in 2002.
First merger where joint dominance applied to more
than two oligopolists.
This case sheds light on the tension between the
dominance test and economic analysis of mergers
(discussions following it contributed to introduce
the new Merger Regulation)
First, main arguments in the EC Decision,
Then, main arguments in the CFI Judgment
98
 UK short-haul package holiday market
MMC review, 1997: Rapid changes in the sector; low
barriers to entry; market shares volatility:
1992: Thomson 24% ; Airtours 11%; First Choice 6%; Thomas
Cook 4%.
1998: Thomson 30.7%; Airtours 19.4%; First Choice 15%;
Thomas Cook 20.4%; Cosmos/Avro 2.9%
EC: after 1997, M&As: four large firms vertically
integrated (from charter airlines to retail distribution),
and many small ones (not vertically integrated).
EC: after V.I. process, no longer mobility and openness.
Purchase of package tours via Internet not significant in 2000.
99
 Main characteristics of the industry
Firms' decisions at two stages.
Planning stage: overall capacity (seats on charter
flights, rooms in hotels) is set for the following 12-
18 months.
Selling season: firms compete under a capacity
constraint, and have a strong incentive to fill
capacity: a given package loses all value after
departure date.

100
 Analysis of joint dominance, I
Standard collusive arguments could not be sustained:
Temptation to deviate from collusive prices would be
strong: discounts on catalogue prices as departure
dates approach, to fill capacity.
Threat of punishment within selling period has little
credibility due to the capacity constraint.
Also, package holidays are heterogeneous goods:
packages differ in terms of destination, type of
hotel, additional services...: difficult to reach
agreement on collusive prices and adjust to shocks.

101
 Analysis of joint dominance, II
EC: firms' profitability determined by overall level of
capacity (number of holidays)
Collusion not on high prices (selling season), but on
low capacity (planning season). (Deviation: high
capacity in planning season; punishment: high
capacity for one/more periods.)
In general, such collusion is unlikely: capacity
decisions constrain firms for a long time:
punishments are very costly and much delayed.
This industry: capacity reviewed periodically,
collusion on capacities not a priori impossible
102
 Analysis of joint dominance, III
Staiger and Wolak (1992). Repeated game, each
period of three stages. 1. firms choose capacity
without knowing demand; 2. demand level
disclosed; 3. firms choose market prices.
The model fits the package tour industry very well.
Collusive equilibria where firms collude by
restricting capacity levels but then set prices which
are not the fully collusive ones.
Lower prices (or even price wars) in selling season
are compatible with collusion on lower capacities
in planning period.
103
Analysis of joint dominance: other factors
(+) High concentration (after merger only three majors)
(+?) EC: transparency in planning period (few charter
operators, large tour operators trade seat capacity,
purchase of planes unlikely to be kept hidden)
(-) High demand volatility: difficult to distinguish btw.
deviations and genuine mistakes in predicting
demand. Collusion more difficult (EC disagrees)
(?) Supply substitution and barriers to entry: hot debate
(+) Symmetry among large operators after merger
Conclusion: Tacit collusion on capacities conceivable,
but is it sufficiently likely?
104
 Economic analysis v. dominance test
Economic analysis: will prices rise after the merger?
High concentration; small firms or potential entrants
unlikely to fully discipline the major operators.
Efficiency gains unlikely to outweigh market power:
“...the merger is only expected to lead to overall synergies
of less than 1% of the overall costs of the combined entity.
Furthermore, the cost savings mostly relate to overhead and
other fixed costs.”
Under a SMP test: prohibition decision easier to
defend. Under dominance test: controversial, but
EC had no choice but use joint dominance.
105
 The CFI Judgment
For tacit coordination sustainable, three conditions:
1. Sufficient market transparency (to monitor each
other and see whether there are deviations)
2. There must be an incentive not to depart from the
common policy, i.e., there must be a credible
mechanism of retaliation if deviations occur
3. Current and prospective rivals, as well as
consumers, must not jeopardise coordination
Therefore, concept of joint dominance used by the
CFI is same as in economic analysis
106
CFI Judgment: Analysis of the industry
M&As did not change industry structure (Th. Cook’s
rise only important change since 1997)
MMC Report still valid: high volatility of market
shares not conducive to collusion
High demand growth (not low, as claimed by EC):
collusion less likely
High demand volatility: collusion less likely
Market not transparent: overall capacity difficult to
observe, as made of hundreds of separate decisions
(routes, destinations, hotels) often going in
different directions.
107
 CFI’s analysis of the industry, II
Even if total capacity levels were meaningful,
difficult to monitor each other’s capacity
decisions:
1. Hotels unlikely to be means of monitoring (they
prefer tour operators from different countries)
2. Purchase of airline seats by tour operators minor
and comes at late stage of planning period
3. Decisions about investments to increase capacities
are observed with delays
Therefore, transparency is low during planning
period
108
 CFI’s analysis of the industry, III
No credible punishment mechanism (also: EC
decision confused about importance of retaliation)
Increasing capacity in selling season not a deterrent:
1. Innate tendency to caution in capacity decisions
2. Since deviations are not detected timely,
reactions would take time
3. Late-added package holidays would be of poor
quality (inconvenient flight times, poor-quality
accommodation)
Increasing capacity following season is poor
retaliatory measure (demand unpredictable)
109
 CFI’s analysis of the industry, IV
Underestimated reaction of competitors and consumers
1. Small tour operators would increase capacity if
prices rise: adequate access to airline seats (charters,
scheduled, low-cost) and to distribution, both
internet and traditional (EC said large operators
would foreclose; 40% in any case independent
agencies)
2. Sizeable European operators would enter UK
3. Consumers compare before buying. Long-haul
foreign package holidays increasingly attractive
 EC Decision vitiated by a series of errors of
assessment of joint dominance 110
 4. Vertical restraints and vertical mergers
Vertical agreements (or restraints): clauses to control for the
externalities arising between firms operating at successive
stages of an industry

Plan
a. Different types of vertical restraints
b. Intra-brand competition: double marginalisation and free-
rider problem
c. Inter-brand competition
d. Exclusive dealing
e. Policy implications
f. Vertical mergers

111
 4a. Types of vertical restraints
Different vertical restraints are used (according to
observability, absence of arbitrage etc.):
Franchise fee (FF) contracts
Resale price maintenance (RPM);
Quantity fixing
Exclusivity clauses: exclusive territories (ET),
exclusive dealing (ED), selective distribution
Tying
Royalties

112
 4b. Intra-brand competition

The problem of Upstream firm

(manufacturer)
double marginalisation:
vertical integration (VI),
RPM (ceiling), and Downstream firm
(retailer)
FF: efficient;
ET: inefficient.
Consumers

113
 Double marginalisation
U has to sell to D, who sells to consumers: q=a-p.
U has marginal cost c<a, D only w. U sets w, D sets p.
Separation and linear pricing.
D’s programme: maxpΠD=(p-w)(a-p).
From FOCs: p=(a+w)/2; q=(a-w)/2.
U’s programme: maxwΠU=(w-c)(a-w)/2. From FOCs:
ws=(a+c)/2; ps= (3a+c)/4; ΠUs=(a-c)2/8; ΠDs=(a-c)2/16.
Vertical integration.
VI firm’s programme: maxpΠVI=(p-c)(a-p). From FOC:
pvi= (a+c)/2< ps; Πvi=(a-c)2/4>;ΠUs+ ΠDs.
114
 Intra-brand competition, II
Interaction among
retailers may create Upstream firm
negative externalities (manufacturer)

Downstream firm Downstream firm

(retailer) (retailer)

Consumers

115
 Intra-brand competition, III
Free-riding among retailers and under-provision of
services: VI, ET and RPM (floor): efficient

(N.B.: Substitutability of vertical instruments)

Quality certification: RPM and selective distribution

Free-riding among producers: exclusivity clauses
Exclusivity may also remove opportunistic behaviour
and promote specific investments

116
 Intra-brand competition, IV
Possible anti-competitive effects of vertical
restraints: the commitment problem of an input
monopolist.
Example of commitment problem: franchise
Solution of the monopolist’s problem:
Vertical integration
Exclusive territories
Resale price maintenance
Most-Favoured Nation clauses and anti-
discrimination laws (transparency is bad)
117
 4c. Inter-brand competition

Upstream firm Upstream firm

Illustration of (manufacturer) (manufacturer)
inter-brand
competition Downstream firm Downstream firm
(retailer) (retailer)

Consumers

118
 Strategic use of vertical restraints
Upstream firms may use vertical restraints so as to make their
own retailers more or less aggressive (depending on the
nature of competition in the marketplace).

For instance, assume that market competition is such that

when a retailer increases prices, the best response of its
rival retailer is also to raise prices. Then, it is optimal for
the manufacturer to use a two-part tariff contract and sell to
the retailer at a higher price than it would be optimal absent
strategic considerations. The retailer would behave less
aggressively, the rival retailer’s price also increase, and
market profits will go up for both (by using the fixed fee
these profits are appropriated by the manufacturer).
119
Strategic effects of VR: intuitions

p2 R1 ( w1 = c) R1′( w1′ > c)

R2′ ( w2′ > c )

E′
R2 ( w2 = c )

p1
120
 Strategic use of vertical restraints

Two upstream firms U1,U2 sell differentiated goods. Demand

is given by:
qi = (1 / 2)[ v − pi (1 + γ / 2 ) + (γ / 2) p j ]

Each upstream firm needs retailer (resp. R1,R2) to sell the

good
Zero production and retail cost, for simplicity
We show that vertical restraints (in the form of delegation
with two-part tariffs) can be used to increase profits

121
 Integration v. delegation

Vertical integration. If R1, R2 are owned by U1, U2, one can

find equilibrium by solving:
max π = p q ( p , p )
p i i i i j
i

From FOCs one obtains:

2v ( 2 + γ )v 2
pVI = ; π VI = .
4 +γ (4 + γ ) 2

122
 VR: Two-part tariffs

1st stage: Ui sets Fi+wiqi for Ri. Contracts are observable. 2nd
stage: Ri chooses pi. We solve by backward induction.
Last stage: each Ri maxpiπiR=(pi-wi)qi (pi,pi). Whence,
pi*(wi,wj), qi*(wi,wj).
First stage: each Ui earns Fi+wiqi . Therefore, Ui sets Fi so
as to appropriate Ri’s profit: maxwiπiU=(pi*-wi)qi*+wiqi*.
At equilibrium: wi*>0 and:
4( 2 + γ ) v 2 ( 2 + γ )(8 + 8γ + γ 2
) v 2

p FF = > p VI
; π FF
= > π VI

16 + 12γ + γ 2 (16 + 12γ + γ 2 ) 2

123
Strategic effects of VR: intuitions

p2 R1 ( w1 = c) R1′( w1′ > c)

R2′ ( w2′ > c )

E′
R2 ( w2 = c )

p1
124
 Exclusive territories
Rey and Stiglitz (1988): exclusive territories allow
manufacturers to relax competition.
Suppose each (differentiated) Ui has two or more
retailers perceived as homogenous by consumers.
Intra-brand competition: pi=wi, and solution as if
Ui are vertically integrated.
Suppose now each retailer is given an ET. Then in
each territory, the game is as the one above, and
prices will be higher.

125
 Vertical restraints might facilitate collusion

An example: Resale price maintenance.

Consider possible collusion among manufacturers.

Assume that manufacturers need to sell through local
retailers.
Absent RPM, when local demand shocks occur, difficult
to see if retail prices differ before of deviations by
manufacturers or demand shocks.
RPM increases observability of deviations and facilitate
collusion upstream.

126
 4d. Exclusive dealing

Outline:
Definition, and motivation
Brief historical perspective
Recent contributions on exclusionary effects
Pro-competitive effects
Policy implications

Advanced session:
Anti-competitive models of exclusive dealing

127
 Exclusive dealing: contracts that require to
purchase products or services for a period of
time exclusively from one supplier.

Efficiency gains Anti-competitive

- stimulate investments effects
into retailers’ services - allow a dominant firm
(free riding problem).to deter efficient entry.
- stimulate specific
vestments (opportunistic
haviour)
LONG SERIES OF HIGH PROFILE CASES. E.g.:
United States v. Microsoft (1995).
Mars v. Langnese/Schöller - art. 81 case (1996)
US v. Dentsply International (2005)
128
Traditional argument

Foreclosure of a crucial input

I (ex. distribution network)
E I: incumbent
B: unique buyer
E: potential entrant
B

129
“Chicago school” critique
(Posner 1976, Bork 1978)

cE<cI Why does the buyer sign the

exclusive deal?
pm A

B=π m C πm < CS(cI)-CS(pm)

cI
D =x* Incumbent’s buyer’s loss
gain

The incumbent cannot profitably use

exclusive contracts to deter entry.
Efficiency considerations explain the use of
exclusive contracts.
130
 Why exclusive dealing can be anti-
competitive
1. Upstream competition matters: if the buyer
expects weak competition, they will accept ED
for very small compensation
2. If there are several buyers and scale economies
(i.e. the entrant needs a minimum number of
orders), then buyers’s miscoordination may arise.
3. With several buyers (or markets), depriving the
entrant of some buyers (market) obliges all to buy
from incumbent, and hence deters entry
4. Exclusive dealing as a rent-extraction mechanism
(advanced, but lower practical relevance)
131
 1. Upstream competition matters
In the Chicago school’s theory, the buyer expects
fierce competition if the entrant will actually enter.
Therefore, he will require a large compensation
(x*=CS(cI)-CS(pm) ), that incumbent cannot
profitably offer.
If instead there would be weak competition if entry
took place, the buyer would require lower
compensation, which the incumbent may be able to
offer. In the limit, if entrant and incumbent
colluded (and had siimilar efficiency), then he
would accept ED even at x*=CS(pm)-CS(pm)=0.
132
 2. Buyers’ miscoordination
Suppose there are several uncoordinated buyers, and
that the entrant needs a certain number of them for
entry to be profitable (scale economies on
production or demand side)
It is possible that exclusive contracts are accepted by
all buyers (even behind a very small
compensation) simply because each buyer expects
all the others to do so (and if one rejected
exclusivity, it anticipates it would not be sufficient
to trigger entry)

133
 3. Discriminatory offers facilitate exclusion

pm A pm A
B=π m C B=π m C
cI cI
D D

Buyer 1 Buyer 2

If 2 πm >∆CS (= B+C), then the incumbent persuades

one buyer, and thus excludes the entrant for both
buyers.
134
 Sequential offers
Stage 1: Incumbent offers ED to buyer 1 (including
compensation x1); no price commitment.
Buyer 1 decides whether to accept or reject.
Stage 2: Incumbent offers ED to buyer 2 (including
compensation x2); no price commitment.
Buyer 2 decides whether to accept or reject.
Stage 3: Entry decision.
Stage 4: Active firms name prices.

Assumption: 2πm>x*

135
 Sequential offers
B1
accept reject

B2 B2

accept reject accept reject

E E E E

In Ou In Ou In Ou In Ou
t t t t
π I = 2π − x1 − x2
m π I = 2π m − x2 π I = 2π m
π I = 2π − x1 − x2
m
π I = π m − x2
π E = −F πE = 0 πE=0 πI=0 πE=0
π E = (c I − c E ) q (c I ) − F < 0
π E = 2(cI − cE )q(cI ) − F > 0

• If at least a buyer signed: Entry does not follow

136
 Sequential offers
I offers x1=
0
B1
accept reject

I offers x2= B2 B2 I offers

0 x2=x*

accept reject accept reject

E E E E
Ou Ou Ou In
t t
π I = 2π m − x1 − x2 π I = 2π m − x2 π I = 2π mt− x2 πI = 0
π bi = CS ( p m ) + xi π b1 = CS ( p m ) + x1 π b1 = CS ( p m ) π bi = CS (cI )

π b2 = CS ( p m ) π b2 = CS ( p m ) + x2

137
 Sequential offers
Buyer 2’s decision:
If B1 accepted,
• B2 accepts behind x2>0 (entry does not follow in any case)
• The incumbent offers x2=0 and B2 accepts.

If B1 rejected,
• B2 accepts behind x2 =x*.
• The incumbent offers x2 =x* (2πm –x*>0) and B2 accepts.

Buyer 1’s decision:

Whatever it chooses, entry does not follow:
• It accepts behind x1>0.
• The incumbent offers x1=0 and B1 accepts.

In equilibrium both buyers accept behind negligible

compensations: profitable exclusion!!!! 138
 Scale economies and exclusion
More generally, the same mechanism will take place
whenever the rival of a dominant firm will need a
certain size of the market to be profitable.
The dominant firm may take actions allowing it to
‘capture’ the number of buyers (or markets)
enough to make the rival unprofitable.
Price discrimination, rebates, (tying) are other tools
which achieve exclusion in similar way as
exclusive dealing (see more below).

139
 Anti-competitive exclusive dealing: summary
Exclusive deals might indeed be used to deter entry
Hypothesis of buyer fragmentation and scale economies
most convincing (but check market features in actual
cases)
Central Purchasing Agencies might help?
Discriminatory offers help exclude

Of course:
- Dominance crucial
- Proportion of buyers covered by ED?
- Length of the ED important (but also for pro-
competitive rationale)
140
 Pro-competitive effects of exclusive dealing

Exclusivity clauses may enhance investments.

1) Avoid free-riding on manufacturers’ investments to
promote retailers’ sales (Besanko and Perry, 1993).
Suppose manufacturers can invest to help retailers’
sales. If retailers carry several brands, low investment
because of spillovers. Exclusivity raises investments
in retailers’ services, promotion, training etc.

141
 Pro-competitive effects of exclusive dealing,
II
2) Segal and Whinston, 2000: When are exclusive
contracts likely to protect relation-specific investments
against opportunistic behaviour?
Incumbent (I) and/or buyer (B) can make a (non-
contractible) investment; buyer may later buy from
external seller (E). An exclusive contract prevents B
from buying from E, but exclusivity is renegotiable.
Their analysis relies on a number of special assumptions,
and the following conclusions are very tentative (more
research needed before policy implication can be
drawn).
142
 Segal-Whinston, cont’d
Incumbent invests Buyer invests
ED increases ED decreases
Complementary investment (absent investment (absent
Investments (increase ED, I would invest ED, B would invest
value of trade btw. little, because more, to increase
E and B) investment favours E) value of trade with E)
ED decreases ED increases
Substitutable investment (absent investment (absent
Investments (decrease ED, I would invest ED, B would invest
value of trade btw. more, to worsen E’s less, not to reduce
E and B) position) value of trade with E)

143
 Balancing anti- and pro-competitive effects

Currently, in the EU per se prohibition of exclusive

contracts by a dominant firm
Better to adopt a rule of reason approach:
iii. Are exclusionary effects likely?
iv. What are the likely pro-competitive effects of
such a practice?
v. Are the latter likely to outweigh the former?

144
 A case: Ice-Cream (1995)
Long series of similar cases in Europe. Here, a EU
case (German market).
Mars complained that exclusive agreements of
Langnese-Iglo (LI) and Schöller hindered its sales
in the German market for industrial impulse ice-
cream (excludes craft trade).
Commission of the EC (CEC) finds that LI and
Schöller had infringed art. 81 and prohibited the
two firms from using such agreements. CFI
upholds the CEC’s decision.

145
 The market

Growing market after reunification

LI and Schöller have over 45% and 20% of market as
defined by CEC; roughly half if craft ice-cream
included. Other manufacturers less than 10%.
Sales occur directly, through agents, or brokers (the
latter have no exclusivity agreements):
– Grocery trade (supermarkets, food stores…)
– Traditional trade, i.e.: specialised trade (kiosks,
petrol stations, cake shops, cinemas, theatres)
and catering trade (hotels, restaurants, cafés…)
146
 The agreements
Manufacturers often use exclusive agreements: buyer
cannot sell rivals’ ice-cream in its outlet
Manufacturers also provide (on loan) the customer
with one or more freezer cabinets, with the clause
that they cannot store rivals’ ice-cream.
Duration of these agreements: on average 2.5 years.
Percentage of sales made by tied outlets: disputed
With CEC’s definition, tied distributors account for
15% (LI) and 10% (Schöller) of total market. With
broader definition, much less.
147
 Foreclosing effects of exclusivity

Do these exclusive agreements foreclose rivals?

Entry not easy: large sunk costs for advertising and
distribution; several outlets tied to existing sellers;
[would shops take new cabinets?]
But Mars is not a minnow, and is already
established with other products in Germany.
Theory: exclusionary effects possible (large number
of uncoordinated retailers; presumably little
competition in the downstream market)

148
 Efficiency effects of the agreements

Manufacturers make large investments to provide

shops with freezers (this explains high growth).
Standard free-riding arguments call for rivals not
to make use of another seller’s investments!
But this applies to freezer cabinet exclusivity.
Doubtful that outlet exclusivity is also crucial (to
guarantee certainty and stability of demand?)
Unclear that outlet exclusivity necessary to enhance
retailer’s services (retailers do little or no
advertising, training, promotion to sell ice-cream)

149
 Conclusions
Neither the CEC nor the CFI make a distinction
between freezer exclusivity and outlet exclusivity.
While outlet exclusivity has a higher foreclosing
potential and no clear efficiency effects, freezer
cabinet exclusivity has little foreclosing potential
(Mars and others could give retailers other
freezers) and clear efficiency effects.

150
 Case II: Mobile Telephony Dealers in Italy

“Costituzione Rete Dealer GSM”, Italian Antitrust

case (2 May 1996)

Italian market for mobile communications. Former

monopolist incumbent (Telecom Italia Mobile),
imposes exclusivity on its dealers as soon as a new
rival (Omnitel) is allowed to enter.
Here, unlikely that efficiency defences would hold,
and the risk that liberalisation process is blocked at
the outset is enormous.
Correct to find exclusivity clauses abusive.
151
 4e. Policy implications
Strong presumption VR enhance efficiency
Possible anti-competitive effects only when enough
market power exists
Market power, not the type of agreement adopted,
matters
(=> change in the approach to VR in Europe in the
late 90’s)
Large enough market power: rule of reason,
balancing efficiency with (possible) adverse effects

152
 4f. Vertical mergers

When two firms at successive production stages merge.

Possible efficiency effects from vertical integration:

Avoiding double marginalisation problems
Generally, avoiding (or reducing, since agency
problems might still exist) vertical externalities, as
joint control of upstream and downstream firms
Avoiding opportunistic behaviour and promote
specific investments
Better coordination of investments and innovations
153
Vertical mergers: Possible exclusionary effects?
If an upstream monopolist integrates downstream,
would it foreclose input to downstream rivals?
Chicago School: No foreclosure effects, because of
“Single Monopoly Profit” theory
(SMP theory: if downstream firms are perfectly
competitive, all profits from the vertical industry can
be reaped by the input monopolist: no incentive to
merge for foreclosure)
Modern IO: yes, foreclosure might be both feasible and
profitable, e.g. because of the “commitment
problem” (Hart-Tirole)
154
Two-step analysis of vertical foreclosure
Step 1. Does the vertical merger harm downstream
rivals? (does the input price paid by them rise?)
a. Will integrated firm cease to supply? (raise input
prices?) No, if downstream rivals serve different
markets and/or other efficient upstream firms exist
b. Assume integrated firm ceases to supply. Input
price paid by downstream rivals will not
necessarily rise: (i) other upstream firms might
increase supply; (ii) lower demand for input
(downstream affiliate withdraws from input
market) tends to reduce prices
155
Two-step analysis of vertical foreclosure, II
If foreclosure will occur (if not, investigation stops):
Step 2. Does the vertical merger harm competition?
(i.e., which final effect on welfare?)
a. Because of removal of double marginalisation
problems, downstream affiliate will tend to reduce
prices
b. If downstream rivals pay higher input price, but are
competitive enough, difficult for downstream
affiliate to raise prices even if it wanted
c. If indeed vertical firm has market power, this may be
balanced by efficiencies from vertical integration
156
 5. Price discrimination
Important, both in itself and to understand other practices

Three types of price discrimination (PD):

1st degree (perfect) PD
2nd degree PD: self-selection of consumers
3rd degree PD: if different observable characteristics

Two main ingredients of price discrimination

- ability to “sort out” different consumers and charge
them different prices
- no arbitrage opportunities (=no parallel imports)
157
 Welfare effects of PD
PD is not always bad: the extreme case of 1st degree PD,
under which the first-best is attained (provocative but
unrealistic example)
Quantity discounts (2nd degree PD). Some consumers
have higher demand than others. If consumers are
charged T+pq, the unit price (T/q+p) decreases with
the number of units bought.
Welfare increases because the fixed fee is used to extract
surplus, allowing for a lower variable component than
under linear pricing
(Proxy of the first-best case where p=c and T is used to
extract all the surplus)
158
 3rd degree PD and parallel imports
Suppose h and l are two regions (h=rich; l=poor) or identifiable
consumer groups, with different demands.
If price discrimination is allowed, the firm sets ph>pl.
If price discrimination is prohibited, two cases may arise:
4) Under uniform pricing, sales in both markets. In this case: Πd > Πu , but
Wd<Wu.
5) Under uniform pricing, one market is not served: the firm may prefer to
set ph even if this implies no sales in country l. (This happens when
country l is relatively unimportant, for instance.)
In this case: Πd >Πu and Wd >Wu.

General result: PD welfare detrimental if qPD does not increase.

159
 Further remarks
PD and investments. Since PD increases the firms’ profits, the
uniform pricing policy may have long-run negative effects (on
investments, innovations etc.)
PD and market power. Both small and large firms will have
incentives to discriminate prices across countries. But in the
former case welfare effects are less relevant.
To the extent that PD will induce firms to invest more, allowing
‘small’ firms to engage in PD may foster competition.

Sensible to use a safe harbour: allow PD for firms below a certain

market share or if not dominant (not the current EU policy).

160
 PD as monopolisation device
PD may be used by an incumbent to exclude rivals.
For instance, discriminatory pricing may exclude
entrants if buyers are uncoordinated and there are
economies of scale (see Figure below)
Also, when only some buyers can be contested, price
discrimination makes it less costly for the incumbent
to exclude (it does not need to lose profits on infra-
marginal buyers)
But an obligation to dominant firms not to discriminate
(transparent pricing) may have adverse effects (helps a
dominant firm to solve the commitment problem).
161
 Discriminatory pricing facilitates exclusion

pm A pm A

B=π m C B=π m C
cI cI
D D

Buyer 1 Buyer 2
The incumbent can set p=cI to one buyer, p=pm to the
other, and it excludes the entrant from both markets.
If entrant can match, equilibrium price will be below cI.
(The incumbent makes losses on one buyer but recovers
on the other. Entrant needs both buyers, so it should162
 Which policy implications?
Price discrimination: difficult to arrive at clear-cut
policy recommendations (see more on rebates)
If no dominance, probably best not intervene (but in
the EU, efficiency is not the only objective of
competition law)
If dominance, rule of reason: price discrimination
implies more aggressive pricing (each customer
can be contested)
- if market structure unaffected, good
- if exclusion can arise, bad
163
 Abusive practices (Introduction)
a. Exclusive dealing
b. Price discrimination
c. Rebates
d. Predatory pricing
e. Excessive pricing
f. Margin squeeze
g. Tying
h. Interoperability

164
 Substitutability among exclusionary practices
Note that exclusion can be achieved
through different practices which
are to some extent substitutable. UI Cost c0

For instance:
If I owns both essential input and a
is seller downstream:
- Refusal to deal (or license)
- Tying UI and DI sales Cost cI Cost cE
DI E
- Price squeeze
- Degrade interoperability
p

165
 Substitute practices, cont’d
Suppose I wants to exclude E.
Different practices are possible,
including:
I E
- Exclusive dealing
- Price discrimination
- Rebates (quantity discounts)
- Predatory pricing

Policy implication: a form-based B1 B2

approach does not make sense.

166