LAW

COMPETITION LAW Introduction to Economics of Competition Law Part-I

Q1: E-TEXT

Module ID I: Introduction to Economics of Competition Law- Part I

Subject Name: Law Paper Name: Competition Law Module ID: 1

Pre-requisites

The series of topics discussed in this module require the prior understanding of the basic

concepts, terms and laws of economic behaviour.

Objectives

The module tries to explain the concepts essential to understand the behaviour of firm as a

business unit satisfying the producers interest of profit maximisation and consumers utility

maximisation, emphasising on the basics of Demand and Supply, elasticity of demand and

supply, cost concepts and the concept of social welfare. The key objective therefore is to give

a good foundation for understanding the economics of competition law and policy.

Key words

Competition law, Demand and Supply, Elasticity, Demand substitution and Supply

substitution, antitrust, cost and cost functions, concept of firm and profit maximisation,

individual and social welfare, price discrimination, consumer welfare ,total surplus, Dead

Weight Loss

Introduction

The paradigm of development today is one of competition with a human face. The basics in

economic understanding, viz. Demand and supply are guided by consumer surplus and

producer surplus respectively. The many facets of demand and supply are understood with

the antitrust analysis. This in turn is geared towards achieving consumer welfare along with

total welfare.

The module has explained the economic benefits of Competition Law along with the details

on Demand and Supply like the elasticity of demand and supply, objectives of the firm and its

profit maximising behaviour , welfare concepts from individual to social welfare keeping in

mind the price discrimination and consumer welfare in the context of monopoly market

power.

Learning Outcome

The module is a good beginning to understand the nuances in the Competition Policy and

Law as given in the chapters on this subject. Economic analysis of the human behaviour as

producer and consumer are well treated in this module

1.1 Economic Benefits of Competition Law

Competition in the market benefits all the participants. But the failure of the market players

to adhere to the ethics of the market requires the understanding of resolving the issues to

benefit everyone.

Competition enables consumer surplus to the consumers; profit maximisation to the

producer/seller and revenue to the state leading to the overall growth and stability of the

economy.

The benefit of competition provide goods to consumers at competitive prices. It also provides

them with new and innovative products. The demand then gets diversified and the consumer

satisfaction is enhanced with multiple varieties of products available in the market. The

lifestyle of the people gets changed and move towards higher levels of satisfaction.

The producer is also the consumer of raw material and energy resources; telecommunication

services; the computer technology’; infrastructure requirements for manufacturing and

storing. Competition also has a positive impact on efficiency and productivity in the pursuit

of getting competitive advantage. Innovation is possible with technology based production.

High standard is aimed at in the quality of the products while enjoying the benefits of

economies of scale.

To the economy, competition fosters restructuring of the sectors of the economy influencing

market demand, product uses, costs, technologies and the like. The demand for capital for

enhanced business activity forces the generation of capital requirements and does the

interlinking of the various economic activities in the country from production to distribution

and to final consumption. In short the micro economic behaviour of producer surplus and

consumer surplus ultimately end in the creation and sustenance of aggregate demand and

aggregate supply essential for growth with stability of the economy.

1.2 Concepts of Demand and Supply

Demand and Supply are the two pillars of market and all the theorising of economics are built

up on them. From Micro economic analysis of simple demand and supply to the Keynesian

aggregate demand and aggregate supply, economic theorising has enlightened the audience,

of the discipline of economics.

1.2.1 Demand

Wants are turned into demand at a price

Economic theory holds that demand is dependent upon-taste and ability to buy. Taste

determines the willingness to buy a good at a specific price. Ability to buy is determined by

money at hand. Demand is generally at a price and popularly understood as the Price

Elasticity of Demand. The following diagram shows the downward sloping demand curve

with reference to the relationship between price and the quantity demanded. It is presumed

that all the other factors such as taste of the consumer, income of the consumer, availability of

substitutes, price of the substitutes and the like remain constant, when only the price and the

quantity demanded are compared.

Demand curves generally have a negative slope.

Demand curves slope downwards due to

1. The law of diminishing marginal utility 2. The income effect 3. The substitution effect

• Demand is determined by

• Income

• Prices of substitutes

• Prices of complements

• Advertising

• Population

• Consumer expectations

• The Demand Function

• Quantity demanded is a function of:

Qxd = f(Px , PY , M, H,)

– Qxd = quantity demand of good X.

– Px = price of good X.

– PY = price of a substitute good Y.

– M = income.

– H = any other variable affecting demand1

Consumer Surplus is defined as the difference between what the consumer is willing to

pay and what he actually pays instead of going without a thing. This is the measure of

surplus satisfaction and Marshall called it as ‘Consumer Surplus’. The summation of the

consumer surplus is the total consumer welfare in the society. Consumer Surplus thus

measures the difference between the ability to pay and the willingness to pay of the

people, a foundation on which the welfare analysis of consumer behavior is built. In the

diagram given below, the portion above the equilibrium price represents the consumer

surplus as given in the shaded area.

1 www.buec.udel.edu

1.2.2 Supply

In the general economic analysis,Supply is at a price and directly proportional to the

increase in price. Since profit making and profit maximization are the basic goals of

production and supply price increase is an incentive to produce more and supply. The

market supply curve is upward sloping from the origin, as the quantity increases with the

rise in price.

Market Supply Curve2

Decisions to supply are largely determined by the marginal cost of production. The supply

curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of

production. The higher marginal cost arises because of diminishing marginal returns to the

variable factors.3

2 http://www.economicsonline.co.uk/Competitive_markets/Producer_supply.html 3 ibid

Factors that bring about upward shift in the Supply are:

• Input prices

• Technology or government regulations

• Number of firms

• Substitutes in production

• Taxes

• Producer expectations

• The Supply Function

An equation representing the supply curve:

QxS = f(Px , PR ,W, H,)

– QxS = quantity supplied of good X.

– Px = price of good X.

– PR = price of a related good

– W = price of inputs (e.g., wages)

– H = other variable affecting supply4

Change in Quantity Supplied

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

Change in Quantity SuppliedPrice

Quantity

S0

20

10

B

A

5 10

A to B: Increase in quantity supplied

Change in Supply

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

Price

Quantity

S0

S1

8

5 7

S0 to S1: Increase in supply

Change in Supply

6

Producer Surplus: The amount producers receive in excess of the amount necessary to

induce them to produce the good

4 www.buec.udel.edu

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

Producer Surplus• The amount producers receive in excess of the amount

necessary to induce them to produce the good.

Price

Quantity

S0

Producer Surplus

Q*

P*

Market Equilibrium • Balancing supply and demand

– QxS = Qx

d

Price Restrictions

• Price Ceilings

– The maximum legal price that can be charged

• Price Floors

– The minimum legal price that can be charged.

– Examples:

• Minimum wage

• Agricultural price supports5

1.2.3 Importance of Supply and Demand effects in Antitrust Analysis

Werden (1981, p. 721)6 argues that:

A market for antitrust purposes is any product or group of products and

any geographic area in which collective action by all firms (as through 5 www.unc.edu 6 WERDEN, G.J., 1981. “The Use and Misuse of Shipments Data in Defining Geographic Markets”, Antitrust Bulletin, Vol. 26, No. 4 (Winter), pp. 719-737.

Collusion or merger) would result in a profit maximizing price that

significantly exceed the competitive price.

1.3.1 Elasticity of Demand

The law of demand states that as the price of a good falls, the quantity demanded rises.

The responsiveness or sensitivity of quantity demanded to a change in price is measured by

the Price Elasticity of Demand.

Price Elasticity of Demand is defined as, the Ratio of the percentage change in quantity

demanded of a product or resource, to the percentage change in its price.

Ed = % Change in Q demanded of product X to % Change in Price of product X

We use percentage change rather than absolute change because: 1. the choice of units can

mislead us, 2. by using percentages we can compare consumer responsiveness to changes in

prices of different products.

1. Consider a bag of popcorn. If the price is reduced from Rs.3 to Rs.2, and quantity

demanded increases from 60 to 100, it makes a difference how we measure the change in

price. (60-100)/(3-2)=-40, while (60-100)/(300-200)=-2/5. Whether we measure in coins or

rupees makes a big difference in how we perceive demand sensitivity. To avoid that, we use

percentage change.

2. If we wish to compare sensitivity of popcorn with sensitivity of airplane tickets, using

simple differences doesn’t help when a rupee change in popcorn is a bigger change than a

rupee change in the price of a plane ticket

Degree of Elasticity

Elastic Demand –demand for a product is elastic if its price elasticity is greater than 1.

(resulting percentage change in quantity demanded is greater than the percentage change in

price)

Inelastic Demand – demand for a product is inelastic if its price elasticity is less than 1.

(resulting percentage change in quantity demanded is less than the percentage change in

price)

Unit Elasticity – The elasticity coefficient of demand or supply is equal to 1. (percentage

change in quantity is equal to percentage change in price)

Perfectly Inelastic Demand – Quantity demanded does not respond to a change in price.

Perfectly Elastic Demand – Quantity demanded will go from 0 to infinity at a particular

product price.

Determinants of Price Elasticity of Demand

1. Substitutability – the greater the number of substitute goods that are available, the greater

the price elasticity of demand (more substitute goods = demand is more sensitive to price).

Eg- there is not a good substitute for insulin, therefore it is relatively inelastic demand;

however, there are many substitutes for Lays chips, therefore, demand is relatively elastic.

2. Luxury versus Necessity – The more a good is considered a luxury rather than a necessity,

the greater is the price elasticity of demand. Eg. Heating, Food, water are all considered

necessities, therefore demand is inelastic.

3. Proportion of Income – The higher the price of a good relative to consumers’ incomes, the

greater the price elasticity of demand. Eg. Price of Television (and Television being a luxury

item)

4. Time – demand is more elastic when the period is longer. Eg. if the price of a Coca Cola

goes up, the consumer may not switch to Pepsi at first, but the more time one has to pay the

higher price, the more he will try Pepsi and to determine whether Pepsi or other substitute

products are good enough.

Price Elasticity of Supply

The ratio of the percentage change in quantity supplied of a product to the percentage change

in its price. (The responsiveness of production to a change in price of a product or resource)

Es = Percentage change in quantity supplied of product to the Percentage change in price of

product X

We can consider a firm’s supply elasticity according to the time period, namely, market

period, short run and the long run.

1.3.2 Cross Elasticity of Demand

Cross Elasticity of Demand measures how sensitive the consumer demand for one product to

the change in the price of the related substitute. The ratio of the percentage change in quantity

demanded of a product to the percentage change in the price of the substitute.

Exy = Percentage change in the quantity demanded of product X to the Percentage

change in the price of product Y

Positive coefficient indicates that the two goods are substitutes. A negative coefficient

indicates that the goods are complements. A zero or near zero coefficients indicate that the

two goods are independent .

1.3.3 Income Elasticity of Demand

Income Elasticity of Demand is the degree to which the consumer demand responds to a

change in income. The ratio of the percentage change in the quantity demanded of a good to

a percentage change in the consumer income is the Income Elasticity of Demand.

Ei = Percentage change in quantity demanded of a product to the Percentage change in

income

A positive coefficient indicates that the good is a normal good. A negative coefficient

indicates that the good is an informal good7

1.3.4 Demand-side substitution

Demand-side substitution takes place when consumers switch from one product to another in

response to a change in the relative prices of the products. If consumers are in a position to

switch to available substitute products or to begin sourcing their requirements from suppliers

located in other areas, then it is unlikely that price increases will be profitable. Therefore, it is

necessary to progressively include in the relevant market the products to which consumers

would most likely switch in response to a relative price rise, repeating the exercise at each

stage until a collection of products is reached that is worth monopolising.

When examining the likely responses of consumers, it is the response of the marginal

consumer, not the average consumer which is important. Therefore, a small but significant

number of consumers (generally 5 to 10 percent) switching to another product when there is a

price increase is considered a sufficient condition for both goods to be defined as forming part

of the same relevant market. Therefore, the existence of a group of consumers who would

never switch in response to a relative price increase is not by itself sufficient to conclude that

the relevant market should be defined narrowly.8

1.3.5 Supply-side substitution

In the absence of the ability of the consumers to react to price increase producers may be able

to do so by increasing their supply to satisfy the demand of such consumers. It will become

unprofitable if other producers respond to an increase in the relative price of the products

supplied by a given supplier by switching over their production facilities to produce the given

product or the group of such products. In this case, such producers with the ability for supply-

side substitution are to be included in the relevant market.

1.3.6 Application in antitrust analysis 7 qed.econ.queensu.ca 8 www.citizendia.org

Both demand-side and supply-side forces may constrain the price that a firm can profitably

sustain. On the demand side, the constraint comes from the degree to which consumers

would reduce their purchases of the product or products at issue in response to a price

increase. On the supply side, the constraint comes from the degree to which other firms

would initiate or increase production or distribution of the product(s) in response to a price

increase. Performed correctly, both approaches generally lead to the same conclusion about

whether a firm possesses monopoly power as long as they are performed correctly. However,

incorrect application of the Merger Guidelines approach has led researchers to draw

erroneous conclusions about the competitiveness of a market. 9

1.4.1 Cost Concepts and functions

Cost of production is defined as the aggregate of price paid to the factors used in the

production of a commodity.

Cost concepts are used:

1. For accounting purposes; and

2. For analytical purposes such as economic analysis

Business Cost is defined as the actual or real cost, namely all payments and contractual

obligations made by the firm and is used for calculating business profits

Opportunity cost is the income foregone for the current best use of a resource. For example,

If a firm is producing mobiles then the accounting costs are the costs incurred for making the

mobiles.

Economic costs include the cost of making the mobiles as well as the opportunity cost.

Suppose, if this firm could lease its office and the plant for say Rs.10 lakhs then that is the

opportunity cost. Economic costs include the costs of producing a product as well as the

opportunities forgone by producing the given product.

Explicit and Implicit costs – Explicit is the actual money expenses recorded in the books of

accounts.

Cost not appearing in the accouning system is Implicit costs. E.g. opportunity costs. 9 www.analysisgroup.com

Explicit + Implicit costs = Economic costs

Actual costs refer to real transactions,

Discretionary costs are not strictly necessary for current production but correspond to

strategic goals (e.g. improving the firm's image through advertising, institutional campaign).

Attributed costs are the computed values from accountancy that are conventionally

attributed to products as part of the process trying to establish profitable prices by appropriate

routines.10

1.4.2 Production costs

Production costs are usually classified according to their responsiveness to different levels of

production attained in a product from material to matter.

The time period is taken into account when considering the fixed cost and variable cost. The

short term or the long term may be defined depending on the nature of the product under

study. For perishable goods even one hour may be taken as a short period and the long term

may be taken as even a day.

Fixed costs are those costs which remain fixed in the short run, namely, infrastructure,

machinery and the like. They are not responsive to production levels. For instance, the cost

of renting a machinery is a fixed cost, since usually the contract fixes it for a certain period of

time independent of the income earned of it in its use in a given establishment.

If there are only fixed costs, the total cost will remain fixed, shown as horizontal straight line

to the X axis.

10 www.economicswebinstitute.org

Variable costs

All costs are variable in the long run. The firm has the capacity to expand its infrastructure,

machinery, capital and the like in the long period. The variable costs increase with higher

levels of production . Total costs show an upward sloping curve which means the cost grow

up with increased production.

Short –run costs

Total cost consists of Total Fixed Cost and Total Variable Cost (TFC and TVC)

TFC is the total fixed cost of all the inputs which are fixed in the short run

TVC is the total variable cost of all the inputs which are variable in the long run

(note that all inputs are fixed in the short run and all inputs can be variable in the long run.

Inputs can be adjusted or contracted/expanded in the long run)

AFC is the Average Fixed Cost and it is the cost of all fixed inputs per unit of output

AFC=TFC/Q

AVC is the Average Variable Cost and it is the cost of all variable inputs per unit of output

AVC=TVC/Q

Average cost enables the measurement of the profitability, if the price is higher than the

average cost, higher is the profit in a given unit of production.

Marginal Cost(MC)=change in TC to change in Q. Marginal costs indicate by how much the

total cost changes because of the addition to the production level by one more unit.

When there are only fixed costs, marginal cost will be zero: any increase in production does

not change costs.

Long- run costs

Long run total cost(LRTC) is the cost of all inputs in the long run, using the least cost method

of producing any given output level.

Long run average cost (LRATC) is the cost per unit in the long run, using the least cost

method of producing any given output level. LRATC=LRTC/Q

1.4.3 Investment Cost

Investment cost, the definition of which is an asset or an input purchased with the

expectation that it will generate income or it will appreciate in its value in future . In finance,

an investment is a monetary asset purchased that the asset will provide income in the future or

appreciate and be sold at a higher price.

1.4.4 Incremental Cost

Incremental or marginal costs come from changes in a given activity. Manufacturing more

parts or changing the hours of a service/ business open would cause incremental costs to

accrue. Variable costs are incremental because they vary with activity. If employees are paid

hourly and work more hours, labour costs will increase incrementally.

1.4.5 Sunk Cost

Sunk costs, also known as fixed costs, are the costs already incurred For example, if a

hospital installs a sophisticated medical equipment, whether there are people trained to use it

or patients required treatment with that equipment or not , the money spent or rent payable

remain the same. Money spent on R&D are also sunk costs if the outcome is successful or

not or usable or not.

Sunk costs represent barriers to exit. A firm which has incurred high sunk costs will have

difficulties in deciding to exit the market even if it sees good opportunities outside.

Conversely, a firm deciding to enter into a certain business has to consider with a particular

attention, the sunk costs. Sunk costs, in this perspective, represent barriers to entry.11

1.5.1 Concept of a Firm

A firm is a unit of an industry. Marshall calls it a Representative firm. That is, a firm

represents the characteristics of a given industry. In general, every firm is a profit maximising

firm in pursuit of remaining in the business. It tries to keep the average cost at the minimum

for a higher margin of profit. However the profit making prospects of a firm is dependent on

the competitive conditions in which it works. For example in the Imperfect competition due

to the enormous number of firms operating in the industry, the competition is severe and

therefore the margin of profit is also limited. In the case of Monopoly, the firm may reap a

high level of profit due to the monopoly market power. 11 www.economicswebinstitute.org

The firm's existence is subordinated either to the shareholders or to all stakeholders. The

shareholder theory, envisages value maximization (for shareholders) as the primary objective

. That is maximization of a firm’s equity, - the present value of expected benefits (cash

flows) that the shareholders can expect from the firm. According to this definition, a firm’s

value can be maximized only when expected benefits are maximized in the long-run. Profits

are not the best proxy of what investors can benefit from a firm. From the perspective of the

shareholder value maximization, expected future (free) cash flows are a far more important

measure of a firm’s performance.12

On the other hand, the primary objective of a firm from the perspective of all its stakeholders

(i.e., shareholders, employees, customers, suppliers, creditors, local community, state and

others), the primary objective would be defined more broadly, as the interests of stakeholders

differ and cannot be expressed using a standard measurement.13

1.5.2 Profit Maximization Pricing

Profit maximization is the short run and the long run objective of any firm in a competition

for survival and growth. To obtain the profit maximising output, profit is equal to total

revenue (TR) minus total cost (TC). Profit maximising output:

Under Perfect competition MC=MR=P

Other market forms MR(P)>MC

1.6 Concept of Welfare

1.6.1 Consumer Welfare

Consumer Welfare is defined as the maximisation of consumer surplus of the whole

economy, realised through, ‘direct and explicit’ economic benefits received by the consumers

of a particular product as with reference to its price and quality. The consumer welfare model 12 Dolenc et al: What is the Objective of a Firm ? Overview of Theoretical Perspectives. http://www.hippocampus.si/ISBN/978-961-6832-32-8/contents.pdf 13 ibid

is built of the prevention of abuse of dominance in competition It is relevant in socio-political

and legal implications. Consumer welfare standard is the basis of different policy decisions

in competition law enforcement especially in merger cases.

.

1.6.2 Social Welfare(Total Welfare)

The welfare of the society is the summation of the utility maximisation of all the individuals

in the society. It is not the greatest happiness of the greatest numbers or the majority rule, but

everyone in the society is able to maximise the utility from their consumer behaviour. That

the market and the state provide to the individuals a quality life for their sustenance. In

welfare economics social welfare is theoretically reached through various approaches, but the

complexity of human behaviour does not enable, to reach a single welfare situation due to the

differences in value judgements and inter personal comparison of utility.

Competition policy increases overall material and its ultimate goal is to increase overall

economic efficiency giving the consumers a fair share in total wealth. While society’s total

welfare is usually the ultimate goal of competition policy it is rarely its exclusive goal.

Competition policy usually focuses on a specific reconciliation of the overall interest of

society with the particular interests of consumers. The difference between competition

policies lies in the particular way in which they reconcile these

interests. Whether a given competition policy strives to achieve pure economic goals, in

particular economic efficiency, or whether it includes non-economic goals, like income

distribution, diffusion of economic and political power or fostering business opportunity, as

well depends on the economic goals of the political system it is part of.

Three approaches are possible. First, competition policy may ignore consumer interests and

focus solely on total welfare and economic efficiency. Second, it may recognise the

immediate and short-term interests of consumers as the primary aim of competition policy.

Third, competition policy might recognise consumer welfare as an essential long-term goal

where the immediate interests of consumers are subordinated to the economic welfare of the

society as a whole.14

1.6.3 Producer Surplus

14 www.clasf.org

Producer surplus measures the benefit to sellers participating in a market. Producer surplus is

measured as the difference between the market price and the cost of production, as shown on

the supply curve. For the market, total producer surplus is measured as the area above the

supply curve and below the market price, between the origin and the quantity sold.

1.6.4 Price discrimination and Consumer Surplus

Price discrimination occurs when a business, or usually a monopolist charges a different

price to different groups of consumers for the same good or service, for reasons not

associated with costs.

Conditions necessary for price discrimination are, price elasticity of demand or precisely

elastic or inelastic demand and segmentation of the markets to prevent consumer switching

Peak and Off-Peak Pricing

• Peak and off-peak pricing and is common in the telecommunications industry, leisure

retailing and in the travel sector.

• At off-peak times, there is plenty of spare capacity and marginal costs of

production are low (the supply curve is elastic)

• At peak times when demand is high, short run supply becomes relatively inelastic as

the supplier reaches capacity constraints. A combination of higher demand and

rising costs forces up the profit maximising price.

Third Degree (Multi-Market) Price Discrimination

This is the most frequently found form of price discrimination and involves charging different

prices for the same product in different segments of the market. The key is that third degree

discrimination is linked directly to consumers’ willingness and ability to pay for a good or

service. It means that the prices charged may bear little or no relation to the cost of

production.

The market is usually separated in two ways: by time or by geography. For example,

exporters may charge a higher price in overseas markets if demand is estimated to be more

inelastic than it is in home markets.

In the peak market the firm will produce where MRa = MC and charge price Pa, and in the

off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers

with an inelastic demand will pay a higher price (Pa) than those with an elastic demand who

will be charged Pb.

The internet and price discrimination

The rapid expansion of e-commerce using the internet is giving manufacturers unprecedented

opportunities to experiment with different forms of price discrimination. Consumers on the

net often provide suppliers with a huge amount of information about themselves and their

buying habits that then give sellers scope for discriminatory pricing. For example Dell

Computer charges different prices for the same computer on its web pages, depending on

whether the buyer is a state or local government, or a small business.

Two Part Pricing Tariffs

• Another pricing policy is to set a two-part tariff for consumers.

• A fixed fee is charged + a supplementary “variable” charge based on units

consumed.

• Examples: taxi fares, amusement park charges

• Price discrimination can come from varying the fixed charge to different segments of

the market and in varying the charges on marginal units consumed (e.g.

discrimination by time).

Product-line pricing

• Product line pricing occurs when there are many closely connected complementary

products that consumers may be enticed to buy. It is frequently observed that a

producer may manufacture many related products. They may choose to charge one

low price for the core product (accepting a lower mark-up or profit on cost) as a

means of attracting customers to the components / accessories that have a much

higher mark-up or profit margin.

• Examples: manufacturers of cars, cameras, razors and games-consoles. Indeed

discriminatory pricing techniques may take the form of offering the core product as

a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the

complementary products once they have been “captured”.15

Consequences of Price Discrimination16

Impact on consumer welfare

• Consumer surplus is reduced in most cases - representing a loss of welfare. 15 tutor2u.net 16 www.slideshare.net

• For the majority of buyers, the price charged is well above the marginal cost of

supply.

• However some consumers who can now buy the product at a lower price may benefit.

Lower-income consumers may be “priced into the market” if the supplier is willing

and able to charge them less.

• Examples might include legal and medical services where charges are dependent on

income levels.

• Greater access to these services may yield external benefits (positive externalities)

improving social welfare and equity. Drugs companies might justify selling products

at inflated prices in higher-income countries because they can then sell the same

drugs to patients in poorer countries.

Producer surplus and the use of profit

• Price discrimination benefits businesses through higher revenues and profits.

• A discriminating monopoly is extracting consumer surplus and turning it

into supernormal profit.

• Price discrimination also might be used as a predatory pricing tactic to harm

competition at the supplier’s level and increase a firm’s market power.

A counter argument is that price discrimination might be a way of making a market

more contestable.

• Low cost airlines have been hugely successful by using price discrimination to fill

their planes.

• Profits made in one market may allow firms to cross-subsidise loss-making

activities/services that have important social benefits. For example money made on

commuter rail or bus services may allow transport companies to support loss-making

rural or night-time services. Without the ability to price discriminate, these services

may have to be withdrawn and jobs might suffer.

In many cases, aggressive price discrimination is a means of business survival during

a recession. An increase in total output resulting from selling extra units at a lower price

might help a monopoly to exploit economies of scale thereby reducing long run average

costs.

1.6.5 Total surplus17

Total surplus is the sum of consumer and producer surplus. This calculation

demonstrates the total profit to the economy from a producer to consumer exchange.

Economists use this computation as a reference point to measure the consequences of

government policies, such as taxation, on the market as well as a means to measure

market efficiency. An efficient transaction is one in which total surplus is maximized.

18Consumer Surplus = Willingness to Pay Price - Actual Purchase Price

Producer Surplus = Actual Selling Price - Economic Cost

To measure total economic welfare, we can add the consumer surplus to the producer

surplus to arrive at the total surplus.

Total Surplus = Consumer Surplus + Producer Surplus

1.6.6 Dead weight loss

In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is

a loss of economic efficiency that can occur when equilibrium for a good or service is 17 www.ehow.com 18 thismatter.com

not Pareto optimal. In other words, either people who would have more marginal

benefit than marginal cost are not buying the product, or people who have more marginal cost

than marginal benefit are buying the product. Deadweight loss can be beneficial when there is

a negative externality, in which case it can be considered a deadweight gain, as it would help

those that the negative externality was hurting

Causes of deadweight loss can include monopoly pricing (in the case of artificial

scarcity), externalities, taxes or subsidies, and binding price ceilings or floors. The term

deadweight loss may also be referred to as the "excess burden" of monopoly or taxation.19

Hicks vs. Marshall

An important distinction should be made between Hicksian (per John Hicks)

andMarshallian (per Alfred Marshall) deadweight loss. The latter is related to the concept

of consumer surplus, such that it can be shown that the Marshallian deadweight loss is zero

where demand is perfectly elastic or supply is perfectly inelastic. However, Hicks analyzed

the situation through indifference curves and noted that when the Marshallian Demand

Curve exhibits perfect inelasticity, the policy or economic situation which caused a distortion

in relative prices will have an income effect and that this income effect is a deadweight loss.20

The following diagram explains the dead weight loss.

19 www.costaricatourguide.org 20 en.wikipedia.org

Summary

This module is the foundation of the understanding of the producer and consumer behavior in

the market and essential for the ordinary business of life. To deliberate on the economic

benefits of Competition Law, it is essential to run through the basic concepts in economics.

The Concepts of Demand and Supply with their details on the elasticity combined with the

cost functions of the firm as well as their profit maximizing behavior have the ultimate goal

of welfare of the consumer, producer or the total welfare of the society. All the concepts

are carefully handled to give a simple and straight understanding of the same.

End notes

Competition Policy and Law requires the economic analysis for a fruitful discussion and

practice. This module has aimed at the same and has given the necessary inputs.

1. Objectives of the firm

2. Dead Weight Loss