III. How Do Courts and Agencies Evaluate Market Power?
Three proxies have received attention in the literature for determining whether a firm (or group of firms) has the ability and incentive to raise or maintain prices above competitive levels (or achieve other anticompetitive effects): (1) the Lerner Index; (2) market shares; and (3) the Herfindahl-Hirschman Index ("HHI"), which turns market shares into a measure of market concentration.(24) The Lerner Index is a method that theoretically could be used to determine whether firms possess market power, but as discussed below, it has proven impractical to apply to transactions. Instead, courts and agencies most typically employ market share and HHI analysis.
A. The Lerner Index
The economic definition of classical market power is the firm's ability to maintain prices above competitive levels at its profit-maximizing level of output. For a perfectly competitive firm, the competitive price level is that firm's marginal cost. The Lerner Index attempts to measure classical market power directly by subtracting a firm's marginal cost from its price, and then dividing the result by the firm's price.(25) Lerner ratios range from 0 to 1. Firms that lack market power show ratios close to zero. As the ratio increases from zero to one, it is more likely that the firm possesses significant market power. At first blush, the Lerner Index seems to offer a quick and easy insight into a firm's market power. Complex product and geographic market definitions are unnecessary. The Lerner Index, however, has not proved particularly useful to courts or agencies because it is often difficult to apply to assess either current or likely future market power.
There are both theoretical and practical difficulties in using the Lerner Index to measure market power. The main theoretical difficulty is that the Lerner Index does not offer a competitive benchmark except in perfectly competitive markets, where the Lerner Index should be zero.(26) The most significant practical obstacle to broader application of the Lerner Index is determining the firm's marginal cost of production at any given point in time.(27) Without a measurement or reasonable estimate of marginal cost, the ratio is incalculable. Moreover, exogenous economic factors, such as shifts in consumer demand or the cost of inputs, could result in dramatic and misleading changes.(28)
Some critics, such as Herbert Hovenkamp, have argued that the Lerner Index could also understate the ability of firms to engage in exclusionary conduct. Even if firms are unable to set price above marginal cost, they may be able to exclude innovations that would force prices even lower.(29) Other critics, such as George Hay, have argued that the Lerner Index could lead courts and agencies to condemn firms that offer superior or lower-cost products.(30) Hay offers a hypothetical involving a successful Washington, D.C. restaurant.(31) Although the restaurant may have long lines, high prices, and low costs, Hay argues that it would be a mistake to conclude that the restaurant is exercising market power. To the extent that the restaurant enjoys market power in the economic sense (by setting prices significantly above marginal cost), its success is attributable to a superior product, not the absence of competition. Moreover, the restaurant could have the ability to set prices significantly above marginal cost and also have a low market share. Hay concludes that "[m]arket power, in an antitrust sense, is intended to convey the degree to which the consumer can be injured because of the absence of competition. But there is no danger that the restaurant's 'power' can be exploited to the detriment of consumers since consumers are free to choose the other alternatives that are available and will continue to patronize a given firm only so long as it continues to provide a superior product."(32)
B. Market Shares
Because application of the Lerner Index may be difficult or inaccurate, courts and agencies have typically focused on other measures of market power. Foremost among these measures is market share, the percentage of sales or capacity that a firm controls in a relevant market. Market share is indirectly related to the firm's ability to set price above marginal cost. As Landes and Posner explain, the Lerner Index is the reciprocal of the demand elasticity facing the firm at its own profit-maximizing level of output. These "own-demand" elasticities may sometimes be difficult to measure directly.(33) When own-demand elasticities cannot be measured directly, economists may attempt to derive them by using a firm's market share and the elasticity of demand in the market. The outcome is conditional on economic assumptions about how firms compete with each other in the market. Landes and Posner demonstrate that for a given level of market-demand elasticity,(34) a firm's own-demand elasticity decreases as its market share increases.(35) A lower own-demand elasticity results in a higher ratio under the Lerner Index. Thus, for any given demand elasticity in a properly defined market, higher market shares reflect greater ability to set price above marginal cost.
Hay argues that market shares may provide more effective insight into market power than the Lerner Index. Returning to his hypothetical involving the Washington D.C. restaurant, Hay contends that if the restaurant had a low market share in a differentiated product market, that would demonstrate that its ability to set price significantly above marginal cost was not due to the absence of competition or high entry barriers.(36) According to Hay, "[t]his suggests that market shares should not be treated merely as a proxy for a direct evaluation of market power. Rather, the ability to price above marginal cost should not be considered antitrust market power unless it is attributable to an absence of competition as indicated by a substantial market share (although it must be acknowledged that, to some extent, this approach simply shifts the battle to one of market definition)."(37) Hay also argues that market share calculations permit courts and agencies to determine how many sales the defendant will lose if it raises prices. The greater the firm's market share, the less likely that other firms will be able to expand production to defeat the unilateral price increase.(38)
But market share analysis has attracted its share of criticism as well. Some critics contend that because market share calculations require product and geographic market definitions, they can become complex and expensive undertakings. Other critics charge that market share analysis may not produce accurate insights into market power. If product and geographic markets are defined too broadly, market shares will underestimate the firm's ability to raise or maintain prices above competitive levels in the relevant market.(39) Because market shares are based upon historical data, some argue that they may be less useful in analyzing potential competitive effects in volatile or dynamic markets.(40) Others argue that historical market share data may not reflect the ability of actual and potential competitors to increase production in the relevant market through expansion or entry.(41)
Variations in three factors -- fringe output (including new entry), supply substitutability, and elasticity of demand -- can result in dramatically different inferences that could be drawn from market shares. Landes and Posner demonstrate that differences in supply and demand elasticities can allow two firms with very different market shares (one with 23%, the other with 61%) to set price 20% above marginal cost.(42) According to Landes and Posner, market share calculations based upon capacity will be more accurate than revenue-based measures because they will incorporate supply substitutability and expansion.(43)
C. HHI Analysis
The HHI has been used in the analysis of horizontal mergers in which parties combine their productive capacities in a relevant market to operate as a single firm. The HHI squares the market shares of all firms in the relevant market to arrive at a statistical measure of concentration. Commentators have noted that, by giving greater weight to the market shares of larger firms, the HHI may more accurately reflect the likelihood of oligopolistic coordination in the post-merger market.(44) Under the 1992 Horizontal Merger Guidelines, the agencies first calculate the HHI for the relevant market before the merger. Next, the agencies calculate the HHI for the post-merger market by combining the market shares of the merging firms and squaring the result. The agencies then compare pre- and post-merger concentration levels to make an initial determination about the likely competitive effects of the transaction.
The 1992 Horizontal Merger Guidelines use the HHI primarily in two ways. First, the Guidelines set out certain safe harbors based on HHI calculations for transactions that are unlikely to create or enhance market power, or facilitate its exercise. If the HHIs of the pre- and post-merger markets fall within certain ranges, the agencies are not likely to challenge the transaction.(45) Low HHIs may therefore bring some transactions into the safe harbors of the Merger Guidelines. If the HHIs fall outside of the safe harbors, however, they may create a presumption that the merger is "likely to create or enhance market power or facilitate its exercise."(46) The Merger Guidelines note that "[t]he presumption may be overcome by a showing that factors set forth in Sections 2-5 of the Guidelines make it unlikely that the merger will create or enhance market power or facilitate its exercise, in light of market concentration and market shares."(47)
24. Other proxies for market power that are not discussed in this memorandum include price discrimination and accounting-based measures of profitability. See Merger Guidelines § 1.12 (describing product market definition in presence of price discrimination); Kay, Assessing Market Dominance Using Accounting Rates of Profit, in D. Hay & J. Vickers (eds.), THE ECONOMICS OF MARKET DOMINANCE (1987).
25. Herbert Hovenkamp, FEDERAL ANTITRUST POLICY § 3.1a (1994).
26. Kenneth Elzinga contends that when firms have high fixed costs relative to sales, the Lerner Index could approach 1 even in industries with low barriers to entry. See Elzinga, Unmasking Monopoly: Four Types of Economic Evidence, in R. Larner and J. Meehan, Jr. (eds.), ECONOMICS AND ANTITRUST POLICY at 27 (1989); see also Jonathan B. Baker, Review of Economics and Antitrust Policy, 33 Antitrust Bull. 919, 926 n.28 (1989).
27. See Landes and Posner, supra note 13, at 939-43; Hay, supra note 2, at 825 (noting that accounting methods are too imprecise to determine whether market power exists under price-cost analysis); Hovenkamp, supra note 25, at § 3.1.
28. Hovenkamp, supra note 5, at 80 (the Lerner Index "ignores essential questions concerning the time period over which market power is exercised. For example, it avoids inquiry into changes in demand or product design, and the impact that these changes may have on a firm's market position.").
29. Id. at 86-87 (in cases involving the exclusion of an innovative product, "when one considers the market in movement, firms have incentives to exclude that (a) do not depend on their short-run, or present, ability to set prices at monopoly levels, and that (b) generate social costs, or deadweight losses analogous to those caused by traditional monopoly or collusion.").
30. The agencies have recognized an analogous issue in the intellectual property context:
If a patent or other form of intellectual property does confer market power, that market power does not by itself offend the antitrust laws. As with any other tangible or intangible asset that enables its owner to obtain supracompetitive profits, market power (or even a monopoly) that is solely 'a consequence of a superior product, business acumen, or historic accident' does not violate the antitrust laws. United States v. Grinnell Corp., 384 U.S. 563, 571 (1966). Intellectual Property Guidelines § 2.2.
31. Hay, supra note 2, at 814-15.
32. Id. at 815.
33. Jonathan Baker and Timothy Bresnahan pioneered the development of empirical techniques for estimating "own-demand" curves in the 1980s. See Baker & Bresnahan, Estimating the Residual Demand Curve Facing a Single Firm, 6 Intl. J. Indus. Org. 283 (1988). They have also identified some of the complexities of using their techniques in defining relevant markets. See Baker & Bresnahan, Empirical Methods of Identifying and Measuring Market Power, 62 Antitrust L.J. 3, 9 (1992).
34. Market-demand elasticities, which measure the willingness of consumers to purchase alternative products at varying price levels, are commonly used to define product and geographic markets.
35. Landes and Posner, supra note 13, at 946.
36. Hay, supra note 2, at 815-16.
37. Id. at 816. Hay contends that Areeda and Turner reach the same result by concluding that no harm arises when a superior firm acquires market power through its business acumen. Id. at n.38.
38. Id. at 822.
39. Id. at 823.
40. Id. at 821.
41. Hovenkamp, supra note 25, at § 3.1b.
42. Landes and Posner, supra note 13, at 947-49. See also Jonathan B. Baker, Product Differentiation through Space and Time: Some Antitrust Policy Issues, 42 Antitrust Bull. 177, 183 (1997).
43. Landes and Posner, supra note 13, at 949.
44. In its 1984 Horizontal Merger Guidelines, the Department of Justice observed that the HHI reflects the distribution of market shares in the relevant market and the relative importance of larger firms "in any collusive interaction." See United States Department of Justice 1984 Horizontal Merger Guidelines § 3.1.
45. Merger Guidelines § 1.51.
46. Specifically, "[w]here the post-merger HHI exceeds 1800, it will be presumed that mergers producing an increase of more than 100 points are likely to create or enhance market power or facilitate its exercise." Id. Other HHI ranges are identified as those that "potentially raise significant competitive concerns depending on the factors set forth in Sections 2-5 of the Guidelines." Id.
47. Id. Among the factors that the agencies examine in §§ 2-5 are whether the transaction will facilitate greater coordination among firms in the post-merger market, whether the merging parties would find it profitable to raise their own prices through unilateral output reduction, whether entry by new firms will be timely, likely and sufficient to defeat or deter unilateral or coordinated price increases, and whether the transaction will produce efficiencies that will be passed on to consumers.