ECON 499 - Module 2 Practice Exam

Pre-merger HHI:

HHI_pre = 35² + 25² + 20² + 20² = 1,225 + 625 + 400 + 400 = 2,650

ΔHHI from the MedNorth + MedSouth merger:

ΔHHI = 2 × 35 × 25 = 1,750

Post-merger HHI:

HHI_post = 2,650 + 1,750 = 4,400

Classification:

• Post-merger HHI = 4,400 → Highly concentrated market (above the 2,500 threshold).
• ΔHHI = 1,750 → Far exceeds the 200-point threshold for a presumption of harm.

Conclusion: Under DOJ/FTC guidelines, this merger is presumptively anticompetitive. It would be subject to close scrutiny and is very likely to be challenged unless the parties can demonstrate compelling efficiencies or timely, likely, and sufficient entry.

Before the merger, MedNorth and MedSouth compete directly for patients in the same city. If MedNorth raises its prices, it loses some patients - and many of them will switch to MedSouth (the closest substitute, given their geographic overlap). From MedNorth's perspective, these are lost revenues. This competitive pressure disciplines MedNorth's pricing.

After the merger, the merged entity internalizes this competitive externality. If a patient switches from MedNorth to MedSouth, the merged firm still captures that revenue. It no longer "loses" when patients divert between its own hospitals. This gives the merged entity a unilateral incentive to raise prices - not through coordination with City General or Riverside, but simply because it no longer competes with itself.

The diversion ratio between MedNorth and MedSouth is the key metric here. Because these are the two closest competitors (together holding 60% of the market), the diversion ratio is likely high - meaning a large fraction of patients who leave MedNorth would go to MedSouth. A high diversion ratio amplifies the unilateral price increase incentive.

Key point: Unilateral effects do not require coordination with any other firm. Even if City General and Riverside continue competing normally, MedNorth-South can profitably raise prices because it has eliminated the competitive constraint that previously kept its prices in check.

Given values:

• P₁ = $10,000, Q₁ = 50,000 (pre-merger)
• P₂ = $11,200, Q₂ = 40,000 (post-merger, no efficiencies)
• ΔP = $1,200 | ΔQ = 10,000

Allocative Loss (A1) - the DWL triangle:

A1 = ½ × ΔP × ΔQ = ½ × $1,200 × 10,000 = **$6,000,000**

Productive Gain (A2) - cost savings rectangle:

Cost savings per procedure = $60,000,000 ÷ 40,000 =$1,500

A2 = $1,500 × 40,000 = **$60,000,000**

Decision criterion: Approve if A2 > A1.

Since $60M >>$6M, the merger increases total social welfare under a total welfare standard.

Important caveat: Under a consumer welfare standard (as applied in the US), efficiencies must actually be passed through to patients as lower prices. If the merged firm captures all $60M in savings as profit while raising prices by$1,200, consumers are harmed even though total welfare improves. The efficiency defense would require the savings to be verifiable, merger-specific, and demonstrably beneficial to patients.

Key insight on the Williamson trade-off: A1 is a triangle (second-order: scales with ΔP²) while A2 is a rectangle (first-order: scales linearly with ΔAC). Even modest cost reductions can easily dominate large price increases - which is why efficiency defenses are economically powerful in theory, even if courts apply them skeptically in practice.

The Horizontal Merger Guidelines require entry to be timely, likely, and sufficient to defeat a competitive concern. The parties' claim fails on multiple criteria:

Timely? The HMGs require entry within approximately 2 years. The parties claim 3–4 years - outside the standard window. Hospital construction, licensing, regulatory approvals, staff credentialing, and accreditation all take years. Entry is not timely.

Likely? Entry into a hospital market requires massive sunk investment with highly uncertain patient volume returns. New entrants cannot easily gauge whether they will attract enough patients away from established, well-known brands. Entry is not clearly likely at pre-merger prices.

Sufficient? Even if two entrants eventually appear, there is no guarantee they will achieve enough scale or geographic reach to fully replace the competitive constraint lost through the MedNorth-MedSouth merger. Entry is not clearly sufficient.

Conclusion: The entry claim does not defeat the competitive concern. Hospital markets are characterized by very high barriers - capital intensity, regulatory requirements, brand trust - which is precisely why hospital mergers are among the most scrutinized in antitrust enforcement.

The SSNIP test asks: Would a hypothetical monopolist of a proposed set of products profitably sustain a 5% price increase for at least one year?

Step 1: Test "premium live sports streaming" alone

If a hypothetical monopolist of premium live sports streaming raised prices by 5% (from $30 to$31.50), would enough subscribers switch to cable to make the increase unprofitable?

Likely answer: No. Cable at $15/month is a meaningfully different product - it lacks live HD quality and on-demand replay. Consumers who specifically value these features and already pay a$15 premium over cable would not abandon StreamMax for an inferior substitute over a $1.50 price difference. The price increase is profitable.

Conclusion: "Premium live sports streaming" constitutes a relevant market on its own. No need to expand.

Step 2 (confirmatory): What if we included cable?

A 5% price increase on the broader basket would also be profitable, but the broad market is over-inclusive - it bundles products consumers treat as meaningfully different. The narrow definition is the right one: the key customer group (HD streaming subscribers) would not switch to cable even at a modest price increase.

Market definition: "Premium live sports streaming" is the relevant product market. Geographic market: wherever StreamMax is licensed to operate.

Lerner Index:

L = (P − MC) / P = (30 − 8) / 30 = 22/30 ≈ 0.73

Interpretation: StreamMax is pricing 73% above its marginal cost - a very high markup indicating substantial market power. In perfect competition, L = 0.

Implied price elasticity of demand:

For a profit-maximizing firm: L = 1/|εd|

|εd| = 1 / 0.73 ≈ 1.37

Demand facing StreamMax is relatively inelastic. A 1% price increase causes only a ~0.73% reduction in quantity demanded. This is consistent with few close substitutes - exactly what the narrow market definition reflects.

No - market share and a high Lerner Index are not sufficient on their own.

Under Sherman Act Section 2, illegal monopolization requires proving two elements:

1. Possession of monopoly power in the relevant market. A 70% share is suggestive, but not conclusive - the firm must also face barriers to entry sufficient to sustain this power over time.
2. Willful acquisition or maintenance of monopoly power through anticompetitive or exclusionary conduct - not through a superior product, better management, or historical accident.

It is not illegal to be a monopoly. If StreamMax achieved dominance by offering a product consumers genuinely prefer, and is not engaging in exclusionary conduct (e.g., predatory pricing, exclusive dealing that forecloses rivals), there is no Section 2 violation - even with L = 0.73 and 70% market share.

The Lerner Index measures outcomes (current price-cost margin), not conduct. The regulator would need to identify specific anticompetitive behavior - not just market power - before a monopolization claim can proceed.

The output coordination is per se illegal under Sherman Act Section 1, which prohibits "every contract, combination... or conspiracy in restraint of trade."

Output coordination among competitors is functionally equivalent to price-fixing - restricting supply drives up price, which is precisely the intended and achieved effect. Price-fixing (and output coordination as a variant) is one of the categories US courts have held to be automatically illegal, requiring no weighing of pro- and anti-competitive effects. The DOJ does not need to demonstrate actual consumer harm; the act of coordinating is sufficient for liability.

The cartel's claim that it provides "price stability" is not a valid defense under the per se rule. Such an argument would only be considered under the rule of reason, which applies to less obviously harmful restraints (e.g., vertical agreements, some joint ventures). For horizontal output coordination among direct competitors, the per se rule applies categorically.

Given:

• Competitive: P_c = $20,000/ton, Q_c = 500,000 tons
• Cartel: P_k = $32,000/ton, Q_k = 350,000 tons
• ΔP = $12,000 | ΔQ = 150,000

DWL calculation:

DWL = ½ × ΔP × ΔQ = ½ × $12,000 × 150,000 = **$900,000,000 per year**

Diagram description:

• Horizontal axis: Quantity (tons/year). Mark Q_k = 350,000 and Q_c = 500,000.
• Vertical axis: Price ($/ton). Mark P_c =$20,000 and P_k = $32,000.
• Downward-sloping demand curve and upward-sloping supply (MC) curve intersecting at (Q_c, P_c) - the competitive equilibrium.
• The cartel restricts output to Q_k and raises price to P_k.
• Rectangle between P_k and P_c, spanning 0 to Q_k: consumer surplus transferred to producers (a redistribution, not a welfare loss).
• Triangle with vertices at (Q_k, P_k), (Q_k, P_c), and (Q_c, P_c): the deadweight loss - welfare destroyed because mutually beneficial transactions at competitive prices no longer occur.

Why cartels are unstable - the core problem:

Every cartel member faces an individual incentive to cheat. If the cartel sets output at Q_k and price at P_k, each firm can secretly expand its own output beyond its quota and sell extra units at the high cartel price. The defector gains extra revenue while everyone else's restricted supply keeps prices elevated. However, if all members reason this way, supply expands, prices collapse, and the cartel disintegrates. This is a classic prisoner's dilemma: the collectively optimal outcome (restrict output) is individually irrational (each firm prefers to expand unilaterally).

Three features that enhance stability in this cobalt market:

1. Only three members controlling 90% of supply. With so few members, it is straightforward to monitor each firm's output volumes. Deviations are detected quickly, and punishment (reverting to competitive output and prices) is swift and credible. Fewer members = easier monitoring = stronger deterrence against cheating.

2. High barriers to entry. New cobalt mining requires enormous capital investment and years of development - the fourth independent producer has a small share and cannot quickly scale. Even if the cartel sustains high prices, the threat of rapid new entry disciplining those prices is limited. This lengthens the time horizon over which cartel profits can be sustained, making the arrangement worth maintaining.

3. Inelastic demand for an essential input. Cobalt is critical for EV batteries with few near-term substitutes. Even at $32,000/ton, manufacturers must buy it. This inelasticity means the cartel can sustain a large price-cost margin without dramatically losing volume - making the profits from coordination large and the temptation to cheat (by undercutting slightly and gaining a few extra customers) relatively weak.

This is not a horizontal merger because AeroTech and PowerJet operate in entirely different product markets - navigation systems and aircraft engines respectively. They are complements, not substitutes: no customer chooses between them; every aircraft needs both. There is no direct overlap in the same product-geographic market, so traditional horizontal merger analysis (HHI, unilateral effects among direct competitors) does not apply.

The European Commission would instead focus on conglomerate effects - specifically, portfolio effects. The concern is that by combining dominant positions in two complementary markets, the merged firm acquires an ability to leverage strength in each market to foreclose competitors in both, through the mechanism of anticompetitive bundling or tying. Rivals who supply only one of the two products cannot replicate the bundle, placing them at a structural competitive disadvantage.

Short run: Aircraft manufacturers face a bundle priced at a discount. Buying AeroTech navigation + PowerJet engine together is cheaper than buying separately from RivalNav and RivalEngine. From a consumer perspective, this looks pro-competitive - prices are lower.

The foreclosure mechanism (medium to long run):

• As manufacturers shift purchasing to the bundle, RivalNav loses volume. With lower sales, RivalNav cannot spread its fixed R&D and manufacturing costs - it becomes less profitable, reduces investment, and eventually exits or is severely weakened.
• Similarly, RivalEngine loses customers to manufacturers who take the bundle, weakening its ability to invest in next-generation engine technology.
• Once rivals have exited or been marginalized, the merged AeroTech-PowerJet faces no meaningful competition in either market and can raise prices on both products - far above what it charged during the bundling period.

Key insight: The short-run discount is funded by the long-run elimination of competitive discipline. Rivals cannot match the bundle because they only operate in one of the two markets - RivalNav cannot discount engines, and RivalEngine cannot discount navigation systems. The bundle weaponizes the complementarity of the two products to simultaneously squeeze out competitors in both markets. The harm is not in today's price but in the future market structure that the bundling creates.

European Commission: Has historically been willing to block mergers on conglomerate/portfolio effects theory even when short-run consumer prices fall. The EU looks forward and asks whether the merger creates a dominant position that will significantly impede effective competition in the long run. It places weight on protecting the competitive structure of the market itself - including protecting rivals' ability to compete - not only on immediate consumer prices. GE/Honeywell (2001) is the defining example: the EC blocked a merger the US had approved, primarily on portfolio effects and bundling grounds.

US DOJ: Applies a stricter consumer welfare standard focused on demonstrable, near-term harm. Bundling that produces lower prices for buyers is generally viewed as pro-competitive. US courts are skeptical of speculative long-run foreclosure theories; they require concrete evidence that rivals will actually exit and that prices will actually rise. The burden of proof for conglomerate theories is high and difficult to meet.

Result: The same merger can be approved in the US and blocked in the EU - precisely what happened with GE/Honeywell - because the two regimes place different weights on speculative future harm vs. observable short-run consumer benefit.

US antitrust authorities would strongly prefer Option A: the structural remedy (divestiture).

Why structural remedies are preferred:

US merger enforcement philosophy favors solutions that restore competition directly in the market, rather than requiring ongoing regulatory oversight. Divesting a plant to an independent buyer creates a new, self-sustaining competitor who will independently constrain the merged firm's pricing. No regulator needs to monitor behavior year after year - the competitive structure does the work.

Key limitations of Option B (behavioral - price cap):

1. Monitoring and enforcement burden: A regulator must continuously verify that prices comply across all product varieties, regional submarkets, and contract forms. Firms can evade price caps through quality reductions, service degradation, or restructuring transactions to avoid the cap's scope.

2. Temporary fix: After 5 years, the cap expires. The merged firm - now with its dominant market position fully consolidated - can raise prices freely. The underlying structural harm is never addressed; the cap only suppresses its symptom.

3. Does not restore competition: The cap constrains the price outcome but not the cause (insufficient rivals in the market). It turns the government into a permanent quasi-regulator of a market it never intended to regulate - inefficient and prone to regulatory capture over time.

Note: Behavioral remedies are more commonly accepted by the European Commission, which has a stronger tradition of ongoing regulatory engagement. US authorities strongly prefer clean structural solutions wherever they are feasible.