Quantitative techniques for competition and antitrust analysis

Quantitative Techniques for

Competition and Antitrust Analysis

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Quantitative Techniques for

Competition and Antitrust Analysis

Peter Davis and Eliana Garc´es

Princeton University Press

Princeton and Oxford

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c 2010 by Peter Davis and Eliana Garc´es

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Library of Congress Cataloging-in-Publication Data

Davis, Peter J. (Peter John), 1970–

Quantitative techniques for competition and antitrust analysis / Peter Davis, Eliana Garc´es.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-691-14257-9 (alk. paper)

1. Consolidation and merger of corporations. 2. Antitrust law.

3. Econometrics. I. Garc´es, Eliana, 1968– II. Title.

HD2746.5.D385 2010

338.80

2015195–dc22 2009005675

British Library Cataloging-in-Publication Data is available

This book has been composed in Times using TEX

Typeset and copyedited by T&T Productions Ltd, London

Printed on acid-free paper. ∞

press.princeton.edu

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

For Lara, Adrian, and Tristan

For Sara

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Contents

Preface ix

Acknowledgments xii

1 The Determinants of Market Outcomes 1

1.1 Demand Functions and Demand Elasticities 1

1.2 Technological Determinants of Market Structure 19

1.3 Competitive Environments: Perfect Competition, Oligopoly, and

Monopoly 37

1.4 Conclusions 61

2 Econometrics Review 62

2.1 Multiple Regression 63

2.2 Identification of Causal Effects 89

2.3 Best Practice in Econometric Exercises 113

2.4 Conclusions 119

2.5 Annex: Introduction to the Theory of Identification 121

3 Estimation of Cost Functions 123

3.1 Accounting and Economic Revenue, Costs, and Profits 125

3.2 Estimation of Production and Cost Functions 131

3.3 Alternative Approaches 149

3.4 Costs and Market Structure 158

3.5 Conclusions 160

4 Market Definition 161

4.1 Basic Concepts in Market Definition 162

4.2 Price Level Differences and Price Correlations 169

4.3 Natural Experiments 185

4.4 Directly Estimating the Substitution Effect 191

4.5 Using Shipment Data for Geographic Market Definition 198

4.6 Measuring Pricing Constraints 201

4.7 Conclusions 227

viii Contents

5 The Relationship between Market Structure and Price 230

5.1 Framework for Analyzing the Effect of Market Structure on Prices 231

5.2 Entry, Exit, and Pricing Power 256

5.3 Conclusions 282

6 Identification of Conduct 284

6.1 The Role of Structural Indicators 285

6.2 Directly Identifying the Nature of Competition 300

6.3 Conclusions 341

6.4 Annex: Identification of Conduct in Differentiated Markets 343

7 Damage Estimation 347

7.1 Quantifying Damages of a Cartel 347

7.2 Quantifying Damages in Abuse of Dominant Position Cases 377

7.3 Conclusions 380

8 Merger Simulation 382

8.1 Best Practice in Merger Simulation 383

8.2 Introduction to Unilateral Effects 386

8.3 General Model for Merger Simulation 401

8.4 Merger Simulation: Coordinated Effects 426

8.5 Conclusions 434

9 Demand System Estimation 436

9.1 Demand System Estimation: Models of Continuous Choice 437

9.2 Demand System Estimation: Discrete Choice Models 462

9.3 Demand Estimation in Merger Analysis 491

9.4 Conclusions 499

10 Quantitative Assessment of Vertical Restraints and Integration 502

10.1 Rationales for Vertical Restraints and Integration 503

10.2 Measuring the Effect of Vertical Restraints 518

10.3 Conclusions 553

Conclusion 555

References 557

Index 577

Preface

The use of quantitative analysis by competition authorities is increasing around the

globe. Whether the quantitative analysis is submitted by external experts, or the com￾petition authority itself undertakes the analysis, empirical analysis is now a vitally

important component of the competition economist’s toolkit. Much of the empiri￾cal analysis submitted to, or carried out by, investigators is fairly straightforward.

This is partly because simple tools are often very powerful and partly because the

need to communicate with nonexperts sometimes places a natural boundary on the

degree of sophistication which can comfortably be used. Of course, one person’s

“cutting-edge” method is another’s basic tool and this difference drives the normal

process of diffusion of new methods from basic research to applied work. The tools

we discuss in this book are broadly the result of the ideas and methods which have

developed over the past twenty years in the empirical industrial organization liter￾ature and which are either gradually diffusing into practice or, no doubt in a small

number of cases, gradually diffusing into obscurity.

While the aim of this book is to examine empirical techniques, we cannot stress

enough that any empirical analysis in a competition investigation needs to be eval￾uated together with the factual, documentary, and qualitative evidence collected

during the case. An empirical analysis will usually be one albeit important element

in a broader evidence base. Only in a small minority of cases will quantitative analy￾sis alone be sufficiently clear-cut, precise, and robust enough to support a finding,

though it will provide one important plank of evidence in a wider range of cases.

Even in cases where quantitative analysis is important, a solid qualitative analysis

and a good factual knowledge of the industry will provide both a necessary basis

for quantitative work and a source for vital reality checks regarding the conclusions

emerging from empirical work.

With those caveats firmly in mind, in this book we discuss the most useful and most

promising empirical strategies available to antitrust and merger investigators. Some

of these techniques are tried and tested, others are more sophisticated and not yet

widely embraced by practitioners. Throughout we try to take a careful practitioner’s

eye to tools that have often been proposed by the academic community. The fact

is that practitioners need to understand both the potential uses and the important

limitations of the available methods before they will, indeed before they should,

choose to apply them. We do that by closely tying the empirical models and empirical

strategy used to answer our competition policy questions to the underlying economic

theory. Specifically, economic theory allows us to define the assumptions required for

a given piece of empirical work to be meaningful. Indeed, no solid empirical analysis

x Preface

is entirely disconnected from economic theory and thus theory usually has a very

important role in providing guidance and discipline in the design of empirical work.

The purpose of this book is not theory for itself but rather the aim is to help compe￾tition economists answer very practical questions. For this reason the structure of the

book is broadly based around potential competition issues that need to be addressed.

The first two chapters provide a review of basic theory and econometrics. Specifi￾cally, the first chapter reviews the determinants of market outcomes, i.e., demand,

costs, and the competitive environment, since those are the fundamental elements

that need to be very well-understood before any competition policy analysis is pos￾sible. The second chapter reviews the basic econometrics of multiple regression

with a particular emphasis on the crucially important problem of “identification.”

Identification—the data variation required to enable us to tell one model apart from

another—is a theme which emerges throughout the book. The subsequent chapters

guide the reader through issues such as the estimation of cost and demand func￾tions, market definition, the link between market structure and price, the scope for

identifying firms’ competitive conduct, damage estimation, merger simulation, and

we end with the developing approaches to the quantitative assessment of the effects

of vertical restraints. Each chapter critically discusses the empirical techniques that

have been used to address that competition policy issue. The book does not aim to

be comprehensive, but we do aim to provide practical guidance to investigators.

Naturally, sometimes tools which are too simple for the job at hand can result in

the investigator getting a radically wrong answer. On the other hand, sophisticated

tools poorly understood will be poorly applied and are more likely to act as a black

box from which a decision emerges instead of providing a great deal of insight. Such

is the challenge faced by antitrust agencies in choosing an appropriate economic

methodology. In some instances, we will discuss empirical techniques that an indi￾vidual agency may well currently judge to be too complicated, too theoretical, or too

time-consuming to be of immediate practical use for time-constrained investigators.

The approach of this book is that these techniques can still be useful in that they

will at least signal the difficulty or complexity of a particular question and even an

abstract discussion still provides guidance on the relevant empirical questions that

need to be investigated if we want to have conclusions on a particular topic. In addi￾tion, the requisite expertise may be built gradually within an institution rather than

within the remit of, say, a particular merger inquiry with a statutory deadline. The

ultimate objective of this book is not to have economists in competition authorities

replicate the examples discussed in these chapters but to help them develop a way

of thinking about empirical analysis which will help them design their own original

answers to the specific problems they will face given the data that they have. We

also hope that the book will help reduce the amount of concurrent rediscovery of

strengths and weaknesses of particular approaches currently undertaken in agencies

across the world.

Preface xi

Finally, it is important to note that while this book explores the variety of meth￾ods available to analysts, the right tool for any particular inquiry will depend on the

context of that inquiry. This book does not aim to explicitly or implicitly set any

requirements as to how competition questions should be addressed empirically in

any particular jurisdiction. We do, however, aim to raise awareness among empiri￾cal economists of the underlying econometric and economic theory that inevitably

underpins all empirical techniques. Our hope is that increased awareness will both

promote high-quality work in the relatively simple empirical exercises and also

reduce the entry barriers hindering the use of more sophisticated approaches where

such methods are appropriate.

Acknowledgments

Dr. Peter Davis currently serves as Deputy Chairman of the U.K. Competition Com￾mission. While he is a principal author of the text, he writes as an individual and the

views expressed in this text are solely those of the author and should not be taken to

reflect the views of the U.K. Competition Commission. Indeed, this text has evolved

from a project undertaken, before his current appointment, by Applied Economics

Ltd (www.appliedeconomics.com) for the European Commission.

Dr. Eliana Garc´es previously worked for the Chief Economist team at DG Com￾petition before taking on her current role as a Member in the Cabinet of European

Commissioner for Consumer Protection Meglena Kuneva. The contribution to this

work is her own and does not represent the opinions of the European Commission.

This book began life as a project in the European Commission to disseminate

practical knowledge and good practices in empirical analysis. We would like to

thank the European Commission and, in particular, the EC’s Competition Chief

Economists who served during the making of this book, Lars Hendrik R¨oller and

Damien Neven, for their continued support of the project.

The book has benefited in numerous ways from contributors. The authors would

like to thank Richard Baggaley from Princeton University Press for his support,

encouragement, and patience and Jon Wainwright from T&T Productions Ltd for

his tireless efforts to typeset the book in the face of numerous corrections and

amendments. Enrico Pesaresi provided valuable support throughout the process.

We also thank Frank Verboven and Christian Huveneers for their detailed comments

on the draft version. And, of course, the anonymous reviewers for their important

contributions. This work builds heavily on the work of many authors who have each

contributed to the literature. The authors would, however, like to thank, in particular,

Douglas Bernheim and John Connor for allowing them to draw extensively from their

work on cartel damage estimation. Last but by no means least, the book incorporates

in substantial part updated and expanded content from classes and lectures Peter has

taught at MIT and LSE over the best part of a decade and a substantial debt of

gratitude is due to former students and colleagues at those institutions as well as to

his former classmates and teachers at Yale and Oxford. In particular, thanks are due

to Ariel Pakes, Steve Berry, Lanier Benkard, Ernie Berndt, Sofronis Clerides, Philip

Leslie, Mark Schankerman, Nadia Soboleva, Tom Stoker, and John Sutton.

1

The Determinants of Market Outcomes

A solid knowledge of both econometric and economic theory is crucial when design￾ing and implementing empirical work in economics. Econometric theory provides

a framework for evaluating whether data can distinguish between hypotheses of

interest. Economic theory provides guidance and discipline in empirical investiga￾tions. In this chapter, we first review the basic principles underlying the analysis

of demand, supply, and pricing functions, as well as the concept and application

of Nash equilibrium. We then review elementary oligopoly theory, which is the

foundation of many of the empirical strategies discussed in this book. Continuing

to develop the foundations for high-quality empirical work, in chapter 2 we review

the important elements of econometrics for investigations. Following these first two

review chapters, chapters 3–10 develop the core of the material in the book. The

concepts reviewed in these first two introductory chapters will be familiar to all com￾petition economists, but it is worthwhile reviewing them since understanding these

key elements of economic analysis is crucial for an appropriate use of quantitative

techniques.

1.1 Demand Functions and Demand Elasticities

The analysis of demand is probably the single most important component of most

empirical exercises in antitrust investigations. It is impossible to quantify the likeli￾hood or the effect of a change in firm behavior if we do not have information about

the potential response of its customers. Although every economist is familiar with

the shape and meaning of the demand function, we will take the time to briefly

review the derivation of the demand and its main properties since basic conceptual

errors in its handling are not uncommon in practice. In subsequent chapters we will

see that demand functions are critical for many results in empirical work undertaken

in the competition arena.

1.1.1 Demand Functions

We begin this chapter by reviewing the basic characteristics of individual demand

and the derivation of aggregate demand functions.

2 1. The Determinants of Market Outcomes

50

100

Q

P

Slope is −2

∆P

∆Q

Figure 1.1. (Inverse) demand function.

1.1.1.1 The Anatomy of a Demand Function

An individual’s demand function describes the amount of a good that a consumer

would buy as a function of variables that are thought to affect this decision such as

price Pi and often income y. Figure 1.1 presents an example of an individual linear

demand function for a homogeneous product: Qi D 50
0:5Pi or rather for the

inverse demand function, Pi D 100
2Qi . More generally, we may write Qi D

D.Pi ;y/.

1 Inverting the demand curve to express price as a function of quantity

demanded and other variables yields the “inverse demand curve” Pi D P.Qi ;y/.

Standard graphs of an individual’s demand curve plot the quantity demanded of the

good at each level of its own price and take as a given the level of income and the

level of the prices of products that could be substitutes or complements. This means

that along a given plotted demand curve, those variables are fixed. The slope of the

demand curve therefore indicates at any particular point by how much a consumer

would reduce (increase) the quantity purchased if the price increased (decreased)

while income and any other demand drivers stayed fixed.

In the example in figure 1.1, an increase in price,
P, of €10 will decrease the

demand for the product by 5 units shown as
Q. The consumer will not purchase

any units if the price is above 100 because at that point the price is higher than the

value that the customer assigns to the first unit of the good.

One interpretation of the inverse demand curve is that it shows the maximum price

that a consumer is willing to pay if she wants to buy Qi units of the good. While a

1This will be familiar from introductory microeconomics texts as the “Marshallian” demand curve

(Marshall 1890).