Economics | Substantial lessening of competition

A number of cases have discussed the meaning of competition and, more specifically, what is necessary for a market to be described as 'competitive'.

In the Matter of Fortescue Metals Group Limited [2010] ACompT 2

Justice FInkelstein (president), Grant Latta and Professor Round

[1049] In considering the meaning of competition it is, we think, necessary to draw a distinction between, on the one hand, the process of competition and, on the other, the extent of competition, which is the outcome of that process.

[1050] In economics, the word “competition” (as a process) has many meanings. Stigler’s well-known definition is “rivalry between individuals (or groups or nations) and it arises whenever two or more parties strive for something that all cannot gain”. Under this definition, competition refers to behaviour, and especially to patterns of business behaviour. Relevantly, it relates to behaviour that may affect the price or quality or conditions of sale of goods exchanged in the relevant market. Hence competition may be described as rivalry that amounts to a process that leads to an increase in economic efficiency.

[1051] The extent of competition is another matter. Economists describe markets as perfectly competitive, effectively competitive or imperfectly competitive (such as monopolies or oligopolies). ...

[1052] ... Professor Brunt says there is effective competition where "the availability of substitutes, both in demand and supply ... act as constraints on each individual firm's market power." [Brunt, "Market Definition Issues in Australia and New Zealand, Trade Practices Litigation" (1990) 18 Australian Business Law Review 86 at 96]

Application by Chime Communications Pty Ltd (No 2) [2009] ACompT 2
Justice Finkelstein (President), R Davey, Professor Round

Competition models

[32] Economists have developed several competition models. First, there is "perfect competition". In a perfectly competitive market every good is priced (a price that includes a margin for profit) at the cost of producing it (this is the good’s marginal cost) and every buyer willing to pay that price can buy it. The conditions for perfect competition are: (a) the goods produced by all sellers are homogeneous; (b) all buyers and sellers have perfect information about any aspect of the market; (c) there are no barriers to entry or exit; and (d) each seller’s market share is so small in proportion to the total market that one seller’s increase in output will not affect the decisions of other sellers ...

[33] A perfectly competitive market produces an equilibrium which results in the efficient use of resources in terms of both productive and allocative efficiency. Allocative efficiency is achieved because no seller will expand production if the marginal revenue or price is less than the cost of producing the good. Productive efficiency is achieved because the goods are produced at the lowest possible cost. A further benefit is dynamic efficiency because competition will force firms to seek to improve their goods or develop new goods as part of the battle.

[34] A monopolist, on the other hand, faces no rivals, and is not forced to sell at marginal cost. It can cut output and force prices above marginal cost. When it reduces output, a monopolist distorts the allocation of resources. It forces some inputs into other markets where their economic value is less. Moreover, a monopolist is under no pressure to invent new products or methods.

[35] Having described the conditions for perfect competition it will be apparent that they do not exist in any market. Nonetheless, because there is a need for a benchmark to analyse market behaviour in real industries, economists have developed other models to define competition, ... The first is "workable competition" ... Quite what workable competition should consist of has caused much controversy. At one level competition might be "workable" if there is rivalry between firms. But, how much rivalry is required is not specified. Another approach is to view competition as not "workable" if there is an absence of restraint on a firm’s economic activities. Yet there are few markets in which a firm is entirely unrestrained. Another possibility is that there is workable competition if no firm is able to influence the market price for goods. This, however, is not significantly different from the model of perfect competition. ...

[37] Perhaps the best shorthand description of workable competition is to envisage a market with a sufficient number of firms (at least four or more), where there is no significant concentration, where all firms are constrained by their rivals from exercising any market power, where pricing is flexible, where barriers to entry and expansion are low, where there is no collusion, and where profit rates reflect risk and efficiency.

[38] There are some economists who speak of "effective competition". For example, Shepherd ((1997) at 18) describes effective competition as requiring internal and external conditions. The internal conditions are: (a) a reasonable degree of parity among the competitors; and (b) a high enough number of competitors to prevent effective collusion among them to rig the market. The external condition is easy entry. Effective competition denotes the idea that firms should be subject to a reasonable degree of competitive constraint from actual and potential competitors as well as from customers.

[39] The ACCC has also adopted an "effective competition" model that borrows much from the models of workable competition and effective competition just discussed. According to the ACCC, effective competition:

• is more than the mere threat of competition – it requires that competitors be active in the market, holding a reasonably sustainable market position;
• requires that, over the long run, prices are determined by underlying costs rather than the existence of market power (a party may hold a degree of market power from time to time);
• requires that barriers to entry are sufficiently low and that the use of market power will be competed away in the long run, so that any degree of market power is only transitory;
• requires that there be ‘independent rivalry in all dimensions of the price/product/service [package]’; and
• does not preclude one party holding a degree of market power from time to time, but that power should ‘pose no significant risk to present and future competition’.

[40] The last model of non-perfect competition which we will discuss is that of the "contestable market". ... According to Baumol, Panzar and Willig, it is not the internal structure of the market that affects competition. Rather, an incumbent firm will be forced to deliver the optimal allocation of resources provided it is possible for a competitor to enter the market without any sunk costs (ie there are no barriers to entry) and leave the market without incurring any losses (ie where "hit and run" entry and exit are possible). A perfectly contestable market is not perfectly competitive but, according to its proponents, will nonetheless produce an economically efficient outcome.

[41] Analysing the competitiveness of a market by reference to potential competition diverts attention from the state of actual competition inside a market. This has led to a substantial attack on the usefulness of the contestable market model. ...

[46] While not subscribing to all that the critics of the "contestable market" say, in the Tribunal’s view the mere physical fact of entry and the potential for further entry in most cases is an inconclusive guide to the competitiveness of a market. A proper understanding of the effect of entry and potential entry requires a comprehensive assessment of the structural and behavioural characteristics of the market and the behaviour of firms in that market.

[48] ... In the Tribunal’s view a market is sufficiently competitive if the market experiences at least a reasonable degree of rivalry between firms each of which suffers some constraint in their use of market power from competitors (actual and potential) and from customers. The criteria for such competition are structural (a sufficient number of sellers, few inhibitions on entry and expansion), conduct-based (eg no collusion between firms, no exclusionary or predatory tactics) and performance-based (eg firms should be efficient, prices should reflect costs and be responsive to changing market forces).

2.4 Determining competitiveness

[49] In a "perfectly competitive" market a firm will not have the ability to deviate profitably from marginal cost pricing: that is, it will not be able to raise prices without a significant loss of sales. On this basis the most reliable measure of competition is to discover whether a firm charges above marginal cost for its goods or services. If there is a high mark up over marginal cost for a sustained period the market is not effectively competitive: ... But ... this measure of competition (or, as some would have it, of market power), known as the Lerner Index, while being the best way in theory of measuring competitiveness, is rarely used in practice because of the difficulty of establishing the marginal cost of a good.

[50] The second, and most widely used, method of measuring competitiveness in real-world markets is to look through the proxy lens of market share and concentration. To measure market share involves identifying the firms in the market, calculating the appropriate unit of measure (for example the dollar value of sales, number of units sold, or capacity) and then computing each firm’s share of the total. Concentration ratios are usually expressed in terms of the HHI index (after its inventors Herfindahl and Hirschman), which is measured as the sum of the squared market share of each firm. As a general proposition if one firm has more than 25 to 30 per cent of the market (some economists use a slightly higher percentage) that firm will be regarded as having significant market power and the market will probably not be competitive. However, a market in which there are four firms each with an equal share is likely to be more competitive than a market where one firm that has an 80 per cent share and the three others split the remaining 20 per cent. Thus it is necessary to consider not only the number of firms in a market but also the distribution of, or variation in, their market shares, especially in relation to the leading or dominant firm whose activities are the subject of the investigation.

[51] The Tribunal acknowledges that the competitiveness of a market cannot be measured simply by the number of firms in the market, their market shares and the market concentration. That can only be the starting point of the analysis. A feature that is "equally important" (to adopt the terminology of Viscusi et al (at 164)), or simply another factor that must be brought to account, is the ease of market entry. ... entry conditions are important in assessing competition in a market, first because the number of firms in the market is partially determined by the cost of the entry as well as by factors such as economies of scale. Hence entry conditions play a role in determining concentration. Second, entry conditions determine the extent of potential competition. Most courts and economists accept ease of entry by potential competitors is likely to affect the competitiveness of the actual competitors. The debate among economists concerns the extent to which it has that effect....

[52] Whether market entry is easy or difficult depends upon what economists refer to as barriers to entry. There is considerable controversy about the proper definition of entry barriers. Joe Bain treats as a barrier any factor, real or perceived, that as a realistic matter discourages entry: J S Bain, Barriers to New Competition (1956) 3. His main antagonist, Stigler, prefers a narrower definition. Stigler treats as a barrier only those costs that a new entrant must incur but which are not (or have not been) incurred by the incumbents. In ‘Ease of Entry: Has the Concept Been Applied Too Readily?’ (1987) 56 Antitrust LJ 43, R L Schmalensee explained the practical differences between the two approaches:

Stigler’s followers tend to look at what an entrant must do to become established ... and to find that those are more or less the same things that established firms had to do to become established firms. Looking at the two identical lists inclines one to say, ‘Gee, there aren’t any barriers.’ The analysis of lists tends to assume away the possibility - real in some cases, I would argue - that, while the same things must be done, they are done on different terms by an entrant than by an incumbent. The entrant faces a different competitive environment when building a reputation, than an incumbent firm did. Bain’s followers ... tend to find a lot of barriers in practice. Followers of Bain tend to look at established firms as they exist in place, not to focus on the process they had to go through to get there. Many of Bain’s followers, for instance, tend to consider the need to raise a lot of capital to be necessarily a barrier to entry because it is hard to raise, say, $200 million quickly - even though of course, established firms also had to raise $200 million.

[53] The Tribunal would proceed on the basis that barriers to entry are both structural, based on exogenously determined market characteristics, and endogenous, being the result of the incumbent’s strategic behaviour to deter entry. Structural barriers are based on cost structures, such as economies of scale, switching costs, demand characteristics (eg preferences for differentiated products), access to information and legal restrictions (eg patents or environmental regulations). Strategic barriers include limit pricing and general entry deterrence, advertising, targeted innovation, product proliferation, expansion of capacity, predatory responses to entry and any other targeted action that would "raise a rival’s costs". Consequential variations in both market share and market concentration over time as entry occurs must also be examined. The Tribunal is of opinion that any assessment of the effect of barriers to entry, in a forward-looking sense, must include a comprehensive assessment of the current structural and behavioural characteristics of the market and firms at issue, and of how past conduct has shaped this structural and behavioural environment.

[54] When the state of actual competition in a relevant market has been assessed, the next step is to determine what is likely to happen in the future in two circumstances: (a) if the exemption is granted; and (b) if the exemption is not granted. This step will involve assessing future events. Many matters may have to be considered. Judgments will have to be made about uncertain matters such as that the preferences of customers may change, new products may be developed, technology may improve, and increased capacity may be achieved.

...

[all emphasis added]

 

A number of cases have discussed the meaning of competition and, more specifically, what is necessary for a market to be described as 'competitive'. For example:

Maureen Brunt, 'Market Definition Issues in Australian and New Zealand Trade Practices Litigation' (1990) 18 Australian Business Law Review 86-128:

[page 96] ... effective competition proceeds through the availability of substitutes, both in demand and supply, which act as constraints on each individual firm's market power.

[page 96] Competition is a process rather than a situation. Dynamic processes of substitution are at work. Technological change in products and processes, whether small or large, is ongoing and there are changing tastes and shifting demographic and locational factors to which business firms respond. ... effective competition is fully compatible with the existence of strictly "limited monopolies" resting upon some short run advantage or upon distinctive characteristics of product (including location). Where there is effective competition, it is the on-going substitution process that ensures that any achievement of market power will be transitory.

Very broadly, when examining conduct that has already occurred a 'but for' test (commonly referred to as the Dandy Power test) is adopted. In the Dandy Power case Smithers J stated:

To apply the concept of substantially lessening competition in a market, it is necessary to assess the nature and extent of the market, the probable nature and extent of competition which would exist therein but for the conduct in question, the way the market operates and the nature and extent of the contemplated lessening. To my mind one must look at the relevant significant portion of the market, ask oneself how and to what extent there would have been competition therein but for the conduct, assess what is left and determine whether what has been lost in relation to what would have been, is seen to be a substantial lessening of competition [p 43,887]

When examining proposed conduct the 'future with and without' (or Stirling Harbour) test is applied. In Stirling Harbour Burchett and Hely JJ stated:

[para 12] in determining whether the proposed conduct has the purpose, or has or is likely to have the effect, of substantially lessening competition in the relevant market, the Court has to:

• consider the likely state of future competition in the market ‘with and without’ the impugned conduct; and

• on the basis of such consideration, conclude whether the conduct has the proscribed anti‐competitive purpose or effect …

The test is not a ‘before and after’ test, although, as a matter of fact, the existing state of competition in the market may throw some light on the likely future of competition in the market absent the impugned conduct. [Emphasis added]

On the issue of counterfactuals (relating to mergers) Justice Emmett in his trial judgment in Metcash stated:

[166] ... Counterfactual assessments are necessarily prospective, in that assessments of the state of competition as it would be with the proposed acquisition, and without the proposed acquisition, both involve a prediction of the future.

[167] Ordinarily, the state of competition expected to prevail if an acquisition does not occur will be a continuation of the state of affairs existing prior to the implementation of the proposed acquisition, which is, in the present case, the acquisition of Franklins by Metcash.  Thus, ordinarily, one would endeavour to define the relevant product and geographic market and to measure the existing level of concentration.  That level of concentration would then be compared with the level of concentration expected to prevail if the acquisition proceeds.  If the market would be relatively unconcentrated both before and after a proposed acquisition, there is a presumption that the proposed acquisition would not adversely affect competition.  Even if the market is relatively concentrated, but the proposed acquisition will have only a small impact on the level of concentration, a conclusion may be drawn that there would be no adverse effect on competition.

Although not defined in the Act, section 4G provides:

For the purposes of this Act, references to the lessening of competition shall be read as including references to preventing or hindering competition.

In determining whether or not competition is likely to be substantially lessened in the case of mergers, section 50(3) sets out a number of criteria the courts must consider. They are:

(a) the actual and potential level of import competition in the market;

(b) the height of barriers to entry to the market;

(c) the level of concentration in the market;

(d) the degree of countervailing power in the market;

(e) the likelihood that the acquisition would result in the acquirer being able to significantly and sustainably increase prices or profit margins;

(f) the extent to which substitutes are available in the market or are likely to be available in the market;

(g) the dynamic characteristics of the market, including growth, innovation and product differentiation;

(h) the likelihood that the acquisition would result in the removal from the market of a vigorous and effective competitor;

(i) the nature and extent of vertical integration in the market.

A number of cases have discussed the meaning of competition and what is necessary in order to establish that competition has the purpose or effect of 'substantially lessening competition'.

See, for example:

ASX Operations Pty Ltd v Pont Data Australia Pty Ltd (No. 1) (1990) 27 FCR 460

Dowling v Dalgety Australia Ltd (1992) 34 FCR 109
Substantial lessening of competition; purpose

AW Tyree Transformers Pty Ltd and Wilson Transformer Co Pty Ltd (1997) ATPR (Com) 50–247
Substantial lessening of competition

Gallagher v Pioneer Concrete (NSW) Pty Ltd (1993) 113 ALR 159
Substantial lessening of competition

Stationers Supply Pty Ltd v Victorian Authorised Newsagents Associated Ltd (1993) 44 FCR 35
Purpose of substantially lessening competition; exclusive dealing