Market Definition and Market Power in Competition Analysis.
‘Economists understood by the term Market, not any particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality easily and quickly.’ (A.A. Cournot, Researches into the Mathematical Principles of the Theory of Wealth, 1838.)
Introduction.
Market definition plays a key role in competition analysis, particularly in mergers and cases of alleged dominance. In general the more narrowly the market is defined the more likely a firm or firms will be found to have market power. Not surprisingly, firms tend to advocate wider market definitions than those adopted by competition authorities.
The SSNIP Test
The introduction of the SSNIP test in the US Department of Justice 1982 Merger Guidelines resulted in the development of new methods for defining markets and for measuring market power directly. The EU Commission has adopted the SSNIP formulation in its Notice on Market Definition.
The SSNIP test seeks to identify the smallest market within which a hypothetical monopolist or cartel could impose a small but significant non-transitory increase in price and defines this as the relevant market. Effectively it asks whether such a monopolist or cartel could sustain a price increase of 5% for at least one year on a ceteris paribus assumption that ‘the terms of sale of all other products are held constant’. If sufficient numbers of consumers are likely to switch to alternative products as to make the price increase unprofitable, then the firm or cartel lacks the power to raise price. The relevant market therefore needs to be expanded. The next closest substitute is added and the process is repeated until the point is reached where a hypothetical cartel or monopolist could profitably impose a 5% price increase. The range of products or the geographic area so defined constitutes the relevant market.
The Critical Elasticity of Demand.
The SSNIP test can be applied by estimating the critical elasticity of demand (e). In the case of linear demand all that is required to calculate the value of the critical elasticity of demand is information on firms’ price cost margins.
If the pre-merger elasticity of demand exceeds the critical elasticity then the decline in sales arising from the price increase will be sufficiently large to render the price increase unprofitable and the products concerned do not constitute the relevant market.
Critical Loss
An alternative method for applying the SSNIP test where demand elasticities cannot be estimated, involves estimating the critical loss (y). The critical loss is defined as the maximum sales loss that could be sustained as a result of the price increase without making the price increase unprofitable. Where the likely loss of sales to the hypothetical monopolist (cartel) is less than the Critical Loss, then a 5% price increase would be profitable and the market is defined.
Some Practical Pointers on Market Definition.
Goods characterised by high fixed costs or sharply upward sloping cost curves will have lower critical residual demand elasticities than those with low fixed costs or relatively flat cost curves.
If the price-marginal cost gap is small, then the loss in sales from a price increase will be relatively small. If the price-marginal cost gap is relatively large then losses on sales foregone will be quite high. Thus the size of the price-marginal cost gap can provide some indication on the extent of the relevant market.
Critical demand elasticities are lower where prevailing price is above the competitive level because margins are higher. In other words firms with market power who are profit maximisers will increase price up to the point where other goods become close substitutes and thus act as a constraint on raising prices further. The SSNIP test therefore ignores the fact that a firm may already have exercised market power because what it shows is that other products are close substitutes at prevailing prices.
Avoiding the ‘Cellophane Trap’.
The essential point of identifying the relevant market in cases of alleged dominance is to assess whether a firm or group of firms have market power, generally thought of as the power to raise price. By considering the degree of product substitution at prevailing prices, one is effectively considering the position after the firm or firms have already raised price to the maximum extent possible, i.e. after they have exercised that market power. In effect the US Supreme Court was seen to have made this mistake in the Cellophane case in what has come to be known as the ‘cellophane trap’.
Thus, in order to define the market in abuse of dominance cases, the SSNIP test would have to be estimated on the basis of competitive prices rather than at the prevailing price level. Of course it may not be possible to calculate the competitive price level.
Such considerations do not arise when defining a market in merger cases. In assessing the competitive impact of a merger the crucial issue is not whether one of the merging parties already enjoys a degree of market power, but whether, as a result of the merger, the degree of market power would increase. Thus the SSNIP test defines the market correctly for the purposes of merger analysis.
Values of Critical Demand and Loss for 5% Price Increase
The following table illustrates values for the critical elasticity of demand and critical loss for various percentage price-cost margins for a 5% price increase.
% margin |
Critical Residual Demand Elasticity |
Critical Loss |
50 |
1.82 |
9.1 |
45 |
2.00 |
10.0 |
40 |
2.22 |
11.1 |
35 |
2.50 |
12.5 |
30 |
2.86 |
14.3 |
25 |
3.33 |
16.7 |
20 |
4.00 |
20.0 |
15 |
5.00 |
25.0 |
10 |
6.67 |
33.3 |
© CompEcon Limited 2002.
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