Lecture 7 Final Complete EC337

Lecture 7 Horizontal Competition Issues: Mergers and Unilateral Effects Part I: 

EC337 Industrial Economics 2: Market Economics, Competition and Regulation Department of Economics University of Warwick Module Leader: Dr. Chris Doyle 26 October 2011 Lecture 7 Horizontal Competition Issues: Mergers and Unilateral Effects Part I

Terminology: 

Terminology Horizontal mergers: mergers between firms that supply competing products Non-horizontal mergers: mergers between firms that operate at different levels of the supply chain of an industry ( vertical mergers ) or mergers between firms supplying products at the same level in the supply chain which do not compete ( conglomerate mergers ) Unilateral effects: May arise in horizontal mergers where the merger involves two competing firms and removes the rivalry between them, allowing the merged firm profitably to raise prices, e.g. as predicted in Cournot oligopoly models Coordinated effects: May arise in both horizontal and non-horizontal mergers where the merger enables or increases the ability for several firms within the market (including the merged firm) jointly to increase price because it creates or strengthens the conditions under which they can coordinate ( tacit collusion, see Lectures 10 & 11 ) Vertical or conglomerate effects: These may arise principally in non-horizontal mergers where the merger creates or strengthens the ability of the merged firm to use its market power in at least one of the markets, thus reducing rivalry

UK Merger Guidelines: 

UK Merger Guidelines Explains the approach of the OFT when considering whether or not to refer a merger to the CC for further investigation and the approach of the CC when exploring more extensively the statutory questions posed in merger references “merger assessment is inevitably case specific. It must take account of the particular transaction and the markets being analysed. The methodologies of merger analysis cannot be applied in a rigid and mechanistic way. The Authorities will therefore consider each merger with due regard to the particular circumstances of the case, including the information available and the time constraints applicable to the case , and will apply these guidelines flexibly, departing from them where they consider it appropriate to do so .”

UK Merger Regime: 

UK Merger Regime Two-phase process like EU Interrelated roles of CC and OFT Anticipated and completed mergers covered Mergers are not required to be notified to the Authorities OFT reviews in Phase 1 OFT has duty to refer to the CC for further investigation any relevant merger situation where it believes that it is or may be the case that the merger has resulted or may be expected to result in an SLC (Substantial Lessening of Competition) Phase 2, the CC investigates mergers that are referred to it The CC determines the outcome of merger cases referred to it by the OFT. In the event that it finds that the merger will lead to an SLC, the CC decides upon remedies and has powers to implement them

Differences between the UK and EU: 

Differences between the UK and EU The UK merger regime applies an SLC test The European Commission under the ECMR considers whether the merger would significantly impede effective competition, in particular as a result of the creation or strengthening of a dominant position Notwithstanding the underlying economic approach to assessment carried out by the UK Authorities is generally similar to that carried out by the European Commission

Substantial Lessening of Competition: 

Substantial Lessening of Competition Competition is viewed by the UK Authorities as set in Lecture 1 slide 4 “The Authorities will consider any merger in terms of its effect on rivalry over time in the market or markets affected by it. Many mergers are either pro-competitive or benign in their effect on rivalry. But when levels of rivalry are reduced, firms’ competitive incentives are dulled, to the likely detriment of customers. Some mergers will lessen competition but not substantially so because sufficient post-merger competitive constraints will remain to ensure that rivalry continues to discipline the commercial behaviour of the merger firms. A merger gives rise to an SLC when it has a significant effect on rivalry over time, and therefore on the competitive pressure on firms to improve their offer to customers or become more efficient or innovative. A merger that gives rise to an SLC will be expected to lead to an adverse effect for customers. Evidence on likely adverse effects will therefore play a key role in assessing mergers. ”

Applying a SLC Test: 

Applying a SLC Test The UK Authorities apply theories of harm in assessing a merger Theories of harm ( terminology for economic models or dimensions within a model ) provide the framework for assessing the effects of a merger and whether or not it could lead to an SLC They describe possible changes arising from the merger, any impact on rivalry and expected harm to customers as compared with the situation likely to arise without the merger ( the counterfactual ) The OFT’s reference test is met when it considers there to be a realistic prospect of an SLC in respect of one or more of the theories it considers The SLC test involves a comparison of the prospects for competition with the merger against the competitive situation without the merger, the counterfactual. The counterfactual is an analytical tool used in answering the question of whether the merger gives rise to an SLC

Analytical Approaches and Methods: 

Analytical Approaches and Methods The SLC test is framed in terms of two related issues : The identification of the market or markets for the goods or services concerned The assessment of the competitive effects of the merger in the market(s ) In applying the SLC test, the UK Authorities generally conduct their analysis under the following headings: market definition (see Lecture 4 ); measures of concentration; horizontal mergers—unilateral effects (including any vertical effects of horizontal mergers ); horizontal mergers—coordinated effects; non-horizontal mergers—unilateral and coordinated effects; efficiencies ; entry and expansion; and countervailing buyer power.

Market Share data and Measures of Concentration: 

Market Share data and Measures of Concentration Market share data are widely used in horizontal merger assessments Recent historical trends to examine variability May be used in conjunction with observations on variable profit margins Concentration measures: Market shares Number of firms Concentration ratios For example the aggregate market share of a small number (three or four generally) of the leading firms in a market ( e.g. the three-firm concentration ratio , or C3, shows the proportion of the market supplied by the three leading firms This fails to show variability across the largest firms The Herfindahl-Hirschman Index (HHI ) (see Lecture 1 ) The change in the HHI (known as the ‘delta’) is calculated by subtracting the market’s pre-merger HHI from its expected post-merger HHI . The absolute level of the HHI post-merger and the delta arising from a merger can provide an indication of the change in market structure resulting from the merger

HHI: Delta: 

HHI: Delta The delta as measured by the change in the HHI can be calculated independently of the overall market concentration by doubling the product of the market shares of the merging firms Example: Merger of two firms with market shares of 30% and 15% increases HHI by 900 (30×15×2 = 900 ) – this is the delta Pre-merger the market shares of the merging firms contribute to the HHI(Pre) by their squares individually: a 2 + b 2 Post-merger the contribution to the HHI(Post) is the square of the sum of their respective market shares: ( a + b ) 2 = a 2 + b 2 + 2 ab Delta = HHI(Post) – HHI(Pre) = 2 ab

UK Practice: Market shares and Number of Firms: 

UK Practice: Market shares and Number of Firms OFT decisions in merg e rs in markets where products are undifferentiated suggest that combined market shares of less than 40 per cent will not often give the OFT cause for concern over unilateral effects In relation to the number of firms , previous OFT decisions in mergers involving retailers suggest that the OFT has not usually been concerned about mergers that reduce the number of firms in the market from five to four (or above )

UK Practice: HHI: 

UK Practice: HHI UK practice is in line with the EC Merger Regulation Guidelines Guidelines 2004/C 31/03 OFT may have regard to the following thresholds: any market with a post-merger HHI exceeding 1,000 may be regarded as concentrated and any market with a post-merger HHI exceeding 2,000 as highly concentrated In a concentrated market HHI>1,000, a horizontal merger delta< 250 is not likely to give cause for concern In a highly concentrated market, a horizontal merger generating a delta<150 is not likely to give cause for concern These thresholds may be most informative for mergers in a market where the product is undifferentiated and where competition between firms involves firms choosing what volume to supply to the market. In other cases the significance of these thresholds will be less

HHI and Delta example for US: 

HHI and Delta example for US

Unilateral Effects: 

Unilateral Effects The unilateral effects arising from a horizontal merger are due to the harm arising from the reduction in competitors and possibly diminution in the effect of rivalry Homogeneous products case Unilateral effects most likely where a market is highly concentrated, where the merger involves a recent ‘maverick’ entrant, and where there are switching costs or network externality effects Differentiated products case Closeness of substitution and make use of diversion ratios Variable profit margins Own-price elasticity of demand

Predictions from Theory: 

Predictions from Theory Cournot Oligopoly From slides 16 & 17 in Lecture 1 I showed: If the pre- and post-merger demand elasticities are the same, and the merger does not affect the industry average marginal cost, it can be shown (see Take-away question 5 ) The problem in practice with the above expression as a predictor is the need for knowledge about HHI pos t prior to a merger

Predictions from Theory: 

Predictions from Theory Cournot Oligopoly: Benchmark case Merger with no effects on cost and no reaction from competitors implies merger is strictly profitable where the firms compete, as the merged entity will reduce quantity and consumer surplus will fall. The non-merging firms also gain. Cournot Oligopoly (Strategic Substitutes) The no reaction from competitors is unrealistic and the cost assumption a simplification Under strategic substitutes if the merged firms reduce output (bad for consumers), other firms increase output (good for consumers) Consider a merged firm’s output at x m with marginal cost c m ´(.), profit maximisation implies: Pre-merger sum of the equilibrium conditions:

Predictions from Theory: 

Predictions from Theory Cournot Oligopoly (Strategic Substitutes) Given the pre-merger quantity ( x i +x j ) and the post-merger quantity ( x m ) a merger increases price (joint-output falls in the merged entity) unless the following condition holds: See Take-away question 6 Next lecture we shall look at merger simulations (Lecture 8) and return to analytical measures of mergers in Lecture 9

Take-away questions: 

Take-away questions Why is the HHI measure of concentration more useful than say a four firm Concentration measure? It reflects variation across firms see slides 19 & 20 Show how the HHI may be related to the Lerner Index in certain market structures See Lecture 1 slide 16 and slide 21 Why might the HHI be unreliable as a test for the unilateral effects of a horizontal merger involving firms with differentiated products? If some firms are more efficient (assume the differentiation is along this dimension), using pre-merger market share data and assuming a symmetric Cournot oligopoly setting is potentially misleading Could a higher HHI following a horizontal merger reflect increased competition in a market? If yes, explain why Cost synergies allow merged firm to set lower prices and gain market share Derive expression (*) relating price change to HHI on slide 15 Answer on slide 21 Derive expression (**) relating price change to HHI on slide 17 Answer on slide 22 The following short paper is a helpful note on answering some of the above: Answers given in following slides Rachel Griffith, Jan Boone and Rupert Harrison (2005) “ Measuring Competition ”, Advanced Institute of Management Research working paper

Notes on HHI (1): 

Notes on HHI (1)

Notes on HHI (2): 

Notes on HHI (2)

Answer to Q.5: 

Answer to Q.5

Answer to Q.6: 

Answer to Q.6 Suppose p= 5 and the individual marginal cost functions for i and j are 4. Output at the merged entity w ould increase as long as the marginal cost of the joint entity was not above 3. Between 3 and 4 o utput falls even though there are cost synergies, these are offset by strengthening market power.