Merger Enforcement Guidelines

Draft for Consultation
March 2004

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Appendix I: Additional Information on Sunk Costs

A.1 This appendix further describes how the potential sources of sunk costs identified in Part 6 can deter entry. Sunk costs are important to the entry analysis because, when present, they provide a cost advantage to incumbents who can ignore such costs in their pricing decisions because they have already made their sunk cost commitment.

Market Specific Assets and Learning

A.2 Entry that requires sunk cost investments may be deterred by the effect that entry itself has on prices. Entry can be deterred by lower prices for two main reasons. First, where significant economies of scale, scope, or density exist, a potential entrant will recognize that output added to the market by any new entry on a minimum efficient scale will exert downward pressure on prices.¹²⁷ The greater the ratio of minimum efficient scale to total market output, the greater the price-depressing effect of entry at that scale, and the less likely it is that such entry will occur.

A.3 Furthermore, a potential entrant recognizes the ability of profit-maximizing incumbents to affect the post-entry price. In particular, incumbents may make new entry unprofitable by maintaining their own output at levels that yield prices that are below the potential entrant's long run average total costs. ¹²⁸ This deterrent effect is enhanced by increased risk and uncertainty based on incumbents vigorously fighting to defend their market position, particularly in stable or declining markets, or where they have significant excess capacity.¹²⁹

A.4 The assessment of entry also involves a determination of whether viable entry is likely to be deterred by the existence of advantages that accrue to incumbents through experience. In some markets, entry by potential entrants may be deterred or hindered by the fact that it takes several years to debug plants, acquire essential production and marketing experience and otherwise learn the tricks of the trade. In other markets, entry may be deterred or hindered by virtue of the fact that knowledge may only be acquired in such a way that potential entrants cannot realistically expect to catch up with incumbents in the foreseeable future.

Product Differentiation

A.5 Firms typically attempt to differentiate their products in several ways including:

• distinguishing the physical nature of the product (its features, durability and quality);
• offering superior pre or post-sales service, including warranties;
• selling from locations that are more convenient to access, or that require less transportation costs to reach, than rival sales locations; and,
• creating perceived attributes through advertising, labelling, packaging, etc.

A.6 When products are successfully differentiated, buyers are generally not indifferent to branded and unbranded products that compete in a relevant market. When buyers find a brand that they like, the brand often becomes the standard against which products of new entrants are judged. In essence, buyers develop brand loyalty, which is generally rooted in satisfactory past experience and in the quality assurance provided by the brand name. Quality assurance is in turn ordinarily reinforced through advertising and other forms of promotion.

A.7 Where significant brand loyalty exists, buyers are often reluctant to switch immediately to a new product in response to a material price increase. This reluctance can be exacerbated by the significant risk associated with purchasing a new product where the product:

• is a component in a production process that will have to be shut down if the product fails to perform as expected;
• is resold by buyers who must therefore place their own reputation at risk;
• is not one which is cheaply sampled;
• is a durable good that is infrequently purchased; or,
• where timeliness of delivery and technical support are important.

A.8 To convince buyers to sample their products, new entrants must often offer a lower price, a superior product, and/or engage in more extensive and more frequent advertising and promotion than incumbent firms. Each of these sources of asymmetry between new entrants and incumbent firms is a source of additional sunk costs that ordinarily deter or delay entry. This is particularly so with goods that are purchased on a self-serve basis, and where there are significant costs associated with obtaining information about a product and its performance relative to other products in the relevant market.

A.9 These disadvantages increase as the proportion of total market output accounted for by minimum efficient scale increases. In short, the more sales that must be made to attain minimum efficient scale, the greater are the sunk entry costs that must be incurred in terms of product discounts, advertising and other forms of promotion.¹³⁰ Moreover, as the level of minimum efficient scale increases, potential entrants are more likely to fear that they will not gain sufficient sales to justify committing to these sunk costs, and/or that the prospect of slow buyer-acceptance will increase their exposure to additional sunk costs.

Strategic Behaviour

A.10 Several kinds of strategic behaviour serve to impose sunk costs on new entrants or delay the ability of a new competitor to eliminate a material price increase. Such behaviour may occur prior or subsequent to entry, and may not necessarily be designed to have an entry-deterring effect.

A.11 In assessing the extent that a material price increase is likely to induce entry on a scale and scope that is sufficient to eliminate such a price increase within two years, particular attention is paid to determining whether entry is likely to be impeded or delayed by one or more of the following:

• existing exclusive dealing or tying arrangements;
• buyers facing significant switching costs;¹³¹
• existing contracts that are long term in nature, and/or that include "meet the competition" or automatic renewal clauses;
• high levels of investment in research and development or advertising by incumbents, or a likelihood that such investments will be made;
• incumbents having filled most significant product niches or geographic location opportunities;
• incumbents having acquired patents for a variety of ways of making a product;
• incumbents having signalled through responses to past entry initiatives that existing excess capacity will be employed to depress prices in response to an attempt to enter; or,
• an expectation that incumbents will likely respond to entry by vigorously defending their market positions.¹³²

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¹²⁷ See ¶ 8.14 of these Guidelines. Economies of scale, scope and density can also exist in relation to other aspects of a business, such as distribution, marketing and management. As discussed in Laidlaw, the need to establish route density to be profitable may be an entry deterrent.

¹²⁸ Incumbents can price below their average total costs until an entry initiative fails because their sunk costs have already been committed and may therefore no longer be considered to be relevant to pricing decisions. It is this asymmetry between incumbents and persons contemplating entry that confers the advantage on the former.

¹²⁹ Due to the fact that many Canadian markets support only a small number of firms, as a result of the existence of scale economies, the Bureau is frequently presented with this source of entry impediment.

¹³⁰ It is important to recognize that there are often economies of scale in advertising that disadvantage new entrants until they reach the level of sales where their per-unit advertising costs are comparable with those of incumbents.

¹³¹ Suppliers can impose significant switching costs on buyers in various ways, including: by making rebates or discounts contingent on total fidelity or a long term commitment; by imposing liquidated damages for breach of contract; by requiring the buyer to include the trade mark of the relevant product on the packaging when it is resold; by manipulating the compatibility of product components; or by requiring buyers to purchase the suppliers' equipment. See for example, Superior Propane at ¶ 147.

¹³² See for example Superior Propane at ¶ 152 - 153.