I.

ECONOMIC FOUNDATIONS OF COMPETITION LAW

A. Introduction

1. This chapter provides a brief introduction to the economic foundations of competition

law. Economics has played a substantial role in the development and implementation of
competition law in North America, Europe and other jurisdictions. A basic understanding of the
economic underpinnings of competition law is necessary for a proper understanding of the role
of competition law. This chapter provides a foundation for the more detailed and issue-specific
analysis of Chapter 2.

2. This chapter is divided into two main sections. The first of these sections focuses on the
economic rationale for having competition law. The second section discusses the economic
interpretation of a number of the key concepts in competition law: market power, market
definition, dominance and abuse of a dominant position.

B. Economic Benefits of Competition Law

3. It is a generally accepted principle that competition is desirable. Competition tends to

lead to cost efficiency, low prices and innovation. Markets that are competitive tend to lead to a
higher level of consumer welfare in both the short-run and the long-run than markets that are
not competitive. Conversely, it is generally believed that monopolies are bad for consumer
welfare. Competition law is about protecting the process of competition for the benefit of
consumers.

4. A good way to understand the benefits to consumers of competition is to compare the

outcomes for consumers under competition with the outcome under monopoly. The application
of competition law should be concerned with those market situations in which intervention on
the part of competition authorities can improve consumer welfare. The scope for such
intervention is illustrated in this section through a discussion of two extreme economic models:
perfect competition and monopoly. These models provide two very different market outcomes.
In oneperfect competitionconsumer welfare is maximized and could not be improved upon
even by an omniscient regulator. In the othermonopolyconsumer welfare is not maximized
and could, in principle at least, be improved upon by regulatory intervention. While neither of
these models provides a good description of the competitive process in most industries, they
can be used to illustrate the potential benefits of competition law intervention.

1. Perfect Competition

5. The model of perfect competition is the economic model that usually comes to an
economists mind when thinking about competitive markets. In the perfect competition paradigm
there are many buyers and sellers of the product, the quantity of products bought by any buyer
or sold by any seller is so small relative to the total quantity traded that changes in these
quantities leave market prices unchanged, the product is homogeneous, all buyers and sellers
have perfect information and there is both free entry into and exit out of the market.
2

6. These assumptions have a number of implications. The most important is that the
market price of the product will be equal to the marginal cost of producing the product,1 and in
equilibrium this will be the same for all producers. The intuition behind this result is simple. If the
market price of the product is above the marginal cost of production for a seller, that seller can
make more profit by selling one more unit of production. Since the price obtained for the good
exceeds the costs incurred in producing it, a positive margin is made on the sale. Similarly, if the
marginal cost were greater than the market price, profits could be increased by reducing output.
Since the product is (by assumption) homogeneous and no seller can affect the market price,
the market price is the same for all sellers. This implies that each seller will expand output to the
point at which marginal cost is equal to the market price. In equilibrium, all sellers have the
same marginal cost and this marginal cost is equal to the market price.

7. Another important implication of this model is that no firm makes positive economic
profits.2 If the price was high enough for firms in the market to make positive economic profits,
other firms that were not in the market would enter in order to earn some of these economic
profits. The assumption of free entry into the market means that entry would continue until the
incumbent firms were no longer making economic profits. The assumption of free exit means
that firms would not remain in the market if they were making losses. So in perfect competition
firms make zero economic profits. This implies that in addition to being equal to marginal cost,
the market price must be equal to the average cost of the firms.

8. To summarize, markets characterized by the assumptions of perfect competition have

the following properties:
price is equal to marginal cost;
price is equal to average cost (thus implying that marginal cost is equal to
average cost); and
no firm makes positive economic profits.

9. These properties are shown in Figure 1.1.

1
The marginal cost of a product is the cost of producing the next unit of the product. So if it costs a car producer
45,000 to produce nine cars but only 47,500 to produce ten cars, then the marginal cost of the tenth car for that
producer is 2,500. Notice that in this example average cost falls from 5,000 to 4,750 as output is expanded
from nine to ten.
2
This does not imply zero accounting profits. Zero profits in economics are taken to indicate that all factors used in
production including capital receive their opportunity cost and no more. The opportunity cost of an asset is the
value of the asset if put to the best alternative use. In particular, assets earn their cost of capital. The resulting
level of profit is also known as normal profit.
 3

Figure 1.1: Perfect Competition in an Industry

Price
Demand
curve
M arginal
cost curve

Average
Pc cost curve

Qc Quantity

10. The straight downward sloping line depicts the industry demand curve. This indicates
how much of the product consumers demand (want to buy) at different prices. As price falls,
consumers will wish to buy more of the product, so the demand curve slopes downward (as do
the demand curves of virtually all products).3 Pc denotes the perfectly competitive price in this
case and Qc is the perfectly competitive level of output. As the figure shows, at Pc marginal cost
is equal to price (i.e., the marginal cost curve cuts the demand curve) and average cost is also
equal to price (so total profits are zero).4

11. If an industry were characterized by perfect competition, then it would not be possible for
even an omniscient regulator to increase social welfare in this industry (i.e., the sum of
consumer welfare and producer welfare (profits)). To understand why requires an understanding
of the two types of benefits that perfect competition delivers. Perfect competition delivers both
productive efficiency and allocative efficiency.

12. Productive efficiency occurs when a given set of products are being produced at the
lowest possible cost (given current technology, input prices and so on). This occurs in industries
characterized by perfect competition because any firm that does not produce at the lowest
possible cost will lose money and exit the market. In perfect competition, economic profits for
efficient firms are zero and so inefficient firms must lose money. Perfect competition leads to
firms being productively efficient because the pursuit of the maximum possible profits gives
firms an incentive to reduce costs as far as possible and, unlike in many other models of
competition, firms that do not have costs as low as their rivals will exit the market due to losses.
These considerations reveal a second possible detrimental effect in those markets not

3
Note that the demand curve in Figure 1.1 is an industry demand curve. This indicates the total demand for the
product at different prices. Industry demand curves are (virtually) always downward sloping. The demand curve
facing any particular firm will be different from the industry demand curve. When discussing a demand curve, it is
important to be clear as to whether it is an industry demand curve or the demand curve for just a single firm. We
discuss this issue in more detail below.
4
Note that the average cost curve in this example initially slopes down. This indicates the presence of some fixed
costs of production (e.g., the fixed costs of a factory).
4

characterized by strong competition. Costs as well as prices may differ between competitive and
less competitive markets. If a lack of competition in an industry gives rise to slack and
inefficiency in production, then welfare losses will occur.

13. Allocative efficiency relates to the difference between the cost of producing the marginal
product and the valuation of that product by consumers. If the marginal cost of producing one
more unit is different from the amount that consumers are willing to pay for that extra unit, then
there is allocative inefficiency. If the marginal cost of producing an extra unit is below the price
that consumers are willing to pay for that unit, then both the seller and consumers could be
made better off if the seller produced one more unit. He could sell it for more than it cost him to
produce but at or below the price that consumers are willing to pay for it. There is allocative
inefficiency because a reallocation of resources towards producing one more unit would
improve social welfare. Equally, if the marginal cost was greater than the price that consumers
are willing to pay for the unit, there would again be allocative inefficiency. In this case
consumers value the product less than it costs to produce and so social welfare would be
increased by a reduction in output. Only if price equals marginal cost is there allocative
efficiency. Thus, perfect competition delivers allocative efficiency because perfect competition
ensures that price and marginal cost are equal.

2. The Monopoly Paradigm

14. At the opposite extreme to perfect competition is monopoly. Here the assumption of
many sellers is replaced by the assumption of just one seller. Figure 1.2 shows that a
monopolist will price above the level that would occur in the presence of perfect competition.
Under perfect competition, price equals marginal cost and is determined by the intersection of
the demand curve and the marginal cost curve. This price is denoted by Pc in Figure 1.2. Under
monopoly, price is at level Pm (also shown in Figure 1.2), which lies above Pc.

Figure 1.2: Monopoly

Price
Demand
curve
Marginal
cost curve
Pm a

d b
Pc

Qm Qc Quantity

Marginal revenue curve

 5

15. The demand and marginal cost curves in Figure 1.2 are the same as those in Figure 1.1
illustrating perfect competition.5 However, an additional curve has been added.6 This is the
marginal revenue curve. This curve shows the amount of extra revenue that the monopolist
earns when he sells one more unit of product. If the monopolist decides to sell x+1 units rather
than x, he will receive additional revenue from selling that additional unit, but because the
demand curve slopes down he will have to charge a lower price not only on that extra unit but
also on all the other units sold.7 Thus, the marginal revenue curve always lies below the
demand curve because the marginal revenue that the monopolist makes is less than the price at
which he sells. The monopolist will expand output to the point where marginal revenue is equal
to marginal cost.8 The intuition is clear. The cost of producing one more unit is the marginal
cost. The benefit to the monopolist of selling that extra unit is the marginal revenue. In
equilibrium, these will be equal. Hence, in Figure 1.2 the monopolist will sell Qm units at Pm.

16. Figure 1.2 shows that the monopolist will sell less than would be sold under perfect
competition, and the price will be higher. This means that the pricing and output decisions of a
monopolist fail to maximise social welfare and thus allow scope for a regulator to improve
matters. The shaded area in Figure 1.2 (abcd) represents the deadweight social welfare loss
from monopoly. This is the cost to society of a market not operating efficiently. It is the area
under the demand curve, but above the marginal cost curve, between Qm and Qc. Between Qm
and Qc the marginal cost of production is less than the value that consumers put on that
production (as shown by the demand curve). There would therefore be a social gain from more
production since the costs involved in producing that additional output would be less than
consumers valuation of that production. Hence, social welfare can be improved by lowering the
price and raising the output of the monopolized good. Monopoly leads to allocative inefficiency
because there is a difference between the marginal cost of production and the valuation of the
marginal consumer.

17. Social welfare is traditionally measured as being made up of two parts: consumer
surplus and producer surplus. Consumer surplus is the area under the demand curve but above
the price. It represents the sum of how much each unit sold is valued by consumers above its
price. The part abd of the shaded area in Figure 1.2 is the consumer surplus loss due to
monopoly. The remainder of the shaded area is made up of producer surplus. This is defined as
the area above the marginal cost curve but below the price (i.e., the excess of what the extra
goods could be sold for above the cost of producing them).

18. Monopoly may also encourage productive inefficiency. Under perfect competition firms
must be productively efficient because otherwise they will make losses. Under monopoly a firm
can still make profits even if it is somewhat productively inefficient. As Hicks famously wrote,
The best of all monopoly profits is a quiet life.9 Note that to the extent that marginal costs are
inefficiently high, prices will be even higher, and output even lower, under a productively
inefficient monopolist than with a productively efficient monopolist.

5
Note that because we are dealing with a monopolist, the demand curve in Figure 1.2 is both the industry demand
curve and the firm demand curve.
6
To prevent Figure 1.2 from becoming too cluttered, the average cost curve has been omitted.
7
This assumes that the monopolist is unable to price discriminate between consumers and so has to charge the
same price to all consumers.
8
This is actually true of virtually all firms, whether the firm operates in a perfectly competitive market, is a monopolist
or forms part of an oligopolistic market (as long as they are not colluding). For a firm in perfect competition, the
price is the same as its marginal revenue because the market price does not vary as the firm varies its output (in
stark contrast to the situation facing a monopolist).
9
Hicks, J. 1935. Annual Survey of Economic Theory: The Theory of Monopoly. Econometrica 3 (8).
6

3. Welfare Standard

19. Economists have traditionally focused on social welfare. They do not make a value
judgment between consumers and producers and so treat 1 of gain to either group as being of
equal value. If pushed, many economists will point out that when companies are owned by
shareholders, many of whom are pension funds, then the distinction between consumer surplus
and producer surplus is much less clear cut than it at first seems.10 However, competition law
focuses on consumer surplus. Thus, for instance, the European Commission wrote recently
that the purpose of the competition law is the protection of competition on the market as a
means of enhancing consumer welfare and of ensuring an efficient allocation of resources. In
the Preface to Promoting competition, protecting consumers: a plain English guide to antitrust
laws, the US Federal Trade Commission describes itself as a consumer protection agency
that promote[s] competition in the marketplace. Competition benefits consumers.

20. Referring back to Figure 1.2, this concern with consumer welfare rather than producer
welfare means that competition law is principally concerned not with the deadweight social
welfare cost of monopoly (the shaded area abcd), but instead with the reduction in consumer
surplus represented by PmabdPc. This area can be broken down into two parts: the area
PmadPc and the area abd. The area PmadPc represents the additional profits that the
monopolist makes from selling Qm units at the monopoly price Pm rather than Qc units at the
perfectly competitive price Pc. It also represents the additional sum that consumer pay to buy
Qm units at Pm rather than Pc. As such it is a pure transfer from consumers to the monopolist.
The area abd is part of the deadweight cost of monopoly.

21. The conclusion to be drawn from the discussion so far is that competition law is
designed to protect competition, or the competitive process (because this leads to more output
and lower prices than in the absence of competitionand lower prices and more output benefit
consumers).

4. Oligopoly

22. However, neither the paradigm of perfect competition nor that of monopoly provide
adequate descriptions of competition in most industries. While the models of perfect competition
and monopoly provide a good basis for understanding the basic economic principles,
particularly in illustrating the detrimental welfare consequences of monopoly, neither model
provides a solid framework on which to base policy prescriptions. These models ignore the
interaction between firms and how this interaction may affect the outcomes of the competitive
process. In the model of perfect competition, each firm is so small that it can put as much or as
little for sale on the market without affecting the market price. For this reason, a firm in a
competitive market has no reason to worry about what other firms will do when it makes its own
plans. For example, a farmer selling his product in an international market does not consider
whether his output will affect the market price but instead takes the market price as a given that
he cannot affect. At the other extreme, the monopolist can directly set the market price as it has
no rivals to worry about.

10
Bork, R.H. 1993. The Antitrust Paradox. New York: Free Press. Robert H. Bork is a strong advocate of the social
welfare criterion.
 7

23. But in most markets firms do need to take into account the commercial decisions of
rivals when formulating their own commercial strategy. In most markets, firms recognize that
changes in their own planse.g., prices, planned production and additions to capacityaffect
the decisions of other firms in the industry and will take this into account when making
commercial decisions.

24. There is a temptation to conclude from this that oligopolies are always characterized by
a lack of competition. The argument is that because firms know that any price reduction will
lead to a response from their competitors (most likely a price cut), they are less willing to
compete strongly by lowering prices. This is not correct. Whilst it is certainly true that under
some circumstances oligopolies can be characterized by rather weak competition, it is also true
that in others they can be characterized by strong competition. An extreme example of the first
proposition is a cartel: here a collection of firms, almost always part of an oligopoly with
relatively few firms, explicitly agree not to compete and to jointly agree on prices. An example
of the second proposition is the economic model of monopolistic competition.

25. Firms in monopolistic competition sell differentiated products and so each firm has a
monopoly over the particular type of product that it sells. If products are differentiated, then if
one firm undercuts the other firms in the market, the higher priced firms do not lose all of their
sales because some consumers will prefer their products to the lower priced product even at the
higher price. For instance, if one car manufacturer lowered its prices, then some consumers
would switch from other makes of cars to the lower priced make, but many consumers would
continue to buy the other makes. The result is that in oligopolies characterized by monopolistic
competition, prices are not driven down to marginal cost (unlike under perfect competition). The
monopolistic competition model is a good description of many real world markets in which a
relatively few firms sell differentiated products.

26. The fact that prices are above marginal cost does not necessarily mean that there is not
effective competition. If there are no barriers to entry, each firm in monopolistic competition
makes zero economic profits because positive economic profits would lead to new entry, thus
driving profits back towards zero. Figure 1.3 illustrates the equilibrium for a firm in a market
characterized by monopolistic competition in which it makes zero economic profits.
8

Figure 1.3: Monopolistic Competition

Price Average
cost

PMC

Demand
Marginal curve
cost
Marginal revenue

QMC Output

27. QMC and PMC in Figure 1.3 are the sales and price respectively of a firm in monopolistic
competition. The demand curve facing the firm is downward sloping, unlike in perfect
competition, because the firm sells a differentiated product. Under perfect competition each firm
makes up only a tiny proportion of the market, with the result that its sales do not affect the
market price of the product. In addition, each firm sells a homogeneous product and so the
products of its competitors are perfect substitutes for its products. This means that the demand
curve of a firm in perfect competition is flat: it can sell any amount of output at the competitive
price level, but would sell none if it raised its price above the competitive level. This is not the
case when a firm sells a differentiated product. When products are differentiated, the products
of other firms are not perfect substitutes and so the firms do not lose all their sales when they
raise prices. Hence they face downward sloping demand curves. As a result, the marginal
revenue curve of a firm selling a differentiated product is also downward sloping. The firm
maximizes profits at the point at which the marginal cost curve cuts the marginal revenue curve
(QMC). At this point the average cost curve just touches the demand curve, so price is equal to
average cost and the firm makes zero profits.

28. It is worth considering why monopolistic competition model leads to prices above
marginal cost. In perfect competition price is equal to marginal cost because a firms output
decision has no effect on the price that it sells its product for. This is not true in oligopoly
models. In monopolistic competition, each firm faces a downward sloping demand curve
because its product is differentiated from the other products. This implies that each firms output
directly affects the price at which it sells, so marginal revenue is less than price and so price is
above marginal cost. An important implication of this is that competition can be effective even
when firms have some control over the price at which they sell their goods.
 9

5. Dynamic Considerations

29. So far we have discussed models of competition that are essentially static. By this we
mean that they are based on the assumption that the range of products available and the
methods of producing those products are fixed. We have ignored issues to do with innovation,
and how the possibility that firms might engage in innovative behavior may change the range of
products available, the production processes and, as a result, the nature of competition in the
industry.

30. Static models focus on prices and quantities and in particular tend to focus on price
competition between firms. This may be inappropriate in a dynamic environment. In many
dynamic competitive environments firms compete not on prices, but on innovation. They
compete not by pricing a given product lower than their rivals, but by carrying out research and
development and so being able to sell a product that no one else has. In environments of this
type it does not make sense for competition policy to focus solely on price.

31. One important sense in which the competition analysis can be changed in dynamic
markets is that rather than competing in the market, firms can compete for the market. For
instance, firms might compete to be the first to patent a drug that cures a particular disease.
Whoever patents a drug first then gets legal protection to be the sole seller of that drug for the
life of the patent. The winner of the patent race faces no competition in the market as he has
a legal monopoly and is the sole supplier in the market. However, he may have faced very
strong competition in the patent race, when different firms were competing for the market.

32. A number of implications flow from this. First, firms spend considerable amounts of
money in the research and development stage in order to be the first to innovate and hence win
the right to earn monopoly profits thereafter. Firms only spend money on research and
development because of the expectation of monopoly profits if they win. If there were no
monopoly profits to be earned, the firms would probably choose not to undertake the research
and development in the first place. The monopoly profits that the winner earns are therefore
essential to the operation of the market.11 Rather than being an inefficient market structure that
harms consumers, monopoly is a necessary market structure that ensures that consumers
benefit from firms undertaking risky innovative activities. This is the form of competition that the
Austrian School of economists focused on. The most famous of these economists,
Schumpeter, described dynamic competition as a process of creative destruction in which
innovative activities led to new markets, new industries and the death of old markets and
industries.12 In this world current monopolists always face the risk that their monopoly will be
replaced by a new innovator with a new and better product.

33. Second, markets such as this are often characterized by very high fixed costs (of
research and development) and very low marginal costs of production. In the case of
pharmaceuticals or software, for instance, marginal costs are almost zero. When fixed costs
are large and marginal costs are low, firms must price substantially above marginal cost to
cover total costs. Further, since firms incur very significant risks when they invest in research
and development in the hope of winning the race, we should expect prices to be high enough to
generate revenue significantly in excess of total costs. The expected returns to winning must be

11
It is the recognition of this that has led to the protection of intellectual property rights via instruments such as
patents.
12
Schumpeter, J. 1950. Capitalism, Socialism and Democracy. 2nd ed. New York: Harper & Row.
10

high enough that even once they are discounted due to the risk of losing, firms expect ex ante to
make a positive return. For instance, three firms will only engage in a patent race if the
expected returns are more than three times the R&D costs.13

34. Third, dynamic industries sometimes exhibit network effects. Some products are more
valuable to a user the more other people are using the same product. For instance, subscribing
to a telecommunications network becomes more valuable when there are already many
subscribers on the network who you can call and who can call you. Equally, consumers value
using the same software platform as other consumers as this makes it easier to swap files,
leads to more software being written for that platform, leads to more self-help manuals being
written for that platform and so on. In the presence of network effects customers tend to choose
the product that already has the largest group of users, regardless of whether this is technically
the best product on the market. In such cases, the market will tend to tip towards a monopoly
and we should expect to see monopoly or near monopoly.

C. Economic Interpretation of the Key Concepts in Competition Law

1. Market Power

35. The concept of market power is at the heart of competition law. Anti-competitive
outcomes can only arise in markets in the presence of market power. The standard definition of
market power is that market power is the ability of a firm or group of firms to raise price, through
the restriction of output, above the level that would prevail under competitive conditions and
thereby to enjoy increased profits from the action. Thus, the UK Office of Fair Trading (para.
1.2, OFT415) states that this guideline usually refers to market power as the ability to raise
prices consistently and profitably above competitive levels,14 the European Commission states
that market power is essentially measured by reference to the power of the undertaking
concerned to raise prices by restricting output without incurring a significant loss of sales or
revenues (para. 65)15 whilst Mehta and Peeperkorn (para 1.18) state that The answer given by
economists on the first questionwhat is market power?concentrates on the power to raise
price above the competitive level.16

36. There are three important points to note about these definitions. First, the exercise of
market power leads to lower output. If a firm (or firms) wishes to increase price, it must be
prepared to sell fewer units. The higher the price that the firm charges, the lower the quantity
demanded and vice versa. For example, an increase in the price of cinema tickets will lead to
fewer people going to the cinema. What is true for an individual consumer is true of the market
as a whole as the market demand curve is the aggregation of individual demand curves.

37. The second important point is that the exercise of market power must involve an
increase in the profitability of the firm. Any firm can choose to raise price at any time, but this
does not mean that every firm has market power. As discussed above, the action of raising
price will cause demand to fall. If demand were to fall sufficiently so that an increase in price

13
This assumes that each firm believes it has a one third chance of winning the patent race.
14
Office of Fair Trading. 1999. Assessment of Market Power, OFT 415. London.
15
European Commission. 2001. Commission Working Document on Proposed New Regulatory Framework for
Electronic Communications Networks and Services. Draft guidelines on market analysis and the calculation of
significant market power. COM (2001) 175 - 28.03.2001
16
K. Mehta and L. Peeperkorn in J. Faull and A. Nikpay. 1999. The EC Law of Competition. Oxford University Press.
 11

above the competitive level were to lead to lower profits, then the firm would not possess market
power. However, if the reduction in quantity sold is sufficiently small that it is outweighed by the
higher price (and lower costs since less needs to be produced), restricting output below the
competitive level will cause profits to rise and the firm does have market power. So the key is
how much demand the firm loses when it raises price. This is measured by the price elasticity
of demand facing the firm. The price elasticity of demand is defined as the ratio of the
percentage decrease in sales resulting from a given percentage increase in price. Thus an
elasticity of 1 means that a 1% rise in prices will lead to a 1% fall in sales. An elasticity of 5
would mean that a 1% rise in price leads to a 5% fall in sales and an elasticity of 0.5 would
mean that a 1% rise in price leads to only a 0.5% fall in sales. If the elasticity of demand is
greater than 1, then a rise in price leads to a reduction in revenue. An elasticity of less than 1
implies that a price rise leads to an increase in revenue. Figure 1.4 shows that a rise in price
from p1 to p2 has a larger effect on quantity demanded in (a) than in (b). Thus the elasticity of
demand is more elastic in (a) than in (b).17

Figure 1.4: Elastic and Inelastic Demand Curves

Price Price

p2 p2

p1 p1

q2 q1 q2 q1
Quantity Quantity

(a) (b)
38. The greater is the elasticity of demand facing a firm, the more sales it will lose if it raises
its price and hence the less profitable a price rise is. Thus the higher the elasticity of demand
facing a firm at the competitive price level, the less market power the firm has.

39. The third important point to note is that the exercise of market power involves increasing
price above the level that would prevail under conditions of effective competitionand therefore
also restricting output to below the effective competition level. For the purposes of examining
whether a firm is currently exercising market power, the prevailing price level does not provide
the appropriate benchmark. This is often forgotten. If a firm is maximizing profits, the answer to
the question of whether the firm could profitably restrict output and raise price should always be
no. If it were profitable to do so, the firm would already have done itthe firm would have set
price at the point at which profits are maximized. This holds true for all firms, from perfectly
competitive firms to monopolists. Thus, in assessing whether market power exists, the issue is

17
In fact, when demand curves are linear, the elasticity of demand varies as price varies (it rises as price rises). So it
is not the case that the elasticity of demand at any given price in (a) is larger than the elasticity of demand at all
prices in (b). However, what is true is that at any given price, the elasticity in (a) is larger than the elasticity at the
same price in (b).
12

not whether the firm could profitably raise price from the current level (to which, if the firm is well
managed, the answer should always be no) but whether the firm is able persistently to price at a
level above that which would prevail in conditions of effective competition.

40. The most common indicators of whether a firm has market power are:
the number of competing suppliers of the same products, market shares and
concentration;
barriers to entry and potential competition;
barriers to expansion;
buyer power; and
profitability.

a. Number of Competing Suppliers, Market Shares and

Concentration

41. It is intuitively appealing to proxy the level of competition a particular firm faces with the
number of competitors it has. In general, as the number of firms in an industry increases, the
demand curve facing any one of them becomes more elastic because consumers have more
alternative suppliers to turn to if a firm raises its price. For most market demand curves, there do
not have to be very many firms in an industry for the elasticity of demand facing a single firm to
be large.

42. However, the number of competitors in a market does not always provide a good
indication of the level of competition in that market. For instance, prices can diverge markedly
from the competitive level even in the presence of other firms if conditions are such that it is
relatively easy to set up and maintain a cartel (e.g., in very transparent markets where the price
set by all firms is very clear). In contrast, under some conditions price competition can be very
vigorous even with just two or a few competitors in a market. Further, if entry and exit were
costless and very easy, then even a monopolist might not be able to raise prices above the
competitive level because the mere threat of entry would keep prices low. Similarly, market
shares are often only weak indicators of market power in bidding markets. In bidding markets
buyers offer a number of firms the chance to be their preferred supplier by bidding the lowest
price. Suppliers therefore bid based on their own costs and on their expectations of what others
will bid. In markets of this type, firms that have previously won only a modest number of
contracts or perhaps have never previously won a contractas would be the case if the firm
were a new entrantcan affect the price at which contracts are awarded. What matters is not
market share but the ability to submit a credible bid. Even a firm with a very low market share
may still have a major effect on the bidding behavior of other firms in the market as long as they
bid credibly and aggressively. Accordingly, current market shares can provide a very misleading
picture as to the level of current competition.18 Equally, where barriers to expansion by existing
players are low, current markets shares are not a good proxy for market power. Finally, highly
variable market shares indicate that a high current market share may only be transient and
suggest the existence of significant competition between firms, thus implying relatively little
market power.

18
The merger of the McDonnell Douglas and Boeing companies in 1997 a good example of this phenomenon. This
involved potential competition concerns in the market for large commercial aircraft. Boeing had a 64% market
share, Airbus had 30% and McDonnell Douglas had 6%. Despite McDonnell Douglas low market share, the
European Commission found that the average winning bid for supplying large commercial aircraft to airlines was
7% lower when McDonnell Douglas was involved in the bidding process, rather than just Boeing and Airbus.
 13

43. Nonetheless, the most commonly used proxy for the existence of market power in an
industry is some measure of market share or concentration within the market. The European
Commission has traditionally become concerned about the market power of firms when their
market share is above 40%. The UK domestic competition authorities have traditionally seen
25% as a threshold figure for significant market power, whilst under South African law 45% is an
important threshold figure.

44. The two most common measures of market concentration are concentration ratios and
the Herfindhal-Hirschman Index (HHI). The concentration ratio provides a simple summary
statistic of the level of concentration in a market. A number of concentration ratios for a given
market can be calculated. For example, one can talk of the two firm concentration ratio
(commonly written as C2) or the four firm concentration ratio (written as C4). C2 is defined as the
sum of the market shares of the leading two firms in the market and C4 is defined as the sum of
the market shares of the leading four firms in the market.

45. However, concentration ratios have two significant deficiencies as proxies for the
effectiveness of competition in an industry. First, they do not take account of the relative sizes of
the leading companies. For example, a market which has four firms each with a 20% market
share will have the same C4 ratio as a market in which the leading four firms have market
shares of 55%, 20%, 3% and 2%. But it is probable that the competitiveness of the two markets
will differ. For instance, in the latter case there is a clear potential leader for the other firms to
follow, whereas in the former case their might be fierce competition to become the largest firm
(particularly if there are significant economies of scale in production). The second problem
stems from taking into account neither the total number of firms in the market nor the market
shares of smaller companies.19

46. The HHI takes account of all firms in the industry. The HHI is defined as the sum of the
squared market shares of all firms in the market. Thus
N
HHI = S
i =1
i
2

where there are N firms in the market and Si is the market share of firm i. The HHI must lie
between zero (an infinite number of firms in the market, each with essentially zero market
share) and 10,000 (a monopolist).

47. Consider the examples mentioned above. Suppose there are 4 firms, each with 20%
market share, and 20 firms each with 1% market share. The HHI will be 1620.20 Now consider
the example of one firm with 55%, another with 20%, another with 3%, another with 2% and
then 20 with 1% each. The HHI in this case is 3458.21 Consistent with the intuition above, the
latter market structure has a higher HHI and so appears to be a less competitive market
structure on the basis of the HHI.

19
In many industries, the ability of existing firms to expand capacity can provide a more important competitive
constraint than the potential for entry. If smaller firms have the capacity to increase output in response to a price
increase by leading firms in the market, then they can provide an effective competitive constraint on market
behavior. We discuss this further below.
20
HHI = (4 x 202) + (20 x 12) = (4 x 400) + 20 = 1,620.
21
HHI = (552 + 202 + 32 + 22) + (20 x 12) = (3,025 + 400 + 9 + 4 + 20) = 3,458.
14

48. Although concentration ratios and HHIs are relatively easy to calculate and have some
intuitive appeal, the use of market shares, concentration ratios and HHIs to assess the
competitiveness of an industry raises a number of potentially serious issues. First, the level of
observed concentration in a market is affected by many factors. In particular, if one firm in a
market becomes more efficient than the others (possibly due to a technological advance), it
should be expected that this firm will earn high profits and gain market share, thus increasing
market concentration. But it would be a mistake to equate increasing concentration with
lessening competition in this case. Firms that are more cost efficient usually charge lower
prices than their less efficient rivals and so increase their market share, but the lower prices
clearly benefit consumers and so should be welcomed.

49. Secondly, the use of market shares logically requires the definition of some market.
Serious problems arise with using market shares to make inferences about competition when
the definition of the market from which market shares are calculated is incorrect. Since market
shares are often used as an important indicator of market power, the definition of the market
should reflect the competitive constraints between products. The question of how best to define
the relevant market is discussed below. If market definition is accurately carried out, market
shares are useful as a screening device. A firm with a low market share is unlikely to possess
market power. However, it does not follow that a firm with a high market share necessarily
therefore has market power. A reasonable rule of thumb is that a high market share of a
correctly defined relevant market can be taken as a necessary condition for the exercise of
market power, but it is not a sufficient condition.

50. Thirdly, as noted above, concentration and the number of competitors in a market does
not always provide a good indication of the level of competition in that market. Markets with
many players and low concentration can sometimes be cartelized, whilst highly concentrated
markets can be characterized by fierce competition when, for instance, entry into and exit from
the market are very easy.

b. Barriers to Entry and Potential Competition

51. Barriers to entry are a necessary condition for the existence of market power.22
Competition analysis has long understood that a firms attempt to exercise market power could
be defeated by a new supplier entering the market. The possibility that price increases will
encourage new firms to enter the market can provide a powerful constraint on the competitive
behavior of incumbent firms. Indeed, the constraint posed by entry, or just the potential for entry,
can (as noted above) prevent even firms which enjoy very high market shares from exercising
market power.

52. Barriers to entry and the potential effect of new entry relate to the ability of firms outside
a particular market nonetheless to impose a constraint on the potential for exercising market
power within the market. Two factors affect the entry decision of a firm: the level of
unrecoverable costs of entry, so-called sunk costs, and the expected profitability of entry. For a
given level of expected post-entry competition, the greater the unrecoverable costs associated
with entry, the less likely entry is to occur. Where sunk costs are large given the size of the
market, only a few players will co-exist in the market. However, even if the costs associated with
entry are low, no firm would consider entering the market if post-entry competition was expected
to result in margins so low that the costs of entry would not be recovered. Vigorous competition

22
Although, as we note below, barriers to entry are not a sufficient condition for the presence of market power.
 15

in the market place or the expectation of it can therefore deter entry. Thus, there is an interplay
between the costs of entry and the degree of price competition expected post-entry which
determines market structure.

53. The 1992 US Merger Guidelines make a distinction between uncommitted and
committed entry. The concept of uncommitted entry effectively incorporates the idea of supply-
side substitution (i.e., of entry from a neighboring market in which firms already have the
necessary assets needed to manufacture products for another market). Uncommitted entry can
take place quickly without the need for substantial investment in new plant or equipment. This
allows such firms to take advantage on a short-term basis of any profit opportunities that should
arise and also to exit once those profit opportunities have disappeared. Committed entrants in
contrast need to invest significant amounts before they are able to compete. This means that
committed entrants expect to be in the market for more than the duration of short run profit
opportunities. Entry is more risky for committed entrants than for uncommitted entrants.
Accordingly, expectations of the level of post-entry competition are more important for
committed entrants than for uncommitted entrants.

54. It is important when assessing the scope for new entry to conduct the analysis in the
appropriate order. The analysis of the competitive constraint provided by the potential for new
firms to enter the market should follow the assessment of the competitive constraints that exist
between firms already active in the market. In many cases, there is a tendency to assert that
barriers to entry are high because no entry has occurred and from this conclude that the firms
already active in the market are not subject to effective competitive constraint. But such an
approach fails to identify those situations in which the reason entry has not taken place is
because competition in the market is already vigorous.

55. Examples of barriers to entry include economies of scale, network effects, advertising
and vertical foreclosure. Economies of scale exist when average cost declines as output rises.
If there are large economies of scale, then this makes it hard to enter a market profitably. If a
new entrant enters on a small scale, it will be hampered by having high average costs. If it
enters on a large scale, then it will be cost efficient but the large scale of entry is likely to lead to
prices falling substantially, thus making entry unattractive. Intellectual property and physical
networks (e.g., telecoms network) can lead to extreme economies of scale as fixed costs are
high but marginal and variable costs tend to be are low.

56. Network effects can have the same effect as economies of scale. Network effects can
arise when the larger the market share of a firm, the more likely consumers are to choose that
firm rather than a rival. Operating systems for PCs are an example. There are significant
advantages to using the same operating system as others do, such as the fact that more
software is written for the dominant operating system. Network effects also arise when a market
requires a physical network that would be uneconomic to replicate (e.g., fixed line telecoms,
gas, electricity, water).

57. Advertising can be used to create a barrier to entry. By investing heavily in brand or
product promotion, an incumbent can make it harder for other firms to enter a market. Firms
can also create barriers to entry through vertical foreclosure. Thus a manufacturer might create
a barrier to entry for rival manufacturers by signing exclusive deals with the best retailers, whilst
a retailer might create a barrier to entry for rival retailers by signing exclusive supply contracts
with the manufacturers of the most popular products.
16

c. Barriers to Expansion

58. Barriers to expansion relate to the ability of firms already operating in the market to
impose a constraint on the potential for a firm or firms to exercise market power within the
market. A barrier to expansion is something that stops a firm already in a market from being
able quickly and cheaply to increase its output. Thus a firm that is capacity constrained and
would have to incur significant sunk costs to expand its output faces a barrier to expansion,
whereas one that currently has spare capacity does not face such a barrier to expansion (up to
the point at which it is using all its capacity). Equally, a firm that is currently producing at full
capacity may not face significant barriers to expansion if it can increase its capacity quickly and
relatively cheaply (in particular, without incurring significant sunk costs). If rival firms in a market
do not face barriers to expansion, then they are likely to be able to respond to a price rise
imposed by another firm by undercutting the price rise and selling more output than previously,
thus undermining the attempt by the original firm to raise prices profitably.

59. Barriers to expansion can be important in competition policy analysis because they can
be low even though barriers to entry are high. A failure of take account of barriers to expansion
might lead to the erroneous conclusion that a firm with a high market share has market power
because there are high barriers to entry into the market, when in fact low barriers to expansion
by firms already in the market mean that the firm with a high market share has no market power.
In the same way that sunk costs are key to the analysis of barriers to entry, they are key to the
analysis of barriers to expansion. If a firm would need to incur significant sunk costs to expand
its output, then it probably faces significant barriers to expansion. However, it is quite possible
that there could be significant sunk costs to entering a market, but low sunk costs to expanding
output once in a market. Two examples should make this clear. When branding matters,
barriers to entry can be high but barriers to expansion low. Firms often need to incur significant
sunk costs (usually of advertising) to create a brand and this may be a pre-requisite for entering
a market. However, once the firm has established its brand and is in the market, expanding
sales may not require significant sunk costs. A second example is that when investment is very
lumpy,23 it may be necessary to incur large sunk costs to enter a market, but then the costs of
expanding output to full capacity may be very low. Of course, once such a firm reaches full
capacity, the lumpiness of investment means that it then faces high barriers to further
expansion.

60. The simple conclusion from this analysis is that a large market share and high barriers to
entry do not necessarily translate into significant market power. The ability of other firms
already in the market to expand their output quickly and cheaply can undermine this apparently
simple relationship.

d. Buyer Power

61. The indicators of market power that we have discussed so far all relate to issue on the
supply-side of the market: the market shares and concentration of the various suppliers, the
barriers to entry for new suppliers and the barriers to expansion for existing suppliers. However,
the characteristics of the demand-side of the market can also be important for determining

23
Investment is said to be lumpy when the investment necessary to produce one unit of a good is very similar to the
investment needed to produce many more units. For instance, if a firm needs to buy a piece of machinery that it
very expensive before it can start producing any units, but this machine will then be able to produce, say, a million
units, then investment is lumpy. If the size of the lumps is large relative to the size of the total market, then we
should expect to see relatively concentrated markets.
 17

whether a supplier has or suppliers have market power. Where buyers are strong, they may
be able to countervail against any potential market power of suppliers. If this is the case, there
is said to be buyer power.

62. An example of buyer power would be a large buyer threatening to switch suppliers if its
current supplier did not lower its price, and that supplier therefore lowering its price. This is a
common business practice. Firms often play suppliers off against each other by threatening to
purchase from an alternative supplier who is offering a lower price. There are two important
points to note about buyer power. The first is that the power of buyers when dealing with a
supplier depends on the buyers outside options. A threat by a buyer to switch to an alternative
supplier is only credible if there are alternative suppliers available. So buyers are more likely to
be able to exert buyer power against a supplier when other suppliers are able to supply similar
products and are not capacity constrained. Conversely, buyers will have little power vis--vis a
supplier when that supplier provides a product for which there are not good substitute suppliers
or when those substitute suppliers are capacity constrained. The second important point is
even when large buyers can exert buyer power, this does not necessarily mean that suppliers
cannot exert market power with respect to smaller buyers. Competition authorities often argue
that whilst large buyers can look after themselves by exerting buyer power, smaller buyers
cannot. Indeed, on occasions they even argue that the fact that large buyers exert buyer power
makes it more likely that suppliers will exploit smaller buyers in order to maintain overall
margins.24

e. Profitability

63. It seems intuitively obvious that the level of profits that a firm is earning could be used as
a proxy for the degree of competition in the market in which it operates. The UK OFT (para.
2.23) states that The ability of an undertaking...to earn excessive profits may provide evidence
that it possesses some degree of market power.25

64. However, care needs to be taken in deducing market power from high profitability (or a
lack of market power from low profitability). The logic that is used to defend the use of profits as
a measure of the degree of competition in a market is broadly as follows: the role of competition
policy is to maximize consumer welfare; profits are a transfer from consumers to producers;
producers need to earn only their cost of capital to stay in the market and any profits above this
level should be dissipated by new entry; so any profits above the cost of capital are excessive
and indicate a competition problem.

65. The starting point for thinking about the use of profitability as a measure of market power
for competition law investigations is to think about the possible sources of economic profits.
Potential sources of profits include:

rewards for taking risks and innovating;

rewards to a competitive advantage such as superior efficiency or better
management; and
the result of having and exercising market power.

24
For instance, this argument has been made in UK grocery retailing. The argument is that the ability of the large
supermarket chains to exert buyer power and so get lower prices from their suppliers has led those suppliers to
increase their prices to the smaller supermarket chains and independent grocers.
25
Office of Fair Trading. 1999. Assessment of Individual Agreements and Conduct, OFT 414. London.
18

66. Only the last of these three categories of possible sources of profits should concern
regulators. Entrepreneurs who take large risks in investing in projects with highly uncertain
returns do not do so in the expectation that if the project turns out to be a success, they will earn
a return equal to their cost of capital. Instead, they invest in the expectation that they might well
lose all their investment, but that if the investment turns out to be successful, they will earn
substantially in excess of their initial investment. An example of the former is the Iridium
satellite telephone system, which cost billions of dollars to start and was a commercial disaster,
leading to the investors losing virtually all of their initial investment. Pharmaceuticals provide
examples of the latter: pharmaceutical firms invest heavily on drug development in the
expectation that most research programs will not lead to marketable drugs, but some will lead to
very successful blockbusters. High profits that are the result of taking a large risk are not a
competition policy concern. What may look like excessive profits once the investment has
turned out to be a success might represent only a modest risk-adjusted return based on the ex
ante risk of the project. If a particular investment has only a 10% chance of success, a firm will
only make that investment if it expects to earn returns of more than 10 times its original
investment if the project is a success. This is necessary to compensate the firm for accepting
the 90% risk that it will earn nothing from the investment.

67. Another legitimate source of high profitability is competitive advantage such as superior
efficiency relative to ones competitors or better management. Economics predicts that even in
a competitive market, it is only the marginal firm that makes zero economic profits. Those firms
that are more efficient than the marginal firm will make positive economic profits, whilst those
that are less efficient will either exit the market or never enter it. Thus we should expect to see
many firms earning more than their cost of capital without therefore concluding that there are
competition policy problems.26

68. We noted above that the exercise of market power requires firms to restrict output.
Firms that invest in risky projects do not do this. They seek to create products that would not
otherwise exist i.e., they seek to expand output. Equally, profits earned from being more
efficient than ones rivals are also not earned by restricting output. So the profits earned from
these two sources are not profits that should concern policy makers.

69. This is not to deny that there may be excess profits that are earned as a result of the
exercise of market power. However, even here analysts need to tread with great care. The
measurement of economic profits (i.e., revenues minus opportunity cost over the lifetime of the
project) is fraught with difficulty. Economic profits are substantially different to accounting
profits. The correct measurement of the economic profitability of an investment involves
measuring the costs and revenues associated with that investment throughout its entire lifetime.
This can only be measured by modeling the activity, over the project lifetime, using discounted
cash-flow techniques. In stylized form, most projects involve an initial investment period, when
accounting profits are low or negative, a mature phase when accounting profits are high, and a
sunset phase when accounting profits fall to zero and the activity is discontinued. Observing
high accounting profits in the mature phase of a products life conveys no useful information on
whether excess profits are being earned over the lifetime of the project. Economists refer to

26
United Kingdom Competition Commission. The Supply of Banking Services by Clearing Banks to Small and
Medium-Sized Enterprises. Chapter 13. Available: http://www.competition-
commission.org.uk/rep_pub/reports/2002/fulltext/462c13.pdf. In the Financial Times of 5 April 2000, Professor John
Kay said that 41 of the 45 FT 500 sectors earned returns above their cost of capital. As Professor Kay argued, this
was not evidence of widespread competition policy problems.
 19

such profits as quasi-profits. They appear as if they are real (excess) profits, but in fact are only
an artifact of taking a snapshot at a particular stage of the product lifecycle.27

70. A good example of the dangers of looking only at a snapshot is provided by the UK
Monopoly and Mergers Commission (MMC) report into Video Games in 1995.28 In para. 2.55,
the MMC concluded that It is reasonable to conclude that Nintendo is an exceptionally
profitable enterprise and, at least until 1993/94, Sega was also very profitable.

71. The MMC treated this as evidence of a competition problem. Some have submitted that
this was an incorrect conclusion to draw, for the following reasons: It took no account of the
level of risk that Sega and Nintendo has incurred when they entered a market in 1987 that had
virtually disappeared or of the fact that there was ample evidence that the firms did not have any
lasting market power. History showed that even very large players had failed in this market
(Atari, Commodore, Philips) and it was public knowledge that Sony was about to enter. Sony
became the worldwide market leader by the late 1990s and Sega exited the market in 2001.
The high levels of profitability generated by Sega and Nintendo in the mid-1990s conveyed no
useful information about the state of competition. The MMC should have looked to evidence of
competitive behavior and barriers to entry to assess whether the market was competitive.29

72. We would not go so far as to say that analyzing the profitability of a firm under
investigation will never yield information that is useful for a competition policy investigator. For
instance, it would be surprising to find long run high returns in a mature capital intensive
commodity business in which brand names and advertising were not important. However, as
we move away from industries of this type towards dynamic industries that are not in long-run
equilibrium, that involve significant ex ante risk and where knowledge and other intangible
assets are important, profitability analysis will be less and less useful.

f. Power to Exclude

73. Market power is traditionally looked at in terms of pricing power and the ability of a firm
(or firms) to raise prices profitably above the level that would exist under conditions of effective
competition (i.e., the effectively competitive price). Discussing market power purely in terms of
pricing power runs the risk of omitting an important alternative type of market power: the power
to exclude or exclusionary power.

74. The concept of exclusionary market power has found its place in both the literature and
judicial interpretation of market power. For example, in Du Pont30 the U.S. Supreme Court
defined monopoly power as the power to control prices or exclude competition. The OFT
states that:31

27
Fisher, F. M. and McGowan, J. J. 1983. On the Misuse of Accounting Rates of Return to Infer Monopoly Profits.
American Economic Review, 73 (1) 8297. For a full discussion of the conceptual and practical problems of
inferring monopoly rents from accounting rates of return.
28
Monopolies and Mergers Commission. March 1995. Video Games, A Report on the Supply of Video Games in the
UK. London.
29
The OFT publication 377 provides a more detailed analysis of this case. Office of Fair Trading. 2002. Innovation
and Competition Policy. London.
30
United States vs. E.I du Pont de Nemours Co, 351 U.S. 377 (1956).
31
Office of Fair Trading. 1999. The Chapter II Prohibition, OFT 402. London.
20

An undertaking may be dominant if it possesses a substantial

level of market power. The essence of dominance is the power to
behave independently of competitive pressures. This can allow a
dominant undertaking to charge higher prices profitably (or, if it is
a dominant buyer, extract lower prices) than if it faced effective
competition. It can also use its market power to engage in anti-
competitive conduct and exclude or deter competitors from the
market. (para. 3.9)

75. Krattenmaker, Lande and Salop (1987)32 argue for the need to:

Recognis[e] explicitly that anticompetitive power can be exercised

by either of two methods: raising ones own prices or raising
competitors costs. These two methods of exercising market
power correspond, respectively, to the power to control price and
power to exclude competitors distinction expressed in the du
Pont formulation.(p. 28)

76. They distinguish between the power to control price profitably, directly by restraining
ones own output and exclusionary or Bainian market power. The latter occurs where a firm
can raise its rivals costs and thereby reduce their ability to compete or to exclude them from the
market altogether.

77. The question arises as to whether there is a genuine distinction between pricing power
and exclusionary power. It might be argued that exercising exclusionary power is a way of
reducing the degree of competition and thus allowing firms to raise prices. There is more than
an element of truth in this. But our view is both that there are occasions where there are
genuine differences between the two types of market power and that there are (more) occasions
when the analysis is simplified by thinking primarily in terms of exclusionary power. Consumers
can be harmed in more ways than just by being forced to pay higher prices than they would
under conditions of effective competition. For instance, they can be harmed by behavior that
limits the ability of competitors to introduce new, innovative products that, as a result of anti-
competitive behavior by an incumbent, never make it to the market. Behavior of this type by an
incumbent can harm consumers and increase the incumbents profits relative to what they
would be absent the anti-competitive behavior, without necessarily raising the prices of any
products in the market. In addition, there are times when it is analytically easier to think in terms
of the power to exclude rather than just power over price. The most obvious example is when a
firm has actually managed to exclude a competitor or potential competitor from the market. In
this case, further analysis of pricing power may not be relevant or necessary.

78. In summary, defining market power in terms of the ability to price above the effectively
competitive level is the definition that will most often be useful. However, there are times when
defining market power in terms of the power to exclude may make the analysis substantially
easier. In addition, there are times when defining market power in terms of the power to
exclude will highlight the potential for anti-competitive behavior that does not directly impact on
prices.

32
Krattenmaker, Thomas G., Lande, Robert H. and Salop, Steven C. 1987. Monopoly Power and Market Power in
Antitrust Law. The Georgetown Law Journal 76: 241269.
 21

2. The Definition of the Relevant Market

79. The concept of the relevant market plays a central and often critical role in the
application of competition law. Most competition law inquiries follow a two-step procedure.
First, define the relevant market so as to encompass all those products or services which are
considered to be effective substitutes for the products or services at the center of the
investigation. The relevant market in effect allows competition authorities and the affected
parties to focus their attention on the important competitive constraints which exist between
products and between regions. The definition of the relevant market allows the second-stage
assessment to include inter alia an analysis of market shares and market concentration, barriers
to entry into the relevant market, barriers to expansion within the relevant market and so on.

80. The definition of the relevant market is merely a tool for aiding the competitive
assessment by identifying those substitute products or services which provide an effective
constraint on the competitive behavior of the products or services being offered in the market by
the parties under investigation. It represents only an intermediate step in the investigation. The
European Commission made precisely this point in its Notice on the Definition of Relevant
Market for the Purposes of Community Competition Law published in December 1997. In para.
2, the Notice states that:

[M]arket definition is a tool whose purpose is to identify in a

systematic way the competitive constraints that the undertakings
involved face. The objective of defining a market in both its
product and geographic dimension is to identify those actual
competitors of the undertakings involved that are capable of
constraining their behavior and of preventing them from behaving
independently of any effective competitive pressure.33

81. The fact that market definition is concerned with identifying substitutes products for the
products under investigation implies that the appropriate basis for defining relevant markets is
one that focuses directly on the competitive constraints that products or services impose upon
one another. Clearly, the approach to defining a relevant market must be consistent with this.

a. Principles of Relevant Market Definition

82. A relevant market has at least two dimensions, the product market and the geographic
market, and sometimes more. The product market dimension relates to which products should
be included in the relevant market, whilst the geographic market dimension relates to which
regions should be included in the relevant market. Thus a relevant market might be the market
for apples in Belgium. The product market in this case is apples (i.e., it does not include other
fruit), whilst the geographic market is Belgium. A relevant market cannot just have a product
dimension or just have a geographic dimension: it must be a collection of products in a given
area.

83. In addition to the product and geographic market dimensions, relevant markets can be
delineated according to other dimensions such as time or distribution method. Temporal

33
European Commission. December 1997. Notice on the Definition of the Relevant Market for the Purposes of
Community Competition Law. Official Journal C 372. Available:
http://ec.europa.eu/comm/competition/antitrust/relevma_en.html
22

markets are often defined in transport markets where the time of day or day of the week has a
substantial impact on the pattern of demand. Thus trains arriving in central London before
9.30am on a weekday might be a separate relevant market to trains arriving in central London
after 9.30am because of significant differences in the pattern in demand (i.e., significantly higher
demand to arrive before 9.30am rather than after 9.30am). Markets can sometimes be defined
with reference to the method of distribution. For instance, in the UK the competition authorities
have consistently defined beer distributed through the off-trade (e.g., supermarkets) as being in
a different market to beer distributed through the on-trade (e.g., bars, restaurants).

84. The relevant market contains all those substitute products and regions which provide a
significant competitive constraint on the products and regions of interest.34 The relevant market
can be defined as a collection of products such that a (hypothetical) single supplier of that
collection would be able to increase price profitably.35 Defining the relevant market in this way
ensures that all products which pose a significant competitive constraint on the parties under
investigation are taken into consideration. In this sense, a relevant market is something worth
monopolizing. A market is worth monopolizing if monopolization permits prices to be profitably
increased. This will be the case if the collection of products contained in this market are not
subject to significant competitive constraints by products outside the market.

85. For example, if an investigation were concerned with a merger between two malt whisky
producers, a first step might be to assess whether a hypothetical single supplier of malt whisky
could profitably increase prices above prevailing levels.36 If the answer to this question is
negative, then the next step is to determine whether control over the closest substitute for malt
whisky, say, blended whisky, would allow a single supplier to increase price profitably. If the
answer to this question is affirmative, then the relevant market would include both malt and
blended whiskies but not other alcoholic drinks. The competitive investigation would then
proceed to the second stage and focus on how the proposed merger would alter the strength of
the competitive constraints which constrain the merging parties commercial behavior within that
market.

86. In general, a group of products or services might not be worth monopolizing due to (i)
demand-side substitution and/or (ii) supply-side substitution.

i. Demand-Side Substitution

87. Demand-side substitution takes place when consumers switch from one product to
another in response to a change in the relative prices of the products. A relative increase in the
prices of products in the collection under consideration may lead consumers to switch their
purchases towards other products. The greater the extent to which consumers do this, the less
likely a price rise is to be profitable and so the less likely it is that the candidate market is worth
monopolizing.

88. If consumers are in a position to switch to available substitute products or to begin

sourcing their requirements from suppliers located in other areas, then it is unlikely that price

34
For simplicity, we are abstracting from other possible dimensions of the relevant market at this stage.
35
More precisely, the test is whether a hypothetical monopolist could profitably raise price above the price
benchmark relevant to the particular case, which is usually the prevailing price in a merger inquiry and often the
competitive price in a non-merger case. We discuss the issue of the correct benchmark price below.
36
If the investigation were in the context of an allegation of anti-competitive behavior then, as discussed above, the
appropriate price level to be concerned with would be the competitive price level.
 23

increases will be profitable. The easier it is for consumers to meet their requirements through
the purchase of other substitute products, the greater the change in the demand for a collection
of products for a given relative price increase. In this case, the attempt by a hypothetical
supplier to increase price is likely to result in a loss in sales sufficient to render the price
increase unprofitable. The products in question would not therefore be worth monopolizing and
so would not define a relevant market. If the relevant market were defined as consisting of this
product alone, any assessment of market power based on market shares is likely to be an
overstatement, potentially to a significant degree. In order for market shares to provide even a
reasonable proxy for the extent of market power it is necessary to add progressively the
products to which consumers would most likely switch in response to a relative price rise,
repeating the experiment at each stage until a collection of products is reached that is worth
monopolizing.

89. As a hypothetical example, consider whether mineral water constitutes a relevant

market. Is mineral water worth monopolizing in the sense that a single supplier would find it
profitable to raise the price of mineral waters by 10% relative to the price of other products? If
90% of mineral water consumers would react to such an increase in the relative price of mineral
water by switching to Coca-Cola and other soft drinks, then mineral water does not delineate a
relevant marketmonopolizing the mineral water market would not be worthwhile. But if only
5% of consumers were willing to switch away to other products, then mineral water would define
a relevant product market.

90. When examining the likely responses of consumers, it is the response of the marginal
consumer and not the average consumer which is important. What matters is how many
consumers will switch to a substitute product in response to a relative price rise, which implies
that the focus is on marginal consumers (i.e., those most likely to switch). It is not relevant that
an average or representative consumer would not switch. The existence of even a large
group of consumers who would not switch in response to a relative price increase is not by itself
sufficient to conclude that the relevant market should be defined narrowly. Suppose that 80% of
the consumers of a particular product (widgets) would not consider changing to another
product in response to a 10% rise in the price of widgets. Does this make widgets a separate
relevant market? If the other 20% would switch to another product in response to a 10% price
rise, then raising prices by 10% will lead to a 12% decline in revenue for the widget
manufacturer. Depending on what costs the manufacturer saves by making 20% fewer widgets,
this may well not be a profitable price increase.

91. The mistake of focusing on the behavior of particular groups of consumers, or on

average consumers, when defining a relevant market has been referred to as the toothless
fallacy after the United Brands decision.37 In this decision, the European Commission argued
that bananas defined a separate relevant market because the very young and the very old (i.e.,
those without teeth) did not consider other fruit a suitable substitute for bananas. However, the
fact that there is a captive group of consumers for whom there are no substitute products
available is not enough to define the relevant market. The important question in United Brands
was not will the toothless switch to other fruit in response to a rise in the price of bananas, but

37
Case 27/76 United Brands Co. and United Brands Continental BV vs. Commission [1978] E.C.R. 207; [1978] 1
C.M.L.R. 429.
24

will enough consumers switch to other fruit in response to a rise in the price of bananas to
make that price rise unprofitable.38

ii. Supply-Side Substitution

92. Even if there are no alternative products to which consumers would consider switching,
a collection of products may still not be worth monopolizing. Even if consumers are unable to
react to an increase in price, producers may be able to do so. If other producers would respond
to an increase in the relative price of the products supplied by the single supplier by switching
production facilities to producing the monopolized collection of products, the increased level of
supply may render any attempted price increase unprofitable. In this case the products in
question do not define a relevant market because of the potential for supply-side substitution.

93. The European Commissions Market Definition Notice39 (para. 22) provides a good
example of supply-side substitution.

Paper is usually supplied in a range of different qualities, from

standard writing paper to high quality papers to be used, for
instance, to publish art books. From a demand point of view,
different qualities of paper cannot be used for any given use, i.e.
an art book or a high quality publication cannot be based on lower
quality papers. However, paper plants are prepared to
manufacture the different qualities, and product can be adjusted
with negligible costs and in a short time-frame. In the absence of
particular difficulties in distribution, paper manufacturers are able
therefore, to compete for orders of the various qualities, in
particular if orders are placed with sufficient lead time to allow for
modification of production plans. Under such circumstances, the
Commission would not define a separate market for each quality
of paper and its respective use. The various qualities of paper are
included in the relevant market, and their sales added up to
estimate total market value and volume.

94. There is considerable debate over whether supply-side substitution should be

considered when defining the relevant market, or whether it should be taken into account after
the market has been defined. Using the European Commissions paper example, the debate is
over whether it is better to define the market as art paper but note that the ability to profitably
monopolies that market may well be constrained by the existence of manufacturers of lower
quality paper; or to define the market as including both art paper and lower quality paper. The
US approach to market definition is essentially to define markets only on the basis of demand-
side substitutability, but then to take account of supply-side substitutability when calculating
market shares. On the other hand, para. 20 of the European Commissions Notice on relevant
market definition states that it will take supply-side substitution into account when defining the
market when its effects are equivalent to those of demand substitution in terms of effectiveness
and immediacy. The UK Office of Fair Trading follows a similar policy. In its guideline on

38
This analysis assumes that sellers of bananas were not able to price discriminate between different groups. If they
were able somehow charge the toothless a different amount to what they charged other consumers, then the fact
that the toothless have no substitutes to bananas might make a price rise directed solely at the toothless
profitable. We have seen no evidence or suggestion that this was the case in United Brands.
39
Op. cit.
 25

market definition (para. 3.19)f,40 it states that Supply-side substitutes will therefore be included
within the market definition when it is clear that substitution would take place quickly and easily.

95. There is a sense in which it does not much matter which approach is taken and a sense
in which it does. The sense in which it does not much matter is that as long as supply-side
substitutability is taken into account at some point of the competitive analysis, the right
conclusion on market power should be reached. The sense in which it does matter is that if you
want market shares to be as meaningful as possible, and we think that this should be one of the
aims of market definition, then you need to take supply-side substitutability into account at the
market definition stage.

96. An example should make this clearer.41 Owners of boats that are kept in seawater need
to paint the hull of the boat with anti-fouling paint to stop barnacles sticking to the boat. Anti-
fouling paint is copper-based. Suppose that manufacturers of ordinary paint can easily begin to
manufacture anti-fouling paint by adding some readily available copper compound to their paint.
Finally, assume that there is only one manufacturer of anti-fouling paint, but many, larger
manufacturers of ordinary paint. One way to analyze the market power of the anti-fouling paint
manufacturer is to define the relevant market as anti-fouling paint only on the grounds that boat-
owners have no choice but to use anti-fouling paint on the hulls of their boats, find that the anti-
fouling paint manufacturer has 100% of the relevant market but then note that he has no market
power due to the supply-side substitutability of ordinary paint manufacturers. Another is to
define the market as including ordinary paint, note that the anti-fouling paint manufacturer has
only a very small share of this market and so conclude that he has no market power.

97. The first point to note is that proper analysis will lead to the same conclusion whichever
market definition is used. The second point to note is that one of the market definitions is
useful, whilst the other is not. If we define the market as all paint, then markets shares within
that market are informative in terms of analyzing market power. If we define the market as just
anti-fouling paint, then market shares within that market are not informative.

98. The key conclusion to be draw here, however, is that you have to do the right
competitive analysis at some point. If you define the market on the demand-side as just anti-
fouling point, but then do the correct competitive analysis, you will conclude correctly that the
monopolist of anti-fouling paint has no market power. Equally, if you define the market taking
into account the supply-side, you will define the market as all paint and hence conclude that the
anti-fouling paint monopolist has no market power. You will only come to the wrong conclusion
about market power if you define the market without taking into account the supply-side and
then mechanically use market shares to infer market power.

b. The Hypothetical Monopolist/SSNIP Test

99. There is a test for the relevant market which is now used in both the US and EU, and
increasingly elsewhere as well. This test is called variously the hypothetical monopolist test, the
SSNIP test or the 510% test. The test is consistent with the principles that we have outlined
above for relevant market definition. In particular, it asks a specific form of the question Is this
a market worth monopolizing?

40
Office Fair Trading. March 1998. Market Definition, OFT 403. London.
41
We are indebted to Franklin Fisher for this example.
26

100. The hypothetical monopolist test originated in the US and is enshrined in the US
horizontal merger guidelines issued jointly by the Department of Justice and the Federal Trade
Commission. The 1992 Guidelines state that:42

A market is defined as a product or group of products and a

geographic area in which it is produced or sold such that a
hypothetical profit-maximising firm, not subject to price regulation,
that was the only present and future producer or seller of those
products in that area likely would impose at least a small but
significant and nontransitory increase in price, assuming the
terms of sale of all other products are held constant.

101. The starting point for the test is the narrowest set of products that could plausibly be
considered a separate market. The Small but Significant and Nontransitory Increase in Price
(SSNIP) is usually taken to be either 5% or 10%.

102. The European Commission has adopted this test. The Market Definition Notice provides
that:

The question to be answered is whether the parties customers

would switch to readily available substitutes or to suppliers located
elsewhere in response to a hypothetical small (in the range 5% to
10%) but permanent relative price increase in the products and
areas being considered. If substitution were enough to make the
price increase unprofitable because of the resulting loss of sales,
additional substitutes and areas are included in the relevant
market. This would be done until the set of products and
geographical areas is such that small, permanent increases in
relative prices would be profitable.43

c. The Cellophane Fallacy

103. Firms with market power will tend to take advantage of that market power by raising their
price above the level that would prevail under conditions of effective competition. Assuming
they are profit-maximizing firms, they will raise price up to the point at which the constraints
imposed on them by other products and firms means that raising price further is not profitable.
As was noted in US vs. Kodak, if the price of the monopolized product is high enough, even
inferior substitutes will look attractive to consumers.44 This is a standard result of economic
theory. However, it has potentially serious implications for market definition and the
assessment of market power. It means that noting that at current prices the firm faces binding
competitive constraints from other products and firms does not tell us much about whether the
firms has market power that it is exercising. Put another way, the fact that a firm has a relatively
high own-price elasticity of demand does not mean that it therefore does not have any market
power allowing it to raise price above the effectively competitive level. It may be that its own
price elasticity of demand at the effectively competitive price level is actually rather low and that

42
Note that the test was not new in 1992. It was included in the 1982 US Merger Guidelines and Adelman expressed
the core idea in his 1959 article Economic Aspects of the Bethlehem Opinion in 45 Va. L. Rev. 684 (1945).
43
Notice, para. 17.
44
Eastman Kodak Co. vs. Image Technical Serv. Inc., 504 US 451 (1992).
 27

it has thus been able to raise price (possibly substantially) above that price level to the current
price level, at which point further price rises are not profitable due to the existence of demand-
side substitutes or supply-side substitutability by other firms.

104. This problem is known in competition policy analysis as the Cellophane fallacy after the
celebrated Du Pont case.45 In that case, Du Pont argued that cellophane was not a separate
relevant market since empirical evidence showed that it competed directly and closely with
flexible packaging materials such as aluminum foil, wax paper and polyethylene. But, as many
commentators have since noted, Du Ponts argument was not sound. Du Pont was the sole
supplier of cellophane and is likely to have already raised its prices to the point at which the
competitive constraints imposed on it by other products became binding on it. The mere fact
that at the prevailing price level Du Pont was unable to raise price further does not provide an
answer to the question of whether Du Pont had market power and so had already raised price
above the effectively competitive price level. The U.S. Supreme Court in this case failed to
recognize that a high own-price elasticity may mean that a firm is already exercising market
power.

105. The difficulty for the hypothetical monopolist test is that this argument implies that if you
apply the test to a single firm, you should always reach the conclusion that a 510% price rise
would not be profitable as the firm should already be pricing at the profit-maximizing level. This
implies that the hypothetical monopolist test will consistently produce market definitions that are
too broad and include firms and products that are substitutes at current price levels but not at
the effectively competitive price level. But it is clear that such definitions would not aid the
competitive assessment as they would tell us nothing about whether the firm in question had
market power or not.

106. Before we conclude that the hypothetical monopolist test is of no use, we need to step
back and think about where the hypothetical monopolist test comes from. It comes from the US
Horizontal Merger Guidelines. Merger analysis does not typically suffer from the problem we
discussed above. In most merger cases, the question is not whether Firm A is currently
exercising market power, or whether Firm B is, but whether the combination of Firm A plus Firm
B will be able to raise prices above the current price level. To help answer this question, it is
useful to use the hypothetical monopolist test to find what is the narrowest group of products
that a firm would need to monopolize before it could raise prices by 510% above current price
levels.

107. So the Cellophane Fallacy is not a problem that arises when defining markets for merger
analysis. The next question to ask is whether the Cellophane Fallacy means that the
hypothetical monopolist test is only useful in merger cases.46 This is the conclusion that
commentators have often reached, but it is wrong. The hypothetical monopolist test remains
useful in some non-merger cases. There are some non-merger cases where the correct
benchmark price level for implementing the test is the current price level. When the allegation is
that a firm is trying to exclude one of its rivals in order to raise prices once they have been
excluded, then carrying out the hypothetical monopolist test from the current price level is the
correct approach. Suppose that even if the rival firm is excluded, then the alleged excluding
firm would have only 5% of the market that it would need to monopolize in order to be able to

45
United States vs. E.I. du Pont de Nemours & Co. 351 U.S. 377 1956); 76 S. Ct. 994; L. Ed. 1264.
46
We include joint venture cases in this designation to the extent that they are often concerned with the issue of
whether prices will rise above the current level once the joint venture is in place.
28

raise prices by 510% above the prevailing price level. In this case, it would be reasonably
clear that the allegedly exclusionary behavior is not going to lead to prices rising.

108. An important question to ask is what approach should be taken to market definition in
those cases where the cellophane fallacy is likely to be a problem? One good answer is that in
these cases a traditional characteristics approach to market definition should be used. The
European Commission, for instance, has frequently defined markets on the basis of the physical
characteristics of the products concerned. Indeed, the European Commissions Market
Definition Notice (para. 7) contains the following definition of a relevant market: A relevant
product market comprises all those products and/or services which are regarded as
interchangeable or substitutable by the consumer, by reason of the products' characteristics,
their prices and their intended use.

109. This is a perfectly reasonable approach to take when direct evidence on substitutability
is not available. However, it is important to ensure that any physically characteristics that are
used to define a market are relevant to the degree of substitutability between products. Thus, it
does not make sense to define a separate market for red cars on the basis of that they differ
from other cars on the basis of a physical characteristic (i.e., color). Consumers may have
preferences over car color, but supply-side substitutability for manufacturers between different
car colors is clearly very high. On the other hand, it might make sense to define separate
markets based on the engine size of the car.

d. Continuous Chains of Substitution

110. An argument that is frequently used in market definition exercises is that there is a
continuous chain of substitution between products so that even products that do not directly
compete against each other should be considered to be in the same relevant market. The
argument often arises in geographic market definition with products that are relatively expensive
to transport. The argument goes along the following lines: output from Plant A competes output
from Plant B because they are relatively close to each other; output from Plant B competes with
output from Plant C because they are relatively close to each other; therefore Plant A and Plant
C are in the same relevant geographic market because the price of output from Plant A
constrains the price of output from Plant B, which in turn constrains the price of output from
Plant C. Figure 1.5 illustrates this example. Competition in Area AB and in Area BC is enough
to ensure that Plant A is price constrained by Plant C and vice versa.
 29

Figure 1.5: A Continuous Chain of Substitution

Plant A Plant B Plant C

Area AB Area BC
111. The continuous chain of substitution argument can also be relevant to product markets.
Where there is a continuum of different types of a product (e.g., cars) it may be that there is a
continuous chain of substitution between them. A small hatchback does not compete directly
with a luxury car, but it may compete directly with a mid-sized car, which may compete directly
with an estate, which may compete directly with a luxury car, thus potentially putting all cars
into a single market.

112. Care needs to be taken with the continuous chain of substitution argument. The mere
fact that there is a continuum of types of a product, or a continuous chain of overlapping areas
of competitive interaction, does not of itself mean that there is a single product market for all
types of the product or a single geographic market containing all the overlapping areas of
competitive interaction. Suppose there is a continuum of products from A to X whereby each
product competes directly with the two nearest it. Thus B competes with A and C, C competes
with B and D and so on. Suppose further that each product is constrained by its neighboring
products so that prices are kept at the effectively competitive level. Does that mean the relevant
market is the full continuum? Not necessarily. It may be that a merger of products D, E and F
would lead to the merged firm being able to raise the prices of D, E and F profitably. The
increase in price of E would lead to some consumers of E switching to D and F, but that would
not harm the merged firm as it now owns D and F. The increase in the price of D would lead to
some consumers of D switching to C, but equally some of them would switch to E, which the
merged firm owns. The same logic holds for an increase in F. The result may be that a price
rise of more than 510% is profitable and that for merger purposes DEF is a separate relevant
market. This is consistent with our intuition that even though there probably is a continuous
chain of substitution from a top-end sports car to a low end small car, they are not in the same
relevant market.

113. The continuous chain of substitution argument may also fail because there is a break in
the chain.

114. Figure 1.6 is similar to , but now includes six plants, not three. In this case there is no
overlap between Plant C and Plant D and hence no competition between them. The result is
that there is a break in the chain and so no mechanism for competitive constraints to be
30

communicated from Plant A to Plant F. The relevant geographic market will be no wider than
ABC (and DEF).

Figure 1.6: A Break in the Chain of Substitution

Area A Area C Area D Area F

Area B Area E
e. Innovation Markets

115. The concept of an innovation market has been used in the US. The idea behind an
innovation market is that there may be times when the competitive issue at hand relates to an
intermediate market for research and development (R&D), rather than to a market for goods or
services. For instance, the issue may be a merger that is likely to reduce the intensity of R&D
post merger because the parties are currently the only firms researching in a particular area. Or
the issue may be a licensing arrangement that reduces incentives to engage in R&D, perhaps
because a firm with a patent on a production process licenses that patent, thus reducing the
incentive of other firms to engage in R&D to try and find an alternative, possibly better,
production process. In cases such as these, it may make sense to define an innovation market.

116. The US DoJ and FTC state that:47

An innovation market consists of the research and development

directed to particular new or improved goods or processes, and
the close substitutes for that research and development. The
close substitutes are research and development efforts,
technologies, and goods that significantly constrain the exercise of
market power with respect to the relevant research and
development, for example by limiting the ability and incentive of a
hypothetical monopolist to retard the pace of research and
development.

117. An innovation market should include those things that constrain the ability of a firm to
exercise market power in R&D. The most obvious manifestation of such market power would
be to have the ability to slow the rate of innovation in the absence of competing R&D.

47
Department of Justice and Fair Trade Commission. 1995. Antitrust Guidelines for the Licensing of Intellectual
Property. Available: http://www.usdoj.gov/atr/public/guidelines/0558.htm
 31

118. There has been considerable disagreement over whether the concept of an innovation
market is useful. However, in cases involving competition to produce the next generation
product, where it is not clear what that product is likely to be or look like, it is hard to analysis the
competitive issues without using the innovation market concept. Thus the FTC used the
concept of an innovation market when analyzing the merger of Ciba-Geigy and Sandoz to form
Novartis in 1996. The competition issue arose in the area of gene therapy research. This
involves treating diseases or medical conditions by modifying genes and then inserting the
modified genes into a patients cells. Until the research produced commercial products, it was
not clear what the relevant product markets were that might be affected by the merger.
However, the FTC believed that Ciba and Sandoz controlled crucial inputs for commercializing
gene therapy products and that after the merger no other firm would have an adequate incentive
to compete against the parties in trying to commercialize the results of gene therapy research.
As a result, the FTC imposed a licensing remedy on the parties in order to safeguard post
merger gene therapy research competition.

119. However, it is important to note that R&D is an input, not an output and the empirical
relationship between the level of R&D expenditure and the speed of innovation is weak. This
means that reducing the level of R&D undertaken is not equivalent to a monopolist constraining
quantities in an output market. Whereas a monopolist restricting output leads to consumer
harm in the standard microeconomic model, the welfare effect of restricting R&D is not clear-cut.
It may lead to slower innovation and consumer harm, or it may avoid wasteful duplication of
R&D effort or even increase the pace of innovation if the reduction in R&D expenditure is
coupled with knowledge sharing across firms (such as in a merger).

120. Our views on innovation markets are as follows. First, where possible it is better to
define standard product markets than more speculative innovation markets. Second, there will
be competition that are best analyzed using the concept of an innovation market. Third, where
the issue is best analyzed using an innovation market, it is important to interpret market shares
with great care. Innovation markets are not likely to be subject to collusion even if concentrated
because the incentives to innovate before your rivals is so strong (e.g., you win and patent the
innovation first). Further, the nature of intellectual property and the patent system is that there is
often only one winner from R&D expenditure: the firm that innovates first gets the patent and
so wins. This means that competition in an innovation market can be very fierce even with only
a very few players.

3. Dominance and Significant Market Power

121. Dominance is a key concept in European competition law and, increasingly, in other
jurisdictions around the world. The definition of a dominant position was established by the
European Court of Justice in United Brands vs. Commission. The Court stated the following:

The dominant position thus referred to [by Article 82] relates to a

position of economic strength enjoyed by an undertaking which
enables it to prevent effective competition being maintained on the
relevant market by affording it the power to behave to an
appreciable extent independently of its competitors, customers
and ultimately of its consumers.48

48
Case 27/76 United Brands Co. and United Brands Continental BV vs. Commission [1978] E.C.R. 207; [1978] 1
C.M.L.R. 429.
32

122. The legal definition of dominance relates to the ability of an undertaking to prevent
effective competition being maintained by acting independently of competitors, customers and
consumers. This is a definition that has been adopted in a number of jurisdictions outside of
Europe.49

123. This definition of dominance contains two elements, the ability to prevent effective
competition and the ability to behave independently, but does not explain precisely either
element nor how the two relate to one another. From an economic perspective, the concept of
acting independently does not provide an adequate basis for discriminating between dominant
firms and non-dominant firms. No firm can act to an appreciable extent independently of its
consumers or customers. This is because each firm is constrained by the demand curve facing
them. Firms typically face downward sloping demand curves, indicating that a firm can only
charge a higher price if it is willing to make fewer sales. It is not open to the firm to raise prices
and sell the same quantity as before. This is true of a dominant firm just as much as it is true of
a non-dominant firm.

124. Although it makes more sense to think of firms acting independently of their competitors
than it does to think of them acting independently of their customers or consumers, there are
still serious problems with using this idea as a useful indicator of dominance. As is the case for
acting independently of customers and consumers, every firm, except for true monopolists, is
constrained in its commercial behavior to some extent by its competitors. Although this is by
definition true for firms operating in a competitive market, it is also true for a dominant firm. All
firms, including those that are held to be dominant, will increase prices above the competitive
level to the point at which further price increases would be unprofitable. In this sense,
competitors do constrain the behavior of firms so that even a dominant firm does not act
independently of its competitors.

125. For these reasons, the focus of the economic analysis ought to be on a firms ability to
engage in business activities that prevent effective competition from being maintained.50 From
an economics perspective, competition can be said to be effective when no firm either acting
individually or in concert is able to exercise market power. However, dominance should not be
seen as applying to all firms with market power. Rather, recognizing that there are different
degrees of market power, dominance should apply only to those firms that possess significant
market power.

126. This is consistent with the Commissions recent discussion paper on Article 82. In
paras. 2324, the Commission states that

For dominance to exist the undertaking(s) concerned must not be

subject to effective competitive constraints. In other words, it thus
must have substantial market power. Market power is the power
to influence market prices, output, innovation, the variety or quality
of goods and services, or other parameters of competition on the
market for a significant period of time....An undertaking that is

49
For instance, in South Africa dominance is related to market power, but market power is defined as the power of a
firm to control prices, or to exclude competition or to behave to an appreciable extent independently of its
competitors, customers or suppliers. (Section 1.1.14 of the Competition Act 1998 [amended 2000]).
50
Or firms, in the case of joint dominance.
 33

capable of substantially increasing prices above the competitive

level for a significant period of time holds substantial market
power and possesses the requisite ability to act to an appreciable
extent independently of competitors, customers and consumers.

127. Although both the Commission and the Community Courts have conceded that market
shares by themselves do not automatically indicate dominance51 and that there are other factors
that are pertinent to a finding of dominance, the most important factor is usually a firms market
share.52 The ECJ has held that a market share in excess of 50% can be considered to be so
large that except in exceptional circumstances such an undertaking could be presumed to be
dominant.53 The Commission has stated that it takes the view that a dominant position can
generally be taken to exist when a firm has a market share greater than 40 or 45%, although it
cannot be ruled out for undertakings with a lower market share.54 Indeed, in Virgin/British
Airways, the Commission held that BA enjoyed a dominant position despite its having a market
share below 40%. Under South African law a firm is considered dominant if it has more than
45% of the relevant market, but can also be found dominant at lower market shares.55

128. So far this analysis has focused on the possibility of a single firm being dominant. This
is referred to as single firm dominance. However, competition law also deals with situations in
which firms are jointly dominant. Joint dominance arises when no firm is single firm dominant,
but where a small collection of firms (usually four or less) together have significant market
power and where they tend to act in parallel. The concept arises frequently in merger analysis,
but very rarely in anticompetitive behavior cases. As such, we discuss it in more detail in the
section on merger analysis in Chapter 2.

4. Abuse

129. It is not illegal to be dominant, but it is illegal to abuse a dominant position. This raises
the question of what constitutes an abuse of a dominant position. The European legal test for
abuse was set out in Hoffman-La Roche56 and restated in Michelin:57

[I]n prohibiting any abuse of a dominant position on the market in

so far as it may affect trade between Member States, Article 8[2]
covers practices which are likely to affect the structure of a market
where, as a direct result of the presence of the undertaking in
question, competition has been weakened and which, through
recourse different from those governing normal competition in
products or services based on traders performance, have the

51
Case 81/76 Hoffmann-La Roche vs. Commission [1979] E.C.R. 461.
52
For example Bellamy and Child set out four steps to establishing whether a firm has a dominant position. Step (ii)
is to show that the undertaking has a persistently high share of current activity in [the relevant] market. C.
Bellamy & G. Child.1993. Common Market Law of Competition, 4th ed. London: Sweet & Maxwell.
53
Case IV/30.698 Engineering and Chemical Supplies (Epsom and Gloucester) Ltd. vs. Akzo Chemie UK Ltd. [1982]
1 CMLR 273; [1981] OJ L374/1.
54
European Commission. 1981. Tenth Report on Competition Policy. Brussels Luxembourg.
55
In fact, the South African provision on dominance in the Competition Act 1998 (amended 2000) is interesting. It
states that A firm is dominant in a market if (a) it has at least 45% of that market; (b) it has at least 35%, but less
than 45% of that market, unless it can show that it does not have market power; or (c) it has less than 35% of that
market, but has market power.
56
Case 81/76 [1979] E.C.R. 461; [1979] 3 C.M.L.R. 211.
57
Case 322/81 [1983] E.C.R. 3461; [1981] 1 C.M.L.R. 282.
34

effect of hindering the maintenance or development of the level of

competition still existing on the market.58

130. As with dominance, the legal definition of abuse is hard to follow. However, it appears to
state that abusive behavior is likely to affect the structure of the market and to weaken
competition and involves the dominant firm behavior in a manner different from normal
competition. This definition suggests that business conduct can only be said to be abusive if it
differs from normal competitive behavior.

131. This raises the question of what constitutes normal competitive behavior and when
commercial practices can be held to hinder competition. A definition consistent with the
economic notion of effective competition is one which equates normal competition with conduct
that does not involve the exercise of market power. In the absence of market power, all conduct
should be considered normal and should not fall foul of competition law. On this view,
commercial behavior which adversely affects competitor firms on the grounds of superior
economic performancebe it through better efficiency, lower prices or better quality products
should not be considered abusive but as pro-competitive. Furthermore it should not be sufficient
to show that a given business practice makes it more difficult for other firms to compete for it to
be concluded that there is an adverse effect on competition. Most business practices involve
harm to competitors since that is the nature of the competitive process.

132. In discriminating between normal competitive behavior and anticompetitive behavior, it is

necessary to establish an appropriate benchmark. When a dominant firm exercises market
power, it harms consumers by charging prices above the competitive level and/or by reducing
the quality of products or services supplied. This implies that a definition of abuse ought to
focus directly on consumer harm. Abuse can therefore be defined as a dominant firm adopting
a particular mode of behavior that significantly reduces consumer welfare relative to the
alternative of the firm not adopting that mode of behavior.59 Where it cannot be shown that the
behavior of a dominant firm adversely affects consumers, either immediately or in the longer
term, such behavior would constitute normal competitive behavior.60

133. The exercise of market power to the detriment of consumers can potentially take many
forms and so drawing up a complete list of abuses would be fraught with difficulties. A finding of
abuse ought to depend not on the form of commercial behavior but rather on the outcome of
that behavior. It is quite possible for activities to constitute abuse in one industry but not in
another industry, or when carried out by one firm but not when carried out by another. So a
case-by-case assessment that takes into account the particular circumstances of the industry
under investigation is required.

58
Ibid. at para. 12.
59
Note that the behavior can either harm consumers immediately by raising prices and/or lowering quality, or in the
longer run by reducing the level of competition (e.g., excluding a rival) and hence leading to higher prices and/or
lower quality.
60
This approach to abuse is consistent with that adopted by the UK OFT. In para. 4.2 of its guidelines on the
Competition Act, the OFT states that Conduct may be abusive when, through the effects of conduct on the
competitive process, it adversely affects consumers directly (through the prices charged, for instance) or indirectly
(for example, conduct which raises or enhances entry barriers or increases competitors costs). Office of Fair
Trading. 1999. The Chapter II Prohibition, OFT 402. London.