1.

Size Matters: Relevant Market

Definition and Competition
Review in a World with
Intermodal Competition

By ChristianM. Dippon

Whether the decision is about allowing two telecommunications firms to

merge,imposing or lifting an incumbent-carrier regulatory burden, or
reconciling claims of anticompetitive behavior in telecornmunications
litigation, any economic analysis used in the decision-making process
must incorporatea comprehensiveawarenessof the level of competition
in the designatedmarket. The reason for this is simple: If the level of
competition is sufficiently high, then a merger is unlikely to harm
competition, ex ante regulation is superfluous, and anticompetitive
behavior is economically irrational, thus allegations of such behavior are
likely wrong.
To illustrate this point, consider the following examples.First, in
zoo4 and 2oo5, the U.s. telecommunications industry experienceda
number of incumbent-carrier consolidations-the most significant ones
were the mergersbetweenVerizon and MCI (now Verizon) and SBC and
AT&T (now AT&T). While opponents of these mergers claimed that these
carriers were trying to rebuild "Ma Bell," the old AT&T monopoly before
its breakup in 1984, federal regulators approved these mergers (albeit with
consent decreesand conditions). The level of marketplacecompetition
before and after the mergers was a crucial factor in obtaining approval.
Specifically, among other reasons,regulators found that in most markets
where ,the parties were competitors significant competition from third
parties as well as the presenceof third-party facilities and in retail voice
markets in particular, growing competition from voice over Internet
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K&L GATES_NERA

protocol (VOIP) and wireless providers was enough to ensure that these
companieswould not gain market power through their mergers.'
Second, regulators in a number of countries are currently considering
motions by incumbent local exchange carriers (ILECs) requesting reclas-
sification from "dominant" to "competitive" status, which would reduce
their regulatory burden and provide more pricing flexibility. In reviewing
these requests, regulators must decide whether granting these motions
would pose any competltive harm and if they are in the public's best
interest. For instance, there is significant debate whether ILECs have
market power in the provision of special access lines-local wholesale
transport facilities that are used to provide high capacity servlces to busi-
nesses and other providers. Competitive local exchange carriers (CLECs),
interexchange carriers, wireless providers, and others argue (and lT'ECs
deny) that continued regulation is necessary as ILECs continue to have
market power in these facilities and that absent regulation these services
would be priced in a way so as to harm competition in local business
services and wireless markets. The answers to these questions again
should be based on the level of competition, potential competition, and
entry conditions in the marketplace. ILECs have traditionally been regu-
lated because of their market power, which could make it impossible for
new entrants to succeed in the same market.2 Therefore, if the economic
analysis reveals sufficiently competitive market conditions to alleviate
concerns of market power, then regulation becomes unnecessary. thus
supporting the ILECs' requests for reclassification.
An analysis of competition is also crucial in the review of telecommu-
nications litigation. As a third example, consider claims of predatory
pdcing. Frequently raised in antitrust court cases,predatory pricing is the
practice of providing services at prices 1ow enough to drive competitors
out of a market in order to monopolize the market. More common in
Asian countries than elsewhere, predatory pricing claims have frequently
been launched against telecommunications carriers, particularly in the
deployment of new services. According to traditional theories of preda-
tion, predatory pricing comes in two stages ln stage one, the predator
prices its services below some measure of economic cost (variable or
incremental cost) with the intention of driving a competitor (the prey) out
of the market. Predation is only a profit-maximizing strategy if once the
prey has exited the market, the predator can enioy market power, sustain
supracompetitive prices, and recoup the losses from stage one. This stage
is often referred to as the second stage, or the post-predation stage, of
 SIZE MATTERS

predatorypdcins.'1"*":T1?JrTi::H:'n:iH;fJi:il:,l#H
can eas eulEr L:::^':::;";:;r
of playersor new plavers v
even after
able to acqute market Power evl
i"iiJ'", tt" p,"tluto' *"' not
p,Jr,,gu"ro*o.,9":"i*_Yl":ffi
the :ffi"Jiif;:J::i::?.'#'#:
claims dePendscrucially on
tion, and entry conditions'
regulation and litigation
Many other examples of telecommunications marketPlaceis
competitive conditions in-the
hlghlight why a review of the
socritical'Whilethisisnot",,"*ph",'o-"''on,thequestionofhowto
..-n"int""f
""",r," :TT']:
T:ii1';*""::Til::'J':"Jii:T:Tr'J""
o
debated issue. Most ot the
with wirelesscarriers?
;;";t;; Jt-' Do *i'"Ii"" t"'riers compete
providers?Do
*i'"li"" t"t'i"t' and VoIP
Is there competition between
providers' such as Wi-Fi and
cellular and other wireless-tetn""f"*t of
i""iIr"' inclt'ding for the provision
WiMAX compete *ittt ti"ritl telecommunlca-
Someanalystsarguethat'all
broadbandaccessservices? th" technology' while
*itt' ott'"' '"g"'dl"t' of
tions carriers comp"t" with
"ucft orily with wireline' wireless
others argue that wireLine t";n;; services with a
r'tiituex are only emerging
wireless, and VoIP, Wi-fi' ana
limited comPetitive imPact'

Presence of Intermodal Competition

Defining the Market in the js obvious:
of wfto cornpeteswith whom
The significanceof the que"tiott
Themorecompani..tt'"t.o*p"t.*itheact|othel,thehigherthe}evelof
of regulationor no regu-
."-t",i,t.", tice versa'Tirus' the questions
or not anti-
"'"u and anticompetitive behavior
lation, merger or no merger'
of what products are considered
competitivebehavio' U"to-"lft-t"ttion
,oi.-tlt rt"t *mch are consideredcomplements' within the
""a u""ty'is ihould be conducted
More formally, a co*p"titio"
tcr-n"ition occurs within a market;
context of a well-defined -"tft"i' the
*itflit market dlctate' prices; and'
supply and demand conditiJ' " of all
*ttt" viewed as the.'welfare
public interest is easier.to *"f""t" often
p"tt"".e, the term "market"
consumerswithin a marKer.irrlopnl", location where
'o'it i""t'iu" it as a physical
has different connotations' as a loose
sold; others define it
goods or services are uoughi "na
l*r'"*"."oftransactionsior::11;:::ilfi
.T:1ffi"i;:?::-::
where those transactionsoc '
t"J*l and geographic'.characteristics
combines both product t"t- markets
o' two products are in different
Generally,two geog'"pttitA "'"ut
 REVIEW
K&L CATES-NERA GLOBAL TELECOM

substantial impact on the other's

if one's price changedoes not have a
sa]esvo]ume.Ineconomicterms,twoproductsaleinthesamemarketif
them' Thus' the key
,"ff.i* substitutability can be establishedbetween
and with
qo"rtiot in aefining the relevant market in telecommunications
other becomes:Does sufficient
it the companiesthat competewith each
exist to include them in
substitutability between rntermodal competitors
the sameeconomic market?3
Theantitlustauthoritieshaveproposedavarietyoftestsasastalting
For instance' the U'S'
point to define the relevant market in an industry'
a market test that is
i"t.rJ t*a" Commission (FTC) has derived
acquisitions' The FTC defines
frequently used in evaluatingmergersand
a relevant market as:

geographicarea in which it
... a product or group of products and a
profit-maximizing
tt nt"a"*a or-soli such that a hlpothetical
was the. only present
firm, not subject to price regulation' that
in that arealikely
f,r,"r" prod,.r..' or seller of those products
""j and nontransitory"
would impose at least a "small but significant
of sale of all other products
increasein price, assumingthe terms
group of products and a
are held constant. A relevant market is a
to satisfy
geographic area that is no bigger than necessary
this test.a

anclnontransitory increasein
In simpler terrns,the "small but significant
possiblemarket and-asksif a 5
iStNtpl ,"rt starts with the smallest
"ri."" lf not' the next closest substitute is
i"r."* nti." t".t"ase is profitable
"aa.a.otherelevantmarket,andthetestisrepeated.Theprocess
continuesuntilthepointisreachedwheleahypotheticalmonopolist
price increase'The market is then
could profitably impose a 5 percent
sSNIp ttti "is employedsolely
clefined.The FTC,however,notes thufthit
mergers:it is not a toletance
*"tnoaotogi.al tool for the analysisof
For
", "
;;ril;-;;;"creases"'5 similar tests exist in other countries'
recently proposedto
;;r;;", ih. J"o"tt".. Fair Trade commission has
markets in Japan'
irrtroao.. tt siNIP test for defining relevant
" antirust method-
A number of anaiystsarguethat the conventional
be applied to telecommunications'
ology fo, a"firrittg a market should also
of the
tn!, ,hat this should be followed by the computation
"i." "rt". (HHI)' which determines tbe level of
Herfindahl-Hirschman index
relevantmarket' and an assess-
concentration(hencecompetition) in the
 SIZE MATTERS

ment of significant market power by a single oPeratoror by a number of

operators combined. For instance, the EuropeanCommission adopted
such an approach and defined r8 different telecommunication markets'
\dhile such an approach rnight provide some insight into the level
of competition in telecommunication markets, the dramatic changes
over the last decadehave rendered this approach clearly insufficient'
Defining markets based solely on substitutability tests, through own- and
cross-price elasticity studies, yields inaccurate market definitions for
severalreasons.
First, as noted above,SSNIPtests were derived,and are t1pically used,
to examine the competitive impact of a merger or acquisition in a nonregu-
lated industry. This limitation is fundamental as the 5 percent price
increasemeasuresconsumers'resPonsesusing the assumption that the
current price is a reflection of their willingness to pay.The telecommunica-
tions industry in most countries, however, is still regulated, albeit in
differing degrees.In regulated industries, a SSNIP test can be highly
problematic as regulated retail or wholesaleprices do not necessarily
correspondto cornpetitiveprices' For instance,if regulatedwireline retail
prices are set below cost, then a 5 percent price increasemight appear
profitable, which then limits the size of the relevant market to include
wireline services only. However, rather than providing information on the
degree of substitutability, the price increase simply reflects the fact that
consumers find the regulated retail price lower than their maximum
willingness to pay;hence,they do not careif the price rises by 5 percent'
Alternatively, if retail prices had been set at competitive levels (which for
the U.S. wireline industry might be significantly higher than regulated
prices), then the price responsecorrectly indicates whether consumers
would be willing to substitute wireline service for other means of commu-
nications, such as wireless or cableVoIP.
Second,given that in many countries the telecommunications industry
is still heavily regulated, there often does not exist any real-world data on
the competitive effect of a price increase,let alone a 5 percent price
increase.In the absenceof such data,analystsfrequently haveto resort to
sulveys, measuring a 5 percent price increaseby a hypothetical carrier'
However,in order to measurethe cross-priceelasticity in a noffegulated
environment, prices would have to be set at competitive levels' This, in
tum, might seriously distort the accuracyof such an exerciseas the hypo-
thetical scenariodepartsfrom actual consumerexperience Thus, rather
 GLOBAL TSLECOMREV1EW
K&L GATES-NERA

$:",Hi:::"##"r:'rTi:1-'.'l':::."
:HJ:1ilfi
relevant market'
t**T:';*;
;iTffi*:i'trffi*"::':'J:***,ff
analysts musr, rc'^l'.^,-l^-''-""f."ions. lor instance'
;:;;;;;",;.*'1"*'1":::lT;::i"."",TlI:'"""H
il;'ffi
"i[:Ti!:t[::ri**$ii:::"lr:;'*":,.'""
's.:,,::i":'IiJ:'::.1"'$:Tlir;i.J';l*:.::
H:''
:1"il'l:x::"'
:i:'J,Ti" ffi;i:*::::::l X5": J1:'.T :1i;
captured '*t"l'r:'#;";"r"*"i
a significant ,n.tt
'.lllli;,
Till,;:;:i'T$' ;:; :it"tl'l: JI:l::
n",.
;:::'"1"J ;ti::= "*' -*i '';;;
:.'xii,u"
gru "olli,';*
5ffi ".:il:
"
",
"!:ii:
beenabandoningtheirsecond xll*l *j:
anu'--1""r.
tnnd, t".::i:T ";IO:;
":
trieshavingmore*T"l::::T:
l,'r,"i""' *t""* altosetherin
areabandomnB
or customers #;;;;;",. T1^::T:.i,f"ijj,l
:ilff oI::l[" i
il'"l] :,il'"1H5:::
l:. :;=::"
:t Jl"i",".lf u,
.'wireline
p"r..r'.uS ro consistor
,oh:':,-:tTl
wirelineservices mttnt t:11:;tr;'"i,";,";;'net mavindi-
al,Iluna-.r'ittevid1nc.1
services onl),a proeer.Timll:r ," .n" .rrket.6 similar
analvses
catethatwireless'l*'u i':::;i:ii., lor wireline
".i"i* ,i" ,"t"u"r',market
potentianv
oranvother
:::*:':Ji"':'i'ii:'"ilT:il1fitM*'
altelnatrves
competitive setvice

be
Assessing cornp"t]t1"." ^-^-r., uefined can the level of competition

i':::
::,#Tl:i:Ti[?::"'#T'[]r'*;:*:U-.:"1;
;31::T,::.:::::i.fi
ii:.Ytr*i;:*:;:tru"':i:::
ffi]:*n::::i*t-?r,
i:ffi'I'iljilH
[H',:'::# i;'"'j]:."'"n""
lk[:::I?'Jill$#:lH::i:::"":#^T'$i'ff
 SIZE MATTERS

market power i{ its market sharehas

may be presumed to have significant
gradually eroding' this
;il; stable over time'8 If its market share is
although that
-"n-*ia"," ,f'r", ,ne market is becoming more competitive'
market power
ili ;;;. does not necessarily preclude a significant
market sharesover time may indi-
ii.ai"g. O" ,lr" -tter hand, fluctuating '
in the relevantmarket
catea iack of significantmarket power
alone are problematic for
Market shares and concentration ratios
by the EuropeanCommission,
,"u".J."".orr.. rirst, as properly requirecl shares
..-n",ni." must be forwartl looking However' market
" """ftsis arithmetical calculations
a"ftrrt lon ttistoric' Since HHIs are simply
"r"i, shares of the various firms in the
,fr", ,"- the squaresof the rnarket
forecastsmust
*"rf."r, t"* alsobackwardlooking' Thus' trends and
"t" of a merger or proposeddereg-
be taken into accountbecausethe effects
until regulatory approvals have
uiation will not be felt in the marketplace
clevelopedand implemented their
f."r, J,"r""u, u"d the companies have
future Plans.
accountthe dvdildbilityof
s"-nd, -"tk"t sharesalso do not take into
substituteservices,importanttechnologicaltrends'andexpansionand
pronouncedin those
porriUititi"r. This shortcomingis particularly
"rriry costs of entry and exit are so
t"-te-col-rrrria"tion markets where the sunk
requirements' that attempts by a
i.* -U"fn due to wholesale access
(such as a firm with a large market share)to
lo-in"nt incumbent firm
becausecompeting
--n t power invariably fails' This happens
"*"t-J. market shares)' unimpeded by
iirr* <"u"r, those with relatively small
sunk costs' can conduct
having to incur signifipant entryi or exit-related
market price down' The supracompet-
"hit-a"nd-run" entry and force the
out a signal that there are
itive price set by the incumbent sends
the incumbent's
profits to be made by slightly undercutting
"..".*f. and the easy entry and exit conditions a1low opportunistic
price,
fringe competitors undercut the
iompetitors to tlo just that' As the
'."-u.".opriceandaddtothetota]marketsupplyofthegoodor
fall and' in the process'dissipates
."r"i.",,ft" -*f."t price itself start to
alike) made
,i. profiis (for the incumbent and comPetitors
".orro*i. to supracompetitive levels'
possible by the initial increase of Prices
market price
iu"nioutly' by the competitive fringe forces th€
"ury "ntry the dominant incumbent powerless
down to competitive levets and leaves
Without costs to
io ,"ir" ttt" irice or coilect economic Profits'1o -sunk
can evenexit the market and
worry about,the opportunlstic competitors
actions in the
pocket the profits made possible by their arbitrage-like
 REVIEW
K&L GATf,S_NERA GLOBAL TELICOM

malket.Fulthelmole,theverythreatofleentlybythosecompetitolscan
attempting to exercisemarket
lirr""a" the dominant incumbent from
be a more realistic
po*"t This, so called"contestablemarket" may
than the
"g"ill.
i"pi.tiolrl ot competition in certain real-world markets
"tt".tive
textbookmodelofperfectcompetitionandisparticularlypronouncedin
yield low costs of
-",t"* l'r'"," ,"gulatory wholesaleaccessobligations
long been applied
Tiis latter standardof competition has
""U ""n. over the last two
""ir,
,o ri" analysisof market structure However'
"aono-i. turned to easeof entry and
decadesor so, economistshaveincreasingly
with the two promi-
.."il.,"Uift,, *,he applicablestandardin markets
f*,"rat of of scaleand'/orscopeand low or nonexistent
"""i "ao,to"ti"t
sunk costs of entrY and exit'1l
service in many developed
The market for residential wired phone
as wholesale regulation
countries has increasingly become contestable
customers a number of
;;; technologies, such as voIP' offer
"";", market can possessor
competitive alternatives No firm in a contestable
of barriers to entry means
exer'cisemarket power becausethe absence
prices (or reducingquality)
that any attempt to increaseprofits by raising
wouldbefoiledbytheimmediateentryofpotentialcompetitorsandthe
for instance' is one of the main
expansionof existing competrtors This'
as described above' cannot
,."rot. *hy the second stage of predation'
markets and claims of such
occur in most developedtelecommttnication
are likely wrong.
Hausman' firms with
In addition, as detailedby MIT ProfessorJerry
and wireless
rrigh'fir"J
-.'"'J"r., costs, such as incumbent wireline
";'."nk of their marginalcosts
-,rrt chargeprices that arewell in excess u
(i'e ' attract and maintain investols)
in order to earn normal profits
portion of its market shareto
Therefore,if such a firm loses evena small
the costs that it catr
;;;;i;tt, its revenueserode much more than
the lost profit
avoid. Thus, if it were to increaseprices' ItoT 9"p"ti"g
customerscouldeasilyexceedtheextlarevenuegainedfromthe
sensitivity ma*:]
remaining customers' This increased .to 1l: evetr
^1:
of retail telecommunications servlces'
rurtfre, discipli.tes the Prices
accuratecompefi:t::,"::ti::t":
t" tOf-r, itgn -arket shares' Thus' an
"f goeswell beyond market sharesand concentra-
f.oi" y a"fi.r"a -arket
of barriers
tion ratios and includes an analysis l" "lt:y.,"ld :1:
importantly a detailed
economiesof scale and scope,and' most
of contestabilitY.
 SIZE MATTERS

In the U.S.,the application of these competition-review criteria have

repeatedly shown that retail telecommunication markets are becorning
increasingly competitive, which may warrant the granting of incurnbents'
requests for reclassification with respect to those services, and also
explains why the recent industry consolidationsare not a rebuild of the
old Ma Bell system,so much as a responseto an increasinglycompetitive
environment.

Notes

Economictheory defines market power as the ability to profitably ruise and

sustain the pdce of a product abovethe level that would prevail in a competi-
tive market.

Market failure is a situation where economic efficiency has not been achieved
through market forces and is ma fested through the system'sinability to
maximize the value of the output from the resourcesavailable

The term "intermodal competitors" refers to communications caEiem that use

different modes to transmit their signals.For instance, wieline, wireless, VoIB
Wi-Fi, and WiMAX are all intermodal competitors.

4 . FederalTradeCommission,1992Hoiizontal MergerGuidelines,SectionI

5 . rbid.
6 . we note that market definitions are not necessarilysymmetric. That is, while
U.S.evidencesuggeststhat wirelessmay be in the samemarketaswftetne, it
does not imply that wireline is in the samemarket as wireless becausewireline
service is not an adequatesubstitute for "mobile" phone service.

7. CommissionGuidelineson Market Analysis,Criteria for AssessingSMB J 75.

8 . rbid.

9. Ibid. lluctuating market sharesmay be empirical evidenceof a contestable

market. Given the relentless lowering of barde$ to entry and exit (through
VoIP or other emerying technologies),certain communications markets have
becomecontestableand, thus, lack market power.

10. The fact that entry must be easyis palamount here. This is equivalent to a high
elasticity of supply of the competing fringe. Without easyentry, competitors
could not take aim at the incumbent's supracompetitive p ce,raise industry
supply, and force the price down eventually.For entry to be easy,potential
competitors must not be deterred by high upfront and, more importantlt
sunk costs.

11. See,e.g.,Baumol, Panzar,and willi8, ContestableMarkets andthe Theotyof

Induitry Structure,revisededition (NewYorki Harcout BraceJovanovich,1988)