Competing Ideas

OXFORD ECONOMIC RESEARCH ASSOCIATES

THE CRITICAL SALES LOSS TEST IN MARKET DEFINITION

The critical sales loss test is a useful empirical tool for applying the SSNIP test. This months Competing Ideas explains the theory of critical sales loss, and suggests how it can help to avoid inconclusive debates on market definition based on product characteristics only

The SSNIP test for market definition

Competition authorities now routinely define markets with reference to the concept of the hypothetical monopolist or small but significant and non-transitory increase in price (SSNIP) test. This test was developed by the competition authorities in the USA in their 1992 Horizontal Merger Guidelines,1 and has been endorsed in the EU and the UK (although with some modifications).2 The SSNIP test works as follows: if a hypothetical monopolist of the collection of products (or geographic areas) in question were able to effect a small but significant (usually 510%) and non-transitory (usually 12 years) increase in the price of those products, then they would form a relevant market. The basic logic of the test is that if the hypothetical monopolist would not raise price, this can only be because consumers would switch to the closest substitute product (or area). This product (area) should therefore be included in the group of products (areas) under consideration, and the test should be applied again to the new group. This process is continued until the smallest group of substitute products (or areas) for which the hypothetical monopolist is able to effect a SSNIP is identified. However, while the SSNIP test is now regularly referred to in competition cases, in practice, the definition of markets is still often based on comparisons of product characteristics only. This is necessarily subjective and can lead to endless debatesfor example, do consumers drink beer to quench thirst (in which case soft drinks might be a substitute), or for its alcoholic content (in which case wine might do the job equally well)? Competition authorities sometimes analyse differences in product characteristics, and from there draw tentative conclusions on the likelihood that consumers would switch after a hypothetical price increase. For example, in a recent decision on Visa International, the global credit-card scheme, the European Commission excluded cash and cheques from the relevant market for credit cards mainly for reasons related to product characteristics (eg, cash is inconvenient and dangerous to carry in large amounts, and cheque books only
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contain a limited number of cheques), rather than relying on economic or empirical evidence of actual consumer behaviour.3 Apart from being subjective, such market definitions based on product characteristics overlook the fact that two products do not have to be perfect substitutes in order to form part of the same relevant market. As explained below, imperfect substitutes can be in the same market even if only a small proportion of consumers would switch between them after relative price changes. The question is: how small is this proportion?

Critical sales loss

The SSNIP test is essentially based on the loss of sales that a supplierin this case the hypothetical monopolistwould suffer if it raised prices. A more direct and robust way of applying the SSNIP test is therefore to use the critical sales loss analysis. An increase in price would normally bring about a reduction in demand for the product by consumers, who would either switch to substitute goods in the market or choose not to spend at all. As a result, the profits of the hypothetical monopolist who tried to raise prices would be: reduced by the loss of profit margins on the volume of sales lost; and increased by the higher profit margins on the volume of sales remaining due to the higher price.4

This is illustrated in Figure 1, which shows a product with a linear demand curve and constant average variable cost (AVC).5 Suppose that existing suppliers collectively sell a quantity of Q1 of that good at price P1. Next, suppose that we hypothetically monopolise the marketie, we assume that there is only one supplier (the hypothetical monopolist) selling Q1 at price P1. The question posed by the SSNIP test is: would the monopolist find it profitable to increase price beyond P1? The profits on current sales are indicated by the rectangle CP 1 D1 G (revenue minus costs). If the hypothetical
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monopolist increased prices by 5% to P2 (a SSNIP), the volume of sales would drop to Q2. Correspondingly, profits would now be indicated by the rectangle CP 2D2 F. The monopolist would find it profitable to effect a SSNIP, increasing prices from P1 to P2, if the rectangle CP2D2F is larger than rectangle CP1D1G . In other words, a SSNIP would be profitable for the monopolist if the increase in profits from the customers who continued to purchase the product (indicated by P1P2D2E) outweighs the decrease in profits from customers who stopped purchasing (indicated by FED1G). Figure 1: Effect of a SSNIP on profits
Price, cost

margin were 60%, the critical sales loss for a 10% price increase would be 14.3%. Therefore, if the empirical evidence gathered in a case indicates, for example, that 1520% of sales would be lost following a 10% price increase, this suggests that such an increase would be unprofitable. Hence, the market should be defined more broadly. Table 1: Critical sales loss for a 5% and a 10% price increase (%) Initial margin 10 20 40 60 80 5% increase 33.3 20.0 11.1 7.7 5.9 10% increase 50.0 33.3 20.0 14.3 11.1

Demand D2

P2 5% P1

D1 E

As can be seen in Table 1, the higher the margin, the lower the critical sales loss threshold. This is because a high margin implies high profits from each unit of sale. Each unit of sale lost as a result of reduced demand in response to a price increase becomes more costly to the supplier. Therefore, when margins are high, the supplier can only tolerate lower levels of sales loss before a price increase becomes unprofitable.
AVC

C F G

O Q2 Quantity ?% Q1

The decrease in profits from customers who stopped purchasing depends on two factors: the extent of the fall in demand (Q1 Q2) in response to the price increase (in economic terminology, this is known as the price-elasticity of demand, which measures the responsiveness of demand to a change in price); the initial pricecost margin (P1 C).

Table 1 also highlights a critical point, that the percentage of consumers switching need not be very high to prevent a hypothetical monopolist from increasing prices. In the United Brands case, for example, the European Court found that bananas were not in the same market as other fresh fruit. This finding was based on the premise that a very large number of consumers having a constant need for bananas are not noticeably or even appreciably enticed away from the consumption of this product. 7 This finding fails to recognise that shifts by the marginal consumers only may be sufficient to exert competitive pressures on a product; the shift does not have to be large to make a difference.

A practical application: holiday parks

Applying the critical sales loss test in a market definition exercise requires information about actual or possible consumer reactions to price changes. A tool commonly used to deduce market demand conditions is the consumer survey, a method that has been recognised by the European Commission in its market definition guidelines.8 In the case of mergers, the test may also be used to determine whether the merged entities would be able to exercise market power and raise prices of the products that they currently supply. Such an exercise was carried out for the merger in 2001 between Gran Dorado (owned by Pierre & Vacances) and Center Parcs, as assessed by the Dutch Competition Authority (NMa).9 The two companies operated a number of holiday parks with villas and a range of facilities, such as indoor swimming pools, sports grounds and restaurants, in the Netherlands and surrounding regions. The issue was whether such holiday parks are a separate relevant market, or face competition from other types of accommodation for short breaks, such as hotels, apartments, theme parks, or holiday parks with facilities not in the park itself but in the neighbourhood. Much of the debate in this case (as reflected in the decision) focused on product characteristics. The NMa considered the product offering of holiday parks with extra facilities to be

The larger the fall in demand due to a price increase, and the greater the initial margin, the more profits will fall due to the loss of customers who stopped purchasing the product (ie, the larger the rectangle FED1G), and the less likely the hypothetical monopolist would be to raise prices. In fact, it can be shown that, in the scenario in Figure 1, it would only be profitable to increase prices if the following condition holds:6 Q1 Q2 Q1 < t m+t (Equation 1)

where t is the percentage increase in price, t = (P2 P1)/P1 and m is the initial margin of price over cost, m = (P 1 C)/P1. Equation 1known as the critical sales loss formulaallows the break-even critical loss to be calculated for various combinations of price increases and initial margins. Some examples of the critical sales loss level for a price change of 5% or 10% are shown in Table 1. In the context of market definition, the critical sales loss is interpreted as follows: if market conditions for a selection of goods are such that sales loss would be greater than the critical value, then the hypothetical monopolist would not be able to profitably increase prices. This implies that the relevant market should be wider than those goods alone. For example, if the initial

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COMPETING IDEAS: NOVEMBER 2002

different from the offering of hotels (the focus is mainly on families with children; self-catering accommodation is provided; access to facilities is offered, etc). However, the parties pointed out that hotels and other types of accommodation are actually quite similar (they also target families with children; apart-hotels also offer self-catering; many hotels also provide access to swimming pools and other facilities). In order to overcome this inconclusive debate, the merging parties commissioned a consumer survey (designed and analysed by OXERA). Those respondents who considered a short break in a holiday park with specific facilities were asked whether they would still do so if all providers of such holidays increased their price by 10% for a two-year period. The survey also asked for their reaction to a simultaneous 10% price increase by the two merging parties. The results showed that between 28% and 34% of respondents would certainly no longer consider such a holiday (and a substantial proportion said they would probably no longer consider such a holiday). As shown in Table 1, such a high proportion of switchers is likely to make a 10% price increase unprofitable as long as the initial margin of price above marginal cost is higher than 2040% (which is likely to be the case here, given the relatively high fixed costs of accommodation). Most switchers indicated that they would indeed go to other types of holiday accommodation.

According to this critical sales loss test, it could therefore be concluded that the market encompasses more than holiday parks with those specific facilities, and that the combined parties would not be able to raise prices after the merger.10

Conclusion
The critical sales loss test is not without limitations. It may, for example, lead to overly wide market definitions where the market players already possess market power. A high margin may reflect the extent to which market power exists and is already exercised. As noted above, the higher the initial margin, the more likely it is that a price increase would be unprofitable. Therefore, a SSNIP test undertaken when market power already exists may lead to the false inference that the relevant market should be widened and that the current players do not have market power. This problem is commonly known as the cellophane fallacy, after the Du Pont case in the USA.11 However, despite such potential limitations, the critical sales loss test is conceptually simple and attractive, and provides a useful empirical tool for defining the relevant market in competition investigations. It can also be used to determine whether merging parties would be able to exercise market power. The application of the test furthermore avoids the endless and often inconclusive debates on product characteristics during the market definition stage.

See Department of Justice and Federal Trade Commission (1992), Horizontal Merger Guidelines, April 2nd. The Guidelines were revised in 1997. 2 See European Commission (1997), Notice on the Definition of Relevant Market for the Purposes of Community Competition Law, OJ C 372/03, December 9th; and OFT (1999), Market Definition, OFT 403, March. 3 See Commission Decision of July 24th 2002 relating to Visa International, Comp/29.373. 4 This assumes that there are no significant economies of scale and unit costs do not rise as output shrinks. 5 Conceptually, the correct cost that should be used is marginal cost, not average variable cost. However, if marginal cost is constant (as is assumed here), then the average variable cost equals the marginal cost. Variable costs refer to the costs of inputs (eg, labour and raw materials) that vary with the level of output in the short run, the period of interest in market definition for most competition cases. In the short run, there are some costs, such as capital investments (machinery and buildings), that are fixed, regardless of output levels. 6 In this scenario, the market is characterised by constant average variable cost. 7 See Case 27/76, United Brands v Commission (1978) ECR 207, (1978) 1 CMLR 429, para. 34. The consumers referred to as having a constant need for bananas were babies and people with dentures. 8 See European Commission (1997), op. cit. 9 NMa (2001), Besluit Zaaknummer 2209/Gran DoradoCenter Parcs, February 20th. 10 The NMa approved the merger after the merging parties committed to divestment of a large number of parks. 11 United States v E.I. du Pont de Nemours & Co. 351 U.S. 377 (1956); 76 S. Ct. 994; L. Ed. 1264.

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COMPETING IDEAS: NOVEMBER 2002