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luxury brands. The SSNIP test provides a conceptual way to determine whether the EC or BMW is correct. According to the SSNIP criterion, the EC is correct if, in the hypothetical event that all three German car makers merged, they could increase profits by raising their prices for at least one year by 5 percent. If this were the case, then we would conclude that the three German car makers competed among themselves but faced minimal outside competition. BMW would be correct if a single firm consisting of Audi, BMW, and Mercedes would lose money were it to try to raise prices by 5 percent for at least one year. This would imply that the three German car makers faced substantial competition from other brands.
EXAMPLE 5.1 THE SSNIP IN ACTION: DEFINING HOSPITAL MARKETS
The 1990s saw a remarkable degree of consolidation among U.S. hospitals, with the result that many metropolitan areas were dominated by just one or two hospital systems. Antitrust laws are supposed to prevent mergers that lead to monopolization, and many casual observers must have wondered what was going on. In fact, the Federal Trade Commission challenged several hospital mergers during the 1990s but lost every challenge. The decisive factor in nearly every case was market definition.
The merger between Mercy Health Center and Finley Hospital in Dubuque, Iowa, is a case in point. These are the only two hospitals in Dubuque, and it seemed that the merger would create an illegal monopoly. The FTC challenged the deal, but the hospitals argued that they competed in a broad geographic market against hospitals located dozens of miles away. Presenting evidence that Dubuque hospitals treated quite a few out of town patients, the hospitals persuaded the federal court that they faced substantial competition from out of town hospitals. The court allowed the merger.
Decisions such as these did not sit well with economists who had studied hospital pricing data and knew that mergers like the one in Dubuque often led to large price increases. Such price increases could only
mean that the court’s expansive view of geographic markets was incorrect; if there really was such competition, then prices could not have increased. Cory Capps and colleagues at Northwestern University used the SSNIP criterion as a foundation for a new method of identifying geographic markets.2 They reasoned that hospitals competed to be part of managed care provider “networks” and that managed care organizations, in turn, offered these networks to local employers and employees. Capps et al. observed that if all of the hospitals in a narrowly defined geographic area were to merge, they could sustain a price increase because the managed care payers could not offer a network that excluded all local providers. Capps et al. developed a statistical model and used it to show that the broad markets affirmed by the courts failed the SSNIP test. Other economists have used different statistical models and reached the same conclusions.
Based on arguments like this, the FTC has pursued hospital consolidation with renewed vigor. It won a court case in which it argued that the northern suburbs of Chicago represented a well-defined geographic market and blocked mergers in Virginia and Ohio on similar grounds. Thanks to SSNIP, U.S. hospital markets may soon be more competitive, with lower hospital prices as a result.
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Putting Competitor Identification into Practice
The SSNIP criterion is sensible, but it relies on a hypothetical question that is often difficult to answer in practice: how would firms behave in the event of a hypothetical merger? Even so, the SSNIP criterion points to the kind of evidence needed for market definition and competitor identification. Specifically, the SSNIP criterion suggests that two firms directly compete if a price increase by one firm causes many of its customers to do business with the other. For example, if the German car makers raise prices by 5 percent and, as a result, lose a lot of customers to Lexus and Acura, then these Japanese brands compete with the Germans.
The SSNIP criterion is based on the economic concept of substitutes. In general, two products X and Y are substitutes if, when the price of X increases and the price of Y stays the same, purchases of X go down and purchases of Y go up. When asked to identify competitors, most managers would probably name substitutes. For example, a manager at BMW might name Audi, Mercedes, Lexus, and Acura as competitors. In fact, when Lexus and Acura entered the 1980s with relatively low prices, they took considerable business away from BMW. When BMW and other European luxury car makers reduced their prices in the early 1990s, they regained market share from Lexus and Acura. Hyundai is hoping that history will repeat itself with its “budget”-priced Genesis luxury sedan.
At an intuitive level, products tend to be close substitutes when three conditions hold:
1.They have the same or similar product performance characteristics.
2.They have the same or similar occasions for use.
3.They are sold in the same geographic market.
A product’s performance characteristics describe what it does for consumers. Though highly subjective, listing product performance characteristics often clarifies whether products are substitutes. BMW and Lexus sedans have the following product performance characteristics in common:
•Ability to seat five comfortably
•High “curb appeal” and prestigious name
•High reliability
•Powerful acceleration and sure handling and braking
•Plenty of features, such as leather seats and excellent audio systems
Based on this short list, we can assume that the products are in the same market. We would probably exclude Subarus from this market, however.
A product’s occasion for use describes when, where, and how it is used. Both orange juice and cola quench thirst, but because orange juice is primarily a breakfast drink, they are probably in different markets.
Products with similar characteristics and occasions for use may not be substitutes if they are in different geographic markets. In general, two products are in different geographic markets if (a) they are sold in different locations, (b) it is costly to transport the goods, and (c) it is costly for consumers to travel to buy the goods. For example, a company that mixes and sells cement in Mexico City is not in the same geographic market as a similar company in Oaxaca because the cost of transporting cement 325 miles from one city to the other is prohibitive.
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Empirical Approaches to Competitor Identification
Although the intuitive approach to competitor identification is often sufficient for business decision making, it can be subjective. When possible, it is helpful to augment the intuitive approach with data. As pointed out in the Economics Primer, the degree to which products substitute for each other is measured by the cross-price elasticity of demand. If the products in question are X and Y, then the cross-price elasticity measures the percentage change in demand for good Y that results from a 1 percent change in the price of good X. yx denotes the cross-price elasticity of demand of product Y with respect to product X, Qy the quantity of Y sold, and Px the price of product X, then
(DQyyQy)
yx 5 (DPxyPx)
When yx is positive, it indicates that consumers increase their purchases of good Y as the price of good X increases. Goods X and Y would thus be substitutes. Thanks to the growing availability of retail scanner pricing data, it is increasingly possible for the makers of consumer products to directly measure cross-price elasticities of demand. Regression analysis uses statistical algorithms to isolate the effects of price changes on purchase patterns, while holding constant other demand-side factors such as product characteristics and advertising spending.
When appropriate data are unavailable, ad hoc product market definition may be a necessary alternative to regression analysis. The U.S. Bureau of the Census’s Standard Industrial Classification (SIC) system identifies products and services by a seven-digit identifier, with each digit representing a finer degree of classification. For example, within the two-digit category 35 (industrial and commercial machinery and computer equipment) are four-digit categories 3523 (farm machinery and equipment) and 3534 (elevators and moving stairways). Within 3534 are six-digit categories for automobile lifts, dumbwaiters, and so forth. One should use caution when using SIC codes to identify competitors because SIC categories are not always as precise as desired. For example, category 2834 includes all pharmaceuticals, which is overly broad for competitor identification because not all drugs substitute for each other. At the same time, some four-digit categories are too narrow. Firms in the four-digit categories for variety stores (5331), department stores (5311), and general merchandise stores (5399) may all compete against each other.
Geographic Competitor Identification
Though ad hoc, government-drawn geographic boundaries provide a good starting point for identifying geographic competitors. City, county, and state lines often provide an adequate first step for delineating the scope of competition. But such boundaries are only a first step. For example, consider trying to define the geographic scope of competition among retail grocers. Is the “city” a reasonable way to delineate markets? The city of Chicago is probably too large to represent a single market; it is unlikely that all the grocery stores in Chicago compete with one another. On the other hand, grocers in the Illinois town of Glencoe surely compete with grocers in the neighboring town of Highland Park.
Rather than rely on ad hoc market boundaries, it is preferable to identify competitors by directly examining the flow of goods and services across geographic
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EXAMPLE 5.2 DEFINING COCA-COLA’S MARKET
In 1986, the Coca-Cola Company sought to acquire the Dr Pepper Company. At the time, Coca-Cola was the nation’s largest seller of carbonated soft drinks, and Dr Pepper was the fourth largest. The Federal Trade Commission (FTC) went before federal judge Gerhard Gesell seeking an injunction to block the merger on the grounds that it violated Section 7 of the Clayton Act, which prohibits any acquisition of stock or assets of a company that may substantially lessen competition. CocaCola apparently sought the deal to acquire, and more fully exploit, the Dr Pepper trademark. Coca-Cola’s marketing skills and research ability were cited as two factors that would allow it to increase the sales of Dr Pepper. Judge Gesell also noted that Coca-Cola was motivated, in part, by a desire to match the expansion of Pepsi-Cola, which had simultaneously been seeking to acquire 7-Up. Although the threat of FTC action caused Pepsi to abandon the 7-Up acquisition, Coca-Cola pressed on.
Judge Gesell granted the injunction, and the Coca-Cola/Dr Pepper deal was never consummated. In his decision, Judge Gesell addressed the question of market definition. He wrote: “Proper market analysis directs attention to the nature of the products that the acquirer and the acquired company principally sell, the channels of distribution they primarily use, the outlets they employ to distribute their products to the ultimate consumer, and the geographic areas they mutually serve.” The judge was concerned not only with the end-user market, but also with intermediate markets for distribution and retailing. Reduction of competition in any of these markets could harm consumers.
Depending on how the market in which Coca-Cola and Dr Pepper competed was defined, one might conclude that the merger
would have either no effect on competition or a significant effect. The FTC argued that the appropriate “line of commerce” was carbonated soft drinks. It presented data to show that under this definition, the merger of Coca-Cola and Dr Pepper would increase Coca-Cola’s market share by 4.6 percent nationwide and by 10 to 20 percent in many geographic submarkets. (Geographic submarkets were considered because of the special characteristics of softdrink distribution channels.) Given CocaCola’s already high market share of 40 to 50 percent in many of these markets, the merger would significantly reduce competition.
In defending the merger, Coca-Cola attempted to define the relevant market as “all . . . beverages including tap water.” Under this definition, the proposed merger would have a negligible effect on competition. Judge Gesell ruled: “Although other beverages could be viewed as within ‘the outer boundaries’ of a product market . . . determined by the reasonable interchangeability of use or the crosselasticity of demand between carbonated soft drinks and substitutes for them, carbonated soft drinks . . . constitute a product market for antitrust purposes.” In reaching this decision, he relied on factors such as the product’s distinctive characteristics and uses, distinct consumers, distinct prices, and sensitivity to price changes. Judge Gesell found such indicia to be present in this case, stating that the rival firms “make pricing and marketing decisions based primarily on comparisons with rival carbonated soft drink products, with little if any concern about possible competition from other beverages.” In other words, carbonated soft-drink makers constrain each others’ pricing decisions, but are unconstrained by other beverages. Thus, carbonated soft drinks constitute a well-defined market.
regions. To illustrate this approach, consider how Lombard Sporting Goods near downtown San Francisco might try to identify its competitors. Lombard might decide that its competitors are the other downtown sporting goods stores. This is mere guesswork and is probably wrong.