Antitrust Analysis Using Calibrated Economic Models Gregory J. Werden Senior Economic Counsel Antitrust Division U.S. Department of Justice The views expressed herein are not purported to reflect those of the U.S. Department of Justice

Calibrated Economic Models Are:  Standard economic tools Monopoly and oligopoly models Consumer demand models  Applied in a straightforward way Using known facts (e.g., prices and shares) Making reasonable assumptions

Applications of Calibrated Economic Models In Merger Cases  Market delineation Modeling the hypothetical monopolist with the standard model of monopoly  Merger simulation Modeling oligopoly interaction with a standard model of oligopoly

Applications of Calibrated Economic Models In Non-Merger Cases  Market delineation Non-merger cases may present prospective market power issues just as mergers do  Analyzing competitive effects Modeling can shed light on the impact of many exclusionary practices

Selection and Calibration of Models  Select a model that generally describes the actual competitive interaction  Make necessary assumptions that are (1) supported by data, (2) unimportant, or (3) biased against the modeler  Calibrate the model by fitting it precisely to a “pre-merger equilibrium”

Calibrated Economic Models Sharpen Focus  Models are built on assumptions  Assumptions can and should be tested against the established facts  Modeling indicates: why price effects are large or small how experts reached different conclusions where resources should be concentrated

Calibrated Economic Models Increase Accuracy  Calculation replaces intuition Expert intuition on quantitative matters is a highly unreliable black box Modeling replaces the black box with transparent calculations  Measurement replaces assumption Real-world data is the basis for calculations

Calibrated Economic Models Enhance Persuasiveness  The analysis is firmly anchored in facts Model assumptions are tested against facts Model parameters are based on data  The analysis employs economic science The models are standard economic theory Econometrics may be used Economists do what they normally do

Artful Construction of Calibrated Economic Models  Highly realistic models are useless Calibration most likely is infeasible Predictions most likely are unclear  Useful models capture what matters most over the relatively short run The essence of the competitive process Critical firm and product attributes

Critical Elasticity of Demand and Critical Sales Loss  Indicate how much substitution is too much for the hypothetical monopolist  Qualitative application Providing a lens for viewing qualitative evidence of substitutability  Quantitative application Using demand elasticities estimated from transaction or survey data

Modeling a Hypothetical Monopolist  Demand models Multiple uses with significantly differing elasticities of demand  Cost models Marginal costs that vary with output Fixed costs for blocks of capacity  Multiple prices Disproportionate price increases

Modeling the Unilateral Competitive Effects of Mergers  Select a standard oligopoly model capturing important industry features  Calibrate the model so it perfectly predicts the pre-merger equilibrium  Compute the post-merger equilibrium, which internalizes the competition among merging products

Presumptions of Merger Simulation  Merger simulation presumes that the fundamental nature of the competitive interaction is not changed by a merger.  Merger simulation presumes that everything “outside the model” is unaffected by the merger.

Oligopoly Models Commonly Used in Merger Simulation  Dominant firm Monopoly with respect to residual demand  Cournot Quantity setting with a homogeneous product  Bertrand Price setting with differentiated products  Auctions Non-cooperative bidding

Bertrand Merger Simulation: Model Calibration  Calibrate prices and shares Normally use those prevailing pre merger May project changes “but for” the merger  Calibrate demand elasticities Commonly estimated from scanner data Can be inferred from price-cost margins

Bertrand Merger Simulation: Modeling Demand  Every demand model is restrictive Each has inherent “curvature” properties  Flexibility is a blessing and a curse Trading off bias and variance  The logit model Substitution proportionate to shares

Bertrand Merger Simulation: Checking the Bertrand Assumption  Compare Bertrand price-cost margins with “actual” price-cost margins  Examine substantial differences for the merging products and major rivals  Intensity of competition may not be as implied by the Bertrand assumption

Bertrand Merger Simulation: Continuing Controversies  Multifaceted marketing strategies  Product repositioning  The retail sector  Demand estimation problems

Merger Simulation in Perspective I  Merger simulation is simply a useful device for clarifying the implications of established facts and plausible market conditions.  Merger simulation combines what is known with reasonable assumptions about what is not known, and evaluates their significance in a precise, objective manner by substituting calculation for intuition.

Merger Simulation in Perspective II  Models simplify the world Models are tractable because they simplify Modeling is as much art as science  Calibration is inexact Assumptions fill gaps in measurement Measurement is inherently imperfect  Predictions are useful rough estimates