Simulating Mergers MSc Regulation and Competition March 2005

Overview This talk on ideas and methods Instruction for the software Practice with the software Input into coursework

Merger simulation overview Legal framework Limitations of earlier approaches What merger simulation is Key assumptions: the economics Implementation Uses and limitations

Legal framework “Balance of advantage” arguments admitted: US anti trust enforcement: application of rule of reason. Merger guidelines on HHI EU Merger Regulation and task force –“create or strengthen an dominant position” UK Enterprise Act 2002…“ substantial lessening of competition”

Standard approaches Define the market Work out market shares and entry barriers Apply judgement on dominance and likely effects

Difficulties Delineation of market not clear (geographic or product) Differing degrees of substitution What would be the impact of merger –pricing –allowing for cost savings

Merger simulation Used in arguing for or against A model of market –typically calibrated by econometric analysis Making assumptions about behaviour Effects on prices and welfare estimated Alternative scenarios and assumptions can be tested

Example cases Staples/Office Depot (FTC) –FTC predict 7% increase –15% pass-through rate WorldCom/Sprint (FCC) –Effects on long distance prices Volvo/Scandia (EU - example) –Price rises in national markets Kimberley Clark (Company)

Behaviour assumptions Mainly Nash equilibria: –Cournot (quantity setting) –Bertrand (price setting) Nash equilibria look at “unilateral effects” Also possibility of looking at collusion effects

The Cournot model Other firms’ outputs are fixed Choose output to maximise profits Unique equilibrium: –market share depends on relative marginal cost Most relevant for: –homogeneous products –markets with important capacity decisions

Bertrand Mainly for differentiated products=> Chamberlin model Own- and cross-elasticities relevant Simple formula: (P i - MC i )/P i = -1/ E i BUT E i may not be constant –choice of demand function matters (Crooke et al)

Demand functions Depends on how fast elasticity rises with price Extremes: –constant elasticity –linear Intermediate –Almost Ideal Demand System (AIDS) –Logit –Probit

Qualifications No substitute for understanding the market Apparent precision is spurious Miss out key features of reality e.g. potential competition

Arguments for “Scientific” – assumptions explicit

“Merger Simulation is Science “Based on well-established economic theory E.g., econometric theory, theory of consumer demand, and oligopoly theory Underlying assumptions are clearly laid out and can often be tested Demand model can be tested Nash-Bertrand assumption can be tested by comparison to pre- merger margins Process and results can be replicated A third party following the same steps would reach the same results Even though there are modeling choices along the way, these choices are fully described “ (extract from Leonard presentation)

Sources of software Canadian Competition Authority –Cournot model – Vanderbilt University –Bertrand, linear demand – – –These give limited control over outputs For this exercise we grew our own teaching aids

Running the software Excel file with macros DiffProdStud1.xls or Coursework handoutDiffProdStud1.xls cournot-102.xls

Further reading Numerous papers by Froeb and Werden Crooke Froeb and Tschantz on functional forms Greg Leonard (Nera) In defense of merger simulation Mike Walker (Charles Rivers Associates) Paper to Industrial Economics Study group Nottingham, December 2005