Some Unexpected Implications of the Draft Horizontal Merger Guidelines

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Barry C. Harris, EI’s Chairman of the Board, is a former Deputy Assistant Attorney General for Economics at the Antitrust Division of the United States Department of Justice.

The focus of the draft Guidelines is quite different from that of the 1992 Guidelines. The draft Guidelines describe the principal analytical techniques and the main types of evidence on which the Department of Justice and Federal Trade Commission (the Agencies) usually rely to predict whether a horizontal merger may substantially lessen competition, while the 1992 Guidelines describe the analytical framework and specific standards used by the Agencies. The draft Guidelines further indicate that “merger analysis does not consist of uniform application of a single methodology” but rather “is a fact-specific process through which the Agencies…apply a range of analytical tools.” While largely retaining the unifying theme of the 1992 Guidelines to prevent the increase of market power, the draft Guidelines are more of a discussion of the “tool kit” the Agencies employ.

The draft Guidelines identify a range of techniques, including many that are not directly contemplated in the 1992 Guidelines. While the changes embodied in the draft Guidelines probably will make challenges by the Agencies more likely, some of the newly introduced techniques may affect the outcome of merger analysis in ways not contemplated by the Agencies. These techniques include the use of value added to measure price (Section 4.1.2); geographic markets based on the location of suppliers (Section 4.2.1); the introduction of critical loss analysis (Section 4.1.3), particularly when markets are defined by targeting customers; and the introduction of diversion ratios and simulation methods (Section 6.1). This article considers one of these techniques, use of a firm’s product-specific pre-merger profit margins to measure the demand elasticity it faces for that product, and explains why its application may indicate that many mergers have little or no impact on competition.

Section 4.1.3 of the draft Guidelines explains how a theoretical relationship between pre-merger margins and demand elasticity will be used in the market definition process. Specifically, the draft Guidelines state that unless the firms in a market are engaging in successful coordinated interaction, high pre-merger margins normally indicate that each firm’s product individually faces demand that is relatively inelastic and not highly sensitive to price. The draft Guidelines further indicate that high pre-merger margins make it likely that there is little substitution with products outside a candidate market, and, thus, suggest that markets should be defined narrowly.

The presumed relationship between margins and demand elasticities, however, presents some logical complications for the Agencies, in large part because the pre-merger margins of a specific firm can at most reflect the demand elasticity facing that particular firm for a specific product. If a firm’s pre-merger margin implies a low overall elasticity for a product, then it also implies low cross elasticities between that product and every other product, whether the other product is inside or outside the defined market. Importantly, these presumed low cross-elasticities also indicate that the products in the defined market are differentiated and not homogenous and that the products of the merging parties are not close substitutes.

The use of margins to indicate elasticities, however, is unlikely to advance the Agencies’ analysis of unilateral and coordinated competitive effects. Unilateral effects analysis involving differentiated products principally depends on whether the products of merging firms are each other’s closest substitutes. Ascertaining whether products are closest competitors does not depend on the absolute level of the substitution between the products of the merging firms but, rather, on how this substitution compares with the extent of substitution with products of non-merging firms. Ironically, the draft Guidelines make a related point in Section 2.1.4, where it discusses the importance of head-to-head competition between products of the merging firms as being “especially relevant for evaluating adverse unilateral effects.” The pre-merger margins of the merging firms are not useful for this purpose.

These implications for coordinated effects analysis are more striking, since the principal analytical reason to define a market is to evaluate the likelihood of coordinated effects involving relatively homogenous goods, a situation inconsistent with low cross-elasticities. Homogenous products necessarily have high cross-elasticities with each other. Consequently, under the presumed margins-elasticity relationship, high pre-merger margins imply that sellers of these products have successfully coordinated their pricing. Thus, if these high margins have persisted for an extended period, then application of the margin-elasticity relationship implies that successful coordination is likely with or without the merger. While the draft Guidelines indicate mergers should not be permitted to entrench market power, successful coordination that persists for an extended time is already entrenched and unlikely to be affected by the merger.

Historically, an argument that a merger would not harm competition because prices were already at monopoly levels has been rejected by the Agencies, largely because the merger could increase the likelihood that successful coordination would continue. The persistence of high pre-merger margins, however, indicates that the likelihood of successful coordination was already high and will not increase significantly. The reasons for this possible conclusion are discussed in the draft Guidelines, which recognize that successful coordination may reflect market conditions other than the number of competitors. For example, Section 7.2 observes that successful coordination is more likely when a firm’s competitive initiatives can be promptly and confidently observed by its rivals, an observation consistent with the economics literature. Whether these conditions exist typically depends on the nature of a product and its uses, which means that these types of conditions are likely to persist in a particular market. The persistence of these conditions, when coupled with persistent high pre-merger margins and homogenous products is one type of historical event that Section 2.1.2 indicates is informative regarding the competitive effects of a merger. Here the history of the market suggests that a merger that reduces the number of competitors may not significantly affect the ability to exercise market power. The economic literature that applies dynamic game theory to various oligopoly models has noted similar results.

How the new techniques in the draft Guidelines will affect analyses of future mergers is unclear, but some of the effects may be different than are currently anticipated. The use of pre-merger margins to indicate elasticities of demand in particular may have significant implications for competitive effects analysis. In general, this technique will not advance the analysis of unilateral effects. Moreover, it may indicate that a merger is unlikely to cause anticompetitive coordinated effects.