Margins and monopoly

Originally posted on the Adam Smith Institute blog.

A while ago, a new working paper that purports to provide evidence supporting the idea that overall market power exhibited by firms in the US has increased over the past 30-40 years.  This was then picked up by a few blogs / media outlets.  In short, the paper claims that there has been an increase overall profit margins (or mark-ups) since 1980 and, therefore, this implies that overall competition between firms has decreased and that antitrust enforcement is not working.

The initial basis for the paper’s argument is that under “perfect competition”, firms are supposed to charge a price equal to their cost. In standard economic theory, “perfect competition” is a rather idealised scenario in which there are many buyers and sellers, each of which is a price-taker (i.e. no individual buyer or seller has any influence over the price of the product). Under these, and a few other conditions, in a “perfectly competitive” market, the price of producing that unit ends up being equal to the cost of producing that unit – i.e. each producer in such a market makes zero economic profit (the “economic” nature of the profit, as compared to accounting profit, is a crucial distinction).  The paper then compares this to the standard economic theory of monopolistic pricing, in which one firm is the sole producer of a product and therefore can charge a price above cost – i.e. the monopolist obtains a positive profit margin on its sales. The paper then claims that the fact that its data indicate an increase in margins over time mean that the US economy has (in the aggregate) moved away from the “perfectly competitive” scenario and towards the monopolistic scenario, thereby implying a reduction in the overall levels of competition in the US economy.

Unfortunately the paper fails to take into account a number of factors. For example, and at a rather basic level that the paper’s authors should really be getting right, the “costs” in the theoretical perfectly competitive market do not coincide with measures of costs that are calculated in companies’ accounts.  In particular, economic costs include an “opportunity cost” of using the resources for the next best option – i.e. economic costs include an additional element beyond the balance-sheet cost of using/purchasing the input that is not usually picked up in accounting measures of cost. Under the perfectly competitive model, therefore, although there is no difference between the price of a product and the economic cost of producing it, there is likely to be a difference between said price and an accounting measure of cost – in other words, even under the perfectly competitive model, individual firms are likely to make some positive accounting profits.

Despite this, the paper goes ahead and calculates margins (and makes inferences thereof) using accounting cost – the paper uses the accounts of publicly-traded firms in the US over the period 1950-2014.  In other words, the paper automatically fails to measure the true margin as is relevant for economic theory. Hence, any attempts to link an increase in the margins in this paper to the competitive landscape as suggested by economic theory is flawed.

Even if the observation that margins increased was valid (i.e. the margin was calculated appropriately including the economic cost of production), then that is still insufficient to support the paper’s claims that overall competition has decreased.  In essence, by making such a claim based on the path of margins, the paper is claiming that the entirety (or, at least, the vast majority) of the increase in margins was due to a decrease in competition, thereby ignoring any other factors that could have resulted in an increase of margins over time.  Although the paper looks at one other factor that could explain the change in margins (changes in the average size of firms), the paper ignores factors such as changes in the types and nature of industries over time (e.g. some industries might have much higher up-front costs and lower marginal costs, and if those types of industries grew over time, then that could explain the increase in average margin without any change in competition levels).

(On a more technical note, margins can also be related to price elasticities of demand via the “Lerner Condition” – this is a mathematical relationship stating that a firm’s margin is inversely proportional to its own price elasticity of demand. Obviously, different industries can have different demand elasticities regardless of the level of competition in each industry and, as such, margins can differ due to that reason as well. This is particularly relevant if, as seems likely, the composition of the economy (in terms of which industries are most prevalent) has changed over time.)

Worse still is that the paper’s result of margins increasing over time is likely to be affected by a “survivorship bias”.  Specifically, as the paper tracks firms over time, clearly the more successful firms (the ones that survive and earn higher profits) will remain in business, while the less successful firms (the ones that go bust due to making lower profits) will exit the market. Consider a stylised example: suppose at the start, an industry consists of six firms of equal size in terms of revenues, but five firms each make a margin of 30%, and the sixth firm makes a margin of 1%. At the start, the average margin would be about 24%. Now suppose that the owner of the firm obtaining a margin of just 1% decides that they can do better in another industry, so decides to shut down – this means that the average margin would increase to 30% despite there not being any real decrease in the level of competition in the industry (as the five remaining firms would still compete against each other).

Hence, over time, one would expect the sample of firms over which the margin has been calculated to contain mainly successful firms and to lose the less successful firms, thereby resulting in an increase in average margin over time. The paper does not seem to have tried to account for this. (Note, too, that firms going bust is a sign of healthy competition – a more efficient firm is able to outcompete a less efficient firm such that the less efficient one stops trading.)

Overall, therefore, although the paper claims that 1) there has been an increase in margins over time; and 2) this implies that industries in the US have become more monopolistic over time, those claims do not stand up to scrutiny. Indeed, the paper’s approach to demonstrating such claims is flawed at the most basic level.

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Is Amazon’s takeover of Whole Foods anti-competitive? Probably not.

This originally appeared as a guest post on the Adam Smith Institute’s blog last week.

A few days ago, Amazon announced its plans to purchase the predominantly USA-based grocery retail chain Whole Foods for almost $14bn. Although both companies operate in many countries, the main competition issues (if any) are likely to arise in the US, were both companies have a non-negligible presence.

Indeed, this announcement has resulted in a number of people claiming that the proposed merger will be anti-competitive. Specifically, there are some claims that the merger would result in 1) bundling and foreclosure of rivals; and/or 2) predatory pricing. In short, the first theory of harm posits that Amazon would force customers that wanted to purchase its distribution (or other) services to also purchase from Whole Foods (or vice versa), while the second theory of harm suggests that the merged entity would price below cost in order to drive out rival grocery firms before increasing prices once those rivals exited.

Importantly, both of these theories of harm require that the merged entity have some form of “market power” (i.e. the ability to charge a price above the competitive level and to act independently of its rivals). Typically, this is most likely to occur when a firm has a share of sales in a particular market of over 40%. However, as a general point, these theories of harm gloss over the fact that Amazon and Whole Foods’ shares in grocery sales are tiny – less than 5% combined in the US. As such, it is difficult to see how the combined entity can have any market power.  Clearly, the merged entity would not satisfy this for sales of groceries at the moment of the merger.

Bundling

However, others might argue that Amazon does have a sufficiently high share of sales of “online retail” to be classed as dominant. As such, they argue that Amazon could “leverage” its power in that area to grocery retail by bundling some of its services with those of its groceries. However, as the merged entity will be active at the retail level of groceries, it is not obvious exactly what other services offered by Amazon could be bundled with them – for the bundling strategy to work, consumers would still have to want at least one of the items in the bundle, and could continue to purchase them separately from Amazon or elsewhere anyway. Hence, there does not appear to be a viable mechanism through which this bundling theory of harm could occur.

Predatory Pricing

Moreover, for the predatory pricing theory of harm to be valid, there must be strong evidence that 1) the merged entity would price its groceries below some measure of cost that represents the extra cost that would be incurred by supplying one extra unit of output (usually measured as average variable cost of long-run average incremental cost); and 2) it would have an incentive to do so.

The first condition is notoriously difficult to prove – one first has to decide which costs should be included / excluded in the measure (which really isn’t as easy as one would think – e.g. should advertising spend that applies to brand-related marketing, but isn’t specifically related to groceries, be included), as well as deciding the relevant time-frame over which costs are assessed.

The second condition requires proving that the merged entity would become dominant (and therefore be able to recoup the losses it had made in pricing below cost) in the future. This is where the theory of harm becomes incredibly speculative – it assumes that sufficient sales would switch to the merged entity from rival grocery firms that the merged entity would be dominant. In other words, it assumes that pricing below cost would be sufficient in and of itself to persuade consumers to switch (regardless of e.g. quality of service provided) and that rival grocery firms would not respond in any way to the merged entity’s actions. Clearly both of these assumptions are likely to be violated in practice and, as such, the predatory pricing theory of harm seems unlikely.

Summary

Given that the merged entity is unlikely to have the incentive or ability either to bundle its products together or recoup any losses made from pricing below costs, both of the theories of harm currently being bandied about are unlikely to be valid. As such, it is difficult to see how the cries that the proposed merger is anti-competitive are anything more than “a big firm is buying someone so they have to be stopped”. That should not be a basis on which a merger can be prevented.

Fact-checking a few claims about the NHS

What with the campaigning for the general election having gotten into full swing last week, many claims have been made regarding which Party would be better for which aspect of security, the economy, education etc. One particular video regarding the NHS started doing the rounds on Facebook a few days ago. This video makes a number of claims regarding the supposed impact that the recent Coalition and Conservative governments have had on the NHS, with the video then going on to suggest that a Conservative government would be bad for the NHS. For a bit of excitement, here is said video:

 

 

The claims made in that video are many. Some are valid, whereas others are not. Let’s take each of them in turn.

Claim 1: We are experiencing the largest sustained drop in NHS funding as a percentage of GDP since the NHS was founded.

Reality: This claim is false. As per the information shown in the graph below (from the Institute for Fiscal Studies) NHS spending as a proportion of GDP has been stable over the past couple of years, and the decrease between 2009 and 2012 was no larger or longer than decreases in the mid-to-late 1970s or mid-1990s.

bn201_fig1

Moreover, the more relevant metric of NHS spending per capita continues to increase – in other words, more is spent per person on the NHS than ever before, although the rate of that increase has slowed in recent years.

bn201_fig2

Claim 2: If the internal market was abolished we [i.e. the NHS] could save billions.

Reality: This claim is also false. The internal market actually creates savings and is not “wasteful” as is claimed in the video. On the contrary, it promotes competition and stimulates the NHS to provide better services – importantly, the benefits of competition in healthcare are well established. Furthermore, it is actually the refusal of many within the NHS to accept the proven benefits of competition that is causing some harm to the NHS – indeed one of NHS Improvement’s main aims is to promote and encourage “buy-in” of competition among those in the NHS. Hence, abolishing the internal market would actually cost billions rather than save them.

Claim 3: Health tourism costs the NHS £200 million per year, which is insignificant in terms of the overall cost of the NHS.

Reality: This is generally true – although the costs to the NHS associated with people who are not ordinarily resident in the UK are of the order of £2 billion per year, that includes many people who did not come to the UK specifically and solely to use the NHS (i.e. it includes people who are not “health tourists”. Instead, estimates put the upper bound of the costs associated with those who travel to the UK for the sole purpose of using the NHS at around £300 million per year. When compared to the total annual NHS budget of about £90 billion, the costs associated with health tourism are indeed a trivial amount.

Claim 4: Immigrants are not ruining the NHS, they’re running the NHS.

Reality: True. Immigrants from within the EU currently represent about 10% of doctors and 4% of nurses. If non-EU immigrants are included, therefore, the figures are likely to be slightly (although probably not a huge amount) higher. Given that there are already quite severe labour shortages within the NHS, it is clear that without the immigrants currently working within the NHS, the functioning of the NHS would be severely hampered. Moreover, immigrants are net contributors in terms of taxes vs benefits, so also contribute to the NHS in that way. Hence, the claim that immigrants are not ruining the NHS is clearly valid.

Claim 5: 1 in 10 nursing posts are vacant and the nursing bursary has been scrapped

Reality: True. The nursing bursary was indeed scrapped at the start of the year – this means that there is a much-reduced incentive for people to train to become nurses as they will now have to pay £9,000 in tuition fees per year in order to do so. This is likely to lead to problems recruiting sufficient nurses in future. Notwithstanding that, there are also problems recruiting nurses now – the Royal College of Nursing suggests that 1 in 9 nursing posts are now vacant. This figure is actually marginally worse than that claimed (11% vacancy rate vs the 10% claimed).

Claim 6: Tens of thousands of sick patients waited on A&E trolleys this past winter

Reality: Likely to be true. Using data from Quality Watch (and a bit of approximation / extrapolation), roughly 6 million people attended A&E last winter. Of these, around 15% were not seen within the government target of four hours – i.e. about 900,000 people waited more than four hours in A&E. Now, it seems unlikely that all of these people waited on trolleys specifically, but even if only 10% of these people (i.e. 1.5% of all admittances to A&E) did then the “tens of thousands” figure would be accurate. Hence, this claim seems plausible.

Conclusion: As with most of these election video type things, the video contains some claims that are true, some that are likely to be true, and some that are demonstrably false. Does this mean that the Conservatives are the worst Party for the NHS? Who knows?! That’s for you to decide and take into account (if you want to) when you vote. But at least when doing so, you’ll now have a more complete set of facts when you do.

 

Anatomy of a competition authority’s merger review.

In this post, I plan to provide a brief overview of some of the sorts of economic evidence and analyses that a competition authority undertakes when it reviews a merger. I’ll skip over the boring legal and threshold-related details to focus on the main avenues of economics that are analysed. This overview is primarily based on the approach used by the European Commission and the CMA (formerly the OFT), but is generally applicable to all competition authorities globally.

Market definition and market shares.

The definition of the “relevant market” and the calculation of market shares are not the be-all-and-end-all of the assessment of the merger, but are intead used as a starting point. The first step is to define the relevant market so as to enable the appropriate market shares to be calculated. This requires the use of a thought experiment termed the “Hypothetical Monopolist Test” – this test starts at the narrowest possible market (usually the combination of the merging parties’ products) and asks the question: could the hypothetical monopolist profitably increase prices by a small but significant amount on a permanent basis? If the answer is yes, then that means that the candidate market contains all products that provide a competitive constraint on those produced by the merging parties and the test stops with the market defined as such.

If the answer is no, then the candidate market is widened to include the closest substitute products to those produced by the merging parties. The question is asked again, with the same approach taken when the result is obtained. The test stops when the result of conducting the thought experiment reaches the answer “yes”, such that all relevant substitute products are thereby included.

This test is conducted for geographic areas as well as products. The latter uses evidence regarding price correlations, product characteristics, consumer behaviour, while the former looks at price correlations across countries, transport costs relative to price of product, and the level of trade. Both are analysed in terms of demand-side substitution (where customers are switching between different products/geographies) and supply-side substitution (where the producers are switching between different products/geographies).

Once the relevant market has been correctly defined, then market shares are calculated and used as an indicator of whether the merger might lead to increases in prices (which is the usual way in which a merger might result in harm to consumers). If the combined market share of the merging parties is small, that tends to indicate that the merger is unlikely to be problematic with some minor exceptions in differentiated markets and the firms being particularly close substitutes – more on which later). Conversely, if the parties’ combined market share is high, that could indicate that the merged entity would have market power. However, this is not always the case – if market is a “bidding” one (i.e. where customers issue tenders for contracts), then the firm with the current highest share might not be in the best position to win future contracts. Hence, market shares are a useful first step, but not a definitive one.

Closeness of competition.

This is the main bulk of the analysis conducted by a competition authority and can include a number of different analyses. The aim of each is to examine the extent to which the merging parties exert a competitive constraint on each other that would be eliminated as a result of a merger (with the end result being that the elimination of a stronger constraint leads to a higher potential for the merger to increase prices).

The sorts of analyses that can be used to assess the closeness of competition between two firms tend to focus on the degree to which the firms’ customers switch between the two firms, with a high degree of switching between the merging parties implying that the merger could eliminate a strong competitive constraint. Some examples of the analyses used to determine the closeness of competition between merging parties include:

  • Price concentration analysis – this analysis looks at the relationship between the number (and identity) of competitors and the price charged by each competitor, and tries to examine if a decrease in the number of competitors (or elimination of a particular rival) would result in price increases. If the analysis indicates that the elimination of one of the merging parties would result in a price increase by the other merging party, that could be evidence that the parties are close competitors. This analysis is often conducted via econometric techniques.
  • Diversion ratios – this analysis uses observed consumer switching to try to find out what proportion of customers that left one of the merging parties switched to the other merging party (and vice versa). If the proportion of switchers (i.e. diversion ratio) between the merging parties is high, that could indicate that the merging parties are close competitors. This analysis is often obtained from firms’ win/loss records or customer surveys.
  • Cross-elasticities of demand – in order to obtain cross-elasticities of demand, a complex demand-estimation (an econometric procedure) is used (the details are too lengthy to include here, but I might cover them at a later date). A high cross-elasticity of demand between the merging parties’ products indicates that the merging parties are close substitutes for each other – if the price of one parties’ products increases, a large proportion of customers would switch to the product of the other merging party. In other words, a high cross-elasticity of demand between the merging parties could lead to a competition authority viewing the merger as problematic.
  • Upward Pricing Pressure (UPP) Indices – these tests are an attempt to combine diversion ratios and margins (i.e. prices minus costs) to obtain an indication of the incentive that the merged entity would have to increase prices. A high UPP index can occur if the parties have high diversion ratios between each other, high margins, or both, and indicates that the merged entity is likely to have a strong incentive to increase prices post-merger. As a result, a high UPP might lead to a competition authority viewing a merger as problematic.

Barriers to entry / expansion

Another important factor that competition authorities take into account is the extent to which firms already producing goods that are within the relevant market could increase their output and whether new firms could start production. If either are true, then if the merged entity were to try to increase prices, other firms could increase output and/or enter the market such that the customers of the merged entity could switch away from the merged entity. This would make the initial price increase less profitable, such that the merged entity would not have an incentive to increase prices in the first place. In this way, the presence of low barriers to entry and/or expansion would mean that a merger might be less likely to be of concern to a competition authority.

In its assessment of barriers to entry / expansion, a competition authority will take into account whether firms are able to enter/expand (since if they cannot enter, then the mechanism described above cannot constrain the merged entity); whether that entry/expansion would occur within 1-2 years (since any longer than that likely would make the merged entity’s initial price increase profitable regardless of the entry/expansion by rivals); and whether firms have an incentive to enter/expand (since without an incentive to do so, firms would not enter/expand and hence the aforementioned mechanism would not occur).

Countervailing buyer power

The final major factor that competition authorities tend to assess (although generally the assessment finds that there is little countervailing buyer power) is the extent to which the merged entity’s customers could themselves constrain the merged entity. If customers have sufficient power (usually in terms of being able to switch to different alternatives and/or bargain with the merged entity) to prevent any attempts by the merged entity to increase prices, then a competition authority might be less concerned by a merger. The assessment of buyer power tends to rely on examining the extent to which customers can switch to viable alternatives easily, the size of those customers, and whether the benefits that large customers might obtain through any power they might wield would also filter down to smaller customers.

Could Tesco’s “Price Promise” be anti-competitive?

For a few years, Tesco has been operating what it calls its “Price Promise”, in which it states that “[w]hen you shop at Tesco, we’ll check your basket against the prices at Asda, Sainsbury’s and Morrisons. If your comparable grocery shopping would have been cheaper there, we’ll give you a voucher for the difference (up to £10)” (see Tesco’s website).

In other words, Tesco is promising to match any lower price charged by a rival. This is precisely what the economic literature refers to as a “price-matching guarantee” (PMG) – one firm promises to match the price of a rival firm should it transpire that the customer could have obtained a lower price at that rival firm.

At first glance, this appears to be uncontroversially beneficial to consumers – they are guaranteed to receive the best possible price wherever they shop, such that they can save on “search costs” (essentially, time and money spent searching for the cheapest price) while at the same time obtaining the cheapest price.

However, this simple assessment fails to take into account the incentive of PMGs on the retailers themselves. If one retailer is considering decreasing its price, it will determine whether or not doing so would be profitable by weighing the decrease in margin per unit sold it would obtain against the increase in sales it would make (via enticing additional customers to purchase the product at the lower price). If its rivals do not have a PMG in place, then the price cut would result in consumers switching from rival retailers such that the price cut might be profitable. On the other hand, if rivals have PMGs in place, then the price cut might not be profitable as consumers have no incentive to switch to the cheaper retailer – they can just tell their current retailer that they have found a cheaper price elsewhere and be refunded the difference. Hence, if rivals have PMGs, then an individual retailer would experience a reduced increase in sales subsequent to a price cut, thereby decreasing that retailer’s incentives to cut prices in the first place. As such, PMGs could harm consumers by maintaining an “artificially” high level of retail prices.

Indeed, the findings in economic literature are generally inconclusive (An excellent non-technical summary of the literature is available here). Some results (see here) suggest that PMGs can act as a credible commitment by a retailer to keep prices low – a retailer making a price guarantee is effectively signalling to consumers that they will do everything they can to keep prices low because they know that if they do not, then consumers will be able to claim money back from them. In this way, PMGs could help competition by making consumers aware of alternatives that charge a lower price than their current provider.

However, other findings (see here) suggest that the incentive effect described above outweighs all other factors, such that the presence of PMGs leads to higher retail prices. In this way, PMGs could hinder competition because they reduce the potential profitability of a price cut by any one retailer (since, if a single retailer were to decrease price, it knows that its rival with a PMG will automatically match it anyway, so the retailer contemplating a price cut would gain fewer customers than it would if its rival did not match its price).

As such, there is a potential that Tesco’s Price Promise is anti-competitive, but it is difficult to reach a definitive conclusion.