1. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Hidden inconsistencies David Stallibrass Shanghai | March 2013 Personal views of author. Does not represent opinion or position of any institutions to which he is affiliated.

2. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contents  Economics, assumptions, and the law  Market shares and equilibrium  Collusion and profit maximisation  Dominance and One Monopoly Profit  Conclusion 2

3. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Economics, assumptions, and the law Joke 3 Engineer: how shall we get water? Lawyer: when we find water, who will own it? Economist: Lets just assume we have some water.

4. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Economics, assumptions, and the law Background  All economic models require simplifying assumptions  In economic law – such as antitrust – the results of economic models inform the substantive application of the law “Even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist” JM Keynes 4

5. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Economics, assumptions, and the law Example – market shares and mergers 5 Law Market share safe harbors Market share as major tool of merger control Model Market shares are a good proxy for market power Assumption Markets are in equilibriumFirms profit maximizeTransition costs are low

6. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Economics, assumptions, and the law Question in China  Has China imported assumptions from other jurisdictions that are not suitable for the Chinese economy? 6 Chinese Law Assumptions about the European economy Inform European Law Based on Assumptions about the Chinese economy Imply Assess?

7. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Economics, assumptions, and the law Caveat  Relative concision of Chinese antitrust decisions and guidance  Exercise is necessarily one of speculative explanation  But…throw some light on what might be different about antitrust in China 7

8. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contents  Economics, assumptions, and the law  Market shares and equilibrium  Collusion and profit maximisation  Dominance and One Monopoly Profit  Conclusion 8

9. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Use of market shares in merger control  MOFCOM relies heavily on market shares  AML Article 27  HHI and market share  Notification form  2 years of market share  Proposal for fast-track (10% combined for horizontal, 20% for vertical)  Cases  All cases mention market share analysis  All but three include market shares  Google – just 1 quarter!  Delphi – “growing market shares” suggests dynamic analysis 9

10. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Use of market shares dominance  Less clear how important  AML article 19  presumptions of dominance  QQ / 360  very high market shares consistent across time, no decision yet  Baidu, J&J  market shares not sufficient (though perhaps market not well defined)  Ad-hoc nature means perhaps a little less important 10

11. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Assumptions behind market share use  Models of mergers utilize “comparative statics” 11 Model of market before the merger (market shares imply cost, product differentiation, etc)  market shares ≈ market power Change in market structure Model of market after the merger (changes in price, production, output) ∆ market shares ≈ ∆ market power Requires equilibriumAssumes quickly move to new equilibrium

12. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Assumptions behind market share use  No authority relies totally on these models  PCAIDS / ALM experimentation by EU / OFT  But central to determining safe harbours  HHI and safe harbor discussions in the US (1970s and 1980s) still a major driver of thresholds in many jurisdictions  Substantial modern criticism  Market share a “lagging variable”  Requires definition of a market (which doesn’t really exist in reality) 12

13. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Assumptions behind market share use  The assumption of equilibrium requires:  The speed of economic change is slower than the speed of firms ability to react to it  In practice:  Change is slow: consumer tastes, regulatory landscape, business opportunities  Reactions are quick: access to capital, low regulation, easy entry 13

14. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Do the assumptions hold in China?  Are tastes and business opportunities moving very quickly?  High growth  Very large regional and sectoral variation  Can firms react quickly?  Extensive regulation  Limited and un-even access to capital markets  Conclusion: assumption less likely to hold than in Europe 14

15. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Suggestions for Chinese enforcement  Market shares a good proxy for young authorities  Limited resources  Learning  Provides legal clarity  Short-term changes  Ask for three years’ market share  Consider  Adopting GUPPI  doesn’t need market shares 15

16. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 16 Profit Cost of production Profit Cost of production Profit Cost of production Firm A Firm C Firm B

17. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 17 Profit Cost of production Profit Cost of production Firm A Firm C Firm B  If firm A raises price, loses sales, but makes extra profit on what it does sell. Profit Cost of production Prof it Co st of pr od uct ion

18. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 18 Profit Cost of production Profit Cost of production Firm A Firm C Firm B  In this instance, it will not raise it’s price. Increased profit < value of lost sales Profit Cost of production Prof it Co st of pr od uct ion

19. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 19 Profit Cost of production Profit Cost of production Profit Cost of production Firm A Firm C Firm B  Some of those sales go to competitors, who make extra profit Prof it Co st of pr od uct ion

20. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 20 Profit Cost of production Profit Cost of production Profit Cost of production Firm A Firm C Firm B  If Firm A owned firm C then it would count firm C’s profit when it thought about raising it’s price Prof it Co st of pr od uct ion

21. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI introduction  “First round incentives” of horizontal mergers always to raise price 21 Profit Cost of production Profit Cost of production Profit Cost of production Firm A Firm C Firm B  In this case, it would raise it’s price Prof it Co st of pr od uct ion Increased profit of firm A and B > value of lost sales to firm A

22. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI calculation  The real drivers of horizontal unilateral effects are not market share or market definition, but diversion ratio’s and profit margins. 22  A has a stronger incentive to raise prices if it either A loses a lot of customers to C when it raises it’s price, or C has very high profits Profit Cost of production Profit Cost of production Firm A Firm C Prof it Co st of pr od uct ion

23. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI calculation  Two things we need to know for UPP  UPP A = Diversion Ratio A  C x Unit profit C  Maybe a lot easier than market definition! 23 Profit Cost of production Profit Cost of production Firm A Firm C Prof it Co st of pr od uct ion Diversion ratio (units diverted to Firm C as proportion of units lost by Firm A) Profit of Firm C

24. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium GUPPI calculation  GUPPI puts that in context  GUPPI A = UPPI A / Price A  In US, if 10% raises concerns 24 Profit Cost of production Profit Cost of production Firm A Firm C Prof it Co st of pr od uct ion Price of Firm A

25. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Market shares and equilibrium Summary  PRC enforcement (especially in mergers) very market share focused  May not be appropriate given nature of PRC economy  Could consider more direct ways of establishing competitive harm from mergers 25

26. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contents  Economics, assumptions, and the law  Market shares and equilibrium  Collusion and profit maximisation  Dominance and One Monopoly Profit  Conclusion 26

27. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Collusion and profit maximisation PRC approach to collusion  Merger control  Co-ordinated effects commonly mentioned: the belief that the merger will increase the likelihood of collusion  Novartis / Alcon, HDD, Potash  All foreign firms. Nexus of competition often outside of China  Administrative enforcement  Unilever pricing intention case  Foreign and domestic firms, competing in China 27

28. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Collusion and profit maximisation Assumptions behind collusion analysis  Primary assumption: firms only collude if it is in their unilateral incentive to do so  Expected gains from collusion > expected cost  Collusion likely sustainable where  Firms are symmetric  Market is stable  Goods are homogenous  Collusion almost always harmful  Raises price and lowers quantity compared to non-collusion 28

29. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Collusion and profit maximisation Do the assumptions hold in China?  No strong evidence. But:  Large number of family owned firms  Theory that Chinese business sometimes more focussed on win-win than win-lose  Theory that Chinese businessmen sometimes care more about winning than maximising profit  Substantial state intervention  Trade associations may sustain collusion where otherwise it would fail  Etc.  Perhaps they hold less 29

30. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Collusion and profit maximisation Implications for enforcement  Enforcement – perhaps correct to be more concerned  If features of market suggest collusion more likely  No evidence that increased Chinese concern is linked to characteristics of Chinese business  In mergers, all firms were foreign, and nexus of business largely outside China  In administrative enforcement, then increased concern may be acceptable 30

31. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Collusion and profit maximisation Implications for enforcement  There may be situations where cartel enforcement would be welfare reducing  Current “Chinese equilibrium” sustains cartel with large number of firms (quantity high, price medium, output high, employment high)  Busting the cartel leads to standard competition  If market is highly competitive, then inefficient firms will leave the market until remaining firms re-enter tacit collusion  This new collusion may involve lower production than previous  Welfare effects may be ambiguous  Further research required 31

32. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contents  Economics, assumptions, and the law  Market shares and equilibrium  Collusion and profit maximisation  Dominance and One Monopoly Profit  Conclusion 32

33. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit PRC approach to Leveraging  Merger control appears open to the idea of a dominant firm “leveraging” market power from one market into another  CocaCola  WalMart  Shenhua  Decisions are short and not much detail is given 33

34. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Leveraging theory  Before merger, Firm 1 is dominant in Market A 34 Market A Market B Producers Consumers Firm 1 Firm 2 Firm 3 Firm 4 Firm 5 Firm 6 Firm 7 Consumer

35. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Leveraging theory  Firm 1 buys firm 3 in market B 35 Market A Market B Producers Consumers Firm 1 Firm 2 Firm 3 Firm 4 Firm 5 Firm 6 Firm 7 Consumer

36. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Leveraging theory  Firm 1 bundles the two goods together… 36 Market A Market B Producers Consumers Firm 1 Firm 2 Firm 3 Firm 4 Firm 5 Firm 6 Firm 7 Consumer

37. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Leveraging theory  Forcing other firms out of the market 37 Market A Market B Producers Consumers Firm 1 Firm 2 Firm 3 Firm 7 Consumer

38. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Leveraging theory  But the Chicago school (1970s, 1980s) says this is wrong:  Before the merger, Firm 1 already charging “monopoly price”  Forcing customers to buy the good of Firm 3 when previously they didn’t want to is the same as lowering the price of the good of Firm 1  This would be unprofitable, since they are already charging the profit maximising price for the good of Firm 1  Firm 1 has only “one monopoly profit” which it has already extracted – it can not extract it again!  Post-chicago modifies this, but Chicago school still starting point for most analysis 38

39. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Application in other jurisdictions  EU comparison  DGCOMP, ‘EU non-horizontal guidelines’, 2008: "it is acknowledged that conglomerate mergers in the majority of circumstances will not lead to any competition problems.“  CFI (Tetra Lavell): “Since the effects of a conglomerate-type merger are generally considered to be neutral, or even beneficial, for competition on the markets concerned,... the proof of anti-competitive conglomerate effects of such a merger calls for a precise examination, supported by convincing evidence, of the circumstances which allegedly produce those effects.”  Pure leveraging theory of harm is not credible  Other arguments necessary: Raising rivals costs, Increased ability and incentive to foreclose, Increased ability and incentive to predate, etc. 39

40. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Key assumption behind Chicago School  All firms are profit maximising  Even dominant firms 40

41. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Does the assumption hold in China?  Substantial intervention of state into management of firms  Large firms  SOE’s  Medium and small firms  Local development plans  Different firm objective  Sustain status quo?  Sense of civic responsibility?  OMP may not hold 41

42. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Dominance and One Monopoly Profit Implications for enforcement  Leveraging theories of harm may be more plausible in China  Monopoly profit not yet extracted in Market A, so may try and extract some in Market B through bundling / tying  Power of government intervention may force firms to accept the bundle, despite not wanting to do so  But unclear whether merger cases are compatible with this  Do not appear to be firms with substantial state involvement 42

43. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contents  Economics, assumptions, and the law  Market shares and equilibrium  Collusion and profit maximisation  Dominance and One Monopoly Profit  Conclusion 43

44. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Conclusion Problem of identification  PRC decisions are short  Hard to know why they were made  Hard to know what assumptions underpinned analysis  Makes it hard for external observers to understand  Lawyers less able to advise firms  Firms less able to self-police  Government less able to benefit from advice and support of academia 44

45. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Conclusion Mixed sensitivity to different assumptions  PRC enforcement appears to have a strong focus on market shares  Not consistent with analysis of economic differences  PRC enforcement appears to be more concerned about collusion  Generally consistent with analysis of economic differences, but unclear in particular cases  PRC enforcement appears to be more concerned about leveraging market power  Generally consistent with analysis of economic differences, but unclear in particular cases 45

46. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Conclusion Further work  RPM in China – a two headed dragon  Practical analysis of GUPPI vs. Market Shares in PRC merger control  Modelling of “Chinese collusion equilibrium”  “Chicago in Shanghai”: how the Chicago school applies to Chinese antitrust 46

47. PRELIMINARY ANALYSIS – SUBJECT TO MATERIAL CHANGE Contact details  economics@davidstallibrass.com economics@davidstallibrass.com  PRC Tel: (+86) 186 1307 4004  www.davidstallibrass.com 47