4584497.2

Geographic Market Definition

Presentation to the CBA Competition Section’s Young Lawyers Committee

Neil Campbell, McMillan LLP Lilla Csorgo, Competition BureauMargaret Sanderson, Charles River Associates

November 19, 2009

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Disclaimer

• Discussions of particular policies and cases are for teaching purposes only.

• These slides are part of a presentation and cannot be fully understood separately from that presentation. Ideas presented here are preliminary and their intent is to promote further discussion and analysis.

• These slides do not necessarily reflect the views of the authors’ organizations.

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Topics for Discussion

• Identifying geographic market definition issues

• Merger analytical framework

• Practical indicators

• Hypothetical monopolist test

• Testing for regional price discrimination

• Critical loss analysis

• Conduct cases and the “cellophane trap”

• Canada Pipe

• Making use of market definition evidence

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Identifying Geographic Market Definition Issues

• Where do the merging parties have overlaps?◦ Sales offices / production facilities

◦ Customers

• Does geographic market matter?◦ Market share similarities / differences

◦ Differences in competitors’ presence / position

◦ Price differences

• Note: need to consider product market definition in parallel◦ Similar questions

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Merger Analytical Framework

Product & Geographic Market Definition

Market Shares /Concentration

Competitive Effects(s. 93) Factors

• “Market definition is based on substitutability and focuses on demand responses to changes in relative prices” (MEGs, 3.3)

• May not correspond to standard company or industry segmentations

• May not follow political boundaries

• 35% unilateral effects safe harbour

• 65% CR4 coordinated effects safe harbour

• Effectiveness of remaining competition

• Removal of vigorous competitor

• Entry

• Change / innovation

• Countervailing power

• Failing firm

• Efficiencies (possible defence)

• Other

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Practical Indicators for Defining Geographic Markets

• Closeness of substitution possibilities◦ Demand side: extent to which buyers would switch suppliers

◦ Supply side: scope for expansion or repositioning

• Potentially relevant factors (MEGs, 3.21-3.26)◦ Buyers’ and trade views

◦ End use and product attributes

◦ Price relationships and levels

◦ Switching costs

◦ Transportation costs

◦ Shipment patterns

◦ Foreign competition

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Hypothetical Monopolist Test

• Product dimension:◦ Smallest group of products over which it would be profitable for a single

firm acting as a monopolist to implement and sustain a small yet significant non-transitory increase in price (“SSNIP”)

• Geographic dimension:◦ Smallest geographic area over which it would be profitable for a single

firm acting as a monopolist to implement and sustain a SSNIP

• Conceptual, iterative process

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Hypothetical Monopolist Test (cont’)

• What is a SSNIP?◦ Usual test is 5% price increases over 1 year (MEGs, 3.4)

◦ May vary depending upon the product

• What base is used?◦ Prevailing prices for mergers (even if not competitive)

◦ Demand responses depend upon price faced by customer(e.g., transportation plus tipping fees in waste disposal)

◦ Supply responses depend upon margin faced by entrant(e.g., FOB mill price in case of delivered pricing where supplier pays for freight cost)

• Is price discrimination relevant?◦ If different buyers pay different prices for the same relevant product,

subsets of buyers may comprise separate markets over which hypothetical monopolist profitably can impose a SSNIP

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Testing for Regional Price Discrimination

• Merger involving two firms based in Western Canada

• Merging parties consider the relevant geographic market to be North America given their extensive exports to U.S. customers

• There are no imports into Canada

• Regression analysis employed to test whether geographic price discrimination exists◦ Test whether the “netback” (per unit sales revenues less freight costs)

from the merging firms’ sales to customers in the U.S. is similar to the netback earned from customers in Western Canada

◦ If netbacks (as a measure of margin) are materially higher for sales to customers in Western Canada than to U.S. customers, the threat of entry from the U.S. does not appear to discipline prices in Western Canada

◦ Common netbacks are a necessary but not a sufficient condition for finding that Western Canada is part of a wider geographic market

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Merger Case – Practical Example (cont’)

• Transaction level data is obtained from merging firms◦ Prices, quantities, discounts, freight costs, customer location, product type

for all shipments to U.S. and Canadian customers

• Regression specification used:

Log(netback per tonne) = α + β*log(volume) + γ*(region dummy) +

δ*(month dummy) + ζ*(product type dummy) + error

• Log-linear regression means the coefficient “γ” measures the % difference in netback per tonne for sales to customers in other regions relative to netbacks earned from customers located in B.C.◦ If no regional price discrimination exists, the netbacks for sales to

customers in B.C. should not be significantly (either economically or statistically) different from the netbacks for sales to customers in other regions

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Merger Case – Practical Example (cont’)

• Netbacks are 10-11% lower for sales to customers in the U.S. compared to netbacks on sales to customers in B.C. and Prairies

• Suggest B.C. + Prairies are in one geographic market, but U.S. Pacific Northwest and U.S. Southwest are in a separate geographic market

Variable Parameter Estimate T-statistic

Intercept 5.970* 10.83

Volume -0.005 -1.47

Prairies -0.030 -1.13

U.S. Pacific Northwest -0.104** -2.07

U.S. Southwest -0.113** -2.11

Observations 1,194

R2 0.481

* Statistically significant at 1% level

** Statistically significant at 5% level

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Critical Loss Analysis in Market Definition

• No regional price discrimination is a necessary but not a sufficient condition for finding a single, common geographic market

• Sufficient test is the hypothetical monopolist test (critical loss analysis)◦ If hypothetical monopolist imposes a SSNIP, are the gains in revenue from

customers who still purchase (area A) greater than the losses from customers who are no longer buying (area B)?

Marginal Cost

Q

P

A

B

P1

P0

Q0Q1

Demand Curve

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Market Definition Tool: Critical Loss Analysis

Estimate the hypothetical monopolist’s initial per unit margin

First Step:Contribution Margin

Second Step:Critical Loss in Sales

Third Step:Lost Customers

Contribution margin = (initial price – marginal cost)÷ initial price

Percentage of customers the hypothetical monopolist could lose before the price increase becomes unprofitable

Critical loss in sales = SSNIP (SSNIP + contribution margin)

Involves quantifying how many customers would be lost either to rival firms or by not purchasing when faced with the SSNIP

Estimate whether the hypothetical monopolist would lose customers beyond the critical level if it increased price

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Critical Loss Analysis - Implications• As the critical loss formula indicates:

◦ The greater the contribution margin, the smaller the critical loss for a given postulated price increase

◦ The greater the postulated price increase, the larger the critical loss for a given contribution margin

Percentage

Contribution

Margin

Percentage Price Increase

5 10 15

0 100.0 100.0 100.0

10 33.3 50.0 60.0

20 20.0 33.3 42.9

30 14.3 25.0 33.3

40 11.1 20.0 27.3

50 9.1 16.7 23.1

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Critical Loss Analysis - Adjustments and Caveats

• Important adjustments and considerations◦ Alternative production facility use may attenuate the effects of lost sales

◦ Joint product production

◦ Margins may be high for a reason (e.g., inelastic demand); therefore do not assume high margins always mean broad geographic markets because the critical loss is small

• Assumptions◦ No price discrimination

◦ Marginal cost is constant over the range of output relevant to the postulated price increase

◦ Average variable cost is often used as a proxy for marginal cost

◦ Accounting data is typically used to calculate the average variable cost, but this introduces measurement problems

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Critical Loss Analysis – Practical Example

• Geographic market analysis for a possible ChemCo / TargetCo merger – separate East and West markets vs. all Canada?◦ Available data only for ChemCo plants throughout North America

• Assume hypothetical monopolist of all Western Canada plants

• Hypothesize 5% price increase in Western Canada only

◦ Price increase is realized by shutting down enough Western Canada capacity to increase price by 5% given elasticity of demand

◦ Calculate the contribution margin associated with the shut down capacity by assuming production is shut down at the highest cost plants – find 2 plants need to be shut down to remove enough volume in Western Canada to raise price by 5%

◦ Contribution margin associated with the 2 shut-down plants is roughly 20%

• Forgone margin = 20%, price increase = 5% → critical loss = 20%

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Critical Loss – Practical Example (cont’)

• Will actual loss > 20% if hypothetical monopolist in West raises price by 5%? ◦ Assume prices in East remain the same and assume netbacks earned by

rival firms are similar to ChemCo netbacks in East

◦ Calculate existing ChemCo netbacks (Transaction Price - Freight Cost) for each eastern plant for sales to current customers

◦ Assume prices in Western Canada rise by 5% and calculate potential netbacks from each eastern plant to ship to customers in the West

◦ Compare post-price-increase netbacks in West with netbacks for current customers in East; if netback to shift an Eastern sale to a Western customer is improved assume East volume is diverted to West

◦ Calculate total volumes that would be diverted to West, assuming diversion begins with the highest netback opportunity

◦ Is the total volume diverted from East to West > 20% of total Western volume?

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Critical Loss – Practical Example (cont’)

• Findings

◦ Price increases up to 5.2% in Western Canada induce cumulative potential divertible volume from ChemCo plants of 41,414 tonnes

◦ Scaling ChemCo divertible volumes by ratio of total plant capacity to ChemCo plant capacity in Eastern Canada (5.64) yields potential industry divertible volume from Eastern Canada to Western Canada of 233,706 tonnes

◦ This represents 37% of total Western Canada sales, which exceeds the critical loss of 20%

• Assumes competitors have freight costs, netbacks and diversion opportunities similar to those of ChemCo’s Eastern plants

• Assumes no contract constraints would restrict diversion of sales from Eastern customers to West

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Conduct Cases and the “Cellophane Trap”

• The wrong base price can lead to overly large markets (cellophane trap) or overly small ones (reverse cellophane trap)

• Cellophane trap: If the prevailing price is one that already exhibits substantial market power as result of anticompetitive conduct, a further (hypothetical) price increase in relation to that price may cause buyers to switch to products they would not normally consider as substitutes◦ U.S. v. Dupont: the alleged monopolist Dupont had priced its cellophane

wrap product so high that substitution of less desirable wrapping materials finally occurred

• Reverse Cellophane Trap: Some suggest that the competitive price be used as the base price instead to avoid the trap, but using the competitive price when market power has already been exercised can lead to overly narrow markets

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Reverse Cellophane Trap Example: Canada Pipe

• In Canada Pipe, prevailing prices were used◦ No switching to imports in face of a price increase was found, but the

absence of switching was possibly due to the anti-competitive act (the stocking distribution program) and the related penalties associated with switching

• It is expensive to transport cast iron product◦ As a consequence, if price is at the competitive level (i.e., at marginal cost

or even average cost), applying the hypothetical monopolist test would likely find that imports are not in the relevant geographic markets

• The price that would prevail absent the anti-competitive act (the “but-for” price) did not appear to be the competitive price◦ At the “but-for” price, imports would be in the market

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Abuse Case Example – Canada Pipe

• Six regions of Canada were defined as separate markets◦ B.C., Alberta, the Prairies, Quebec, Ontario and the Maritimes

◦ Commissioner submitted that Canada Pipe had at least 82% market share in each geographic market

• Canada Pipe has production facilities in only one of the geographic markets, Quebec◦ Finding on geographic market would imply that buyers located in B.C.

would not find sellers located in Quebec to be adequate substitutes

◦ How can the location of Canada Pipe be reconciled with its participation in all six geographic markets?

• In considering the potential effects of the alleged anti-competitive acts, the Tribunal considered the effects on imports from the U.S. ◦ How can this be reconciled with a geographic market that consists of

regions of Canada?

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Conundrum 1: Correlations and Price Discrimination

• Tribunal decided in favour of six markets based on evidence that prices across those six regions were not correlated (para. 112).

• MEGs: “When price discrimination is feasible, it may be appropriate to define relevant markets with reference to the characteristics of the classes of buyers or to the particular locations of the targeted buyers.” (para. 3.9)

• Telecom Abuse Bulletin: “The Bureau generally aggregates locations that have the same competitive alternatives (within the product market) for the relevant telecommunications services into a single geographic market.” (section 2.6)

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Canada Pipe - Location of Manufacturers and Importers

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Sellers of Relevant Product in North America

Seller Location Area of Distribution

Canada Pipe Ste Croix, QC Canada

Vandem Hamilton, ON Ontario

Fernco Sarnia, ON Canada

New Centurion Nanaimo, BC British Columbia (?)

Sierra Abbotsford, BC British Columbia and Alberta (?)

Mission Rubber California ?

Ideal Indiana and Arkansas ?

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Conundrum 2: Hypothetical Monopolist Test in Abuse Cases

• Base Price◦ The Tribunal noted that markets are based on sufficiently close substitutes.

Substitutes are considered close if buyers are willing to switch from one product to another in response to a relative price change (para. 68)

◦ Nowhere does it consider the relevant base price

◦ Based its conclusions on the Commissioner’s submissions on price correlations

• Those correlations were based on prices that prevailed during the stocking distribution program (the alleged anticompetitive conduct)

◦ The prevailing price is not typically the right base price when defining markets in abuse cases

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Market Definition in Conduct Cases

• Test: hypothetical monopolist

• Base price: an “appropriate benchmark”◦ Likely the price level that would prevail absent the alleged anti-competitive

act(s)

◦ Allows for a determination of the products and geographic areas that an allegedly abusive firm would have to control, or otherwise adversely affect, in order to be able to raise price above the price that would prevail absent the anticompetitive act

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Abuse Case Example

• Sections of relevant geographic markets can overlap

• The alternative supply locations buyers have available to them need not be uniform

• For example, a product is imported into both Eastern and Western Canada from Central America

• Within Canada, the product imported into or produced in the East is not shipped past Manitoba, and product imported into or produced in the West is not shipped past Saskatchewan

• Buyers throughout Canada have the option of buying product from Central America

• The relevant geographic markets are Eastern Canada plus Central America, and Western Canada plus Central America

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Making Use of Market Definition Evidence

• Who is proving (or disproving) what?

• Use visuals (maps, graphs, tables)

• Disclose methodology◦ Assumptions

◦ Data sets

• Reality check◦ Is the economic analysis compatible with key business documents and the

client’s market behaviour?