ESTIMATING INCREMENTAL MARGINS FOR DIVERSION ANALYSIS

• Published in: Antitrust law journal Vol. 83; no. 2; pp. 527 - 556
• Main Authors: Sacher, Seth B, Simpson, John D
• Format: Journal Article
• Language: English
• Published: Chicago American Bar Association 01.01.2020
• Subjects: Acquisitions & mergers; Antitrust laws; Elasticity of demand; Profitability; Profits; United States > US
• ISSN: 0003-6056; 2326-9774

Obtaining and compiling the information required to estimate incremental margins can be difficult in practice. [...]antitrust economists often use proxies based on measures found in aggregate accounting data, such as the difference between price and the cost of goods sold (the gross margin) or the difference between price and average variable costs.2 However, as noted by economists in other contexts, such proxies sometimes provide a poor measure of a firm's market power and a poor measure of performance in an industry.3 In this article, we offer our views on how best to estimate incremental margins given the shortcomings of measures based on aggregate accounting data. Assuming firms set prices to maximize profit, Firm A earns less profit on any price other than the one it actually charges, i.e., at price P0A. [...]a stand-alone Firm A finds it unprofitable to increase price, as the amount of profit it stands to lose from a price increase (as represented by area B) exceeds the amount of profit it stands to gain from doing so (as represented by area A). [...]a given price increase is profitable for the merged firm if the sum of areas A and C exceeds area B. The diversion analysis depicted in Figure 1 captures the intuition of the impact of a merger on pricing where a firm acquires a noncontrolling ownership interest in a rival firm.5 It is also applicable in the analysis of a situation where two firms merge and the owner now controls prices at both firms.6 However, because the owner also has the incentive to increase prices at Firm B, such an analysis would seek to estimate the optimal post-merger price increases at both firms A and B, rather than at Firm A alone.7 The courts in FTC v. Swedish Match, United States v. H&R Block, Inc., and FTC v. Advocate Health Care have accepted similar merger simulations as useful in analyzing the competitive effects of the proposed mergers.8 The diversion analysis depicted in Figure 1 also captures the basic intuition of the market definition approach described in articles authored by Michael Katz and Carl Shapiro and by Daniel O'Brien and Abraham Wickelgren.9 To see this, simply assume that a hypothetical monopolist controls Firm A and that Firm B represents the set of firms composing the rest of the candidate market. [...]Firm B's incremental margin over the range Q0B to Q1B measures the profits the merged firm recovers on the amount of lost sales from Firm A that are recaptured by Firm B. The three incremental margins depicted in the example could be the same, or they could well be different.