Introduction to Competition Analysis

1
Introduction to Competition Analysis

• Regional Training Workshop on Competition Law
  Enforcement
• 13-15 January 2010
• Abuja, Nigeria

2
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

3
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

4
Whats Important When Defining a Market?

• Demand substitution to other
• Products
• Geographic areas
• Supply substitution from
• Quick entry
• Product repositioning

5
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

6
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
7
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??

8
Chain of substitution
A
B
C
D
E
F
G

• 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 ABCDEFG
• This how the new car market has been defined in
  Europe
• Beach model applies to both geographic market and
  product market definition

9
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

10
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

11
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

12
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

13
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

14
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

15
Product Market Definition
Merger of Brand C and D

Brand A
Brand B
Brand F
Brand E
Brand D
Brand C
Low Quality
High Quality
Expanded Market
Candidate Market
Brand C, D and E May Be a Relevant Market
16
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?)

17
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).

18
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

19
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
20
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

21
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.

22
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

23
What Does High Price Correlation Look Like?
PB

PA
x
x
x
x
x
o
x
x
o
x
x
o
o
o
x
o
o
o
x
o
x
o
x
o
o
o
Time
24
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.

25
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.

26
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.
• RD 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)

27
Further issues

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

28
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

29
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

30
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

31
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.

32
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

33
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

34
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 RD,
  innovation etc.
• High profits could be good enables funding for
  product development (although also encourages
  rent seeking)

35
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
  entrants 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.

36
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

37
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 customers 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 entrants
  product will reduce the profitability of entry

38
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

39
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.

40
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)

41
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

42
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.