Calibration of Upward Pricing Pressure under the New DOJ/FTC Horizontal Merger Guidelines

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Lona Fowdur is a Senior Economist with EI. She specializes in Applied Industrial Organization, and has analyzed the antitrust implications of several mergers and acquisitions in the energy and health care industries.

The Gross Upward Pricing Pressure Index (GUPPI), a new tool to assess unilateral merger price effects in markets for differentiated products, has become prominent since the release of the new Horizontal Merger Guidelines (2010 Guidelines) by the Department of Justice (DOJ) and the Federal Trade Commission (FTC). This new tool provides a quick, albeit crude, measure of Upward Pricing Pressure, the unilateral incentive for the merged firm to increase prices post-merger. The GUPPI calculation does not rely on market definition or concentration. Instead, it calibrates the value of sales diverted to one merging firm’s product due to a post-merger increase in price of the other merging firm’s product, relative to revenue lost due to fewer sales of the product with the price increase.

For example, suppose Firm 1 and Firm 2, which produce Product 1 and Product 2, plan to merge. While a GUPPI can be computed for each of the products of the merging parties, this example focuses on the incentive to increase the price of Firm 1’s product. The GUPPI’s measurement of Upward Pricing Pressure hinges on two factors: a diversion ratio and the net incremental profits from Product 2. The diversion ratio is an estimate of the degree of substitutability between the products of the two merging firms. Net incremental profit from Product 2 is its price less its marginal cost. To see how the GUPPI works, consider the pricing decision for Product 1. Suppose that a price increase causes the sales of Product 1 to fall by five units. Since Product 1 and Product 2 are substitutes, the price increase also causes some sales of Product 1 to shift to Product 2. The diversion ratio is the ratio of sales gained by Product 2 to sales lost by Product 1. Suppose a five unit decline in the sales of Product 1 causes the sales of Product 2 to increase by one unit; then the diversion ratio is 0.2. Before the merger, Firm 1 would not find the price increase to be profitable because the price of Product 1 was already set at Firm 1’s profit-maximizing level. Firm 1 would not consider the gain in sales for Firm 2 when considering the profits from the price increase. After the merger, however, the merged firm would realize that for every unit of Product 1 it loses due to the price increase, it gains 0.2 units in additional sales of Product 2. The benefits of the increase in sales of Product 2 depend on the net incremental profits from that product. For each unit of Product 1 that it forgoes due to a price increase, the merged entity collects extra profits equal to the product of the diversion ratio and the net incremental per-unit profit from Product 2. Thus, the merged firm has an incentive to increase price that it did not have before the merger.

The GUPPI expresses the incentive trade-off between a gain equivalent to the profits on sales diverted to Product 2 and a loss equivalent to the profits on the foregone sales of Product 1. When the GUPPI is small, the post-merger incentive to increase the price of Product 1, measured by the proportional profits on diverted sales to Product 2, is likely small. The converse is likely to be true with a high GUPPI. Unfortunately, the 2010 Guidelines do not establish any clear thresholds for what constitutes a high as opposed to a low GUPPI or what values are likely to trigger enforcement actions, simply stating, “If the value of diverted sales is proportionately small, significant unilateral price effects are unlikely.”

An advantage of the GUPPI is that it can be extended to include potential efficiencies. Efficiencies reduce the incentive to raise price, producing downward pricing pressure, because they increase the margin on each unit of sales lost due to a price rise. In particular, for every unit of Product 1 that it forgoes due to a price increase, the merged entity loses the efficiency saving on the unit, and the merged firm needs to factor this loss into the pricing decision for Product 1. The reduction in the cost of Product 1 due to the efficiencies can be expressed in the same units as the GUPPI. Hence it is straightforward to include efficiencies in the calculation of the GUPPI to determine whether or not the transaction gives an incentive to raise price.

In spite of their theoretical elegance, GUPPIs provide only a crude and incomplete estimate of unilateral incentives because they disregard other factors that affect a firm’s pricing decision, such as repositioning by non-merging firms, new entry and changes in demand. Furthermore, GUPPIs cannot be used to quantify the extent of a price change post-merger; they merely indicate the change in the merged firm’s incentives to raise prices relative to pre-merger prices. Given the limitations of a GUPPI analysis alone, the 2010 Guidelines specify that the Agencies may also use other tools, such as merger simulation techniques, as well as any other relevant qualitative or quantitative evidence to determine the extent to which unilateral effects would reduce competition. For example, in a paper reviewing the activities of the Economic Analysis Group (EAG) of the DOJ Antitrust Division for 2009 and 2010, Carl Shapiro, then Deputy Assistant Attorney General for Economics at the Antitrust Division of the DOJ, summarized EAG’s analysis of the proposed Baker Hughes/BJ services merger and pointed out that EAG determined that the proposed merger would generate significant upward pricing pressure on the products of the two firms on the basis of a GUPPI calculation. That paper highlights that in addition to the GUPPI analysis, EAG also considered other factors including the elasticity of the residual demand curve, the number of additional firms in the market and capacity constraints.