Competition, Concentration

1
Competition, Concentration Market Power in
Transportation

• Chapter 7

2
Objectives

• Specify the socially efficient combination of
  goods and services in a perfect market
  environment
• Examine the effects of transportation costs on
  trade flows
• Examine the effects of Market Power on market
  efficiency and government responses to Mkt Pwr
• Examine cases of the use of Market Power in the
  Transportation industry

3
The Spectrum of Market Structures

• Markets range from perfect competition
• Large number of small buyers and sellers
• Identical products and production technologies
• No control over price
• Monopolistic competition
• Large number of small buyers and sellers
• Highly similar products and production
  technologies
• Some limited control over prices
• Oligopoly
• A few large highly interdependent firms control
  large share of mkt
• Products can be highly differentiated or standard
• Large amount of control over prices
• Monopoly
• Single firm controls all of market
• Firms price is market price

4
Socially Efficient Market Outcome

• Requirements
• All production inputs are used optimally
• All produced goods are distributed optimally
• The output mix and its distribution achieve the
  highest possible level of satisfaction for
  society
• In perfect competition
• The ratio MCT/MCX is the opportunity cost of
  increasing T by one unit and is also known as the
  MRPTT,X (margl rate of product transformation)
• Since all firms and consumers face same price
  ratio

5
Transportation Cost and Efficiency

• The PC market outcome assumes a spaceless economy
• No recognition of need to transverse space to
  move goods between sellers buyers
• Enter the reality of spatial separation
• Markets for same product may be isolated by
  distance
• Different equilibrium prices may emerge in
  markets
• Regional markets can be united by trade

6
The Benefits of Interregional Trade

• Interregional price differences create
  opportunities to improve societys well-being
• Two regions A B producing same product (Fig
  7.4)
• B has lower supply costs than A
• A has higher demand than B
• pA gt pB
• Combining the two markets, total D and S yield
  price p
• At p there is excess demand in A excess supply
  in B
• If trade is costless, higher price in A will
  attract excess supply from B, until price in both
  regions rises to p
• Gain of welfare by consumers (sellers) in A (B)
• Compared to separate markets in pre-trade
  environment, society as whole is better off

7
Transportation Cost (TC) and Welfare

• Positive TC reduces gains from trade (Fig 7.5)
• Let t transport rate/unit of Q from B to A,
  then
• The presence of transport rate
• Decreases total market supply (Fig 7.5c)
• Raises price paid in A, decreasing QD in A
• Reduces price received in B decreasing Qs in B
• Raises the overall market price
• Reduces the quantity traded and the derived
  demand for transport
• Welfare losses as result of transport cost are
  split between sellers in B and consumers in A

8
Empirical Implications

• Interregional price differentials for a good
  should be positively related to trade flows
• Price differentials depend on
• Factors that affect demand in each region
• e.g. Differences in income, tastes, substitute
  prices, etc.
• Factors affecting supply in each region
• e.g. cost of resources, technology differences,
  natural endowments, taxes, substitutes in
  production
• Transportation rate per unit/per mile should be
  inversely related to trade flows

9
Freight Flows An Empirical Analysis

• Freight flows of nine different aggregate
  (2-digit SIC) commodities between five major US
  regions
• Dependent variable
• K 1.9 commodities and O,D 1.5 regions
• Independent variables
• Delivered price from region X and delivered
  price for all other regions
• Destination regions household income
• Origin and Destination regional dummy variables

10
Results Price, Income Transport Costs

• All commodity flows inelastic w.r.t. delivered
  price except
• Food and Kindred E -1.5
• Since the prices from other regional sources not
  important, may reflect role of foreign imports of
  foods
• All commodity flows are income elastic
• Primary fabricated metals have largest EI
• May reflect that higher income regions also have
  more economic growth and the need for metal
  products for expansion of buildings and other
  capital goods
• Flows are very inelastic w.r.t. transport costs
• As might be expected, bulk commodities such as
  Clay, concrete, etc. and Pulp, paper and
  allied are most responsive to transport costs.
• Reasontransport cost is larger share of total
  cost for these goods

11
Market Power in Transportation

• Until 1970s-80s most of U.S. transportation
  industry operated as regulated monopolies
• Existence of a monopoly (unregulated or
  regulated) reduces societys overall welfare
• Output is reduce in comparison to perfect
  competition
• Prices are higher than in PC
• Prices do not equal marginal cost of production
• Monopoly firms enjoy pure long-run economic
  profits or economic rents

12
Using Monopoly Rents

• Primary goal of monopolist is protecting position
• Consequences of rents
• Rent seekinguses govt lobbyists, advertising,
  etc. to stifle competitionMC and output not
  affected
• Rent sharingresource sellers demand share of
  rents
• Results in higher resource costs and increase in
  cost curves
• Output is reduce, price is raised even higher,
  total rents reduced
• Reduces incentives to innovate and control costs
• In PC, firms have to use best technology to
  survive
• Monopoly rents stifle push for efficiency
  innovation
• May result in creeping costs which eventually
  could lead to reduced output and even higher
  prices

13
Natural Monopolies (NM) and Transportation

• Regulators argued that sectors of transportation
  industry should be viewed as natural monopolies
• Argument was based on supposition that many
  transportation industries have
• production processes with significant economies
  of scale
• LRAC decrease very sharply with increases in
  output
• Level of output to achieve lowest LRAC is gt than
  market demand
• Leap-frog competition among firms leads to
  emergence of one large firm
• Enforcing a break-up of market into two, or more,
  firms
• Results in a significant jump in production costs
• Costs are likely to exceed price that any buyer
  would pay for product

14
NM in Transportation Sectors?

• Evidence from previous empirical cases
• TL motor carriersIRTS exhibited w.r.t. output
  and possibly network size
• General Freight (LTL) carriersCRTS w.r.t. output
  but very strong IRTS w.r.t. network size
• Airlines
• IRTS w.r.t. output when holding network size
  fixed
• Strong IRTS w.r.t. network size when holding
  output fixed
• CRTS when allowing both output and network size
  to change
• Conclusion
• RTS w.r.t. to network size appears consistent
  with NM
• Qualificationmay have been result of regulatory
  restrictions on routes during era of regulation
• Post regulatory experience in motor freight
  suggests economies of scale may influence
  industry structure in LTL but not TL
• In case of airlines, post regulatory experience
  suggests economies of scale are not significant
  enough to control industry structure.

15
Govt Treatment of Transport Monopolies

• Govt support for transportation monopolies based
  on arguments other than NM
• In the national interest to have a stable
  coordinated system of transportation
• Reliability and industry stability more important
  than economic efficiency considerations
• Govt approaches to transport monopolies
• Marginal cost pricing with subsidiese.g. Amtrak
• Requires firm to price on basis of MC (less than
  AC) and subsidizes any losses
• Ensures efficient level of output and provides
  firm with normal return to investment

16
Govt Treatment of Transport Monopolies (2)

• Rate of Return Regulation
• Avg cost pricingfirms price must be equal to
  LRAC
• Firm provides service to all buyers that are
  willing to pay LRAC
• LRAC includes normal rate of return to investment
• Level of output lt efficient level, but better
  than monopoly level
• Economic profits 0
• Rates based on firms operating cost ratioratio
  of LRAVC/AR
• ICC argued that approach was better for motor
  freight because LRAFC very small compared to
  total cost
• ICC defined 93 to be appropriate OR, implied
  RofR of 20-40
• Government operation
• Not likely to achieve economic efficiency
• break between price paid by consumers and
  marginal benefits
• Usually results in higher consumer prices large
  deficits

17
Measuring Monopoly Power

• Concentration indices
• of industrys total market controlled by
  largest four, or eight firms in industry
• Market shares usually based on firms total
  revenue
• CR4 gt 60 tight oligopoly, 40 lt CR4 lt 60
  loose oligopoly
• Problems
• Doesnt account for distribution of shares
  between top four, or eight
• HHI index designed to overcome this problem
• Squaring each firms share gives more weight to
  larger firms
• Includes all firms in industry
• The larger the HHI, the more monopolistic the
  industry
• Justice Departments rule HHI lt 1000 is
  un-concentrated
• HHI gt 1800 is highly concentrated

18
Concentration in LTL Motor Carrier Sector?

• As noted earlier, LTLs have IRTS w.r.t. networks
• Incentive exists to expand and achieve lower cost
• Expansion thru merger and acquisitions is most
  frequent method
• Number of firms has decreased and size of firms
  have increased since deregulation
• Measures of concentration in LTL (Tbl 7.3)
• CR4 52 CR8 66 implies a loose oligopoly
  and some market power
• However, HHI 843 (i.e. lt 1,000) suggests that
  industry not concentrated enough to exercise any
  major price threat
• Recent developments in freight movement have
  provided more competition for LTL sector
• Increased competition from freight brokers and
  forwarders
• Perform the freight handling and packing and
  contract with TL to haul
• Increased competition from multi-modal freight
  haulers
• e.g. Piggy-back and fishy-back

19
Concentration in US Airline Industry

• Since 1977, airline industry has become more
  concentrated (tbl 7.4)
• Continued concentration at major airports since
  1990
• In 1996, CR4 68 CR8 92 and HHI 1,489
• Concentration even greater on individual routes
• Table 7.5 shows decreasing concentration for all
  city-pair routes by all airlines, However
• Examination of largest (20) US airports shows
  very high levels of concentration in 1996
• Consumer union estimates that HHI for city pairs
  which include one of top 20 largest airports
  ranges from 3,300 to over 5,000 (in contrast to
  data in book)

20
Effects of Hubbing on Airfares

• Fare premiums at all hub airports
• Between 1988-90, fares at 15 hub airports
  reflected a 10 premium over avg. fares at all
  airports
• Same study reports premium reduced to 5.2 in
  1993
• Fare premiums at restricted slot hub airports
• The above numbers are dampened by decrease in
  fare premiums in western region where expansion
  is possible and slots are not restricted
• However, more recent evidence on restricted slot
  airports (mostly in east and upper mid-west) show
  higher levels of concentration and increased
  hub-fare premiums in these airports

21
Contestable Markets (CMs) in Transportation

• CMs are markets in which
• Relatively few producers
• Firms major concern is not existing competitors,
  but potential competitors
• Relatively small capital requirements to enter
  industry
• Firms operate with decreasing LRAC
• Pricing to forestall entry by existing firms
• Existing firms can not price on basis of MC MR
• To do so would produce excess profits and invite
  entry
• To completely forestall entry, firm must price at
  LRAC
• However, if there are barriers to entry and/or
  exit, firm can price at a level which doesnt
  exceed LRAC EEC (entry/exit costs)
• Most markets are not likely to be perfectly
  contestable

22
US Airlines Contestable Markets?

• Study undertaken for period 1978-88
• Purpose compare effects of actual potential
  competitors on airline prices
• Sample 18,573 US air routes
• Dependent variable
• Airfare (cents per passger mile)
• Independent variables
• competitors on routes at fixed-slot airports
• competitors on routes at non-fixed-slot
  airports
• Minimum of effective competitors at routes
  endpoint
• of potential carriers

23
Measuring Independent Variables

• of effective competitors
• Calculate HHI for each route
• Determine the number of firms required to achieve
  this HHI if all firms had equal market share
• More firms means lower fares
• Expect effects to be larger for fixed-slot
  airports
• Min of effective competitors at routes
  endpoint
• Intended to capture hubbing effects
• Larger means less concentration and higher
  fares
• Potential Competitors
• Sum of of carriers operating at origin,
  destination or both cities which do not fly the
  route
• Expected to decrease fares

24
Results

• As expected of effective competitors is
  negative and significant in all but one case
• Also the neg. price effects are larger at
  fixed-slot than non-fixed slot airports
• Size of effects have increased in later
  post-regulator period
• The effect of potential competition also has the
  expected negative effect, however
• Effect is much smaller than that of actual
  competition
• Effect appears to have fallen over time
• Suggests that airline markets are not highly
  contestable
• Although entry costs are relatively low
• There may be substantial sunk costs

25
Summary (1)

• Introduction of space separation between markets
  means
• Interregional trade required to move markets
  closer to pareto optimality
• The existence of transportation costs pushes
  markets even further from the pareto optimal
  solution
• Monopolistic market structures (oligopoly
  monopoly) means
• Reduction in output and societys welfare
• Inefficient allocation of resources and increases
  in prices and cost
• Most sectors of transport industry have
  monopolist elements
• Stage was set for monopoly by early regulation

26
Summary (2)

• Some evidence of increased concentration in LTL
  freight industry, however, doesnt appear
  concentrated enough to have provided pricing
  power
• On a aggregate industry basis, concentration in
  airline industry has decreased since deregulation
• However, focus on specific routes between major
  city pairs suggests that concentration has
  increased significantly at major airports in East
  Mid-west
• Further, contrary to merger arguments by
  airlines, airline markets do not appear to be
  contestable.