Preparing for Competition in a Network Utility - Essay Example

PREPARING FOR COMPETITION IN A NETWORK UTILITY Preparing for Competition in a Network Utility Introduction The efficiency maximization objective of competition is now recognized all over the world while at the same time, economic regulation is considered as desirable in many network industries due to their special features. Anticompetitive behaviour is becoming common in these industries and hence to avoid its possibility, many nations including UK are introducing many legislations. The Competition Act 1998 is one such legislation in UK which was implemented to make the competition policy consistent with that of European Court law. The Chapter 2 of this Act prohibits any activity which abuses dominant position of a firm in the market that affects the trade within UK. For assessing this abuse, the relevant market needs to be defined. In this essay, the test to define relevant market called SSNIP test is discussed with reference to two closed cases under OFT. This essay is organized as follows. Second section discusses the economic theory behind competition, section 3 discusses the Competition Act 1998, Section 4 discusses the cases ,section 5 discusses the analysis and findings and section 6 concludes the essay. 2. Theory According to economic theory, competition and antitrust law are supposed to maximize allocative, productive and dynamic efficiency (Economides, 2004).However, in the case of network industries, due to their special features, economic regulation is established as an alternative to competition and antitrust law in many of these industries(Economides, 2004). The complimentarity of network industries to each other and the increasing returns to scale in consumption effects of these industries called network effects are tow distinguishing features of network industries. Due to the network effects of these industries, contrary to the law of demand for traditional industries, the willingness to pay for last unit will be higher here(Economides,1996; Brenan,2000). The following are the main special features of the network industries that arise due to the network effects. The first is the possibility of making money from both sides of a network. Second is the existence of externalities in the market which means incomplete internalization of benefits by the market. Third is the high speed market penetration in network industries compared to the other industries. Fourth is the very high market share and profit inequality for markets with strong network effects. Fifth is the possibility of maximisation of social surplus by monopoly. Sixth is that it is not necessary for the existence of anti competitive acts to create market inequality due to the natural existence of market inequalities. Seventh is that free entry does not lead to perfect competition. Eight is the possibility of antitrust interventions to be counterproductive in these industries. Ninth is the very high competition for the firm which has the most dominant position and with maximum benefits. Tenth is the dependence of the network industries on past decisions of consumers (Economides, 2004). Due to the above mentioned special features of the network industries, a firm with dominant position can use its dominance to push a firm to lower ranks with very low profits and in extreme cases closing down of the firms .This is mainly due to the high inequality of market shares, profits and prices here (Klein and Gray, 1997).Hence it is argued that technical standards are important to leverage market power across markets (Economides, 2004).However ,it is argued that due to the possibility of vertical integration in network industries, many anticompetitive issues like bundling of components ,contract or manipulation of technical standards may arise(Economides, 2004).The manipulation of technical standards may arise to achieve market power in network industries through a number of ways as argued in the economic literature(Klein and Gray, 1997). Several remedies are suggested in the literature to stop the illegal practices in the network industries and to prevent their recurrence and to retain any damage due to the illegal practices without affecting the efficient production and competition in the market (Economides, 2004).This is because antitrust intervention can produce larger damages when applied to industries with faster technological change. In order to prevent competition being undermined and to restrict anticompetitive behaviour, many countries have implemented laws restricting such practices. Given this theoretical background for network industries, the next section discusses the UK Competition Act 1998 with particular reference to Chapter 2 Section 18. 3. UK Competition Act 1998 and SSNIP Test The power for European Commission to handle the cartels and abuse of market dominance was given by Articles 81 and 82 of the European Commission Treaty. Before this treaty itself, in UK the first legislation was implemented through the establishment of Monopolies Commission by the Monopoly and Restrictive Policy Act to investigate anticompetitive behaviour. Several changes were implemented to this Act later on in 1965, 1973 and 1980 for strengthening the competition law. Office of Fair Trading (OFT) was established within the government for investigating competition within markets (Parker, 2000). As a part of the efforts to make the UK legislation consistent with the European Commission Law, in 1992 a white paper outlining changes were published but the changes were not put into practice. Thus till 1997, the UK competitive law remained unchanged. In November 1998, with the government change in UK, new competition Act was approved. There were changed including the setting up of Competition Commission in 1999 and a new prohibition based policy to outlaw anticompetitive behaviour from March 2000.The new Competition Act was more or less consistent with the European principles of competition. One main change under the Act was the setting up of Appeal Tribunal within the Commission for considering appeals against the infringement of Chapters 1 and 2 of the Competition Act 1998. In chapter1 of the Act, restrictive practices are dealt with while chapter 2 deals with the abuse of dominant position (Parker, 2000).Chapter 1 of the Act sets a general prohibition against the cartel agreements replacing registration of the agreements under 1956 Restrictive Trade Practices Act. Price fixing, output restrictions, investment restrictions, collusive tendering etc which affect competition come under the prohibition mentioned in Chapter 1 of the Act. Chapter 2 of the Act deals with the prohibition related to a business conduct leading to abuse of dominant position in the market place. Any part of the UK is included in the definition of market while the ability to act independently of competitors and customers is meant by dominance following the EU case law (OFT, 1999; Parker2000).An alternative framework is given by Section 18(1) of the Competition Act introducing a prohibition on ‘any conduct on the part of one or more undertakings which amounts to the abuse of a dominant position in a market if it may affect trade within the UK’ (OFT, 1999; Parker2000).Since the Competition Act needs to be consistent with the European law the definition of relevant market serves a major role in the assessment of competition done under chapter2(OFT,2001).Based on the European Court Law, dominance is defined based on market share of a firm which needs the relevant market to be defined(OFT,2001). Hence the definition of relevant market becomes important under Chapter 2 of the Competition Act 1998 also. Moreover, based on the economic theory it is argued that firms in a properly defined relevant market may not engage in abuse of dominant position (OFT, 2001). One common test based on European Commission and OFT guidelines to define a relevant market based on competitive constraints existing between products and areas is the Small but Significant Non Transitory Increase in Price (SSNIP) test or hypothetical monopoly test (OFT 1999a; OFT, 2001).Based on this test, a relevant market is defined as the “smallest set of products worth monopolising” (OFT, 2001, p15).The geographical market dimension and the product market dimension form the two dimensions of relevant market based on this definition. Based on the definition above, the set of products defined in geographical and product market terms need to be worth monopolising as it can raise profitably the prices by 5 to 10 percent if it is a relevant market. Otherwise the set of products need to be expanded to include those in next geographical area and other products and SSNIP test needs to be done again(OFT,2001).The profitability of the 5 -10% rise in prices depend on the cost savings from the lower production volumes .The lost sales quantity also needs to be assessed again here based on demand side substitutes and supply side substitutes. However there are many challenges to this test especially in the case of mergers. The next section provides an application of this test based on closed cases under OFT with case reference CP/0980/01and CE/2709-03. 4. Cases The case with reference CP/0980/01 is used here first to illustrate the SSNIP test. The case here is complaint against British Standards Institution (BSI) and the British Standards Publishing Limited (VSPL) by Barbour Index plc regarding whether an alleged refusal to supply an online license to Barbour Index plc for British Standards infringes the Chapter 2 of Competition Act 1998.Hence OFT had to inquire whether BSI and BSPL were abusing the dominant position in the market. This case is used here to illustrate the SSNIP test because for inquiring into the alleged abuse of dominant position in the market, the relevant market needs to be defined .For this SSNIP test is used(OFT,1998). The joint venture made by BSI and Information Handling Services Group (IHSG) made BSPL the main worldwide provider of BSI Standards online. The complaint made by Barbour Index plc was that BSPL refused to give an online license to Barbour. Without the online license it was not able for the Barbour Index plc to compete effectively in the market for the reproduction of British standards. Hence the alleged complaint was that BSPL was abusing its dominant position in a relevant market, it was an infringement of the Chapter 2 of Competition Act 1998.However, BSPL denied the refusal of supplying online license. The second case is the case with reference CE/2709-03, which is the case against X-changing Insure Services Ltd, a supplier of office backup services to Lloyds and London Insurance Market by Euro base Systems, a supplier and developer of software for insurance industry. The alleged complaint was the abusal of the dominant position held by X-changing Insure to sell its own software product. This case is used here to illustrate the SSNIP test because for inquiring into the alleged abuse of dominant position in the market, the relevant market needs to be defined .For this SSNIP test is used(OFT,1998). 5. Analysis and Findings For investigating this case, the relevant market needs to be defined in both the cases first. The full text of current and withdrawn British standards is provided online by BSPL. Since the standards are available online, the subscribers can check revisions and changes to standards online any time. The demand side substitution and supply side substitution need to be analyzed for examining the competitive constraint between two products. Demand side substitution occurs when the price of one product in relation to other rises, the customers switch their purchase from one whose price is raised to the other whose price has fallen. For this to occur, the customers need to be able to switch between them. For the definition of relevant market if a 5%increase in price is not profitable with enough switching taking place is sufficient. The products with different physical characteristics can be considered by customers as substitutes if they are sufficiently substitutable. Selling price need not be the same for products to be effective demand substitutes. The possible response for the consumers and suppliers for a price differential between low quality product selling at low price and a high quality product selling at high price matters than the selling price of these products for them to be considered as effective demand substitutes. In the case of the BSPL, the alternatives for the online services need to be examined first. The extent to which the consumers switch to other products for a rise in price level above the competitive price level, what will be involved in their doing and how long will they take to switch need to be examined for analyzing the effective demand substitutes. The alternatives available to the online services are CD-ROM and microfiche. The subscribers get faster delivery of the up to dates to the British Standards in a more flexible and convenient format than the above mentioned alternatives. Hence it is unlikely that the customers will switch to the alternatives for a price differential of 5to 10%. Two products are effective supply side substitutes if the supplier of one of the products has all the assets needed to produce the other. If the suppliers has only some of the assets needed, this need not be effective supply side substitution since large amount of additional investment is needed in this case. In the case mentioned above, effective supply side substitution is not available since the other suppliers do not have all the assets need to produce the British Standards online services .This is because due to the joint venture between BSI and BSPL, BSPL is the only provider of online services for British standards. Hence the supply of online British Standards is defined as the relevant market here by OFT .This is because it is proved that a hypothetical monopolist with control over the products here will be able to profitably raise the price of these products by 5-10% permanently. BSPL is proved to held dominant position in this market. Hence OFT considered the alleged refusal of denying online license to Barbour as an abuse of the dominant position in the market by BSPL. In the second case, effective demand substitution is possible since there are lot of alternatives available for the supply of office backup services other than the X-changing Insure Services Ltd to the Lloyds and London Insurance Market .The customers can easily switch off to other products with a price differential of 5to 10 percent. Moreover, the other suppliers have all the assets needed to produce the backup services provided by the X changing Insure. Hence effective supply side substitution is also possible. Thus, a hypothetical monopolist with control over the products is not able to raise the price by 5 to 10 percent profitably. In this case, OFT thus considered the Lloyds and London Insurance market as not the relevant market and the market as too narrow. Moreover it considered X changing Insure not holding a dominant position and hence the alleged complaint as not an infringement of Chapter2 of the Competition Act. 6. Conclusion In this essay, the relevant market definition with regards to SSNIP test is discussed with reference to two closed cases under the OFT. The analysis with reference to both the cases shows that in the first case, the relevant market definition was correct while in the second case, the relevant market definition was very narrow. Based on the definition of relevant market using this test, thus the abuse of dominant position in a market can be identified. References Brenan,T, J (2000): “The Economics of Competition Policy: Recent Developments and Cautionary Notes in Antitrust and Regulation”, Washington: Discussion Paper00-07,Resources for the Future Economides,N(1996): “The Economics of Networks”, The International Journal of Industrial Organization, Volume 16.No4,pp675-699. Economdies ,N(2004): “Competition Policy in Network Industries”, Working paper04-23,NewYork: Net Institute. Klein, M and P, Gray (1997): “Competition in Network Industries: Where and How to Introduce it”, Note No: 4, The World Bank Group. OFT (1998): “Competition Case Closure Summaries 2003”, London: Office of Fair Trading. OFT (1999a): “Quantitative Techniques in Competition Analysis”, OFT 266, London: Office of Fair Trading. OFT (1999b): “The Competition Act 1998: Market Definition”, OFT 403, London: Office of Fair Trading. OFT (2001): “The Role of Market Definition in Monopoly and Dominance Enquiries”, OFT342, Economic Discussion Paper2, London: Office of Fair Trading. Parker, D (2000): “Reforming Competition Law in the UK: Competition Act 1998”, Occassional Paper 14, Bath: The University of Bath, CRI. Read More