In their seminal 2010 paper, Farrell and Shapiro introduced a novel metric for the evaluation of unilateral price effects in horizontal mergers, which they called Upward Pricing Pressure (UPP). Since then, the UPP has emerged as a viable alternative to conventional concentration indices such as the Herfindahl-Hirschman Index (HHI).
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Why are mergers screened?
One of the primary concerns in company mergers revolves around the potential amplification of market power, wherein the merged entities, no longer competing, decide to raise prices above pre-merger levels.
Meanwhile, antitrust authorities lack the resources to examine in detail all the proposed mergers for anticompetitive effects. As a result, in practice, simple preliminary tests are commonly used to identify mergers with a higher likelihood of harming consumers. These mergers are then typically subjected to more detailed examinations, in which authorities assess the validity of any competition concerns.
The Herfindahl-Hirschman Index (HHI)
A commonly used indicator for merger screening is the HHI, which is calculated by adding the squares of the market share of all companies in a particular market, scaled by 100. The precise formula is presented below:
where si is the share of the ith firm.
The HHI is a measurement of market concentration, and it falls with the number of effective firms in the market. In qualitative terms, according to the US Horizontal Merger Guidelines (2010), an HHI above 2,500 implies that a market is highly concentrated, between 1,500 and 2,500 that it’s moderately concentrated, and below 1,500 that it’s unconcentrated (see Figure 1, below).
Figure 1: The HHI falls with the number of effective firms in a market.
Data: Bonsai Economics, US Department of Justice Horizontal Merger Guidelines (2010)
By assuming that market concentration indicates market power, competition authorities investigate mergers that lead to significantly more concentrated markets. In the US, for example, a rise of more than 100 points in the HHI in moderately and highly concentrated markets is flagged as a potential risk to competition, and it can trigger authorities to scrutinise further the proposed merger.
The market definition issue
In their paper, Farrell and Shapiro (2010) highlight a notable limitation of market concentration measures such as the HHI – their heavy dependence on the definition of the relevant market (you need a market definition to derive the company market shares). To substantiate their criticism, the authors delve into the case of the proposed merger between Whole Foods and Wild Oats in 2007, in which both companies were grocery chains specialising in natural and organic food.
In this case, the Federal Trade Commission (FTC) and the grocery stores used different market definitions, which led to different views on the impact of the merger. The FTC insisted on defining the relevant market as “premium natural/ organic supermarkets”, which suggested the merger would substantially increase market concentration in some locales. In contrast, the grocery stores asserted that their customers also shopped at traditional supermarkets, which should be included in the relevant market. Under this latter definition, the anticipated increase in concentration would be minimal. According to the authors, the court was unable to find a robust way to choose between the two; this suggested to them that concentration measures weren’t always appropriate for the evaluation of mergers in markets with differentiated products.
The Upward Pricing Pressure (UPP) alternative
Farrell and Shapiro (2010) introduced an interesting alternative to traditional market concentration measures – Upward Pricing Pressure (UPP). Departing from reliance on specific market definitions, the UPP assesses the price implications of mergers by considering two opposing forces:
The upward pricing pressure from the elimination of competition between merging firms. It is quantified by evaluating the degree to which a price increase in the merging firm’s product would simply divert consumers to the other one’s product.
The downward pricing pressure from the efficiencies generated by the merger. It is typically estimated by reference to some other analogous merger.
Assuming that two firms compete on price with differentiated products, the UPP for firm 1’s product can be calculated using the following formula:
where D12 denotes the diversion ratio from firm 1’s product to firm 2’s, ‘P’ and ‘C’ denote the price and cost of each firm’s product, and ‘E1’ is the efficiency gain of firm 1 because of the merger.
Using this formula, a positive UPP indicates that the merger’s adverse impact on competition may outweigh any efficiency gains, necessitating a more thorough examination of the merger.
Conclusion
Overall, the UPP presents a robust alternative to traditional market concentration measures, particularly in situations where determining the appropriate market boundaries is difficult. Nevertheless, as with the HHI, the UPP should not be regarded as conclusive evidence that a merger would harm competition. Instead, Farrell and Shapiro (2010) propose that the UPP should be primarily used as a screening tool, pinpointing those mergers which warrant closer examination by authorities.
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