How, and Whether, to Define a Market (in Mergers)

Joseph Farrell

Based on work with Carl Shapiro

Merger Review

• Flood of cases

• Need for transparent, manageable screens

• Green light

• Yellow/red lights– Identify targets for further analysis– Stop some mergers when things are complex or

hard to prove?

Full Merger Review

• How will an oligopoly change with a merger?

• Oligopolies are hard to predict

• How to avoid analysis paralysis?

For green light

• For this, use pessimistic theory:– Merger might cause full collusion in any set of products

where it substantially raises concentration• Greed, incompetence, and “market power”?

• Is there any set of products for which– Merger substantially raises concentration, AND

– we’d be badly harmed by full collusion?

• Roughly hypothetical monopoly approach– No narrowest market “principle”

Concerns about Market Definition

• Can be hard to prove even when competitive effect seems fairly clear– Staples, Evanston Northern, Oracle

• Despite technical flavor of hypothetical monopolist test, very lawyer-driven

• Also complex and disputable—not a screen• Verbal confusion of “same market” phrase• Etc. Etc.

For orange light

• “Merger could trigger collusion” theory seems alarmist for this purpose– Arch Coal case (AirTours?)

• What class of oligopoly theories would imply concern?

Least-Alarmist Oligopoly Theory of Merger

• Oligopoly game among firms– Merging parties– Other industry participants

• Merging parties’ reaction functions surely shift

• Others’ may also– Probably in less-competitive direction?

Two Concepts of Unilateral Effects

• General concept: outsiders’ reaction functions don’t shift with merger– Approximation or quasi-bound?

• Special model: e.g. static differentiated-product Bertrand, or Cournot– Often not accurate description of oligopoly

• Reactions as sign that firms “compete”?

• Intangibles, complements…

Model (price) level before & after?

• Typically use static differentiated-product Bertrand, or Cournot– Often not accurate description of oligopoly

• Reactions as sign that firms “compete”?

• Intangibles, complements…– Problem both with modeling levels and with

market definition paradigm

• Focus on change due to merger!

Unilateral-Effect Analysis: Focus on Change

• Reduced elasticity of demand– Sales diverted to (equal-margin) partner not effectively

lost– Raise partner’s price also: less consumer response– Hypothetical monopoly test often conceived this way

• What elasticity remains for HM?• How does elasticity change if introduce HM?

• Cannibalization cost internalized– New “private marginal cost” of competitive moves– Our focus here

Internalizing competitive effects

• Change from merger• Newly internalize effect of price cut, etc• Opportunity cost or cannibalization cost• Thought-experiment: how would you

manage firm on the day after merger?– Should we focus on such “short-run” effects?– Efficiencies– Manageability

Quantify internalization term

• As per-unit “tax” on own product• In static Bertrand competition, diversion ratio

times absolute gross margin• More generally, how much own-sales boost from

competitive move that hurts rival/partner?– After (pre-merger) industry dynamics play out

– Price-matching dynamics reduce own-sales effect

– Non-price competition

What if quantify cannibalization?

• Compare to MC efficiency?• Critical efficiency

– Werden, Goppelsroeder et al., …

• We seek – Simpler, transparent versions– Bounds rather than precision– Targeted replacement of market definition, not

just part of efficiencies question

A Robust Theory of Oligopoly

• “When some marginal costs rise, consumers will be worse off”– [Comment on use of consumer surplus

standard…]

• What if some rise and some fall?

Treatment of Efficiencies

• Incorporate them into the screen early on

• But then don’t tolerate potentially small adverse effect

• How to estimate efficiencies?

• “Standard deduction”?

Characterize Unilateral Effect

• Net effect of merger on price is the oligopoly pass-through of asymmetric “cost shock” from adding internalization terms and MC efficiencies– Implicit in HM market definition question

– Implicit in merger simulation

• Not a closed-form solution because internalization terms endogenous

• Bound them?

Bounding Internalization Term

• Horizontal merger without (yet) efficiencies has predicted price increase

• Hence underestimate equilibrium margins if use pre-merger prices

• Adding MC efficiencies raises margins further• For negative net impact, efficiencies must

outweigh internalized margins using pre-merger prices

Pass-Through in Hypothetical Monopoly

Can also use these ideas in hypothetical monopolist calculations

Hypothetical monopolist will raise price by sp if and only if pass-through of equilibrium cannibalization terms is at least sp.

Pass-through is small if highly elastic segment of demand from unaffected competition

But if highly elastic everywhere, strong pass-through!

If pass-through is source of trouble, why go there?

Avoid Pass-through Calculations?

• Illinois Brick/Hanover Shoe rule – often misinterpreted

• Theoretically and econometrically difficult– Non-transparent: battle of the experts

• Already see this in discussion of efficiencies• Substantive disagreement and ignorant rhetoric

– Assumed functional form matters a lot• Froeb Tschantz Werden IJIO 2005

• Hard to use for screening/presumption• Unnecessary to sign net effect!

A proposal

• When antitrust agency shows that internalization tax is likely to outweigh MC efficiencies for any (substantial?) product,

• Agency should be entitled to court presumption that merger is anticompetitive– How strong a presumption?– What kinds of rebuttal evidence? Entry?– How sensitively used?

Should market definition remain route to adverse presumption?

• Could the theories (in practice) fail to nest as they ought?– What if coordinated effects actually predicted?

• False negatives from strong competition between merging products if use pre-merger margins as proposed– Catch this with market definition?– Or refine bound as needed—but keep simple?

How can one not define market?

• Market definition is a locus to analyze alternatives/substitutes

• That’s a helpful thing to do…BUT:

• Doesn’t have to be done that way

• Margins capture revealed-preference information on substitutes