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ABSTRACT:
Introduction: Market definition analysis, which is often central in merger cases, usually claims to follow the 1992 Horizontal Merger Guidelines issued by the U.S. Department of Justice and the Federal Trade Commission (“Guidelines”). The Guidelines describe a relevant product market as a group of products for which a hypothetical monopolist would profitably impose a “small but significant and non-transitory increase in price” (“SSNIP”). Seeking relatively simple approaches to market definition that are consistent with the Guidelines, courts and agencies often rely on Critical Loss Analysis. For example, the FTC recently challenged the proposed merger between Whole Foods and Wild Oats, two chains of grocery stores, alleging that the relevant market was “premium natural/organic supermarkets” (“PNOS”). In that market, the merger was very highly concentrating in a number of geographic areas where Whole Foods and Wild Oats operated nearby stores. But the merging parties successfully argued that PNOS was too narrow a grouping of products and that the relevant market included all supermarkets. In that broader market, there were many other competitors and the merger was not highly concentrating. Arguing that PNOS was not a relevant market, the merging firms echoed the Guidelines by asking whether a hypothetical PNOS monopolist would find a SSNIP profitable, or whether a SSNIP would deter enough sales to make it unprofitable. Critical Loss Analysis calculates the hypothetical monopolist’s Critical Loss, meaning the magnitude of lost sales that would (just) make it unprofitable for the hypothetical monopolist to impose a SSNIP, and compares it against the so-called Actual Loss of sales that would result from the SSNIP. If the Actual Loss would be less than the Critical Loss, the SSNIP would be profitable, so PNOS would form a relevant market. Whole Foods and Wild Oats argued that the Actual Loss would instead exceed the Critical Loss: a hypothetical PNOS monopolist who imposed a SSNIP would lose enough business to make the SSNIP unprofitable. Merging parties have used Critical Loss Analysis regularly, and with considerable success, to argue in court for a broader market than the government asserts. Estimating a hypothetical monopolist’s Actual Loss is difficult, so that a substantial range of estimates could seem plausible. Incentives in litigation may push parties toward exploiting that range. Thus it is highly desirable, if possible, to anchor estimates of Actual Loss and to facilitate reality checks based on actual pre-merger conduct. When it comes to demand responsiveness, economics suggests that it is particularly helpful to examine firms’ own pre-merger pricing conduct. It has been suggested, however, that pre-merger pricing is so remote from the hypothetical monopolist question that these reality checks are unhelpful. In this paper we examine that claim. We find that leading suggestions of how pre-merger pricing may be uninformative about a hypothetical monopolist’s incentives are not compelling. As a result, we are able to offer two powerful new tests to determine, using Critical Loss Analysis, whether a candidate group of products forms a relevant market. These tests extract information from the gold standard for evidence about competitive conditions in antitrust cases: firms’ actual business decisions made in the normal course of business.

SUGGESTED CITATION:
Joseph Farrell and Carl Shapiro, "Improving Critical Loss Analysis" (December 17, 2007). Competition Policy Center. Paper CPC07-079.
http://repositories.cdlib.org/iber/cpc/CPC07-079