DEPARTMENT 1510790 TAKE HOME PROBLEM SET Answer BOTH questions

DEPARTMENT OF ECONOMICS

 

 

EC337 Industrial Economics 2:

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Market Economics, Competition and Regulation

 

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your ID number here:

 

 

1510790

 

TAKE HOME PROBLEM SET

 

Answer BOTH
questions

Section A (40 marks)

Section B (60 marks)

 

·        
This take-home problem set is
worth up to 20 marks of your final mark on this module (i.e. up to 20% of the
total marks available) and for visiting students not taking the final exam it
is worth 100 marks

·        
The take-home problem set will be marked out of 100 and for
students taking the final exam it will be adjusted pro rata to a mark out of 20

·        
Write your answers in a suitable
word processing package and convert the final file into *.pdf format and upload
via the e-submission system managed by the Department

·        
You must adhere to the word count limits – penalties will apply
for exceeding the word count (mathematical notation will be excluded from the
word count but ALL other text included)

·        
The take-home problem set is partly
modelled on the final exam structure but differs in detail from the final exam
where you must answer the two questions in section A each worth 25 marks and answer
one question from a choice of three questions in section B worth 50 marks

 

The
deadline for submission of your answers is no
later than 23:55, Wednesday 10th
Jan 2018 (UK time)

SECTION A one question

 

1.      
Market Definition

 

a.      
In no more than 200 words describe
the salient economic characteristics of a relevant market.

10 marks

Moreover, relevant markets may
have various economic markets combined made of products that are sufficiently
substitutable. In addition, relevant markets foster competitive behaviour.
Consequently, anti-trust enforcement agencies may recognise such markets with
an aim to ensuring competition is encouraged, upheld and continued to benefit
consumers.

 

Relevant markets are identifiable
through Hypothetical Monopolist testing. The test finds that relevant markets
must adhere to the relevant product and geographic markets. This means the
products sold must be viewed as substitutable by the consumers given the
products’ characteristics, prices and intended use. The definition also makes
reference to the location of manufacture and/or sales. A hypothetical
profit-maximising firm in such a market without price regulation would always be
the sole producer of those products in that area. The firm is likely to impose
“small but significant and non-transitory increases in price” which tends to
typically be a 5-10% increase, while successfully maintaining positive profits.
Therefore, a relevant market is a group of products and a geographic area which
is small enough to satisfy this test.

 

Word Count: 172

 

 

b.      
In no more than 200 words describe
critical loss analysis. 

10 marks

As with the Hypothetical
Monopolist test, Critical Loss Analysis (CLA) is also a simple algebraic tool
used to identify anti-trust markets. CLA addresses the amount of sales required
to be forgone to make a hypothetical price rise unprofitable i.e. if prices
were raised by x%, the rise/fall of profits depends on the response of quantity.

 

Critical Loss is the smallest
percentage loss in sales that makes a 5% or 10% increase in price, by a
hypothetical monopolist, unprofitable.

I will use a basic model to explain CLA. Suppose we have an
industry with market price p and quantity q. For a monopolist, an increase
in price would cause profits gained to be equal to ?p(?q+q). The subsequent
fall in quantity sold would cause a profit reduction of (p-c)?q. Equating both
equations enables us to find Critical Loss (?q*/q*):

Then dividing through by pq,

thus allowing to solve for ?q*/q*:

In the above equation, the Gross Margin (m) represents the price-cost markup (or the ‘Lerner Index’). For
instance, if the SSNIP=10% and the Gross Margin=30%, Critical Loss would be
equal to 25%. In this case, if quantity sold fell by 25% or more, negative
profits would realise.

Word Count (without mathematical
notation): 196

 

c.      
Suppose that the estimated actual
loss associated for a 5% price increase for local radio advertising is no
greater than the estimated critical loss for a 5% price increase.  In no more than 200 words explain what
inference can be made about the relevant market.

10 marks

Actual Loss (AL) is the actual percentage
decrease in sales (observed or predicted) due to increasing price by 5% or 10%.
In the case, where AL>CL, the relevant market can be assumed to be wider
than the market currently considered. This is because there are close
substitute goods that consumers turn to as a result of the price increase,
causing the price increase to fail to realise profits. The firm is therefore
hindered by competition forces. Thus, widening the market would diminish the
extent of rivalry.

 

For this question the 5% price
increase results in AL?CL. In this case, we can infer that there exist no close
substitutes, potentially due to the lack of competition in the market. This
consequently allows the firm to utilise market power and thus exercise
price-setting power, which in turn will adversely affect the consumer. Moreover,
another reason for AL?CL may be due to a relatively larger increase in the
price of substitute goods, if the cross elasticity is sufficiently large (A
Critical Analysis of Critical Loss Analysis, O’Brien and Wickelgren, 2004). As
AL?CL, we can also assume that the market for local radio advertising forms the
boundary for the relevant market.

 

                Word Count: 197             

 

d.      
In no more than 200 words describe
how competition authorities like the Competition and Markets Authority in the
UK typically operationalise critical loss analysis in merger cases.

10 marks

The Competition and Markets Authority (CMA) is mainly responsible
for investigating mergers which could stifle competition, and conducting
research in markets where competition problems arise. Furthering the earlier
answer, CLA is commonly used to assess mergers, as evidenced below.

One example of a merger case is
that conducted by the Office for Fair Trading (OFT) in 2008. Dunfermline Press
(who owned 23 local and regional papers in the UK and 3 in Berkshire) acquired
Berkshire Regional Newspapers portfolio from Trinity Mirror plc (six local
newspaper titles). As they both advertised the supply of newspapers, the
question arose as to whether the relevant market was only local newspaper
advertising, or whether it included advertising in other sources of media (e.g.
local radio). Dunfermline Press conducted a telephone survey of 300+ advertisers,
where all participants were asked about a hypothetical 10% increase in price.
Consequently, 13% said they would no longer advertise, while 48% would spend
less on advertising, producing an Actual Loss in excess of 13%. Dunfermline
then estimated that AL>CL, suggesting that the market for local advertising
was wider than just newspapers. In order to maintain competition, the OFT
cleared acquisition subject to divestiture of one local title.

 

                Word Count:
198

 

 

 

 

SECTION B one
question

 

2.      
Vertical Restraints

 

a.      
A manufacturer of product X sets
out contractual terms and conditions applicable to distributors selling product
X.  In no more than 300 words outline and
describe the competitive characteristics of the three main categories of
vertical restraints that may be applied by the manufacturer.  

15 marks
This part will be marked according to the University’s 20-point scale: https://warwick.ac.uk/services/aro/dar/quality/categories/examinations/marking/ug2017/

                       

In this case, vertical restraints are
competition restrictions between the manufacturer and distributor of product X
through a contractual agreement. Exclusivity
clauses form three main categories of vertical restraints, covering
geography, brands, and customers.

 

One category of exclusive clauses
is Exclusive Distribution. This restraint places a restriction on
territory by fixing the number of retailers permitted to sell a brand in an
area, limiting intra-brand competition. The main intentions of doing so, from
the manufacturer’s standpoint, are control and costs. For manufacturers, it is
cheaper to form contracts with fewer distributors than many due to improved management
of production and storage costs, and distribution. For retailers, benefits from
such a contract arise due to the subsequent lack of competition in their
geographical areas, resulting in greater sales.

 

Exclusive Dealing restricts the downstream distributor’s ability to sell competitor
brands, limiting
inter-brand competition. It is considered to be vital for the manufacturer in
order to maintain product image, safety and reputation. It also enables
manufacturers the chance to exercise control over their retailing chains for
strategic purposes. Exclusive Dealing also causes the prevention of free riding
amongst downstream firms (which reduces investment levels below that of the
social optimum welfare maximising level), thus solving the Horizontal Externality
Problem.

 

Finally, Selective Distribution allows
manufacturers to choose which type of distributors to use. By restricting the
sale of their brand to certain retailer types will enable the manufacturer to
target a particular clientele to maximise sales. It will also allow a
manufacturer to gain price-setting power. 
For instance, if Gucci used both Lidl and Harvey Nichols as
distributors, the average customer willingness to pay would be lower than if
Gucci simply used Harvey Nichols. Due to the diminished brand image, the
utility obtained by the consumer would also subsequently fall.

 

Word Count: 296

 

b.      
Suppose the manufacturer of X limits
intra-brand competition among distributors. 
Is this restriction of competitive rivalry defendable?  In no more than 300 words explain your
reasoning.    

15 marks
This part will be marked according to the University’s 20-point scale: https://warwick.ac.uk/services/aro/dar/quality/categories/examinations/marking/ug2017/

               

The limitations on intra-brand
competition is due to the manufacturer agreeing on exclusive distribution of
product X with the distributor. Although this may be deemed anti-competitive by
the CMA due to an attempt of the manufacturer to monopolise an area, such a
restriction also has advantages which will be addressed in this answer.

 

This particular restriction would
reduce consumer choice below the socially optimal level, which would be a cause
for concern for the CMA. It could also encourage upstream firms to charge the
distributors higher prices to largen profits. This would indirectly be filtered
into higher market prices which would be incurred by customers.

 

However, such a clause is
justifiable when addressing other market concerns. Horizontal externalities may
arise when many retailers sell the same brand. In a given market with several
distributors, one firm is likely to under-invest in things such as marketing
and after-sales servicing, assuming other distributors of the same brand will
make such investments. The distributor can reap the benefits of other distributors’
investments without spending anything, thus minimizing costs and potentially
reducing prices to attract an entire client base. This is a form of
free-riding. However, if all distributors adopt the same mentality, similar to
that shown in the Prisoner’s Dilemma, every distributor will under-invest
compared to that which will achieve the social optimum. Although price
reductions will benefit consumers, they will also incur costs such as a lack of
access to information and lower product quality.

I will consider the case of BMW (manufacturer) and its
relationship with showrooms (distributors). Instead of using several
distributors who may free-ride upon one another (and thus refrain from
investing in things such as advertising and free test drives), BMW distributes
its cars exclusively to ensure necessary investments are made to reach socially
optimal levels.

                Word Count: 298

 

c.      
In a competition case in the UK
currently under appeal to the Competition Appeal Tribunal, golf club
manufacturer Ping Europe Limited (Ping) has been fined £1.45 million for
banning UK retailers from selling its golf clubs online.  Imagine you have been commissioned by a newspaper
to prepare a summary of the economic
arguments of both parties in the case (CMA and Ping).  In no more than 600 words write a clear and
concise account for the newspaper.

30 marks
This part will be marked according to the University’s 20-point scale: https://warwick.ac.uk/services/aro/dar/quality/categories/examinations/marking/ug2017/

 

On 24th August 2017,
golf club manufacturers Ping Europe Limited (Ping) received a £1.45 million
fine by the Competition and Markets Authority (CMA) due to anti-competitive
practices 1.

 

The CMA is the UK’s main
competition enforcement authority, with the primary aim of promoting
competition for the benefit of consumers 4. Ping has received the
aforementioned fine as the firm banned UK retailers from selling its golf clubs
online, thus violating the TFEU Article 101 and the UK Competition Act 1998. Both
of these cover anti-competitive agreements which restrict or prevent
competition both within the UK and between EU member states respectively 1.

 

In October 2017, Ping finalised an
appeal via the Competition Appeal Tribunal under Section 46 of the Competition
Act 1998 3. Their main reason behind the banning of online sales was due to
the importance of Dynamic Face-to-Face Custom Fitting.  As the name suggests, the firm intended to
ensure that each customer was offered enhanced product choice and customer
satisfaction, a benefit which cannot be offered online. This point is extended
further within the appeal; representatives argue that the fine is unfair as the
decision is incorrect to characterise Ping’s Internet Policy as a competition restriction
as it pursues a legitimate aim of custom fitting, and customer satisfaction. On
this basis, Ping drew the conclusion that the fine imposed upon them by the CMA
was unjust as Ping never intentionally chose to be anti-competitive.
Subsequently, instead of accepting the £1.45 million fine, Ping sought to annul
the fine, and that the costs of the appeal were covered by the CMA 3. Moreover,
the network externality effect can be used as an argument for Ping to defend
such selective distribution. This effect suggests that if a producer makes its
product available to many distributors, the brand value may diminish, resulting
in consumers’ willingness to pay to also fall 7. The lack of such a restraint
could also be at the cost of lower service quality and lower availability in
the long term 4.  

 

The CMA is not unfamiliar with
such anti-competitive behaviour. Even prior to this case, in March 2016, Oxera
Consulting and Accent undertook market research as assigned by the CMA to study
businesses’ incentives to use vertical restraints, and subsequent effects on
e-commerce. As alluded to earlier, findings suggested that firms’ reasoning
behind such restraints was in an attempt to prevent free-riding, maintain pre-
and after-sales service quality, and protect brand image 4, all of which can
be applied to Ping.

 

However, the CMA similarly has
valid reasons to rebut Ping’s appeal. By the end of 2016, it is estimated that
consumers in the UK will have collectively spent £126 billion on online goods
and services due to the privilege of using Direct Comparison Tools 5.
Therefore, the CMA has understandably dedicated much time to ensuring
competition is appropriately sustainable on the internet too. Ann Pope, a
Senior Director for Antitrust enforcement, issued a statement saying such bans
enforced by Ping prevents all retailers from competing to attract internet
users to find the best deals, and also prevents retailers from reaching a large
consumer base on online platforms 5. On this basis, the European Commission’s
Guidelines on Vertical Restrictions (2010) has dubbed such restrictions of
competition as being “hardcore”.   

 

In conclusion, although efforts
were made by Ping to either nullify or reduce the fine, the appeal is yet to be
responded to. The CMA’s intent with the fine is to both punish the golf company
for their anti-competitive behaviour and deter other firms who may be tempted
to follow suit.

 

Word Count: 593

 

To prepare
your report in part (c) you will find it helpful to use lecture notes from
Topic 9 and to do some desk-based research by visiting the following sites:

 

1 https://www.gov.uk/government/news/cma-fines-ping-145m-for-online-sales-ban-on-golf-clubs CMA media release

 

2 https://www.gov.uk/cma-cases/sports-equipment-sector-anti-competitive-practices CMA Timeline for case with links to various documents

3 http://www.catribunal.org.uk/237-9999/1279-1-12-17-Ping-Europe-Limited.html Competition Appeal Tribunal case details and documentation

 

4 http://ec.europa.eu/competition/antitrust/e_commerce_files/competition_and_markets_authority_en.pdf CMA submission to the European Commission on the draft sector inquiry
report on E-Commerce – a useful piece outlining several issues, some relevant
to this case

 

5 https://www.hausfeld.com/news/eu/uk-enforcement-agency-issues-statement-of-objections-to-ping-on-online-sale German law firm summary of case – includes discussion of
experience in Germany of similar cases (short document)

 

6 http://www.klgates.com/files/Publication/7fbd8efb-cb87-44bb-8dc4-d1f348fddba6/Presentation/PublicationAttachment/cd700e9e-b5dc-4176-b554-d5d901ae86f1/1012-059_Practice_Note-The_Internet_and_Competition_Law.pdf Lexis-Nexis short document on the Internet and competition law

 

7 https://www.slaughterandmay.com/media/64575/the-eu-competition-rules-on-vertical-agreements.pdf Document produced by leading law firm looking at vertical
agreements in general, including VABER (Vertical Agreements Block Exemption
Regulations) and MVBER (Motor Vehicle Block Exemption Regulations)

 

Note part (c)
makes use of the fact this is a take-home problem set

 

 

 

Dr. Chris Doyle

Module Leader EC337

20 December 2017

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