The First-Order Approach to Merger Analysis

Abstract

Using only information local to the pre-merger equilibrium, we derive approximations of the expected changes in prices and welfare generated by a merger. We extend the pricing pressure approach of recent work to allow for non-Bertrand conduct, adjusting the diversion ratio and incorporating the change in anticipated accommodation. To convert pricing pressures into quantitative estimates of price changes, we multiply them by the merger pass-through matrix, which is close under conditions we specify to the pre-merger rate at which cost increases are passed through to prices. Weighting the price changes by quantities gives the change in consumer surplus. How should we predict the unilateral impact of a merger on prices and welfare? The United States and United Kingdom horizontal merger guidelines released last year incorporate an approach based on the work of Werden (1996), Farrell and Shapiro (2010a) and others that uses information local to pre-merger prices to indicate the directional impacts of the mergers. This "first-order" approach to merger analysis (FOAM) is admirable for adopting both the simplicity and transparency of approaches based on market definition and the firm grounding in formal economics of market simulations. This paper takes this strategy a step further, attempting to incorporate the remaining strengths of alternative approaches: the quantitative precision of merger simulation and the agnosticism about market conduct and cost structures embodied in market definition. We show that FOAM, thus modified, provides * We could not have written this paper without the encouragement and guidance of Joe Farrell and Carl Shapiro. We are also grateful to

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