1. Market Definition and Effects Analysis European Commission, DG Competition, Chief Economist Disclaimer: the views expressed cannot be regarded as stating an official position of the European Commission Kai-Uwe Kühn Chief Economist, DG Competition Prepared for GCLC Lunch Talk, Brussels, 15. February 2012

2. Outline Assessing the effects of mergers The role of quantitative methods in effects analysis Qualitative evidence in effects analysis What role does market definition have? Effects analysis in practice Some challenges for traditional market definition analysis Market definition in antitrust cases 2

3. Assessing the Effects of Mergers What are the constraints the merging parties were imposing on each others’ pricing behavior? If firm A raises the price it loses sales to firm B and others. After the merger losing sales to product B does not impose the same cost on firm A. Hence, there is an incentive to raise prices. This effect is the greater the better substitutes products A and B are. It is smaller if other products outside the merger are very close substitutes. How do we determine substiutability? 3

4. Substitution: Elasticity and Cross-elasticity of demand 4 p q p q inelastic elastic

5. Identifying an Elasticity empirically 5 p q Shifts in marginal cost trace out demand. Cost information crucial to identify slope of demand (i.e. elasticity) Generally: Anything that shifts supply

6. Substitution: Elasticity and Cross-elasticity of demand 6 p q Cross-elasticity: How much does demand shift out when the price of another product increases Close substitutes: Big shift (RED) Poor Substitutes: Small shift (BLUE)

7. Substitution: Elasticity and Cross-elasticity of demand 7 p q Size of the price effect depends on how good a substitute How do we generate price increases of rivals empirically? Increases in marginal cost of rivals Entry/exit by rivals Any other relative change in competitive constraints

8. Examples for this type of analysis Correlation and/or stationarity analysis (Arsenal/DSP, M-real Zander Reflex) –A cost shock for B should increase the price of A as well if the goods are good substitutes. –Similarly: In geographic area A there is a massive increase in capacity. The price drops in area A but remains at the same level in B. Conclusion: no substitution between A and B (“different markets”) “Estimation in reduced form”: Impact of market entry by a new competitor or cross-sectional estimation of impact of presence of the competitor on price(Lufthansa/SN Holding, Lufthansa/Austrian, OneWorld Alliance, Ryan Air/Air Lingus) “Estimation in reduced form”: Temporary boycott of one competitor by a retail store. (Like temporary exit and re-entry). Estimation of Demand system with AIDS model (Friesland/Campina) Estimation of discrete choice demand system and merger simulation (Unilever/Sara Lee)

9. But it doesn’t always work. 9 p q Demand needs to shift independently of own cost shifting: Increases in marginal cost of rivals, but not of own marginal costs Idiosyncratic shocks to cost Otherwise I cannot separate elasticity and cross-elasticity. Hence: Price constraining effect not identified! Examples: Demand estimation, Correlation analysis

10. Qualitative Analysis If you cannot do sophisticated empirical work this does not mean you cannot address the question whether merging firms impose important constraints on each others’ pricing pre-merger Qualitative data: –Internal documents: price reactions (to whom), who’s behavior is monitored etc. –“Market share” data –Switching data –Existing studies of related markets –Cross-sectional studies –Consumer surveys –Questionnaires of customers and competitors –Trade press Qualitative Analysis is important even when you can do good econometrics –Cross-checking the plausibility of the estimates –Good evidence uses complementary pieces of evidence that go in the same direction

11. Does “Market Definition” Play any role in the analysis? If we can directly analyze effects, why bother with market definition? –A traditional view of market definition requires one to identify ALL firms constraining the merging parties. (the SNNIP test). –More information required than for the effects analysis! –Some have concluded this means that market definition makes no sense Market Definition as a qualitative first step in a structured investigation –Scoping the competitive landscape –Identifying the relevant (potential competitors) –Using readily available data already collected by firms –Focusing the more data intensive effects analysis on the relevant issues –In such an analysis the exact market definition will often remain open. –It is a first step in an effects analysis This is effectively how market definition is now used in practice (and fully compatible with the market definition notice). I tend to use market definition and effects analysis almost synonymously

12. How useful are market shares? In many markets readily available data Market shares do contain information: For example, we know from theory, empirical work, and experiments that in very concentrated markets there tend to be large unilateral effects (especially if the merger leads to asymmetric market structures) Strong market fragmentation can lead to easy closure of a case without having to do more complex data analysis But you always want to start with the most easily available information the parties have because that gives you the best starting point

13. The pitfalls of market share analysis 1 Marketshares ≠ Substitutability A probably higher market share However: merger between B and C probably greater price effect than for A and B. Implications for the “chain of substitution” argument A BC

14. Pitfalls of market share analysis 2 The market dynamics problem –Small markets can be ex-ante competitive and ex-post concentrated. Market trunover can be large even with 100% market share –Innovation can lead to frequent entry and overtaking of market leaders –Shares in stocks may be high while shares in sales may vary greatly.

15. The pitfalls of market shares 3 Firms with national pricing strategies competing against firms with local presence only –Local market structure can vary greatly –National pricing by one firm is often taken for definition of a national market –But: Neither the same incentive as national market nor same incentive as local markets –Appropriate approach: market definition describes national/local structure. Then one goes on to effects analysis. Given that the effects analysis is done it does not matter much, whether the market is called national or local.

16. How does UPP fit into all this? UPP: (Q(lost to B)/Q(losttotal)*(p-MC) –Incentive to raise the price –Diversion ratio captures cross-elasticity –Issue: The Diversion ratio must be a change induced by a relative price increase of the firm. Quantities from a switching study NOT correct. You essentially still need to estimate demand or use a (well-phrased) survey, Is UPP a new test? Is UPP a useful first filter that can replace market shares? From our perspective one tool in a tool box for the analysis of substitution and merger effects

17. Non-price Competition and Market Definition Very low price elasticity leads to –High margins –Large incentives to compete in non-price dimensions –“We do not compete on price we compete on other dimensions” Good or Bad Effects for Consumers –Informative advertising: better allocation/match given prices –Persuasive Advertising: Purely Dissipative Market Definition Implications: –Has to be adapted to the problem: Go more directly to effects? –Non-price competition always gives information about the relevant products generating R&D incentives

18. Market definition in antitrust No fundamental differences between mergers and antitrust conceptually However, market definition often has to be done with respect to a counterfactual: What market would a dominant firm (an entrant) compete in if it were not foreclosed? In mergers we can use ex-ante variations in relative costs to infer constraints among existing firms. In antitrust both firms might not be on the market.

19. Market Definition and Effects Analysis When there is sufficient data for demand estimation or effects analysis there should be no impact! A Pharma Example: p t M1 M2 M3 Time of generic entry

20. Conclusions Market definition is a tool of effects analysis How statistically sophisticated the analysis can be depends very much on data availability When possible do econometrics! It is the best anchor for analysis that we have. Never use econometrics without qualitative evidence that gives the relevant context to estimation results. Multiple sources of economic evidence are better than a single one. But remember: one can do rigorous economic analysis also when econometric analysis is not feasible.