Assessing Entry & Efficiencies Mark Woodward African Competition Forum Workshop March 26, 2013

Entry Market entry is an important factor in assessing market power If new entry into a market is easy and inexpensive, then even a firm with a large market share is unlikely to have significant market power Question for investigation: How likely is it that new entry would deter or counteract anticompetitive conduct in the market?

Types of Barriers to Entry Structural Barriers – conditions outside the control of firms in the market –Examples: government regulations, economies of scale, cost of capital Behavioral Barriers – conditions within the control of firms in the market –Examples: predatory pricing, exclusive contracts, excess capacity

Structural Barriers to Entry Government Regulations –Explicit barriers: permits, licenses, zoning, tariffs and quotas –Implicit barriers: regulations intended to promote health, safety, and the environment Sunk Costs –Costs that a firm cannot avoid by exiting the market –The size of sunk costs can affect a firm’s decision whether to enter the market

More Structural Barriers to Entry Economies of Scale –Economies of scale exist when the cost of production falls with increasing output –Economies of scale can be a barrier to entry if they make smaller-scale entry expensive Large Capital Requirements –Entering some industries take substantial amounts of capital –Where it is difficult to get access to capital, capital may be a barrier

Behavioral Barriers to Entry Predatory Pricing –The threat or actual use of predatory pricing may scare away potential entrants Excess Capacity –By maintaining a lot of unused capacity a firm may signal potential entrants that if they try to enter the firm will flood the market

More Behavioral Barriers to Entry Vertical Restraints –Relationships between firms (or within a firm) at different levels in the chain of distribution Examples: –Exclusive contracts –Vertical integration

Sources of Information for Assessing Entry Market Participants –Competitors, retailers, suppliers, distributors, customers Potential Entrants –Firms located in other geographic areas –Firms that make closely related products –Large customers of existing firms Industry Experts and Other Sources –Consultants, academics, trade associations, government officials

Facts to Investigate Current market structure Most likely entrants History of market entry and exit Start-up costs and magnitude of sunk costs Capital costs and sources of financing Time needed to get business up and running Economies of scale and scope Presence of vertical restraints Conditions of demand Profitability of incumbents Customers willingness to do business with new entrant

Assessing Entry Conditions 1.Identify any potential entry barriers 2.Collect the relevant information about each 3.Apply a three-part test: a. Timeliness – can entry occur relatively quickly? b. Likelihood – is new entry likely to be profitable? c.Sufficiency – will new entry likely defeat any anticompetitive effect of the conduct at issue?

Assessing Entry Conditions, Cont’d 4.In the U.S., entry generally is considered difficult if new entry is unlikely to restore prices to the competitive level within two years - Not a hard-and-fast rule 5.Recognize that precise and detailed information may be difficult to obtain

Entry: U.S. Examples Inova Health System Foundation (2008) –Proposed acquisition of Prince William hospital by Inova, the largest hospital system in the area –Merged hospital system would control approximately 73% of licensed hospital beds in the relevant market –FTC alleged entry was unlikely due to regulatory requirements: It is unlikely that entry into the market would remedy, in a timely manner, the anticompetitive effects of the merger. A new hospital, or expansion of an existing hospital, sufficient to defeat a price increase or other anticompetitive effect would likely take three years or longer. In addition to planning and construction lead times, such projects would require state regulatory approval which can take a significant amount of time.

Entry: U.S. Examples Exxon-Mobil (1999) –Proposed merger of leading producers of jet turbine oil, a specialized lubricant that can operate in an extreme environment –Failure by the lubricant could lead to engine failure –Jet turbine oil producers had to submit their products for extensive testing, including testing on a customer’s specific model engine, to secure sales –Commission determined entry not likely due to substantial sunk costs in product testing and time delay in entering –Consent agreement required, among other things, divestiture of Exxon’s jet turbine oil business

Entry: U.S. Examples Swedish Match-National Tobacco (2000) –Proposed merger of the first- and third-largest producers of loose leaf chewing tobacco –Merged entity – 60% market share –Top two firms post merger – 90% market share –Entry not likely due to strong brand loyalty –Historical evidence of new brand introduction showed, at best, only a nominal effect on constraining prices of existing brands

Efficiencies A fundamental purpose of competition policy is to ensure the efficient use of society’s resources Cost reductions from efficiencies generated by a transaction or practice may be large enough that prices decline, even if profit margins increase. If so, consumers are better off. Competition investigations should thus include an assessment of possible efficiencies

Definition of Efficiency An efficiency is a gain in productivity Efficiencies result from savings that may involve any of the following: –Using fewer resources to produce the same output –Using the same resources to produce a larger output –Using the same resources to produce higher-quality output –Using the same resources to produce a greater variety of output –Using the same resources to produce a product that was not available or possible absent the new practice

Potential Sources of Efficiency Economies of Scale –When costs fall with increasing output –Can be found in production, purchasing, distribution, warehousing, marketing, advertising, and research and development Economies of Scope –When it is cheaper to produce two products together than it is to produce them separately Transaction Cost Savings –Savings that result from lowering the cost of trading and dealing with others Synergies –.

Assessing Efficiencies 1.Is there any evidence to support the claimed efficiency? –How will it be achieved? –What is the likelihood it will be achieved? –How large is it likely to be? –When will it be achieved? 2.Is the efficiency related to the business practice under investigation? 3.Can the same efficiency be achieved in a less anticompetitive way? 4.Will some part of the efficiency savings likely be passed on to consumers?

FTC v. Staples: Assessing Efficiencies

The FTC v. Staples Case Proposed merger between Staples and Office Depot (1997) Office Supply “Superstores” –Staples, Inc. –Office Depot, Inc. –Office Max, Inc. Other Suppliers of Office Supplies –Wal-Mart –Mail Order & Delivery

Staples’ Efficiency Claims “Base Case”: $ 4.9 billion over 5 years “Aggressive Case”: $ 6.5 billion over 5 years Product Cost Savings:$ 2.190B (direct sourcing, buyer power) Distribution Cost Savings: $.883B (direct distribution, freight savings) Marketing Savings: $.854B (scale & scope) General & Admin Savings: $.469B ( scale ) Goods & Services Savings: $.533B (best practices, scale)

FTC Response to Efficiency Claims Different efficiency claims were made to the U.S. SEC, the Staples Board, and to the Court Some claims were not merger specific - Ignored savings that would have resulted absent the merger Some claims were unsubstantiated - Could only find a basis for 15% of the Goods & Services claim of $533 million Some claims based on unsound methodology - Staples estimated product cost savings from set of selected vendors, then extrapolated to estimate savings from all its vendors

Conclusion Of Staples’ total efficiency claims of 5.03% of sales in 1998: –32% lacked substantiation –39% were erroneous, mostly due to non- merger specificity –29% survived close scrutiny