Assessing Monopoly Power in Abuse of Dominance Cases

Assessing Monopoly Power in Abuse of Dominance Cases Dr. Kenneth Danger OECD, Senior Economist Ken.Danger@OECD.org

Two Parts to Dominance Cases • Show that the firm is dominant • Show that the dominant firm has abused its position. During this presentation I will focus on the first part, (i.e., the types of evidence that has been used to show that a firm is dominant).

When is a Firm Dominant? How Much Market Power is Enough? • I define dominance as when a firm has substantial, durable market power. • Sometimes substantial market power is called monopoly power in order to differentiate it from ordinary market power.

Indirect Evidence of Market Power • Market shares • Entry barriers/barriers to expansion • Buyer power???? Standard analysis focuses on indirect evidence, even though we know it is imperfect. That is because direct evidence of monopoly power is hard to gather.

Why Define a Market? (1) • The structure conduct and performance paradigm associates more concentrated markets with higher prices and market power. This model implies • Higher concentration → less intense rivalry • Less intense rivalry → higher prices • This paradigm has received a lot of criticism.

Why Define a Market? (2) • A fair point, however, is that a firm with 100% of a well defined relevant market may have substantial market power.1 • And, firms with an insignificantly lower share are not likely to be fundamentally different. • And, so firms with 80 or 95% of the market, for example, could also have substantial market power.

The Hypothetical Monopolist Test and Share Assignments • Typical dominance cases CANNOT typically employ the standard hypothetical monopolist paradigm to define markets. • Most dominance cases involve conduct that has already occurred. • Employing the HMT ignores the obvious fact that firms set price at the profit maximizing point and that any further increase necessarily requires unprofitable losses to the firm’s business. • The HMT can be used correctly, however, when the concern is over future conduct by a dominant firm.

The Hypothetical Monopolist Test and Defining Markets in Single Firm Conduct Cases P Firms raise their price to the profit maximizing level, here Pm. Raising it further generates more losses than gains. Thus, when you define a market under the HMT, you necessarily will be adding additional competitors. P m AC MR Q Q m

Adapting The HMT to Single Firm Cases • Several fixes to the hypothetical monopolist test have been proposed. • Determine the competitive price and define markets relative to that price. • Use price decreases instead of increases to define the relevant market • Each of these methods have problems that are discussed in the following slides.

Determining the Competitive Price for the HMT in Single Firm Conduct Cases • A fierce debate is likely to occur over the determination of the competitive price • E.g., the agency says it is lower, the defendant says it is the prevailing price. • Empirical techniques for determining competitive price include: • Cross sectional comparisons across markets • Most useful when there are a lot of data points (e.g., might be used successfully in cases involving local retail services, transportation services on city-pair routes, or goods with high weight to value ratios, like concrete) • Time series examination of the impact of structural or “key” changes • Need enough data to control for other factors so as to isolate key issue • Estimate long-run marginal cost – “the competitive price” • Highly data intensive and estimates have a potentially large variance • No reason to think that LRMC would be the price that prevailed but for the illegal conduct, which is what we typically call the competitive price. • Use simulations (comparable to merger simulations) • Note if you can properly determine the competitive price then you can measure market power directly (i.e., current price minus competitive price provides direct evidence of market power). Thus, there would be no need to define markets and assign shares.

Adapting the HMT to Allow for Price Decreases • Some practitioners have suggested considering the effects of a 5-10% price decrease from prevailing levels (See Krattenmakker et al). • Comments on this approach have included the following: • The prevailing price may not exceed the competitive price by 5-10%. • Regulation may prevent significant price increases or the defendant may have no significant market power. Werden suggests that the proper benchmark in these cases is the prevailing price as 5-10% isn’t very significant. • If the prevailing price does exceed the competitive price, and it could be proved, then there is no reason to delineate markets. • A 5-10% price decrease may not be enough to purge all of the poor substitutes from the market. Thus, the Cellophane fallacy may infect the market delineation.

Share Assignments and Other Methods • In sum, we don’t have a model like the hypothetical monopolist test (SSNIP test) for defining the market in abuse cases. • When assigning shares, care needs to be exercised. For more information, see the article by Gregory J. Werden, “Assigning Market Shares,” Antitrust Law Journal, 70, 67-104. • Other methods for assessing monopoly power include examining barriers to entry. See next slides.

Entry Barriers • Entry barriers are arguably the single most important factor in assessing whether a firm has substantial, durable market power. • Without the ability to exclude entrants (and in absence of other factors that prevent entry) market power will likely not be long lasting. Australian High Court - A large market share may well be evidence of market power … but the ease with which competitors would be able to enter the market must also be considered. It is only when for some reason it is not rational or possible for new entrants to participate in the market that a firm can have market power… There must be barriers to entry. (See Boral v. ACCC) Canadian Abuse of Dominance Guidelines – “… market share is in itself not sufficient to prove market power. Without barriers to entry, any attempt by a firm with high market shares to exercise market power is likely to be met with entry or expansion by existing firms such that the firm with the high market share loses enough customers to its rivals that it is not profitable to attempt to raise prices above competitive levels.”

Entry Barrier Challenges(1) • The first problem is that of definition. Over the years numerous attempts to define an entry barrier have occurred. • The OECD Competition Committee recently characterized entry barriers as market conditions and circumstances that will delay or prevent entry from curing the anticompetitive effects at issue in individual cases. • The reason the subject of barriers to entry often comes up is not because the barriers themselves are allegedly detrimental. It is because the competitive harm that some other event or conduct might cause could be cured by entry unless, of course there are barriers that will prevent or deter it.

Barriers to Entry in Merger Cases -Example • In a merger case, for example, the court’s typical concern with entry barriers is whether they are high enough to prevent or retard new firms from entering if a merger would result in a price increase. • For example, a law might require that one of two technologies be used and if the only two patent holders of these two key technologies are merging then entry barriers might be deemed high. • In contrast, the court does not typically concern itself with validating or invalidating a law that protects public health by imposing certain safety requirements.

Barriers to Entry in Abuse Cases - Example • In some cases, something that could be described as an entry barrier is on trial. This might happen in an exclusive dealing case. In these cases, the judge is being asked to reduce or eliminate the barrier to entry through judicial intervention. • Thus, in dominance cases it is the conduct which is often said to be creating a barrier to entry. Think of exclusive dealing, repeat buyer discounts, refusals to deal, vertical integration, bundling and tying, and predation, etc. • But focusing in on the conduct as THE barrier of importance (for entry barrier analysis) would be wrong (see next slide).

Barriers to Entry in Abuse Cases – Example Continued • Even in abuse cases, there is often (or should be) a more general inquiry about entry barriers that goes beyond the one at the root of the litigation. • For example, predatory behaviour might be alleged to create a barrier to entry (no firm would entry if only to earn a loss), but a broader analysis would ask whether the predator would be able to recoup losses once it raises prices. In other words, would entry or expansion by rivals make a price increase unlikely? If not, what are the entry barriers? • Stated differently, sunk costs investments by the predatory might create entry barriers that would make entry or expansion by other firms unlikely to defeat a price increase. The sunk cost investments are not illegal in and of themselves but they are definitely relevant as other firms may not want to entry if they cannot achieve minimum viable scale and even then that may not be sufficient to counter act the illegal behaviour. Thus, significant sunk costs might be deemed an entry barrier.

Barriers to Entry Must Focus on the Relevant Market • Mylan v. IBM • Appeals court reversed a lower court finding that IBM did not have market power over mainframe computers. Lower court had relied on evidence of the growth of leasing companies. But these segments and product lines should have not been included in the main product market. • Dentsply • Appeals court reversed a lower court finding that Dentsply did not have market power. Lower court had relied on the idea that manufactures could go directly to end users. Appeals court instead focused on the idea that access to the dealer network was the key.

Entry Factors For entry to be competitively relevant it has to be • Likely • Question whether companies that could enter actually would do so • Timely • Long delay is less of a deterrent as the incumbent has more time to earn supra-competitive profits • Typically 2 years considered maximum delay • Sufficient • Scope and magnitude has to have competitive impact • Entry barriers have an influence on all three aspects, not only on the first one

Most Common Types of Entry Barriers • Structural market conditions • Sunk costs • Regulatory barriers • Network effects • Customer loyalty and reputation effects • Economies of scale and scope • Barriers to exit • Vertical integration • High capital costs • Behaviour by incumbents • Patent ring fencing • Exclusive dealing arrangements • Fidelity and bundled rebates, tying • Predatory and limit pricing • Excess capacity • Differentiation and advertising

Measuring Entry Barriers • Very difficult to try to quantify entry barriers in exact and absolute terms – The question of whether the cost of entry is too high is relative, anyway. E.g., Some firms might not entry if sunk costs are 100k but others would. • Entry is always an adventure that requires efforts, which some potential competitors might complain about • However, in the end, companies will determine entry on a pure profitability calculation - competition analysis has to aim at translating perceived barriers into cost and profitability terms • Information requests and interviews with market participants should focus on hard data and facts rather than qualitative statements and considerations (“Do you consider entry to be difficult in this market?” alone does not produce evidence reliable before courts)

Some Final Thoughts on Entry Barriers • High barriers can be consistent with vigorous competition • High market shares can be consistent with vigorous competition as the large firm vigorously innovates and lowers prices

Further Reading On Entry Barriers • OECD Roundtable on Barriers to Entry, DAF/COMP(2005)42, available at www.oecd.org/dataoecd/43/49/36344429.pdf • EC Guidelines on the assessment of horizontal mergers, OJ 2004 C 31/5, available at www.europa.eu.int/comm/competition/mergers/legislation/guidelines.htm • US Horizontal merger guidelines (1997) and Commentary (2006) with extensive case examples, available at www.ftc.gov/bc/bcburguidelines.htm • OFT Guidelines on Assessment of market power 2004, available at www.oft.gov.uk/NR/rdonlyres/A92F91BC-B556-4724-8D2B-7002F6CDEA65/0/oft415.pdf

Is Buyer Power a Legitimate Defence? • In my opinion, the word buyer power has been misused some. Buyer power has often been associated with larger firms. • Yet, large firms may not have any buyer power. What counts is a firm’s options which can include buying another product, vertically integrating or sponsoring entry. • These choices are what really give a firm “buyer power.” • See, for example the Canadian Tribunals case involving Nutrasweet. In that case, Nutrasweet had a 90% market share. Nutrasweet tried to argued that it didn’t have market power as its two principle buyers, Coke and Pepsi, were large.

Direct Evidence of Market Power • Firm-level elasticities • Profitability • Conduct evidence (natural experiments)

Estimating Firm-Level Demand Elasticities • A number of approaches have been developed that directly measure a firm’s market power. One such method is to estimate a firm’s demand elasticity using econometric techniques which tend to require a lot of data. • The basic idea if that when the demand elasticity is low a firm does not lose many sales in response to a price increase. • And, the lower a firm’s demand elasticity is the greater the firm’s market power. • It is important to note that many firms have relatively low demand elasticities. But, these same low demand elasticities should not necessarily be taken as evidence that the firm has substantial market power. For example, a firm needs to cover its fixed costs and as a result some commentators have said that elasticity evidence should be based on long-run marginal cost.

Implication of Margins for the Demand Elasticity1 • Yearly data obtained from a manufacturer of sleeping pills. • P = $1 per pill Marginal cost = 25 cents • Q = 100 million Initial profits = $75 million • Consider the implications of a 5% drop in price. • P = 95 cents Marginal cost = 25 cents • If Q = 105 million → Profit = $73.5 million • If Q = 110 million → Profit = $77 million • Bottom line: • Since firms choose prices to maximize profits we know that no more than 107.1 million pills would be sold if price = 95 cents. Establishes upper limit for price elasticity (εd = 1.42 = 7.1/5). 1. Example from Katz, Michael and Carl Shapiro, “Critical Loss: Let’s Tell the Whole Story,” Antitrust, Spring 2003. They describe exceptions to this idea.

Performance - Profitability • Another approach which might be useful in certain circumstances is to determine whether a firm’s performance (profitability) is consistent with the finding that the firm has substantial market power. • The question is whether a firm’s persistent profits can be considered excessive compared to some competitive norm. • Intuitively makes sense as perfectly competitive firms earn zero profits while monopolists can earn substantial profits. • The Market Power Guidelines from the Office of Fair Trading state “it might, for example, be reasonable to infer that an undertaking possesses market power from evidence that it has …. Persistently earned an excessive rate of profit. • The Canadian Competition Tribunal has considered profits as evidence of market power. • The Commission in its Microsoft decision also included a reference to high profits.

Performance – Profitability (2) • However, while the economic and legal literature has generally been supportive of the logic behind the use of profitability estimates ….. ……that same literature has, in general, been rather sceptical about the use of profitability data as evidence of substantial market power.

Criticisms of Profitability Data • Reflects accounting rather than economic costs • High returns could be due to factors other than market power, such as a superior product. • Should be measured in the long run. • Allocating costs is especially difficult (some argue impossible) with a multi-product firm. • Excess profits could be taken as a reward for risks or to superior efficiency.

What about Low Profitability Evidence? • Some have argued that low profitability should be taken as evidence that a firm does not have market power. • But others point out that a firm may spend profits to insulate itself from competition or undertake unprofitable expenditures.

Bottom Line on Profitability Evidence • Despite the criticisms, evidence on profitability might in the right circumstances be a useful method to support the finding of dominance or suggest the absence of market power, if relevant and reliable data are available and are carefully examined. • High rates would not provide decisive proof but they could be relevant if they are persistent and consistent with other evidence.

Performance - Pricing • Excessive pricing as an indicator of market power suffers from the same criticisms as profitability. • However, cross-sectional comparisons might provide useful evidence. • Simply comparing the prices that two firms charge or that the same firm charges in different markets, however, will not produce useful evidence as there may be alternative reasons which confound the analysis (e.g. differences in costs).

Conduct and Anticompetitive Effects • In certain cases, the conduct of a firm and its competitive effects may also be used as evidence that a firm has substantial market power. • Some have argued that that the focus should be on conduct and competitive effects in abuse of dominance cases; if substantial anticompetitive effects can be shown, then an initial separate inquiry into whether a firm has substantial market power should not be required.

Conduct Evidence – The Case of Re/max v. Realty One • Case concerned a real estate commission split policy. Remax agents were paid less than other agents that competed with the defendant. Normally, commissions are split 50-50 but in this case Realty One kept 70-75% in instances where Re/max was on the other side. • Defendant admitted the policy was designed to deter defections of their real estate agents to plaintiffs. • Some evidence in the record that the policy was successful and had limited competition. • the court considered evidence that showed that commissions were higher in the area where the defendant had implemented their policy. • the defendants conceded that they were able to charge higher rates because of their market position.

Inferences of Market Power Should Not be Drawn from Conduct Alone • Where conduct is used as evidence of monopoly power, it is necessary to evaluate this evidence as part of a broader story about competitive harm. • Why? • Well, as John Fingleton observed, “Any conduct that could be exclusionary has a pro-competitive rationale in that it might also be practiced by a competitive firm.” • Therefore, conduct alone should not be relied upon and instead one needs to look at the circumstances in which the conduct occurs.

Conduct Evidence: The Case of Price Discrimination • Price discrimination is a conduct that has frequently been characterized as evidence of market power. • Some commentators have emphasized that while price discrimination does show that a firm has market power, it does not inevitably imply the kind of market power (i.e., substantial) that antitrust law should be concerned with in abuse of dominance cases.

Conduct Evidence can be Inconsistent with Substantial Market Power • Conduct evidence could also work in the defendant’s favour or it could be used by the agency to reject a case. • For example, the evidence might point to bidding wars for customers where smaller competitors were successfully winning new customers or where the alleged dominant firm was forced to lower its prices.

Conclusions • There is not a single method that will in all circumstances produce 100% reliable evidence on whether a firm has substantial market power. All methods have some weaknesses. • Almost invariably a single item will not be sufficient to determine whether a firm has substantial market power. Therefore, decision makers should look at all of the evidence. • The assessment of whether a firm has substantial market power should not divert attention from the ultimate goal of the inquiry -- the assessment of the competitive effects of a firm’s conduct.

Assessing Monopoly Power in Abuse of Dominance Cases