67
sing marginal costs rather than to incur the fixed costs of production twice (Knieps,
2005a: 23).
In the case of a multi-product firm, economies of scope are a necessary condition
for subadditivity of the cost function. Economies of scope are defined by the fact
that it is less costly to produce two or more product lines in a single firm rather than
to produce any combination of the product lines in several firms (Panzar and Willig,
1981). Economies of scope are, however, not a sufficient condition for subadditivity
of the cost function. Intuitively, to prove subadditivity it must be shown that the
additional costs of producing an output vector z are lower when output vector x + y
is already being produced by the firm than when only the output vector x is already
being produced (Knieps, 2005a: 27):
C(x+z) – C(x) ? C(x+y+z) – C(x+y), whenever x,y,z ? 0.
This property of the cost function is called cost-complementarity. Costcomplementarity of production is a sufficient condition for subadditivity of the costs
function in the multi-product case.
The formal definition of strict and global subadditivity of a cost function, both for
the single-product and the multi-product case, given by Baumol (1977: 810) reads:
A cost function C(y) is strictly and globally subadditive in the set of commodities N = 1,…, n,
if for any m output vectors y1, … , ym of the goods in N we have C(y1,…, ym) < C(y1) + …
+ C(ym). This is clearly the necessary and sufficient condition for natural monopoly of any
output combination in the industry producing (any and all) commodities in N, for subadditivity
means that it is always cheaper to have a single firm produce whatever combination of outputs
is supplied to the market, and conversely.
4.3.2 Theories of monopolistic competition
A long history of regulation in network industries is evidence to the fact that competition authorities in past times often doubted that effective competition is possible
in these markets. A wave of deregulation in network industries since the 1980s demonstrates a changed perspective. Network sectors may not correspond to perfectly
competitive markets. Economic theory does, however, offer models of monopolistic
competition that allow for economies of scale, economies of scope and network
externalities in competitive market environments. Using these models as reference
models to judge competition in network industries increases the spectrum of observable market structures and market behavior that competition authorities can tolerate
without calling for market intervention.
Chamberlin’s theory of monopolistic competition (Chamberlin, 1933) is generally
considered the forerunner of the models of monopolistic competition. When Chamberlin developed his theory he was looking for an explanation of competition in real
markets. Chamberlin argued that competition in reality is characterized not by a
large number of competitors producing homogeneous products; rather it is a struggle
68
for market shares, fought on the basis of product differentiation, price differentiation
and investments into reputation. In real markets buyers choose between combinations of price and quality. As long as consumers view products as potential substitutes, they can be considered to be in the same relevant market. Because buyers have
preferences for particular product characteristics, however, the demand facing each
firm is not perfectly elastic. Through product differentiation each firm has a degree
of price-setting competency. Firms can therefore charge prices which exceed marginal costs of production.
The theory of monopolistic competition assumes free market entry. As long as
economic profits are being made, new firms enter into the industry. The theory assumes that the effect of entry is spread evenly across all firms already active in the
market. With more products available on the market, the demand curve for any particular product shifts back towards the origin and demand for this product becomes
more elastic (the slope of the demand curve decreases). Once price is equal to average costs of production, no economic profit is made and entry into the market ceases. In equilibrium, monopolistically competitive markets therefore feature fewer
firms, prices that exceed marginal costs, and product differentiation. The equilibrium is not characterized by stable market power since no firm is able to make positive economic profits over a substantial time period.
The theory of monopolistic competition was subsequently refined in various models of product differentiation.58 These models build on a theory of consumer behavior, which puts the spotlight on consumer valuation of product diversity. Consumers derive utility not directly from goods and services, but rather from the characteristics of these goods and services. Products represent bundles of characteristics
and depending on individual preferences a consumer will choose her optimal bundle
(Lancaster, 1966). This can be represented in a theoretical model by using a spatial
setting as in Hotelling (1929). In a spatial model, consumers choose between those
bundles closest to their preferred bundle as represented by proximity in geographic
space (Lancaster, 1975). The valuation of product diversity has alternatively also
been modeled by an explicit treatment of the value of product diversity in the utility
function of a representative consumer. In such a model the representative consumer’s utility depends positively on the number of goods produced in the market and
all products are potentially substitutable (Dixit and Stiglitz, 1977).
One central theme of the theory of product differentiation is that in markets featuring economies of scale, there is a trade-off between taking advantage of these economies of scale and offering product diversity in the market. A first-best equilibrium, in which prices equal marginal costs, would require transfers to firms making
losses and would have a tendency to lead to too little product diversity in the market.
The monopolistically competitive equilibrium allows firms to charge prices above
marginal costs such that transfers for losses are no longer required. Whether this
equilibrium corresponds to a second-best optimum which maximizes social welfare
under the restriction that revenues must be sufficient to cover all fixed and variable
58 For an overview see also Knieps (2005a: Chapter 9).
69
costs of production is not clear (Carlton and Perloff, 2005: 230; Dixit and Stiglitz,
1977: 301). The monopolistically competitive equilibrium could be biased either in
the direction of too much product diversity or of too little product diversity in the
market, depending on the preferences of consumers for product variety and the extent of the economies of scale. Because divergence from a second-best optimum is
not systematic, it is difficult, if not impossible, for policy makers to correct the monopolistically competitive result towards a second-best optimum. Monopolistically
competitive markets therefore offer no justification for government intervention.
4.3.3 Entry barriers
The central characteristic common to the models of monopolistic competition is that
their positive equilibrium properties depend on the assumption of free market entry.
The theories of monopolistic competition show that the question of when competitive forces are sufficient to restrain market power can be approached by analyzing
the possibilities for market entry. As long as economic profits in a market entice
market entry, firms in this market cannot be said to have market power. Only when
economic profits are realized over an extended time period without inducing market
entry is market power present.
There are different traditions with respect to defining barriers to market entry.
The traditional industrial economic theory on entry barriers is represented by Bain
(1956). Embedded in the structural approach, which explains market outcomes by a
given market structure, Bain formulated a broad theory of market entry barriers that
includes variations of economies of scale, product differentiation advantages of
incumbents, and capital requirements (Schmalensee, 1989: 968). In essence, Bain
considers all market characteristics that lend cost advantages to an incumbent firm to
be barriers to entry, even if these cost advantages are only temporary. For example,
if economies of scale allow the installed firm to produce a higher level of output at
lower average costs of production, then, according to Bain, this must be looked at as
a barrier to market entry. Potential entrants would initially produce less output at
higher costs. Also, when product differentiation by the incumbent forces potential
entrants to spend more on advertising than the incumbent is currently spending, then
this is considered a barrier to market entry.
A far more narrow definition of barriers to entry was formulated by Stigler, a representative of the Chicago School. Stigler defines: “A barrier to entry [...] as a cost
of producing (at some or every rate of output) which must be borne by a firm which
seeks to enter an industry but is not borne by firms already in the industry” (Stigler,
1968: 67). This definition focuses on long-run cost asymmetries between an incumbent firm and firms willing to enter the industry. The foremost reason for long-term
cost advantages held by incumbents is the irreversibility of investments necessary
for production. When the incumbent has already made these investments, their costs
are no longer decision-relevant to him. They are, however, relevant to a firm contemplating entering the industry. Other reasons for asymmetric cost advantages can
Chapter Preview
References
Zusammenfassung
Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.