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Competition policy and import competition - a New Zealand perspective.

The 1980's have witnessed a trend in competition policy toward a reliance on potential entry to provide a competitive discipline on incumbent firms with market power.(1) Thus mergers that previously might have been condemned as leading to dominance may now be considered innocuous, providing that significant new entry is likely to follow attempts by the merged firm to exercise market power through raising its price. This trend is perhaps no more strongly evident than in New Zealand.(2) Under the Commerce Act 1986 the Commerce Commission (the enforcement agency) can approve a merger proposal providing that it does not lead to a firm acquiring or strengthening a "dominant position" in a market. After a survey of key cases, Greer concluded that the Commission, following Australian precedents, defined dominance to mean "independence of behavior." A finn would be dominant when its behavior was not much constrained by actual or potential competition. Greer went on to attribute the "leniency" of recent decisions to the Commerce Commission's unwillingness to infer dominance in two circumstances: when one strong competitor to the merged firm remains in the market, or when there are other prospective sellers outside the market.(3) Even where a merger proposal would lead to a firm attaining a "dominant position" in a market, the Commerce Act 1986 requires the Commission to "authorize" the proposal when the prospective "benefit to the public" exceeds the detriments from the reduced competition.

Underpinning this legal stance appears to be a belief that economies of scale in production are often so large relative to the small domestic demand in New Zealand that many markets are (or are close to being) natural monopolies.(4) A problem may then arise whenever domestic potential entry is unlikely to offer an effective competitive constraint. In that situation the efficiency gains from scale economies have to be weighed against the higher prices arising from lack of competition. However, as Frederiksen, Pugel and other scholars have emphasized, the presence of import competition may help to resolve this tradeoff, thus serving as a partial substitute for antitrust control.(5) Such competition is likely to play an increasingly important role in New Zealand competition policy, partly because of rises in domestic industry concentration caused by the aforementioned leniency in merger policy, and partly because of the vigorous policy of import liberalization (aimed at improving efficiency by reducing protection) implemented in recent years.(6)

In large countries like the United States the analysis of the import constraint assumes that the foreign (excess) supply curve is upward sloping. Foreign firms can divert supplies to the U.S. when U.S. domestic prices rise. This led Landes and Posner to conclude that foreign producers are part of the market, and that their production should be included as part of the U.S. domestic market.(7) Support for this approach came from Leitzinger and Tamor, who found in a cross-section study of 45 manufacturing industries that a "world concentration ratio" influenced domestic industry profitability much more strongly than did the domestic concentration ratio.(8) A more refined approach was advocated by Abbott.(9) He recognized that the more elastic (or responsive) the foreign supply curve, the less likely are domestic firms to exert their market power by raising price. Since the elasticity of the foreign supply curve depends upon the elasticities of the foreign domestic demand and supply curves, which generally cannot be measured, he recommended an evaluation of the various factors that may influence those elasticities, such as import restrictions of various kinds, transport costs, product differentiation, and so on. The process leads to the assigning of judgmental weights to the market shares of foreign firms to reflect their likely supply response to a price increase.

However, in a small country like New Zealand the foreign supply response is likely to be perfectly elastic; domestic importers can make their relatively small purchases without influencing the price on world markets.(10) Here the economic analysis of import competition focuses on how far import barriers raise the horizontal foreign supply curve, and on how domestic firms incorporate that barrier into their pricing behavior. The analysis is also simplified, for while barriers to domestic entry are notoriously difficult to define and measure,(11) typical import barriers such as freight charges and tariff duties pose fewer problems, especially when combined with a horizontal foreign supply curve.

The purpose of this article is to examine the welfare tradeoff between competition and monopoly when economies of scale are substantial (in section I), and the impact when imports become a source of political competition (section II). The possibility of encouraging import competition as a substitute for antitrust policy is then considered (section III). The role of the import constraint in some recent New Zealand merger cases is reviewed (section IV), followed by a summary and conclusions (section V).

I. A welfare tradeoff model

Imports are likely to be the most important source of competition when the market is highly concentrated and domestic entry is difficult. This may occur when scale economies are large relative to the market size. A model reflecting these conditions is shown in figure 1.(12) The domestic demand curve for an homogeneous product is given by D. Scale economies are incorporated through the expedient of using a linear, nonproportional (long-run) total cost curve. The AVC curve is horizontal and equal to MC, and the downward sloping AC curve asymptotically approaches AVC.(13)

In the absence of import competition, a pure monopolist would maximize profit at a price [P.sub.m] and output [Q.sub.m] Substantial economic profit would be earned because of the firm's market power and its ability to lower unit cost through scale economies. The process by which the firm achieved its monopoly position need not be specified, but it could be the culmination of several mergers from an initially competitive market.(14) This outcome thus reflects a strongly proefficiency ("hands off") competition policy.

The equilibrium described in figure 1 is a long-run equilibrium, so post-merger rationalization of production facilities is complete.

At the other extreme, a stringent procompetition policy would keep firms small. Market power enhancing mergers would be blocked, and dominant firms broken up into smaller units. In figure 1 each firm produces only [q.sub.c], thereby incurring substantial diseconomies of small scale. Assuming a purely competitive structure and a horizontal long-run supply curve [S.sub.c], industry price would be [P.sub.c] and output [Q.sub.c]. As drawn, the competitive price is above the monopoly price and the output is smaller, the opposite outcome to that of the conventional textbook comparison of the two market structures.

The authorization provision of the Commerce Act mentioned above suggests that it is appropriate to evaluate those two market structures--dominance and competition--using social welfare analysis. This can be done by employing the following conventional partial equilibrium welfare function:

W = (TR + S) - (TC - R) where: TR = total revenue; S = consumers' surplus; TC = total pecuniary costs; and R = intramarginal rents or producers' surplus (here zero given the horizontal MC curve).(15) A simplified version of figure 1 is shown as figure 2, where the relevant geometrical areas are labeled. Social welfare under monopoly equals the sum of areas A, B, C, D and E, comprising consumers' surplus and monopoly gross profit. Under competition, welfare shrinks to a consumers' surplus equal to area A. Hence there is a large welfare loss from competition measured by the sum of B, C, D and E. Areas C and E are the surplus and profit respectively lost by output being reduced from Q. to Q., and B and D are the surplus and profit absorbed by the higher production costs of competition. This analysis goes some way toward supporting New Zealand's "lenient" stance on structural competition policy, providing that economies of scale in the relevant market are large.

But some words of caution are also in order. Firstly, the monopoly outcome is flattered by comparison with the outcome from an unattainable perfectly competitive market structure. Indeed, one might question how well competition could flourish in a market where firms are artificially constrained in size. A more realistic comparison might be made with some form of oligopolistic market structure, although such a market type is more difficult to incorporate in the model.(16) Secondly, the use of a partial equilibrium framework is subject to the usual limitations, in particular the exclusion of dynamic effects. For example, the monopolist, lacking the competitive incentive to remain efficient, may experience an erosion of its productive efficiency advantage over competition. Moreover, neither extreme form of market type may best foster innovation, where the advantage may rest with some form of oligopoly.(17) Finally, the economic model excludes consideration of wider social and political consequences of market power. The desire to preserve opportunities for small, local businesses to compete, and to avoid the economic power of large corporations translating into political power--if considered valid goals of competition policy--would favor competitive market structures over monopoly.

If scale economies are smaller the [S.sub.c] curve in figure 1 would be lower. The competitive price might then be below the monopoly price and the industry output would be higher. The welfare analysis of this case is shown in figure 3. Social welfare under monopoly is represented by the sum of areas A', B' and D', and under competition by the areas A', B' and C'. The change in welfare from monopoly to competition now equals C' minus D', C' being the consumers' surplus gain in expanding output from [Q.sub.m] to [Q.sub.c], and D' being the loss of monopoly profit absorbed by higher costs of competition. The situation is now essentially that of the Williamson merger tradeoff model;(18) competition could be preferred on welfare grounds, but only if the cost advantage to monopoly is very small. The area of C' would get bigger and that of D' smaller as scale economies moderate further. The lower price associated with competition thus does not necessarily generate a net social benefit. This would be more likely, however, if we depart from the implicit assumption of distributional neutrality. The area B' would then be treated not as a transfer, but as a welfare loss to monopoly on equity grounds.(19) This issue, and the difficulties of measuring the prospective cost savings to merger, are examined in Pickford.(20)

II. The role of imports

The situations examined above perhaps typify those in the past in New Zealand when licensing and tariffs on many products were so restrictive that imports did not impose a competitive constraint. Quotas have now been virtually eliminated, and normal tariff rates on goods competitive with local manufactures, although often high, are being progressively reduced. The section I analysis, however, would continue to apply to nontradeable goods and services that experience substantial scale economies.

To introduce import competition to the model, foreign producers are assumed to face the same cost curves as the New Zealand monopolist, but are able to fully exploit scale economies in the large markets they supply.(21) The international market is assumed to be competitive, and so the world price is set equal to MC at [P.sub.f].(22) By invoking the small country assumption, the foreign supply curve, [S.sub.f], becomes horizontal at that price. Freight costs and tariff duties raise the supply curve to [S'.sub.f] at a price [P.sub.l], which is above the monopolist's unit cost (A[C.sub.m]) but below its preferred price ([P.sub.m]). This absolute cost advantage glows the monopolist to choose between two familiar intertemporal pricing strategies: charging the short-run profit-maximizing price [P.sub.m], which will induce entry, and therefore lower profit, in the long run; and limit pricing at [P.sub.1], which will earn moderate profits and exclude entry indefinitely. The strategy that maximizes long-run profitability normally depends on several factors.(23) However, the key characteristic of imports, which may override other considerations, is that entry can occur very quickly, perhaps within 3 months for shipped items. Rapid entry of competitors is likely to favor limit pricing. Some of the case studies examined below support this contention.(24)

Suppose then that trade liberalization has lowered the import price to [P.sub.1] in figure 1, and that the monopolist reacts by limit pricing. In figure 4 the social welfare arising from unconstrained monopoly is the areas [bar]A, [bar]B and 5, while for limit pricing it is [bar]A, [bar]B, [bar]C, [bar]D, and [bar]E. The net gain arising from potential competition is the extra surplus ([bar]C), and the extra profit ([bar]E), associated with the output expansion from [Q.sub.m] to [Q.sub.l]. Thus, when imports are priced low enough to constrain a domestic monopolist, welfare will be enhanced. The benefit of low unit cost from large scale production is gained without the detriment arising from the full exercise of market power.

Even with limit pricing and a standardized good it seems unlikely that imports will be completely excluded. Some firms may "test the market" for the feasibility of imports, or domestic producers may set the price too high, perhaps because of minor demand changes or exchange rate movements. Demand for imports may be augmented if the model's assumptions are relaxed and product differentiation is introduced. Kaplow argued that when goods are differentiated and consumer tastes vary, a rise in the domestic price may not cause a significant increase in imports.(25) He cites a hypothetical example in which both domestic and foreign unit costs are $100, but transport and tariff charges raise the import price to $150. If the two products were standardized, a domestic monopolist would capture the entire market at a price of $149 (assuming whole dollar prices). Suppose, however, that the imported good is considered inferior, such that at any given import price most consumers would be prepared to pay $5 more for the domestic good, but that five percent of consumers would pay only $2 more. The monopolist could charge $154 and capture 95% of the market, or $151 and exclude imports completely. Providing that the monopolist meets with an inelastic demand response, he earns a larger profit by charging the higher price and sharing the market with imports. The example shows that product differentiation combined with certain pricing strategies can lead to some importing, which in turn may mislead the competition authorities into believing that the market power of the monopolist is effectively constrained.(26)

This is one illustration of a wider danger emphasized by Kaplow, that of focusing on "substitution possibilities by reference to prevailing market conditions."(27) Since a finn with market power maximizes profit on the elastic section of the demand curve, some substituting for related products (e.g., including imports) by buyers is to be expected. Such substitution is "not inconsistent with the exercise of significant market power."

III. Encouraging import competition

So far we have analyzed theoretically how the threat of import competition may constrain the market power of a dominant firm--one that may face little competition from domestic entry because of scale economy entry barriers. Where the constraint is binding the price may be lower, and social welfare higher than otherwise would be the case. This raises the possibility that encouraging import competition might be a useful weapon in the competition policy armory. Further gains could be made in figure 1 if the import price [P.sub.l], were to be lowered by reducing tariff duties or transport costs.(28) Tariff policy potentially becomes a component of competition policy.(29) Its use would also avoid some of the disadvantages associated with price controls as a "last resort" substitute for domestic competition.(30) Note that the setting of a controlled maximum price of [P.sub.l] in figure 1 would generate exactly the same immediate welfare gains as having imports priced at [P.sub.l]. Both policies pose practical problems over the level at which to set [P.sub.l], but tariffs suffer less from adjustment problems over time, market distortionary effects, and compliance and enforcement Costs.(31)

However, a reliance on import competition suffers from a number of potential limitations, some of which can be illustrated by drawing upon various Commerce Commission decisions. The first problem is that the constraint posed by import competition depends upon the height of entry barriers, which are often difficult to measure. The Commerce Commission has attempted to do so in a partial and ad hoc manner.(32) Tariff rates, import licensing, transport costs (e.g., for ice cream, water heaters, reinforcing mesh and paperboard) and nonprice barriers (e.g., for ice cream, wire, paperboard and cartons) were mentioned in various cases, but little effort was made to assess their overall impact on the landed price. An attempt is made in table 1. Tariff rates quoted by the Commission for certain steel products are given in columns (2)-(4).(33) Freight costs can be estimated for the corresponding 10-digit SITC category by deducting the "value-for-duty" (v.f.d.) import cost figure from the "cost-insurance-and-freight" figure. These are expressed as a percentage of the former in column (5).(34) Since tariffs are levied on the v.f.d. figure, the sum of columns (2) and (5) give the markup for normal tariff and freight costs (column (6)). These markups raise a substantial entry barrier against imports, even without allowing for nonprice disadvantages.

[TABULAR DATA 1 OMITTED]

Secondly, a review of Commission cases where import competition was considered shows that domestic supply is often preferred because of nonprice disadvantages (or costs) associated with imports. This applied even to products which might appear to be relatively undifferentiated. A good example is provided by kraft linerboard used in packaging, for which New Zealand Forest Products (NZFP) was (and is) the sole domestic manufacturer.(35) U.S. companies were the most likely source of imports, but buyers emphasized the difficulties of maintaining long-term supply arrangements. Problems included: wide fluctuations in the import price because of exchange rate and world price changes; the small size of the New Zealand market, which meant that foreign suppliers sometimes were not interested in meeting local specifications; longer supply lines and larger minimum shipments, which meant less reliable deliveries and higher outlays on purchases and inventories; the need to adapt corrugating and converting machinery; and the loss of the benefit of technical advice and prompt rectification of problems facilitated by the close proximity of supplier and user. A tariff consultant considered that these nonprice disadvantages of imports warranted a 20% premium in favor of NZFP's product. Other factors raised in the cases include: difficulty of procuring supplies conforming to the NZ standard (reinforcing mesh); quality and metallurgical characteristics (nails); repackaging to meet local requirements (rod, nails); unwillingness to supply in a range of sizes and small volumes (wire, cartonboard); service important to remedy defects and supply technical advice (nails, wire, kraft liner, carbon brushes); quick delivery (folding cartons); superior quality (ice cream, bull semen); and design and service (packaging of various sorts). Such factors should be evaluated and incorporated into the overall import entry barrier, although this may be difficult to do.

Thirdly, Baker argues generally that international trade pattern are less stable than domestic trade patterns for both political and economic reasons, and hence "a snapshot assessment of economic effect in an international market is less significant than a similar assessment in a domestic market."(36) For example, a future change in New Zealand government policy away from import liberalization toward protectionism could remove the only constraint on the market power of a dominant firm, whose formation by merger might have been justified on import competition grounds.(37) An illustration is provided by Dunlop/Goodyear, which involved the merger of two of the three large vertically integrated tire companies, having a combined 60% market share in manufacturing and wholesaling.(38) The Commission approved the proposal, stressing that the merged company would face competition from Firestone, and also from imports given the government plan to eliminate quotas and gradually reduce the tariff rate from 25% to 10%. However, the vulnerability of competition decisions predicated upon planned industry deregulation was revealed subsequently. As a result of intense lobbying by tiremakers over the 6 months leading to the October 1990 general election, alleging probable collapse of the industry if there was further import liberalization, the planned tariff of 20% in 1992 was held at that level pending a review in 1994.(39)

Another illustration of the Baker thesis is the fluctuating nature of the import constraint, since the import price will vary inversely with changes in the floating dollar exchange rate, and directly with changes in the world price. A high exchange rate or low world price will flatter the constraint offered by import competition. This probably happened in the case of Pacific Steel, since the decision came only a few weeks after the NZ$ reached its post-1985 float high against the US$.(40) It is generally held that the "high" rate of recent times is attributable to a tight monetary policy aimed at curbing domestic inflation. Potential import competition thus provides a variable constraint on domestic monopolists, and one that is not independent of other policy goals. This hardly provides a satisfactory basis for a competition policy.

Fourthly, a dominant firm could use strategic behavior designed to keep out entrants--imports--while allowing it to raise price above [P.sub.1] in figure 1. Price controls would not permit such an increase. For example, the price could be cut periodically for short periods to demonstrate a willingness to fight entry should it occur, or the finn might build excess capacity involving sunk costs to demonstrate a credible commitment to stay in the market. The company might enter into a market-sharing arrangement with an overseas competitor(s) (as NZ Forest Products did with Amcor, its Australian counterpart); or engage in heavy advertising to support consumer preferences for the local product (e.g., beer); or seek to deny imports access to key retail outlets (as alleged in the Fisher & Paykel exclusive dealing case).(41) A dominant firm might thus extract higher profit from the market--and generate a welfare detriment--without inducing new entry. A recent questionnaire survey of a sample of U.S. firms by Smiley found a high frequency of use of entry deterring strategies by respondents, and that the main source of potential entrants into established product markets was perceived to be existing rivals; surprisingly few firms were concerned about new entry from other countries.(42) Smiley concluded: "If policy makers want to encourage entry and the healthy competitive effects of a vigorous set of potential entrants, these results suggest that the major focus should not be directed toward international trade barriers."

An example of how established firms may seek to thwart the competitive impact of threatened or actual entry by imports is provided by Frederiksen.(43) He examined how four concentrated U.S. industries--sheet glass, primary aluminum, typewriters, and wheel tractors--responded to the emergence of foreign competition after World War Il. Price competition became a characteristic feature of most of the markets, except where product differentiation and established distribution networks imposed significant entry barriers. In some industries attempts were made to have import barriers raised; in others, U.S. firms expanded overseas, sometimes by acquisition, thereby eliminating potential or actual competitors in the domestic market. In New Zealand the acquisition of Australian competitors has been a feature of the free trade arrangement between the two countries, phased in over the period 1983-1990. Moreover, local dominant firms have often also been the major importer of the competing foreign good. For example, over the period 1985-1990 NZFP accounted for two-thirds of linerboard imports, which in total amounted to about two percent of domestic production. Frederiksen suggested that where the domestic market is one of tight oligopoly, competition policy should be directed at lowering import barriers and preventing anticompetitive acquisitions.

Fifthly, import competition does not provide a uniform constraint on domestic firms. In a cross-section statistical study of 318 U.S. manufacturing industries covering the period 1980-1984, Clark, Kaserman and Mayo found that import penetration varied depending on three broad factors: trade barriers (both natural and government imposed), market structure, and comparative advantage.(44) Of the specific variables tested empirically, domestic industries were found to be insulated from increasing import shares of the market by nontariff barriers, high transport costs and product differentiation, and were more vulnerable to import penetration with greater economies of scale and with a larger proportion of industry output going to final consumer demand.

Finally, the assumption embodied in our model that world markets are competitive has been questioned by some populist writers, such as Adams and Brock.(45) They claim that global competition is fragile because "global markets, like domestic markets, are susceptible to control." Giant transnational corporations seek to suppress competition through international cartels, joint ventures and mergers. If they were to succeed in raising world prices, the constraining influence of import competition could be reduced.

IV. Case studies

Here we examine briefly some Commission decisions on cases that seem to fit rather closely the model set out in sections I and II, and in which the potential for import competition played a significant part.(46)

The Wattie/Taylor Freezer decision concerned the nationwide market for ice cream.(47) Wattie had market shares exceeding 90% in three of the market segments, but only 47% of the soft serve mix segment in which Taylor had a 45% share. The merger would thus have given Wattie a "virtual monopoly" in the market. The barriers to entry on a significant national scale were high.48 The potential competition from Australian imports was considered but rejected, on the grounds that ". . . cost, quality and transport would make this impossible now and also unlikely in the future." The proposal was refused because of the resulting reduction in competition in the domestic market, and the lack of any import constraint. This decision would seem to be consistent with our welfare model.

In Robertshaw/Repco the two companies' product lines overlapped only in the manufacture of electro-mechanical heating controls, for which they were the only suppliers in New Zealand and Australia.(49) Production required a "large capital investment" that generated substantial scale economics, and consequently new domestic entrants were unlikely. It would seem that the market was a natural monopoly. Import competition was considered. Robertshaw estimated the prices of importing five overseas brands. Four of these ranged between $4.70 and $4.80, and the fifth was NZ$4.40, compared to its own price of $4.00. The Commission recognized that the merger would give rise to a pure monopoly, that no controls had ever been imported, and that future imports were "most unlikely"; yet it consented to the proposal on the grounds that the merged firm's market power would be constrained by the potential ability of large customers to import.

The question raised is how much discretion over price must a constraint allow a monopolist before that finn is considered to exercise dominance. The evidence suggests that Robertshaw could probably have raised its price by at least 10% without inducing entry, and the price may already have been inflated by lack of competition. The Commission argued that while the import price was "much higher" than the domestic price, the difference in absolute terms contributed insignificantly to the total cost of an oven. This argument seems to condone the exercise of market power by a pure monopolist, and fails to recognize that the price differential is a much larger proportion of the price charged by repairers for the replacement of control devices.

The Fletcher Challenge (FCL)/Consolidated Metal (CMI) merger case involved vertically related markets for certain steel products: rod, wire, various wire products (e.g., nails, fencing), and their distribution to end users.(50) Since FCL had a major role in all of these markets, the addition of CMI's production of wire products might raise both the horizontal and vertical market power of FCL. The Commission considered that the potential for import competition was "critical" to the evaluation of the proposal. This was particularly so in rod production, where the FCL subsidiary Pacific Steel Ltd. (PSL) was the only supplier, and where new entry was "highly unlikely" because of large scale economies in a small market. Imports had previously been limited by PSL setting its price on an "import equivalent basis," i.e., according to the landed after-duty price and allowing for nonprice advantages (e.g., lower inventories) of the local product. The price--effectively the limit price--was reviewed every 3 months. About 85% of PSL's rod output was sold to another FCL subsidiary, NZ Wire Industries Ltd. (NZWI), with recent entrants Hume Industries (NZ) Ltd. and Nauhria Group Ltd. taking the balance, largely for their own use. Entry barriers were considered modest. Imports of wire were only a few percent of domestic production, some of it comprising specialized wires not produced locally. NZWI, like PSL, set its price on an "import equivalent basis." Nonprice factors--including quality, metallurgical and customer service elements--were more important for wire than for rod, allowing NZWI to include a "far higher" nonprice premium. This effectively raised the limit price, though the Commission chose to emphasize the constraint imposed by imports.

Like Robertshaw/Repco, FCL/CMI raised a problem associated with the potential competition doctrine, namely how a competitive constraint is defined. FCL argued that PSL's pricing to exclude imports did not indicate a lack of competitive constraint on the company, but rather showed that it "was responding to the competitive pressure provided by imports and that its operations were effectively constrained." Hume countered this by stating that the "import equivalent pricing method illustrates an ability to influence prices and is indicative of dominance," and that "although FCL may vary its prices to combat imports, it increases prices to take advantage of high import prices when the New Zealand dollar is low."(51) In my view, the Hume statement provides the proper focus; it is not just whether a company's price is constrained by potential competition, but the extent to which the company is able to exercise its market power despite the presence of the constraint. For example, suppose a dominant firm had constant unit costs of $5 and maximized profit at a price of $8. If potential competition forced the firm to price at $7 the firm would be constrained, but it would still be exercising substantial market power in setting price above costs. By comparison, a competitive market would set a price of around $5. The emphasis, therefore, needs to be on prices and costs, or on profitability. In the case of PSL, the Commission appeared to be swayed by evidence that the company was "not trading profitably at present," which it "attributed, at least partially, to the constraint imports imposed on its domestic selling prices." On the other hand, the Commission was prepared to overlook the high nonprice premium embodied in NZWI's price for wire, and the scope for exploiting market power in heating controls where import barriers were high. It seemed that only when import barriers were prohibitive (e.g., high freight costs with ice cream) was a zero constraint from potential import competition likely to be inferred.

The Commission's treatment of potential import competition has been sharpened in the most recent of a series of cases involving the vertically integrated forestry company New Zealand Forest Products Ltd. (NZFP).(52) These have detailed the market power of the company, which was one of three monopoly concerns established with government help in the 1940's and 1950's to develop forestry processing. NZFP was given a domestic monopoly over "fine" and packaging papers and paperboards, a position that it still holds. In the past it has also operated various restrictive supply arrangements with Amcor, its Australian counterpart, and with converters and dealers. New domestic entry into kraft liner production is highly unlikely: not only do large scale economies lead to the capital cost of a minimum-sized plant being huge (over Nz$750m); the incumbent also has very large sunk costs, capacity (currently being expanded) far in excess of domestic demand, and huge wood resources not available to a new entrant. Imports are the only possible source of competition, but until recently NZFP has received absolute quota protection. Tariff rates of 40% prior to mid-1986 were roughly halved by 1990.

The Commission found that NZFP, recognizing the disadvantages of overseas supplies, practiced limit pricing by setting domestic prices at a level just below that at which converters would consider importing. The price was set to give a 10% premium over the cheapest imported alternative. This seems at least partially confirmed by linerboard prices (in NZ$) over the period April 1982 to April 1987,53 where the following averages can be calculated: NZFP, $859; U.S. imports, $959; U.S. imports derived ex-Asia, $851; and U.S. domestic, $535.

In the 1987 decisions the Commission focused on the general lack of competitive constraints in finding NZFP dominant in the kraft paper and paperboard market. In the 1990 decision the Commission used a more sophisticated approach.(54) It argued that the import landed price placed a ceiling on NZFP's domestic price, and to that extent the company was constrained--an argument used by NZFP, like FCL previously, to claim that it therefore was not in a dominant position. However, the Commission found that NZFP was able to set domestic prices above those likely in a competitive market. The company's export price was currently about 30% below its domestic price, yet exporting must still have been profitable since its capacity expansion program was aimed at increasing export production at about the same unit cost as its current production. The Commission concluded that NZFP was taking advantage of its dominant position to earn supemormal profit in the domestic market. The case provides a perfect illustration of the welfare model discussed above, with the tradeoff between economies of scale and market power in the small market, and its partial resolution through potential competition from imports.(55)

The Commerce Commission's inclusion of potential import competition as a factor in determining whether a firm may have, or a merger may lead to dominance was decisive in several cases, but its stance has varied: from approving Robertshaw/Repco, where imports provided an ultimate, if nonbinding, constraint on price; to approving NZ Wire, despite its limit pricing and the inclusion of a large premium (alias monopoly profit?) for its nonprice advantages over imports; to condemning NZFP for limit pricing and earning supernormal profits. If any trend is discernible, it is perhaps a growing recognition that for imports to offer some sort of constraint is not enough; the constraint must be sufficiently strong to prevent the firm from using its domestic market power to earn excessive profit.

V. Conclusions

Competition policy in New Zealand is a comparatively recent development. The first law governing mergers was enacted only in 1975. As a result, the Commerce Commission has tended to look to overseas experience for guidance. However, the special circumstances of the New Zealand economy, in particular the small size of the domestic market and the developing nature of the manufacturing sector, have limited the attractiveness of strict overseas precedents. The view that relatively large firms are needed to gain the scale economies necessary for international competitiveness is widely held, and seems to lie behind the lenient merger policy that has contributed to rising concentration and limited domestic competition in many industries. For example, the former chairman of the Commission wrote bluntly that the market share guidelines used in United States merger cases "seem ridiculously small to us and are inapplicable here."(56) Perhaps in no other country is the tradeoff between efficiency and competition focused so sharply.

However, the government's policy of import liberalization, which is designed to improve industry efficiency by increasing foreign competition, may help to curb the market power of otherwise dominant firms. In large countries like the United States the more responsive the upward sloping foreign supply curve to rises in the domestic price, the greater the constraining influence likely. But in a small country such as New Zealand the foreign supply curve is likely to be horizontal at a level determined by the height of entry barriers. This permits domestic firms to exercise market power (if any), and earn excess profits, by raising price up to, but not exceeding, the import-imposed ceiling. Our welfare model suggests that this situation might enhance welfare compared to one where (a) the market is competitively structured, but inefficient from diseconomies of small scale, or where (b) a dominant firm is able to maximize profit without constraint.

The model also suggests that for tradeable goods, welfare could be further enhanced by lowering the price ceiling through reducing import barriers. Of the three sorts of barrier--natural (i.e., freight charges), artificial (i.e., trade restriction), and nonprice--only the second can easily be reduced. In the case studies it was found that generally all three elements are important, and that the overall barrier can add 40% to the foreign ex-factory price.57 Even if artificial protection were to be eliminated, it seems that import competition generally could become at best only a partial substitute for competition policy.58 This view is strengthened when allowance is made for such factors as the variable nature of the import price ceiling caused by fluctuations in world prices and the exchange rate, and the fickle nature historically of political support for import liberalization.

When evaluating the constraint placed on domestic firms by import competition, the Commerce Commission has tended to place weight on whether importing has actually occurred or is likely, rather than on considering the height of entry barriers and the latitude to domestic pricing that these allow. Proportionately small levels of imports are often viewed as representing a significant constraint. The analysis rised here, however, suggests to the contrary that limit pricing firms are likely to adopt strategies that induce some imports for product differentiation and other reasons, and so the presence of imports does not necessarily indicate that they offer a competitive constraint. Indeed, the major importer is sometimes the very firm under investigation, as in the case of 14Z Wire and NZ Forest Products.

The correct focus appears to be on the degree to which import barriers allow the limit pricing firm to exercise market power, measured by the extent to which price exceeds unit cost, and by the size of excess profit (after making allowance for any inflation of costs through protection induced inefficiency). This seems to have been recognized by the Commision in As 1990 decision concerning NZ Forest Products, although that case was exceptional even by New Zealand standards for the monopoly power of the firm involved. Thus a firm may be constrained to some degree by import competition yet still be perceived as dominant, in that it can independently set price above the competitive level without inducing entry. Two further issues are then raised: what elevation of price is required for dominance to be found, and whether in such cases the Commission should be empowered to recommend a tariff reduction. (1) For United States policy see Briggs, An Overview of Current Law and Policy Relating to Mergers and Acquisitions, 56 Antitrust L. J. 657 (1987); Schmalensee, Ease of Entry: Has the Concept Been Applied too Readily? 56 Antitrust L. J. 41 (1987). For Australian policy see M. Brunt, The Use of Economic Evidence in Antitrust Litigation: Australia, 14 Australian Bus. L. Rev. 261 (1986). In contrast, a nonsystematic consideration of entry conditions is a feature of British merger policy [see Fairburn, British Merger Policy, 6 Fiscal Studies 70 (1985)]. (2) Even before the passing of the Commerce Act 1986 the former chairman of the Commerce Commission was emphasizing the importance of entry conditions and market contestability [J. Collinge, Mergers and Takeovers (1): Towards a Competition Policy in New Zealand, New Zealand L. J. 262 (November 1985); Mergers and Takeovers (2): Towards a Competition Policy in New Zealand, New Zealand) L. J. 391 (December 1985)]. (3) D. F. Greer, Market Dominance and Anticompetitive Effect Under New Zealand's Merger Policy (NZIER Research Monograph No. 51, Wellington, 1989), at 39-41. (4) See A. Bollard, The Applicability of Contestability Theory to New Zealand Competition Law and Policy (NZIER Working Paper 87/04, Wellington, 1987), at 19; Greer, supra note 3, at 85-86. (5) See P.C. Frederiksen, Prospects of Competition from Abroad in Major Manufacturing Oligopolies, 20 Antitrust Bull. 339 (1975h Pugel, Foreign Trade and US Market Performance, 26 J. Indus. Econ. 119 (1980). Statistical evidence provided by cross-section industry studies in the United States see Pugel, supra; Britain see Turner, Import Competition and the Profitability of UK Manufacturing Industry, 29 J. Indus. Econ. 155 (1980); and Belgium see de Ghellinck, Geroski & Jacquemin, Inter-Industry Variations in the Effect of Trade on Industry Performance, 37 J. Indus. Econ. 1 (1988) uniformly support the "trade-as-discipline" effect of import competition, but find that the disciplining effect varies with industry structural factors, being greater when domestic industry concentration is high. Thus, import competition tends to constrain profits when high domestic concentration would otherwise lead to monopoly profits being earned. In less concentrated industries, import competition has no effect because domestic competition already restrains profits. (6) See Collinge, Merger and Takeover Criteria: Competition and the Commerce Act, New Zealand L. J. 92 (March 1987); Pickford, Industry Inefficiency, Monopoly and Import Liberalization in New Zealand--An Assessment of the Static Welfare Effects, 63 Econ. Rec. 162 (1987). Note also that New Zealand competition policy has been modeled on the Australian, where the importance of import competition has been emphasized. (7) Landes & Posner, Market Power in Antitrust Cases, 94 Harv. L. Rev. 937 (1981). (8) Leitzinger & Tamor, Foreign Competition in Antitrust Law, 26 J. L. & Econ. 87 (1983). (9) Abbott, Foreign Competition and Relevant Market Definition Under the Department of Justice's Merger Guidelines, 30 Antitrust Bull. 299 (1985). (10) Although large minimum orders may make the supply response somewhat "lumpy." (11) See Schmalensee, supra note 1; D. F. Greer, "Contestability in Competition Policy: Replacement, Supplement or Impediment?" Paper in the Fulbright Economic Seminars, Wellington, 1988. Hindsight reveals deficiencies in Bain's pioneering empirical study on entry barriers in a sample of 20 U.S. industries [J. S. Bain, Barriers to New Competition (1956)]. See Harris, Entry and Long-term Trends in Industry Performance, 21 Antitrust Bull. 295 (1976); F. M. Scherer, Industrial Market Structure and Economic Performance (2d ed. 1980), at 277 m36. (12) This model is a modified version of that to be found in Scherer, supra note 11, at 21-22. (13) Following S. Martin Industrial Economics: Economic Analysis and Public Policy 194-95 (1988). The assumed cost structure simplifies the welfare analysis below, but at the expense of restricting scale economies to involving only the spreading of long-run nonvariable "set up" costs over larger outputs. (14) Many New Zealand markets are dominated by firms that have emerged from successive mergers, e.g., Magnum Corporation and Dominion Breweries in beer; Goodman Fielder Wattie in bread and other food items; Wrightson Daigety in stock and station agent services; NZ Dairy Group in dairy products; Alliance in meat freezing; and so on. (15) See O. E. Williamson, Economies as an Antitrust Defense Revisited, in Welfare Aspects of Industrial Markets 237-71 (Jacquemin & de Jong eds. 1977). (16) The competitive domestic market alternative is likely to become redundant once import competition is introduced. See section II infra. (17) See, for example, Scherer, supra note 11, at ch. 15. (18) Williamson, supra note 15. (19) For example, it can be shown that with a price elasticity of demand of two, and a five percent higher price under monopoly, cost savings of only 0.27% would be needed to balance D' with C' [see Williamson, supra note 15, at 246]. If B' is also regarded as a welfare loss from monopoly pricing, it can be shown that cost savings of 5.26% are needed to balance D' with B' plus C'. (20) M. Pickford, Competition Policy, Mergers and the Net Social Benefit Test, in The Economics of the Commerce Act (NZIER Research Monograph No. 52, Wellington, A. Bollard, ed. 1989), at ch. 5. (21) Scherer, supra note 11, at 249. (22) The cost structure assumed implies that such firms would be selling at a loss on the international market; presumably these losses would be covered by economic profits earned in their respective domestic markets. (23) Scherer, supra note 11, at 243-35; Martin, supra note 13, at 71-73. (24) See infra section IV. (25) Kaplow, The Accuracy of Traditional Market Power Analysis and a Direct Adjustment Approach, 95 Harv. L. Rev. 1817 (1982). (26) Abbott, supra note 9, at 321, gives several reasons why product differentiation may hinder foreign suppliers from increasing imports in response to a rise in the domestic price. See case studies infra, which give several examples of "non-price disadvantages" associated with imports. (27) Kaplow, supra note 25, at 1833. (28) For example, container handling charges at the Port of Wellington we said to be up to 15% lower than before the October 1989 ports reform. See Gosling, Port's charges drop by up to 15 pc, The Dominion, July 3, 1990. (29) Note that the Commerce Commission no longer has the power conferred by the former 1975 Act to recommend changes in tariff rates to enforce competition policy. Moreover, current trade liberalization policy appears to be targeted at improving industry efficiency rather than curbing the market power of dominant firms. Nonetheless, tariff policy could also be used for the latter purpose. (30) While natural gas is currently the only commodity subject to the price control provisions of the Commerce Act 1986, these provisions are regarded as "an important last-resort mechanism to deal with problems arising from market dominance." See Department of Trade and Industry, Review of the Commerce Act 1986: A Discussion Paper (Wellington, 1988), at 52. (31) For an analysis of former price control problems in the cement industry, see R. A. Miller, J. Ayto, R. Bowie & D. Harper, Price Setting and the Commerce Act (NZIER Research Monograph No. 37, Wellington, 1987), at ch. 2. (32) Bollard, supra note 4, at 22, reached a similar conclusion from an earlier survey of cases. His statement that: "It is particularly unusual to be able to point to examples of actual entry in the past," is not borne out by all the cases examined here, however. (33) Commerce Commission, Decision No. 218: Fletcher Challenge Ltd./Consolidated Metal Industries, Ltd., Wellington, 1988. (34) Freight costs can be estimated using this approach only where imports have actually occurred, a problem that limits its applicability. Note that a domestic firm supplying from a single location could be disadvantaged relative to imports brought in through two or more ports by having to incur higher internal freight costs to more distant regional markets. (35) See Commerce Commission Decision No. 199: NZFP Ltd./UEB Industries Ltd., Wellington 1987; Decision No. 249B: Carter Holt Harvey Ltd./Elders Resources NZFP Ltd., Wellington, 1990. (36) Baker, Market Definition and International Competition, 15 N.Y.U. J. Int'l L. & Pol. 377 (1983). (37) A residual threat would arise from the possibility of the imposition of price controls under part IV of the Commerce Act. The "Closer Economic Relations" free trade arrangement with Australia also seems likely to persist. (38) Commerce Commission, Decision No. 204: Dunlop NZ Ltd./Goodyear NZ Ltd., Wellington, 1987. (39) H. Barlow, Tyre move not |vote catching,' The Dominion, October 3, 1990. (40) Commerce Commission, supra note 33. This case is discussed in section IV infra. (41) A good summary of strategic behavior associated with limit pricing is found in G.H. Burgess, Industrial Organization (1988), at 176-79. (42) Smiley, Empirical Evidence on Strategic Entry Deterrence, 6 Int'l J. Indus. Organ. 167 (1988). A replication of this study in New Zealand produced similar findings. See M. Pickford, Further Empirical Evidence from New Zealand on Strategic Entry Deterrence, Massey Economic Papers, B9102. (43) Fredericksen, supra note 5. (44) Clark, Kaserman & J.W. Mayo, Barriers to Trade and the Import Vulnerability of US Manufacturing Industries, 38 J. Indus. Econ. 433 (1990). (45) Adams & Brock, The "New Learning" and the Euthanasia of Antitrust, 74 Calif.L. Rev. 1516 (1986). (46) Other relevant cases not discussed here include: Rheem/Zip, Dunlop/Goodyear, Animal Enterprises/NZ Dairy Board, Carbon Products/Donald Brown, and Fisher & Paykel. (47) Commerce Commission, Decision No. 127: Wattie Industries Ltd./Taylor Freezer Holdings, Ltd., Wellington, 1985. (48) See also Commerce Commission, Decision No. 20]A: Goodman Fielder Ltd./Wattie Industries Ltd., Wellington, 1987, at 6-7. (49) Commerce Commission, Decision No. 181: Robertshaw Controls (NZ) Ltd./Repco Controls NZ Ltd., Wellington, 1986. (50) Commerce Commission, supra note 33. (51) Commerce Commission, Draft Determination: Fletcher Challenge Ltd./Consolidated Metal Industries Ltd., Wellington, 1988, at 9. (52) Commerce Commission, supra note 35; Decision No. 208: Amcor Ltd./NZ Forest Products Ltd., Wellington, 1987; and Decision No. 213: Fletcher Challenge Ltd./NZ Forest Products Ltd., Wellington, 1987. (53) Commerce Commission, NZFP/UEB, supra note 35, at appendix 2. (54) Commerce Commission, supra note 35. (55) See supra sections I & II. A similar situation was uncovered in the cartonboard market: NZFP was the sole domestic producer, new domestic entry was unlikely, and limit pricing up to the ceiling set by import prices had allowed the company to earn excessive profits. (56) Collinge, supra note 2, at 391. (57) Freight charges are likely to be inflated in New Zealand's case by the country's geographic isolation, and by the inefficiently regulated shipping industry in Australia, a major trading partner. See J. Gardiner, Talks aim to improve transtasman shipping, The Dominion, April 2, 1991. (58) Although, to depart from the assumptions of the model, the natural and nonprice barriers faced by foreign firms might be offset by lower production costs because of comparative advantage or superior efficiency.

MICHAEL PICKFORD Senior Lecturer in Economics, Massey University, Palmerston North, New Zealand.

AUTHOR'S NOTE: Thanks are due to Rex Ahdar, Mark Berry, Douglas Greer and to participants both at a Massey economics seminar, and at the Second Annual Meeting of the Competition Law and Policy Institute of New Zealand (Wellington, August 9-11, 1991), for their helpful comments on an earlier version.
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