Assessing Market Power – What is the best factor to use to determine market share and assess dominance?

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[Response by Sophie Trémolet and Diane Binder, October 2009]

Market power exercised by a dominant firm, insofar that it raises prices above competitive levels, may stifle consumer demand, generate efficiency losses and harm the public interest. In addition, firms with significant market power or dominance may implement strategies to further reduce competition and enhance their position in the market. The importance of assessing market power is also related to the future of regulation: at what point are competitive forces sufficient so that regulatory control of prices and service quality is no longer useful?

A sound approach therefore needs to be developed in order to assess dominance and measure competition. Sector regulators (and competition authorities) can rely on several tools and types of indicators to identify evidence of market dominance, as set out below:

  • Price level observations. A regulator should look for a sustained increase in price level. An increase in price level alone is not a sign of market power, however: it could be related to an increase towards cost-recovery tariffs.
  • Market share observations. Market shares are often used as a proxy for market power. Although a high market share alone is not sufficient to establish the possession of significant market power1, it is unlikely that a firm without a significant share would be in a dominant position. Regulators or competition authorities then set different thresholds to determine when a market share should raise concerns about market power issues. The European Commission, for instance, sets the following criteria to assess dominance: a firm with a market share of no more than 25% is not likely to enjoy a dominant position; a firm with market shares of over 40% raises concerns, and over 50% is said to have a dominant position if its market share has remained stable for a long time. With regards to methods used for measuring market shares, volume sales, value sales, productioncapacities or inputs (such as labor and capital) provide useful information. The criteria to be used will depend on the characteristics of the relevant market and the availability of information.
  • Collusive activities. The regulator should watch whether firms collude to limit competition, by fixing prices and dividing markets.
  • Analysis of the firm’s strengths. The European Commission, for example, takes into account additional factors to measure the extent to which a firm acts independently of its competitors and customers. These factors include the overall size of the firm, control of the infrastructure that is not easily duplicated, technological advantages, absence of buying power, privileged access to capital markets / financial resources, product diversification, economies of scale, economies of scope, vertical integration, a highly developed distribution network, absence of potential competition and barriers to expansion.
  • Analysis of barriers to entry. Market dominance also depends on the assessment of ease of market entry. Barriers to entry are costs that new entrants incur but that an incumbent firm avoids. This cost asymmetry may reveal dominance, as it may prevent new entrants from competing with the incumbent. Barriers to entry may arise due to high fixed or sunk costs (costs that a new entrant must absorb, while the incumbent operator does not incur the same risks and costs), or restricted access to essential facilities (a new entrant must incur the costs of purchasing access to a network, costs that the firm who owns the facility does not have).
  • Quantitative measures of market dominance. Several quantitative measures exist that can help assess whether a firm may have market power, such as the Herfindahl-Hirschman Index (HHI)2, which is an index of the number of firms in the market and their market shares, and the Lerner Index that measures the degree to which prices exceed marginal cost. Such concentration measures are rather imperfect measures of potential market power and an overreliance on them could lead to biased policy decisions, as this happened in the energy sector in the United States in the 1990s. Yet, the guidelines on mergers used by the US (and now EU) competition authorities contain explicit thresholds defined in terms of the HHI. A market with an HHI of below 1000 is regarded as ‘unconcentrated’, a market with an HHI of between 1000 and 1800 is regarded as ‘moderately concentrated’ whilst a market with an HHI of above 1800 is regarded as ‘highly concentrated’ (in which case a merger will be subject to further scrutiny).

In conclusion, a regulator (or a competition authority) may use a combination of such factors in order to assess market dominance in a given utility sector so as to avoid the potential pitfalls of using certain indicators in isolation.

 

Resources

Analyzing Telecommunications Market Competition: Foundations for Best Practices
University of Florida, Department of Economics, PURC Working Paper, 2009.
Hauge, Janice and Mark Jamison

Looking for Trouble: Competition Policy in the U.S. Electricity Industry
CSEM Working Papers, CSEMWP-109, 2003.
Bushnell, J.

Auctions and Trading in Energy Markets — An Economic AnalysisWorking Papers in Economics, Department of Applied Economics, University of Cambridge, U.K., 2002.
Newbery, D., and T. McDaniel

Mitigating Market Power in Electricity Networks
prepared for a conference titled “Towards a European Market of Electricity: What Have We Learnt from Recent Lessons? Spot Market Design, Derivatives and Regulation” held in Rome, June 2002.
Newbery, D.

Competition in the Provision of Fixed Telephony Services
Director General of Telecommunications, Office of Telecommunications, London, U.K., 2001.
Oftel

Methods for Increasing Competition in Telecommunications Markets
University of Florida, Department of Economics, PURC Working Paper, 2008.
Jamison, Mark A.

Commission Guidelines on Market Analysis and the Assessment of Significant Market Power under the Community Regulatory Framework for Electronic Communications Networks and Services
Official Journal of the European Communities, 2002/C 165/03, July 2002.
European Commission

Commerce Commission: Mergers and Acquisitions Guidelines
Commerce Commission, New Zealand, January 2004.
New Zealand Commerce Commission

Footnotes

  1. Firms may gain high market shares through other means than market power (e.g. a successful new invention); alternatively, a firm may have a high market share for historical reasons (e.g. incumbent telecommunications firms were once monopoly franchises in most countries).
  2. The HHI measures the sum of the squared market shares of all suppliers in the market. The convention is to multiply the resulting sum by 10,000. Thus, for example, a market with 4 equal sized producers would yield a HHI of 4 * 0.252 * 10,000 = 2,500 (Bushnell, 2003)