Market Definition & DOJ’s Approach to Mergers

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

2. 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

3. 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.

4. 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.

5. 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.

6. 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?

7. 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)?

8. 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

9. 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)

10. 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

11. 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

12. 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

13. 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:

14. 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

15. 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

16. 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

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

18. 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