Critical Loss Analysis 산업조직연구회 * 이는 Ken Danger 박사가 OCED RCC 에서 발표한 자료중 일부임

Market Definition Broad Points US Merger Guidelines (1982) were initially greeted quite harshly but have become the standard. Market definition required by US courts. 1 –Many economists would like to do away with the market definition portion of litigation and focus solely on competitive effects. Demand substitution and supply substitution (to a much lesser extent) are the key issues. Many tools have been proposed to assess the boundaries of an antitrust market and many are still actively used. 1. In 1962, the Supreme Court mandated the market share requirement in Brown Shoe Co. v. United States, 370 U.S. 294, 325, 335.

What is a Market? USDOJ and FTC Guidelines A market is defined as a product or a group of products and a geographic area in which it is produced or sold, such that a hypothetical profit maximizing firm, not subject to price regulation, that was the only present or future producer or seller of those products in that area likely would impose a “small but significant and nontransitory” increase in price, assuming the terms of sale of all other products are held constant U.S. Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines, 1992, revised April 1997.

What is the purpose of Market Definition? EU Guidelines Market definition is a tool to identify and define the boundaries of competition between firms... The objective of defining a market in both its product and geographic dimension is to identify those actual competitors of the undertakings involved that are capable of constraining their behavior and of preventing them from behaving independently of an effective competitive pressure EU Guidelines.

What’s Important When Defining a Market? Demand substitution to other Products Geographic areas Supply substitution from Quick entry Product repositioning

What is Meant by the Words Geographic Market? Geographic market refers to the location of production when price discrimination is not a concern. Geographic market refers to the location of consumption when price discrimination is a concern.

Geographic Market Definition Econo-land Company A Company B Company C Company D Company E Company F Merger Between Company B and D Candidate Market Expanded Market Companies A, B, and C May Be the Relevant Market Note that the market is location of production - not consumption - when price discrimination is not possible.

Product Market Definition Brand A Candidate Market Expanded Market Merger of Brand C and D Low QualityHigh Quality Brand B Brand F Brand E Brand D Brand C Brand C, D and E May Be a Relevant Market

Determining Smallest Relevant Market  Start with ONE of the products of concern.  Expand the market by adding the next best substitute.  Calculate profit maximizing price increase. Most likely this will not be done mathematically. When using questions, ask will the hypothetical monopolist be able to increase the price of each good in the candidate market by 5%. In the US, there is some disagreement over whether the courts require ALL goods to be increased by 5%. USFTC uses smaller thresh holds in low margin cases.  Is the price increase at least 5%. Yes, stop. No, repeat steps 2-4. Repeat this procedure for other product of concern. Are they in the same market? Why do it this way? Because the authority should not be too quick to conclude that they are in the same market.

What Does Expanding the Market Mean? Expanding the market means allowing the hypothetical monopolist to control an even wider range of products or assets than the set that is currently being considered. This is done by adding the next best substitute to the set of products or assets currently controlled by the hypothetical monopolist. Example: A hypothetical monopolist currently controls products A and B. If a significant price increase for both products is not possible because of substitution to product C. We “expand the market” by allowing the hypothetical monopolist to control product C.

Critical Loss Overview Introduction Mathematics Various Formulae Practical Issues Computer Exercise

Introduction to Critical Loss Barry Harris and Joseph Simons developed critical loss to operationalize something that was thought to be “completely nonoperational” – the USDOJ merger guidelines. 1 Critical loss is one of the standard tools used by US enforcement agencies to assess mergers. Often a key feature of litigation. –U.S. v. SunGard and Comdisco –FTC v. Tenet Often seen in White Papers presented to the antitrust agencies, pre-trial affidavits, and expert testimony. 1. Harris, Barry and Joseph Simons, “ Focusing Market Definition: How Much Substitution is Necessary? ” Research in Law and Economics, pp. 216, 224 (note 19), 1989; and Stigler, George J. and Robert A. Sherwin, 1985, “The Extent of the Market,” Journal of Law and Economics, 28,

What is the Critical Loss? The critical loss identifies for any given price increase the quantity in sales that can be lost before the price increase becomes unprofitable. Application of this definition is said to be a break-even analysis. Another definition focuses on profit- maximizing behaviour.

Building Critical Loss Intuition Consider these facts. A firm is considering a price increase of the only product it owns. P = $1Q = 100 marginal cost = 10 cents, Fixed costs = $10, Profit = $80 * (note that fixed costs are irrelevant for the purpose of this example but they are included for completeness) If prices rise by 5% then P New = $1.05 If profit is to be no less than $80, then Q New can be no less than That is, the actual loss can be no greater than = Thus, 5.27 is the critical loss. If the firm loses more than 5.27 units in response to the 5% price increase then price increase is unprofitable.

Applying Critical Loss Analysis in Three Steps  Estimate critical loss  Estimate actual loss  Compare the critical loss to the actual loss. If …. –Actual loss > critical loss, market must be expanded –Actual loss < critical loss, market definition is sustainable for that price increase.

Critical Loss Mathematics (break-even analysis) Break-even analysis means the profits after the price increase are equal to the status quo. Thus, Define Simplification leads to

General Notes on Critical Loss Various formulae have been developed –Generally little difference among the predictions for small price changes. –Key parameters are the margin and the price increase. –Often linear demand is assumed because it is more conservative than the isoelastic demand. –Assumption of an isoelastic demand curve tends to generate large predicted price increases.

Demand Curve Shapes Constant Elasticity Linear P Q

Critical Loss v. Critical Elasticities Compare critical elasticities to demand elasticities Compare critical loss to the actual loss in demand Critical loss is more commonly used than critical elasticities because it is more intuitive in many people. Its weakness is that a variety of threshold (5%, 10%, etc.) must be evaluated. Critical elasticities have one key advantage vs. critical loss. That is, if demand is more inelastic than the critical elasticity then you know that a hypothetical monopolist would raise the price by at least the thresh-hold amount (usually 5%). Thus, you need not check a variety of price changes.

Critical Elasticity The break-even critical elasticity is the maximum elasticity of demand a monopolist could face at pre-merger prices and still not experience a net reduction in profit from a given price increase, e.g., 5%.

Critical Elasticity Formulae 1 Demand CurveProfit Maximization Break-even Linear Demand Constant Elasticity 1.Werden, Gregory, “Demand Elasticities in Antitrust Analysis”, Antitrust Law Journal, 66.

Critical Elasticities of Demand for a 5% Price Increase Demand Curve Pre-merger Price Cost Margins 0%40%50%60%70%100% Profit Maximization Linear Constant Elasticity Break-even Linear Constant Elasticity 

Critical Loss Formulas 1 Demand CurveProfit Maximization Break Even Linear Constant Elasticity 1.Werden, Gregory, “Demand Elasticities in Antitrust Analysis”, Antitrust Law Journal, 66.

Critical Loss for a 5% Price Increase (measured as a percentage) Demand Curve Pre-merger Price Cost Margins 0%40%50%60%70%100% Profit Maximization Linear Constant Elasticity Break-evenAny curve

Break-Even Critical Loss (Any Demand Curve) Price increase Margin 1%3%5%8%10%15%20%25% 10% % % % % % % %

Profit-maximizing Critical Loss (assuming linear demand curve) Price increase Margin 1%3%5%8%10%15%20%25% 10% % % % % % % %

Implications of Critical Loss Formulae Large margins imply a small critical loss –This basic finding is simple algebra. –Large margins do not necessarily imply a “broad market” definition as demand may also be highly inelastic. Litigation difficulties –Courts have had difficulty understanding the governments complaints in large margin industries. –Many cases have been lost by US agencies.

Applying Critical Loss to a Single Firm: An Example A firm’s current margin is 25%. It is considering a 7% price increase. What is the break-even critical loss? What is the break even critical elasticity? What assumption did you have to make? Answers on next slide.

Answers to Single Firm Hypothetical Assuming the demand curve is linear, we know that the This means that if the firm loses more than 21.9% of its sales in response to a 7% price increase that that price increase is unprofitable. Alternatively, if the demand facing the firm is more elastic than we know that a price increase of at least 7% is not profitable.

Applying Critical Loss to Define the Antitrust Market Two firms are merging. We would like to know if they form a relevant antitrust market. The pre-merger margin for each firm is 35% and the relevant price increase is 5%. What is the critical loss? What is the critical elasticity?

Answers to Market Definition Hypothetical Assuming the demand curve is linear, we know that the This means that if the combined firm loses more than 12.5% of its sales in response to a 5% price increase that that price increase is unprofitable. Alternatively, if the demand facing the combined firm is more elastic than 2.5 we know that a price increase of at least 5% is not profitable.

What are the Key Issues in Estimating the Critical Loss? Margin estimation –Differences between economic and accounting costs. –Econometric estimation of costs functions is unrealistic. –Therefore, use accounting data but check to see if the margin that is calculated corresponds (approximately) with firms internal pricing decisions. Price increase –Price increase estimated for competitive effect should roughly comport with the one used to define the market. –Candidate market may fail loss tests for small price increases, but pass for large ones, or vice versa. U.S. v. Mercy Health Services –Judged used a 5% price increase even while DOJ claimed that a 20-30% price increase was likely. Judgement for defendant.

Estimating Actual Loss: Key Information Sources Estimating consumer responses to a price increase is a complex undertaking. Useful information comes from: –Testimony, –Business documents, –Survey evidence, –Customer switching analyses, and –Econometric estimates of demand elasticities. Competition agency needs to choose the most credible information source or sources in estimating actual loss. Courts often fail to appreciate the role of diversion to products inside the candidate market. In other words, the actual loss is often less than what it would otherwise appear to be. THIS IS A KEY ISSUE and one which is discussed much more below.

Determining Relevant Market Once the actual and critical loss have been estimated, determining whether the candidate market is indeed the relevant market is straight forward. –Compare actual loss to critical loss. –If actual loss is less than critical loss then candidate market is the relevant market. If not, then the market must be expanded.

Consistency Counts! Consider these facts –Merger between A and B –Each firm has constant and equal marginal costs of production –Neither firm has reached a binding capacity constraint –Margins for firms estimated at 50% –Estimate of aggregate demand elasticity is 3 within 5% of pre-merger price. Facts imply –Break-even critical elasticity = Therefore, the candidate market must be expanded because demand is more elastic than the critical value. –Facts also imply hypothetical monopolist margin of 33% = 1/3. –But note: The monopolist mark up is LESS than the firm’s mark up. 1 Conclusion –Demand elasticity estimates are wrong or margin calculation is wrong. –Sheffman, Harris and others argue for a “kinked demand curve.” 1. Example from Daniel P. O ’ Brien and Abraham L. Wickelgren, The state of Critical Loss Analysis: Reply to Scheffman and Simons, The Antitrust Source, March 2004.

Critical Loss Summary Defendants will often trivialize critical loss by changing the units. For example, the critical loss for a 5% price increase in a typical hospital merger case may only 2 patients per day. Critical loss is commonly applied by both defendants and plaintiffs. Margin and demand elasticity estimation is difficult. Critical loss can be used for both market definition and assessing competitive effects. Critical loss methodology can be used to assess coordination concerns. Care must be taken to account for diversion to products inside the candidate market.