REVIEW: LECTURES 11.1, 11.2 AND 12.1 MARKET DEFINITION AND HORIZONTAL MERGERS
Review 17 October 2013Date
ANTITRUST ECONOMICS 2013Alexis G. PirchioCPI
Elisa MariscalCIDE, Global Economics Group
2Overview
Review
Role of Market Definition
Competitive Constraints
and Two-Sided Market
Definition
Legal and Economic
Background on Mergers
3 Role of Market Definition
4Market Definition and Market Power
Market power is important for assessing whether a firm has the incentive and ability to engage in anti-competitive behavior and whether merger will result in an increase in market power
Market power depends on the constraints that a firm faces in increasing the price of a product profitably; these constraints typically involve substitutes in demand and changes in supply by other firms.
The “relevant market” identifies the producers the impose significant constraints on the power or a firm or group of firms to raise price profitably.
Market definition is primarily (perhaps solely) used for the purpose of helping the courts and competition authorities assess dominance/market power.
5Market Definition and Context
• Identifies sets of firms, substitution patterns, and strategic relationships among firms.
Market definition provides a context for examining firm strategies
Market definition limits the discussion of rival products and firms to a manageable group.
Firms in the market
A, B, C, D, E
Firms outside of the market: F, G, H, …
F G
H
6Hypothetical Monopolist Test
• Is a “market” worth monopolizing?• If yes, then the substitutes outside the “market” must be weak• If no, then the substitutes outside the “market” must prevent the
exercise of market powerThus the group worth monopolizing pulls in all of the relevant substitutes.
Logic of the test
• Start with the narrowest candidate market and assume that there is a monopoly supplier
• Could this hypothetical monopolist profitably impose a “small but significant not-transitory increase in price” (SSNIP)?
• Yes Candidate Market = Relevant Market• No Candidate Market < Relevant Market Include the closest
substitutes and repeat the testThis means that too many customers switch to demand-side or supply-side substitutes
Implementing the test
7
How to Proceed? Demand-side then supply-side
Potential substitute products
Demand-side
1
2
ACandidate Market
BCD
3 A+B+CSupply-side S1
S2
A+B+C
A+B+C+S1
X
X
8
Critical Loss Analysis is a Method for Implementing SSNIP Test in Practice
Step (1)—Profits, output, and sales before the price change for hypothetical monopolist (e.g. products A and B).
MC$10
$20
100
Price
Quantity
Profit = ($20 - $10) x 100 = $1,000
9Step (2): How many units of sales would have to switch to substitutes to make a 10% price increase just unprofitable? Suppose the answer is slightly more than16.7 (with 16.67 roughly break even).
MC$10
$20
100
Price
Quantity
$22
83.33
If fewer than 16.7 units of sales switch than a 10% price increase is profitable
Critical Loss Analysis is a Method for Implementing SSNIP Test in Practice
Profit = ($20 - $10) x 100 = $1,000
Profit = ($22 - $10) x 83.33 = $999.96
10
Critical Loss Analysis Depends on Customer Switching—an Example of a Calculation
How many customers have to switch to substitutes to make a 10% price increase unprofitable?
• Initial price = $20; MC = $10; Profit Margin = $10; Quantity = 100; Profit = $10 x 100 = $1,000
• New price = $22; MC = $10; Profit Margin = $12; Quantity = 83.33; Profit = $12 x 83.33 ≈ $1,000
Consider this example
• If sales fall by less than 16.7% the price increase is profitable• Candidate market is then no wider than the relevant market
(i.e. a smaller market could have a profitable price increase too).• If sales fall by more than 16.7% the price increase is unprofitable
• Candidate market is too narrow (one can also say that the true market is even broader than the candidate market).
• The “critical loss” is 16.7%--this is the dividing line.
This implies that:
11
Comparison of Actual Versus Critical Loss Determines if Market is Large Enough to be Monopolized.
Critical Loss
Actual loss greater than critical loss Implies price increase is unprofitable so
assumed “market” can’t be profitably
Monopolized and is therefore too small.
Actual loss less than CriticalLoss implies that price increase is profitable so assumed “market” can be profitably monopolized. Market is therefore at least this narrow.
12 Competitive Constraints and Two-Sided Market Definition
13The “Other” Side Acts as a Price Constraint
If a platform increases the price on side A that will not only reduce demand on side A but also—through the indirect network effects— demand on side B.
The loss of demand on side B degrades the value of the platform to side A, leading to a further reduction in demand by side A customers.
The complementary side B therefore magnifies the effect of a price increase on side A.
Demand on side A is more elastic after taking the cross effect into account.
14
Avoid Excluding One Side of the Platform From Analysis
Consider a unilateral practice that concerns one side of a two-sided platform business.
Traditional market definition would start with the product/service for that side and define a market that only concerned that side.
It would therefore exclude the other side of the platform from the analysis.
As a result the analysis would be forced to ignore the interlinked customer sides and other relationships.
15Single-Sided Market Definition Tools Don’t Apply
The analytical machinery for the traditional SSNIP test is based on the simple price-cost markup rule that percent markup is equal to the inverse of the elasticity of demand for the product.
The formulas for actual and critical loss are based on the simple markup rule.
The formula for diversion ratios is based on the simple markup rule.
Since the simple markup rule does not apply for two-sided platforms other formulae that are based on that rule do not apply for two-sided platforms.
16
Key Lesson: Avoid Approaches that Result in the Exclusion of a Customer Side from the Analysis
Mechanical approaches such as traditional SSNIP may exclude important economic relationships coming from the other side of a two-side platform.
Could obscure linkages that provide additional avenues for consumer harm or additional sources of efficiencies.
Could ignore linkages that provide significant constraints on market power.
17 Legal and Economic Background on Mergers
18Horizontal vs. Vertical Mergers
Horizontal merger of B and C in market of A, B, and C which have substitutable products
Vertical merger of A and f where f supplies a downstream service to A.
A B C
ef
19Possible Benefits of Mergers
Permit the exchange of property to higher valued uses; ultimately mergers are about selling property. (Why is Nokia selling and Microsoft buying Nokia’s handset unit?)
Acquirer finds it cheaper to buy than to build (Why did Facebook buy Instagram?)Mergers can generate economies of scale and scope; reduce duplicative costs; create synergies through complementary technologies. (One of the arguments for EU efforts to break down national boundaries e.g. in capital markets.)Encourage innovation and investment; an acquisition provides major potential source of reward for the target. (eBay just bought processor Braintree for $800m providing exit for Braintree’s entrepreneurs and investors.)Mergers and takeovers—and the mere threat of them—can discipline corporate management and thereby solve separation of ownership and control problem (CEO loses job in takeover, would like to avoid that.)
20Possible Harm from Mergers
Mergers could increase prices and reduce output through increased concentration. Merger to monopoly is the extreme case.
Mergers could also reduce innovation, service, and other desirable non-price aspects of competition.
Mergers could increase entry barriers and thereby result in durable market power.
Vertical mergers could facilitate the extension of market power from one market to another or help maintain market power through control of essential suppliers.
21Example of Calculating HHI and Change in HHI
Pre-Merger
Firm ShareA 50%B 25%C 15%D 10%HHI 3450
Post-Merger
Firm ShareA 50%B+D 35%C 15%
HHI 3950
HHI (Pre) = 502 + 252 + 152 + 102 = 3450HHI (Post) = 502 + 352 + 152 = 3950
Change in HHI = 500
22OFT’s Merger Guidelines
HHI Investigate?
< 1,000 NO
> 1,000and<1,800
YES IF HHI > 100NO OTHERWISE
> 1,800 YES IF HHI > 50NO OTHERWISE
HHI and Change in HHI Serve as Screening Devices
23Unilateral vs. Coordinated Effects
Unilateral effects: The acquiring firm may raise price because the merger gives it more market power.
Coordinated effects: The merger either strengthens or makes possible tacit collusion among firms thereby leading to an increase in price.
A given merger could involve either or both types of effects.
24Mergers are presumed to be pro-competitive
Mergers are commonplace in the market economy.
Most are not examined by competition authorities because they do not involve large enough acquirers or targets.Most mergers that are examined by competition authorities are cleared without conditions. A few are cleared after the divestiture of some overlapping products.Mergers are an integral part of the market process and are presumed to foster competition and innovation. In practice, merger prohibitions are a small fraction of all mergers—but without rules there would likely be many more problematic mergers. Firms seldom propose 3-2 mergers, for example.
25
Merger of Firms in an Oligopoly Industrywith Homogeneous DemandIn an oligopoly
industry (with Cournot competition) market price is lower than a monopolist would charge, but higher than the competitive price so each firm has some degree of market power
Deadweight loss is also lower than that in the monopoly case in the same market, but still positive qC
D(P)
COMPETITION
COURNOT
MONOPOLY
QQ COURNOTqMA,B
MC
P
PM
PCOURNOT
26
Consequences of a Reduction in the Number of Firms with Homogeneous Products
After a merger, we see:
• Higher prices• Lower output
But:
• How significant is the effect?• Is it counteracted by efficiencies?
qC
D(P)
COMPETITION
N = 2 MONOPOLY
QqM
MC
P
PM
Basic economic theory shows that reducing the number of firms results in higher prices (Cournot Model)
N = 3
N = 4
27Efficiencies and Merger to Monopoly
0 1 2 3 4 5 6 7 8 9 10$ 0
$ 1
$ 2
$ 3
$ 4
$ 5
$ 6
$ 7
Merger
Q
P
Dead Weight Loss
Surplus from cost savings
Surplus transferred from consumers to producers
Demand
Pre-merger Marginal Cost
Post-merger Marginal Cost
MR
Consider also when marginal cost decreases from $3.00 to $2.50
QPre
PPre
PPost
QPost
In this example price to consumers increases and social welfare declines less than consumer welfare because of efficiencies.
The firms in a competitive industry with p=MC are all bought up and merged into monopoly.
28Efficiencies and Merger to Monopoly
0 1 2 3 4 5 6 7 8 9 10$ 0
$ 1
$ 2
$ 3
$ 4
$ 5
$ 6
$ 7
Merger
Q
P
Dead Weight Loss
Surplus from cost savings
Surplus transferred from consumers to producers
Demand
Pre-merger Marginal Cost
Post-merger Marginal Cost
MR
Consider also when marginal cost decreases from $3.00 to $1.50
QPre
PPre
PPost
QPost
In this example price increases, consumer welfare declines, but social welfare increases because the efficiency benefits outweigh the deadweight losses to society.
29End of Review, Next Class Topic 12.2
Topic 12.2
Unilateral Effects: Economic Evidence
Coordinated Effects: Economic Theory and Evidence
