Analysis Group vguppi Online Tool Detailed User Guide Revised August 13, 2014
1. Detailed user guide 2 Introduction 2 The vguppi Methodology 2 1. vguppi U 2 2. vguppi R 3 3. vguppi D 3 Input Parameters 3 1. Prices 4 2. Margins 5 3. Diversion Ratio 6 4. Input Substitution 7 5. Pass-Through 9 vguppi Pricing Scores 11 A. Upstream Market: vguppi U 11 B. Downstream Market: vguppi R and vguppi D 12 Frequently Asked Questions 14 1. Merger-Specific Elimination of Double Marginalization 14 2. Upstream Versus Downstream Pricing Pressure 14 3. Antitrust Relevance of vguppi U (Upstream Input Price Increase) 14 4. vguppi and the Vertical Arithmetic Methodology 15 5. vguppi and the Single Monopoly Profit Theory 15 6. Print vguppi Scenario 16 Limitations of the vguppi Methodology 16 Disclaimer 16 2014 Analysis Group, Inc., all rights reserved. PAGE 1
1. DETAILED USER GUIDE Introduction Competitive effects screens and safe harbors in merger analysis have traditionally been based on market shares and concentration ratios such as the Herfindahl-Hirschman Index (HHI). These ad hoc measures lack a direct connection to anticompetitive concerns and require market definition. Hence, these simple competitive effect screens rely on an market definition exercise that is often unclear, lacks rigour, and does not allow for fine gradation of competitive constraints. 1 Recently advanced price pressure indexes (PPIs) provide numerical scores of pricing incentives of the merging firm and its rivals for both horizontal and vertical mergers. PPIs are based on rigorous economic models underlying merger analysis and have various advantages compared to traditional market-sharebased methods: i) PPIs are directly related to the pricing incentives of firms, ii) they do not rely on market definition, and iii) they can incorporate some of the efficiency benefits of the merger. The vguppi Methodology The Vertical Gross Upward Pricing Pressure Index (vguppi) can be used as a preliminary antitrust screen for vertical mergers that may raise input foreclosure concerns. 2,3 The methodology evaluates the impact of a vertical merger on the unilateral pricing incentives of the merged parties to raise its rivals costs, which may subsequently lead to pressure on downstream prices. The methodology yields direct evidence on pricing incentives numerical scores expressed as the equivalent marginal cost increase and is simpler to implement than full-blown merger simulation models. The economic model of competition underlying the vguppi methodology features differentiated product competition and assumes constant returns to scale. There are three types of vguppis, the upstream vguppi U for the integrated firm, the downstream vguppi D for the integrated entity, and the downstream vguppi R for the downstream rival firm(s): 1. vguppi U The vguppi U measures the merging upstream entity s pricing incentives in selling to un-integrated downstream rivals. It weighs the incremental value from diverted downstream sales against the lost revenues resulting from the input price increase. 4 1 The market definition exercise treats firms as either in or out of the market. 2 Moresi, Serge and Steven C. Salop (2013): vguppi: Scoring Unilateral Pricing Incentives in Vertical Mergers, Antitrust Law Journal, 79, pp. 185-214. 3 Input foreclosure refers to the merged entity s incentive to stop supply or raise input costs of rival downstream competitors while customer foreclosure refers to an integrated firm not purchasing from upstream input competitors, thereby reducing its addressable market. 4 The idea behind the vguppi U is derived directly from the 2010 Horizontal Merger Guidelines: Adverse [input] price effects can arise when the [vertical] merger gives the merged entity an incentive to raise the price of [the input] previously sold by [the upstream] merging firm [to a rival of the downstream merging partner] and thereby divert sales [of the downstream rival] to products previously sold by the [downstream] merging firm, boosting the profits on the latter products. Taking as given other prices and product offerings, that boost to profits is equal to the value to the merged firm of the sales diverted to those products. The value of sales diverted to a product is equal to the number of units diverted 2014 Analysis Group, Inc., all rights reserved. PAGE 2
2. vguppi R The vguppi R measures the downstream rival s incentives to increase its price in response to the input price increase of the merging upstream entity. The rival is more likely to increase its price if the upstream input price increase is large and if it cannot easily switch to another upstream supplier. 3. vguppi D The vguppi D measures the merging downstream entity s incentives to change its price post-merger. The price increase is more likely if its competitors have few alternative upstream suppliers and the efficiencies (elimination of double marginalization) from the vertical merger are small. Input Parameters The stylized industry configuration is simple: An upstream merging firm, Firm U 1, sells a production input to two (downstream) firms, the merging partner Firm D and its rival Firm R, who compete in the downstream market for customers. An upstream rival to the merging entity, Firm U 2 could possibly provide an alternative input to (partially) replace sales from U 1 to the downstream rival R if input substitution is possible. The three vguppi measures correspond to the three prices of interest in the vertical merger analysis: P U1, the price the upstream merging firm charges the downstream rival, P D, the downstream price of the merging entity, and P R, the downstream price of the rival firm. Figure 1: Industry Configuration The vguppi pricing incentives require various input parameters. Easily accessible tooltips additional explanations for each required input parameter and simplifying assumption. provide to that product multiplied by the margin between price and incremental cost on that product. [ ] If the value of diverted sales is proportionately small, significant [input] price effects are unlikely. See U.S. Department of Justice and Federal Trade Commission (2010): Horizontal Merger Guidelines, available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf. The words in brackets are inserted in the original text to illustrate the potential application of the Horizontal Guidelines to vertical mergers (See Supra 2). 2014 Analysis Group, Inc., all rights reserved. PAGE 3
1. Prices Parameter P U1,R Description Price Firm U1 charges Firm R Price charged by the upstream merging firm U1 to the downstream rival R for the production input. P U1,R must be greater than zero. P D Price Firm D charges its customers Output price charged by the downstream merging firm D to its customers. P D must be greater than zero. For simplicity, the online tool additionally assumes that: i. P U1,D, the price charged by the upstream merging firm U1 to the downstream merging firm D for the input, is equal to P U1,R. ii. P R, the output price charged by the downstream rival R to its customers, is equal to P D. The measurement units for P U1,R are such that one unit of the relevant upstream input produces one unit of downstream output. 5 Price inputs are based on their pre-merger values. The relative ratio of the upstream input price to the downstream price(s) plays an important role for all three vguppi measures. Even if the upstream merging firm U1 has a massive incentive to increase its price P U1,R at which it supplies the downstream merging rival firm R, the downstream merging firm D and its rival R may have a very small incentive to raise their price if the input is not a significant cost factor in the production of the downstream good (relative price ratio). 5 In other words, the input price P U1,R is equal to Firm R s total payments to the upstream merging firm U1 divided by the total quantity of (downstream) output produced with the relevant input purchased from Firm U1. 2014 Analysis Group, Inc., all rights reserved. PAGE 4
2. Margins Parameter M U1,R Description Variable profit margin of Firm U1 from sales to Firm R Variable profit margin of the upstream merging firm U1 from sales to the downstream rival R expressed as a percentage of its price, M U1,R =(P U1,R C U1 ) / P U1,R. C U1 is the Firm U1 s marginal cost of production and includes the costs of all other inputs. M U1,R must be strictly positive and cannot exceed 100%. For simplicity, the online tool additionally assumes that M U1,D, the variable profit margin of the upstream merging firm U1 from sales to the downstream rival D expressed as a percentage of its price, is equal to M U1,. 6 M D Variable profit margin of Firm D Variable profit margin of the downstream merging firm D expressed as a percentage of its price, M D = (P D C D ) / P D. C D is the Firm D s marginal cost of production and includes the costs of all other inputs. M D must be strictly positive and cannot exceed 100%. M R Variable profit margin of Firm R Variable profit margin of the downstream rival R expressed as a percentage of its price, M R = (P R C R ) / P R. C R is the Firm R s marginal cost of production and includes the costs of all other inputs. M R must be strictly positive and cannot exceed 100%. Margins are based on their pre-merger values. The size of the margin of the upstream merging firm U1 relative to the downstream margin determines the extent to which the vertically integrated entity is willing to trade of the revenue loss from input sales with increased profits from diverted downstream sales. 6 This assumption implies that there are efficiency effects of the vertical merger whenever the upstream merging firm U1 has a positive margin M U1,R > 0. Essentially, the contractual and pricing relationship between the upstream merging firm relative to the downstream merging firm D and its rival R pre-merger is assumed to be symmetric, i.e. Firm U1 was not able to asymmetrically eliminate or weaken double marginalization through sophisticated (two-part or non-linear tariffs) pricing contracts with one of the downstream firm. 2014 Analysis Group, Inc., all rights reserved. PAGE 5
3. Diversion Ratio Parameter D R to D Description Fraction of Firm R s lost sales following a price increase by Firm R that are gained by Firm D When the downstream rival R raises its price, consumers will buy less, in part because they switch to the downstream merging firm D, in part because they switch to other downstream firms (not modeled), and in part because they will stop buying the product at all. D R to D measures the fraction of lost sales of Firm R gained by the downstream merging firm D, which will depend on the level of product differentiation and alternatives available in the market. D R to D must be between 0 and 1. D D to U Fraction of Firm D s lost sales following a price increase by Firm D that are gained by Firm U1 through input sales to Firm R When the downstream merging firm D raises its price, consumers will buy less and some of them will switch to the downstream rival firm R. Increased sales for Firm R will raise Firm R s demand for the input supplied by the upstream merging firm U1. D D to U measures the fraction of lost sales of the downstream merging firm D that are recaptured by the upstream merging firm U1 through input sales to firm R. This diversion ratio will depend on the level of product differentiation, alternatives available in the market, and Firm R s reliance on the production input from upstream merging firm U1. D D to U must be between 0 and 1. Similar to the horizontal GUPPI, the diversion ratios are at the heart of the three GUPPI measures: The vguppi U and vguppi D measures are related to the size of the horizontal diversion ratio between the downstream merging firm D and its rival R, D R to D. It determines the magnitude of the vertically integrated firm s incentive to trade off the revenue loss from input sales with increased profits from diverted downstream sales. If the downstream diversion of sales is minimal, so is the incentive to raise the upstream input price. The vertical diversion ratio from the downstream merging firm D to the upstream merging firm U1, D D to U, measures the extent to which lost downstream sales of Firm D are recaptured through input sales by the upstream merging firm U1 to the downstream rival R. This diversion ratio determines the magnitude of the (upward) pricing pressure of the downstream merging firm D, vguppi D. 2014 Analysis Group, Inc., all rights reserved. PAGE 6
4. Input Substitution Parameter S U1,R Description Firm U1 s share of Firm R s total purchases of the relevant input S U1,R is the input share the downstream rival firm R purchases from the upstream merging firm U1. This input share pertains solely to the relevant input under consideration and ignores all other production inputs (e.g. capital, labor). S U1,R must be between 0% and 100%. S U1,R (P U1,R ) Firm U1 s share of Firm R s total purchases of the relevant input if P U1,R were to increase by 10%. The change in Firm U1 s share of Firm R s total purchases of the relevant input in response to a price increase P U1,R determines the input substitution elasticity IS U1,R. S U1,R (P U1,R ) must be greater than zero but less than S U1,R. The difference between S U1,R (P U1,R ) and S U1,R measures the extent to which the downstream rival R can substitute away from the input from the upstream merging firm if it raises the price by 10%. The difference will depend, among other things, on the availability of other input supplier(s) and the extent of input substitutability. If the downstream product is produced using a fixed proportion technology, i.e. the input from the upstream merging firm U1 is necessary to produce a unit of output, then the S U1,R (P U1,R ) is equal to S U1,R. S U1,D Firm U1 s share of Firm D s total purchases of the relevant input S U1,D is the input share the downstream merging firm D purchases from the upstream merging firm U1. This input share pertains solely to the relevant input under consideration and ignores all other production inputs (e.g. capital, labor). S U1,D must be between 0% and 100%. S U1,D (P U1,D ) Firm U1 s share of Firm D s total purchases of the relevant input if P U1,D were to increase by 10%. The change in Firm U1 s share of Firm D s total purchases of the relevant input in response to a price increase P U1,D determines the input substitution elasticity IS U1,D. S U1,D (P U1,D ) must be greater than zero but less than S U1,D. The difference between S U1,D (P U1,D ) and S U1,D measures the extent to which the downstream merging firm U can (and will) substitute away, pre-merger, from purchasing the input from the upstream merging partner U1 if it raises its price. The difference will depend, among other things, on the availability of other input supplier(s) and the extent of input substitutability. If the downstream product is produced using a fixed proportion technology, i.e. the input from the upstream merging firm U1 is necessary to produce a unit of output, then the S U1,D (P U1,D ) is equal to S U1,D. 2014 Analysis Group, Inc., all rights reserved. PAGE 7
The tool provides for an assumption of No Input Substitution, which can be invoked by selecting the corresponding check mark (Unselecting the check mark allows for input substitution). This assumption eliminates the need to provide any parameter inputs related to the substitutability of the relevant input of production. This scenario is characterized by the downstream firms inability to substitute between the input sold by the upstream merging entity U1 and other inputs following a price increase in the input price P U1,R. Furthermore, no input substitution implies that the downstream rival R s marginal cost change one-for-one in absolute terms with a change of the input price charged by the upstream firm U1 for the input, i.e. C R / P U1,R = 1 (see pass-through section below). All purchase share inputs are based on their pre-merger values. The model assumes that the downstream merging firm D and its downstream rival R purchase multiple inputs from several suppliers, including capital and labor. It is assumed that the merger has no effect on the price of inputs, with the exception of the input supplied by the upstream merging firm U1. The relevant inputs are imperfect substitutes. 7 When downstream firms have the ability to substitute away from the input of the upstream merging firm U1 and switch to other suppliers, then the market power of the upstream merging firm U1 will be lower, pre-merger and post-merger. The possibility of input substitution will mitigate or possibly eliminate any increase in production costs and the associated increase in output price for the downstream rival firm R. A lower price increase of the downstream rival firm R will also weaken the diversion to the downstream merging firm D and therefore significantly reduce the incentives for input foreclosure. 7 Perfect substitution implies that inputs are price at cost and the vguppis will be equal to zero. 2014 Analysis Group, Inc., all rights reserved. PAGE 8
5. Pass-Through Parameter PTR U1 C R / P U1,R PTR R Description Firm U1 s pass-through rate The rate at which Firm U1 passes through a marginal cost increase to the input price charged to the downstream rival R. Linear demand for the input supplied by the upstream merging firm U1 implies a pass-through rate of 50%. PTR U1 must be greater than zero. Absolute change in Firm R s marginal cost of production from a $1 increase in the input price P U1,R The rate at which a $1 change in the input price translates into marginal cost increases for the downstream rival R depends on the extent to which it can substitute away to other inputs. No input substitution implies C R / P U1,R = 1, with input substitution this parameter is restricted to the unit interval 0 C R / P U1,R < 1. Firm R s pass-through rate The rate at which Firm R passes through a marginal cost increase to the output price P R charged to its customers. Linear demand for the output of the rival firm R in the downstream market implies a pass-through rate of 50%. The change in the production cost C R / P U1,R and the pass-through rate PTR R determine the elasticity (E UR ) of Firm R s output price P R with respect to an increase in Firm U1 s input price charge to Firm R. PTR R must be greater than zero. PTR D Firm D s pass-through rate The rate at which Firm D passes through a marginal cost increase to the output price P D charged to its customers. Linear demand for the output of the merging firm D in the downstream market in the downstream market implies a pass-through rate of 50%. PTR D must be greater than zero. 2014 Analysis Group, Inc., all rights reserved. PAGE 9
The tool provides for a Linear Demand System assumption, which can be invoked by selecting the corresponding check mark (Unselecting the check mark removes the linear demand assumption). The assumption eliminates the need to specify input parameters for pass-through rates. To translate an upward pricing index into a corresponding post-merger price increase requires information about cost-pass-through rates of the merging firms and its rivals. 8 A vguppi measure of 10% implies that the firm has the same incentive to raise its price as it would have if its marginal cost increased by an amount equal to 10% of the pre-merger price. Linear demand is a common simplifying assumption in merger analysis and corresponds to a cost pass-through rate of 50%. 9,10 Hence, vguppi measures higher than 10% imply a (first-round) price increase in excess of 5%, which is a typically used threshold for market definition. Linear Demand Parameter Restriction Parameter Value PTR U1 50% PTR R 50% PTR D 50% Salop and Moresi (2013) suggest using the 50% pass-through rate assumption as a default, absent contrary evidence in a specific case. 11 All cost pass-through inputs are based on their pre-merger values. Pass-through rates PTR U1, PTR R, and PTR D can be best understood through a simple example: Suppose an increase of $4 in a firm s marginal cost of production cause it to raise its (output) price by $3. In this example the cost pass-through rate is $3/$4 or 75%. The higher the pass-through rate is, the larger is the effect of the pricing pressure on the corresponding price. The choice and combination of parameter inputs embed assumption on market structure and demand. For the vguppi methodology to provide a plausible first-look screen of a vertical merger,, these implicit assumptions need to be internally consistent and in agreement with industry structure and case evidence. 8 The vguppi incentive scoring measures are expressed as an equivalent marginal cost increase; a cost pass-through rate is required to translate it into an corresponding price increase. 9 The imposed linear demand assumption applies at the firm-level, and not the industry level. 10 Hausman, J., S. Moresi, and M. Rainey (2011): Unilateral Effects of Mergers with General Linear Demand, Economics Letters, 111(2), 119-121. 11 Moresi, Serge and Steven C. Salop (2014): vguppi: Scoring Unilateral Pricing Incentives in Vertical Mergers, Antitrust Law Journal, 79, footnote 30 on p. 195. 2014 Analysis Group, Inc., all rights reserved. PAGE 10
vguppi Pricing Scores The input parameters, possibly in combination with simplifying assumptions, determine the three vguppi pricing measures. These three vguppi measures, the upstream vguppi U for the integrated firm, the downstream vguppi D for the integrated entity, and the downstream vguppi R for the downstream rival firm(s), are expressed as an equivalent marginal cost increase. An appropriate pass-through assumption will then translate the pricing pressure into an indicative price increase. A. Upstream Market: vguppi U The vguppi U measures the merging upstream entity U1 s pricing incentives to raise the price P U1,R of the input it sells to the un-integrated downstream rivals. The vguppi U measures is generally positive (as long as the margin and diversion ratio are positive) since there is no off-setting effect to the incentive of the merged entity to divert sales from the downstream rival to its own downstream entity. The pricing pressure vguppi U is large if: a large fraction of customers who stop buying from the downstream rival firm R switch to the merging downstream entity D (D R to D ). the margins earned by the downstream merging firm D are substantial (M D ). the relative value of the downstream product relative to the upstream input is large (P D / P U1,R ). 12 there is little opportunity for the downstream rival to substitute to other inputs (IS U1,R ). the downstream rival passes on a large fraction of the input price increase to its customers (E UR ). Given the upstream merging firm U1 s cost pass-through rate PTR U1, the vguppi U translates into an corresponding price increase. The denominator of the vguppi U formula captures the effect of input substitution: the denominator is equal to 1 if there is no input substitution, and larger than 1 if input substitution is possible, which tends to reduce the pricing pressure in the upstream input market (vguppi U ). Input substitution implies that the downstream rival firm R can substitute a large share of inputs previously purchased from the upstream merging firm U1 with input purchases from other suppliers (instead of raising its output price) which weakens the incentive for Firm U1 to raise the input price P U1, R to the downstream rival R. The possibility of input substitution can have a large impact on the incentive to raise input prices post-merger. 12 The vguppi U can be very large if the price ratio P D / P U1,R is large, in which case there is also a large difference between vguppi U and vguppi R. 2014 Analysis Group, Inc., all rights reserved. PAGE 11
B. Downstream Market: vguppi R and vguppi D The vguppi R measures the downstream rival s incentives to increase its price in response to the input price increase of the merging upstream entity U1. The vguppi R is generally positive since an increase in cost for the downstream rival tends to lead to positive pricing pressure. The pricing pressure vguppi R is large if: the upstream input pricing pressure and subsequent pass-through for the merging entity, Firm U1, is large (vguppi U, PTR U1 ). the relative value of the upstream input relative to the downstream product is substantial (P U1,R / P D ). the downstream rival R cannot easily switch to other upstream input suppliers (IS U1,R ). The vguppi D measures the downstream merging firm D s incentives to change its price post-merger. There are two offsetting incentives at work. First, the price increase of its downstream rival R puts upward pressure on Firm D s price it charges to customers. 13 Second, the elimination of the double mark-up for the vertically integrated entity puts downward pressure on Firm D s price. Post-merger, the (first-round) effect on the price of the downstream merging firm may be pushing its downstream price upwards or downwards. The pricing pressure vguppi D is large and positive if: the downstream merging firm D can partially recapture a large part of lost downstream sales by selling its upstream input to the downstream rival firm (D D to U ) the upstream mark-up is small and there is little possibility for the downstream merging firm D to increase post-merger - the use of the upstream input from its merging partner U1 (IS U1,R, M U1,D ). This effect corresponds to the merger-specific elimination of double marginalization whereby the vertically integrated downstream partner can obtain the upstream input at marginal cost. The mathematical formula for the vguppi D illustrates the two opposing effects on pricing incentives of the downstream merging firm D: 13 Prices are strategic complements in the underlying model of competition with differentiated products. That is, the firm s best-response functions are upward sloping and a firm s strategic response to a price increase by a competitor is to increase its own price. 2014 Analysis Group, Inc., all rights reserved. PAGE 12
i. If two firms at different levels in the supply chain upstream and downstream both have market power, two consecutive mark-ups (double marginalization) lead to a dead-weight loss. With vertical integration, the merging upstream firm U1 can effectively transfer the input at marginal cost to its downstream partner, firm D, eliminating one mark-up which may lead to downward pricing pressure on P D. The possible elimination of double marginalization can be an important efficiency effect of vertical mergers. ii. The downstream merging firm D may have a unilateral incentive to raise its price P D above the pre-merger level. Raising its price P D will reduce sales. Yet, if consumer substitution to its downstream rival R raises R s demand for the input supplied by upstream merging firm U1, then U1 s profits rise. Pre-merger, the downstream merging firm D did not account for this positive effect on its upstream merging partner U1, but will do so post-merger. This additional effect may lead to upward pricing pressure on P D. It is the only pricing pressure for the downstream merging firm D if it does not use the input produced by the upstream merging firm U1. The prevailing industry values used as inputs will determine which of these two effects will dominate post-merger and whether there will be upward or downward pressure on the price of the downstream merging firm D, P D. Again, the two downstream vguppi measures, vguppi R and vguppi D, can be translated into corresponding price increases given the cost pass-through rates of the downstream rival R and the downstream merging firm D. 2014 Analysis Group, Inc., all rights reserved. PAGE 13
Frequently Asked Questions 1. Merger-Specific Elimination of Double Marginalization Vertical mergers may potentially carry substantial efficiency benefits, the most well-known is the elimination of double marginalization (EDM). The merged entity can effectively transfer the upstream input at marginal cost to its downstream partner which may lead to lower consumer prices. If the EDM efficiency exists, it can offset incentives to raise the price for the merged entity, but the EDM efficiency may not be present in all vertical mergers. 14 2. Upstream Versus Downstream Pricing Pressure There are vguppi measures at two different levels of the vertical supply chain and the difference is important: Even if the upstream merging firm U1 has a massive incentive to increase its price P U1,R at which it supplies the downstream rival firm R, the downstream rival R may have a very small incentive to raise its price if good substitutes are available, or if the input is not a significant cost factor in the production of the downstream good. Suppose, for example, that Ford (a car manufacturer) acquired Electric Auto-lite (a spark plug producer) and had an incentive to substantially increase the price for spark plugs sold to competing car manufacturers (high vguppi U ). There is unlikely to be a significant increase in the price of automobiles (negligible vguppi R and vguppi D ) since spark plugs constitute only a small fraction of the cost of producing a car, and there may exists alternate providers of smart plugs that are good substitutes. 3. Antitrust Relevance of vguppi U (Upstream Input Price Increase) The vguppi D is evidently the relevant measure for the pricing pressure of the downstream merging firm D. It is however a question for debate whether the competitive effects analysis of the downstream rival firm R should be based on the vguppi U, the vguppi R, or both. The vguppi R is directly relevant to gauge harm to downstream consumers, while even a large vguppi U may not lead to significant downstream effects if the input is sufficiently unimportant. However, harm to the downstream rival firm R may be cognizable under antitrust law in some jurisdictions. In the United States, Aspen Ski suggests that it is necessary to show downstream harm to consumers, and not solely harm to rival firms. 15 Vertical restraint cases are treated similarly. 16 Along the same line, the EU Guidelines on the Assessment of Non-Horizontal Mergers state that [ ] a merger will raise competition concerns because of input foreclosure when it would lead to increased prices in the downstream market thereby significantly impeding effective competition. 17 Yet, the U.S. Horizontal 14 The double mark-up issue may not exist if the upstream market is competitive or sophisticated (two-part or non-linear tariffs) pricing contracts are used and the input is transferred between firms at marginal cost. 15 Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585, 608 09 (1985). 16 Jefferson Parish Hosp. Dist. No. 2 v. Hyde, 466 U.S. 2 (1984); see also United States v. Dentsply, Int l, Inc. 399 F.3d 181 (3d Cir. 2005). 17 European Commission, 2008, Guidelines on the Assessment of Non-Horizontal Mergers Under the Council Regulation on the Control of Concentrations Between Undertakings, 2008 O.J. (C 265), 47. 2014 Analysis Group, Inc., all rights reserved. PAGE 14
Merger Guidelines state that competitive effects of horizontal mergers between competing buyers will not be primarily evaluated on the effects on the downstream market. 18 4. vguppi and the Vertical Arithmetic Methodology The Vertical Arithmetic is another quantitative technique currently used in analyzing the competitive effects of vertical mergers. It assesses the post-merger incentives to foreclose a downstream rival by comparing the upstream loss resulting from foregone revenue of input sales to non-integrated downstream rivals with the downstream gain from additional revenue on sales diverted from foreclosed downstream rivals. Although the vertical arithmetic has minimal data requirements, the Vertical Arithmetic evaluates complete (or partial) input withholding assuming prices and margins are fixed (only volume effects) It also and does not evaluate any price effects in the downstream market and cannot account for the elimination of double marginalization due to vertical integration. If input prices are not regulated (fixed), the vguppi U is preferable and more realistic, even absent the elimination of double marginalisation and downstream effects. Input forclosure is generally more profitable to by raising the input price rather than through non-price rationing (fixed prices, partial or complete refusal to deal), which implies a greater incentive for input foreclosure. 5. vguppi and the Single Monopoly Profit Theory The single monopoly profit (SMP) theory contends that an upstream monopolist can claim only one monopoly profit. If the upstream monopolist can fully extract the monopoly profit from the downstream market (using contracts), then vertical integration cannot leverage upstream monopoly power into the downstream market to obtain any additional profit. The SMP theory does not apply in this vguppi setting even if the input sold by the upstream merging entity U1 is used in fixed proportions with other production inputs. No input substitution makes the upstream entity U1 a monopolist for the relevant input. The SMP theory does not apply because the downstream firms D and R sell differentiated products. To illustrate this point, suppose that the upstream merging firm U1 is the only supplier of the relevant input to the downstream rival firm R, and suppose for simplicity that the downstream merging firm D does not use the input from the upstream merging firm U1. If the downstream firms sell differentiated products, then the upstream merging firm will have an incentive to raise the price from the pre-merger monopoly price (fixed proportions) even further since the input price increase will cause the downstream rival firm R to raise its price and allow the downstream merging firm D to earn additional profits. 19 18 The guidelines suggests that harm to sellers may be sufficient to render a horizontal merger among competing buyers anticompetitive, irrespective of the effect on the downstream market (U.S. Department of Justice and Federal Trade Commission (2010), Horizontal Merger Guidelines, August 19, 2010, 12; http://www.ftc.gov/sites/default/files/attachments/merger-review/100819hmg.pdf). 19 In technical terms, at the margin, the loss of profit of the upstream merging firm U1 from an increase in the input price P U1,R has only a secondorder effect, while the profit gain to the downstream merging firm is of first-order magnitude. 2014 Analysis Group, Inc., all rights reserved. PAGE 15
6. Print vguppi Scenario The online tool allows for the labelling of any scenario of input parameters, which can subsequently be printed (or saved as a pdf-document if you have software installed to print to pdf) for future reference. Limitations of the vguppi Methodology The vguppi methodology has several distinct advantages: Incentive scoring measures such as the vguppi are based on a model of competition among rational, profit-maximizing entities and are therefore more closely connected to the competitive effects arising from a merger compared to structural measures such as concentration indexes (e.g., HHI). They measure economic incentives of firms in the upstream and downstream market, merger and rival; incentives that are at the heart of any input foreclosure concerns. Additionally, the vguppi methodology does not rely on market definition, which can be a contentious issue in merger analysis. There are however several limitations of the vguppi methodology that may make it unsuitable in some circumstances: a. Although the vguppi methodology has been used by Analysis Group and regulatory authorities in the investigation of vertical mergers, the methodology has not yet been subjected to a contested merger proceeding. b. Like its horizontal Gross Upward Pricing Pressure Index (GUPPI) counterpart, the vguppis are based on prices, price-cost margins and diversion ratios. Some of these parameters may not be observed or can only be estimated with a full merger simulation model. c. The methodology is not equivalent to a complete competitive effects analysis: vguppis gauge only first-round incentives to raise prices (evaluated at the pre-merger equilibrium) and do not take into account feedback effects between the two merging firms and their rivals. vguppis also ignore any effect of the merger on the incentives of other upstream input suppliers, which may respond to the vertically integrated entity s input price increase with its own input price response in the upstream market. A full merger simulation is the most sophisticated and complete way to assess the impact of a vertical merger on competition, but requires sophisticated modeling and numerous assumptions. d. vguppis do not account for entry, merger-specific efficiencies other than the elimination of double marginalization, or other supply-side effects (e.g. product repositioning). e. There are currently no safe harbor thresholds established for vguppis. Disclaimer The vguppi webtool and related information and documentation provided herein (collectively, the Tool ) has been designed by Analysis Group as a user-friendly online tool that implements the vguppi methodology developed by others. 20 The Tool is provided for general information purposes to help users evaluate upward pricing pressure that could result from a proposed vertical merger. The vguppi method 20 Supra note 2. 2014 Analysis Group, Inc., all rights reserved. PAGE 16
is not a complete competitive effects analysis and its applicability will vary according to case specific details. Any information derived from this website and the Tool shall not be attributed to any individual staff or affiliate of Analysis Group unless specifically cited. Any information derived from this website and the Tool should also not be construed as professional advice from Analysis Group, and users should consult with a professional for answers to specific questions. Your use of the Tool and this website constitute agreement to the Online Tools Terms of Use. 2014 Analysis Group, Inc., all rights reserved. PAGE 17