Market definition - Essay Example

Often concern is expressed as to the pivotal role played by market definition in competition law cases and the amount of time spent on “getting the market definition right”. In part this is a product of the structuralist approach which requires an accurate market definition before analysis of the competition issues can proceed. The E. U. recently published guidelines in relation to market definition. [FN32] These are structuralist in approach and imply or are conducive to a structural approach to the analysis of competition issues.

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Yet recognition of the role of strategic behaviour in oligopolistic markets might, in some circumstances, *233 involve a rather different approach to market definition. Market definition is integral to the analysis of market power and traditionally it has only been separated and determined first as a matter of convenience: “Defining the market and evaluating the degree of market power in that market are part of the same process, and it is for the sake of simplicity of analysis that the two are separated. ” [FN33] Assume that a firm is alleged to be involved in predatory pricing.

The facts reveal a pattern of behaviour which is clearly not consistent with and cannot be explained as, for example, a competitive response to new entry. This implies that the firm concerned has market power (or that it is irrational in an economic sense). It may be that its power in one market actually derives from its position in some other market. To this point no market has been identified. The relevant market is that in which the market power is exercised, that is, where the anti- competitive effect is analysed. In some cases this may mean that more than one market is relevant or that a broader market should be considered.

Under these conditions, market definition is not the start of the process but is developed as the analysis takes place. There is some suggestion of this approach in Kingfisher plc and Dixons Group plc, [FN34] which involved a proposed merger between two retailers of brown goods (televisions, videos and the like). Initially the market was defined as the market for the distribution of electrical goods, but when it was recognised that market behaviour differed between different types of retailers of electrical goods, the market was redefined. Market shares and concentration

The strategic behaviour model takes a fairly neutral view of firm size and market shares. Under oligopolistic conditions, little can be inferred about the likely competitiveness of a market simply by looking at the number of actual and potential market participants and their market shares. A market with only two participants may be highly competitive; whilst a market with considerably more participants but which is otherwise structurally identical may be highly uncompetitive. Recent antitrust literature indicates that even firms with quite a small market share may exercise unilateral market power, through strategic behaviour.

[FN35] This does not sit comfortably with the traditional structuralist approach to market concentration. For example, in the U. S. and Australian merger guidelines, market concentration is taken as an indicator of whether further analysis of the structural features of the market is warranted. If market concentration is below a certain predetermined level, the merger proposal would not be further considered. However, past European cases suggest a more significant role for market concentration. It is seen more as a problem in its own right because it facilitates greater market co-ordination, whether explicitly or tacitly.

Joint strategies Strategic behaviour may consist not of a single act but rather of a group of actions jointly intended to achieve a particular goal. Thus, to focus on one aspect only may fail to reveal the true impact on competition, suggesting an abuse of market power or an anti-competitive outcome where none is likely, and vice versa. This may be illustrated as follows. Assume that in a particular geographic market there are three grocery wholesalers; two are integrated forward into retailing, while the third supplies only to independent retailers.

The latter competes with the retail outlets owned by the integrated suppliers, but the integrated suppliers do not supply the independents. One of the vertically integrated grocery suppliers proposes to acquire the independent wholesaler. The competition authorities assess barriers to entry into the relevant market to be high and are concerned that following the acquisition, the supply price to the independent retailers will be raised. With reduced competition at the retailing level, even though there will still be one other market participant, the acquirer will become the market leader and will be able to raise retail prices.

Suppose, however, that over a period of years the acquirer has invested substantial funds in building a reputation for low prices and high quality service. In analysing the proposed merger, using a structuralist approach, the competition authorities are unlikely to take account of the acquirer’s investment in its reputation. Yet this sunk cost may constrain the firm, inhibiting it from raising retail prices even if had forced the independent retailers from the market by raising supply prices.

Under these circumstances it may not be rational following acquisition to raise supply prices in an industry where profits are directly related to the volume of business. Nevertheless, the acquisition may be rational because it lowers average unit costs. *234 Multiple markets Business structures have become more complex during the last several decades as most firms produce not just one product but a range of products and often operate in a number of different markets. Generally, this results in synergies for the whole business because the markets are linked through common processes, inputs, information or management.

Thus, to understand conduct in any one market it may not be sufficient to look simply at the structure of that market in isolation. Assume that a firm operates in an oligopolistic market but is part of a broader corporate entity which operates in other markets as well. Then assume that new technology becomes available which will result in lower costs not only in the first market but also in the other markets. However, achieving the full cost saving involves learning, which is a function of the level of production.

In order to achieve the benefits from cost saving as quickly as possible, the firm drops its prices quite drastically in order to acquire market share. The competition authorities looking only at the one market and the price reduction may well conclude that the lower price is predatory. Yet predatory pricing also implies a later price increase. In this case there is no reason to assume that such an increase will occur, as there has been an increase in efficiency not just in this business but flowing through to the company’s other businesses as well.

Assumptions which were appropriate for single product-single firm businesses are not necessarily relevant to today’s more sophisticated entities. Kay [FN36] suggests that firms will not price at marginal cost. He suggests that firms should segment their markets (price discriminate) in order to appropriate added value most effectively. The firm should operate in as many markets as possible, given its competitive advantage, in order to earn something approaching the value of its product. Within each market pricing and marketing strategies should be designed to suit the characteristics of that market.

Segmentation may be based specifically on buyer groups or it may be via product differentiation; that is, a more “global” perspective is necessary if the aim is to analyse individual firm behaviour. The Law A problem raised by strategic behaviour under some circumstances is the reach of the relevant competition legislation. This is clearly illustrated by the Du Pont titanium dioxide case in the United States. [FN37] In this case Du Pont did not possess market power prior to initiating its strategy; it was one of a number of suppliers with fairly similar market shares.

However, as a result of strategic research and development, coupled with capacity expansion, it quickly achieved a dominant position in the market. Under the U. S. antitrust legislation there is a prohibition on monopolisation and so action was taken against Du Pont. Similar action appears possible in the E. U. However, in other jurisdictions (such as Australia) action cannot be taken unless the firm already possesses market power. Whether this is a problem depends on the extent of such conduct. The role of strategic behaviour within firms also raises concerns in relation to remedies for breach.

Porter argues: That an overall strategy guides strategic interaction also implies that a remedy aimed at one aspect of a firm’s behaviour must be probed to see how it will affect the ability of the firm to carry out its previous strategy, and whether the firm is likely to adjust other elements of its strategy to compensate or redefine its strategy completely. The firm will strive to maintain an internally consistent approach to competing, and one to which it is uniquely suited. [FN38] Providing an Analytical Framework: An Example

One of the main attractions of the structuralist approach to competition issues is its simplicity. The same cannot be said of an approach based on strategic behaviour. The following example is intended to illustrate, in simplified form, how strategic behaviour might be analysed. The first step is to set out the alternative claims which might be made for it; generally the company concerned will argue that the conduct is pro-competitive, while the competition authorities will be concerned with the alternative hypothesis.

It is also important to keep clearly in mind the end result sought by the antitrust authorities, that is, to establish whether the conduct is likely to be efficient and is unlikely to affect consumers adversely by causing prices to increase or quality to decrease. To arrive at a conclusion it is necessary to *235 set out the various conduct options open to the firm and assess whether a rational profit-maximising firm would benefit from the conduct in question. Generally, a detailed quantification of the outcomes is not necessary.

The example to be considered is a proposed acquisition of a producer of concrete roofing tiles by a producer of clay roofing tiles. [FN39] We begin with the following assumptions. Within the geographic market there are three producers of concrete roofing tiles and one producer of clay roofing tiles. The only other type of roofing available is assumed to be metal roofing. Market inquiries indicate that metal roofing is around 20 per cent more expensive than concrete tiles (taking into account the lower construction cost because of its lighter weight).

These inquiries also indicate that there is a strong consumer preference for tiles compared with metal roofing. This places the two in separate markets. Market information also suggests that while some clay tiles are on average more expensive than concrete tiles and that there is a consumer preference for clay, the higher price of clay tiles does not place them in a separate market from concrete tiles. It is also assumed that market conditions are generally unfavourable and have been so for some time.

This reflects a cyclical downturn in the building industry, but even under “normal” demand conditions there would be substantial excess capacity in concrete tile production. No plant is operating more than one shift per day and capacity utilisation is no more than 50 per cent. Even at peak demand, the target company could supply most of the market’s requirements (on a two-shift basis). As a consequence, prices and hence profits are very low and have been so for some years. Significant economies of scale are assumed to exist in the manufacture of clay tiles, but not concrete tiles.

This reflects technical differences in the production processes of the two. Thus, during the period of low activity, some clay tiles were heavily discounted to steal market share from concrete tile producers. This reduced the average unit cost of total clay tile production. The target company has announced its intention to quit the market either by selling the business or closing it down and selling off the plant and land. The claimed reason for the acquisition is that the clay tile producer will be able to achieve significant savings in both operating and distribution costs for concrete tiles.

The implications for competition appear slight: 1) There will be a reduction in the number of market participants from four to three whether through the merger or through exit. 2) Owing to the substantial excess capacity, even though the technology used is comparatively simple, barriers to entry appear high and it is unlikely that they would be heightened by the merger. Thus, it is difficult to see why the competition authorities would interfere with the acquisition when the alternative is for the target firm to exit the market.

However, we should also consider the pricing options that are available to the clay tile producer as a result of the acquisition. These are set out in Table 1, which shows the likely consequences for the other tile manufacturers of different pricing strategies initiated by the acquiring firm. Table 1: Pricing options for acquirer post-acquisition Concrete Tiles Clay Tiles Raise prices Maintain prices Lower prices Raise prices no exit no exit no exit Maintain prices no exit no change exit Lower prices no exit exit exit

Taking account of the interdependence within the oligopolistic tile market, which of these options is most likely and what are their consequences? First, assume that the aim of the acquirer is to raise tile prices in the longer term. The first option, which might be termed the “do nothing” option, is to make no change to the pricing structure but to enjoy higher profits as a result of the cost reduction associated with the acquisition. This will only be the preferred outcome if none of the alternative options produce a better result for the acquirer.

First, any strategy which results in the price of concrete tiles rising, irrespective of what happens to clay tile prices, is unlikely to result in either of the other concrete tile producers exiting the market in the short run as they too would be likely to raise their prices, thereby improving their profitability. Secondly, any pricing strategy which causes clay tile prices to increase is likely to shift demand to concrete tiles. This would make it more difficult/costly to achieve exit. The outcome will be similar if clay tile prices simply remain unchanged.

The best option available to the merged firm would be to use the cost savings associated with *236 the acquisition to fund price cuts for concrete tiles, while maintaining or lowering the price of clay tiles. The latter action would encourage users to shift from concrete tiles to clay tiles, and as a result of the increased volume of sales, unit costs would fall. Reduced sales of concrete tiles, together with more aggressive price competition between concrete tile producers, would create a difficult environment for the other two concrete tile producers who would not have the benefit of the cost savings available to the merged firm.

Given the losses incurred by the concrete tile producers over a sustained period, if the merged firm were prepared to maintain this pressure for some time, one or both of the concrete tile producers would probably exit the market. If rationalisation of concrete tile production were to occur, the question still remains: would the clay/concrete tile producer then be able to force up tile prices? Assume that only one of the two concrete tile producers exits the market following the price war. Given its initial losses and the impact of the price war, the remaining firm is now likely to be even weaker.

Under these circumstances, it is unlikely to resist price rises initiated by the merged firm; rather it is likely to follow the price leader. Nevertheless, metal roofing still exists as an alternative and may thwart attempts to raise tile prices. However, market research suggests that this is not a close substitute and so tile prices could rise quite significantly before consumers would switch from tiles to metal roofing. In addition, by forcing at least one tile producer out of the market, this would reduce, but not eliminate, the extent of excess capacity in the market and would improve the clay tile producer’s cost position.

This suggests that while the structural features of the market support a conclusion that the acquisition is unlikely to lessen competition substantially because exit is the alternative outcome to the acquisition, the conclusion may be different if the conduct facilitated by the acquisition is considered. Conclusion Strategic behaviour occurs where a firm acts in order to improve its market position relative to its rivals, in order to gain a permanent competitive advantage.

Such conduct is likely in oligopolistic markets and while not generally anti-competitive, under certain circumstances it may be. The traditional approach to analysing competition issues based on the structural features of the relevant market provides a relatively simple approach. However, structure tends to be a poor guide to conduct in oligopolistic markets where recognised mutual interdependence is the key feature. For this reason, we strongly urge greater consideration of strategic behaviour in future competition analysis.

FN Rhonda Smith, Commissioner of the Australian Competition and Consumer Commission, and David Round, University of Adelaide, Associate Commissioner of the Australian Competition and Consumer Commission. The opinions expressed in this paper are those of the authors alone. The article is a further development of a paper presented to the Trade Practices Workshop conducted by the Business Law Section of the Law Council of Australia on July 19, 1997 in Adelaide and subsequently published in revised form in Agenda. The authors gratefully acknowledge the support of John Kay for the ideas presented here.