International Think-Tank on Innovation and Competition
An Economic Perspective on Market Dominance
October 1st, 2006
In line with the recent evolution of US antitrust, the European Commission is trying to implement an important reform for the EU approach to abuse of dominance with foreclosure of competitors, moving from a formal approach to antitrust to a more modern welfare-based approach focused on the protection of consumers and of competition (not of the competitors). While this attempt is positive, there is some concern that these efforts are not be fully carried through into the recent proposal of the Commission, the DG Competition Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses. For instance, still in line with outdated economic views, dominance is associated too closely with large market shares and the efficiency defence - the chance for the dominant firm to prove that its aggressive strategy enhances consumer welfare or improves the allocation of resources - is virtually excluded in case of large enough market shares. This article will approach the debate on this reform focusing on the particular issue of market dominance. The analysis will be largely based on an economic point of view, hence, it will start with a description of the basic insights of economic theory on this issue. Intertic organized a Round Table on the reform of EU Competition Law with top economists, lawyers and antitrust experts in Corfù on July 15th.
Recent developments in the economic research on market structure suggest the need of a new approach to competition policy. The new theory of market leadership, inspired by the classic analysis of pioneers such as Stackelberg, Schumpeter and Modigliani, tries to integrate the Chicago approach of the 60’s and 70’s, which has emphasized the importance of competition in constraining market leaders and the post-Chicago approach of the 80’s and 90’s, which has emphasized the strategic interaction between market leaders and competitors. While the former approach has ignored strategic interactions and the asymmetric role of market leaders, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor: the theory of market leaders tries to fill these gaps. The results, however, are conflicting: under price competition, while the post-Chicago approach associates any aggressive pricing with predatory purpose, the new theory of market leaders shows that aggressive pricing can have a pro-competitive and welfare enhancing role without exclusionary purposes.
The general theory of market leaders clarifies the role of market leaders by studying their incentives to undertake preliminary investments and other market strategies to gain advantage over their competitors (see Competition Policy: Toward a New Approach, 2006, European Competition Journal). Traditionally, the post-Chicago approach taught us that when competition in quantities takes place between two firms, one of them would usually gain by over-investing to reduce costs, which allows it to be aggressive in the market (expanding production and inducing its rivals to produce less), but under competition in prices, the same firm would prefer to under-invest in cost reductions so as to be accommodating (increasing its price so as to induce its rivals to raise price). The theory of market leadership, however, shows that things change when entry is endogenous, that is when firms endogenously decide to enter or not in the market according to their opportunities to make profits. In this case, the pressure of entry induces a firm to undertake always investments to be aggressive in the market; that is, to expand production under competition in quantities and decrease prices under competition in prices. For instance, a leader will always find it optimal to over-invest in cost reductions to be able to produce more and to reduce its price below the price of its competitors. This outcome emerges in many other contexts: in any market where entry is endogenous, the leader always over-invests to gain a strategic advantage and conquer a larger market share. However, this results in a reduction in prices with a net gain for consumers (see Aggressive Leaders, 2006, RAND Journal of Economics).
Such a phenomenum happens under any form of competition (including in prices and in production levels) as long as entry for competitors is endogenous. As long as this condition applies, the competitiors’ fear induces the leader to be aggressive: its best strategy requires reducing costs, improving product quality, engaging in a lot of advertising, producing complementary products and so on. This allows the leader to lower its price, gain market share and gain from a reduction in the average costs of production, but it also disciplines competitors and keeps prices at a low level, with unambiguous benefits for society.
It is also easy to derive simpler and even more radical results in a more basic context where the leader does not undertake a preliminary strategic investment but directly decides its own strategy before the other firms. In general, a leader in a market where fixed or sunk costs constrain entry will produce more and will set lower prices than its competitors. Actually, in a market of homogeneous products where production requires a fixed sunk cost and a constant marginal cost of production and firms choose their production levels (a simple structure typical of energy and telecommunication industries and some high-tech sectors), the competitive equilibrium implies that only the leaders produces in the market. Paradoxically, such apparently monopolistic markets completely dominated by a single firm are perfectly competitive and extremely efficient since they save in costs of entry, making the productive process much cheaper, and consequently keep prices at a low level. With this kind of market leadership, society gains from greater cost efficiency and lower prices. Hence, a proper competition policy in this situation should not obstruct the market leader and should limit its intervention to promote entry.
Now, to extend the analysis to other contexts, imagine that goods are not homogeneous but they differ in quality. This happens when consumer needs or tastes are quite differentiated, as is the case in many sectors where the design and the inner quality of products play an important role. Under these circumstances, firms often compete in prices by choosing different mark-ups for different products. When quality differs, it is important to have a number of firms producing different varieties of goods. A competitive market typically satisfies this requirement, but it tends to induce excessive proliferation of products. The presence of market leaders is again beneficial: they will not conquer the entire market as before, but they will expand production and consequently reduce their prices below the prices of their competitors, some of which will be driven out of the market. Consumers will then face a lower variety of alternative products but pay less for some of them. Again market leadership with endogenous entry creates a net gain for society. An analogous situation appears when we relax the other assumption adopted in the basic example, that of constant marginal costs. When the average cost function has a standard U-shape due to increasing marginal costs (at least beyond a certain production level), the leader again produces more than each competitor. In such a case, the price of the market leader is also equal to its marginal cost: hence, the theory of market leaders confirms that, in this situation, the theoretical price above which there cannot be predatory purposes corresponds to the marginal cost, which, according to the traditional Areeda-Turner test, is best approximated with the average variable cost (the adoption of other standard price levels in general is here inconsistent with our results).
This discussion implies two main conclusions. First, a leading market position associated with aggressive strategic investments can be the consequence of a competitive market environment and not the result of market power. Second, whenever firms engage in price competition, the post-Chicago approach associates aggressive pricing or other aggressive strategies (including bundling) with a predatory purpose, while the theory of market leaders provides arguments for which an aggressive strategy is generally pro-competitive and without exclusionary purposes. This creates doubts about the traditional approach to predatory pricing and other exclusionary conducts that characterises EU competition policy.
Moreover, the new theory of market leaders provides insights into what constitutes a dominant position in a market and what an abuse of that position should consist of. First of all, it would be better to differentiate market leaders from dominant firms: market leaders have some strategic competitive advantage over their competitors, but only when they can use it to prevent effective competition and harm consumers should they be considered to be dominant and their behavoiur potentially abusive. The point is to understand when market leaders can prevent effective competition and when they cannot.
As previously noticed, the behaviour of market leaders tends to be pro-competitive whenever entry of competitors in their markets is constrained by entry barriers or fixed costs of entry. Second, there should be no presumption that a certain market share amounts necessarily to dominance. As a matter of fact, the theory of market leaders shows that, paradoxically, the correlation between market share and effective market power can be negative. Consider a market where a leader and its rivals compete on price. According to the post-Chicago approach, the leader could try to deter entry with a predatory strategy, or just be accommodating, sharing the market with competitors, in which case its market share may be even smaller than that of its competitors. However, when entry into the market is endogenous and constrained just by technological conditions, the leader has to adopt a strategy of aggressive pricing, and, by undercutting its competitors, it acquires a larger share of the market. In this case, the market share of the leader is increasing when product differentiation is weaker, when fixed costs of production are higher and when variable costs do not increase too much as production level goes up. Actually, as we have seen before, the theory of market leaders describes the conditions under which endogenous entry induces the leader to be so aggressive as to conquer the whole market. But this implies that the same possibility of entry and hence lack of effective market power is associated with the largest market share for the leader. In conclusion, considering a large market share per se a finding of dominance is potentially highly misleading.
Competition in the high-tech markets is dynamic in the Schumpeterian sense that it takes place as competition for the market in a so called winner-takes-all-race, and such an element requires an even deeper rethinking of industrial policy than suggested in the analysis of the previous sections, which was mostly focused on a static concept of competition in the market. Even if most economists are used to thinking about market leaders as firms with weaker incentives to invest in R&D, recent theoretical and empirical research has also noticed that market leaders play a crucial role in the innovation sector for competitive markets. Indeed, wide empirical evidence shows that dominant firms invest a lot in R&D and obtain relatively more innovations. An important economist in the field, Paul Segerstrom talks about Intel Economics referring to a main example of a technological leader, in the chips market, which in 2000 invested 11.5% of its total sales in R&D. High investments can also be found in many other major firms of high tech sectors. In the same year, the R&D/Sales ratio was 15% for Pfizer and 5.8% for Merck, two leaders in the pharmaceutical sector, 16.4% for Microsoft, the leading firm in operating systems, and 5.8% for IBM, and 5.4% for Hewlett Packard, two leaders in computer technologies and services, 11.8% for Motorola and 8.5% for Nokia, leaders in wireless, broadband and automotive communications technologies, 10% for Johnson & Johnson, the world's most comprehensive manufacturer of health care products and services, 6.6% for 3M and 6.3% for Du Pont, which are active in many fields with a leading role, 5.6% for Xerox (mostly focused on the legendary Palo Alto Research Center) and for Kodak, leaders in the markets for printers and photographs. The fact that these companies remain at the top of the technological frontier in their respective industries may not be the sign of a monopolistic position in the traditional sense, but the fruit of their investments and of the competitive threat deriving from other firms and potential entrants.
The recent theories of market leadership have clarified the mechanics of these results. Dominant firms have more incentives to invest in innovation than the outsiders when the market for innovation, or what sometimes is called the patent race, is characterized by endogenous entry (as long as the dominant firms have a leadership, which in economic jargon means just that they can commit to an investment choice before the other firms). The crucial thing here, is that market leaders often remain on top thanks to their investments, but this should not be seen as evidence of inefficiency or of dominance, but rather as a proof of the opposite: the competitive environment spurs investment by leaders and consequently induces a chance that their leadership persists.
Clearly, this has strong implications for competition policy. What the above theory suggests in this case, is that market leaders in high-tech sectors investing a lot in innovation may create an efficient situation: antitrust authorities should be especially careful when trying to stamp out monopoly power in markets that are marked by technical innovation.
The Discussion Paper on exclusionary abuses recently issued by the European Commission states that the purpose of Article 82 is “the protection of competition on the market as a means of enhancing consumer welfare and of ensuring an efficient allocation of resources” (# 4). This implies that antitrust should protect competition and not competitors and be based on an economic approach aiming at the maximization of consumer welfare and allocative efficiency rather than based on a legalistic approach. In the current proposal there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines.
According to the European Competition Law, dominance in a market or its creation cannot be punished, while only its abuse by dominant firms is subject to antitrust screening. Hence, the preliminary phase of any antitrust case applying Article 82 must define the relevant market and verify the existence of a dominant position. The Discussion Paper briefly refers to the definition of a proper market, which can be more complex in Article 82 cases because the market price could be above its competitive level (#11-19). This creates problems with the usual methods of market definition. For instance the SSNIP-test, which defines the relevant separate market as the smallest market where a Small but Significant Non-transitory Increase in (competitive) Prices (say of 5-10%) increases the profits of a hypothetical monopolist, is biased when the market is characterized by higher than competitive prices (which is more likely in cases of abuse of dominance): such a bias usually leads to a too-wide market definition, which in turn may lead to a finding of no dominance, the so-called “cellophane fallacy” (from the du Pont case). However, it should be noticed that the cellophane fallacy only applies in presence of a single monopolist in the market and when entry is impossible, while the SSNIP-test at the prevailing prices remains a valid test whenever the market leader is constrained by effective competition and/or potential entry.
Following a traditional definition, the Discussion Paper associates dominance with “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, its customers and ultimately of the consumers” (# 20). Such a definition requires “a leading position on that market” compared to the rivals (# 22) and the lack of “effective competitive constraints” (# 23) in the process in which “the undertaking and the other players act and inter-act on the market”( # 23). Given the positive stress put on an economic-based approach to competition policy, it is important to notice that this definition of dominance is clearly associated with two situations: the pure monopoly, as an extreme case of dominance, and the market leadership where the dominant firm faces some competitors, which is the subject of the theory of market leaders previously studied. It should be emphasized that, according to this theory, a market leader can really act independently of its rivals (so as to satisfy the above condition for dominance) only when the number of competitors is exogenously set and further entry is impossible, while a market leadership constrained by effective competition and potential entry cannot be associated with dominance: in this case, modern economic theory tells us that leaders tend to be aggressive (pro-competitive) in their pricing and investment strategies, conquering larger market shares in a way that has nothing to do with dominance as defined above, and which is also beneficial to consumers.
As a consequence of the approach of the Discussion Paper, a certain ambiguity emerges in the statement at # 27 saying that “the fact that an undertaking is compelled by the pressure of its competitors’ price reductions to lower its own prices is in general incompatible with […] the existence of substantial market power” and hence with dominance. In particular this should be always true and not just “in general”, since in this case the market leader is constrained by effective competition and cannot act independently from it, as the definition of dominance would require and should be extended to any other form of aggressive competition, that is not only competition in prices, but also competition in quantities or in alternative forms of strategic investments. Hence, the fact that an undertaking is compelled by the pressure of its competitors’ aggressive strategies to adopt aggressive (pricing and investment) strategies should be always incompatible with dominance.
The stress on market shares in the evaluation of dominance (# 29- 33) appears in clear contrast with the conclusions of the theory of market leadership: market leaders have larger market shares exactly when they are constrained by effective and potential competition since in this case they adopt more aggressive (pricing and investment) strategies which expand their market shares. In other words there is not necessarily a positive correlation between the presence of larger market shares and a dominant position and, especially in highly dynamic markets, there is not unambiguous theoretical support for a statement saying that “[m]arket share is only a proxy for market power” (# 32). The structural indicators which traditionally serve as proxies for ‘dominance’ can be accurate at most in some traditional markets, but not in others, as indeed in high-tech and New Economy industries (as computer hardware and software, online businesses, mobile telephony and biotechnology).
Finally, and maybe even more importantly, the part on dominance clearly refers to competition in the market, while it is hardly useful to evaluate cases where competition for the market takes place. In these cases, typical of the New Economy, competition is dynamic and innovators conquer large parts of a market, so that any static analysis of market shares cannot say anything about dominance. In other words, a market can be currently dominated by a single firm, but if many other firms which are not even active in this market are investing in R&D to enter into it, as it happens in many high-tech sectors, this market is substantially competitive in a dynamic sense. Nevertheless, any leader in such a competitive winner-takes-all market would be always characterized as dominant by the static and market-share-based approach of the Discussion Paper.
Moreover, as we saw earlier, the theory of market leaders tells us that in these dynamic sectors market leaders, as long as they are constrained by effective competition in the market for innovations, invest more than their competitors and hence are more likely to remain leaders. In this sense, statements saying that “high market shares, which have been held for some time, indicate a dominant position” can be true in some sectors, but not in high-tech sectors with competition for the market. In conclusion, the general impression is that there is an excessive stress on the importance of market shares to evaluate dominance, and that this can be highly misleading especially for dynamic markets.
Finally, the part of the Discussion Paper on barriers to expansion and entry (# 34-40) concerns a concept which is far from unambiguous in economic theory. The definition of these barriers as “factors that make entry impossible or unprofitable while permitting established undertakings to charge prices above the competitive level” (# 38) applies well to legal barriers but not to other factors which are sometimes seen as barriers. For instance, high fixed costs of production and R&D or investments needed to develop network externalities or learning by doing advantages, do not make entry impossible: the correct definition in these cases would be that these factors endogenously limit entry or endogenously determine how many and which firms profitably enter. The difference is not just in the definition but also in the economic consequence, since modern economic theory has shown that when entry is impossible market leaders may behave in an anti-competitive way, but when entry is constrained by technological or demand conditions they (always) behave in a pro-competitive way even if the cited factors limit entry and the market leaders obtain high market shares.
