Core Antitrust Concepts - ECON 499 Study Guide

Lectures 1 and 2 | Self-contained exam reference

Part 1 - What Is Antitrust and Why Does It Exist?

The Origin: Trusts in the Late 19th Century

A "trust" was a legal arrangement where shareholders of competing companies handed their stock over to a single board of trustees. In return they got dividend-paying certificates, but actual control of all firms merged into one. The board could then coordinate prices and eliminate competition across an entire industry.

The textbook example is Standard Oil (1882), formed by John D. Rockefeller. It controlled ~90% of US oil refining through three tactics you should know:

• Predatory pricing: slashing prices in specific regions to bankrupt rivals, then buying their assets cheaply.
• Secret railroad rebates: using massive volume to negotiate shipping discounts denied to competitors - an insurmountable cost advantage.
• Vertical integration: controlling wells, pipelines, refining, and distribution, creating enormous entry barriers.

Public outrage led to the Sherman Antitrust Act of 1890, the cornerstone of US competition law.

The Goal of Antitrust Policy

Antitrust law is not designed to protect individual competitors from failure. It is designed to protect the competitive process itself.

Two core economic objectives:

1. Promote economic efficiency - allocative efficiency (right quantities produced) and productive efficiency (produced at minimum cost).
2. Maximize consumer welfare - lower prices, higher output, more innovation. This is the dominant standard in US enforcement today.

Antitrust vs. Regulation - a distinction the exam may test:

Key US Antitrust Laws

Sherman Act (1890)

• Section 1 - Restraint of Trade: prohibits contracts, combinations, or conspiracies that restrain trade. Targets collusion between competitors (price-fixing, bid-rigging, market allocation).
  • Per se rule: some acts (price-fixing) are automatically illegal - no need to show harm.
  • Rule of reason: other acts are evaluated by weighing pro- and anti-competitive effects.
• Section 2 - Monopolization: it is not illegal to be a monopoly. It is illegal to acquire or maintain monopoly power through anticompetitive or exclusionary conduct (e.g., predatory pricing, exclusive dealing).

Clayton Act (1914)

• Section 7: prohibits mergers where the effect "may be substantially to lessen competition, or to tend to create a monopoly." This is the legal basis for all modern merger analysis.
• Section 3: restricts tying arrangements and exclusive dealing that foreclose competitors from a substantial market share.

Enforcement agencies - DOJ (Department of Justice) and FTC (Federal Trade Commission) jointly enforce these laws at the federal level. The EU equivalent is the European Commission (DG COMP).

Part 2 - Defining the Relevant Market

Before you can assess market power or analyze a merger, you must define what market you're talking about. This is often the most contested issue in any antitrust case - and almost certainly will be on the exam.

A relevant market has two dimensions:

Product Market

Which products are reasonable substitutes? Two types of substitution matter:

• Demand-side substitution: would consumers switch if the price rose? (Look at cross-price elasticity, product characteristics, intended use.)
• Supply-side substitution: could producers easily switch to making the product? (Look at production flexibility, switching cost, time required.)

Geographic Market

Where can buyers practically turn for supply? Factors: transportation costs relative to product value, perishability, information costs, regulatory barriers. Markets range from local (cement, hospitals) to global (aircraft, software).

The SSNIP Test - The Modern Standard

The SSNIP test (Small but Significant and Non-transitory Increase in Price) is the practical tool for drawing market boundaries.

Core question: Would a hypothetical monopolist controlling a proposed set of products profitably sustain a 5% price increase for at least one year?

• If YES → customers don't have good enough alternatives → the proposed set is the relevant market.
• If NO → too many customers switch away → the market is too narrow. Add the next-best substitute and re-run the test.

Worked example - Butter vs. Margarine:

Step 1: Test "butter" alone. A 5% price hike by a hypothetical butter monopolist → many consumers switch to margarine for baking and spreading → unprofitable. Butter alone is too narrow.

Step 2: Test "butter + margarine." A 5% hike → consumers would need to switch to olive oil or lard, which most won't. The price increase is now profitable. Butter + margarine = the relevant market.

Exam tip: Narrow market definition → higher concentration → easier to show antitrust harm. Broad market definition → dilutes market shares → harder to show harm. Both sides in a case argue the definition that serves them.

Part 3 - Measuring Market Concentration

Once the market is defined, regulators measure how concentrated it is.

Concentration Ratios (CRn) - the old approach

CR4 = sum of the market shares of the four largest firms. Simple, but flawed: it ignores the distribution of shares within those four firms. Both of these markets have CR4 = 80, but they're very different:

• Market A: {20, 20, 20, 20, 5, 5, 5, 5} - relatively symmetric
• Market B: {70, 5, 3, 2, and 20 tiny firms} - one firm dominates

The Herfindahl-Hirschman Index (HHI) - the standard today

$HHI = \sum_{i=1}^{N} s_i^2$

Market shares are expressed as whole numbers (30% → 30). The squaring gives more weight to larger firms, so it captures dominance better than CRn.

Benchmarks:

Key reference points:

• Monopoly (one firm, s = 100): HHI = 100² = 10,000
• 4 equal firms (s = 25 each): HHI = 4 × 625 = 2,500
• 10 equal firms (s = 10 each): HHI = 10 × 100 = 1,000

Calculating ΔHHI for a merger of firms i and j:

$\Delta HHI = 2 \times s_i \times s_j$

Example: Firm A has 30% share, Firm B has 20% share. They merge.

• Pre-merger HHI contribution from these two: 30² + 20² = 900 + 400 = 1,300
• Post-merger: (30+20)² = 2,500
• ΔHHI = 2,500 − 1,300 = 1,200 ← also equals 2 × 30 × 20 = 1,200 ✓

Important caveat: HHI is only a screen. A merger in the "safe" zone can still be challenged if there's strong evidence of harm. A merger in the "harmful" zone can be cleared if efficiencies are large or competitive effects are weak.

Part 4 - Market Power

High concentration suggests firms might have market power - but structure alone is not enough. You need a direct measure.

Definition

Market power is the ability of a firm to profitably maintain a price above its marginal cost.

In perfect competition, P = MC → no market power. A firm with market power faces a downward-sloping demand curve and can raise price without losing all its customers.

The Lerner Index

$L = \frac{P - MC}{P}$

• Ranges from 0 (perfect competition) to 1 (extreme monopoly power).
• A higher L means the firm is pricing further above cost - more market power.

Relationship to elasticity: For a profit-maximizing firm (MR = MC), it can be shown that:

$L = \frac{1}{|\varepsilon_d|}$

where ε_d is the price elasticity of demand facing the firm. This means:

• More inelastic demand → fewer substitutes → greater market power → higher L.
• More elastic demand → many substitutes → less market power → lower L.

Worked examples from lecture:

Example 1 - Patented drug: P = $100, MC =$20. $L = \frac{100 - 20}{100} = 0.80$ Substantial market power. Implied |ε_d| = 1/0.80 = 1.25 (relatively inelastic).

Example 2 - Wheat farmer: P = $5, MC =$4.90. $L = \frac{5 - 4.90}{5} = 0.02$ Nearly zero - as expected in a competitive commodity market.

Part 5 - Economics of Horizontal Mergers

A horizontal merger is between firms competing in the same product and geographic market (e.g., two airlines operating the same routes, two banks in the same city). The antitrust question under Clayton Act §7: does the merger substantially lessen competition?

Every merger analysis involves a core trade-off:

• Anticompetitive effect: more concentration → more market power → higher prices.
• Pro-competitive effect: cost-saving efficiencies (economies of scale, better management, R&D savings).

Unilateral Effects

Unilateral effects are price increases the merged firm can profitably impose on its own, without any coordination with rivals.

The logic: Before the merger, if Firm A raises its price, it loses customers to Firm B. After the merger, Firm AB doesn't care if customers switch from product A to product B - it still captures those sales. The merger internalizes the externality, giving the merged firm an incentive to raise price unilaterally.

Cournot model illustration (3 firms → merger of 2):

Pre-merger (triopoly), with inverse demand P = a − bQ and MC = c:

• Each firm's output: q* = (a−c)/4b
• Total output: Q_pre = 3(a−c)/4b
• Price: P_pre = (a+3c)/4

Post-merger (duopoly), no efficiency gains:

• Merged firm's output: q_M = (a−c)/3b
• Total output: Q_post = 2(a−c)/3b
• Price: P_post = (a+2c)/3

Since Q_post < Q_pre and P_post > P_pre, the merger is anticompetitive - it raises prices and reduces output.

The Merger Paradox

Here's the surprising part: even though the merger harms consumers, it may be unprofitable for the merging firms in the simple Cournot model.

• Combined pre-merger profit (Firm 1 + Firm 2): 2 × (a−c)²/16b = (a−c)²/8b
• Post-merger profit of Firm M: (a−c)²/9b

Since 1/9 < 1/8, the merged firm earns less than the two firms did separately. Why? The outsider (Firm 3) free-rides - it raises its own output and profit in response to the merged firm's higher price, capturing the gains.

Resolution - why do mergers happen then?

1. Efficiencies: if the merger reduces marginal cost sufficiently (cM < c), it becomes profitable. With enough savings, prices could even fall post-merger.
2. Wrong model: Cournot with homogeneous goods is stylized. Mergers are more profitable (and more anticompetitive) with differentiated products or dominant firms.

The Williamson Trade-Off

When a merger creates both higher prices (harm) and lower costs (benefit), regulators must weigh:

• Allocative loss (A1) - the deadweight loss from higher post-merger price: $A_1 \approx \frac{1}{2}(P_2 - P_1)(Q_1 - Q_2)$

• Productive gain (A2) - the cost savings on surviving output: $A_2 \approx (AC_1 - AC_2) \times Q_2$

Permit the merger if A2 > A1, i.e., cost savings exceed the deadweight loss.

Note: A2 tends to be large (applies to all output) while A1 is a triangle (second-order effect). Small cost reductions can justify even significant price increases under a total welfare standard. Under a stricter consumer welfare standard, efficiencies must be passed through to consumers as lower prices.

Coordinated Effects

Even if the merged firm can't raise prices on its own, the merger may make it easier for the remaining firms to collude.

Why mergers facilitate coordination:

• Fewer firms → easier to monitor compliance with a tacit or explicit agreement.
• More symmetry between remaining firms (similar costs, similar shares) → less incentive to deviate.
• If entry barriers are high, a cartel can sustain elevated prices longer.

A merger from 6 firms to 5 might barely move the HHI - but if it makes the market more symmetric and entry is hard, coordinated effects can be the real danger.

Part 6 - The DOJ/FTC 5-Step Merger Analysis Framework

This is the structured process regulators follow and what you should apply in any exam question involving a merger:

Step 1 - Market Definition: Define the relevant product and geographic market using the SSNIP test.

Step 2 - Market Concentration: Calculate the post-merger HHI and ΔHHI. Use the thresholds to determine the screening result.

Step 3 - Competitive Effects: Assess unilateral effects (can the merged firm raise price alone?) and coordinated effects (does the merger make collusion easier?).

Step 4 - Efficiencies: Are there verifiable, merger-specific cost savings? Are they large enough to offset the price increase (Williamson trade-off)?

Step 5 - Entry: Would new entrants respond quickly enough to discipline a post-merger price increase? Entry must be timely (within 2 years), likely (profitable at pre-merger prices), and sufficient (enough scale to constrain price).

Part 7 - Quick Math Reference (No Calculator Needed)

Part 8 - Common Exam Mistakes to Avoid

On market definition: Don't define the market too broadly (it dilutes concentration and market power) or too narrowly without justification. Always use SSNIP logic: "would consumers switch if price rose 5%?"

On HHI: Remember shares go in as whole numbers (30, not 0.30). The formula is squaring and summing - don't add first then square.

On the Lerner Index: It measures current market power, not just structure. A firm with a large share but lots of competitive pressure (high elasticity) can still have a low Lerner Index.

On unilateral vs. coordinated effects: Unilateral = the merged firm acts alone; coordinated = the merger changes the strategic environment for all remaining firms. Both can matter simultaneously.

On efficiencies: They must be (1) merger-specific - couldn't be achieved without the merger, and (2) verifiable - not speculative. Courts are skeptical of efficiency claims.

On graphs: Always label axes (Price on Y, Quantity on X), mark P_competitive, P_monopoly, Q_competitive, Q_monopoly, and shade the DWL triangle clearly. Missing labels = lost points.