TOPIC 11: MARKET DEFINITION

Topic 11| Part 1 26 September 2013Date

ANTITRUST ECONOMICS 2013David S. EvansUniversity of Chicago, Global Economics Group

Elisa MariscalCIDE, Global Economics Group

2Overview

Part 1

Role of Market

Definition

General Principles of

Market Definition

Hypothetical Monopolist

Test

Critical Loss Analysis

Part 2

Overview of Issues in

Multisided Platforms

The Case of Additive Prices

Newspaper Markets

One-Sided Biases

3Key Questions to Think About

Why “market definition” isn’t used by economists outside of their work on competition policy matters.

Why “market definition” is used by courts and competition authorities

Could the courts and competition authorities dispense with market definition?

What is the role of false positives and negatives in market definition analysis, and does it matter whether it is merger or non-merger?

4Things You Really Need to Know

Relevant market and why it isn’t the same as what laypeople or businesspeople might call a market

Hypothetical monopolist test which is very popular among competition authorities

The SSNIP test which is the name of the standard way of implementing this test.

5 Role of Market Definition

6Market Definition and Market Power

Market power is important for assessing whether a firm has the incentive and ability to engage in anti-competitive behavior and whether merger will result in an increase in market power

Market power depends on the constraints that a firm faces in increasing the price of a product profitably; these constraints typically involve substitutes in demand and changes in supply by other firms.

The “market” identifies the producers the impose significant constraints on the power or a firm or group of firms to raise price profitably.

Market definition is primarily (perhaps solely) used for the purpose of helping the courts and competition authorities assess dominance/market power.

7Market Definition and Context

• Identifies sets of firms, substitution patterns, and strategic relationships among firms.

Market definition provides a context for examining firm strategies

Market definition limits the discussion of rival products and firms to a manageable group.

Firms in the market

A, B, C, D, E

Firms outside of the market: F, G, H, …

F G

H

8Market Definition and Measures

• Share = Sales of firm’s product/total sales in the “market”

Courts and competition authorities use “market share” as an indicator of possible “market power” or “dominance” for a firm (or group of firms in the case of collective dominance)

• Bigger market results in smaller share• Smaller market results in bigger share

Must make decision on what other products compete in the “market” to calculate the denominator of share.

Other measures of concentration such as the HHI are based on market shares (HHI is sum of the shares, each squared, of all the firms in the market—see below).

9Market Definition, the Case Law, and Economics

“A relevant product market comprises all those products and/or services that are regarded as interchangeable or substitutable by the consumer, by reason of the products' characteristics, their prices and their intended use." (EC Notice of Definition of Market)

• Market share calculations put equal weight on all products in the market and zero weight on all products outside the market; no economic basis for this and it is obviously wrong.

• By putting products outside of the market we lose information which may be valuable and may make errors if the products outside do matter

• Economist claim they can analyze economic effects of business practices without defining the market first (is this true?).

Economists see constraints on market power as a continuum rather than having some products “in” the market vs. “outside” the market.

10

Market Definition Sets Hard Boundaries Between Products that are “In” or “Out” of the Market.

Think of the “Hotelling Line” with many ice cream stands on a beach of infinite length. Start with stand in the middle. Market definition would say that there is a definite point at which stands to left or right are not “in the same market” because they don’t impose enough of a constraint.

Out OutIn

Product in question

Continuum of product substitutes—farther away are less substitutable

11 General Principles of Market Definition

12

Identifying Relevant Substitutes by Asking What Would Constrain an Increase in Price

The goal of market definition is to identify the group of products which provide significant and timely competitive constraints to the firm/product as issue.

Product market

Geographic market

Demand-side Supply side

How will marginal

customers react?

Will customers buy from

other areas?

Would firms in one area supply

another?

Will producers of other products divert capacity?

13Demand-side substitution

Substitution among products provides the main immediate competitive constraint and therefore plays the most important role in market definition in practice

“Average” customers are not necessarily relevant. What matters most is the behavior of “marginal” customers – the ones who are most likely to move between products as a result of price changes and who therefore have biggest impact on revenue changes.

Asymmetric substitution• “Will the average buyers of product A switch to product B?” is not the same

question as “Will the average buyers of product B switch to product A?” since neither is necessarily the marginal consumers who matter

• Key question is whether many consumers are at the “margin” between using this product or an alternative and would switch following a price increase

14

$ 0

$ 1

$ 2

$ 3

$ 4

$ 5

$ 6

$ 7

0 1 2 3 4 5 6 7 8 9 10

Pric

e pe

r Pin

t

Pints of Beer Demanded (Millions per Year)

Pub Beer

Demand-side substitution and the marginal consumer

The “average” consumer may not switch to a substitute product in response to a small price increase; producer needs to worry about what consumers “at the margin” between buying and not buying the product will do.

O

G is not a consumer of beer at current prices

A,B, C, D are at “the margin” of buying or not buying beer.

F is an “average consumer” of beer (from O to C)

F

DC

A

BG

15Supply-side substitution

Would firms quickly switch capacity to producing demand-side substitutes for the product of the firm under investigation in reaction to a price increase of that product?

Relevant when firms can produce a range of different products using the same, or very similar, technologies and assets

• For example,• Can the same plants be used to produce different products?• Can competitors utilize their existing marketing and distribution networks for

new products?Geographic market is often important for assessing supply-side substitution

• Will firms in distant economic areas increase supply?

16Standard Steps for Identifying a Relevant Market

The first step is to consider a reference “product” (or “products”)

• The “candidate market”

Identify the closest potential substitutes for products in the candidate market

• As discussed above, there are two potential sources of substitution• Demand-side substitution• Supply-side substitution

• But which substitutes do we consider?

17

Which products to consider as demand and supply substitutes for BMW’s MINI Cooper

Or maybe buyers of MINI Coopers would switch to scooters or bicycles….

Mini Cooper

Other small cars

Supply of new small

cars

Mid-size cars

All cars All means of transportation

18 Hypothetical Monopolist (SSNIP) Test for Market Definition

19Hypothetical Monopolist Test

Logic of the test

• Is a “market” worth monopolizing?• If yes, then the substitutes outside the “market” must be weak• If no, then the substitutes outside the “market” must prevent the exercise of

market power• Thus the group worth monopolizing pulls in all of the relevant substitutes.

Start with the narrowest candidate market and assume that there is a monopoly supplier

• Could this hypothetical monopolist profitably impose a “small but significant not-transitory increase in price” (SSNIP) or will too many customers switch to demand-side or supply-side substitutes?

• Yes Candidate Market = Relevant Market• No Candidate Market < Relevant Market Include the closest substitutes and

repeat the test

20

How to proceed? Demand-side then supply-side

Potential substitute products

Demand-side

1

2

ACandidate Market

BCD

3 A+B+CSupply-side S1

S2

A+B+C

A+B+C+S1

X

X

21Issues Concerning Hypothetical Monopolist Test

Focuses entirely on price and excludes non-price dimensions of competition. Firms may adjust quality and other attributes to compete instead of price and engage in other non-price strategies not considered.

The assumptions and measures may not be correct

• The standard Lerner equation doesn’t always apply (e.g. two-sided markets).• Estimates of demand and cost may not be reliable.

Cost of errors that lead to “too narrow” a market is that competitive constraints are completely excluded; cost of errors that led to “too broad” is that if all substitutes are weighted the same then overstates competitive constraints.

22

Hypothetical Monopolist Test Depends on Where One Starts

There is not a unique solution to market definition. The market can depend on where one (arbitrarily perhaps) starts.

Starting with small cars competing with scooters could lead to a different answer than starting with small cars competing with large cars

Large Cars

Small cars

Scooters

23Relevant Market at End of Analysis

A, B, C, D, E, F

G, H

I

L

K

A…..F is the “relevant market” based on the SSNIP test. C is the firm whose actions we are assessing. G, H, L, and K are firms that the SSNIP test says are outside of the market.

24

Implementing the Hypothetical Monopolist (SSNIP) Test

Critical Loss Analysis

25

Critical loss analysis is a method for implementing SSNIP test in practice

Step (1)—Profits, output, and sales before the price change for hypothetical monopolist (e.g. products A and B).

MC$10

$20

100

Price

Quantity

Profit = ($20 - $10) x 100 = $1,000

26

Critical loss analysis is a method for implementing the SSNIP test

Step (2): How many units of sales would have to switch to substitutes to make a 10% price increase just unprofitable? Suppose the answer is slightly more than16.7 (with 16.67 roughly break even).

MC$10

$20

100

Price

Quantity

$22

83.33

If fewer than 16.7 units of sales switch than a 10% price increase is profitable

27

Critical Loss Analysis Depends on Customer Switching—an Example of a Calculation

How many customers have to switch to substitutes to make a 10% price increase unprofitable?

Consider this example

• Initial price = $20; MC = $10; Profit Margin = $10; Quantity = 100; Profit = $10 x 100 = $1,000

• New price = $22; MC = $10; Profit Margin = $12; Quantity = 83.33; Profit = $12 x 83.33 = $1,000

This implies that:• If sales fall by less than 16.7% the price increase is profitable• Candidate market is the no wider than relevant market (i.e. a smaller market

could have a profitable price increase too).• If sales fall by more than 16.7% the price increase is unprofitable

• Candidate market is too narrow (one can also say that the true market is even broader than the candidate market).

• The “critical loss” is 16.7%--this is the dividing line.

28 Step (3)--Whether actual loss of sales is higher or lower than the critical loss depends on the elasticity of demand which depends on the slope of the demand curve at the initial price (in previous example critical loss corresponds to a “critical” demand elasticity of 1.66; what if the true demand elasticity was 5.75?)

MC$10

$20

100

Price

Quantity

$22

83.33

Dimplied by critical lossDmore inelastic

Dmore elastic

Regression analyses, natural experiments, and internal market studies can help determine actual loss.

Critical Loss Analysis is a Method for Implementing the SSNIP Test

29

Critical Loss Analysis is a Method for Implementing the SSNIP Test

To conduct the demand-side portion of the test in practice we need

• Marginal costs: data from at least one merging parties (and an assumption that these marginal costs are representative of other players in the market).

• Demand elasticities: natural experiments, regression studies, consumer surveys, diversion ratios are all ways to estimate the elasticity of demand.

To conduct the supply-side portion of the test in practice we need

• Supply elasticities: change in output of substitute products by firms that aren’t currently producing those products

• In practice the supply-side response is usually ignored for critical loss.

30

Comparison of Actual Versus Critical Loss Determines if Market is Large Enough to be Monopolized.

Critical Loss

Actual loss greater than critical loss Implies price

increase is unprofitable so assumed “market” can’t be

profitablyMonopolized and is therefore

too small.

Actual loss less than criticalLoss implies that price increase is profitable so assumed “market” can be profitably monopolized. Market is therefore at least this narrow.

31The Simple Math of Critical Loss Analysis

• For an X% price increase, the critical loss is

• Where M is the Lerner index (% difference between price and marginal cost)

• We can compare the critical loss to the actual loss based on data on elasticity of demand to assess whether a price increase would be profitable

• In the previous example the actual loss will be greater than the critical loss if a 10% increase in price leads to a more than 16.7% decline in sales which means in turn that the elasticity demand is greater than 1.66 (in absolute value).

Formal calculation

MXXCL

PMCPM

32The Simple Math of Critical Loss Analysis—Example

For an 5% price increase with a 50% contribution margin, the critical loss is

Which equals 1/11=roughly 9 percent

We can compare the critical loss to the actual loss based on data on elasticity of demand to assess whether a price increase would be profitable

Suppose the elasticity of demand is 3.0. Then a 5% increase in price would reduce sales by 15%. If correct, we could conclude that the true market is larger.

Suppose the elasticity of demand is 1.5. Then a 5% price increase would reduce sales by 7.5 percent. If correct, we would conclude that the true market is at least this narrow.

50.05.05.

CL

33End of Part 1, Next Class Part 2

Part 1

Overview of Market Definition

General Principles of Market Definition

Hypothetical Monopolist Test

Critical Loss Analysis