3. HoustonKemp.com
Outline
• How economists can help assess the competitive
effect of mergers
• How does the market function?
• Coordinated effects
• Barriers to entry
• Unilateral effects (firms set quantity)
• Unilateral effects (firms set prices)
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4. HoustonKemp.com
Mergers can be very valuable for the economy
• ACCC assessed 322 mergers in 2014-15, conducting
public reviews of 42
• Cost synergies estimated to be 3-4% of transaction
value, on average
• Value of mergers estimated to be US$1.3 trillion in
Asia-Pacific region in 2015
• BUT, some mergers can reduce competition, driving
up prices
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5. HoustonKemp.com
Economics is only relevant if it can assist in the
assessment of conduct with reference to the law
• Section 50 of the Competition and Consumer Act
(CCA) prohibits mergers that…
‘would have the effect, or be likely to have the effect,
of substantially lessening competition [SLC] in any
market’
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6. HoustonKemp.com
Economics can help determine whether there has
been a SLC
6
How does the market function?
What are the credible theories of harm?
Does the evidence support a credible
theory of harm?
• What information is needed?
• Market definition
• Use qualitative and quantitative
evidence
• What is the likely effect of the
merger?
• Theories of harm need to be
consistent with how market operates
• Under what conditions would theory
of harm be true?
SLC • Relate back to competition law
7. HoustonKemp.com
How does the market function?
• Strategic environment
› Price setting
› Quantity/capacity setting
› Auction
› Bargaining
• Type of products
› Homogenous or
differentiated?
› Substitutes
7
• Entry/expansion
› Capacity constraints
• Market structure
› Concentration (over time)
› Vertical relationships
• Type of customers
› Small
› Large
• Others
› Two-sided market
› Network effects
› Innovation
8. HoustonKemp.com
What are the credible theories of harm?
• Vertical mergers
› Similar arguments for vertical restraints
• Horizontal mergers
› Coordinated effects
Collusion becomes more likely/stable
› Unilateral effects
Firms act independently
8
Firm A Firm B
Firm C Firm D
9. HoustonKemp.com
Coordinated effects
• Three conditions necessary for collusion to take
place
› Firms reach agreement as to conduct
› Collusive agreement is internally stable
› Collusive agreement is externally stable
• Merger may affect first two conditions
› Easier to reach agreement with fewer firms (in particular if
merge with maverick)
› Reduced incentive to cheat in more concentrated market
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11. HoustonKemp.com
Contestable markets and barriers to entry
11
• Perfectly contestable market
› One supplier
› Technology/knowhow for production
available to all
› Fixed, but no sunk costs
• Outcome
› Price=average costs
› Mergers have no effect
• But
› Fixed costs often sunk – no
‘hit and run’ entry
› New entrants may have higher
variable costs
12. HoustonKemp.com
Barriers to entry allow incumbents to set prices above
the competitive level without entry occurring
• Some disagreement on exact definition
• Something that allows the incumbents to earn above-normal
profits
• A cost of producing that must be borne by an entrant but not
incumbents
• Additional profit earned as a sole consequence of being
established in the industry
• Barriers to entry allow firms to have market power
• Extent to which the threat of entry restricts market
power depends upon
› Likelihood of entry
› Timeliness of entry
› Impact of entry on the incumbents
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Unilateral effects when firms set quantities
• Cournot model
› Firms independently and simultaneously decide their own
quantity/capacities
› Products are homogeneous
› Prices determined by total amount supplied by all firms
• Examples
› Airlines
› Farms
› Mining
13
14. HoustonKemp.com
Herfindahl-Hirschman Index (HHI)
• HHI is the sum of the squared market shares
› 𝐻𝐻𝐼 = 𝑠𝑖
2
• Eg
› Market shares, 20%, 30% and 50%
› HHI = 202+302+502=3,800
• Take into account
› HHI post merger
› change in HHI as a result of the merger
• ‘The ACCC will generally be less likely to identify horizontal
competition concerns when the post-merger HHI is:
› less than 2000, or
› greater than 2000 with a delta less than 100.’
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Limitations of Herfindahl-Hirschman Index
• Post merger market shares will not be sum of pre
merger market shares if the merger is anticompetitive
• Industry average marginal cost will change if there
are efficiencies and/or if market shares change
• Need to consider possibility of entry
• Requires market shares of all firms
• Only applies to Cournot competition
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Unilateral effects when firms set prices and sell
differentiated products
• Bertrand competition
› Firms set prices
› Products are differentiated – they are imperfect substitutes
› Eg, differentiation may be
Brand
Quality
Location of stores
• Examples
› Restaurants/ coffee shops
› Retail
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Store A Store B Store C
18. HoustonKemp.com
Merger simulation for differentiated products
• Use model calibrated to observed features of market
to predict the effects of a merger
› Estimate cost and demand parameters
Assume form of demand
› Calibrate demand system to give prices and market shares
actually observed
› Specify model of competition – Bertrand in this case
› Re-estimate model with new market structure, and
potentially, efficiencies
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Drawbacks of merger simulation
• Assume form of competition, demand system and
functional form of marginal cost unchanged by
merger
• Assumes no supply side response
• Data availability
• May not provide precise result
• Time intensive
• Results can appear to be opaque
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20. HoustonKemp.com
Simplified merger simulation – pricing pressure
tests
• Number of assumptions have been suggested
› Hold prices of third party firms constant
Only need price elasticities and cross-price elasticities of merging
firms
› Use Lerner index to determine own-price elasticities from
mark-ups
› Use diversion rations instead of cross price elasticities
› Demand curvature
Assume linear or constant elasticity of demand
Assess effects at current prices
• Leads to a variety of different tests
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The economic intuition behind UPP
24
Price
rises
Quantity falls Quantity Increases
Significance of this incentive
depends upon:
• Quantity of sales that switches
(closeness of competition)
• Profit margin for silver (benefit
from each switched sale)
27. HoustonKemp.com
Calculating UPP
• Calculating profit maximising prices involves
determining the FOC and setting this equal to 0
• Upward pricing pressure when FOC>0
• So UPP only measures direction of effect
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Calculating UPP (firm 1)
28
Pressure for prices to rise Pressure for prices to fall
Marginal cost reduction (firm 1)
as fraction of the price
e1 =
∆𝑐1
𝑝1
Profit margin (firm 2)
p2−c2
p2
Diversion ratio (from 1 to 2)
D12 = −
ε21
ε1
×
Q2
Q1
𝑝2
𝑝1
p2−c2
p2
× 𝐷12 − 𝑒1
35. HoustonKemp.com
Market share and UPP approaches give different
results
35
68%
DG𝑃 = 0.25
UPPG = −0.0896
UPP𝑃 = −0.0438
D 𝑃𝐺 = 0.15
Post merger HHI: 5,648
Change in HHI: 2,070
Market share UPP
36. HoustonKemp.com
Benefits and limitations of using UPP
• Benefits
› UPP is relatively easy to calculate
› Does not rely on market definition
• Limitations
› Assumptions about functional form for demand
› Does not account for
supply-side response (entry and repositioning)
multi-product nature of firms (eg effect on complementary
products)
response to price changes by other firms
› Often relies on surveys or switching analysis for diversion ratios
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Outline
• What are vertical restraints?
• How economists can help to assess the competitive
effects of vertical restraints
• Pro-competitive effects of vertical restraints
• Anti-competitive effects of vertical restraints
• Overall assessment
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40. HoustonKemp.com
Common vertical restraints
• Selective distribution
• Exclusive distribution
• Exclusive supply
• Single branding
• Quantity forcing
• Restraints to prices
› Resale price maintenance
› Most favoured nation contracts
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Vertical restraints are important in the economy
• Vertical restraints are common
› Includes lots of types of conduct
• Can be pro and anti competitive
• Topical issue
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Vertical restraints can be prohibited under the
Competition and Consumer Act
• Anti-competitive agreements (s 45)
› SLC test
• Misuse of market power (s 46)
› Substantial market power
› Take advantage of market power
› Damage an actual or potential competitor
• Exclusive dealing (s 47)
› Parts per se, parts subject to SLC test
• Resale price maintenance (s 48)
› Per se offence
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43. HoustonKemp.com
Economics can help determine whether there has
been a substantial lessening of competition
43
How does the market function?
What are the credible theories of harm
and benefit?
Does the evidence support a credible
theory of harm or benefit?
• What additional information is
needed?
• Market definition
• Use qualitative and quantitative
evidence
• What is the likely net effect of the
conduct?
• Theories of harm need to be
consistent with how market operates
• Under what conditions would theory
of harm be true?
SLC • Relate back to competition law
45. HoustonKemp.com
Vertical restraints can prevent free-riding
45
Manufacturer
High quality
retailer
Discount Store
Customer visits
store
Customer
purchases product
48. HoustonKemp.com
Vertical restraints can facilitate downstream
collusion
48
Manufacturer A
Retailer A Retailer B
Agree retail price Agree retail price
Agree to
collude using
vertical
restraints
49. HoustonKemp.com
Vertical restraints can facilitate collusion upstream
49
Manufacturer A
Retailer A
Agree retail price Agree retail price
Manufacturer B
Collusion
over
wholesale
prices
52. HoustonKemp.com
Risk of vertical restraints being anti-competitive
increases with market power
52
Risk of anti-competitive effect increasing
No
market
power
Downstream
market
power only
Upstream
and
downstream
market
power
Upstream
market
power only
53. HoustonKemp.com
Assessing vertical conduct
Do any of the
firms involved
have significant
market power?
Is there an anti-
competitive
theory of harm
that is consistent
with the facts?
Is there a pro-
competitive
theory that is
consistent with
the facts?
Weigh up pro
and anti-
competitive
effects
53
No
No
SLC
Yes, significant benefit,
and little harm
No
SLC
Yes
Small, or
no
significant
benefit
No
No
SLC
Yes
54. HoustonKemp.com
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