BSc Economics and related programmes Economics of Competition and Regulation EC 3015 Week 3: Market definition

Overview Why we need market definition Key ideas: – substitutes – constraints on pricing Hypothetical monopolist /SSNIP approach Practical methods and examples 2

Market definition... is a preliminary stage in the assessment of competition, such as: the existing state of competition in a market, or the effect of a merger on competition. Reasons for market definition 3

Reasons for specifying a market definition The market is the context in which competition is assessed, e.g.: – Significant lessening of competition (mergers) – Significant market power (ex ante regulation) Practical: impossible to consider every possible way of specifying the market Choice may be contentious: => must be – clear – based on evidence Reasons for market definitionKey ideas 4

Example: Vue/Ster cinema merger OFT referred a merger between 2 cinema chains. Concern about SLCs in: – Romford/Upminster/Thurrock area – Leeds – Edinburgh – Basingstoke Questions: – what is the product market? – how to define the geographic market? Reasons for market definitionKey ideas 5

The product market Candidates – cinema exhibition of films/movies – films including DVD – the leisure market including restaurants Reasons for market definition Key ideas 6

Which market definition makes most sense to you for assessing competition? 1.Cinema exhibition of mainstream movies 2.Cinema and DVD movies 3.Leisure activities including dining out 4.Something else or don’t know 7

Key ideas Substitution: – if two goods are good substitutes they are effectively in the same market Constraining pricing power – if the presence of another product “B” limits the ability of “A” to raise prices above competitive levels then B is in the same market as A These ideas are obviously related Key ideasReasons for market definition 8

Hypothetical monopolist test -a framework for considering market definition. X Y Z X = e.g. Cinema exhibition of films (the main activities of the merging firms) Y= e.g. Films and DVD (A broader selection of activities) Z= e.g. films + DVD +leisure activities (A broader still selection of activities) “It is an alternative to ad hoc determination of the relevant market by arguments about product similarity.”LinkLink Reasons for market definitionKey ideasHypothetical monopolist test 9

Hypothetical monopolist test (2) 1. Start with the narrowest definition (X) 2. Could a hypothetical monopolist of X raise price above the competitive level? Or does the presence of the extra products in Y (DVDs) make this impossible? X Y Z If yes, keep this as the definition and stop If so, new definition is Y. Repeat the procedure with Y and Z Reasons for market definitionKey ideasHypothetical monopolist test 10

Hypothetical monopolist test (3) What do we mean by “raise price above the competitive level” ? A S mall but S ignificant Non-transitory I ncrease in P rice X Y Z Hence, a SSNIP test Usually 5-10% CC mergers 5% Typically around a year Reasons for market definitionKey ideasHypothetical monopolist test 11

Attempt Workshop Activity 3 around now Reasons for market definitionKey ideasHypothetical monopolist testPractical methods 12

Workshop Activity 3 feedback Reasons for market definitionKey ideasHypothetical monopolist testPractical methods 13

Question 1 14 Case Elasticity - definition X Elasticity - definition Y Elasticity - definition Z A B C D X Y Z

What is the relevant market for case A? 15 1.X 2.Y 3.Z 4.Contradictory/unclear X Y Z AX: -1.8Y: -1.0Z: -0.5

What is the relevant market for case B? 16 BX: -0.4Y: -1.5Z: -5.6 X Y Z 1.X 2.Y 3.Z 4.Contradictory/unclear

What is the relevant market for case C? 17 CX : -7.4Y: -6.1Z: -2.0 X Y Z 1.X 2.Y 3.Z 4.Unclear/ contradictory

Case D? 18 DX: -12Y: -2.1Z: X 2.Y 3.Z 4.contradictory/unclear

What is the nearest to competitive price? >7

Elasticity?

Monopoly price?

Elasticity at monopoly price?

Some practical methods Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Journey time analysis (“isochrones”) Reasons for market definitionKey ideasHypothetical monopolist testPractical methods 23

Price level comparisons Law of one price: Homogeneous products in same market will have the same price because of arbitrage. Large price differentials (if unexplained by quality differences) tend to indicate separate markets Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 24 Practical methods

Price correlations Similarly, if prices move closely together (for differentiated products)  suggests in same market Issues: How closely is “closely?” Can we get a benchmark Deflate by RPI or CPI first? Some other cause of correlation? Use stationarity & other analyses to correct for possible biases? See conference paper by MnCube et.al.MnCube et.al Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 25 Practical methods

Price correlations Examples mentioned in MnCube et al: 1. “Stigler and Sherwin (1985) used correlation analysis to test whether the cities of Chicago, Detroit and New Orleans are in the same market for wholesale petrol. They correlate monthly fuel prices in the three cities during the period inclusive. Their results indicate that the correlation coefficients are very high: the coefficient between New Orleans and Chicago is 0.792; that between New Orleans and Detroit is 0.967; and that between Chicago and Detroit is 0.77, hence the three cities are in the same market.” 2. Nestlé/Perrier (EU) (1992) 3. Rexam/AN (2001) Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 26 Practical methods

Demand elasticities See examples in workshop 3 Own elasticities: “low” elasticity => we have found relevant market. How low is low? Cross elasticities: High cross elasticitiy suggests we should add another product/location Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 27 Practical methods

Critical loss analysis When we do not have econometric estimates, but have a knowledge of costs: “Critical Loss Analysis calculates the hypothetical monopolist’s Critical Loss, meaning the magnitude of lost sales that would (just) make it unprofitable for the hypothetical monopolist to impose a SSNIP, and compares it against the so-called Actual Loss of sales that would result from the SSNIP. If the Actual Loss would be less than the Critical Loss, the SSNIP would be profitable, so PNOS would form a relevant market.” Farrell and Shapiro “Improving Critical loss analysis” linklink See Workshop 3 for an example Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 28 Practical methods

Diversion ratio analysis Response to question: If you could not buy A, what would you buy instead? B? C? It is a hot summer’s day and you fancy a Coke. But the Coke is all gone... Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 29 Practical methods

What will you have instead? 30 1.Pepsi 2.Dr Pepper 3.Lemonade 4.Other soft drink 5.Hot drink 6.Beer 7.Other 8.I do not drink Coke

Diversion ratio analysis Does not require actual behaviour (revealed preference) to be observed. But Stated Preferences tend to be mistrusted by economists In combination with other techniques can provide corroboration (or otherwise) Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 31 Practical methods

Price-concentration studies Based on structure-conduct -performance paradigm Do prices depend on concentration in this candidate market? If so, suggests it is a relevant market Example: Staples/Office World As always, econometric studies are contested! Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 32 Practical methods

Transport costs Useful for geographic definition If transport cost are low between P & Q  suggests P & Q are in same geographic market (can be checked by comparing prices and price trends) Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 33 Practical methods

Isochrones Useful for geographic definition: Used in CC inquiries: Supermarkets, SE airports, Vue/Ster merger, Stericycle (hospital waste) Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 34 Practical methods

Isochrones Simplified case: Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 35 Store max distance travelled by most consumers

Isochrones Simplified case: Price level comparisons Price correlations Demand elasticities Critical loss analysis Diversion ratio analysis Price-concentration studies Transport costs Isochrones 36 Store A max distance travelled by most consumers Store B Overlap area Are there enough consumers in the overlap area to constrain the pricing of the other store? If so they are in the same market

Summary Some basic theory to learn Understand the SSNIP test Many practical methods Widely used because competition agencies require objective, auditable evidence Different parties submit competing analyses Interesting field for an applied economist More next week, including “Cellophane fallacy” 37