Is a Relevant Market Irrelevant

A paper proposing a new method for the antitrust agencies to use in screening mergers between manufacturers of differentiated products was released last November by Joseph Farrell and Carl Shapiro, who soon after became chief economists at the FTC and DOJ Antitrust Division respectively. While the paper, “Antitrust Evaluation of Horizontal Mergers: An Economic Alternative to Market Definition,” presents their personal views and does not necessarily reflect the official position of the agencies, it provides some insight into how the authors are likely to approach these types of mergers.

Farrell and Shapiro claim that a new screening mechanism is needed for mergers involving differentiated products because it may be hard for the antitrust agencies to define the relevant market and compute market shares following the methodology in the Horizontal Merger Guidelines. They argue that market boundaries are unclear when dealing with differentiated products and that what really matters is the proximity of the products.

Farrell and Shapiro suggest screening differentiated product mergers for anticompetitive effects using what they term upward pricing pressure (UPP). Under a unilateral effects theory of competitive harm, the merger gives the merged entity a unilateral incentive to raise price. UPP measures the incentive to raise price. It does not measure actual price changes, which depend on shapes of demand curves and responses of the other firms. The authors argue that actual price changes are too hard to measure to use in screening.

The key factors determining UPP are the merging firms’ prices, marginal costs and diversion ratios. These are the same factors identified for determining unilateral effects many years ago. Before the merger, neither merging party would increase price because if it did, the loss of sales to other firms would make the price increase unprofitable. The diversion ratio is the share of those lost sales that would go to the other merging party. After the merger, that share of sales would be recaptured by the firm rather than lost. As a result, the merger would increase the incentive to increase price. The increase in incentives depends on the price-cost margin enjoyed by the other firm, which indicates how profitable it would be to recapture those sales, and the diversion ratio.

For tractability, the authors assume a particular model of competitive behavior, Bertrand, and assume constant marginal costs and constant diversion ratios. Given these assumptions, the UPP is equal to price minus marginal cost multiplied by the diversion ratio. They assume that the results from their simplified model are not misleading – but the analysis does not necessarily accurately reflect all industries.

There will always be a positive UPP if the two firms have a positive price-cost margin and there is any substitution between their products. Recognizing that the screening mechanism cannot forbid all mergers with a positive UPP, Farrell and Shapiro propose incorporating some standard level of efficiencies into the analysis – a standard deduction. For example, any merger could be assumed to reduce costs by a given percent, say 5%. A merger would be presumed to raise prices if the UPP was greater than that percent times marginal costs.

Michael G. Baumann has expertise related to modeling the effects of mergers.  He has analyzed the likely competitive effects of mergers in a variety of industries.