Merger Simulation: Additional Methods

• Pages: 311-335

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CHAPTER XII

MERGER SIMULATION: ADDITIONAL METHODS

A. Introduction

This chapter discusses two techniques that have been used

extensively for predicting the price effects of mergers in the past and

continue to receive substantial attention today in both merger and in non-

merger investigations: residual demand analysis and the use of profit or

price-cost margins in antitrust analysis.

B. Residual Demand

1. Introduction

Residual demand analysis played an important historical role in the

development of the econometric analysis of mergers among sellers of

differentiated products, and continues to have value in a number of

applications. Its utility goes beyond analyzing the unilateral competitive

effects of mergers; it can also be useful for defining markets or assessing

single firm market power. Moreover, the simplicity of residual demand

analysis makes it useful for understanding the empirical issues that must

be addressed in any statistical analysis of demand, and thus for

suggesting which empirical methods are most suitable for application to

a particular data set. This section highlights the use of residual demand

analysis as a method for evaluating and addressing the wide range of

econometric issues that arise in empirical studies of market power and

mergers, regardless of the empirical technique employed. Its theme is

simple: to choose the appropriate empirical technique for analyzing

demand, it can help to start with the estimation of the parameters of

residual demand.

312 Econometrics

2. Identifying, Estimating, and Interpreting Residual Demand

Functions

Demand analysis is important in antitrust because it is related to the

identification and measurement of market power. However, market

power—the ability of a firm or a group of firms to raise price profitably

above the competitive level—does not depend only on buyer demand. It

also depends on the way firms interact. If a dominant firm seeks to raise

price above the competitive level, that effort could be subverted by

buyers substituting other products, or by fringe sellers expanding their

own supply.1

These two economic forces—buyer demand and seller rivalry—are

often disaggregated in antitrust analysis. The Horizontal Merger

Guidelines,2 for example, recognize demand substitution in market

definition and consider firm interaction separately when analyzing likely

competitive effects. However, residual demand analysis permits a

consideration of the total effect of these forces combined.

The key economic distinction is between a structural and a residual

demand curve. The familiar structural (or Marshallian) demand function

relates buyer behavior to prices; if the products are sold by different

firms, it does not matter how the firms interact. Mathematically, in the

structural demand function, the quantity of a product sold depends on its

price, the price of demand substitutes (i.e., competing products), and a

variety of other variables thought to be important in explaining buyer

purchasing decisions that do not vary with price or quantity sold (e.g.,

income, season of the year).

Market power is related to the slope of the structural demand

function. In particular, a downward sloping structural demand function

for the product of a single firm or group of firms is a prerequisite for the

firm or firms to exercise market power by reducing output in order to

raise price above the competitive level.3 Market power is also related to

1. The price increase could also be defeated by the supply response of

potential rivals (entry), but this discussion assumes that the market is

protected against new competition.

2. U.S. DEP’T OF JUSTICE & FEDERAL TRADE COMM’N, HORIZONTAL

MERGER GUIDELINES (1992) [hereinafter 1992 MERGER GUIDELINES],

reprinted in 4 Trade Reg. Rep. (CCH) ¶ 13,104.

3. The demand elasticity must be related to the price-cost margin on the lost

sales to determine whether a downward sloping demand curve is steep

enough to make profitable a strategy of reducing output in order to raise