Market Definition and Margins in the New Guidelines

Cite this Article
Joshua D. Wright, Market Definition and Margins in the New Guidelines, Truth on the Market (April 25, 2010),

I’m still working through the 2010 Horizontal Merger Guidelines, and like Dan, I find myself puzzling over some of the revisions, and in favor of others.  I wanted to start with some first impressions.  The big movement here, is that the new HMGs repudiate the market definition requirement in the new Section 4 and in Section 6 on Unilateral Effects.  Consider the language in Section 4 on market definition:

Market definition is not an end in itself: it is not of the tools the Agencies use to assess whether a merger is likely to lessen competition … .  This exercise is useful to the extent it illuminates the merger’s likely competitive effects.  The Agencies analysis need not start with market definition.  Some of the analytical tools used by the Agencies to assess competitive effects do not rely on market definition, although evaluation of competitive alternatives available to customers is always necessary at some point in the analysis.

An announcement that one must consider competitive alternative available to customers is always necessary is quite a bit different than an announcement that one must do “market definition” at some point in the analysis; and the proclamation that market definition is only useful to the extent it illuminates the merger’s likely competitive effects runs directly into the legal requirement, as Dan points out, that plaintiffs in a Section 7 case define a relevant market.   And in case it was unclear where the new 2010 HMG are heading, lets just go straight to the Unilateral Effects section for the assertion that: “diagnosing unilateral price effects based on the value of diverted sales need not rely on market definition or the calculation of market shares and concentration.”

I believe that the HMG should not repudiate the requirement that the Agencies define a relevant market as required by Section 7.  Thus, I agree with Dan, though for slightly different or complementary reasons.  Dan argues that the agencies should, in their guidelines, stick to market definition because (1) the exercise is consistent with the law, and (2) the agencies might “develop intellectual laziness on market definition over time” by failing to use it.  Fair enough.  I suspect (1) is the bigger issue.  But, at its best, the market definition procedure has the potential to screen out frivolous cases and costly errors.   Of course, the market definition procedure itself is prone to error as well.  But so long as it is consistent with the law, the agencies ought to be telling us more about how they are going to define markets and a little bit less about what they plan on doing instead.

A few other quick points.  The big move in the Guidelines is obviously away from market definition and into margins, diversion ratios, and upward pricing pressure.  That is, competitive effects analysis is going to depend primarily on whether the loss of competition between A and B because of the post-merger incentive to raise price (when A raises price, some of A’s lost sales are diverted to B), leads to a substantial lessening of competition. Obviously, the key inputs to diagnosing unilateral price effects are knowledge about the diversion ratios and the gross margins of the products involved.  There is much to be said about all of this.  But let me start with a few key points.

The first is that I am puzzled by the Guidelines suspicious talk of high gross margins.  Consider, for example, the statement that “if a firm sets price well above marginal cost that normally indicates either that the firm is coordinating with its rivals or that the firm believes its customers are not sensitive to price.”   “Normally” in that sentence has empirical connotations.  Do the Guidelines really believe that high margins “normally” indicate collusion?  I’d love to see evidence of that proposition.  The inference about elasticity is more reasonable, but of course, we know that high gross margins can occur in intensely competitive markets with high fixed costs and product differentiation and have nothing to do with antitrust relevant market power.  Independent Ink anyone?  What is puzzling about this margin paranoia is that it seems unnecessary to get where the Agencies want to go under unilateral effects analysis.  The presence of a unilateral price effect does not require one to be suspicious of high pre-merger margins as a competitive problem and it seems harmful to leave language in the Guidelines that might be interpreted as suggesting as much.  High margin businesses beware!

The second point I’d like to highlight, for now, is that the new approach pretty clearly leads to trouble in the case where a market has a relatively small number of players and relatively large firm A merges with relatively tiny firm B.  In that case, one is likely to have very large diversion ratios between A and B despite the fact that the acquisition doesn’t change market structure.   Some unilateral price effect is going to be present in nearly all mergers under these conditions (ignoring repositioning and entry for the moment, which is going to require a separate blog post).  But it is not clear that this change in pricing incentive has anything to do with the type of acquisition of monopoly power that antitrust is traditionally concerned with.  Further, the Clayton Act demands that only mergers that “substantially lessen” competition violate Section 7.  Surely, the substantiality requirement means something.  At some point, the tension between the Guidelines’ “find-a-consumer-that-is-harmed-and-define-markets-around-them” approach and Section 7 is going to come to have to come to a head.  Under the current draft of the Guidelines, I suspect that moment will come sooner than later.  That might be a good thing.