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Quantitative Application of the Hypothetical Monopolist Paradigm Gregory J. Werden Senior Economic Counsel Antitrust Division U.S. Department of Justice* *The views expressed herein are not purported to reflect those of the U.S. Department of Justice.

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Page 1: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Quantitative Applicationof the

Hypothetical Monopolist Paradigm

Gregory J. Werden

Senior Economic CounselAntitrust Division

U.S. Department of Justice*

*The views expressed herein are not purported toreflect those of the U.S. Department of Justice.

Page 2: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

The Hypothetical Monopolist Test in theU.S. 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 profit-maximizing 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, assuming the terms of

sale of all other products are held constant.

Page 3: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

The Hypothetical Monopolist Test in theOFT’s Market Definition

One way to look at this problem is to consider an

undertaking that was the only supplier of the products (or

group of products) at the centre of the investigation and

use the conceptual framework of whether a hypothetical

monopolist of these products would maximise its profits

by consistently charging higher prices than it would if it

faced competition.

Page 4: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

The Hypothetical Monopolist Test in theOFT’s Mergers: substantive assessment

[A] market is defined by asking whether it would be

profitable for a hypothetical monopolist to impose a small,

but significant (five to ten per cent), non-transitory increase

in price (the SSNIP test) on a given product or group of

products. Starting from the product or products immed-

iately affected by the merger, further products are added to

the group until a price increase of five to ten percent would

be profitable because customers would not switch away

from the postulated group in sufficient numbers.

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Merger and Non-Merger Scenarios

! The hypothetical monopolist test is designed to address

whether proposed conduct would create market power.

! That is the issue when the conduct under review (e.g.,

a proposed merger or new business practice) has not

fulfilled any potential to create market power.

! The hypothetical monopolist test is not well suited for

addressing whether a firm is exercising significant

market power (i.e., whether it is dominant).

Page 6: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Application vs. Full Implementationof the Hypothetical Monopolist Test

Mere application of the hypothetical monopolist test asks

whether a profit-maximizing monopolist over a given set

of goods would increase price significantly.

Full implementation of the test applies it only to a

sequence of “candidate markets,” starting with a “focal

good” produced by a merging firm, and constructed by

adding the best substitute for the focal good, and so on.

Page 7: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Standard Formulae for Applying theHypothetical Monopolist Test

Critical Elasticity of Demand Analysis

Profit-Maximization Calculation

Breakeven Calculation

Critical Sales Loss Analysis

Profit-Maximization Calculation

Breakeven Calculation

Page 8: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Critical Elasticity of Demand Analysis

Profit-Maximization Calculation:

The maximum elasticity of demand a profit-maximizing

monopolist could face at pre-merger prices and still want to

increase price by some significance threshold, e.g., 5%

Breakeven Calculation:

The maximum elasticity of demand a monopolist could face

at pre-merger prices and still not experience a net reduction

in profits from a given price increase, e.g., 5%

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Critical Sales Loss Analysis

Profit-Maximization Calculation:

The maximum reduction a hypothetical, profit-maximizing

monopolist would be willing to tolerate in its quantity sold

to sustain a given price increase, e.g., 5%

Breakeven Calculation:

The maximum reduction a monopolist could experience in

its quantity sold and still not experience a net reduction in

its profits from a given price increase, e.g., 5%

Page 10: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Profit-Maximization vs. Breakeven

Profit-Maximization Calculations:

These calculations implement the HMGs’ hypothetical

monopolist test but are sensitive to the unknown shape of

the hypothetical monopolist’s demand curve.

Breakeven Calculations:

These are close to profit-maximization calculations for

small price increases and high margins, and critical sales

loss is independent of the shape of the demand curve.

Page 11: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Critical Elasticities of Demandfor Market Delineation

DemandCurve

ProfitMaximization

Break-Even

Linear1 1

m + 2t m + t

Isoelastic1 + t log(m + t) – log(m)

m + t log(1 + t)

m = price-cost margin t = price increase significance level

Page 12: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Critical Elasticities of Demandfor a 5% Price Increase

DemandCurve

Premerger Price-Cost Margin

0% 40% 50% 60% 70% 100%

Profit Maximization

Linear 10 2.00 1.67 1.43 1.25 0.91

Isoelastic 21 2.33 1.91 1.62 1.40 1

Break-Even Linear 20 2.22 1.82 1.54 1.33 0.95

Isoelastic 4 2.41 1.95 1.64 1.41 1

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Critical Sales Lossfor Market Delineation

DemandCurve

ProfitMaximization

Break-Even

Lineart t

m + 2t m + t

Isoelastict

1– (1+ t)

–1– t

m+ t m + t

m = price-cost margin t = price increase significance level

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Percentage Critical Sales Lossfor a 5% Price Increase

DemandCurve

Premerger Price-Cost Margin

0% 40% 50% 60% 70% 100%

ProfitMaximization

Linear 50.0 10.0 8.3 7.1 6.3 4.5

Isoelastic 64.1 10.8 8.9 7.6 6.6 4.8

Break-Even Any 100 11.1 9.1 7.7 6.7 4.8

Page 15: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

FTC v. Tenet Health Care Corp.17 F. Supp. 2d 937 (E.D. Mo. 1998),rev’d, 186 F.2d 1045 (8th Cir. 1999)

! The district court accepted the FTC’s contention that the

geographic scope of the relevant market was a 50-mile radius

around Poplar Bluff, Missouri.

! On appeal, the defendant argued that its critical loss analysis

demonstrated that the FTC’s market was too narrow.

! The Eighth Circuit held that the FTC failed to show that

hospitals outside its alleged market were not “practical

alternatives for many Poplar Bluff consumers.”

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United States v. Mercy Health Services902 F. Supp. 968 (N.D. Iowa 1995),

vacated as moot, 107 F.3d 632 (8th Cir. 1997)

! Relying on defendant’s breakeven critical loss of 8%, the court

found sufficient switching would occur “in the event of a 5%

price rise” “to make the price rise unprofitable.”

! The government predicted the total elimination of managed care

discounts—a far larger price increase, so the court also

considered a larger (albeit not large enough) price increase.

! The court reckoned the critical loss at 20–35%, although it was

actually about 46%.

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California v. Sutter Health System84 F. Supp. 2d 1057 (N.D. Cal. 2000), aff’d, 217 F.3d 846 (9th

Cir. 2000), amended by 130 F. Supp. 2d 1109 (N.D. Cal. 2001)

! A major point of contention was whether the critical loss

analysis should consider only a 5% price increase.

! Purporting to follow the Horizontal Merger Guidelines, the court

held that only 5% should be used.

! This may be the most clear-cut and serious error ever made by

a court in applying the hypothetical monopolist paradigm.

! Although a 5% price increase is unprofitable, a far greater price

increase still could be profit maximizing.

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FTC v. Swedish Match131 F. Supp. 2d 151 (D.D.C. 2001)

! Both sides’ experts relied on critical elasticity analyses, which

differed as to both on the critical and actual elasticity.

! Although the court discussed these analyses in detail, it found

neither expert’s evidence “persuasive.”

! The court, however, applied its own critical loss analysis,

finding that “it cannot be unprofitable for the hypothetical

monopolist to raise price . . . because the hypothetical

monopolist would lose only a small amount of business.”

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United States v. SunGard Data Sys., Inc.172 F. Supp. 2d. 172 (D.D.C. 2001)

! The court noted defendants’ contention that margins exceeded

90% so the critical loss was very low.

! The government and its expert said nothing about this analysis.

! The court held that the government had failed to show that the

customers who would not switch in the face of a price increase

were “substantial enough that a hypothetical monopolist would

find it profitable to impose such an increase in price.”

Page 20: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Assessing Price-Cost Margins: Theory

! The relevant cost concept is avoidable cost, and which costs are

avoidable depends on

the magnitude of the change in output and

the time period considered.

! The relevant change in output depends on how much price

actually would be increased and on the elasticity of demand.

! Sales contracts and other institutional details may affect which

costs are avoidable.

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Assessing Price-Cost Margins: Practice

! Never simply use whatever the parties call their margins; rather,

get data from which margins can be computed.

! Get disaggregated revenue and cost data supporting a range of

options as to which costs and which products are included.

! Find out from the parties exactly how the data were complied.

! Treat the determination of margins as a central task of the

investigation and anticipate the parties’ arguments.

! Premerger margins should be explainable as the product of an

equilibrium of the premerger game.

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Assessing Price-Cost Margins: Issues

! Could shutting some capacity down avoid fixed any costs?

! Does some capacity entail higher-than-average marginal cost?

! Could capacity be diverted to other profitable uses?

! Do sellers price discriminate, and if so, would the margins on

the lost sales be above or below average?

! How would the hypothetical monopolist and actual competitors

raise price and reduce output?

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The Paradox of High Price-Cost Margins

! A high pre-merger margin implies a low critical elasticity and

critical sales loss, perhaps suggesting a broad market.

! In equilibrium, however, a high margin tends to imply a low

actual demand elasticity and actual sales loss.

! In standard oligopoly models, higher pre-merger margins imply

larger unilateral price effects from mergers.

! Small differences in demand elasticities are important when they

are nearly unitary as with very high margins, and it may be

difficult to measure them precisely enough to be useful.

Page 24: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Pitfalls In Applying Standard Formulae

! While typical applications posit small price increases, the profit-

maximizing monopoly price increase, and even that from the

merger, may be large.

! While standard formulae presume constant marginal cost and no

avoidable fixed costs, actual cost functions may be quite

different.

! While standard formulae implicitly increase all prices

proportionately, profit-maximization often implies highly

disproportionate price increases.

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Modeling the Hypothetical Monopolist

! The demand and cost assumptions of critical loss and critical

elasticity analysis can be relaxed.

• On the demand side, it is possible to have distinct customer

types with different demands.

• On the cost side, many things are possible.

• Information needed to calibrate more flexible demand and

cost functions commonly is available.

! The implicit assumption that the hypothetical monopolist

increases prices proportionately can be dropped.

Page 26: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 28: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 29: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 32: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 33: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 34: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 37: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

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Page 38: Quantitative Application - Vanderbilt Business School · Quantitative Application of the ... a proposed merger or new business practice) ... Relying on defendant’s breakeven critic

Full Implementation of the

Hypothetical Monopolist Test

! The hypothetical monopolist test is applied only to candidate

markets built up through an iterative process.

! The process begins with a focal good sold by one of the merging

firms, and the next-best substitute added at each iteration.

! The process generally stops when a hypothetical monopolist over

a candidate market would raise price significantly.

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The Candidate Market Sequence

! Goods are ranked on the basis of closeness to the focal good,

normally using a metric based on cross elasticities of demand.

! The first candidate market is just the focal good; the second is the

focal good and its closest substitute; and so on.

! The hypothetical monopolist test is applied to each candidate

market and only to each candidate market.

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The Hypothetical Monopolist Test

! The hypothetical monopolist selects prices for all goods in a

candidate market so as to maximize its profits.

! Prices of goods outside a candidate market generally are assumed

to be held constant.

! The hypothetical monopolist’s many prices are combined (e.g.,

by averaging) to form a price-increase norm.

! Every candidate market is a market if the price increase norm

exceeds the price increase significance threshold (e.g., 0.05).

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The Relevant Market Rule and Property

! From the many markets, a single relevant market is selected,

using a relevant market rule, e.g., the smallest market principle,

which holds that the relevant market is the smallest one.

! The relevant market actually alleged is the relevant market

property, which distinguishes goods in the relevant market from

all others on the basis of traits.

! The relevant market property may employ natural market

boundaries, which are groupings recognized in the industry or by

data compilers and national or other political boundaries.