Introduction to Competition Analysis

Introduction to Competition Analysis Regional Training Workshop on Competition Law Enforcement 13-15 January 2010 Abuja, Nigeria

Overview • Market Definition • Hypothetical Monopolist (SSNIP Test) • Product Market Definition • Geographic Market Definition • Price Correlation Tests • Market Power • Market shares • Concentration indices • Constraints to market power • Welfare effects • Barriers to Entry • Theories of Harm • Assessing Competition in a Market • Efficiency Gains

What is a Market? US DOJ and FTC Guidelines • A market is defined as a product or a group of products and a geographic area in which it is produced or sold, such that a hypothetical profit maximizing firm, not subject to price regulation, that was the only present or future producer or seller of those products in that area likely would impose a “small but significant and nontransitory” increase in price, assuming the terms of sale of all other products are held constant. EU Guidelines • Market definition is a tool to identify and define the boundaries of competition between firms . . . The objective of defining a market in both its product and geographic dimension is to identify those actual competitors of the undertakings involved that are capable of constraining their behavior and of preventing them from behaving independently of an effective competitive pressure

What’s Important When Defining a Market? Demand substitution to other • Products • Geographic areas Supply substitution from • Quick entry • Product repositioning

Market definition • It is all about market power – if market power exists then there must be a market over which is can be exerted • Often difficult, but nearly always crucial to any case • Means to an end • Requires: 1) theory of market workings and 2) data to be sustained through expert evidence and testimony • Hypothetical monopolist • smallest product group and geographic area such that a hypothetical monopolist could profitably and permanently raise price by a small but significant amount • SSNIP test: Small but Significant Non-Transitory Increase in Price • There may be several different markets all affected to differing extents

Hypothetical monopolist Example of ice cream sellers on a beach A Consumers have no choice but to buy from A Single ice cream seller at A Two Sellers: A and B A B C Consumers in C can buy from A or B NB: No price discrimination

Hypothetical Monopolist cont. • Consumers within A all pay same price i.e. cannot charge lower price to those within C • If A raises price those within C can move to B – how big is this overlap? • If products are different not in space but in characteristics, then can ask the same question: can and will a significant group of consumers move to an alternative? (Example of different qualities of products: premium beer?) • If a significant number do so then price rise is unprofitable • Similarly if B raises price • A and B are together the “hypothetical” monopolist • Market definition plus increase in concentration: will prices increase as a result of the merger??

Chain of substitution • If overlap significant then price of A • constrained by B and price of B by C etc • A and I in same market and hypothetical • monopolist is A+B+C+D+E+F+G • This how the new car market has been defined in Europe • Beach model applies to both geographic market and product market definition A B C D E F G

Market definition in practice • All about substitution: • demand and supply-side • Elasticities – responsiveness of output to change in price, • Own price and cross price elasticities • Very difficult empirically • How big is overlap? • can buyers switch supplier if price rise? • what are the buyers costs of switching? • How many will switch? • is likely switching enough to constrain price rise? • Sources of evidence • Not a precise science

Demand side substitution • What is a significant relative price rise? - 5% or 10% • What is significant switching? • If more than 10% of customers would switch in response to a 10% price rise then the rise is unprofitable (absent changes in costs) • Often cannot calibrate effects to this precision - switching of 10% or more - taken as evidence of demand substitution • Marketing documents – give firms’ own understanding of competitive threats to their products

Supply-side substitution • Can existing firms profitably and quickly switch production/supply using existing capital and production facilities? • Producers of red and blue T-shirts? • If so, their potential output is included in the market • Common plant but quite different markets, different inputs etc? • Substantial advertising and distribution costs? • In US SSS not included in market definition

Sources of evidence • Interviews with market participants • Trends in volumes sold and prices charged • Price correlations (and more powerful econometric tests) between possible substitutes • But: spurious correlations • Common costs • Common causal factors etc • Consumer surveys • Event studies

Evidence, documents, data • Consistency of understanding of actual workings of market with data • Theory of harm solidly grounded in reality • Triangulation: working at the same problem from different stand points • Dealing with anomalies – they may just be that (and explainable without undermining the case) • Obtain price and sales data, over time, to different groups of customers • Delivered prices and ex-factory prices

Approach • Make initial product selection • Talk to all market participants; producers, major buyers and consumers, possible supply side substituters • Gather other evidence on price trends and volumes • Test product selection against all the evidence - revise market definition if appropriate • Look for pragmatic and workable solution using facts not assertion

Product Market Definition Merger of Brand C and D Brand E Brand F Brand D Brand C Brand B Brand A Low Quality High Quality Expanded Market Candidate Market Brand C, D and E May Be a Relevant Market

Product Market Definition • It matters where you start • Start narrow • This determines the questions you ask about substitution • Need to understand from consumers what and why they are buying – how they view the product (where, when consumed?)

What is Meant by Geographic Market? • Geographic market refers to the location of production (when price discrimination is not a concern). • Geographic market refers to the location of consumption (when price discrimination is a concern).

Geographic market • Equivalent to product definition • Geographic markets within country? • With regard to international trade flows? • To what suppliers can consumers switch? • Transport costs • Trade flows: imports, exports, transport flows within country • Other barriers • May be asymmetric

Geographic Market Definition Note that the market is location of production - not consumption - when price discrimination is not possible. Merger Between Company B and D Company A Expanded Market Companies A, B, and D May Be the Relevant Market Company B Company C Company D Candidate Market Company E Company F Econo-land

Note: Cellophane fallacy • What is the appropriate counter-factual? • The ‘competitive price’? • A profit maximising monopolist would operate such that any rise in price was not profitable • Have to form a view about the current price

Price Correlation “Theory” • If two products or geographies are in the same market then the price of each will have a constraining impact on the other. Price correlation theory suggests that when the prices of two products (that are substitutes) are highly correlated, each product places some constraint the on the price of the other product. • The idea is that switching by marginal customers should keep relative prices unchanged. • Price correlations have been extensively used for purpose of market definition, especially in Europe, where agencies have used them, but also in U.S. (e.g., high fructose corn syrup, where, though agencies have shied away from using them, courts have accepted them). • Using price correlations analysis to define the market is suspect and should generally be avoided.

Market Definition Through Price Correlation: What Kind of Data Do You Need? • Price correlation analysis has been used to define the geographic market and the product market. • Geographic market definition • Price data over time for the same product in two geographic areas • Product market definition • Price data over time for two different products in the same geographic area • Price data across different geographic areas for two different products

What Does High Price Correlation Look Like? PB PA x x x x x o x o x x x o o o o x o o x o x o x o o o Time

Correlation Does Not Mean Causality • Sales of rum and number of lawyers are positively correlated. What does this mean? • Both the sales of rum and the number of lawyers are correlated with the number of people in the U.S. As the number of people increases, it causes an increase in demand for both lawyers and for rum. • If you adjusted for the number of people, for example by computing the sales of rum and the number of lawyers per capita, then the association would disappear. • There are many examples where a high correlation between two variables can be explained by a third factor. Always look for an alternate explanation of the correlation.

Using Price Correlation Analysis Can lead to a Overly Broad Market Definition • Common Influences • Common inputs, correlated demands over time (e.g., GDP effect, inflation) • Cost advantages • Incumbent may price just below the price level of another product to keep it out of the geographic area. This strategy leads to high price correlations. • Cellophane problem • Colluding firms will raise price and “use up their monopoly power” to the point where other products become good substitutes.

Using Correlation Analysis May lead to a too Narrow Market Definition • Multiple poor substitutes • Often referred to as death by a thousand cuts. • Products can be negatively correlated and still be good substitutes. • R&D reduces the cost of one good over time and making it a better substitute over time. • Good news over time increases the price of one product while reducing that of another (e.g., Ford and Hyundai)

Further issues • Two sided markets • Primary and secondary products (and after-markets) • Measuring capacities or actual production and sales volumes • Temporal/seasonal markets

Market Power • Market definition is only an intermediary objective, what is more important is to assess market power in the defined market • Market power measures the extent to which a firm can act independently of consumers and competitors? • Competition is a means, not an end; it constrains market power • Why worry? • The power of consumers versus the power of producers - we are all consumers, but producers maximise profits? • Efficient organisation of production across the economy requires matching the value placed on goods with the costs of producing them • In the absence of market power (and lots of other assumptions holding) the free market system achieves this

Assessment of Market Power The traditional approach • Central role of market shares • Which thresholds for market shares? • Measurement and relative strengths (reserves, capacities, persistence of shares) • Ease and likelihood of entry • Buyers’ power • Import competition Econometric techniques • Estimation of residual demand elasticity • Logit models

Challenges in assigning market share • Common denominator • Output measures • Bread (weight vs. slices vs. loaves) • Toilet paper (rolls vs. sheets, vs. length) • Coal (ton from one mine may produce same heat BTUs as two tons from another, low sulfur vs. high sulfur coal) • Sweeteners (some sweeteners are 200 times more powerful, by weight, than sugar) • Durable vs. non-durable products (in surgery, durable product may be used hundreds of times, non-durable just once, though purpose is same) • Revenue measures • Shares assigned on basis of revenues may account for efficiency and durability differences, at least in part • Challenges: • price differences may be based entirely on brands (e.g. store brands may be cheaper than name brands, but not objectively inferior) • Integrated and non-integrated products (e.g. chips may be sold with a dip included, while at other times with dip excluded

Concentration indices • Concentration indices are statistics of the degree of concentration in a given market • Could look at market shares: below 35%, above 45% • Another popular index is the Herfindahl-Hirschman Index (HHI), given by the sum of the squares of the market shares (in percentage terms) of all the firms participating to the market • A market with a result of 1,000-1,800 is considered to be a moderately concentrated ;1,800 or greater to be a highly concentrated • HHI is only one measure of concentration and can provide some initial guidance as an exclusionary measure ( • low HHI and low HHI change in correctly defined market generally suggests little competitive effect from merger • high HHI and high HHI change does not establish competitive effect. • As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise concerns.

Constraints on market power • Price elasticity of demand: the responsiveness of quantity to price • Very responsive (highly elastic): • an increase in price means a very large reduction in quantity purchased; • a lower price means a very large increase in quantity purchased • Inelastic: means there will only be a very small reduction in quantity for an increase in price • Lerner index: the markup of price over marginal cost, expressed as a proportion of price

Constraints (over time)? • The availability of substitutes: • Good substitutes means a change in the price of one product leads to switching and big changes in the quantities purchased of each: cross price elasticities of demand (response to changes in relative prices) • The ability of competing firms to respond (capacity constraints) • Likelihood of entry: sunk costs; access to inputs; marketing/advertising expenses; reputation of incumbent • Countervailing power

Welfare effects • Allocative efficiency: pricing with market power means under-consumption of these goods (a mis-allocation of goods produced to consumption) • Productive efficiency: using the resources efficiently to minimise the costs of production • Dynamic efficiency: the incentives and allocation of resources for changing what is possible: R&D, innovation etc. • High profits could be good: enables funding for product development (although also encourages rent seeking)

Barriers to Entry • Entry barriers are factors that make entry unprofitable while permitting established firms to set prices above marginal cost and persistently earn monopoly returns • Barriers to entry exist only if after entry, the entrant’s long-run costs are greater than those of the incumbent • Three factors generally contribute to entry barriers: • Economies of scale • Product differentiation • Absolute cost advantages • These are entry barriers because they are potential sources of disadvantage for entrants vis-à-vis incumbents.

Economies of Scale • Economies of scale imply that the entrant has to have minimum market share to be profitable • The ability to sink costs allows incumbent to commit to greater level of output, thereby restricting the equilibrium market share of the entrant • Incumbents can strategically deter entry of an equally efficient rival if there are economies of scale and some mechanism whereby the incumbent can commit to producing greater output • The greater the economies of scale the smaller the required degree of commitment

Product Differentiation • Product differentiation is a barrier to entry if it leads to significant buyer preferences between established products and the products of new entrants. • We assume that entra • nts cannot enter and produce a product identical to the incumbents from the customer’s perspective • Product differentiation can raise entry barriers when it reduces the size of the market and thereby enhances the effect of economies of scale • Incumbent products that have characteristics that appeal to most consumers or that have greater cross-elasticities of demand with an entrant’s product will reduce the profitability of entry

Absolute Cost Advantages • Absolute cost advantages make entry deterrence on part of incumbent more likely • Absolute cost advantages occur when the incumbent firm has lower average costs than an entrant at any potential scale of operation

Barriers to Entry (cont.) • Product differentiation, economies of scale and capital cost differentials create entry barriers because of the costs of information • To the extent that product differentiation, economies of scale and cost differentials create entry barriers and preserve monopoly profits, they supplement the incentives provided for research and development • Barriers to entry into production reduce barriers to entry into innovation and vice versa.

Theories of Harm • Unilateral effects (horizontal mergers) – Market power – Elimination of an effective competitor • Co-ordinated effects (horizontal and vertical mergers) – Ability to collude, market structure, number of players – Flow of information, detecting cheating, retaliation • Foreclosure (vertical mergers) – Input or customer • Portfolio effects (conglomerate mergers)

Key Factors in Assessing Strength of Competition Factors considered when assessing the strength of competition in the relevant market • Actual and potential levels of import competition • Ease of entry, tariff, regulatory barriers, contestability of the market • Trends in concentration, history of collusion • Degree of countervailing power • Dynamic characteristics of the market, growth, innovation, product differentiation • Nature and extent of vertical integration: foreclosure, collusion • Failing firm arguments • Removal of an effective competitor

Weighing of Efficiency Gains • Evaluation of technological, efficiency or other procompetitive gains • Defence to an anti-competitive merger or restrictive vertical or horizontal practice • Efficiencies must be quantifiable, sustainable, and attainable by no means other than the merger or restrictive conduct • Total welfare concept vs consumer welfare concept. Consumer welfare more important consideration.

Introduction to Competition Analysis