Download (04/28/2016) Unilateral Effects in Horizontal Mergers

Unilateral Effects In Horizontal
Mergers
Jeffrey Prisbrey
Charles River Associates
April 28, 2016
Types of Mergers
• Horizontal
– The products of the firms are substitutes
• Vertical
– The products of the firms are complements
• Conglomerate
– The products are unrelated
Categories of Effects
• There are unilateral effects if the postmerger firm would change its behavior on
its own unilaterally.
• There are coordinated effects if the postmerger firm would change its behavior in
coordination with other market
participants.
The Goal of Merger Analysis
• There can be both positive and negative effects
from a merger.
• For example:
– A merger may eliminate a competitive constraint and
give the post-merger firm an incentive to increase
prices.
– And, a merger may lead to marginal cost savings and
give the post-merger firm an incentive to lower prices.
• Merger analysis weighs the negative and positive
effects against each other to come up with a net
effect.
Unilateral Effects in The
Horizontal Merger Guidelines
• §6 of the HMGs describes unilateral effects in
several situations:
– in markets with differentiated products
– in markets where sellers negotiate with buyers or
prices are determined through auctions
– relating to reductions in output or capacity in
markets for relatively homogeneous products
– arising from diminished innovation or reduced
product variety
• My plan is to give an introduction to the first
two of these.
Markets with Differentiated
Products
• In markets with differentiated products, some
products are closer substitutes than others.
• The “ready to eat cereal” market is an example.
– If the price of Wheaties increases, more Wheaties
customers might switch to Corn Flakes than to Lucky
Charms.
• Other examples abound:
–
–
–
–
Automobiles
Baby food
Restaurants
Grocery stores
Diversion Ratios
• Diversion ratios are a way to measure how close
substitutes are.
• The diversion ratio from Product 1 to Product 2 is the
percentage of lost customers that switch to Product 2 if
the price of Product 1 increases.
• For example, if Product 1 loses 10 customers due to a
price increase, and 5 of those switch to Product 2, then
the diversion ratio from Product 1 to Product 2 is 50%.
• Close substitutes have relatively higher diversion ratios.
Optimal Price Setting
• As a firm increases its price:
– It gains profits from customers that continue to
buy at the higher price.
– It loses profits from customers that switch to
substitute products.
• As long as the gain is more than the loss, the
firm will increase its price.
• What if a firm decreases its price?
Optimal Price Setting
(continued)
• At the optimal price, the amount the firm would gain from a
price change is exactly equal to the amount it would lose.
– If it increased price, it would not gain enough from customers that
continue to buy to make up for the loss from customers that
switched.
– If it lowered price, it would not gain enough from new customers to
make up for the loss from customers that would have continued to
buy.
• When the gain and loss are equal, the firm has no incentive to
change price.
• What if the gain and loss are not equal?
Upward Pricing Pressure
• When one firm merges with another that offers a substitute
product, the firm’s optimal prices for its products change.
• Because the now jointly owned products are substitutes,
some diverted customers that would have been lost if prices
were increased pre-merger are now recaptured.
• Now, if the firm increased the price of its product:
– the gain from customers that would continue to buy doesn’t
change, but
– the loss from customers that switch is lower.
• Since the gain now outweighs the loss, the post-merger firm
would have an incentive to increase price.
• This is called upward pricing pressure or UPP.
The Value of Diverted Sales
• Pre-merger, a lost sale would be worth nothing to the firm.
• Post-merger, a lost sale would be worth something, because
some sales would be diverted to the acquired products.
• The value of diverted sales is:
D12 * (p2 – c2)
where:
D12 is the diversion from product 1 to product 2
p2 is the price of product 2
c2 is the marginal cost of product 2
• Is this dollar amount big or small?
The GUPPI
• Gross Upward Pricing Pressure Index or GUPPI
• D12 * (p2 – c2) / p2 * (p2 / p1)
or
D12 * (p2 – c2) / p1
• The GUPPI is the value of diverted sales as a
proportion of the value of lost revenue.
• Can the GUPPI be used as a screen?
• Some have suggested that < 5% is small, while >
10% is big.
Caveats
• GUPPIs are always positive – they
implicitly assume other things are
constant:
– No change in marginal costs due to
efficiencies
– No entry or expansion
– No product repositioning
• Each of these factors (and others) can
cause downward pricing pressure.
Compensating Marginal
Cost Reduction
• Efficiencies can lead to lower marginal costs for the postmerger firm, and lower marginal costs provide an incentive to
lower prices.
– If a firm lowers price, the loss from customers that would have
purchased remains the same, but the gain from new customers
increases.
• The cost savings that exactly offsets the upward pricing
pressure is known as the Compensating Marginal Cost
Reduction or CMCR.
• Thus the CMCR is equal to the value of diverted sales. Or,
the CMCR / revenue is equal to the GUPPI.
• The CMCR does not depend on entry, exit, other prices, etc.
Merger Simulation
• A simulation can do more that show upward
pricing pressure – it can provide an estimate of a
price change.
• Unlike the GUPPI, allows other market participants
to respond to the merger by changing price or
output.
• More complicated simulations can also incorporate
entry, repositioning, and efficiencies.
• Still requires assumptions, in particular about
demand curve.
Example of a Bidding
Market
• A buyer wants to purchase a large turbine for
generating electricity.
• The buyer holds an auction, where it awards a
contract to the lowest bid that meets its
specifications.
• A handful of firms have the technical capability to
participate.
• The firm’s bids can be arrayed by the buyer from
lowest to highest.
• How will a merger between two of those firms
affect the outcome for the buyer?
Information is Key
• If there is complete information – everyone
knows the order of the bids – then a merger
between the lowest and second lowest bidder
will allow the lowest bidder to charge a higher
price, and other mergers will not affect the
outcomes.
• But if the order of the bids is uncertain, then
you can estimate diversion ratios (based on
the probability of winning) and we are back to
GUPPIs.
What didn’t we do?
• We did not do market definition.
• We did not count firms.
• We did not calculate HHIs.
• What is your reaction to what I left out?