05 market definition and tests of market power

Market Definition and Tests of Market Power

Christian Michel

Universitat Pompeu Fabra

Fall 2013

Christian Michel (UPF) Tests of Market Power Fall 2013 1 / 22

Key objectives of this lecture

Understand the difficulties of measuring market powerIntroduce tests of market definitionIntroduce basic tests of market power


Introduction

So far derived market power theoreticallyI Cournot

I Differentiated Bertrand

I Collusive Equilibria

Now try to assess market power empiricallyThis lecture: definitions and basic tests

I Next lectures: Empirical “structural” framework


Problems of Computing Market Power

Lerner Index: Li = pi−cipi

The Achilles Heel of Industrial OrganizationMarginal costs are not observable (at least not in a reliable way).

Usually at best aggregate accounting data availableI Not a good proxy for a products true marginal costs

I Cannot reliably compute price cost margins directly

Will have to work around this problem1 Define relevant market and use baseline tests

2 Indirect Assessment of market power

3 Direct estimation of market power


Side note

Sometimes price-cost margins can also be misleadingI Monopolies often inefficient

I If entry costs high then low competitive pressures for industry

I Therefore market power can lead to low price-cost margin

Will not pursue this point further in this course


Market Definition

Relevant market“[..], the relevant market should not be a set of products, which’resemble’ each other on the basis of some characteristics, but ratherthe set products (and geographical areas) that exercise somecompetitive constraint on each other. (Motta, 2004)”

Will work with a more specialized definition1 Product Market Definition2 Geographical Market Definition


Is Market Definition important?

Market definition important preliminary stepI Can give important insights about the different rivaling products

I Might also help setting up

I Ultimate goal to assess market powerPractically important for various reasons

I Computing market sharesI Focus on important rival firms


Product Market Definition – SSNIP Test

SSNIP: Small but Significant Non-Transitory Increase in Prices“Suppose that there exists a hypothetical monopolist that is the onlyseller of bananas. Would this hypothetical monopolist find it profitableto increase the price of bananas above the current level in anon-transitory way? (Motta, 2004)”

Idea: if market defined broadly enough, then all potentialsubstitutes will also be owned by market monopolist

I If test yields yes: market is defined broadly enough

I If test yields no: need to include more products for market definition

Also called Hypothetical Monopolist Test

Next show how to apply several variants of the test


SSNIP 1: Demand and Supply Substitutability

Natural to think first of products that are considered as substitutesfor consumersBut supply-side substitutability also possible

I If firms can quickly change production process towards otherproduct

I Also constraints competitorsExample (Motta, 2004): bus service between cities A and B:

I Train probably bad substitute

I But if there are different bus providers in city A, and different in B,they might access the route

I Thus market can be defined more widely than only the city


SSNIP 2: Supply Substitutability vs Entry thatconstraints Market Power

If entry costs (and time) are low, this will be another competitivethreat to existing firms

I Will lower market power

I Can then use wider market definitionWider market has two effects

1 Market shares of will usually be lower for single firms (harmonizeout over different markets)

2 Antitrust authority have to discuss less with other parties about highmarket share definition


Beware of the “Cellophane Phallacy”

Suppose one firm only seller in a well defined marketI Monopolist will set prices such that further increase in prices is not

profitable anymore

I Therefore, SSNIP will call for wider market definition – because firmis dominant

I du Pont Cellophane caseF Finally, high elasticity of substitution between products was used

against du PontF Set prices so high that consumers substituted to inferior goods

Important in non-merger cases, such as abuse of dominantposition


SSNIP - Implementation 1: Elasticities

Own-price elasticitiesI ε ≡ −

dQQdpp

F Elasticity normalized by - sign: .2 means if price increases by 10%,quantity decreases by 2%

I Very insightful about how close the pricing is to monopoly pricing

Cross-price elasticitiesI How easily do people switch from firm A to firm B

I Helps inferring what the closest substitute is

I If low: indicate not real substitutes

But have to be observable to compute the testI Econometric estimations

I Sometimes evidence from surveys


SSNIP - Implementation 2: Prices

Price correlationsI Idea: products in same market tend to have same price movement

over time

I Problems 1: sales periods, differences movements of input items

I Problems 2: Falsely infer same market because of common pricemovements across different product categories

F inflation: can affect demand

F oil price: supply shock

Price differencesI Idea: products in same markets have roughly same prices

I But highly problematicF Example: Kellogg’s Corn Flakes same ingredients as no name corn

flakes, still more than twice the price:F Brand valuation differs for different products in same market, thus

prices should do so, too


SSNIP - Implementation 3: Product Characteristicsand Temporal Markets

Physical product characteristicsI Thirst quenchers: mineral water and lemonade differ hugely in

sugar contentI Look at consumer surveys

Temporal marketsI Restaurants and bars might compete for lunch (sandwiches), but

not for (fancy) dinnerI Some fruits only available in winter time (e.g. oranges): cannot

compete the whole yearSecondary markets

I CarsI Washing machinesI Large used market that might partly ensure competition for the new

product market


Geographical Definition

Similar to product market SSNIP testExample: “Would 5% price increase in country x be profitable forhypothetical monopolist in industry?

I If yes: country is market defined as geographical market

I If no: need wider definition

I In some cases can even start smaller: for example county level


Geographics 2:

Role of imports (shipment test)I Do imports account only for small part of consumption?

I Do exports only account for small part of production?Transportation costs

I Importance of transportation costs relative to prices

I If low, then market tends to be geographically biggerF Food retailers usually only considered to compete within same city

F Market for aircrafts global

Other characteristicsI Preferences sometimes follow local borders

I Merger between Spanish and French TV station might be lesscritical than merger between two Spanish stations


Indirect Assessment of Market Power – Market Shares

Market shares often given important role in market power analysisI si = 1: Monopoly – should have high market power

I Small market share should have low market power (if market is welldefined)

I But not sufficient to argue that a large market power firm isdominant

Very often market shares first screening deviceI OFT guidelines: below 40% market share for one firm no danger of

being dominant, over 50% market share: dominance can beassumed

I Not so clear guidelines in other jurisdictionsMeasuring market shares

I Units: number of products sold: relative market positionI Values: economic meaning


Market Shares and Concentration

Important to distinguish between individual and industry markupsI Assume constant marginal costs ci

I πi = p(Q)qi − ciqi

I dπidqi

= p(Q) + dpdqi− ci = 0

Lerner index for firm i according to model:Li = p∗(Q)−ci

p∗ = −qiQ

1dQdp

pQ

= siε

Under monopoly this yields Li = 1ε


Concentration cont.

Industry Lerner Index L ≡∑n

i siLi =∑n

is2

iε

With HHI ≡∑

i s2i : L = HHI

εI HHI: Herfindahl Hirschmann Index: very important concentration

measure

I Also used in many other economic subfields as measure forconcentration

I Advantage: Easy to estimate given market shares

Industry Lerner index here is measure for market power derivedunder Cournot conditions


Entry and endogenous sunk costs

ContestabilityI If entry is easy, high concentration should not be able to increase

market power muchEndogenous sunk costs

I High investment costs needed to enter market, such as R&D, maymake entry more costly and unlikely

I Firms in the industry might strategically make such investments,that’s why “endogenous”

History of entry in marketI How aggressive have incumbents responded to entry in the past?I How often has entry occurred?


Summary

Market definition not of intrinsic value, but important preliminarystep

I Market shares, concentration measures and preliminary tests cangive some useful insights about an industry

I But have to be vary about the weaknesses of the tests

Indirect tests of market power especially important when data formore elaborate empirical model are not available

Each industry is different: cannot apply a general rule to all


Next Steps

Estimate Demand

Compute elasticities using structural model

Recover marginal costs


05 market definition and tests of market power

Documents

market definitionalso

market monopolisti

set of products

important insights

price of bananas

low pricecost marginwill

products true marginal

transitory way