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The math of the market

EDITORIALS: THE SATURDAY PAGE / THE MAGIC NUMBER 4

July 22, 2006

THERE ARE FOUR MAJOR RECORD companies, four national wireless phone carriers, four Baby Bells and four international auditing firms. Mere coincidence? Perhaps not. Each of those industries has consolidated in the last decade, and the ranks of music and phone companies may shrink further if pending or rumored deals win approval. The increasing concentration in these and other market segments has forced antitrust officials around the globe to grapple with a fundamental question: How many competitors do you need to generate real competition?

Lately, the answer often given by federal regulators is "four." Mergers that would leave a market segment with three or fewer significant players are far more likely to be challenged by the Federal Trade Commission or the Justice Department than those that leave a market with four or more powerful rivals.

Economists will tell you that there's no magic number. There are too many variables, including the type of product, the openness of the market and how easily buyers can switch from one seller to another. Two big players could be enough in an industry with products that are easy to make and differentiate: Witness the fierce competition between Coke and Pepsi, which yields relentless innovation (and anyone who doesn't consider Diet Black Cherry Vanilla Coke an innovation just hasn't tried it). In other markets, such as the oil industry, regulators have challenged mergers even when there are 10 significant rivals.

Still, a recent study written by the Federal Communications Commission's chief economist, among others, noted that the number favored by regulators has been shrinking. In the 1960s, the FTC and Justice were most likely to challenge mergers that would winnow markets to fewer than 13 competitors. In the '70s, the threshold was nine. By the 1990s, the number was four. The shift came in part because the courts made it harder to block mergers, but also because regulators learned more about the way markets worked.

When evaluating a merger, the feds don't simply tote up the number of competitors. They also look at how equally the market is divided. Here are a few more rules of thumb: When a company controls more than 85% of the market, it tends to ignore competitors' price cuts, innovate more slowly and generally act more like a monopoly. And when two dominant companies have comparable shares of the market for a commodity, they tend to focus on maximizing profits instead of luring customers away from each other.

Ultimately, the goal is to make sure rivals compete. The fewer the competitors, the easier it is for them to coordinate prices and products without explicitly colluding. In many industries, that kind of coordination is just too difficult when there are at least four meaningful players. It's an aspect of markets that any parent with two or more children can understand.

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