Unilateral Effects In Horizontal Mergers. Jeffrey Prisbrey Charles River Associates April 28, 2016

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1 Unilateral Effects In Horizontal Mergers Jeffrey Prisbrey Charles River Associates April 28, 2016

2 Types of Mergers Horizontal The products of the firms are substitutes Vertical The products of the firms are complements Conglomerate The products are unrelated

3 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.

4 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.

5 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.

6 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

7 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.

8 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?

9 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?

10 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.

11 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: D 12 * (p 2 c 2 ) where: D 12 is the diversion from product 1 to product 2 p 2 is the price of product 2 c 2 is the marginal cost of product 2 Is this dollar amount big or small?

12 The GUPPI Gross Upward Pricing Pressure Index or GUPPI D 12 * (p 2 c 2 ) / p 2 * (p 2 / p 1 ) or D 12 * (p 2 c 2 ) / p 1 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.

13 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.

14 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.

15 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.

16 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?

17 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.

18 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?