Market Definition & DOJ’s Approach to Mergers

Market Definition & DOJ’s Approach to Mergers What Constitutes a Market? When Does A Merger Concern DOJ?

Markets & Mergers • If Coke & Starbucks are unrelated goods, then merger for market power is a non-issue. • If Coke & Dr Pepper compete "in the same market" then MFM is an issue and antirust authorities may act. • Definition of what constitutes a market is critical

Proposed Methods of Defining Markets • Cross-elasticities • If increase Pcoke causes increase DDpepper they are in same market • But how strong must this be? • Price Correlations • If we observe that prices of Coke and Dr. Pepper move together, they are affected by the same forces, and hence might be considered in same market.

DOJ’s Approach to Market Definition • Two or more goods define a market if a significant, collusive, price increase of these goods would be profitable. • Example: let the lemonade market be competitive w/ 1000s of identical sellers.

If two lemonade firms were to collude on their own (or merge), their attempt to raise price would be futile. • If Coke (which has market power) purchases a lemonade firm and substitution is weak, a price increase would not be profitable. • But if Coke bought Pepsi? • Raising prices would raise profits, so they are in the same market.

Geographic Considerations • Many markets are local • A merger of 100 gas stations spatially dispersed across S. Carolina would not cause concern • A merger of 100 gas stations in the Clemson – Seneca – Anderson would create significant market power • How does DOJ consider local conditions?

Demand substitution • Can consumers substitute purchases elsewhere? • Yes for mail order items • No for gasoline • Can consumers buy something else? • Yes for Earl Grey Tea • No for gasoline • Supply substitution • Will other suppliers elsewhere pick up the slack? • Yes for • No for gas • Will quick entry be likely if none of the above margins of substitution are operative? • Are there market or legal barriers to entry (permits, environmental restrictions)?

DOJ/FTC MERGER GUIDELINES • Est. in 1968*, revised periodically since • Provide a screen: "mergers should not be permitted to create or enhance market power or to facilitate its exercise…." • Also useful to firms contemplating efficient mergers: "Agency seeks to avoid unnecessary interference with the larger universe of mergers that are competitively beneficial or neutral

5 Step Method of Application • Step 1. Market Definition & Concentration • A market is defined by the following procedure: • Could a small (say 5 per cent) price increase, if maintained, be profitable? If not, add the next closest substitute. Continue until the answer is affirmative. • Example: • Natural Light beer in cans (switch to NL bottles and other cans of light beer) • Natural Light beer (people switch to other cheap light beers) • Cheap Light beer (people switch to other cheap beers and other light beers • Light beer (people switch to other beers)

Measuring Market Concentration • Herfindahl Index • H = Σ Si2 • H with identical firms • Monopoly: Si2 = 1002 = 10000 • Duopoly: 2(Si2) = 2*502 = 5000 • 4 firms: 4(Si2) = 4*252 = 2500 • General: H = N(100/N)2 = 10000/N • Example: for N = 10, H = 1000

Herfindahl Index & Scrutiny of Mergers • Three Classes of Markets for Merger Challenges • Un-concentrated Markets: H < 1000 • no merger challenges • Moderately Concentrated: 1000  H  1800 • only mergers that raise H by 100+ points get scrutiny • Concentrated: H > 1800 • ΔH < 50: no scrutiny • Δ H > 50: scrutiny • Δ H > 100: challenge likely: "such mergers are likely to create or enhance market power or facilitate its exercise," thus subject to scrutiny and must meet additional requirements to avoid a challenge

Herf & Concentration Example • Example: Merger of two firms in a market with 8 firms of equal size: • H = 10000/8 = 1250 • Market is moderately concentrated • H’ = 6*12.52 + 252 = 1462.5 • ΔH = 212.5 so merger gets scrutiny

Step 2: Adverse Competitive Effects • Does merger raise concerns in light of failing the test in Step 1? • -- i.e. will price be likely to increase? • i) "coordinated interactions" -- does merger increase likelihood of collusion? • ii) "unilateral effects" -- does merged firm have sufficient market power to profitably raise price ? • If not, merger ok. If so, then Step 3:

Step 3: Entry • Is timely entry likely in the event of a price increase? • Timeliness: < 2 years • Likelihood: Do incumbents control essential assets? Other barriers? • Sufficiency: Assess sales opportunities at min efficient scale & pre-merger prices • If merger fails to pass this hurdle, it is in trouble, but there are still a few "outs" left

Step 4 : Efficiencies • The merging companies can make a case that the merger creates substantial cost-savings and should be permitted on those grounds • This is a high hurdle as many claims are viewed with skepticism by DOJ

Step 5: Failing Firm Exception • Two prong test: • i) acquired firm must be failing • ii) no less anticompetitive partner is available • DOJ must be convinced that assets of failing firm would otherwise exit the market and be unused • follows the S. Court decision in Citizen Publishing (1969) where two Tucson newspapers were denied the right to merge

Recent Applications • Coca-Cola-Dr. Pepper (1986) • Staples-Office Depot (1997) • Exxon-Mobil (1999) • Chevron-Texaco (2001)

Summary & Commentary on Merger Guidelines • Guidelines are warning flag to MFM practitioners • Systematic process implies approval for clearly benign mergers • Most injunctions stop mergers • Market definition remains contentious in contested cases • Still, Big Improvement over earlier practice

Market Definition & DOJ’s Approach to Mergers