The Internal Market I Market Size and Scale Effects

1
The Internal Market I Market Size and Scale
Effects

• EC329 Economics of the European Union
• Holger Breinlich
• University of Essex

2
Plan of Talk

• EU integration and industrial restructuring
  Overview
• Theoretical tools the BE-COMP diagram
• EU integration and industrial restructuring
• Firm size, efficiency, number of firms and
  price-cost margins
• Welfare effects (short run, long run)
• EU policies
• Effects of anticompetitive behaviour and state
  aid
• EU competition policy (state aid and
  anticompetitive behaviour)
• Some empirical facts on EU market integration and
  industrial restructuring

3
EU Integration and Industrial Restructuring

• Market size perceived to be important since the
  beginning of European integration
• The countries of Europe are too small to give
  their peoples the prosperity that is now
  attainable and therefore necessary. They need
  wider markets. (Jean Monnet, 1943)
• The economic logic
• Many industries characterised by increasing
  returns to scale
• Small home markets will only sustain a few
  uncompetitive firms
• Market integration will raise market size,
  increase competition and force firms to grow
  bigger and more efficient Liberalisation ?
  de-fragmentation ? pro-competitive effect ?
  industrial restructuring (via MA, bankruptcy
  etc.)
• Result fewer, bigger, more efficient
  (manufacturing) firms facing more effective
  competition from each other

4
Theoretical Tools The BE-COMP Diagram
5
Preliminaries

• Recall from introductory economics
• Monopolies charge higher prices, produce less
  output and make higher profits than perfectly
  competitive markets
• As the number of firms increases (? duopoly,
  oligopoly), prices and profits decrease and
  output increases
• Important characteristic price-cost margins
  mark-ups
• Mark-up price marginal cost
• Highest under monopoly, zero with perfect
  competition
• Many industries operate under fixed costs and
  increasing returns to scale (IRS)
• Firms need to make initial investment (F)
• Means that average costs decline as we produce
  more (initial investment spread over more units)
  ? IRS

6
IRS (with constant MC)
AC, MC
Total vs. average costs TC F xc AC TC/x
F/x c
A
AC F/x c
B
AC F/x c
AC
MC c
x
x
7
The BE-COMP Diagram

• Allows us to find the equilibrium number of
  firms, mark-ups, prices and output per firm in a
  given market
• Can be used to analyse what happens to these
  variables as we increase market size and
  competition
• Elements
• The competition curve (COMP)
• The break-even curve (BE)
• Demand and cost diagrams

8
The COMP Curve
Mark-up (m)

• Market becomes more competitive as number of
  firms increase
• Firms charge lower mark-ups (µ) as competition
  gets tougher
• ? COMP-curve downward sloping

mmono
mduo
m
COMP curve
n2
n1
n
Number of firms
9
The BE-Curve

• Firms have to cover fixed cost F
• Earn µ p-MC for every unit sold (assume MC
  constant)
• The fewer firms, the more each one can sell for
  given mark-up
• ? BE-curve upward sloping

10
The BE-Curve Details
Mark-up (i.e., p-MC)
MC, AC
price
Demand curve
pomoMC
BE
A
ACgtpo
ACopo
B
A
po
mo
B
ACltpo
AC
MC
no
n
n
Sales per firm
Total sales
Co
x Co/n
x Co/n
xo Co/no
11
BE COMP Curves Together

• Shows equilibrium n and µ
• Firms never off the COMP-curve (suboptimal
  profits)
• Can be off the BE-curve in the short-run (but
  making losses!)

Mark-up (m)
BE (break-even) curve
m
COMP curve
n
Number of firms
12
The Full BE-COMP Diagram
AC, MC
Price
Mark-up
Demand curve
BE
E
E
m'
E
p
p
AC
COMP
MC
n
Number of firms
Total sales
Sales per firm
C
x C/n
13
EU Integration Industrial Restructuring
14
Effects of EU Integration

• For simplicity, assume
• Move from no-trade situation (autarky) to full
  integration
• Two symmetric countries
• Effects identical for both countries (in effect
  only one market!)
• Two effects
• Market size doubles (twice as much demand)
• Number of competitors also doubles
• In BE-COMP diagram BE curve shifts outwards

15
BE COMP Curve with Integration

• At initial mark-up, market could sustain 2n
  firms (point 1)
• But mark-ups decrease immediately due to tougher
  competition
• Initially at point A, firms make losses
• In the long-run will move along COMP to point E
  (restructuring via MA, bankruptcy etc.)
• Total number of firms down, mark-ups slightly up
  again
• Mark-ups lower than before but profitability
  restored (remaining firms larger, more efficient)

Mark-up
BE
BEFT
E
1
m'
E
A
mA
COMP
2n
n
n
Number of firms
Exclusive Territories State Aid I State Aid II
16
Effects on prices, sales and average output
AC, MC
price
Mark-up (p-c)
Demand curve
BE
BEFT
E
E
E
m'
p
p
E
E
E
p
p
AC
COMP
MC
Number of firms
n
n
x
C
C
x
Total sales
Sales per firm
17
Welfare Effects (Long-Run)
AC, MC
price
Mark-up
Demand curve
BE
BEFT
E
E
E
m'
p
p
E
C
E
E
p
p
AC
COMP
MC
Number of firms
n
n
x
C
C
x
Total sales
Sales per firm
Evidence
18
Economic Effects of Integration Summary

• Economic integration triggers industrial
  restructuring which leads to fewer but bigger and
  more efficient firms
• Economic logic
• Integration increases market size but also
  competition
• Squeezes price-cost margins, prices and profits
• The profit squeeze triggers exit of firms
  (industrial restructuring)
• Profitability restored through (partial) recovery
  of mark-ups and increase in efficiency (larger
  firms IRS)
• Long-run welfare gains but short-run adjustment
  can be costly (job losses, relocation of workers
  )

19
Economic Effects of Integration Summary

• Two immediate questions
• Dont firms have incentives to engage in
  anti-competitive measures as profits are
  squeezed?
• Since industrial restructuring can be politically
  painful, isnt there a danger that governments
  will try to keep money-losing firms in business
  via subsidies and other policies?
• Answer to both questions is Yes
• EU regulations on state aid and competition
  policy aimed at counterbalancing this

20
EU Policies on State Aid and Competition
21
The Economics of Anti-Competitive Behaviour

• Economic integration decreases prices and
  mark-ups and puts pressure on firms profits
• Restructuring is one solution but can be painful
  in the short-run
• ? Firms tempted to stabilise prices via
  collusion and other forms of anti-competitive
  behaviour
• In the BE-COMP diagram (figure)
• Collusion shows as outward shift of COMP-curve
• Increases mark-ups and allows larger number of
  firms to stay in the market (but smaller and less
  efficient)
• Reduces welfare increase due to market
  integration
• Note collusion can arise before but market
  integration may make it more likely

22
Effects of Collusion
price
Mark-up
Demand curve
BEFT
pmono
Perfect collusion
mmono
A
B
B
pB
E
Partial collusion
E
p
COMP
nB
n1
n
Number of firms
Total sales
CB
23
Forms of Anti-Competitive Behaviour

• Examples of anti-competitive behaviour cartels,
  exclusive territories
• Cartels
• Join up with other firms, set monopoly price and
  split production quotas
• Examples OPEC, Vitamin Cartel
• Exclusive territories
• Split up market geographically, e.g. domestic
  firms only sell at home, foreign firms only in
  their market (BE-COMP?)
• Example Nintendo

24
The Economics of State Aid

• Another way of preventing restructuring is
  through government subsidies for loss-making
  firms
• In BE-COMP diagram remain at point A
• Competition increases
• Mark-ups, prices and profits down but firms
  compensated for losses
• Look at
• Size of required subsidy
• Welfare impact

25
Size of Subsidy

• Pre-integration fixed costs operating profit
  area ab
• Post-integration operating profit bc
• Since number of firms and fixed costs per firm
  unchanged
• ? Breakeven subsidy ab-b-c a-c

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Welfare Effects of Subsidy

• Change producer surplus zero (abnormal profit
  is zero pre post).
• Change consumer surplus ad.
• Subsidy cost a-c.
• Total impact (ad) (a-c) d c

Price
Mark-up
COMP
Demand curve
BEFT
E
E
p
a
d
A
A
pA
b
c
2n
Number of firms
C
CA
27
Subsidies Summary

• Welfare gains from liberalising subsidising.
  But
• Lower than from liberalization and restructuring
  in the long-run (more competition but firms dont
  become more productive)
• Negative long-run effects as firms get used to
  state aid and avoid or postpone all forms of
  restructuring
• Also danger of unfair competition
• With restructuring, total number of firms ? from
  2n to n (figure)
• But not clear whose countrys firms will survive
• If I subsidise long enough, only the other
  countrys firm will exit
• In our simple examples, this is a loss-making
  strategy but
• Doesnt take into account short-run losses (?
  resistance from unions, industry lobby groups
  etc.)
• Economics only part of the picture (e.g. European
  Airlines)

28
EU Competition Policy

• Look at EU policy that constrains
  anti-competitive behaviour (? private actors) and
  subsidies (? governments)
• EU founders aware that European integration would
  trigger consolidation and also attempts to resist
  it (see e.g. Spaak Report, 1956)
• Concern that some nations might cheat and this
  would undermine political support for integration
• Treaty of Rome
• Demands institution of a system ensuring that
  competition in the common market is not
  distorted (Art. 3f)
• Puts the European Commission in charge with no
  possibility of veto by member states! (only
  European Court can overrule)

29
EU Competition Policy

• Commission has considerable power to investigate
  breaches of EU competition law
• Can force companies to hand over documents
• Can order on-site inspections without prior
  warning (dawn raids)
• With court order, can inspect homes of company
  personnel
• Can enforce competition law by imposing fines on
  firms
• Anti-competitive conduct up to 10 of firms
  worldwide turnover
• Can order full repayment of subsidies deemed
  illegal

30
EU Law on Anti-Competitive Behaviour

• Article 81 of the Treaty of Rome forbids
  practices that prevent, restrict or distort
  competition (cartels, exclusive territories,
  vertical agreements )
• But Commission can grant exemptions
• Individual or block exemptions
• Examples Technology transfers, RD agreements,
  motor vehicles
• Art. 82 restricts abuse of a dominant market
  position (e.g. Microsoft and Windows Media Player
  ? fine of 497 million)
• Control of Mergers and Takeovers
• No specific provisions on mergers in Treaty of
  Rome but explicit rules since the late 1980s (in
  anticipation of Single Market)
• Commission weighs anti-competitive effects vs.
  efficiency gains

31
EU Policies on State Aid

• Treaty of Rome bans state aid that provides firms
  with an unfair advantage and distorts competition
• Commission is in charge of enforcement, with
  power to force repayment of illegal state aid
  from member states!
• State aid can take the form of grants, interest
  relief, tax relief, state guarantees, state
  provision of goods and services on preferential
  terms
• Numerous exceptions
• Social policy aid, natural disaster aid, economic
  development aid to underdeveloped areas
• Further block exemptions for aid to small and
  medium-sized entreprises, aid for training and
  employment

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Empirical Facts on EU Market Integration
Industrial Restructuring
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Industrial Restructuring in the EU

• Strong increase in MA transactions in
  manufacturing around implementation of Single
  Market (figure)
• Share of four largest firms in the EUs total
  market rose from 20.5 to 22.8 in 1987-1993
  while same measure of concentration fell at the
  national level (Commission, 1996)
• Econometric evidence by Allen et al. (1998)
  suggest SMP reduced price-cost margins by 4 on
  average (large variation 15 in office
  machinery to 0.1 in brewing)
• Welfare effects not clear
• ?W Output ?P (slide 17)
• EU manufacturing accounts for ca. 30 of
  output/GDP
• ?P ? (depends on costs and price-cost margins!)
• With ?P ?µ ?W/GDP Output/GDP ?µ 0.3
  0.04 1.2
• No study shows clear link to EU market
  integration (but evidence for U.S. in Campbell
  and Hopenhayn, 2002)

34
MA Transactions, EU Manufacturing
1500
1000
500
0
1986
1988
1990
1992
1994
1996
1998
2000
2002
Domestic
Cross-Border
35
Summary Learning Outcomes

• Economic logic linking market integration with
  industrial restructuring (firm size, number,
  prices)
• Theoretical tools the BE-COMP diagram
• Process of industrial restructuring after
  liberalization
• Integration defragments markets
• Markets bigger but also more competition
• Price-cost margins, prices and profits squeezed
• Profitability restored through firm exit and
  increased efficiency of remaining firms
• Motivation for collusion and state aid economic
  consequences
• EU competition policies (anti-competitive
  behaviour, state aid)
• Empirical evidence on EU integration