Market Definition

To apply accurate analysis on conduct in markets, we need to define what we would identify as a market first. As obvious as this sounds, this can be a very difficult process depending on the situation. Market definition is one of the most crucial stages of any antitrust investigation, and is a definite prerequisite for the other most crucial aspect of investigations - Market Power. Basic metrics like market share and barriers to entry can be calculated only after the market has been defined.

Providing a framework for further competition analysis, Market definition is a key step in identifying the competitive constraints acting on a supplier of a given product or service. Therefore, market definition is important in the process of establishing whether or not particular agreements or conduct fall within the scope of the competition rules.

The Process of Defining the Market (HMT Test)

The process of defining a market typically begins by establishing the closest substitutes to the product (or group of products) that is the focus of the investigation. These substitute products are the most immediate competitive constraints on the behaviour of the undertaking supplying the product in question. In order to establish which products are 'close enough' substitutes to be in the relevant market, a conceptual framework known as the "Hypothetical Monopolist Test (HMT) is usually employed.

In essence the test seeks to establish the smallest product group (and geographical area) such that a hypothetical monopolist controlling that product group (in that area) could profitably sustain 'supra competitive' prices, i.e. prices that are at least a small but significant amount above competitive levels. That product group (and area) is usually the relevant market. If, for example, a hypothetical monopolist over a candidate product group could not profitably sustain supra competitive prices, then the candidate product group would be too narrow to be a relevant market. If, on the other hand, a hypothetical monopolist over a subset of a candidate product group could profitably sustain supra competitive prices, then the relevant market would usually be narrower than the candidate product group.

The steps in applying this approach are as follows.

1. We start by considering a hypothetical monopolist of the focal product (i.e. the product under investigation) which operates in a focal area (i.e. an area under investigation in which the focal product is sold).
2. We then ask whether it would be profitable for the hypothetical monopolist to sustain the price of the focal product a small but significant amount (e.g. 5 to 10 per cent12) above competitive levels. This is known as a "Small but Significant Increase in Prices" ("SSNIP" test).
3. If the answer to this question is 'yes', the test is complete. The product and area under the hypothetical monopolist's control is (usually) the relevant market.
4. If the answer to this question is 'no', this is typically because a sufficiently large number of customers would switch some of their purchases to other substitute products (or areas). In this case, we assume further that the hypothetical monopolist controls both the focal product and its closest substitute.
5. We then repeat the process, but this time in relation to the larger set of products (or areas) under the hypothetical monopolist's control. As before, we ask whether it would be profitable to sustain prices 5 to 10 per cent above competitive levels. If so, the test is complete.

The relevant market is (usually) the focal product and its closest substitute. If not, we assume that the hypothetical monopolist also controls the second closest substitute to the focal product and repeat the process once more. We continue expanding the product group in this way (i.e. by adding the next best substitute) until we have found a group of products (or areas) for which it is profitable for the hypothetical monopolist to sustain prices 5 to 10 per cent above competitive levels (by adding the next best substitute).

Issues with the Hypothetical Monopolist Test

• Price/Quality Tradeoffs - SSNIP focuses on price but different prices do not necessarily imply different markets, there can be price/quality trade offs. For example, higher end clothing brands and fashion outfits need not necessarily belong to the same market as lower priced brands, especially when higher price might mean better quality products.
• Different Domains - When it comes to geographic market definition, some products and their prices might be determined based on a different goegraphical market than the market where the product development has taken place (or where the quality of the product was determined). An example is pharmaceutical products, where the development of the product and the associated innovation is determined globally, but the prices are determined based on different geographies or countries.
• Not Unique -Market definition is not “unique” and there could be overlaps in the markets this definted. For instance, a collection of regions could constitute a market for a particular good/service. And one of those regions could appear in another market, but fact remains that the markets differ. 
• Asymmetric - Market definition can be asymmetric in its composition. Bigger/better markets may constrain smaller/worse markets in competition constraints. But the reverse may not be true. 
• Cellophane fallacy - A common criticism to the HMT test is the Cellophane Fallacy. To put simply, the monopolist may get to a point where rising prices further maybe unprofitable simply because they are already pricing their products at the monopoly price. At that point, other products may appear close substitutes, but would not have been if the price was set at a competitive level (than the monopoly price that the price was actually set in).

Practical Empirical Tests

In practice, applying the Hypothetical Monopolist Test could be tricky, due to lack of good data that is required to estimate elasticities. In such situations, there are other tests that can give practical application of the same idea in a less accurate but determinable ways.

• Critical Loss Analysis - Some level of sales would be lost due to increase in prices, even though that loss could be really small. If the loss of sales is much smaller than the additional revenue that will come as a result of higher prices, then it makes economical sense to raise prices. But at some threshold, the loss in sales will overpower the benefits of higher prices. The intuition of Critical loss analysis is "What amount of sales would have to be lost to make a hypothetical price increase unprofitable?"
• Price Correlation Analysis - Price correlation analysis is based on the assumption that prices of products that are close substitutes move together, i.e. that exists a strong mutual correlation. In other words, there are limits to which product prices may diverge within the same relevant market, because the demand-side substitution or supply-side substitution always bring them back to the equilibrium level. Therefore, we should expect that movements in prices of all products in a particular relevant market are correlated over time. The price correlation analysis demonstrates the strength of these links, i.e. the degree to which two price series are related. If a price of one product limits the price of another product, which is characteristic of affiliation to the same relevant market, both price movements must demonstrate similar patterns.
• Surveys - Surveys can give an idea of what the customers consider as substitute products, what they consider as switching costs are etc. Surveys themselves need to be undertaken with proper care and thought, especially when selecting the sample of population that needs to be surveyed.
• Shock Analysis - The extent to which events associated with a new entrant to the market may affect incumbent revenues can give us an idea of the extent of competitive constraints within the market.