Market Definition and Assessment of Market Power Brasilia, May 2010
Lorenzo Ciari Lear
Plan of the Lecture 1. Market Definition • • • •
SSNIP Test supply & demand substitution the importance of the benchmark implementing the SSNIP
2. Assessment of Market Power • Lerner index; • traditional approach: a. b. c. d.
market shares; determining relative strengths; entry; buyers’ power. 2
Why assess market power?
The concept of market power is central to competition policy, since it is directly linked to efficiency and welfare. In practice, market power is defined as the ability of a firm to raise prices above its marginal cost (MC). However, firms set prices at their MC only in the abstract world of perfect competition. As a result, in the real world all businesses are expected to enjoy some degree of market power, let it be low or high. Therefore, the specific question competition policy wants to answer, when assessing market power for a given case, is whether it produces or is likely to produce any negative competitive effects. 3
Two-steps approach In order to assess the extent of market power, competition authorities need first to address the question of what the market in question is. Thus, the widespread approach involves the following two steps, which we will analyse in this presentation: 1.  Definition of the Relevant Market 2.  Assessment of Market Power Market definition is not relevant per se. It is instrumental to the assessment of market power.
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Market Definition The relevant market should not be a set of products resembling each other on the basis of some characteristics but, rather, the set of products (and geographical areas) that exercise some competitive constraint on each other. The framework used for market definition is the Small but Significant Non-transitory Increase in Prices (SSNIP) test. To see how it works, imagine a competition authority of a given country looking into a merger between two firms selling bananas.
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SSNIP Test The SSNIP approach begins by supposing that there is a hypothetical monopolist selling bananas and asks: would it be profitable for him to increase the price above the current level in a non-transitory way by 5-10%? If the answer is YES, then bananas do not face a significant competitive constraint and, hence, form a separate market. If NO, because customers may decide to switch to other fruits, then bananas are constrained by these fruits and do not form a separate market. Thus, in the latter case, we should continue with the test by widening the definition until a relevant market is found. 6
Substitutability I As we have seen, substitutability is a key element in understanding how products possibly constrain each other in function of relative price changes. The bananas versus other fruits was an example of demand substitutability, which brings consumers to choosing another product upon a price increase. Yet, substitution can happen on the supply side as well (supply substitutability), since a price increase for a certain good can convince other firms to enter the market and start producing a substitute. 7
Substitutability II - supply
For instance, we could have a merger between two bus companies (A & B) serving alone the same town X. In this case, the relevant market definition in terms of demand substitutability would call for bus services of A and B (suppose trains are not a valid substitute). However, there are other bus companies (C,D) active in nearby towns (Y,Z) that operate on other routes. If obtaining a licence in town X is easy and if C and D have spare capacity, these will exercise a competitive constraint on the merged entity since, following a possible price increase, they could easily and profitably enter the market in city X. Potential competition 8
Substitutability III - factors The main elements for substitution could be summarized as follows: • Supply side: skills, assets, sunk costs, easiness of entry. • Demand side: characteristics and usage, temporal, seasonal, multiple and secondary markets.
We shall briefly go through each one.
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Supply substitution I
In order to switch production easily and rapidly, the producer of another good must already possess the skills required (i.e. know-how) and have the financial possibilities. An example is the merger of Torras/Sarrio (1992), two firms active in the paper industry. Here the EC found that there are different demands for different qualities of paper (e.g. art books publishers need high quality paper, low quality is not a substitute). However, the immediate switching to a different quality of paper is a possibility for all paper producers (same skills, no additional costs). Thus, a wider product market definition was established and, thereafter, the EC posed no opposition to the concentration. 10
Supply substitution II Another important factor is the possible presence of sunk costs. For example, the technology of producing a cola could be available to other firms operating in other markets (e.g. mineral water), but advertising campaigns expenditures create a brand and determine the success (endogenous). Similarly, when a firm operating in country A decides to enter country B, it may face very high setup costs in relocating its production to country B (exogenous).
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Supply substitution III Therefore, in summary of the above, the key element for potential supply substitution is the easiness of entry. This easiness does allow for a possible existence of entry barriers of some degree – such as physical, legal, financial and human capital – but these must be easily and quickly surmountable.
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Demand substitution I Physical characteristics of products and their usage might give some indication of their degree of substitutability, but only in the framework of the SSNIP test. For example, the fact that both mineral waters and soft drinks are used to satisfy one’s thirst does not imply that they are in the same market. Conversely, if two products differ they can still be part of the same market: trains and buses are indeed different, but provide a similar service in transporting people from city A to city B.
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Demand substitution II
Sometimes the extent of the competitive pressure products exercise on each other is not always straightforward, because the markets may be particular. For example, bars and restaurants may be part of the same market during lunch time, when most people look for a quick meal. However, at dinner time, as people might prefer a relaxing environment, it is unlikely that a sandwich is a good substitute for a restaurant meal (temporal markets). Similarly, bananas are largely available throughout the year, whereas oranges only in certain months. As a result, they might belong to the same market in some seasons but are separate in others (seasonal markets).
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Demand substitution III (a) One important question is how to define markets when there exist primary and secondary markets, such as cars (primary) and spare parts (secondary). Here the relevant question is whether a hypothetical monopolist selling spare parts for a certain car brand would be able to profitably increase prices. For consumers who have already bought this brand it may be impossible to switch. However, consumers deciding which car to buy might turn to another brand, to the extent that they base their purchase decision on the overall lifetime cost of the car (i.e. cost of the car and total expected cost of the spare parts). 15
Demand substitution III (b) Therefore, if spare parts are a sufficiently important part of the overall expected cost, and there are sufficient buyers taking this into account, the hypothetical monopolist will not find the increase profitable and the market ought to be defined as to include more brands. Hence, the following factors are important in such markets: • The price of the secondary good in relation to the price of the primary product; • The probability of the replacement, which also affects expected costs; • The level of information buyers need and its availability at the time of purchase of a product. 16
The importance of the benchmark I The use of the SSNIP test in non-merger cases can present some problems. Consider an investigation where a firm is alleged to have abused of its dominant position. To establish whether such firm is dominant, a preliminary step is to check its market power and define the relevant market. Yet, in this case, the question is not whether the hypothetical monopolist can apply a SSNIP relative to current prices but, rather, relative to competitive prices. In a merger case, we want to assess whether the transaction is likely to lead tomorrow to a substantial lessening of competition (SLC) relative to the situation today. In the other case, we want to see whether the current situation is causing a SLC. 17
The importance of the benchmark II Hence, while in a merger case the benchmark ought to be today’s situation, in other cases it may be today’s prices the object of the investigation. It could also be, for example, that a firm is the only seller in the correctly defined product market. Being a monopolist, it might have set its prices at such a high level that a further increase may not be profitable (i.e. it is already maximizing its profits). Therefore, applying the SSNIP test to current prices might lead to a too-wide market definition precisely because the firm under investigation has a dominant position. This last argument is known as the “cellophane fallacy”, from the United States v. du Pont case of 1956. 18
The Cellophane Fallacy Here the US Supreme Court maintained that the existence of high cross elasticity of demand between cellophane (sold by du Pont) and other wrapping materials called for a wide definition of the market (i.e. include all possible wrapping materials). However, this decision was later criticised as the high elasticity was itself an indication of the high market power enjoyed by du Pont. During the trial there was evidence that the firm was setting the price of cellophane so high that consumers would have considered replacing it with inferior substitutes. Therefore, the cellophane argument calls for caution in applying the SSNIP in non-merger cases.
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Implementing the SSNIP test The very reliance of the SSNIP test on a hypothetical (monopoly) situation means that there exist no data that would allow for a literal application of the test. Nonetheless, there is a set of quantitative tools that can be used to implement it, but it must kept in mind that all data and results obtained ought to be interpreted within the framework of the test. These include: own-price elasticity of demand, cross-price elasticity of demand, price correlation tests and price differences. We shall focus on the first two as the last two will be analysed in a dedicated lecture. 20
SSNIP test: Own-Price Elasticity I Own-price elasticity of demand is defined as the percentage change in the quantity demanded following a one-percent increase in the price of a product:
Suppose, for instance, that we are still interested in the merger of two sellers of bananas and we want to define the relevant market. Knowing that the own-price elasticity is, say, 0.2, one can infer that a 10% increase in the price of bananas will lead to a 2% decrease in the demand for bananas. 21
SSNIP test: Own-Price Elasticity II Given these (imaginary) numbers only very few consumers will turn to other fruits (or stop buying altogether) and, hence, the price rise is likely to be profitable. However, the simple observation of the elasticity does not get us very far. Indeed, it might be that other factors play a role in determining the change in demand; for example, it might be that the fall in demand was dampened because in the meantime: • prices of substitute fruits have risen; • the availability of other fruits has decreased; • disposable incomes have risen, etc…
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SSNIP test: Own-Price Elasticity III Hence, not considering other factors, which may be correlated with the change in the quantity of bananas demanded or with the change in prices, can lead to a bias when defining the market. To take these into account, one should formulate and estimate an econometric model, through which obtaining estimates of elasticities that can be used for competition analysis. Note also the timing factor when collecting data. In some markets consumers’ reaction following price changes may be immediate, in others there could be a time lag. Therefore, the time span in data collection should always take this into account. 23
SSNIP test: Cross-Price Elasticity I Cross-price elasticities help to understand the competitive constraints exercised by other products on the product under examination. We define the cross-price elasticity between products A and B as the percentage change in the demand for product B when there is a one-percent increase in the price for product A:
Generally, if two products are substitutes their cross-price elasticity is positive, whereas if they are complements it is negative.
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SSNIP test: Cross-Price Elasticity II When own-price elasticity for the product A is high enough such that a hypothetical monopolist cannot profitably raise its price, it becomes important to identify which products exercise a constraint on A. Thus, cross-price elasticities can help us to rank the closest substitutes of A, which will be included in the widened SSNIP test. Going back to our fruits example, if estimates of cross-price elasticities between bananas and any other fruits are low, they indicate that such products are not perceived by consumers as substitutes for bananas and, hence, suggest a separate market for bananas. 25
Geographic Market Definition I Most of the considerations made before for product markets also hold when considering the definition of geographic markets, with the SSNIP being the conceptual framework to be used. For example, suppose we consider a merger between mineral water producers in Italy. The SSNIP test then takes the following form: would a hypothetical monopolist of all Italian waters find it profitable to increase its price by 5-10%? • If yes, then the geographic market will be defined as Italy; • If no, for instance because one expects imports from France to become more competitive, then the test should be repeated comprising the Italian and French mineral waters. 26
Geographic Market Definition II Therefore, when implementing the test to define geographic markets, in addition to estimates of elasticities and correlation tests, information aimed at establishing the role of imports and transportation costs might also be used. A test taking into account such information, the Shipment Test, will be better analysed in a subsequent lecture.
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Assessment of Market Power Recall that market power as the ability of a firm to raise prices above its MC, and that all firms enjoy some degree of market power. Two issues need to be addressed when assessing market power: 1. which measure should be used, and 2. which threshold should be taken to indicate that a firm has enough market power for it to call for the attention of competition authorities. While the first question can be well answered by economic theory, the second calls largely for an arbitrary answer, and it is solved in different ways by different antitrust legislations. 28
Lerner Index
A theoretical measure of market power is given by the Lerner Index, defined as the firm’s mark-up over price ratio:
Although theoretically sound, the application of the LI to the real world is rather problematic because: 1. Estimating the MC of a firm is a very difficult task; 2. A low LI could may also indicate a monopoly, since monopolistic firms tend to be characterized by productive inefficiencies. Therefore, as there are several empirical problems, the traditional approach assesses market power in an indirect way. 29
The Traditional Approach Once the market definition step is completed, the analysis of market power generally rotates around the measurement of market shares (MS) held by the firm(s). Indeed, a monopolist is a firm with 100% of the market, hence the highest possible market power. Conversely, a firm with a tiny share of the market to is unable to exercise much market power. However, a firm’s high market share is not sufficient to conclude that is dominant and there are other factors to be taken into account. Let us begin with a talk on market shares and then proceed with these factors. 30
Market Shares I
Market shares can be used as a screening device. For instance, if the MS of a firm being investigated is below a given threshold (e.g. 40%) there might be a presumption that the firm does not hold enough market power to be considered dominant. Hence, the eventual burden of proof should fall entirely on the competition authority. Conversely, if it were above a certain threshold (e.g. 50%) there might be a presumption of dominance, and the burden of proving the non-existence of such dominance would fall on the defendant. This approach could help legal certainty and reduce the cost of investigations. Nonetheless, the framework should not hide that many other elements must be assessed to establish the market power of a firm. 31
Market Shares II
Some competition authorities are explicit with regard to market shares, some others are vague. For example, in its guidelines the UK Office of Fair Trading indicates two thresholds: below 40% it is unlikely that a firm is considered dominant, above 50% dominance can be presumed. The European Commission would probably set the lower threshold at 25%, since in its Merger Regulation it states that a concentration is presumed not to impede competition if the combined share does not exceed 25%. US courts seem to indicate higher thresholds for finding dominance. In some cases it was written that a market share of 33% is certainly not sufficient to establish dominance, whilst in others they found firms with shares of 40% not to be dominant. 32
Market Shares III – which measure? Depending on the sources and the nature of the investigation, in some cases there might be the availability of having market shares both in number of units and in values. The latter generally have more economic meaning, although the former might contain some additional information about the relative market positions. For instance, in the NestlÊ/Perrier case of 1992, the EC calculated market shares in the French mineral water industry both in volumes and in values. The three major firms held higher shares when total values were considered, indicating that consumers were willing to pay higher prices for a bottle of their water than for that of competitors. 33
Relative Strengths I In order to assess the relative strengths within a market, some other factors ought to be considered. In some industries with production constrained by a crucial input, existing reserves might be more informative than MS. For instance, in the mineral industry, if a firm holding 20% MS is expected to exhaust its reserves it is unlikely to exercise a competitive constraint in the future. Similarly, if a market participant carries a less efficient technology, he is unlikely to be a relevant player in the future. In this case, the current (or past) MS would over-estimate the competitive constraint he will exercise.
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Relative Strengths II Consider the case of a firm under investigation. If the existing capacity of rival firms is just enough to satisfy their current demand (i.e. very low supply elasticity), then they cannot exercise any competitive pressure. If, however, the industry has considerable excess capacity, then it is reasonable to expect that the market power of a firm under investigation is reduced. Therefore, the share of capacity of each firm over total industry capacity might be a relevant information.
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Relative Strengths III
Some markets may be characterized by large and infrequent orders made by few firms. Here there might be a large variance in MS if these are calculated over a small period of time, as one order alone might represent a considerable proportion of the period’s sales. As a consequence, MS are more informative if over a longer horizon. Furthermore, also the persistence of MS over time could give strong signals. If a firm’s MS was consistently above 50% over an horizon of 5-10 years, this could be an indication of its likely dominance, ceteris paribus. Conversely, a distribution of MS that varies considerably over a short period of time could be an indication of a competitive situation with no dominant firm. 36
Ease and Likelihood of Entry I As we already mentioned, if a firm tries to exercise its market power (i.e. increases its prices), existing competitors might increase capacity, thus limiting its market power. However, potential entrants might also constrain a firm’s market power. Yet, this depends on a number of factors that may characterise the industry under consideration. 1. As we saw before, a key role is taken by sunk costs: the higher, the less likely that entry will occur, which in turn makes it less likely that new firms will discipline the incumbents. 2. There might also be switching costs, lock-in effects and network externalities. These might represent an obstacle to entry as consumers do not have the right incentive to turn to new suppliers, even when they are more efficient and/or offer superior products. 37
Ease and Likelihood of Entry II 1.  Care should also be devoted to the history of the industry, in particular to previous episodes of entry and the incumbent’s reactions. It might be that the market leader, by always reacting aggressively, has built a reputation of being a tough player and potential entrants will take this into account when deciding entry. Therefore, the expectation of a price war after their entry could discourage them from entering in the first place.
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Buyers’ Power I The ability of a firm to charge higher prices also depends on the degree of concentration of buyers. A firm is clearly more free to exert market power if it faces a large number of dispersed consumers than if it faces few strong buyers. Indeed, a strong buyer can make use of its bargaining power to stimulate competition among sellers and obtain more favourable prices and conditions, either • by threatening to switch orders from one seller to another, or • by threatening to start upstream production itself.
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Buyers’ Power II The role of buyer power in constraining sellers is typically well taken into account by competition authorities. One example was Enso/Stora of 1998, where the merging parties produced Liquid Packaging Board. The merger was expected to give them a MS between 50 and 70%. Other industry characteristics, such as high entry barriers, also suggested an anticompetitive impact. Yet, the merger was approved on the grounds that buyer power was so large (Tetrapak alone buys 60-80% of total sales) that the merging firms would have been unlikely to exercise market power. Indeed, the EC argued that the main buyer would have the option of developing new capacity with other existing or new suppliers, should the parties attempt to exercise market power. 40