**Market Definition Under the Merger Guidelines:**

**Some Modest Proposals**

**Willard K. Tom**[^1]

**Comments Submitted to the DOJ/FTC Merger Workshop**

**February 17, 2004**

The Merger Guidelines and its 1982 and 1984 predecessors represent a
major advance over the state of the law and enforcement practice prior
to 1982. I know this because I was a brand new lawyer in the Antitrust
Division in 1979, and I well remember my sense of befuddlement at being
presented with my first merger matter. A disciplined framework for
thinking about market definition, in particular, would have been most
welcome. The Guidelines provided that framework.

In the face of that signal contribution, the comments here might seem
like mere caviling. In the spirit of continuous improvement, however, I
offer a few modest suggestions, grouped under two headings:

-   More explicit recognition of the role of uncertainty, and

-   More explicit recognition that the assessment of competitive effect
    is the underlying purpose of market definition.

I.  More Explicit Recognition Of The Role Of Uncertainty

    A.  The Hypothetical Monopolist Test Tempts Staff to Reverse the
        Proper Burden of Proof

It is a truism that the government bears the burden of proof in a merger
case. The very nature of the hypothetical monopolist test, however,
tempts staff into reversing that burden. This is so even though the
Guidelines explicitly state that they do not attempt to assign the
burden of proof or the burden of coming forward with evidence.

The agencies "begin with each product . . . and ask what would happen if
a hypothetical monopolist . . . imposed at least a 'small but
significant and nontransitory' increase in price" \[SSNIP\]. "If, in
response to the price increase, the reduction in sales of the product
would be large enough that a hypothetical monopolist would not find it
profitable to impose such an increase in price, then the Agency will add
to the product group the product that is the next-best substitute for
the merging firm\'s product." It is a natural human tendency to place
the burden of proof on those who argue that something would happen, not
on those who say it would not happen. Put another way, the hypothesized
price increase is treated as fact, and the hypothesized diversion to
other products is treated as speculation. The result will be a bias in
favor of narrower markets---a boon to the merging parties if their
products are not in the same market as a result, but an impediment to
them otherwise.

I am not suggesting that this is a huge or frequent problem. Oftentimes,
the market definition issue is not a close one, or the issue turns on
issues such as whose econometric model is more convincing. Often, too,
neither side explicitly defines a market, at least not in discussions
with each other. The staff's Merger Screening memo may contain somewhat
off-the-cuff market definitions, and associated HHIs, but nothing of
substance turns on them. Nonetheless, the bias is there, subtle as it
is, and in rare cases, it may actually make a difference.

At the risk of being branded an antediluvian, let me suggest a possible
role for the *Brown Shoe* "practical indicia" here. If, as a practical
matter, business people in the ordinary course of business treat the
market as being broader, someone applying the Guidelines test should
stop and think twice, or maybe three times, before concluding that the
market really is significantly narrower.

B.  "Too Many Notes"

A second uncertainty-related issue springs not from the hypothetical
monopolist test itself, but from the fact that product and geographic
market determinations are only two of many steps that an analyst
theoretically takes to make a judgment on the ultimate question of
overall competitive effect. Without in any way denigrating the masterful
symphony that is the Guidelines, and with apologies to the playwright
Peter Schaffer, I am reminded of the scene in the movie Amadeus in which
Emperor Joseph II comments that Mozart's opera has "too many notes."
Perhaps the Guidelines contain "too many steps." If merger analysis
consists of a long series of steps, all of which must be answered in a
particular way for the merger to be anticompetitive, and all of which
are inherently uncertain, it is easy to reach the wrong result if one
treats each step as fully answered and concluded before moving on the
next.

A simple example will illustrate the point. Suppose that in the proposed
merger of A and B, C is a firm (perhaps in an adjacent market) that
might be able to enter quickly and without sunk costs, and D is a firm
that might be able to enter within two years after incurring substantial
sunk costs. Suppose there is a 51% probability that, absent the merger,
if A were to raise the price of its product, customers would turn to B
in sufficient quantities to defeat the price increase. Suppose further
that there is a 49% probability that C is in fact an uncommitted entrant
that could defeat the price increase, and suppose further that there is
a 49% probability that the entry of D would be timely, likely, and
sufficient to defeat a price increase. The probability of an
anticompetitive effect from the merger is 51% x 51% x 51%, or about 13%.
An inexperienced analyst, however, could easily reason as follows: "It
is more likely than not that A and B collectively constitute a market.
It does not appear likely that C is an uncommitted entrant. Nor does it
appear likely that entry by D would prevent an anticompetitive effect.
Therefore, we should challenge the merger." Given that the staff and the
parties have asymmetric access to the witnesses and documents of
customers and other third parties, and given the staff's proper
reticence in disclosing information obtained from third parties, it can
be extremely difficult to know when the staff has inadvertently fallen
into this logical trap.

C.  "Customers Say They Wouldn't Switch"

The information asymmetry issue comes into play in a context other than
the layered uncertainties of a multi-step analysis. This was truer in
the early days of the Merger Guidelines, when it was more common for the
staff to ask customers the "hypothetical price increase" question
outright. Today, the focus seems to be more on either concrete past
behavior or on objective circumstances such as the timing and costs of
switching products. In consumer products, where scanner data are
available, the hypothetical question neither needs to be nor can easily
be asked directly in any event. Ultimate consumers are simply too
numerous; if one were to try to ask the question directly, one would
engage survey experts who would, one hopes, explain the limitations and
pitfalls of such research and try to protect against the most obvious
errors. With intermediate goods, however, staff often begins by doing
telephonic interviews of the principal customers. Here, the danger of
badly worded questions eliciting misleading information about the
unknowable is at its greatest. At the same time, the difficulty of staff
and parties joining issue on the implications of conversations to which
the parties cannot be privy is also at its greatest. To the extent that
staff says, "customers say they wouldn't switch," the likelihood of a
productive dialogue is quite small. The discussions are off to a much
more productive start if the conversation begins, "customers say they
wouldn't switch for the following four objective reasons."

II. More Explicit Recognition That The Assessment Of Competitive Effect
    Is The Underlying Purpose Of Market Definition.

    A.  When Should the Analysis Depart from 5%?

The Guidelines state that "what constitutes a 'small but significant and
nontransitory' increase in price will depend on the nature of the
industry, and the Agency at times may use a price increase that is
larger or smaller than five percent." I suggest that---on the principle
that the assessment of competitive effect is the underlying purpose of
market definition---there is a rational basis for departing upwards from
5% in particular cases. I also suggest that, although there is a
principled basis for departing downwards from 5% in particular cases,
one should never do so, and that one should accordingly delete the
sentence in Section 1.0 that states: "The 'small but significant and
non-transitory' increase in price is employed solely as a methodological
tool for the analysis of mergers: it is not a tolerance level for price
increases."

Let us takes the upward departure first. Imagine a situation in which a
price increase of 5% would lead to the loss of x units of sales. Suppose
that the profit on those x units is greater than the increased profits
on the sales that the seller would continue to make. Therefore, a 5%
price increase would not be profitable. Now suppose that the next
tranche of customers is highly price-inelastic. Even with a price
increase of 10%, the seller still loses no more than x units of sales.
But this time, with a 10% instead of a 5% price increase, the increased
margin on the sales that are kept is great enough to outweigh the lost
profits from the sales that are lost. Now the price increase is
profitable. Because the purpose of the market definition exercise is to
protect consumers from being harmed, why would we not want to guard
against this 10% price increase?

The same argument could be applied, of course, to price increases
smaller than 5%. A price increase of 1% might cause a small enough loss
of unit sales to be profitable, whereas a 5% price increase would not.
If we knew exactly what would happen with perfect foresight---if the
world resulting from the merger and the but-for world could be known
without any uncertainty---I would be perfectly comfortable defining the
market based on such a 1% price increase. I suggest, however, that, on
average, the uncertainties of life swamp any effort to make such fine
distinctions. In order to have some reasonable benchmarks---not only for
planning and counseling, but also to avoid unnecessary interference in
procompetitive mergers---I propose that we accept 5% as a tolerance
level.

B.  It Is Time to Reconcile Unilateral Effects With Market Definition.

There are some confusing redundancies between market definition and
competitive effect in the Guidelines. For the most part, they do no
harm. Nonetheless, there are confusing. If one is going to revisit the
Guidelines anyway, one might want to consider eliminating such
redundancies. Probably the leading example is trying to make sense of
unilateral effects in light of the sentence in Section 1.11 that reads:
"In performing successive iterations of the price increase test, the
hypothetical monopolist will be assumed to pursue maximum profits in
deciding whether to raise the prices of any or all of the additional
products under its control." This appears to mean that the
sustainability of 5% price increase in only a single one of the
hypothetical monopolist's products is sufficient to define a market. If
that is so, then market definition vitiates the need for a unilateral
competitive effects analysis. Unilateral effects analysis says that a
merger is anticompetitive if, as a result of a merger of A and B, the
post-merger entity can raise the price of at least one product without
accommodating reactions by other competitors. This may occur, for
example, because the market is differentiated and A and B are each
other's closest competitors. But if the sustainability of a 5% price
increase in only a single one of A's and B's products is sufficient to
define a market---as the above-quoted sentence from Section 1.11 seems
to say---then by definition, a unilateral effect consisting of a price
increase of 5% or more is also a merger to monopoly.

Three possibilities come to mind for reconciling market definition and
competitive effects in this context:

-   The two sections are simply redundant.

-   The market definition section allows the agencies to evade the 35%
    benchmark in the competitive effects section.[^2]

-   The competitive effects section allows the agencies to attack a
    price increase of less than 5%, assuming the agencies do not want to
    achieve the same goal by varying the 5% benchmark for market
    definition.

Whatever the explanation is, some clarification appears desirable.

A.  Bring Supply Substitution Back Into Market Definition.

I hesitate to talk about a case that I know only from the outside. Both
the staff and the lawyers for the parties saw many documents that I will
never see and talked to witnesses to whom I will never talk. So take
this discussion for what it is: a "methodological tool" for talking
about the Guidelines, not a comment upon the outcome in a particular
case. With that caveat, can "intense mints" really be a market? Would
not makers of regular mints easily be able to carry out line extensions
into the "intense mints" space? Or was this a case in which, once the
market was defined, it was all too easy to skip over steps such as
uncommitted entry, product repositioning, or committed entry?

I don't know, and the answer may be as simple as the fact that when the
staff has the leverage to extract a consent order, all doubts about the
effect of the merger tend to be resolved against the parties. But I do
sometimes wonder whether the need to obtain a current market share to
plug into the spreadsheet in order to generate an HHI number leads staff
to systematically underweight the competitive influence of firms whose
current market share is zero.

**Conclusion**

As I said at the outset, my comments on the market definition sections
of the Merger Guidelines are minor ones. The Guidelines represented a
significant advance, and their achievement has withstood the test of
more than two decades. If the agencies are inclined to do some
fine-tuning, however, I hope these modest suggestions prove useful.

[^1]: ^\*^ Partner, Morgan, Lewis & Bockius LLP. These comments reflect
    only the views of the author and not necessarily those of Morgan
    Lewis or any of its clients.

[^2]: Dropping the 35% benchmark would probably be a good idea in any
    event; I have yet to understand how it is helpful to a unilateral
    effects analysis.