Anatomy of a competition authority’s merger review.

In this post, I plan to provide a brief overview of some of the sorts of economic evidence and analyses that a competition authority undertakes when it reviews a merger. I’ll skip over the boring legal and threshold-related details to focus on the main avenues of economics that are analysed. This overview is primarily based on the approach used by the European Commission and the CMA (formerly the OFT), but is generally applicable to all competition authorities globally.

Market definition and market shares.

The definition of the “relevant market” and the calculation of market shares are not the be-all-and-end-all of the assessment of the merger, but are intead used as a starting point. The first step is to define the relevant market so as to enable the appropriate market shares to be calculated. This requires the use of a thought experiment termed the “Hypothetical Monopolist Test” – this test starts at the narrowest possible market (usually the combination of the merging parties’ products) and asks the question: could the hypothetical monopolist profitably increase prices by a small but significant amount on a permanent basis? If the answer is yes, then that means that the candidate market contains all products that provide a competitive constraint on those produced by the merging parties and the test stops with the market defined as such.

If the answer is no, then the candidate market is widened to include the closest substitute products to those produced by the merging parties. The question is asked again, with the same approach taken when the result is obtained. The test stops when the result of conducting the thought experiment reaches the answer “yes”, such that all relevant substitute products are thereby included.

This test is conducted for geographic areas as well as products. The latter uses evidence regarding price correlations, product characteristics, consumer behaviour, while the former looks at price correlations across countries, transport costs relative to price of product, and the level of trade. Both are analysed in terms of demand-side substitution (where customers are switching between different products/geographies) and supply-side substitution (where the producers are switching between different products/geographies).

Once the relevant market has been correctly defined, then market shares are calculated and used as an indicator of whether the merger might lead to increases in prices (which is the usual way in which a merger might result in harm to consumers). If the combined market share of the merging parties is small, that tends to indicate that the merger is unlikely to be problematic with some minor exceptions in differentiated markets and the firms being particularly close substitutes – more on which later). Conversely, if the parties’ combined market share is high, that could indicate that the merged entity would have market power. However, this is not always the case – if market is a “bidding” one (i.e. where customers issue tenders for contracts), then the firm with the current highest share might not be in the best position to win future contracts. Hence, market shares are a useful first step, but not a definitive one.

Closeness of competition.

This is the main bulk of the analysis conducted by a competition authority and can include a number of different analyses. The aim of each is to examine the extent to which the merging parties exert a competitive constraint on each other that would be eliminated as a result of a merger (with the end result being that the elimination of a stronger constraint leads to a higher potential for the merger to increase prices).

The sorts of analyses that can be used to assess the closeness of competition between two firms tend to focus on the degree to which the firms’ customers switch between the two firms, with a high degree of switching between the merging parties implying that the merger could eliminate a strong competitive constraint. Some examples of the analyses used to determine the closeness of competition between merging parties include:

  • Price concentration analysis – this analysis looks at the relationship between the number (and identity) of competitors and the price charged by each competitor, and tries to examine if a decrease in the number of competitors (or elimination of a particular rival) would result in price increases. If the analysis indicates that the elimination of one of the merging parties would result in a price increase by the other merging party, that could be evidence that the parties are close competitors. This analysis is often conducted via econometric techniques.
  • Diversion ratios – this analysis uses observed consumer switching to try to find out what proportion of customers that left one of the merging parties switched to the other merging party (and vice versa). If the proportion of switchers (i.e. diversion ratio) between the merging parties is high, that could indicate that the merging parties are close competitors. This analysis is often obtained from firms’ win/loss records or customer surveys.
  • Cross-elasticities of demand – in order to obtain cross-elasticities of demand, a complex demand-estimation (an econometric procedure) is used (the details are too lengthy to include here, but I might cover them at a later date). A high cross-elasticity of demand between the merging parties’ products indicates that the merging parties are close substitutes for each other – if the price of one parties’ products increases, a large proportion of customers would switch to the product of the other merging party. In other words, a high cross-elasticity of demand between the merging parties could lead to a competition authority viewing the merger as problematic.
  • Upward Pricing Pressure (UPP) Indices – these tests are an attempt to combine diversion ratios and margins (i.e. prices minus costs) to obtain an indication of the incentive that the merged entity would have to increase prices. A high UPP index can occur if the parties have high diversion ratios between each other, high margins, or both, and indicates that the merged entity is likely to have a strong incentive to increase prices post-merger. As a result, a high UPP might lead to a competition authority viewing a merger as problematic.

Barriers to entry / expansion

Another important factor that competition authorities take into account is the extent to which firms already producing goods that are within the relevant market could increase their output and whether new firms could start production. If either are true, then if the merged entity were to try to increase prices, other firms could increase output and/or enter the market such that the customers of the merged entity could switch away from the merged entity. This would make the initial price increase less profitable, such that the merged entity would not have an incentive to increase prices in the first place. In this way, the presence of low barriers to entry and/or expansion would mean that a merger might be less likely to be of concern to a competition authority.

In its assessment of barriers to entry / expansion, a competition authority will take into account whether firms are able to enter/expand (since if they cannot enter, then the mechanism described above cannot constrain the merged entity); whether that entry/expansion would occur within 1-2 years (since any longer than that likely would make the merged entity’s initial price increase profitable regardless of the entry/expansion by rivals); and whether firms have an incentive to enter/expand (since without an incentive to do so, firms would not enter/expand and hence the aforementioned mechanism would not occur).

Countervailing buyer power

The final major factor that competition authorities tend to assess (although generally the assessment finds that there is little countervailing buyer power) is the extent to which the merged entity’s customers could themselves constrain the merged entity. If customers have sufficient power (usually in terms of being able to switch to different alternatives and/or bargain with the merged entity) to prevent any attempts by the merged entity to increase prices, then a competition authority might be less concerned by a merger. The assessment of buyer power tends to rely on examining the extent to which customers can switch to viable alternatives easily, the size of those customers, and whether the benefits that large customers might obtain through any power they might wield would also filter down to smaller customers.

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