ECON6034 Lecture Two
Lecture Two
Market Structure and Market Boundary
Learning objectives
Students should be learnt about
•How to define different market structures
•Measuring market concentration
•Market structure determinants
• How to define a market, determine the market boundary
•SNNIP Test
INTRODCUTION
• What is a market?
• All firms and individuals willing and able to buy or sell in a particular
product place e.g. Stock exchange
• Market boundary is defined as the availability of the substitutes and
available of potential competitor.
• For example: milk product market,
• What are the potential products that can substitute?
• What kinds of farm can change to rear cattle?
• What kinds of factories can change to produce dairy products?
• How to define a market
• Economists like to classify market by its structure and structure defined by
attributes of some quantitative measures on an industry
• Competition authority need to have a practical way to define market
• In practices, if the boundary of market is defined, market concentration can be
measure; high concentration is related having high market power, low market
concentration is related as less market power.
• Structural approach implicitly assumed monopoly and oligopoly with market
power, no market power with perfect competition.
Types of Market Structure
• Theoretical Economic Approach – defined the market structure some abstract
features
– Perfect competition (Fragmented market)
• Insignificant effect to the market, highly affected by the market prices
and reactions
– Monopoly (Dominant Firm)
• With ability to act without taking into accounts of reaction of competitors
– Monopolistic competition (Loose oligopoly)
• Free entry but with product differentiation
– Oligopoly (Tight Oligopoly)
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ECON6034 Lecture Two
• Independence, significantly affect the market outcome and response to
rivals action
Perfect competition characteristics (Fragmented market)
• Many buyers and sellers
• Product homogeneity
• Low cost and accurate information
• Free entry and exit
• Since there are many buyers and sellers, somehow individual buyer or seller
has no power to alter general consensus of the market prices
Firm demand curve - perfect competition
The firm’s short-run/long-run supply curve
Competitive Firm Behavior
• Short run of the firm
– Firms will still operate as long as they cover theirs variable costs
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– Firms can make temporary extra profit or loss in the short run
• Long run of the firm
– Firms are able to adjust fixed factors, flexible to change its production
pattern or process to minimize costs.
– If alternating production pattern cannot make
ke profit, exit the market, so
firms still can make profit but not loss.
• Long run of the industry
– Because of free entry, firms keep entering the market as long as some firm
still make extra profit.
Competitive equilibrium new firms enter
Monopoly
• Strong barriers to entry Ö single supplier or a dominant player
• Profit maximization faces whole market demand and sets prices in the market
Barriers to entry
Incumbent reactions
• Specific assets
• Economies of scale
• Excess capacity
• Reputation effects
Incumbent advantages
• Pre-commitment contracts
• Licenses and patents
• Learning-curve effects
• Pioneering brand advantages
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ECON6034 Lecture Two
An Example of Monopoly
Price ($)
Profits from uniform pricing
= $2300M (Fixed cost =$200M)
100
Surplus Loss = $1250M
75
50
25
P = 100 - Q
25
50
75
100
MC = 0
Quantity (mil)
MR = 100 - 2Q
Monopolistic competition
• Firms produce differentiated products
• Firms face with their own customers but customers are willing to shift to other
products if the price is low enough.
• In
the limit, firms compete out economic profits because of free entry if
possible.
Tight Oligopoly
• A few firms produce most market output
• Products may or may not be differentiated
• Effective entry barriers protect firm profitability
• Firms’ business plan or business conducts affect
each other and are highly
interdependence.
• Business
Plan requires strategic thinking – to predict the response of your
competitors, don’t think they are machines without brain
The Cournot model
` Duopolists A and B face industry demand
P=100-Q, Q=Q A +Q B
` Each firm takes the other’s output as fixed
E.g., P A =(100-Q B *)-Q A
` Marginal revenue for A is
MR A =(100-Q B *)-2Q A
` If MC=0 (simplify), profit is maximized if
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ECON6034 Lecture Two
Q A =50-.5Q B , which is reaction function of the duopoly A
` Other firm takes the A’s output as fixed
E.g., P B =(100-Q A *)-Q B
` Marginal revenue for B is
MR B =(100-Q A *)-2Q B
` If MC=0, profit is maximized if
Q B =50-.5Q A , which is reaction function of duopoly B
QUANTITATIVE MEASURES ON MARKET STRUCTURE
• Different industries have different market structures, market structure can be
primarily measured in terms of quantitative measure such as firm relative
industry concentration
• Other factors affect long run market structure (usually called market structure
determinants)
– Technological / cost conditions
– Demand features
– Potential for entry
– Product life cycle
Industry Concentration
• The size distribution of firms within an industry
• Some industries are dominated by a few large
firms, while others are
composed of many small firms
• Managerial decisions of a firm that faces little competition are quite different
from those of a firm in a highly competitive industry.
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ECON6034 Lecture Two
Measures of Industry Concentration
Two measures that economists use to measure the degree of industry
concentration:
• Four Firm Concentration Ratio
• Herfindahl-Hirschman Index (HHI)
(1) Four-Firm Concentration Ratio
– The fraction of total industry sales generated by the four largest firms in the
industry
C 4 = (S 1 + S 2 + S 3 + S 4 ) / S T
• S 1 , S 2 , S 3 and S 4 are the sales of the four largest firms in an industry, and
S T is the total sales of all firms in the industry
– Equivalent, it is the sum of the market shares of the top four firms in the
defined industry:
C 4 = w 1 + w 2 + w 3 + w 4 (where w i = S i / S T )
Example:
• Suppose an industry is composed of 6 firms. Four firms have sales of $10M each, and
two have sales of $5M each. What is the four-firm concentration ratio for this industry?
• Total market turnover = $50M
• Four largest firms turnover = $40M
• So C 4 =.8
• In a highly competitive industry in which there are many small firms, C 4 is
close to zero
• In an industry in which there are four or fewer firms, C 4 is equal to one.
• The closer C 4 is to zero, the less concentrated is the industry (i.e. much
competition).
• The closer C 4 is to one, the more concentrated is the industry (i.e. little
competition)
(2) Herfindahl-Hirschman Index (HHI)
• The sum of the squared market shares of firms in a given industry, multiplied
by 10,000:
HHI = 10,000 × Σ w i 2
– Where w i = S i / S T , which is firm i’s share of total market output
Example:
• Suppose there are three firms in an industry. Two firms have sales of $10 each, and one
has sales of $30. What is the HHI for this industry? What is the C 4 ?
• C 4 = 1, and W 1 = .6 and W 2, W 3 equal .2
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• HHI = 10000x(.62+.22+.22) = 4040
• The value of HHI lies between 0 and 10,000:
– When there are few large firms in an industry: high HHI value
– When there are many small firms in an industry: low HHI value
• Typically, industries with high C 4 tend to have higher HHI value
MARKET STRUCTURE DETERMINANTS
Technological Conditions
• Industries differ also in terms of the technologies used for production.
• Some industries are more labour intensive, while others are more capital
intensive.
• Industries in which firms have access to identical technologies have similar cost
structures.
• Industries in which one or two firms have access to a technology that is not
available to other firms will have an advantage over other firms.
Demand Features
• Which demand features matter?
• How to qualify it?
– Demand is about the willingness and ability to pay customers
– A mathematical representation of the relation between the quantity
demanded and all factors influencing demand:
Q = f(X 1 , X 2 ,… X n )
where Q is quantity demanded and the X i s are the factors influencing demand
Demand for 4-wheel drive
Q = 117 - 6.6P + 1.66P s - 3.3T + 0.00661I + .02A
where P is price of X-brand 4-wheel drive, P s is price of saloon, T on 2000c.c
vehicles, I target customer group average income and A advertisement expense.
(Interpret each term of the above mathematical equation.)
Crucial Demand Measurement
The price elasticity of demand is given by
⎛ %ΔQ ⎞
η =⎜
⎟
⎝ %ΔP ⎠
[Note: the convention used here is to express the elasticity as a negative number]
Rothschild Index
• A measure of the price elasticity of industry demand for a product relative to
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that of an individual firm:
R = ηT / η F
– η T = price elasticity of demand for the total market
– η F = price elasticity of demand for the product of an individual firm.
– R has a value between 0 (perfect competition) and 1 (monopoly).
• When an industry is composed of many firms, each producing similar
products, the Rothschild index will be close to zero.
Own-Price Elasticities of Demand and Rothschild Indices in US
Industry
Food
Tobacco
Textiles
Apparel
Paper
Chemicals
Rubber
Elasticity
of Market
Demand
-1.0
-1.3
-1.5
-1.1
-1.5
-1.5
-1.8
Elasticity
of Firm’s
Demand
-3.8
-1.3
-4.7
-4.1
-1.7
-1.5
-2.3
Rothschild
Index
0.26
1.00
0.32
0.27
0.88
1.00
0.78
Potential For Entry
• In some industries, it is relatively easy for new firms to enter the market, in
others it is more difficult, because of the existence of barriers to entry.
• Sources of barriers to entry: capital requirement, patents, economies of scale
• Barriers to entry have important implications for the long-run profits a firm can
earn in a market.
Product Life Cycle
• Products born and die in the market, at different stage of product, they are
characterized by their
– Customers
– Number of firms in the market
– Profits
– Product varieties
– Distribution channel
– Foreign trade
– Marketing tactic
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Product Life Cycle: Four Phase of Product Demand
MARKET DEFINITION
Importance of Market Definition
• Market definition defines the boundary of the market, thus can calculate the
market share that implicitly deduces the extent of monopoly power of a firm or
a group of firm.
• Often regarded as first step in any competition analysis
• It is particularly important in mergers and abuse of dominance cases.
• Help to formulate the effect of any business strategies.
Frequently controversial
• The more narrowly the market is defined the more likely a firm or group of
firms will be found to have large market share.
• Firms tend to advocate wider market definitions than those adopted by
competition authorities.
• Example: the industry concentration in construction market in Hong Kong.
Claims of Arbitrary Approach to Market Definition
• EU Commission has been accused, on occasion, of defining markets so as to
secure a particular outcome.
• If one wants to accuse of any company having market power, it can be done
by defining the market boundary as the extent of the company business
• If one wants to exempt any company, it can be done by defining the market
boundary much larger than the extent of the company business
• Certainly evidence of this in some Article 82 cases
• Facilitated by subjective approach
The ECJ and the Banana
• Declined to apply a cross price elasticity of demand test.
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• “The banana has certain characteristics, appearance, taste, softness,
seedlessness, easy handling and a constant level of production which enables it
to satisfy the constant needs of an important section of the population
consisting of the very young, the old and the sick.”
– United Brands Co .v. Commission, [1978] ECR 207, [1978] 1 CMLR 429.
• “the interests of the toothless are sufficiently protected by the inability of the
dominant firm to discriminate against them. It would lose so much market
share from the rest of the population that it would not be worth raising prices
to exploit the weak.”
–V. Korah, (1990): An Introductory Guide to EC Competition Law and Practice, 4th
ed.
The Ice Cream Case
• Masterfoods t/a Mars v. HB Ice Cream Ltd., [1993] ILRM 145.
• Keane J defined market as being that for impulse ice-cream products
• largely on what has been described as the “common sense” or “innate
characteristics” test.
• Keane J on Ice Cream
1. “I do not think that someone going into a confectioner’s or newsagent to
buy an ice cream who finds the cabinet temporarily empty would treat their
appetite as slaked by a can of coke or a bag of crisps.”
2. Judgement rejected cross-price elasticity analysis because the
“acknowledged incapacity of that procedure to embrace all the significant
variables which would have to be taken into account significantly reduces
its value.”
Economics and Market Definition
• In the past largely neglected by economists
• “My lament is that this battle on market definitions…..has received virtually no
attention from ... economists. Except for a casual flirtation with cross-elasticities
of demand and supply, the determination of markets has remained an
undeveloped area of economic research at either the theoretical or empirical
level.”
– G. Stigler (1982): The Economists and the Problem of Monopoly, American
Economic Review.
Traditional Economic Definition
• “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, (1838):Researches into the Mathematical Principles of the Theory of
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ECON6034 Lecture Two
Wealth, translated by N.T. Bacon, (1927).
• People argued that arbitrage may lead to price equality between two
geographic regions because of regional trade.
• Market boundary should be limited by its extent or human imagination.
Traditional Methods for Defining Markets
•“A relevant market is something worth monopolizing” Owen and Wildman
(1992) Video Economics
• Cross price elasticities
• Price correlations
• Shipments data (geographic market definition)
• All have serious limitations
Cross Price Elasticity
⎛ %ΔQi ⎞
⎟
ηij = ⎜⎜
⎟
%
P
Δ
j
⎠
⎝
• where Q and P denote
the quantity and price of two products i and j
respectively and Δ denotes the change.
i
j
Short Comings of Cross Price Elasticity
• How high does Cross Price Elasticity need to be?
• May be asymmetrical η ij ≠ η ji
• Focus on only 2 products
• breakfast cereal example, more than two choices
The “Cellophane Fallacy”
• Du Pont produced 85 per cent of all cellophane
• Court ruled that other packaging materials substitutes at prevailing market
prices, and thus market not limited to cellophane.
• In dominance case such an analysis is flawed.
• Need to use competitive rather than prevailing prices.
• But how can competitive prices be identified?
Why Cellophane Wrong
• Profit-maximising monopolist will generally raise price to the point where
other products become close substitutes.
• Cross-price elasticity tests will indicate that there are good substitutes at
prevailing prices.
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ECON6034 Lecture Two
• Essential point of identifying the relevant market in dominance cases is to
assess whether firm has power to raise price.
• Cross price elasticity looks at the position after the firm has raised its prices.
Price Correlation
• Based on traditional economic view of markets as areas within which the price
of homogeneous products will generally be equal, after allowing for transport
costs.
• The prices of two products will be perfectly correlated if a specified percentage
change in the price of one results in a consistent percentage change in the other.
• If prices not closely correlated products are clearly not substitutes.
Nestle/Perrier
• Commission originally contended that still and sparkling mineral waters
constituted separate markets
• Parties argued for wider market definition including soft drinks, as well as still
and sparkling waters.
• Prices of still and sparkling mineral waters highly correlated, but little
correlation with soft drink prices.
Shortcomings of Price Correlations
• Not designed to define a market for competition analysis
• Possible to have high levels of price correlation even though products are not
good substitutes for one another.
• Slade (1986) spurious correlations can arise result if one fails to control for
mutual causal factors.
• Requires detailed model.
Product Flows – Geographic Market
• Elzinga and Hogarty (1973 and 1978) proposed using data on product flows in
and out of areas to define geographic markets.
• Elzinga-Hogarty test measures % of a product consumed in an area that is
produced there and % of a product produced in an area that is also consumed
in that area.
• Where both these values high the geographic area in question a separate
geographic market.
• Critical values for the test but no theoretical or practical justification for them
Italian Flat Glass
• Threat of shipments from producers in one area may be sufficient to constrain
the pricing decisions of producers in another area making actual shipments
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•
•
•
•
unnecessary. Italian Flat Glass (1988 OJ l33/34) illustrates this point.
EU Commission argued market definition ought to be based on actual product
shipments, not those that were “theoretically possible.”
Italian producers supplied 80 per cent of Italian flat glass - Court judged that
there could be “no doubt” that the geographic market was Italy.
Decision overlooked fact that prices may already have been at competitive
levels - absence of trade flows did not indicate how consumers and other
suppliers might have responded to any significant price increase.
Appeared troubled by geographic market definition Societa Italiana Vetro Spa
and Others v. Commission (re Italian Flat Glass), [1992] ECR II 1403.
• Certain documents indicated that Italian producers took account of
competition from producers in other member states and in Turkey and
Eastern Europe.
The Case of FTC v. Staples 1997
•Merger of two office supply superstore chains
„ FTC - relevant market office supply superstores
„ Parties – market all office equipment stores
„ Market share in wider market quite small
„ “a seemingly hopeless case". Newsweek 13.7.1998
•Detailed econometric analysis based on scanner data showed that presence of
smaller suppliers in a given geographic location did not constrain pricing
behaviour of the merging firms.
Main Competitors
•Staples, an OSS chains pioneered the office superstore concept in 1986.
„ 550 stores in 28 states
„ In 1996 revenue $4 billion
„ Stock market value $3 billion
•Office Depot
„ 500 stores in 38 states
„ Sales of $6.1 billion
„ Capitalization value of $2.2 billion
•OfficeMax
„ 575 stores in 48 states
„ Revenue if $3.2 billion
•Once the market 23 OSS competing, at 1996 only three able competing
OfficeMax, Staples and Office Depot
Business Model
•Typical customers are SME, home office customers and individuals
•Typical superstore 23,000 –30,000 sq feet
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•Stock 5000-6000, look like a warehouse
•Price at 30%-70% discount below manufacturer-suggested retail prices
•OSS concepts drive out thousands of independent stationers out of business but
benefit consumers
Event
•In Sep 1996, Staple acquire Office Depot by exchanging 1.14 Staples shares for
each outstanding Office Depot share, a deal aprox. $4 billion
•After 7 months investigation, FTC challenged the merger.
•Various studies focusing on four issues
„ The produce market boundary
„ The effect of the merger on competition
„ Possible Entry
„ Efficiency gain and benefit to consumers
Evidence to define the OSS market “Consumables Office Supply Sell Through
OSS”
•OSSs offer a distinct set of products and services;
•OSSs regard each other as their primary competitors;
•non-OSS retailers do not tightly constrain OSS pricing; and
•a hypothetical merger to monopoly among all three OSSs could be expected to
result in a significant increase in their prices for consumable office supplies—an
outcome that would not occur if OSSs and other stores selling office supplies
were in the same product market.
Market Share with relevant boundary
•By using OSS market boundary definition
•The most concentrated market with HHI = 7000, where least concentrated
market with HHI of 3600.
•HHI would rise at average 2715 after merger
Property Market in Hong Kong
•CK is the major property developer in HKSAR
•CK only holds around 4000 unsold newly built units in the market and supply
6000 units each year
•Total annual new supply is around 20000-30000.
•Is CK the major player?
SSNIP TEST
`
The SSNIP Test is stated in 1982 US Department of Justice Merger Guidelines.
`
SSNIP test seeks to identify smallest market within which a hypothetical
monopolist could impose a small significant non-transitory increase in price
`
Defined as a price increase of 5%-10% for at least 12 months.
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`
`
`
SSNIP Test Widely Accepted
◦ Nestle/Perrier EU Commission concluded that “an appreciable
non-transitory increase in the price of source waters” would not lead to a
significant shift to soft drinks.
◦ EU Commission adopted SSNIP in 1997 Notice on Market Definition.
◦ Many Competition Authority has adopted SSNIP test.
◦ EU Commission in Virgin/British Airways
◦ SSNIP test only one of possible tests of market definition - somewhat
troubling.
◦ “Any statement to the effect that SSNIP is just one example of how to
define a relevant market without clearly specifying what the alternative to
SSNIP might be, clearly runs the risk of a return to a process of market
definition by ad hoc reference to product characteristics.”
x NERA, (2001): The Role of Market Definition in Monopoly and
Dominance Inquiries, Office of Fair Trading, Economic Discussion
Paper 2.
Applying SSNIP Test
◦ Start with smallest possible market and ask if 5% price increase profitable
◦ If not, then firm does not have sufficient market power to raise price.
◦ Next closest substitute is added to the relevant market and test repeated.
◦ Process continues until the point is reached where a hypothetical
monopolist could profitably impose a 5% price increase.
◦ Market then defined.
Other Methods for Defining Market
◦ Consumer surveys - FTC in US soft drinks merger cases in mid 1980s.
◦ Examine firms’ past responses:
x to unexpected market shocks. EU Commission in Kimberley/Clark
Scott. Failure of prices to converge following Sterling exit from
ERM
x to new entry. Procter & Gamble/ VP Schickedanz EU Commission
had to consider whether there was a single product market for
tampons and sanitary towels in Germany. Entry of P&G’s Always
brand in 1991. Following 2-3 years tampon prices increased by over
18%, prices of sanitary towels increased by just over 2%.
x to cost increases.
Other Factors considering define Market
◦ Supply side substitution.
◦ Potential competition.
x Probably more important in merger cases.
x Barrier to entry
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`
`
◦
x
◦
Residual Demand Elasticity – Measures Market Power Directly
◦ Lerner index (p-c)/p where p equals price and c is marginal cost.
x LHS of profit maximisation condition for a monopolist
x (p-c)/p= 1/e
x No need to define market
Accepted in US cases.
“The profit-maximization condition for the dominant firm is precisely the
same as that for a monopolist, provided that the elasticity of demand in the condition is
understood to be that faced by the dominant firm.”
Werden (1998)
NB Residual elasticity not the same as market elasticity
Measure Market Power – Dominant Firm Pricing
`
The absolute value of the elasticity of demand facing a single firm, given the supply
curves of its price-taking rivals and the demand curve of the buyers, is governed by
three variables:
◦
The underlying demand elasticity for the product
◦
The elasticity of supply of the firm’s rivals
◦
The firm’s market share
Measure Market Power – Cournot Firms Pricing
`
Suppose that there are N firms, with each firm i choosing its output X i
simultaneously. The
`
Cournot equilibrium is a Nash equilibrium in these quantities. Total output is X
≡X 1 +...+X N .
`
Industry or market (inverse) demand is given by P=P(X). Given the output of the
other firms, marginal cost C i
`
Firm i chooses its output to maximize its own profits, the first-order condition for
this firm is P(X) + X i P’(X)−C i =0 .
`
Therefore
Means of Inferring Market Power
`
Price Cost Margin
◦
Direct measurement
◦
Price comparisons
◦
Price discrimination
◦
Persistent profit
`
Firm’s Elasticity of Demand
◦
Direct measurement
◦
Substitutes, market definition and market share
◦
Rivals’ supply response: barrier to expansion, mobility and entry
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