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24 Antitrust 27 (2009-2010)
Will Use of the Upward Pricing Pressure Test Lead to an Increase in the Level of Merger Enforcement

handle is hein.journals/antitruma24 and id is 29 raw text is: Will Use of the Upward Pricing Pressure Test Lead to an Increase in the Level of Merger Enforcement? BY GOPAL DAS VARMA OSEPH FARRELL AND CARL SHAPIRO, Chief Economists of the Federal Trade Commission and the Antitrust Division of the Department of Justice, respectively, have recently proposed an alter- native to market definition as a screen for the unilat- eral effects of a merger between firms that produce differen- tiated products.' This alternative is called the Upward Pricing Pressure (UPP) test. It eschews the traditional structural approach, in which a relevant antitrust market is defined and shares and concentration are calculated to determine whether the merger exceeds certain thresholds (structural presumption).2 Instead, the UPP test appeals directly to the economic theory of how a merger alters unilateral pricing incentives.' Separately, in his recent writings, Shapiro has argued forcefully that merger enforcement by the agencies was too lax during the George W. Bush administration and he recommended strengthening merger enforcement activi- ty by, among other things, updating the structural presump- tion.4 The agencies' recently announced plans to consider revising the Horizontal Merger Guidelines has led to con- siderable interest in the UPP test and the possibility that it might supplant the traditional structural presumption.' Two questions are raised by the potential replacement of the structural presumption with the UPP test. First, what are the characteristics of mergers that do not create a structural presumption but are likely to create a UPP presumption, and vice versa? Second, overall, will the UPP alternative to the structural approach lead to fewer or more instances in which the agencies will subject mergers to additional scrutiny on unilateral effects grounds? Background of the UPP Test To answer these questions, it may be helpful to review how the UPP test works in practice and how it differs from struc- Gopal Das Varma is a Principal in the Washington, DC office of Charles River Associates. The views expressed in this article are the author's per- sonal opinions and do not necessarily represent the views of Charles River Associates or its other consultants. The author would like to thank, without implicating, Martino DeStefano, Andrew Dick, and Serge Moresi for helpful comments on an earlier draft. tural analysis.' A key determinant of the competitive con- straint imposed by one differentiated product on another is the extent to which the products are close substitutes of one another in the chain of buyer substitution. Closeness of sub- stitution may not be reflected accurately by market shares. For example, a large proportion of the buyers of one product might consider another specific product to be their second choice even though the collective share of the two products in a defined relevant market is small. A merger between two such products, by eliminating the local competitive con- straint between them, might nevertheless result in higher prices. The UPP test avoids this potential problem with the structural approach because it directly evaluates the potential for a merger's unilateral price effects by appealing to the the- ory of how a merger affects the merging firms' post-merger pricing incentives. A related practical problem with the structural approach is the decision regarding where to draw the boundaries of the relevant market, i.e., which products to include in the mar- ket definition. In both Whole Foods-Wild Oats and Oracle- PeopleSoft-two relatively recent mergers in which the agen- cies sought enforcement action-the district courts held that the relevant market definitions proposed by the agencies were too narrow because they did not include other prod- ucts that, in the courts' judgment, were reasonably inter- changeable with the merging firms' products.7 The UPP test can avoid such controversies regarding which products to include in the relevant market and which ones to leave out. UPP derives from the basic economic theory of unilater- al effects. Under certain assumptions, the UPP test measures the competitive constraints that are eliminated by a merger. Following a merger, each merging firm has an incentive to raise its price because it stands to recapture through its merg- ing partner's product some of the sales that it loses due to the price increase. The value of the recaptured sales is measured by the appropriate diversion ratio between the merging firms' products multipled by the dollar value of the variable margin earned on the merging partner's product. The more closely substitutable are the merging firms' products, the higher is the diversion ratio between them. The higher is the variable margin earned on the merging partner's product, the greater FALL 2009 - 27

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