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. 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. 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. 4 Upwards pricing pressure (UPP) A first order approach to calculating the impact of a merger on price UPP on product 1 = D 12 (P 2 – C 2 ) – EC 1 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. 5 GUPPI = Gross Upward Pricing Pressure Index GUPPI for product 1 D 12 * (P 2 – C 2 ) P 1 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. 6 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. Illustrative price rises with symmetric demand and cost

7. 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. 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. 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 2s price as fixed

10. 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. 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 1s 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. 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. 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 dont just plug this diversion ratio into a standard UPP formula, as this will ignore the EAR term and could therefore bias the outcome –Dont mix and match models: implement GePP fully or stick to UPP –But it may be difficult to estimate EAR here

14. 14 Intuitive implications of GePP Even if GePP cant 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. 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 wouldnt the merger change conjectures? Perhaps we shouldnt try to pack too much into a single model

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