Econometric Analysis in the Assessment of Coordinated Effects Opportunities and Constraints

1. Identifying Competition ProblemsThe Hague, December 10th 2008 Econometric Analysis in the Assessment of Coordinated EffectsOpportunities and Constraints Miguel de la Mano* Member of the Chief Economist Team Directorate General for Competition, European Commission *The views expressed are my own and should not be taken to represent the views of DG COMP, the European Commission, or any other EU official.

2. Preliminaries • The theoretical explanation of collusion is based on the theory of (non-cooperative) repeated games: • collusion can be an equilibrium in a repeated game if, • the short run profit from deviating from the collusive behaviour is < the long run loss from being punished by the other firms after the deviation. • This applies both to tacit and explicit collusion

3. Repeated interaction • Collusion emerges when firms interact frequently and conjecture that any attempt to undercut the collusive price will be detected and followed by tough retaliation from competitors. • The profit loss imposed on a deviant firm by retaliation must be sufficiently large to prevent the short-term benefits from “cheating” on the collusive arrangement; • These short-term benefits, as well as the magnitude and likelihood of retaliation, depend in turn on the characteristics of the industry.

4. Enforcement Instruments • Cartels • Limited role for econometric analysis in specific cases (per-se illegal) • Role for econometric/quantitative analysis in detection? • Mergers: • Need to distinguish: • Tacit (or explicit) collusion: a state where there is no or only rudimentary competition and • Coordinated effects, i.e. the change in the state of competition. • “A merger may make coordination easier, more stable or more effective for firms, which were coordinating prior to the merger” • In the absence of explicit collusion or a merger: enforcement gap? • Article 81: [concerted practices  tacit collision] ? • Article 82: [collective dominance + excessive pricing  tacit collision] ?

5. Tacit collusion in merger control:An evolving concept • Collective dominance (yes/no test) • Early years: The substantive test of the Merger regulation (creation of strengthening of dominance) applies to collective dominance [Nestle/Perrier,1993] • 1996-1998 - Confirmation of legal basis: Court endorses Commission’s approach in Kali/Salz & Genco/Lohnro • 1999 - Check-list approach: Airtours/First Choice prohibited • A mechanism for tacit coordination (yes/no test) • 2001 - The coordination mechanism: Airtours decision annulled by the CFI • 2004 - Underenforcement?: Sony/BMG cleared. • In the meantime…May 2004. New merger regulation and HMG: adoption of the concept of “coordinated effects” • 2006: Sony/BMG decision annulled by the CFI (Impala judgment): need to proof that no coordination mechanism exists or is unsustainable. Lack of transparency is not enough. • Coordinated effects (a question of degree) • Summer 2008: Impala CFI decision overturned by the ECJ. • September 2008: ABF/GBI: First time since Airtours that the Commission intervenes solely on the basis of coordinated effects.

6. Bringing a coordinated effects case • Must prove: • Firms will likely reach an understanding on the collusive mechanism (arguably the toughest condition) • Collusion post-merger can be sustained (i.e. enforced) • There is a co-ordinated effect (i.e. the merger makes collusion easier, more stable or more effective) • Note that: • If collusion can be shown to exist pre-merger it may be possible to prove (2) and past conduct will provide a basis for identifying (1). But it can be difficult to prove the merger worsens the situation (3) • If there was no collusion pre-merger it may be possible to show that a change in market structure (3) makes collusion more sustainable (2). But, in all likelihood, there is no hard evidence to substantiate (1)

7. How do firms “meet minds” in practice (i.e agree on “one among many” equilibria)? • An analysis of structural factors conducive to competition is insufficient. • Example, is transparency necessary? • Collusion will break due to secret price cuts (Stigler 1964) • Increases probability of detecting deviations • Increases probability of recognising punishment behaviour • With imperfect information Collusion is less sustainable but still arises in equilibrium (Green and Porter, 1984) • But with information about rivals’ sales and profits, imitation of most successful rival leads to the competitive outcome (Vega-Redondo, 1997)

8. Experimental evidence rejects the hypothesis that more information about competitors yields a tendency towards collusion • e.g. Huck et al, 2000. • If subjects have only aggregate information about their rivals’ actions, behaviour converges to the Nash outcome. • Neither in the Bertrand nor in the Cournot case does additional information about rivals’ actions and profits facilitate collusion.

9. 6 groups of 4 per treatment; 40 rounds Frequencies of actions in the last 20 rounds * non-cooperative Nash equilibrium outcome

10. Learning through trial an error to collusion(Huck, Normann, Oechssler, 2004) • Trial & error process: Every time a player increases or decreases his output choice he checks whether this results in an increase or a decrease in profits. • If it increases his profits the movement in this direction is continued. If it does not, it is reversed. • Simple: • it requires fairly low cognitive effort of players. • it does not require any information about rivals. actions or the payoff function of the game

11. (plausible, yet hard to prove)mechanisms to meet minds • Pareto superiority (market transparency and symmetry matter) • Cheap talk (announcements) • Information exchange (public/private) • Status quo (e.g. value of incumbency in liberalised markets) • Regulation (e.g. price caps, standards) • Other focal outcomes • Preserve price differentials • Preserve market or capacity shares • Customer categories • Geographic regions • Vertical restraints (e.g. RPM) • Should it be necessary to pin down the terms of the tacit agreement? or simply to provide persuasive arguments that it is likely some will emerge.

12. Assessing the sustainability of collusion • To measure the influence of the industry characteristics on the sustainability of collusion, we can look at how these industry characteristics would affect this critical threshold • A facilitating factor will reduce this critical threshold, while an industry characteristic that makes collusion more difficult will raise it.

13. (Critical) Factors • Many competitors • the long-run benefit of maintaining collusion is reduced as the pie is shared among many • And the short-run gain from deviation increases, • Low entry barriers • would erode the profitability of collusion. • Firms lose less from retaliation if entry occurs anyway • Frequency of interaction (or of price adjustments) • Allows firms to react more quickly to a deviation by one of them. Thus, retaliation can come sooner. • Relatedly if purchases are lumpy the incentive to deviate is high. • Market transparency • Allows to distinguish deviations from demand shocks

14. (Influential) Factors • Demand growth • today’s profits are small compared with tomorrow’s • Innovation makes collusion on prices less easy to sustain. • It reduces both the value of future collusion and the amount of harm that rivals will be able to inflict if the need arises. • multi-market contacts • increases the frequency of the interaction • it may allow softening asymmetries that arise in individual markets. • may allow the firms to sustain collusion in markets where the industry characteristics alone would not allow such collusion.

15. (More influential) Factors • Capacity constraints have ambiguous effects • a capacity-constrained firm has less to gain from undercutting its rivals….but, • tbcapacity-constraints limit firms’ retaliatory power. • Cost (and capacity) asymmetry (and quality differentiation) • difficult to agree to a common pricing policy. Low cost firms want lower prices and higher market share • the diversity of cost structures may rule out any “focal point” in pricing policies • Low cost firms gain more from undercutting their rivals and have less to fear from retaliation from high-cost firms

16. (More influential) Factors • Horizontal differentiation appears ambiguous. • It limits the short-term gains from undercutting rivals, since it becomes more difficult to attract their customers • It also limits the severity of price wars and thus the firms’ ability to punish a potential deviation. • But likely reduces scope of collusion: it is hard to infer the relevant information from their own prices and quantities • Structural links • Cross-ownership reduces the gains derived from undercutting the other firm. • a firm can punish a deviating partner by investing less in a joint venture

17. Practical difficulties to establish the sustainability of collusion • Many of the relevant quantities cannot be observed directly (collusive profits, deviation profits, punishment loses, discount rate) • Many factors affect these quantities (in different ways and to different degree). Most often, a given market will have some characteristics that facilitate collusion, and some that tend to hinder collusion.

18. The (coordinated) effects of a merger • The merger induces some structural market changes (e.g. the number of firms may decrease, firms may become more symmetric, or a maverick firm might be involved in the merger etc.). • These changes have an impact on the existence of collusive equilibria (i.e. they reduce the critical discount rate threshold above which collusion is sustainable). • E.g. if the punishment becomes more severe, the payoff after deviation will decrease. • Further, the profit from deviation will be smaller when there are fewer firms in the market (as e.g. in a Bertrand-model). Due to these changes in the structural conditions, it is now "easier“ to satisfy the condition for the existence of coordinated equilibria, i.e. the critical discount threshold has decreased.

19. Facilitating factors unlikely to be affected by the merger: • Demand and product characteristics, market transparency or frequency of interaction • Exogenous entry barriers • Buying power (reduces the profitability of collusion and large buyers may be able to break collusion). • Existence of credible commitment not to deviate (e.g. MFC… but can be costly to retaliate) • Existence of credible commitments to retaliate (e.g. Meet competition clauses)

20. “Coordinated-effects of a merger” • Mergers that may (i) facilitate the reaching a common understanding on the terms of coordination (ii) increase the sustainability of collusion by • Reducing the number of participants • Increasing symmetry: it is easier to collude among equals, that is, among firms that have similar cost structures, similar production capacities, or offer similar ranges and quality of products. • Elimination of “maverick” • Creating structural links • Reducing incentives to innovate • Increasing multi-market contacts • Vertical mergers may increase transparency (e.g. regarding input demand) and increase entry barriers

21. ABF/GBI

22. Background • ABF - an international operator mainly active in food sector (including yeast and bakery products): • One of the main yeast producers worldwide • Activities in Spain, Italy, France, Portugal, Belgium and a participation of 50% in a joint venture in Germany (Uniferm) • GBI - one of the main producers, currently owned by Gilde BV, a private equity firm • Gilde divided GBI into two : • sold the european part to ABF (except for UK business) • the remaining worldwide assets to Lesaffre (including UK business)

23. Relevant markets • Three types of bakers yeast • Liquid yeast • Compressed yeast • Dry yeast • Geographic market • National dimension due to strong demand side considerations • Focus on Spanish and Portuguese markets

24. Assessment of Coordinated EffectsA question of degree • Existing degree of coordination • Analysis of structural factors that facilitate tacit collusion • Quantitative proof: Estimation of the conduct parameter across time/markets • Assessment of the coordination mechanism • How the structural factors influence...? • Reaching a common understanding on the terms of coordination • Detection of deviations • Retaliation • Reaction of outsiders • Merger specific effects of the merger (3 to 2; increased symmetry; multi-market contacts) • Economic reasoning • Quantitative proof: Simple assessment of incentives to increase the degree of tacit coordination

25. Payoff analysis • Measure the post-merger payoffs from fully explicit collusion by all potential subsets of the remaining firms in the industry. • Extend unilateral effects analysis (that investigates a change from to n to n-1) can be extended to investigate a change from n-1 to n-2. In general, the analysis can be extended to look at a change from n-1 to where n−k. • Three steps: • Select a model of competition ( quantity competition, differentiated products price competition, bidder competition within an auction or procurement, a discrete choice model, etc). • Fit and/or calibrate the model to the pre-merger market and to relevant features of the pre-merger firms, such as their market shares. • Within the fitted and/or calibrated competitive framework, the final step is to calculate the merger’s effect and the effects of various post-merger explicit collusion scenarios. • Benefits: to quantify the payoff to all market participants from incremental explicit collusion between any pair, or any subset, of remaining firms in the industry. • By quantifying the incremental payoff to any subsequent collusion, and assuming the probability of such collusion is increasing in the incremental payoff, this analysis offers indirect qualitative probability assessments.

26. Benefits of a structural model of competitive interaction • Allows to empirically compare and test alternative theories of strategic behavior. A better fitting model can be deemed to be more descriptive of the phenomenon • Estimated parameters of a structural model are invariant to policy changes (i.e., they are not subject to the Lucas critique). • One can therefore use these estimates to perform "what-if" analysis to understand what effect their actions will have on the market. • It allows decomposing the determinants of market power and profitability. • Lerner index is a good measure of market power and serves as a measure of the profitability of firms. • Structural NEIO models decompose the sources of market power (profitability) into components associated with consumer preferences (demand structure), efficiency (cost advantages) and anti-competitive conduct (tacitly cooperative behaviour).

27. A NEIO “structural model” • An NEIO model has three basic ingredients: a demand specification, a cost specification and a specification for competitive interactions. • Demand specifications have ranged from simple models such as linear or log-linear demand to flexible nonlinear models such as the logit model with random coefficients to account for heterogeneity of customer preferences. • Costs have been specified using a simple constant marginal cost model or as a linear or loglinear function of production cost factors. • Two commonly used approaches to model competitive interactions: the menu approach and the conjectural variation approach

28. Basic specification of an NEIO oligopoly model • In standard theory, a supply curve represents a unique functional relationship between price and quantity supplied of the form P = MC(Q). • For a perfectly competitive firm, the supply curve coincides with that portion of marginal cost above average cost. • Outside the perfectly competitive model, firms do not have supply curves, but supply relations; that is, the locus of points that result from equating marginal revenue and marginal cost. Mathematically, the supply relation represents the equality of perceived marginal revenue and marginal cost. For an n-firm, homogeneous-goods, quantity setting oligopoly, the ith firm’s supply relation is (where i = dQ / dqi ) • Two possible interpretations of i: • as a measure of the equilibrium wedge between price and marginal cost • as a measure that embodies a firm’s conjectural variation with respect to its rivals (Bresnahan, 1989).

29. A typical NEIO oligopoly model consists of equations for a demand curve and a supply relation. • The simultaneous determination of demand and supply raises an important issue: namely, whether and how the structural parameters of the model are identified. • Various possibilities: • Constant marginal costs • Exogenous changes in the slope of the demand function • …

31. Identification problem with increasing marginal costs (Bresnahan 1982)

32. Demand Rotation

33. NEIO infers market conduct and unknown cost parameters through the responsiveness of price to changes in demand elasticities and cost components. Broadly speaking there are two methods: • Menu approach: • derive the first-order conditions under different equilibrium interactions between the two firms and then choose the equilibrium that best fits the data (e.g. Bertrand, Stackelberg leader–follower and collusive equilibrium) • In the estimation step, each of these sets of first-order conditions for the different games is estimated separately • non-nested statistical tests to distinguish among the various specifications • Goodness of fit test performed to select the best-fitting models. • Conduct parameter approach: another strand estimates  as a free parameter, using nonproportional shifts of the inverse demand curve to identify both it and cost parameters. Two interpretations: • a measure that embodies a firm’s conjectural variation with respect to its rivals (not clear this is appropriate outside well defined competitive interactions • as a measure of the equilibrium wedge between price and marginal cost (common current interpretation)

34. NEIO in the ABF/GBI case • Analysis failed: • Lack of proper benchmark to establish the significance of the conduct parameter • No appropriate firm-level instruments available • Incomplete data on demand and cost shifters over time and space • However: improved understanding of tacit coordination as a matter of degree

35. Competitive AssessmentFactors conducive to coordination I • Few active competitors (3 to 2 merger) • Small, very frequent orders (no incentive to ‘cheat’) • Demand is relatively inelastic (yeast is only 3-5% of baking costs) • Mature, declining markets(no incetive to get a bigger piece of the cake) • High degree of product homogeneity (enhances tranparency, can agree easier) • No leap frog innovation

36. Competitive AssessmentFactors conducive to coordination II • High barriers to entry • Need to build a distribution network • Local sales and technical sales force • Brands and reputation • No greenfield entry can be expected • Economies of scale • Limited ability for actual or potential competitors in neighbouring markets to expand into Portugal and Spain • Low buyer power (small distributors serving mostly artisan bakers) • Spare capacity as deterrence • Market transparency in final prices, volumes and capacity • Multi-market contacts (players meet accross countries)

37. Competitive AssessmentCoordination mechanism • Focal point: prices • Role of distributors in implementing coordination • extreme 'simplicity' of the market • past cartels in the sector • stories of local coordination in ES: cartel case?

38. Competitive AssessmentChange of the merger • the change of the market structure facilitates coordination: • 3 to 2: better understanding on terms of coordination enhancing transparency better punishments and retaliation less likely to deviate • removing GBI as a destabilizing factor • plant in IT, not present in industrial segment and in liquid: no fear of retaliation there • increasing symmetry • cost structure (production re-location) • market shares ES, • more spare capacity of the merged entity