1. From Market Concentration to Market Outcome: The evolution of US antitrust agency horizontal merger guidelines Russell Pittman Antitrust Division, U.S. Department of Justice and New Economic School, Moscow Presented at Seoul National University, Sookmyung Women’s University, and Korea Fair Trade Commission October 2010 The views expressed are not purported to represent the views of the U.S. Department of Justice.

2. Timeline 1968: U.S. Department of Justice Merger Guidelines 1982: U.S. Department of Justice Merger Guidelines 1992: U.S. Department of Justice and FTC Horizontal Merger Guidelines – 1997: revision and expansion 2010: U.S. Department of Justice and FTC Horizontal Merger Guidelines

3. 1968 Guidelines: Concentration rules Emphasis on market structure, especially 4-firm concentration ratio – “[T]he primary role of Section 7 enforcement is to preserve and promote market structures conducive to competition. Market structure is the focus of the Department's merger policy….” – Consistent with the “structural presumption” in the law: Brown Shoe and Philadelphia National Bank Market definition relatively informal, intuitive – “A market is any grouping of sales …in which each of the firms whose sales are included enjoys some advantage in competing with those firms whose sales are not included. The advantage need not be great….” Specific concentration levels triggering challenge remarkably low

4. 1968 Guidelines, continued Market Highly Concentrated (CR4  75%) Market Less Highly Concentrated (CR4  75%) Note misleading appearance of precision: Product and geographic markets must be defined Acquiring FirmAcquired Firm 4%4% or more 10%2% or more 15% or more1% or more Acquiring FirmAcquired Firm 5%5% or more 10%4% or more 15%3% or more 20%2% or more 25% or more1% or more

5. 1982 Guidelines: Hypothetical monopolists and collusion Unifying theme: “market power” replaces “market structure” Market definition: “Hypothetical monopolist test” – “Smallest relevant market” – Succession of “next-best substitutes” HHI replaces CR4 – Market share, levels and changes in concentration remain important – Again arguably a misleading appearance of precision “Plus factors” reflect focus on likelihood of collusion, i.e. “coordinated effects” – Stigler, “A Theory of Oligopoly”

6. 1992 Guidelines: Unilateral effects FTC now joins DOJ in jointly issued Guidelines “Competitive effects” now separate “coordinated interaction” from “unilateral effects” – Emphasis shifting from homogeneous to differentiated products – Hotelling-style analysis – “Closeness of the Products of the Merging Firms”: cross-price elasticity of demand, or “diversion ratio” – “Repositioning”

7. 1992 Guidelines, continued Concentration, measured as HHI, remains important – In unilateral effects context, market share interpreted as informative of diversion ratio – Willig, “Merger Analysis, Industrial Organization Theory, and Merger Guidelines” Entry analysis becomes more sophisticated – Timely, likely, and sufficient 1997 amendments: Expanded treatment of, and increased emphasis on, efficiencies

8. 2010 Guidelines: From hedgehog to fox “Merger analysis does not consist of uniform application of a single methodology” Market definition, market share, and concentration remain important… – … but mostly in coordinated effects cases – “Smallest market” and “next-closest substitute” principles de-emphasized In unilateral effects cases, focus moves to “extent of direct competition between the products” – New emphasis on diversion ratios and margins – Market shares no longer assumed to be good proxies for diversion ratios

9. At the profit-maximizing price, the marginal benefit from an increase in price must be exactly offset by its cost (in terms of lost profits) Because fixed costs don’t enter into this cost-benefit analysis, they play no direct role in price setting Fixed costs do affect prices through entry A Geometric Interpretation Price Quantity Demand Incremental (Marginal) Cost $10 Benefit of Small Increase in Price Cost of Small Increase in Price

10. Fixed Costs $6,000 Profit $3,000 Demand 100 $100 Variable Profit $9,000 85 $90 Entry of Differentiated Competitors Price Quantity Incremental (Marginal) Cost $10 Variable Profit $6,800 $85 80 Variable Profit $6,000 Fixed Costs $6,000 Profit $800 Fixed Costs $6,000 Profit = $0*

11. Monopolistic Competition Theory dates back to Chamberlin (1933) As additional firms enter, profits erode until firms break even – i.e., earn a normal, risk- adjusted rate of return on their capital These firms still have market power in a technical sense – Because each firm faces downward sloping demand, it can profitably set price above its incremental costs – The competitive price in such markets includes a margin to allow for recovery of fixed costs

12. A Merger (Without Efficiencies) Price Quantity Demand Incremental Cost $10 Benefit of small increase in price Cost of small increase in price Firms A and B merge Consider the merged entity’s incentive to raise the price of A’s product Price Quantity Demand Incremental Cost $10 Firm A Firm B An additional benefit (or reduced cost) when A’s price is increased PRE-MERGER POST-MERGER

13. The green rectangle is the value of diverted sales It is the product of two separate terms The sales lost by A that are subsequently recaptured by B. All else equal, the greater the diversion between A and B, the greater the size of this term. The margin on product B The second term is entirely intuitive, even if it receives less attention than diversion in the 1992 HMGs Both terms must be non-trivial for significant effect A Closer Look at Recaptured Sales Margin on B’s product Sales lost by A and recaptured by B

14. How much has changed with the new Guidelines? (Remember my initial disclaimer) On paper, the 2010 Guidelines look very different from the 1992 Guidelines In practice, they reflect already existing gradual evolution of agency practices We’ve always sought whatever best reflects reality in particular setting – Example: Natural experiments – Example: Merger simulation – Example: Critical loss analysis Accurate presentation of complexity better than misleading presentation of precision

15. Recommended reading George Stigler, “A Theory of Oligopoly,” Journal of Political Economy 72 (1964) Robert Willig, “Merger Analysis, Industrial Organization Theory, and Merger Guidelines,” Brookings Papers on Economic Activity: Microeconomics (1991) Gregory Werden, “The 1982 Merger Guidelines and the Ascent of the Hypothetical Monopolist Paradigm,” Antitrust Law Journal 71 (2003) Carl Shapiro, “The 2010 Horizontal Merger Guidelines: From Hedgehog to Fox in Forty Years,” Antitrust Law Journal 77 (2010)