Lecture 13 & 14 - Competition Policy
Introduction
Competition policy is a core institutional pillar of economic integration. As markets integrate across borders, firms gain access to larger consumer bases, enabling greater production scale and efficiency. However, integration also increases incentives for firms to restrict competition, whether through collusion, mergers that reduce market rivalry, or abuse of dominant market positions.
The European Union has developed a comprehensive competition framework designed to ensure that integration leads to efficiency gains and consumer welfare improvements, rather than market concentration and monopoly pricing.
This lecture explores three interconnected themes:
- Competition policy and large firms
- Collusion and mergers in integrated markets
- Competition policy challenges in digital and AI-driven markets
The Role of Large Firms in Integrated Markets
Economic integration often produces large multinational firms. This outcome is not necessarily harmful. In many industries, large firm size reflects the presence of fixed costs and economies of scale.
Economies of scale occur when average production costs fall as output increases.
Firms operating in larger markets can spread fixed costs across greater output, reducing unit costs and increasing productivity.
Key empirical observations:
- Multinational enterprises generate roughly one quarter of global GDP
- Around 70% of global business R&D is produced by the largest multinational firms
- Integration often leads to mergers and acquisitions (M&A)
These patterns reflect an important structural feature of modern capitalism: concentration of production in large firms can be efficiency-enhancing.
However, concentration also creates the risk of reduced competition, motivating the need for regulatory oversight.
Mergers and Acquisitions in Integrated Markets
In developed economies, merger activity is significant.
Within the EU:
- Around 55% of mergers occur domestically
- Approximately 24% involve non-EU firms
- Around 15% involve cross-border EU firms
These patterns indicate that economic integration promotes cross-border corporate restructuring, but national markets still remain highly relevant.
Integration increases market size. Larger markets allow firms to exploit scale economies, encouraging consolidation through mergers. While mergers may reduce production costs, they can also reduce competitive pressure if too many firms disappear from the market.
Competition authorities must therefore evaluate whether mergers:
- improve efficiency
- or reduce effective competition.
Why Competition Policy Exists
Large firms can create economic benefits but may also engage in anti-competitive behaviour.
Examples include:
- price fixing cartels
- market sharing agreements
- abuse of dominant positions
- anti-competitive mergers
Collusion refers to coordination between firms to reduce competition, typically by fixing prices or limiting output.
If firms collude perfectly, they effectively behave like a monopoly.
Rising Mark-ups and Market Power
This figure shows a long-run increase in average mark-ups for US firms.
The rising mark-up trend raises an important policy question: are increasing profits driven by greater efficiency and innovation, or by declining competition and market power?
A mark-up measures the gap between price and marginal cost. Rising mark-ups suggest firms may have increased pricing power, possibly due to market concentration or weaker antitrust enforcement.
This debate has become central to modern competition policy.
Real-World Examples of Cartels
Competition authorities frequently uncover illegal cartels.
Examples include:
- Financial institutions manipulating markets
- Sausage producers fixing prices in Germany
- Major breweries coordinating price increases
- Technology firms abusing dominant platform positions
Cartels are illegal because they raise prices and reduce output relative to competitive markets.
Illustration of Cartel Behaviour
The cartoon illustrates how firms may secretly coordinate prices while pretending to compete.
The joke highlights the central idea of cartel behaviour: firms cooperate privately while maintaining the appearance of competition.
Collusion allows firms to replicate monopoly outcomes. By restricting output and increasing prices collectively, firms capture higher profits at the expense of consumers.
EU Competition Policy: Three Pillars
EU competition policy rests on three main pillars:
- Antitrust policy
- Merger control
- State aid control
Each pillar targets a different source of market distortion.
Antitrust Policy
Antitrust laws prevent:
- cartels
- collusive agreements
- abuse of dominant market positions
These policies ensure that firms compete on price, quality, and innovation.
Merger Control
Merger control prevents corporate mergers that significantly reduce competition.
Authorities evaluate whether mergers:
- increase market concentration
- allow price increases
- reduce consumer welfare
State Aid Control
Governments may attempt to support domestic firms through subsidies.
However, subsidies can distort competition within the integrated market.
State aid refers to government financial support provided to firms that may distort competition within a market.
State Aid and Political Tensions
This slide highlights debates surrounding EU state aid rules, particularly in the context of Brexit.
State aid regulations prevent governments from artificially supporting domestic firms, ensuring that competition across the single market remains fair.
Without state aid restrictions, governments could subsidise national firms to maintain employment or industrial capacity. This would trigger subsidy races between countries and undermine the level playing field of economic integration.
State Aid Cases
This figure presents examples of EU competition rulings involving multinational corporations.
Cases involving Apple, Amazon, and Starbucks show how tax advantages granted by individual countries can be interpreted as illegal state aid if they distort competition.
These rulings demonstrate that competition policy increasingly intersects with tax policy and global corporate structures.
Economic Integration Without Collusion
To understand competition policy, economists model how integration affects market structure.
Assume:
- two identical countries
- identical firms
- constant marginal cost
- positive fixed costs
Total cost function:
Average cost:
As output increases, average cost falls, reflecting economies of scale.
Mark-ups Under Perfect Competition
Even under perfect competition with fixed costs, prices must exceed marginal cost in order to cover fixed costs.
Profit is:
Under long-run equilibrium:
Thus:
This result explains why competitive industries with fixed costs often display positive mark-ups. Firms must charge prices above marginal cost to cover fixed costs while still earning zero economic profit.
The BE–COMP Model of Market Structure
Two curves determine the equilibrium number of firms:
- Competition curve (COMP)
- Break-even curve (BE)
- COMP: more firms → stronger competition → lower mark-ups
- BE: more firms require higher mark-ups to cover fixed costs
Equilibrium Without Economic Integration
This diagram illustrates the equilibrium market structure in a single domestic market.
At equilibrium:
- number of firms =
- mark-up =
- price =
Firms earn zero economic profit but maintain a positive mark-up due to fixed costs.
Equilibrium With Economic Integration
Economic integration changes two key conditions:
- Firms gain access to a larger market
- Firms face more competitors
As a result:
- firms produce more output
- prices fall
- average costs decline
- firms become more efficient
Key effects of integration without collusion:
- Larger market size
- Higher firm productivity
- Lower prices
- Greater consumer welfare
The Risk of Collusion
Despite the efficiency gains from integration, firms may attempt to coordinate behaviour.
Perfect collusion occurs when firms coordinate prices and output exactly as a monopolist would.
Under collusion:
- firms restrict output
- prices increase
- profits rise
Collusion in the BE–COMP Framework
When firms collude:
- the industry behaves like a single monopolist
- output falls to
- price rises to
Consumers lose because prices increase and consumption decreases.
Effects of Collusion
Compared with competitive integration:
- prices increase
- production falls
- firms become smaller
- average costs rise
- consumer welfare declines
Exam trigger: Explain how economic integration can improve efficiency but still create incentives for collusion.
Mergers and Welfare Effects
Firms may merge rather than collude.
Mergers can have ambiguous welfare effects:
- prices may rise due to reduced competition
- costs may fall due to efficiency gains
Welfare Analysis of a Merger
The welfare effect depends on the balance between:
- efficiency gains
- consumer losses from higher prices
Total welfare change:
If efficiency gains exceed consumer losses, the merger may increase welfare.
Regulation of Mergers in the EU
EU merger regulation was introduced in 1990.
Large mergers are reviewed if combined turnover exceeds approximately €5 billion globally.
Authorities assess whether mergers:
- significantly impede competition
- create dominant market positions
Only mergers that satisfy competition criteria are approved.
Competition Policy in Digital Markets
Digital markets present unique competition challenges.
Major digital platforms include:
- Alphabet (Google)
- Amazon
- Apple
- Meta
- Microsoft
These firms dominate digital ecosystems.
Structural Characteristics of Digital Markets
Key features include:
- strong network effects
- extremely low marginal costs
- global scale
- massive data accumulation
Network effects occur when the value of a product increases as more users adopt it.
These forces often lead to winner-takes-most markets, producing highly concentrated industries.
Data as a Source of Market Power
Digital platforms collect enormous volumes of user data.
Data provides competitive advantages because it allows firms to:
- improve algorithms
- personalise advertising
- refine pricing strategies
Switching costs are also high.
For example, sellers on Amazon may hesitate to switch platforms because they would lose accumulated customer reviews and reputation data.
Dominant Platform Behaviour
Digital platforms frequently face allegations of abusing their dominant positions.
Examples include cases involving Google and digital advertising markets.
These cases illustrate how platform dominance can distort competition in adjacent markets.
Online Advertising Markets
Google’s search advertising system operates through auctions.
Advertisers:
- choose keywords
- submit bids
Ads are ranked based on bids and relevance.
The advertiser with the highest bid receives the most visible position.
Market Power in Digital Advertising
This figure compares advertising costs between Google and Bing.
The data suggests that Google commands higher prices due to its dominant position in search markets.
Artificial Intelligence and Collusion
Traditionally, collusion required explicit communication between firms.
The example of Christie’s and Sotheby’s shows how firms historically coordinated prices through direct communication.
However, modern technology introduces a new possibility.
Algorithmic Collusion
Pricing algorithms increasingly determine market prices.
Firms program algorithms with objectives such as profit maximisation.
AI systems then learn pricing strategies autonomously.
Experimental Evidence
Experiments show that AI pricing algorithms can learn collusive strategies even without explicit coordination.
Algorithms punish price deviations and converge toward high-price equilibria.
Reinforcement learning algorithms optimise strategies through repeated interaction. In oligopoly settings, these learning processes can converge toward collusive outcomes even when firms never explicitly communicate.
This creates major challenges for competition authorities.
Policy Responses for Digital Markets
Potential policy solutions include:
- expanding antitrust enforcement
- introducing data portability requirements
- increasing interoperability between platforms
- shifting burden of proof onto dominant firms
- regulating acquisitions of small start-ups
Competition authorities must also understand how AI systems shape market outcomes.
Key Takeaways
- Economic integration expands markets and allows firms to exploit economies of scale.
- Without collusion, integration leads to larger, more efficient firms and lower prices.
- Collusion and anti-competitive mergers can undermine these gains.
- EU competition policy relies on three pillars: antitrust enforcement, merger control, and state aid regulation.
- Digital markets create new challenges due to network effects, data accumulation, and AI pricing algorithms.
- Algorithmic pricing may enable new forms of collusion that regulators must address.
Bibliography
Assad, S., Clark, R., Ershov, D. and Xu, L., 2024. Algorithmic pricing and competition: Empirical evidence from the German retail gasoline market. Journal of Political Economy, 132(3).
Baldwin, R. and Wyplosz, C., 2022. The Economics of European Integration. 7th ed. London: McGraw-Hill.
Calvano, E., Calzolari, G., Denicolò, V., Harrington, J.E. and Pastorello, S., 2020. Protecting consumers from collusive prices due to AI. Science, 370(6520), pp.1040–1042.
Lancieri, F. and Sakowski, P., 2021. Competition in digital markets: A review of expert reports. Stanford Journal of Law, Business and Finance, 26, p.65.