Class 15 Whiteboard Antitrust, Fall, 2012 Horizontal Mergers Randal C. Picker Leffmann Professor of Commercial Law The Law School The University of Chicago Copyright © Randal C. Picker. All Rights Reserved.

May 15, 2015Copyright © Randal C. Picker2 Decisions According to an Economist n Maximize Utility Subject to Constraints u U(x1,x2,x3, … xn) u Subject to p1x1 + p2x2 + p3x3 + … + pnxn = B u Xi’s are amounts of each good in the market place u Pi’s are prices u B is amount of money to spend

May 15, 2015Copyright © Randal C. Picker3 Buying Diet Cola n Assume u Two relevant goods: Diet Coke and Diet Pepsi u General Form of Utility Function w U(x1,x2) = s(a1x1 + a2x2) u Consumer will spend B on the two products w Budget constraint given by p1x1 + p2x2 = B w B = $10 (set arbitrarily)

May 15, 2015Copyright © Randal C. Picker4 Buying Diet Cola n Three Versions of the Demand Function u The Diet Coke Lover w a1 = 1, a2 = 0 Will never buy Diet Pepsi at any price u The Diet Pepsi Lover w a1 = 0, a2 = 1 Will never buy Diet Coke at any price

May 15, 2015Copyright © Randal C. Picker5 Buying Diet Cola u Brand Doesn’t Matter w a1 = 1, a2 = 1 Either one works and will just buy the cheapest

May 15, 2015Copyright © Randal C. Picker6 Demand: DC by DC Lover Demand Curve 10 P Q Independent of p DP

May 15, 2015Copyright © Randal C. Picker7 Demand: DP by DP Lover Demand Curve 10 P Q Independent of p DC

May 15, 2015Copyright © Randal C. Picker8 Demand: DC by Indifferent Demand Curve 10 P Q When p DP = 2

May 15, 2015Copyright © Randal C. Picker9 Demand: DC by Indifferent Demand Curve 10 P Q When p DP = 5

May 15, 2015Copyright © Randal C. Picker10 Substitutes n Definition u Goods for which demand curve of the first depends on the price of the second n Here u DC and DP aren’t substitutes (at all) for two of our consumers u Perfect substitutes for the third

May 15, 2015Copyright © Randal C. Picker11 Cost Conditions and Extent of Competition n Introduce Costs u Assume no fixed costs u Marginal cost of making DC = 2 u Marginal cost of making DP = 5 n Competitive Structure u Assume both produced competitively so P = MC

May 15, 2015Copyright © Randal C. Picker12 Demand: DC by DC Lover Demand Curve 10 Marginal Cost 2 P Q Independent of p DP

May 15, 2015Copyright © Randal C. Picker13 Demand: DP by DP Lover Demand Curve 10 Marginal Cost 5 P Q Independent of p DC

May 15, 2015Copyright © Randal C. Picker14 Demand: DC by Indifferent Demand Curve 10 P Q When p DP = 5 Marginal Cost 2

May 15, 2015Copyright © Randal C. Picker15 Results n 10 units of DC at $2, 2 units of DP at $5 u DC lover buys 5 units at market price of $2 u DP lover buys 2 units at market price of $5 u Brand indifferent compares price of DC ($2) with price of DP ($5); buys no DP and buys 5 units of DC at $2

May 15, 2015Copyright © Randal C. Picker16 Results n Social Welfare u Add utilities of the the three types, assuming that utilities are measured in dollars u Subtract cost of production n Here u 5s + 2s + 5s – (10 x 2) – (2 x 5) u 12s - 30

May 15, 2015Copyright © Randal C. Picker17 The Mission n What We Can’t See u Utility functions n What We Can See u Behavior changes in response to price changes

May 15, 2015Copyright © Randal C. Picker18 Try It n Assume MC of Making DP Drops from $5 to $4: What Happens?

May 15, 2015Copyright © Randal C. Picker19 Results n DC Lover u No change n DP Lover u Buys more DP; buys 2.5 units rather than 2 n Brand Indifferent u Price of DP above price of DC still u No change

May 15, 2015Copyright © Randal C. Picker20 Results n Social Welfare u 5s + 5s + 2.5s – (10 x 2) – (2.5 x 4) u 12.5s – 30 n Cross-Elasticity and Markets u The price of DP dropped: what happened to sales of DC?

May 15, 2015Copyright © Randal C. Picker21 Results u No change in DC sales u No substitution u Not in same market?

May 15, 2015Copyright © Randal C. Picker22 Next Change n Unilateral Cost-Unrelated Price Increase in DC u Price of Diet Coke rises from $2 to $5 u Price of Diet Pepsi still at $4 n What happens?

May 15, 2015Copyright © Randal C. Picker23 Results n DC Lover u Reduces consumption of DC from 5 units to 2 units; buys no DP n DP Lover u Still buys 2.5 units of DP; 0 units of DC n Brand Indifferent u Price of DC 5 exceeds price of DP 4 u Stops buying 5 units DC, buys 2.5 units DP

May 15, 2015Copyright © Randal C. Picker24 What Does this Mean? n We have seen substitution n We can calculate a cross-elasticity of demand u DP sales increased 2.5 units with an increase in the price of DC from $2 to $5 n Are DP and DC in the same market? What can we say about “market power”?

May 15, 2015Copyright © Randal C. Picker25 Calculating Market Shares n Volume of Diet Pepsi u (2.5 x Number of Diet Pepsi Lovers x Number of Brand Indifferent) x Price of Diet Pepsi n Volume of Diet Coke u 5 x Number of Diet Coke Lovers x Price of Diet Coke n Market Share of Diet Coke: Vol DC / (Vol DC + Vol DP)

May 15, 2015Copyright © Randal C. Picker26 Evaluating Substitution n Are DC and DP Substitutes? u Depends on prices of related products u Not when one product has a cost- advantage over the other (first example) u But exercise of pricing power as to DC induces substitution between DC and DP

May 15, 2015Copyright © Randal C. Picker27 The Cellophane Fallacy n Price Determines Scope of Substitution u Whether products are perceived as substitutes is a function of price. High prices—monopoly power—expand the number of goods that will serve as substitutes. u Actual behavior, given monopoly power, would suggest a broader definition of the market than might be appropriate.

May 15, 2015Copyright © Randal C. Picker28 The Harm of Monopoly Again n Substitution may mitigate reduction in output u Need to focus not only on reduction in DC output but increase in consumption of substitutes u If MC of DC = 2 and MC of DP = 2 and no market power in DP market, Brand Indifferent could switch over completely and drop in DC sales would overstate harm