This presentation by Jorge PADILLA, Senior Managing Director and Head of Compass Lexecon was made during the roundtable discussion on geographic market definition held during the 124th meeting of the OECD Working Party No. 3 on Co-operation and Enforcement on 28 November 2016. More papers and presentations on the topic can be found out at www.oecd.org/daf/competition/geographic-market-definition.htm

1. Jorge Padilla (joint work with
Georges Siotis)
28 November 2016
A presentation to the OECD
Supply Side Substitution in Geographic
Market Definition
An economic perspective

2. COMPASS LEXECON 1
TWO QUESTIONS
 When should we use supply-side substitution (SSS) to widen the geographic
scope of markets?
 Should we bother dealing with SSS arguments given that we can consider the
competitive constraints imposed by entrants?

3. COMPASS LEXECON 2
ONE PRELIMINARY COMMENT
 Some consider SSS a variant of entry. SSS is taken to mean faster, costless
entry.
 That is wrong.
 The assessment of entry is made at a company level. The conclusions of that
assessment may lead to change market structure within a given relevant
product market.
 Instead, the assessment of SSS takes place at the market level and involves all
the companies that are part of the market which may be aggregated to the
initial candidate or putative market. This assessment may lead to change the
boundaries of the relevant product market.

4. COMPASS LEXECON 3|
Scenario I

5. COMPASS LEXECON 4
SCENARIO I
 All yellow firms serve the red customer located in the middle of the Union
territory; the orange firms serve both the red and the purple customer. The
orange firms price discriminate between the red and purple customers
 The Union is a relevant geographic market
 Market shares are calculated taking into account the production and
capacity of all yellow and orange firms
UNION
Red customer
Firms serving
red customer
Firms serving
red and purple
customer
Purple customer

6. COMPASS LEXECON 5|
Scenario II

7. COMPASS LEXECON 6
SCENARIO II
 All yellow firms served the red customer located in the middle of the Union
territory; the orange firm serves both the red and purple customers and price
discriminates between them; the green firm does not compete for the red
customer’s business
 The Union is a relevant geographic market
 Market shares are calculated taking into
account the production and
capacity of all yellow firms and
the orange firm
 But we may also have to take into
account the green firm – SSS
Firm not serving any
customer
UNION

8. COMPASS LEXECON 7|
Scenario III

9. COMPASS LEXECON 8
SCENARIO III
 All yellow firms serve the red customer located in the middle of the Union
territory.
 The orange firm also serves the red customer but is no longer part of the Union.
 The orange firm engages in price discrimination
 All yellow firms compete with the
orange firm on a level playing field – there
are no barriers to trade (soft union exit)
 The green firm does not serve
the red customer but competes with
the orange firm for the purple
customer
UNION

10. COMPASS LEXECON 9
SCENARIO III
 What are the boundaries of the relevant geographic market?
 How should we compute market shares?
 What do we do with the green firm?
UNION

11. COMPASS LEXECON 10|
Option 1
Narrow geographic market
+
Imports

12. COMPASS LEXECON 11
OPTION 1 – NARROW MARKET
 What are the boundaries of the relevant geographic market?
– UNION
 How should we compute market shares?
– INCLUDING SALES/CAPACITY OF
YELLOW FIRMS AND
SALES TO/CAPACITY AVAILABLE
FOR SALE IN THE UNION
OF ORANGE FIRM
 What do we do with the green firm?
– CONSIDER WHETHER IT
COULD ENTER THE MARKET
IF THE RED CUSTOMER’S
PRICES INCREASED
SSNIP
UNION

13. COMPASS LEXECON 12|
Option2
Wide geographic market

14. COMPASS LEXECON 13
OPTION 2 – WIDE MARKET
 What are the boundaries of the relevant geographic market?
– UNION + LIGHT BLUE COUNTRY
 How should we compute market shares?
– INCLUDING SALES/CAPACITY OF
YELLOW, ORANGE AND GREEN
FIRMS
 What do we do with the green firm?
– IT IS PART OF THE RELEVANT
PRODUCT MARKET
UNION

15. COMPASS LEXECON 14|
Comparing options 1 and 2

16. COMPASS LEXECON 15
COMPARING OPTIONS 1 AND 2
 Option 1
– Competitive constraint exerted by
orange firm likely to be
underestimated in practice, since it
may be very difficult to estimate
the capacity available for the Union
market
– This means that only actual imports
would be taken into account, even
when the orange firm could export
more if the yellow firms raised their
prices
– So, a cross-border merger may be
incorrectly cleared, while a
domestic merger may be wrongly
prohibited if the assessment is
largely driven by structural factors
UNION

17. COMPASS LEXECON 16
COMPARING OPTIONS 1 AND 2
 Option 2
– The strength of the competitive
constraint exerted by the orange
firm on the yellow firms competing
for the demand of the red customer
may be over- or under-estimated
– On the one hand, the inclusion of
the green firm into the market will
dilute the competitive significance of
the orange firm
– On the other, adding sales of the
orange firm to the purple customer
will inflate its market share and
cause authorities to over-estimate
the constraint it imposes on the
yellow firms
UNION

18. COMPASS LEXECON 17
COMPARING OPTIONS 1 AND 2
 Option 2 (cont.)
– The strength of the competitive
constraint exerted by each yellow
firm on the other yellow firms
competing for the demand of the
red customer will be under-
estimated
– First, the inclusion of the green firm
into the market will dilute the
competitive significance of each
yellow firm
– Second, adding the sales made to
the purple customer will reduce its
market share and cause the
authorities to under-estimate the
constraint it imposes on the other
yellow firms
UNION

19. COMPASS LEXECON 18
COMPARING OPTIONS 1 AND 2
 Option 2 (cont.)
– So, a cross-border merger may be
incorrectly prohibited or approved,
while a domestic merger may be
wrongly approved if the assessment
is largely driven by structural factors
– Option 2 creates a bias in favour of
domestic mergers, and option 1 a
bias in favour of cross-border
mergers
UNION

20. COMPASS LEXECON 19|
Aggregating geographic
markets

21. COMPASS LEXECON 20
WHEN SHOULD MARKETS BE AGGREGATED?
 Simple answer is when aggregation would
produce market share figures that provide
a more reliable view of the competitive
position of the merging parties and their
competitors or of the companies whose
behaviour is being investigated
 Necessary condition: there are no green
firms in the candidate market for
aggregation to the putative Union market
– near universal substitutability
 But while the condition above may be
sufficient for assessing the impact on the
Union of cross-border mergers, it is
clearly not sufficient for the assessment
of domestic mergers in the Union
UNION

22. COMPASS LEXECON 21
WHEN SHOULD MARKETS BE AGGREGATED?
 Necessary condition: there are no
green firms in the candidate market
for aggregation to the putative Union
market – near universal
substitutability
 But while the condition above may be
sufficient for assessing the impact on
the Union of cross-border mergers, it
is clearly not sufficient for the
assessment of domestic mergers in
the Union
 For that purpose we should require
symmetric conditions of competition
– i.e. all suppliers should be orange
UNION

23. COMPASS LEXECON 22|
Supply-side substitution

24. COMPASS LEXECON 23
SUPPLY-SIDE SUBSTITUTION
 Consider the scenario depicted in the
figure below, should we aggregate the
Light Blue market to the Union market
when assessing the competitive
implications of a domestic merger?
 Three conditions: UNION

25. COMPASS LEXECON 24
SUPPLY-SIDE SUBSTITUTION
 Consider the scenario depicted in the
figure below, should we aggregate the
Light Blue market to the Union market
when assessing the competitive
implications of a domestic merger?
 Three conditions:
– Timely and costless entry: A green
firm can transform itself into an
orange firm quickly and a minimal
cost
UNION

26. COMPASS LEXECON 25
SUPPLY-SIDE SUBSTITUTION
 Consider the scenario depicted in the
figure below, should we aggregate the
Light Blue market to the Union market
when assessing the competitive
implications of a domestic merger?
 Three conditions:
– Timely and costless entry: A green
firm can transform itself into an
orange firm quickly and a minimal
cost
– Near universal substitutability: all
green firms will become orange in
the event of a SSNIP by the yellow
firms
UNION

27. COMPASS LEXECON 26
SUPPLY-SIDE SUBSTITUTION
 Consider the scenario depicted in the
figure below, should we aggregate the
Light Blue market to the Union market
when assessing the competitive
implications of a domestic merger?
 Three conditions:
– Timely and costless entry: A green
firm can transform itself into an
orange firm quickly and a minimal
cost
– Near universal substitutability: all
green firms will become orange in
the event of a SSNIP by the yellow
firms
– Symmetry: the yellow firms also
compete for the purple business
UNION

28. COMPASS LEXECON 27
SUPPLY-SIDE SUBSTITUTION
 Consider the scenario depicted in the
figure below, should we aggregate the
Light Blue market to the Union market
when assessing the competitive
implications of a domestic merger?
 Three conditions:
– Timely and costless entry: A green
firm can transform itself into an
orange firm quickly and a minimal
cost
– Near universal substitutability: all
green firms will become orange in
the event of a SSNIP by the yellow
firms
– Symmetry: the yellow firms also
compete for the purple business
UNION
 The last two requirements make the
assessment of SSS very different from the
assessment of DSS, where symmetry is
not necessary

29. COMPASS LEXECON 28|
What else?

30. COMPASS LEXECON 29
WHAT ELSE?
 Refine Option 1
– Focus on capacity shares as
opposed to volume shares or
revenue shares, and
– Try to estimate accurately the
capacity of orange firm that is
available for the Union market UNION

31. COMPASS LEXECON 30
WHAT ELSE?
 Forget about market definition
– Focus on diversion ratios and assess
predicted price increases directly
 Problem market share analysis is
attractive to both competition
authorities and companies
 Once market shares have been
calculated, everyone forgets how the
sausage was made, so structural
presumptions are very hard to
overcome
UNION

32. COMPASS LEXECON 31
WHAT ELSE?
 Price correlation evidence and/or
price cointegration evidence is not
conclusive regarding SSS
 In the scenario below, there is no
symmetry and no near-universal
substitutability and there is price
discrimination and, hence, markets
should not be aggregated
 Yet, we may observe prices in both
markets to be correlated /
cointegrated. This is a price reduction
in the union may lead to a diversion of
orange capacity to the Light Blue
Country and therefore to a price
reduction there
UNION

33. COMPASS LEXECON 32|
Geo markets in Cyber space

34. COMPASS LEXECON 33
GEO MARKETS IN CYBER SPACE
 Suppose the orange and yellow firms
below are considering to merge
 Markets are regarded as separate
because the orange firm price
discriminates between the Union and
the Light Blue Country
 The merger is treated as a two to one
in the Union and remedies are
imposed; it is cleared in the Light Blue
Country as there is no overlap
 But suppose the merged entity’s
business plan implied that it would
not price discriminate any longer (no
geo blocking), should the merger be
conditioned in the Light Blue Country
as well?
UNION

35. COMPASS LEXECON 34
GEO MARKETS IN CYBER SPACE
 Suppose the orange and yellow firms
below are considering to merge
 Markets are regarded as separate
because the orange firm price
discriminates between the Union and
the Light Blue Country
 The merger is treated as a two to one
in the Union and remedies are
imposed; it is cleared in the Light Blue
Country as there is no overlap
 But suppose the merged entity’s
business plan implied that it would
not price discriminate any longer (no
geo blocking), should the merger be
conditioned in the Light Blue Country
as well?
UNION
 Market definition pre and post merger may
be different – market definition may be
endogenous; this possibility may be more
relevant in digital industries

36. COMPASS LEXECON 35
GEO MARKETS IN CYBER SPACE
 Suppose the orange firm in the light
does not price discriminates between
the Union and the Light Blue Country
and, due to that, a single market is
defined comprising both countries
 The orange firm is not dominant in the
wide market
 The orange firm engages in
exclusionary behaviour against the
green firm
 After the green market exits, the
orange firm starts to price
discriminate and becomes dominant
in the Light Blue Country
 Is this an abuse of a dominant
position?
 Market definition may be determined
endogenously by the conduct of the
dominant company; this possibility may be
more relevant in digital industries
UNION

37. COMPASS LEXECON 36
THANK YOU!
jpadilla@compasslexecon.com
View my research on my SSRN author
page: http://ssrn.com/author=47132