Market Denition and Tests of Market Power

Christian Michel
Universitat Pompeu Fabra

Fall 2013

Christian Michel (UPF)

Tests of Market Power

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Key objectives of this lecture

Understand the difculties of measuring market power Introduce tests of market denition Introduce basic tests of market power

Christian Michel (UPF)

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Introduction

So far derived market power theoretically

Cournot Differentiated Bertrand Collusive Equilibria

Now try to assess market power empirically This lecture: denitions and basic tests
Next lectures: Empirical structural framework

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Problems of Computing Market Power

Lerner Index: Li =
pi ci pi

The Achilles Heel of Industrial Organization

Marginal costs are not observable (at least not in a reliable way). Usually at best aggregate accounting data available
Not a good proxy for a products true marginal costs Cannot reliably compute price cost margins directly

Will have to work around this problem

1 2 3

Dene relevant market and use baseline tests Indirect Assessment of market power Direct estimation of market power

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Side note

Sometimes price-cost margins can also be misleading

Monopolies often inefcient If entry costs high then low competitive pressures for industry Therefore market power can lead to low price-cost margin

Will not pursue this point further in this course

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Market Denition

Relevant market
[..], the relevant market should not be a set of products, which resemble each other on the basis of some characteristics, but rather the set products (and geographical areas) that exercise some competitive constraint on each other. (Motta, 2004) Will work with a more specialized denition
1 2

Product Market Denition Geographical Market Denition

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Is Market Denition important?

Market denition important preliminary step

Can give important insights about the different rivaling products Might also help setting up Ultimate goal to assess market power

Practically important for various reasons

Computing market shares Focus on important rival rms

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Product Market Denition SSNIP Test

SSNIP: Small but Signicant Non-Transitory Increase in Prices
Suppose that there exists a hypothetical monopolist that is the only seller of bananas. Would this hypothetical monopolist nd it protable to increase the price of bananas above the current level in a non-transitory way? (Motta, 2004) Idea: if market dened broadly enough, then all potential substitutes will also be owned by market monopolist
If test yields yes: market is dened broadly enough If test yields no: need to include more products for market denition

Also called Hypothetical Monopolist Test Next show how to apply several variants of the test

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SSNIP 1: Demand and Supply Substitutability

Natural to think rst of products that are considered as substitutes for consumers But supply-side substitutability also possible
If rms can quickly change production process towards other product Also constraints competitors

Example (Motta, 2004): bus service between cities A and B:

Train probably bad substitute But if there are different bus providers in city A, and different in B, they might access the route Thus market can be dened more widely than only the city

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SSNIP 2: Supply Substitutability vs Entry that constraints Market Power

If entry costs (and time) are low, this will be another competitive threat to existing rms
Will lower market power Can then use wider market denition

Wider market has two effects

1

Market shares of will usually be lower for single rms (harmonize out over different markets) Antitrust authority have to discuss less with other parties about high market share denition

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Beware of the Cellophane Phallacy

Suppose one rm only seller in a well dened market

Monopolist will set prices such that further increase in prices is not protable anymore Therefore, SSNIP will call for wider market denition because rm is dominant du Pont Cellophane case
Finally, high elasticity of substitution between products was used against du Pont Set prices so high that consumers substituted to inferior goods

Important in non-merger cases, such as abuse of dominant position

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SSNIP - Implementation 1: Elasticities

Own-price elasticities

dQ Q dp p

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

Very insightful about how close the pricing is to monopoly pricing

Cross-price elasticities
How easily do people switch from rm A to rm B Helps inferring what the closest substitute is If low: indicate not real substitutes

But have to be observable to compute the test

Econometric estimations Sometimes evidence from surveys

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SSNIP - Implementation 2: Prices

Price correlations
Idea: products in same market tend to have same price movement over time Problems 1: sales periods, differences movements of input items Problems 2: Falsely infer same market because of common price movements across different product categories
ination: can affect demand oil price: supply shock

Price differences
Idea: products in same markets have roughly same prices But highly problematic
Example: Kelloggs Corn Flakes same ingredients as no name corn akes, still more than twice the price: Brand valuation differs for different products in same market, thus prices should do so, too

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SSNIP - Implementation 3: Product Characteristics and Temporal Markets

Physical product characteristics
Thirst quenchers: mineral water and lemonade differ hugely in sugar content Look at consumer surveys

Temporal markets
Restaurants and bars might compete for lunch (sandwiches), but not for (fancy) dinner Some fruits only available in winter time (e.g. oranges): cannot compete the whole year

Secondary markets
Cars Washing machines Large used market that might partly ensure competition for the new product market

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Geographical Denition

Similar to product market SSNIP test Example: Would 5% price increase in country x be protable for hypothetical monopolist in industry?
If yes: country is market dened as geographical market If no: need wider denition In some cases can even start smaller: for example county level

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Geographics 2:
Role of imports (shipment test)
Do imports account only for small part of consumption? Do exports only account for small part of production?

Transportation costs
Importance of transportation costs relative to prices If low, then market tends to be geographically bigger
Food retailers usually only considered to compete within same city Market for aircrafts global

Other characteristics
Preferences sometimes follow local borders Merger between Spanish and French TV station might be less critical than merger between two Spanish stations

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Indirect Assessment of Market Power Market Shares

Market shares often given important role in market power analysis
si = 1: Monopoly should have high market power Small market share should have low market power (if market is well dened) But not sufcient to argue that a large market power rm is dominant

Very often market shares rst screening device

OFT guidelines: below 40% market share for one rm no danger of being dominant, over 50% market share: dominance can be assumed Not so clear guidelines in other jurisdictions

Measuring market shares

Units: number of products sold: relative market position Values: economic meaning

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Market Shares and Concentration

Important to distinguish between individual and industry markups

Assume constant marginal costs ci i = p(Q )qi ci qi
d i dqi dp dqi

= p (Q ) +

ci = 0

Lerner index for rm i according to model: )ci si 1 i Li = p (Q = q p Q dQ p =

dp Q

Under monopoly this yields Li =

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Concentration cont.

Industry Lerner Index L With HHI

i

n i si Li

2 n si i

si2 : L =

HHI

HHI: Herndahl Hirschmann Index: very important concentration measure Also used in many other economic subelds as measure for concentration Advantage: Easy to estimate given market shares

Industry Lerner index here is measure for market power derived under Cournot conditions

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Entry and endogenous sunk costs

Contestability
If entry is easy, high concentration should not be able to increase market power much

Endogenous sunk costs

High investment costs needed to enter market, such as R&D, may make entry more costly and unlikely Firms in the industry might strategically make such investments, thats why endogenous

History of entry in market

How aggressive have incumbents responded to entry in the past? How often has entry occurred?

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Summary

Market denition not of intrinsic value, but important preliminary step

Market shares, concentration measures and preliminary tests can give some useful insights about an industry But have to be vary about the weaknesses of the tests

Indirect tests of market power especially important when data for more elaborate empirical model are not available Each industry is different: cannot apply a general rule to all

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Next Steps

Estimate Demand Compute elasticities using structural model Recover marginal costs

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