Conjectural variations: unilateral effects

1. Conjectural variations: unilateral effects Incorporating rival responses into simplified unilateral effects measures • Adrian Majumdar & Chris Doyle • adrian.majumdar@rbbecon.comchris.doyle@rbbecon.com

2. Overview • Authorities’ use of price pressure tests • Theoretical approach to integrating rival responses into UPP: GePP • Applying GePP in practice • Formal implementation • Informal implementation • Intuitive implications of GePP • Policy implications

3. Authorities’ Use of Price Pressure Tests • Recognition that market share based screens can be poor indicators of harm in differentiated goods markets (Werden 1996, Shapiro 1996) CC • Somerfield Morrisons, 2005 (symmetric IPR) • Zipcar /Streecar, 2011 (GUPPI) OFT • Lovefilm/Amazon (rebuttable presumption of SLC arising from high D and high M) • [NB. Rebuttable presumption no longer applies] • Asda/Netto, 2010 (IPR, isoelastic, asymmetric diversion ratio, efficiencies) • Unilever/ Alberto Culver, 2011 (GUPPI with multi products, upstream market) • These days GUPPI is more likely to be considered than IPR?

4. Upwards pricing pressure (UPP) • A first order approach to calculating the impact of a merger on price • UPP on product 1 = D12 (P2 – C2) – EC1 • Standard approach – internalisation of demand spill-over to firm 2 • Opportunity cost (cannibalisation) intuition of Farrell & Shapiro • Weighed up against efficiency gain (reduction in marginal cost) • Can then think about pass through of higher cannibalisation cost

5. GUPPI = Gross Upward Pricing Pressure Index • GUPPI for product 1 D12 * (P2 – C2) P1 • Perceived increase in marginal cost of selling another unit, as a percentage of price • Intuition: post merger, the owner of product 1 faces a perceived increase in cost, if the cost increase is a high share of the price of product 1, then pass through (higher prices) are more likely. • Can multiply GUPPI by pass through rate to obtain “first order” estimate of price increase caused by a merger.

6. “Illustrative” price rises with symmetric demand and cost What is a price pressure test? • Merger simulation? • A way to put information on percentage margins and diversion ratios in context? • Screen: IPR > 5% or GUPPI > 10% => worth looking further? (Retail mergers with many local overlaps.) • Evidence weighed up with other factors.

7. Judging a price pressure test • Lucid (understood by policy makers) • Implementable at Phase I (data, time) • Predictive power (good or bad?!) • Example: • Do “equilibrium properties” of IPRs trump First Order Approach to Mergers (FOAM)? • Not if FOAM offers a better LIP service… • Both are approximations anyway (e.g. ignore supply side responses) • The research question: given an environment where the OFT uses price pressure tests, should such tests be updated to include pricing conjectures?

8. Jaffe and Weyl – Generalised Pricing Pressure (GePP) • Extend UPP to incorporate rival responses using conjectural variations • A complex theoretical model which covers a range of issues • We aim to simplify and present the main intuitive implications for policy • Adding greater realism should act towards better predictive power… • But is GePP implementable and clear to policy makers?

9. GePP: incorporating CVs requires a conjectured diversion ratio • Conventional UPP uses the standard diversion ratio which holds rivals’ prices constant following a price increase by firm 1 • Jaffe and Weyl consider the implications of rival responses for diversion patterns, and how this affects incentives to change price in the first place • In particular they consider firms as having “accommodating” pricing reactions • Post merger, firm 1 also considers how rivals will respond but treats firm 2’s price as fixed

10. GePP: incorporating CVs requires a modified diversion ratio • This “conjectured” diversion ratio is different from the standard one in 2 ways: • Fewer customers will be lost by firm 1 as a result of a price increase, as accommodating rivals will be more expensive • More customers will be recaptured at firm 2 as a result of the price increase by firm 1, as firm 2 will now be relatively cheaper than accommodating rivals • Therefore with accommodating reactions the conjectured diversion ratio is greater than the standard one – indicating the potential for greater price increases than with standard UPP

11. GePP: end of accommodating reactions • Jaffe and Weyl highlight that a consideration of rival responses introduces a new effect - the merger will lead to the “end of accommodating reactions” (EAR) • Pre-merger the fact that an increase in firm 1’s price would lead to an increase in the price of firm 2 would have encouraged higher pricing by firm 1 • Post merger the price of product 2 is directly controlled by firm 1, so this indirect incentive to increase price is removed • Indicates the potential for smaller prices increases than with UPP • Broad intuition: if 1 and 2 were accommodating each other pre-merger, there is less competition to be “lost” as a result of the merger • Overall 2 opposing effects: conjectured diversion vs. EAR

12. Implementing GePP formally • By assuming consistent conjectures GePP can potentially be formally estimated using data obtained from cost shocks • However this is potentially (very) complex: • Clean cost shocks to the merging parties • Sufficient data to allow us to accurately observe their impact • Econometric approaches required to estimate GePP using this data • Given the time and data constraints faced during the screening phase for mergers, unlikely that this formal approach will be practically implementable • Simplified versions of GePP outlined by Jaffe & Weyl may be more implementable – but they appear to be based on strong assumptions (as are IPRs)

13. Implementing GePP informally • Sometimes measures used to imply diversion ratios may in some senses already incorporate the reactions of rivals (e.g. internal business documents) • Notable exception is surveys which potentially measure the standard diversion ratio • Rather than being a problem, Jaffe & Weyl claim this may be an advantage as GePP emphasises that we actually want a measure that incorporates rival responses • Though note this information will only be a rough approximation as it typically will not hold the price of product 2 constant as desired • BUT don’t just plug this diversion ratio into a standard UPP formula, as this will ignore the EAR term and could therefore bias the outcome • Don’t mix and match models: implement GePP fully or stick to UPP • But it may be difficult to estimate EAR here

14. Intuitive implications of GePP • Even if GePP can’t be properly implemented, it may provide an indication of when standard UPP over- or understates true upwards pricing pressure • Example: NBTY/Julian Graves • 2 major specialist retailers of nuts seeds and dried fruit • Key question is the role of supermarkets in providing a competitive constraint • Evidence indicated supermarkets did not monitor the parties’ pricing • Implies zero conjectures, meaning conjectured DR equals the conventional DR • But EAR is likely to be present (parties monitored each other) • This indicates that UPP here likely overstates upwards pricing pressure

15. Policy Implications • GePP may potentially provide a way to take into account rivals’ reactions in an upwards pricing pressure measure • However,this approach will usually not be (properly) implementable at Phase I • Nevertheless, GePP indicates that if we ignore conjectures and undertake standard UPP, no obvious bias is introduced into merger control (benchmarked against a standard UPP screen) • Parties may not volunteer to the OFT that they accommodate each other! • But why wouldn’t the merger change conjectures? • Perhaps we shouldn’t try to pack too much into a single model

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