MSc in Business Economics/ Int business Economics Market Definition

Economics of Competition and regulation

Market definition

Why we need a market definition

Consider a case involving the terms of sale for replacement car parts for diesel engines.

Is the relevant market:

·  replacement car parts;

·  diesel engine cars;

·  new cars; or

·  new and second-hand cars?

Furthermore should we look at the local market the UK market, the European market ,

or the global market?

It is normal for the Competition Commission, the European Commission and the Courts to spend some time on the appropriate definition of the market for the problem at issue. In merger cases market definition is often the major determining factor.

Legal reasons

Sometimes the law defines e.g. a scale monopoly in terms of the share of a relevant market, which obviously requires a market to be defined. Competition bodies sometimes issue guidelines which are expressed in terms of shares of the relevant market.

Applications to finding of Dominance:

“The European Court [AKZO case] has stated that dominance can be presumed in the absence of evidence to the contrary if an undertaking has a market share persistently above 50%. The Director general considers it unlikely that an undertaking will be individually dominant if its market share is below 40%, although dominance could be established below that figure if other relevant factors (such as the weak position of competitors in that market) provided strong evidence of dominance.”[1]

Application to assessment of “Appreciable Effect” in anti-competitive agreements:

“The Director-General takes the view that an agreement will generally have no appreciable effect if the parties’ combined market share of the relevant market does not exceed 25% although there will be circumstances where this will not be the case.”[2]

Practical reasons

In order to avoid ambiguity (e.g. who are the competitors) it is important to be clear about the market. The process of market definition may itself yield insights into the economic issues.

However, it is unlikely that a sound economic analysis would find its conclusions greatly altered simply by defining the market in a different way, so if the definition makes an important difference to your analysis (as opposed to conclusions on jurisdiction), you should ask yourself why. The OFT considers alternative definitions and considers the sensitivity of its findings to these alternatives.

Why market definition may be contentious

Contrary to the assumptions of the perfectly competitive firm, there are no definite limits to a market. Despite recent attempts to make the process more objective, there is ultimately an element of judgement. Each party to a case may find that one definition suits its position better.

For example, firms involved in mergers typically want the definition cast wider so that market shares look smaller. Customers, especially those who regard themselves as "captive" may argue for a narrower definition. The same applies to competitors who may oppose a merger because they think it puts them at a commercial disadvantage.

The economic concept of a market

The term market is used in the ordinary sense to indicate a place where trade takes place. For competition policy purposes we need to think in more general terms.

The starting point for market definition is the law of one price. Within a single market for a homogeneous commodity there will only be one price, for no one would buy at the high price. (Or if they did, no one would sell at the low price.)

This is obviously an idealised situation. Even where the product is homogeneous different buyers will have different information, or different costs of collecting information, and this can give rise to a price spread reflecting the costs of finding out about the lower prices.

Once goods are differentiated, either in terms of product characteristics or distance in space or time, the possibilities for price differences increase.

The key issue: ability to raise price

For competition policy purposes we are usually interested in whether having control of the whole "market" would (hypothetically) confer the ability to raise price above competitive levels. If the answer is no, then monopolisation would have no price effects and the market has been defined too narrowly. If the answer is yes, we should consider narrowing the market definition.

We can always get to the answer yes by broadening our definition sufficiently. The economic market is therefore the narrowest group of products where a hypothetical monopolist would raise prices above the competitive level.

This is called the hypothetical monopolist test. A more specific version is called the SSNIP test (see below).

Substitutability as the criterion

The limit on any monopolist's ability to rise price is the availability of substitutes. Thus the definition of the market often boils down to an analysis of substitutability.

Examples: Wet baby foods and dry baby foods, wet shaving and dry shaving. Which pair belongs in different markets, which in the same? Is dry shaving in the same market as dry baby food?

Product and geography

There are always two dimensions to market definition - the product and the geographic market. As the car part example indicates we need to make sure we get the geographic market definition right as well.

Consider the market for furniture. Suppose consumers in town A will often drive to town B for shopping, those in B to C, those in C to D, etc. Then we have a chain of substitutes. The normal approach to defining the market is to look for a break in the chain of substitutes as the boundary of the market. For many goods in Britain the English Channel has formed such a break, but for many people the gap is not big enough to overcome, say, beer price differentials.

Some formal definitions

The EC Commission Notice on Market Definition (1997)[3] uses the following approach:

“…the concept of relevant market is different from other concepts of market often used in other contexts. For instance, companies often use the term market to refer to the area where it sells its products or to refer broadly to the industry or sector where it belongs

“The regulations based on Articles 85 and 86 of the Treaty, in particular in section 6 of Form A/B with respect to Regulation 17, as well as in section 6 of Form CO with respect to regulation 4064/89 on the control of concentrations of a Community dimension have laid down the following definitions. Relevant product markets are defined as follows:

"A relevant product market comprises all those products and/or services which are regarded as interchangeable or substitutable by the consumer, by reason of the products' characteristics, their prices and their intended use."

“Relevant geographic markets are defined as follows:

"The relevant geographic market comprises the area in which the undertakings concerned are involved in the supply and demand of products or services, in which the conditions of competition are sufficiently homogeneous and which can be distinguished from neighbouring areas because the conditions of competition are appreciably different in those areas".

“The relevant market within which to assess a given competition issue is therefore established by the combination of the product and geographic markets. The Commission interprets the definitions at paragraphs 7 and 8 (which reflect the jurisprudence of the Court of Justice and the Court of First Instance as well as its own decisional practice) according to the orientations defined in this Notice.

The previous approach, fund on Merger Regulation notification form CO. This applied before the current EC Commission market definition notice, also included the following text:

" A relevant product market may in some cases be composed of a number of individual product groups. An individual product group is a product or small group of products which present largely identical physical or technical characteristics and are fully interchangeable. The difference between products within the group will be small and usually only a matter of brand and/or image. The product market will usually be the classification used by the undertaking in its market operations."

"Factors relevant to the assessment of the relevant geographic market include the nature and characteristics of the products or services concerned, the existence of entry barriers or consumer preferences, appreciable differences of the undertakings' market shares between neighbouring areas and substantial price differences."

Although these correctly identify the importance of substitutability by consumers, such broad shopping lists are not very helpful as a practical guide. The 1984 US merger guidelines (updated 1992). This defines the market as follows:

"Formally, a market is defined as a product or group of products and a geographical area in which it is sold such that a hypothetical, profit maximising firm, not subject to price regulation, that was the only present and future seller of those products in that area would impose a 'small but significant and non-transitory' increase in price above prevailing or likely future levels"'[ssnip].

The 1997 EC notice on Market Definition ( on the Internet, handed out with these notes, also at CMLR 4,177(1988) also incorporates the possibility of carrying out the ssnip test. . . "One way of making this determination [about substitutes] can be viewed as a speculative experiment, postulating hypothetical small, lasting change in relative prices and evaluating the likely reaction of customers to that increase." (Note the absence of a reference to the profitability of such a change.)

Although there are a number drawbacks to this approach, it has the advantage of being directed at the objectives of competition policy and relatively specific, in that it points

the way to particular tests that could be made. Uncertainties that arise in particular applications can be resolved in the spirit of the guideline.

The ssnip test is most useful in looking prospectively at mergers. For existing monopoly situations one might reasonably assume that any profitable price increases have already been made.

The EU Commission Notice suggests role for the snip test:

“The assessment of demand substitution entails a determination of the range of products which are viewed as substitutes by the consumer. One way of making this determination can be viewed, as a thought experiment, postulating a hypothetical small, non-transitory change in relative prices and evaluating the likely reactions of customers to that increase. The exercise of market definition focuses on prices for operational and practical purposes, and more precisely on demand substitution arising from small, permanent changes in relative prices. This concept can provide clear indications as to the evidence that is relevant to define markets.”

“Conceptually, this approach implies that starting from the type of products that the undertakings involved sell and the area in which they sell them, additional products and areas will be included into or excluded from the market definition depending on whether competition from these other products and areas affect or restrain sufficiently the pricing of the parties' products in the short term.”

“The question to be answered is whether the parties' customers would switch to readily available substitutes or to suppliers located elsewhere in response to an hypothetical small (in the range 5%-10%), permanent relative price increase in the products and areas being considered. If substitution would be enough to make the price increase unprofitable because of the resulting loss of sales, additional

substitutes and areas are included in the relevant market. This would be done until the set of products and geographic areas is such that small, permanent increases in relative prices would be profitable. The equivalent analysis is applicable in cases concerning the concentration of buying power, where the starting point would then be the supplier and the price test allows to identify the alternative distribution channels or outlets for the supplier's products. In the application of these principles, careful account should be taken of certain particular situations as described under paragraphs 56 and 58.”

“A practical example of this test can be provided by its application to a merger of, for instance, soft drink bottlers. An issue to examine in such a case would be to decide whether different flavours of soft drinks belong to the same market. In practice, the question to address would be if consumers of flavour A would switch to other flavours when confronted with a permanent price increase of 5% to 10% for

flavour A.. If a sufficient number of consumers would switch to, say, flavour B, to such an extent that the price increase for flavour A would not be profitable due to the resulting loss of sales, then the market would comprise at least flavours A and B. The process would have to be extended in addition to other available flavours until a set of products is identified for which a price rise would not induce a sufficient substitution in demand.”

Specific techniques

Common sense often goes a long way to help. For example, the MMC decided to include matches and disposable lighters in the same market. Although physically different, they perform the same function and for most purposes they are good substitutes.

But to the extent that this relies on introspection it is subject to small-sample estimation inaccuracy. To inject objectivity in the process, a range of techniques may be used. It is useful to be aware of some of the more formal approaches which may be employed by others or may be required where common sense gives no clear guidance.