Merger Enforcement Guidelines

Draft for Consultation
March 2004

---

Part 3 – Market Definition

Overview

3.1 Typically, the first stage in the Bureau's review of a merger involves defining the relevant market(s) in which the merging parties operate. Relevant markets are assessed from two perspectives: the product dimension and the geographic dimension.

3.2 As a general principle, it cannot be assumed that merging parties operate in the same relevant market(s), even where there appears to be some overlap between their products and the geographic areas in which they conduct business.In addition, the relevant market(s) being analysed for competitive effects may not necessarily correspond to the product categories or service areas established by the managers of the merging firms or their rivals for operational purposes.²⁵

3.3 Market definition is based on substitutability and focuses on demand responses to changes in relative prices. The ability of a firm or group of firms to profitably raise price without losing sufficient output to make the price increase unprofitable ultimately depends on buyers' willingness to pay the higher price.²⁶ Supply responses are also important when analysing market power, but is are examined later in the analysis, either when identifying the participants in the relevant market or when examining entry or expansion into the relevant market.²⁷

3.4 Conceptually, a relevant market is defined in terms of the smallest group of products²⁸ and the smallest geographic area in which a sole profit-maximizing seller (a "hypothetical monopolist") would impose and sustain a significant and non-transitory price increase above levels that would likely exist in the absence of the merger.In most cases, the Bureau considers a five per cent price increase to be significant and a one-year period to be non-transitory.²⁹

3.5 The analysis focuses on what would happen if a hypothetical monopolist of a product attempted to impose a five per cent price increase.If the price increase is likely to cause buyers to switch their purchases to another product in sufficient quantity to render the price increase unprofitable, that other product is added to the candidate market.This process continues until the point at which a hypothetical monopolist would impose and sustain the price increase for each product in the candidate market.The smallest set of products in which the price increase can be sustained is defined as the relevant product market.This analysis occurs for each of the products of the merging parties.

3.6 The same approach applies to assessing the geographic scope of the market.As above, if buyers are likely to switch their purchases to suppliers located in a more distant area in sufficient quantity to render a five per cent price increase unprofitable, the more distant area is added to the candidate market. This process continues until the smallest set of areas over which a hypothetical monopolist would impose and sustain the price increase is identified.This analysis occurs for each of the areas where the merging parties sell the relevant products.

3.7 The base price used to postulate a price increase is generally the prevailing price in the relevant market.The Bureau may not use the prevailing price if it is likely that market conditions (absent the merger) would result in a lower or higher price in the future.³⁰

3.8 In general, the base price used to postulate a price increase is whatever is ordinarily considered to be the price of the product at the stage of the industry (for example, manufacturing, wholesale, retail) being examined.

3.9 In some circumstances, sellers may identify and set different prices to a targeted sets of buyers within a market. Sellers may price discriminate when certain buyers cannot effectively switch to other products or geographic locations and cannot engage in arbitrage with other buyers by taking advantage of price differences. When price discrimination is feasible, it may be appropriate to define narrower relevant markets with reference to the characteristics of the classes of buyers or to the particular locations of the targeted buyers.³¹

3.10 Factors considered in the analysis of product and geographic dimensions of market definition are addressed below. ³²

Product Market Definition

3.11 For the purpose of product market definition, what matters is not the identity of suppliers, but the characteristics of the products and buyers' ability or willingness to switch from one product to another in sufficient quantity in response to changes in relative prices.³³ A relevant product market consists of a given product of the merged entity and close substitutes for it.

3.12 When detailed data on the prices and quantities of the relevant products and their close substitutes are available, statistical measures can be used to define relevant product markets.³⁴ Demand elasticities make it possible to determine how buyers change their consumption of a product in response to changes in the product's price (own-price elasticity) or in response to changes in the price of another identified product (cross-price elasticity).While cross-price elasticities do not in themselves directly measure the ability of a firm to raise price, they are particularly useful when determining whether differentiated products are close substitutes for one another and whether such products are part of the same relevant market. ³⁵

3.13 While reliable statistical evidence of demand elasticities may help determine market definition, such evidence of buyer price sensitivities is often unavailable.Therefore, weight is given to factors that provide indirect evidence of substitutability, including evidence from market participants and the functional indicators highlighted below.

3.14 The views, strategies and behaviour of buyers (for example, what buyers have done in the past and what they are likely to do in response to changes to technology) often provide a reliable indication of whether buyers would likely switch to other products in response to a five per cent price increase.Additional information from industry surveys and industry participants, such as competitors and suppliers of the relevant product, is also taken into account. This information advances the analysis by providing details on historical developments and likely future developments in the relevant product (including the past behaviour of the merging parties and others who sell the relevant product) relative to other products that are alleged to provide a significant constraining influence. Documents prepared by the merging parties in the ordinary course of business are also very useful in this regard.

3.15 Various functional indicators help to determine what products are considered close substitutes, including end use, physical and technical characteristics, price relationships and relative price levels, as well as the switching costs incurred by buyers as discussed below.

3.16 While products may be purchased for similar end uses, they may not be close substitutes from the perspective of buyers.Therefore, functional interchangeability is not sufficient for two products to warrant inclusion in the same relevant market.³⁶ In general, if buyers place a high value on the actual or the perceived unique physical or technical characteristics of a product (including product warranties, post-sales service, and order turn-around time), it may be necessary to define distinct relevant markets based on such characteristics.

3.17 Buyer switching costs may discourage a sufficient number of buyers from switching to products that are functionally interchangeable thereby allowing a hypothetical monopolist to raise price by five per cent.Products are not included in the same relevant market when costs that must be incurred by buyers are sufficient to render switching unlikely in response to a five per cent price increase.Examples include costs for buyers to retool, re-package, adapt their marketing, breach a supply contract, learn new procedures, or convert essential equipment.³⁷ Other costs include the expenses (and risk) that must be incurred if a product fails to satisfy expectations, which may lead to damaging a buyer's reputation as a reseller, or requiring the shut down of an entire production line.

3.18 A relevant market may consist of a grouping of diverse products that are not themselves close substitutes for each other. This occurs where a sole supplier sustains a profitable increase in the price of the grouping of products because a sufficient number of buyers will not respond to the price increase by purchasing the various components separately from different suppliers.This reaction may occur when transaction costs associated with using a number of suppliers, including physical transportation costs and the time taken to negotiate with various suppliers, are significant and economies of scope exist. ³⁸ In these circumstances, the Bureau examines buyers' propensity to purchase a number of products from a single supplier and the extent to which buyers have broken up their purchases of a grouping of products in response to relative price changes.

Geographic Market Definition

3.19 For the purpose of geographic market definition, what matters is not the identity of the suppliers, but buyers' ability or willingness to switch their purchases in sufficient quantity from one location to another in response to changes in relative prices.A relevant geographic market consists of all areas that are regarded as close substitutes by buyers.

3.20 When defining geographic markets, the Bureau first determines whether a relevant geographic market for a given product market is local, regional, national or international in nature. The Bureau generally relies on indirect evidence of substitutability including evidence from market participants and the functional indicators described below.

3.21 The views, strategies and behaviour of buyers in a given area (for example, what buyers have done in the past and what they are likely to do in response to changes to technology) often provide a reliable indication of whether buyers would likely switch their purchases to sellers located in other geographic areas in the event of a five per cent price increase.Industry surveys and the views, strategies and behaviour of industry participants also inform the analysis by providing information on how buyers of a relevant product in one area respond or have responded to changes in the price, packaging or servicing of the relevant product in another area.The extent to which distant sellers are taken into account in business plans, marketing strategies and other documentation of the merging parties and other suppliers are also useful indicators for geographic market definition.

3.22 Various functional indicators can assist in determining whether geographic areas are considered to be close substitutes, including particular characteristics of the product, switching costs, transportation costs, price relationships and relative price levels, shipment patterns, and foreign competition.

3.23 Several price and non-price factors could affect a buyer's ability or willingness to consider distant options.Non-price factors include, among other things, the fragility or perishability of the relevant product, convenience, frequency of delivery, and the reliability of service or delivery.

3.24 As with product market definition, high switching costs incurred by buyers may also discourage substitution between geographic areas. In addition to the types of switching costs described above for product definition, transportation costs ordinarily play a central role in defining the geographic scope of relevant markets because they directly affect price. For example, if the price of a product in a distant area plus the cost of transporting that same product to a candidate geographic market is found to exceed the price in the candidate market including a five per cent price increase, the products of sellers located in the distant area will not generally be included in the relevant market.³⁹

3.25 Evidence that prices in a distant area have historically either exceeded or beenlower than prices in the relevant area by more than transportation costs may indicate that the two areas are in separate relevant markets, for reasons that go beyond transportation costs. ⁴⁰ However, before reaching this conclusion, the Bureau determines whether a five per cent per cent price increase in the relevant area may change the pricing differential to the point where distant suppliers may be able to constrain such an increase.

3.26 Significant shipments of the relevant product from a more distant area into an area in relation to which a price increase is being postulated may suggest that both areas are in the same relevant market. However, pre-merger shipment patterns do not, by themselves, establish the constraining effect of distant suppliers and may be insufficient to justify broadening the geographic market.⁴¹ Further analysis is necessary to determine whether shipments from the distant area would result in making the five per cent price increase unprofitable.

Foreign Competition

3.27 Buyers' willingness or ability to turn to foreign suppliers may be affected by buyer tastes, preferences, and border-related considerations. Buyers may be less willing or able to switch to foreign substitutes when faced with exchange rate risk, industry imposed standards, ⁴² initiatives to "buy local" and difficulties or uncertainties when crossing the border. Conversely, buyers may be more willing to turn to foreign substitutes when they have a high level of information about foreign products and how to source them, when foreign suppliers or their products have already been placed on approved sourcing lists, or when technology licensing agreements, strategic alliances or other affiliations exist between domestic buyers and foreign firms.

3.28 Where it is clear that the sales area of the merged entity and that of foreign suppliers belong in the relevant market (because sufficient buyers are willing to respond to a five per cent price increase by turning to these suppliers), the boundaries of the market are expanded beyond Canada to include the sales area of the foreign sellers.

Delineating Geographic Boundaries

3.29 Once the nature of the relevant market has been identified as local, regional, national or international, it may be necessary to delineate the actualspecify or estimate the geographic boundaries of the market.⁴³ When markets are local or regional in nature, location factors are particularly relevant in delineating such boundaries.The underlying assumption is that profit-maximizing firms make decisions about where to locate based on the density of their buyer base and an attempt to avoid cannibalization of their own sales that can occur when one of their locations is closely situated to another.In this way, demand responses are still a key determinant of market boundaries. Spatial competition analysis can usefully assist in delineating the boundaries of such localized geographic markets.⁴⁴ The methodology for applying spatial competition analysis depends on the characteristics of the industry and the market under consideration.⁴⁵

3.30 It is important to emphasize that market boundaries are not, in many instances, precise.⁴⁶ In addition, restraints on a merged firm's pricing behaviour can come from both inside and outside the relevant market as defined. These issues are further discussed below.

---

²⁵ See Superior Propane at ¶ 85, 101 and Canadian Waste at ¶ 72.

²⁶ Product and geographic substitutes that are included in a single relevant market are typically considered to be "acceptable" within the meaning of section 93(c) of the Act. When products within a relevant market are differentiated, some may be closer substitutes to each other than others.

²⁷ In instances where the merging firms compete across a large number of markets and face the same competitors in each market, the Bureau may aggregate these markets as a matter of convenience.

²⁸ A market may consist of a single homogeneous product or a group of differentiated products.

²⁹ Market realities may sometimes necessitate using a different price increase or time period. For example, a larger price increase may be required where using 5 per cent threshold would fail to identify an obvious horizontal relationship between the merging parties, such as situations where prices are measured in cents rather than dollars. Conversely, a lower price increase may be appropriate where the products are particularly good substitutes for one another, relative to other substitutes.

³⁰ As noted in Canadian Waste at ¶ 90-94, where the evidence suggests that a change in the future price (absent the merger) can be predicted with confidence, it is appropriate to delineate markets based on the likely future price, even if the future level of that price cannot be predicted precisely.

³¹ See for example Canadian Waste at ¶ 78 - 80 and Superior Propane at ¶ 81.

³² Critical loss analysis may also assist in defining product or geographic markets. If a firm's expected loss in sales following a hypothetical price increase is greater than its breakeven point (i.e.that is, critical sales loss), the price increase will be unprofitable. This means that a candidate market is expanded to include other products (or other areas) that account for lost sales until the point where the hypothetical price increase over the group of products (or areas) is profitable. See Canada (Commissioner of Competition) v. Canadian Waste Services Holdings Inc. (CT-2000/002),2001 (Comp.Trib.) 34 (" Reasons and Order Regarding Remedy"), at ¶ 64.

³³ As noted in Superior Propane at ¶ 49, in this context, switching refers to "economic substitutability" defined as a change in consumption patterns in response to a price change, holding all other factors constant.

³⁴ See for example Superior Propane at ¶ 58 and ¶ 63.

³⁵ A more detailed discussion on differentiated products is contained in Appendix I.

³⁶ See Canada Federal Court of Appeal and Supreme Court of Canada in Director of Investigation and Research, Competition Act) v. Southam Inc., (1997) 1 S.C.R.748, reversing (1995), 127 D.L.R. (4th) 263 (F.C.A.)

³⁷ See, for example, Superior Propane at¶ 30-31, 49 and 54.

³⁸ If the cost to a supplier of providing the grouping is less than the sum of the costs of providing the components individually, the price a consumer pays for separately purchasing the individual components is likely to be higher than the price of the grouping.

³⁹ It is recognized that distant firms that have excess capacity may in certain circumstances be willing to ship to another market even when the net price received is less than the price in their own market.

⁴⁰ For example, the existence of tariffs or other trade-related factors may create price differentials.

⁴¹ See for example Canadian Waste at¶ 71-72.

⁴² See for example Director of Investigation and Research v. ADM Agri-Industries Ltd. (CT-1997/002), Notice of Application for a Consent Order, Schedule "A" Statement of Grounds and Material Facts, at ¶ 10. See also ¶ 42.

⁴³ See Superior Propane at¶ 83 where the Tribunal distinguishes between the nature of the geographic market and the boundaries of the market.

⁴⁴ When using spatial competition analysis, the Bureau identifies and plots all locations (such as stores, branches, hubs, outlets) of both the merging parties and their product market competitors, to determine how firms are situated relative to one another.

⁴⁵ See for example Superior Propane at ¶ 87-91.See also Canadian Waste at ¶ 76.

⁴⁶ As noted by the Tribunal in Hillsdown at 37-38, "as long as market share statistics are not taken as the only indicators of the existence of market power, the exact location of those boundaries becomes less important."