REVIEW:LECTURES 11.1, 11.2 AND 12.1 MARKET DEFINITION AND HORIZONTAL MERGERS Review17 October 2013 Date ANTITRUST ECONOMICS 2013 Alexis G. Pirchio CPI Elisa Mariscal CIDE, Global Economics Group

2 Overview Review Role of Market Definition Competitive Constraints and Two-Sided Market Definition Legal and Economic Background on Mergers

Role of Market Definition 3

4 Market Definition and Market Power Market power is important for assessing whether a firm has the incentive and ability to engage in anti-competitive behavior and whether merger will result in an increase in market power Market power depends on the constraints that a firm faces in increasing the price of a product profitably; these constraints typically involve substitutes in demand and changes in supply by other firms. The “relevant market” identifies the producers the impose significant constraints on the power or a firm or group of firms to raise price profitably. Market definition is primarily (perhaps solely) used for the purpose of helping the courts and competition authorities assess dominance/market power.

5 Market Definition and Context Identifies sets of firms, substitution patterns, and strategic relationships among firms. Market definition provides a context for examining firm strategies Market definition limits the discussion of rival products and firms to a manageable group. Firms in the market A, B, C, D, E Firms outside of the market: F, G, H, … F G H

6 Hypothetical Monopolist Test Is a “market” worth monopolizing? If yes, then the substitutes outside the “market” must be weak If no, then the substitutes outside the “market” must prevent the exercise of market power  Thus the group worth monopolizing pulls in all of the relevant substitutes. Logic of the test Start with the narrowest candidate market and assume that there is a monopoly supplier Could this hypothetical monopolist profitably impose a “small but significant not-transitory increase in price” (SSNIP)? Yes  Candidate Market = Relevant Market No  Candidate Market < Relevant Market  Include the closest substitutes and repeat the test This means that too many customers switch to demand-side or supply-side substitutes Implementing the test

7 How to Proceed? Demand-side then supply-side Potential substitute products Demand-side 1 2 A Candidate Market B C D 3 A+B+C Supply-side S1S1 S2S2 A+B+C A+B+C+S 1 X X

8 Critical Loss Analysis is a Method for Implementing SSNIP Test in Practice Step (1)—Profits, output, and sales before the price change for hypothetical monopolist (e.g. products A and B). MC$10 $ Price Quantity Profit = ($20 - $10) x 100 = $1,000

9 Step (2): How many units of sales would have to switch to substitutes to make a 10% price increase just unprofitable? Suppose the answer is slightly more than16.7 (with roughly break even). MC$10 $ Price Quantity $ If fewer than 16.7 units of sales switch than a 10% price increase is profitable Critical Loss Analysis is a Method for Implementing SSNIP Test in Practice Profit = ($20 - $10) x 100 = $1,000 Profit = ($22 - $10) x = $999.96

10 Critical Loss Analysis Depends on Customer Switching—an Example of a Calculation How many customers have to switch to substitutes to make a 10% price increase unprofitable? Initial price = $20; MC = $10; Profit Margin = $10; Quantity = 100; Profit = $10 x 100 = $1,000 New price = $22; MC = $10; Profit Margin = $12; Quantity = 83.33; Profit = $12 x ≈ $1,000 Consider this example If sales fall by less than 16.7% the price increase is profitable Candidate market is then no wider than the relevant market (i.e. a smaller market could have a profitable price increase too). If sales fall by more than 16.7% the price increase is unprofitable Candidate market is too narrow (one can also say that the true market is even broader than the candidate market). The “critical loss” is 16.7%--this is the dividing line. This implies that:

11 Comparison of Actual Versus Critical Loss Determines if Market is Large Enough to be Monopolized. Critical Loss Actual loss greater than critical loss Implies price increase is unprofitable so assumed “market” can’t be profitably Monopolized and is therefore too small. Actual loss less than Critical Loss implies that price increase is profitable so assumed “market” can be profitably monopolized. Market is therefore at least this narrow.

Competitive Constraints and Two-Sided Market Definition 12

13 The “Other” Side Acts as a Price Constraint If a platform increases the price on side A that will not only reduce demand on side A but also—through the indirect network effects — demand on side B. The loss of demand on side B degrades the value of the platform to side A, leading to a further reduction in demand by side A customers. The complementary side B therefore magnifies the effect of a price increase on side A. Demand on side A is more elastic after taking the cross effect into account.

14 Avoid Excluding One Side of the Platform From Analysis Consider a unilateral practice that concerns one side of a two- sided platform business. Traditional market definition would start with the product/service for that side and define a market that only concerned that side. It would therefore exclude the other side of the platform from the analysis. As a result the analysis would be forced to ignore the interlinked customer sides and other relationships.

15 Single-Sided Market Definition Tools Don’t Apply The analytical machinery for the traditional SSNIP test is based on the simple price-cost markup rule that percent markup is equal to the inverse of the elasticity of demand for the product. The formulas for actual and critical loss are based on the simple markup rule. The formula for diversion ratios is based on the simple markup rule. Since the simple markup rule does not apply for two-sided platforms other formulae that are based on that rule do not apply for two- sided platforms.

16 Key Lesson: Avoid Approaches that Result in the Exclusion of a Customer Side from the Analysis Mechanical approaches such as traditional SSNIP may exclude important economic relationships coming from the other side of a two-side platform. Could obscure linkages that provide additional avenues for consumer harm or additional sources of efficiencies. Could ignore linkages that provide significant constraints on market power.

Legal and Economic Background on Mergers 17

18 Horizontal vs. Vertical Mergers Horizontal merger of B and C in market of A, B, and C which have substitutable products Vertical merger of A and f where f supplies a downstream service to A. AB C e f

19 Possible Benefits of Mergers Permit the exchange of property to higher valued uses ; ultimately mergers are about selling property. (Why is Nokia selling and Microsoft buying Nokia’s handset unit?) Acquirer finds it cheaper to buy than to build (Why did Facebook buy Instagram?) Mergers can generate economies of scale and scope ; reduce duplicative costs; create synergies through complementary technologies. (One of the arguments for EU efforts to break down national boundaries e.g. in capital markets.) Encourage innovation and investment ; an acquisition provides major potential source of reward for the target. (eBay just bought processor Braintree for $800m providing exit for Braintree’s entrepreneurs and investors.) Mergers and takeovers—and the mere threat of them—can discipline corporate management and thereby solve separation of ownership and control problem (CEO loses job in takeover, would like to avoid that.)

20 Possible Harm from Mergers Mergers could increase prices and reduce output through increased concentration. Merger to monopoly is the extreme case. Mergers could also reduce innovation, service, and other desirable non-price aspects of competition. Mergers could increase entry barriers and thereby result in durable market power. Vertical mergers could facilitate the extension of market power from one market to another or help maintain market power through control of essential suppliers.

21 Example of Calculating HHI and Change in HHI Pre-Merger FirmShare A50% B25% C15% D10% HHI3450 Post-Merger FirmShare A50% B+D35% C15% HHI3950 HHI (Pre) = = 3450 HHI (Post) = = 3950 Change in HHI = 500

22 OFT’s Merger Guidelines HHIInvestigate? < 1,000NO > 1,000 and <1,800 YES IF  HHI > 100 NO OTHERWISE > 1,800 YES IF  HHI > 50 NO OTHERWISE HHI and Change in HHI Serve as Screening Devices

23 Unilateral vs. Coordinated Effects Unilateral effects : The acquiring firm may raise price because the merger gives it more market power. Coordinated effects: The merger either strengthens or makes possible tacit collusion among firms thereby leading to an increase in price. A given merger could involve either or both types of effects.

24 Mergers are presumed to be pro-competitive Mergers are commonplace in the market economy. Most are not examined by competition authorities because they do not involve large enough acquirers or targets. Most mergers that are examined by competition authorities are cleared without conditions. A few are cleared after the divestiture of some overlapping products. Mergers are an integral part of the market process and are presumed to foster competition and innovation. In practice, merger prohibitions are a small fraction of all mergers— but without rules there would likely be many more problematic mergers. Firms seldom propose 3-2 mergers, for example.

25 Merger of Firms in an Oligopoly Industry with Homogeneous Demand In an oligopoly industry (with Cournot competition) market price is lower than a monopolist would charge, but higher than the competitive price so each firm has some degree of market power Deadweight loss is also lower than that in the monopoly case in the same market, but still positive qCqC D(P) COMPETITION COURNOT MONOPOLY Q Q COURNOT q M A,B MC P PMPM P COURNOT

26 Consequences of a Reduction in the Number of Firms with Homogeneous Products Higher prices Lower output After a merger, we see: How significant is the effect? Is it counteracted by efficiencies? But: qCqC D(P) COMPETITION N = 2 MONOPOLY Q qMqM MC P PMPM Basic economic theory shows that reducing the number of firms results in higher prices (Cournot Model) N = 3 N = 4

27 Efficiencies and Merger to Monopoly Dead Weight Loss Surplus from cost savings Surplus transferred from consumers to producers Demand Pre-merger Marginal Cost Post-merger Marginal Cost MR Consider also when marginal cost decreases from $3.00 to $2.50 Q Pre P Pre P Post Q Post In this example price to consumers increases and social welfare declines less than consumer welfare because of efficiencies. The firms in a competitive industry with p=MC are all bought up and merged into monopoly.

28 Efficiencies and Merger to Monopoly Dead Weight Loss Surplus from cost savings Surplus transferred from consumers to producers Demand Pre-merger Marginal Cost Post-merger Marginal Cost MR Consider also when marginal cost decreases from $3.00 to $1.50 Q Pre P Pre P Post Q Post In this example price increases, consumer welfare declines, but social welfare increases because the efficiency benefits outweigh the deadweight losses to society.

29 End of Review, Next Class Topic 12.2 Topic 12.2 Unilateral Effects: Economic Evidence Coordinated Effects: Economic Theory and Evidence Topic 13.1 Price Discrimination and Other Complex Pricing Limit Pricing