Summer 2008 Antitrust Insights From the Editor Market definition has always played a prominent role in merger analysis, and the analytical principles that must be applied have been debated and scrutinized for decades. Nevertheless, every once in a while, a court decision appears to challenge conventional wisdom, and the 2008 decision of the Court of Appeals in FTC v. Whole Foods Market Inc., et al. is a recent and noteworthy one. The controversial question it raises for market definition can be summarized simply: should market definition depend on the behavior of marginal customers or should the analysis focus on the behavior of the merging parties core customers? In this issue of Antitrust Insights, Senior Vice President Sumanth Addanki and Vice President Jeff Daskin assess the reasoning by the Court of Appeals that the District Court committed an error in assuming that market definition must depend on the actions of marginal consumers. Their conclusion is that the behavior of marginal customers is and should be the focus of an analysis of market definition. This does not mean, however, that core customers are ignored. As Sumanth and Jeff explain, whether there is a set of core customers who might be adversely affected by a transaction will also depend on the number of marginal consumers and their behavior in response to an increase in price. Sumanth specializes in antitrust, intellectual property, and the evaluation of commercial damages. In the area of antitrust, he has analyzed the competitive consequences of numerous mergers in a wide range of industries, including agricultural products, chemicals, consumer products, medical devices, pharmaceuticals, and semiconductors, among many others. Jeff also has considerable experience in assessing the competitive effects of mergers and acquisitions. The industries he has studied include, among others, writing instruments, concert promotion, clinical testing, turbomachinery, travel agency, beef packing, and pharmaceuticals. I hope you enjoy this issue. Who Defines the Relevant Market The Core Customer or the Marginal One? Sumanth Addanki and Alan J. Daskin In a recent decision, the United States Court of Appeals for the District of Columbia Circuit (Appeals Court) reversed the denial by the United States District Court for the District of Columbia (District Court) of an injunction blocking the merger of Whole Foods Market, Inc. (Whole Foods) and Wild Oats Markets, Inc. (Wild Oats). In its majority opinion, the Appeals Court explained that the district court committed legal error in assuming market definition must depend on marginal consumers; consequently, it underestimated the FTC s likelihood of success on the merits. 1 From an economic perspective, the Appeals Court s statement about marginal consumers is, at best, misguided, and it is likely to cause considerable confusion. In fact, market definition must indeed depend on the behavior of marginal customers (i.e., purchasers who may switch to an alternative product in response to a price increase) and not merely on the existence of a set of core customers (i.e., purchasers who are unlikely to change their purchasing behavior in response to a price increase). In this paper, we take no position on the merits of this particular case, the boundaries of the relevant market, or whether the District Court should have issued a preliminary injunction. 2 Rather, we take issue with the Appeals Court s reasoning. Lawrence Wu, Editor
Although we agree entirely with the sentiment that core customers are worthy of antitrust protection, delineation of the appropriate relevant market ultimately does depend critically on the number of so-called marginal consumers and their behavior in the face of a price increase. 3 To set the stage, we begin with a very brief overview and chronology of Whole Foods. We then explain why the behavior of marginal customers is of paramount importance in defining relevant antitrust markets and address the Appeals Court s concern about so-called core customers. A Brief Overview of the Proceedings in Whole Foods In February 2007, Whole Foods, a supermarket chain that focuses on natural and organic products, entered into an agreement to buy Wild Oats, a competing chain of supermarkets with a similar focus. In June 2007, the Federal Trade Commission (FTC) filed a complaint, alleging that the acquisition, if consummated, would violate Section 5 of the FTC Act and Section 7 of the Clayton Act. The FTC s Complaint asserted a relevant market in the operation of premium natural and organic supermarkets (dubbed PNOS ) and alleged that the proposed acquisition would substantially lessen competition and cause significant harm to consumers. 4 The FTC also sought a temporary restraining order and preliminary injunction in federal district court pending an administrative trial on the merits of the case. 5 On 16 August 2007, after fact discovery, the filing of several rounds of expert reports, and a hearing, the District Court denied the FTC s petition for an injunction. 6 In late August, the parties consummated the transaction. Nearly a year later, on 29 July 2008, the Appeals Court reversed the District Court s denial of the injunction and remanded the case to the District Court. Throughout the proceedings, definition of the relevant market has played a prominent role and for obvious reasons. Although market definition is generally just the beginning of the analysis in antitrust, a market definition that implies extremely high or extremely low shares for the parties often leads to strong presumptions about the likely competitive effects of an acquisition or merger. In this case, the FTC alleged that the acquisition would give Whole Foods a monopoly in at least 17 geographic markets i.e., in those areas, the acquisition would eliminate Whole Foods s only PNOS competitor and would reduce the number of competitors from three to two in another geographic market. 7 According to the FTC, such high market shares create at least a strong, if rebuttable, presumption that the acquisition will harm consumers. If, on the other hand, as the parties claim, Whole Foods and Wild Oats typically compete with many conventional supermarkets, the appropriate relevant market is at least as broad as all supermarkets, and the parties combined share is much smaller. In that case, it might be more reasonable to assume that the deal is competitively innocuous. 8 Thus, it is hardly surprising that the District Court stated, As in Staples, this case hinges almost entirely on the proper definition of the relevant product market. 9 Subscribe Our newsletters report and analyze antitrust and competition policy matters around the world. In addition to Antitrust Insights, our Antitrust and Competition Policy Practice also publishes the Global Antitrust Weekly, which summarizes news about current cases in Europe, the Americas, Asia, Australia and Oceania, and Africa. To view the latest editions or to receive our newsletters each time they are published, click here: www.nera.com/newsletters.asp. 2 Summer 2008
Why Marginal Customers Are the Proper Focus of Market Definition Notwithstanding the Appeals Court s skepticism, the behavior of marginal customers is the proper focus of market definition. As we explain below, this focus is consistent with the principles of economics and the appropriate application of those principles in merger review. The Role of Marginal Customers in Determining Market Prices At the outset, it is important to understand what economists mean by marginal customers. Marginal customers are those customers who may change the quantity of their purchases of the product in question in response to a small change in price. There may be customers whose purchases are not affected by small changes in price. Economists often refer to such purchasers as inframarginal customers. In Whole Foods, the FTC and the merging parties apparently used core customer, committed customer, and inframarginal customer interchangeably. 10 However, as we explain below, economic theory teaches that a profit-maximizing firm will focus on the marginal customers when setting its price. To understand why, recall the textbook principle that a profit-maximizing firm charges the price at which its marginal revenue equals its marginal cost. To see the intuition behind that principle, consider a firm that is contemplating a small reduction in price. The reduction in price will increase the quantity demanded and, as long as the demand curve facing the firm is elastic, will increase the firm s revenue. 11 If that extra, or marginal, revenue exceeds the firm s marginal cost for producing and selling the extra output, the price reduction will increase the firm s profits. In that case, the initial price could not have been the profit-maximizing price. A similar thought experiment applies if the firm considers a small increase in price: the profitability of a small price increase depends on how many sales and how much revenue the firm will lose as a result, as well as the cost savings from producing and selling a smaller quantity. Again, if a small price increase would increase the firm s profits, the initial price could not have been the profit-maximizing price. Ultimately, a profit-maximizing firm will choose the price at which its marginal revenue equals its marginal cost. Notwithstanding the Appeals Court s skepticism, the behavior of marginal customers is the proper focus of market definition....it is the behavior of the marginal customers those on the brink of buying or not buying, or increasing or decreasing the quantity they purchase, depending on the price that affects the firm s pricing decision. Contributors Sumanth Addanki, Senior Vice President White Plains, NY: +1 914 448 4060 Alan J. Daskin, Vice President White Plains, NY: +1 914 448 4133 Lawrence Wu, Senior Vice President/Editor San Francisco, CA: +1 415 291 1007 3 Summer 2008
Although all of the firm s customers will pay the same price, it is the behavior of the marginal customers those on the brink of buying or not buying, or increasing or decreasing the quantity they purchase, depending on the price that affects the firm s pricing decision. 12 If there are relatively few customers who would reduce their purchases in response to a price increase, the firm is more likely to find it profitable to increase price. On the other hand, if there are a sufficient number of marginal customers, then the firm would not find it profitable to increase its price, even though there are some inframarginal or core customers. In this way, the presence of a sufficient number of marginal purchasers keeps prices low for inframarginal purchasers. This economic principle helps explain the role of marginal customers in determining the limits of a relevant antitrust market. Marginal Customers and the Merger Guidelines SSNIP Test In the context of merger review, the relevant market includes all products that customers regard as reasonable substitutes for the products of the merging firms. That is, the relevant market must include all alternatives to which customers of the merging firms might turn in the event of a price increase. A market that is too narrowly drawn will exclude some of those alternatives; marginal customers, when faced with a price increase, will turn to other products outside the provisional market. Therefore, the relevant market must exhaust the alternatives to which marginal customers might turn. This important principle is embedded in the SSNIP test described in the Department of Justice (DOJ) and FTC Horizontal Merger Guidelines: A market is defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profitmaximizing firm, not subject to price regulation, that was the only present and future producer or seller of those products in that area likely would impose at least a small but significant and nontransitory increase in price [SSNIP], assuming the terms of sale of all other products are held constant. A relevant market is a group of products and a geographic area that is no bigger than necessary to satisfy this test. 13 This test has come to be known as the hypothetical monopolist test or the SSNIP test. In conducting this test, the same principles apply as in the discussion above. A hypothetical monopolist considering a small but significant and nontransitory increase in price recognizes the obvious benefit of selling at a higher price to inframarginal, or core, customers. At the same time, however, the firm considers the likely reaction of marginal customers to an increase in price. If there are very few marginal customers i.e., the quantity demanded will fall only slightly as a result of the price increase the contemplated price increase is more likely to be profitable. Intuitively, in this case, demand is relatively inelastic because many of the customers do not consider the alternatives to be attractive substitutes for the product in question. If so, the provisional relevant market satisfies the SSNIP test, and it is not necessary to expand the relevant market by including next-best substitutes. If, on the other hand, there are many marginal customers i.e., the quantity demanded will fall sharply as a result of a price increase the contemplated price increase is likely to reduce the hypothetical monopolist s profits. Intuitively, in this case, demand is relatively elastic, because customers do have attractive alternatives that they can substitute for the product in question. If so, the provisional relevant market does not satisfy the SSNIP test, and, as a result, the relevant market has to be expanded to include additional products (i.e., the nextbest substitutes). 4 Summer 2008
Application of the test in practice requires analysis of the hypothetical monopolist s profit margin and the behavior of marginal customers. In order to evaluate whether a candidate market is sufficiently broad, we carry out the following exercise. First, evaluate the sales that would be lost in response to a small price increase on the products in the candidate market (which depend, of course, on the behavior of marginal customers). Second, estimate the profit lost as a result of those lost sales. Finally, assess whether the additional profits earned on the inframarginal customers (those who do not defect in response to the price increase) more than compensate for the profits on the lost sales. If so, the SSNIP is profitable and the candidate market includes all the relevant products. If not, the candidate market is too narrow and should be expanded. Market Definition in Whole Foods Much of the disagreement about the definition of the relevant market in Whole Foods focused on what a SSNIP test would show and, ultimately, on the number of marginal customers or purchases. In particular, the FTC and the parties disagreed about the results of a properly conducted SSNIP test. Whether a SSNIP is likely to be profitable for a candidate PNOS market depends on the extent to which an increase in PNOS prices would lead to a significant reduction in the purchases at PNOS, which, in turn, depends largely on the diversion of purchases to other types of supermarkets and grocery stores (i.e., substitutes for PNOS). Estimating the size of this effect is really an assessment of the behavior of PNOS customers who may be willing to change their purchasing behavior in response to the increase in price i.e., marginal consumers, not inframarginal (core) customers. Marginal customers, therefore, are the proper focus for market definition a view with which the District Court agreed. 14 The Appeals Court s Focus on Core Customers The Appeals Court, however, disagreed, choosing to focus instead on core customers: As the FTC presented its case, success turned on whether there exist core customers, committed to PNOS, for whom one should consider PNOS a relevant market. The district court assumed the marginal consumer, not the so-called core or committed consumer, must be the focus of any antitrust analysis. Whole Foods, 502 F.Supp.2d at 17 (citing Horizontal Merger Guidelines, 57 Fed. Reg. 41,552 (1992)). To the contrary, core consumers can, in appropriate circumstances, be worthy of antitrust protection. See Horizontal Merger Guidelines 1.12, 57 Fed. Reg. at 41,555 (explaining the possibility of price discrimination for targeted buyers ). 15 Our Practice NERA economists employ economic theory and quantitative methods grounded in a thorough understanding of the market facts to provide a full range of theoretical and empirical economic analysis and testimony in matters involving mergers and acquisitions, antitrust litigation, and competition policy. We advise companies and their attorneys, as well as governments and regulators, throughout the world on investigations of alleged monopolization, abuse of dominant position, and market power. We analyze the entire range of economic issues that arise in antitrust cases, including market definition and market power, market structure and entry conditions, pricing, and other conduct affecting competition, profitability, and damages. NERA s expertise includes assessing and, when necessary, testifying to the economic merits of allegations of foreclosure and exclusionary conduct, tying and bundling, refusals to deal, vertical restraints, collusive behavior, essential facilities, and anticompetitive pricing behavior. 5 Summer 2008
Elaborating on this theme, the Appeals Court wrote: In appropriate circumstances, core customers can be a proper subject of antitrust concern. In particular, when one or a few firms differentiate themselves by offering a particular package of goods or services, it is quite possible for there to be a central group of customers for whom only [that package] will do. What motivates antitrust concern for such customers is the possibility that fringe competition for individual products within a package may not protect customers who need the whole package from market power exercised by a sole supplier of the package. Grinnell, 384 U.S. at 574. Such customers may be captive to the sole supplier, which can then, by means of price discrimination, extract monopoly profits from them while competing for the business of marginal customers. Cf. Md. People s Counsel v. FERC, 761 F.2d 780, 786-87 (D.C.Cir.1985) (allowing natural gas pipelines to charge higher prices to captive customers would be anticompetitive). 16 This language suggests that the Appeals Court may have had concerns about price discrimination against core customers. The DOJ and FTC Horizontal Merger Guidelines recognize the possibility that the hypothetical monopolist might be able to engage in price discrimination, and the Guidelines explain how and when the agencies will define relevant markets limited to those customers against whom price discrimination can be targeted: Existing buyers sometimes will differ significantly in their likelihood of switching to other products in response to a small but significant and nontransitory price increase. If a hypothetical monopolist can identify and price differently to those buyers ( targeted buyers ) who would not defeat the targeted price increase by substituting to other products in response to a small but significant and nontransitory price increase for the relevant product, and if other buyers likely would not purchase the relevant product and resell to targeted buyers, then a hypothetical monopolist would profitably impose a discriminatory price increase on sales to targeted buyers. This is true regardless of whether a general increase in price would cause such significant substitution that the price increase would not be profitable. The Agency will consider additional relevant product markets consisting of a particular use or uses by groups of buyers of the product for which a hypothetical monopolist would profitably and separately impose at least a small but significant and nontransitory increase in price. 17 About NERA NERA Economic Consulting (www.nera.com) is an international firm of economists who understand how markets work. We provide economic analysis and advice to corporations, governments, law firms, regulatory agencies, trade associations, and international agencies. Our global team of more than 600 professionals operates in over 20 offices across North America, Europe, and Asia Pacific. NERA provides practical economic advice related to highly complex business and legal issues arising from competition, regulation, public policy, strategy, finance, and litigation. Founded in 1961 as National Economic Research Associates, our more than 45 years of experience creating strategies, studies, reports, expert testimony, and policy recommendations reflects our specialization in industrial and financial economics. Because of our commitment to deliver unbiased findings, we are widely recognized for our independence. Our clients come to us expecting integrity and the unvarnished truth. 6 Summer 2008
As the Guidelines indicate, however, a number of important conditions are required to delineate a market based on price discrimination. The hypothetical monopolist must be able to (a) identify targeted buyers with particularly low elasticities of demand, (b) charge them prices that differ from the prices the monopolist charges other customers, (c) prevent re-sale of the product by other (non-targeted) buyers who purchase at lower prices, and (d) do so profitably because the targeted buyers are unable to defeat the targeted price increase by substituting to other products in response to a small but significant and nontransitory price increase for the relevant product. Review of the public record reveals little focus on price discrimination during the proceedings before the District Court. In any case, it is by no means clear that the four conditions discussed above are satisfied in Whole Foods. It is certainly not obvious how to identify core customers in this case. The FTC and the Appeals Court note, for example, that core values espoused by the parties are important to some buyers. But it is not clear who those buyers are or how one would identify them. Unless the parties can identify such customers, they cannot target them for higher prices. Even if it were possible to identify them, the Appeals Court fails to explain how Whole Foods could charge them higher prices than other customers. 18 And even if Whole Foods could identify such customers and charge them higher prices, nothing prevents other customers from buying at lower prices and re-selling the products to targeted customers. 19 Establishing that these three prerequisites are met would require detailed economic analysis of customer preferences and purchasing patterns as well as the pricing, marketing, and promotional behavior of suppliers. Finally, even if painstaking analysis establishes that the first three conditions are satisfied, the hypothetical monopolist must be able to impose a small but significant and nontransitory price increase on targeted buyers profitably before it is appropriate to define a market based on sales to so-called core customers. In short, within the putative market of committed or core customers who are by no means perfectly homogenous there must be sufficiently few marginal customers for a price increase to be profitable. Thus, even in this context, marginal customers determine the boundaries of the relevant market. Although price discrimination against core customers does not seem possible, the Appeals Court s discussion of firms that differentiate themselves by offering a particular package of goods and services suggests that the Court may have a different relevant market in mind and one that is even narrower than the one defined by the FTC: a market for premium natural and organic produce sold by PNOS, for example. 20 If so, a SSNIP test for that market would be appropriate, and the results of the test would again hinge on the behavior of marginal customers. Conclusion In sum, it is not clear what prompted the Appeals Court to eschew analysis of the behavior of marginal customers and to focus instead on core customers. There will always be core (i.e., inframarginal) customers in the market. Indeed, if the market is properly defined, as described by the Guidelines SSNIP test, it is largely the plight of the inframarginal customers in that market that is the concern of the merger review exercise: 21 will sufficient alternatives be available within the relevant market to discipline the pricing of the merged firm and thereby protect these customers? But that question can only be addressed after the boundaries of the market have been delineated a process that depends on analyzing the behavior of marginal customers under successively broader definitions of the market. Thus, at its core, market definition must depend on the behavior of marginal customers. To overlook this bedrock economic principle and shift the focus to core customers at the market definition stage simply invites confusion and mischief. 7 Summer 2008
NOTES 1 See Federal Trade Commission v. Whole Foods Market, Inc., et al., US Court of Appeals for the District of Columbia Circuit, No. 07-5276, 2008 WL 2890688, 29 July 2008 (Appeals Court decision), at 5. Similarly, at page 8, the majority states, We conclude the district court acted reasonably in focusing on the market definition, but it analyzed the product market incorrectly. 2 We were not involved in this matter in any way, and much of the relevant discussion related to market definition has been redacted from the public versions of various pleadings and expert reports that are available. 3 The case raises other interesting issues that we do not address here, including (a) the proper standard for issuance of a preliminary injunction under Section 13(b) of the FTC Act and (b) the practical issues involved in revisiting an acquisition that closed nearly a year ago. Note, however, that the FTC argues that many of the eggs remain unscrambled, so the case is not moot. See, for example, the Proof Reply Brief for Appellant Federal Trade Commission, Federal Trade Commission v. Whole Foods, Inc., and Wild Oats Markets, Inc., February 27, 2008. Available at http://www.ftc.gov/ os/caselist/0710114/080227wholefoodsftcproofreplybriefpublic.pdf (last accessed 15 August 2008). 4 See the Complaint, In the Matter of Whole Foods Market, Inc., and Wild Oats Markets, Inc., Docket No. 9324. Available at http://www.ftc.gov/os/adjpro/d9324/index.shtm (last accessed August 15, 2008). 5 Complaint for Temporary Restraining Order and Preliminary Injunction Pursuant to Section 13(b) of the Federal Trade Commission Act, Federal Trade Commission v. Whole Foods Market, Inc., and Wild Oats Markets, Inc., 6 June 2007. Available at http://www.ftc.gov/os/caselist/0710114/070605complaint.pdf (last accessed 15 August 2008). 6 Federal Trade Commission v. Whole Foods Market, Inc., and Wild Oats Markets, Inc., US District Court for the District of Columbia, Civil Action No. 07-1021(PLF), 502 F.Supp.2d 1 (District Court decision). 7 According to the FTC, there are 25 such locations. See the Memorandum in Support of Plaintiff s Motion for Temporary Restraining Order and Preliminary Injunction, Federal Trade Commission v. Whole Foods Market, Inc., and Wild Oats Markets, Inc., 6 June 2007, at 20. Available at http://www.ftc.gov/os/caselist/0710114/070710publi cversiontromemo.pdf. (last accessed 15 August 2008). The District Court decision lists 17 locations in which the parties are allegedly the only PNOS competitors and another in which they are two of the three. See the District Court decision at 38 (as cited in note 6). Although the defendants have criticized the FTC s methodology for delineating geographic markets, most of the discussion has focused on the product market. 8 In its filings with the Appeals Court, however, the FTC also suggested that precise market definition may not be necessary for the Commission to prevail: Market definition, while long an important tool, is a means to an end to enable some measurement of market power not an end in itself. Where direct evidence of anticompetitive effects is presented, courts have recognized that traditional market definition may be altogether unnecessary to the adjudication of antitrust claims. (See Proof Brief for Appellant Federal Trade Commission, Federal Trade Commission v. Whole Foods Market, Inc., and Wild Oats Markets, Inc.,14 January 2008, at fn. 26. Available at http://www.ftc.gov/os/caselist/0710114/080114ftcwholefoodsproofbrief. pdf (last accessed 15 August 2008)). See also fn. 25 of the same brief, which discusses anticompetitive unilateral effects. 9 See District Court decision at 8 (as cited in note 6), citing FTC v. Staples, Inc., US District Court for the District of Columbia, 970 F.Supp. at 1073. 10 District Court decision at fn. 11 (as cited in note 6). 11 A demand curve is elastic at a particular price if a small percentage change in price is associated with a larger percentage change in quantity. 12 The possibility that the firm may charge different prices to different customers often referred to as price discrimination is discussed below. 13 US DOJ and FTC Horizontal Merger Guidelines, revised 8 April 1997, Section 1.0. 14 District Court decision at 17 (as cited in note 6). 15 Appeals Court decision, at 9 (as cited in note 1). 16 Appeals Court decision, at 10 (as cited in note 1). 17 US DOJ and FTC Horizontal Merger Guidelines, Section 1.12 (emphasis added) (as cited in note 13). 18 The Appeals Court asserts that the FTC documented exactly the kind of price discrimination that enables a firm to profit from core customers for whom it is the sole supplier. (See Appeals Court decision at 11 (as cited in note 1).) The Court points to evidence presented by the FTC suggesting that Whole Foods s margins were lower in cities in which it faced competition from Wild Oats than their margins in cities in which Whole Foods did not face such competition. While such evidence might suggest something about the proximity of the parties products in product space, it does not indicate that Whole Foods engaged in price discrimination targeted at core customers: within the geographic markets defined by the FTC, Whole Foods apparently charged all customers the same prices. 19 If Whole Foods somehow identified you as a targeted customer and charged you a higher price, nothing would prevent your neighbor from buying produce at a lower price and selling it to you with a slight markup (for his neighborly shopping service ). This arbitrage, of course, would effectively undo Whole Foods s attempted price discrimination. 20 See also the Appeals Court s language at p. 9: The district court s error of law led it to ignore FTC evidence that strongly suggested Whole Foods and Wild Oats compete for core consumers within a PNOS market, even if they also compete on individual products for marginal consumers in the broader market. See, e.g., Appellant s Br. 50, 53. 21 Of course, the merger review process is also concerned with marginal customers, who, even if they switch to alternative products in response to a price increase, may be harmed as well. For further information, please visit our global website at: www.nera.com. Copyright 2008 National Economic Research Associates, Inc.