Resource Economics 453
Public Policy in Private Markets
Midterm Exam #2 (practice) Total Points = 100
PART I: Multiple choice questions (4 points each). Total points for this section = 40.
[correct answers in bold and italic; explanations for wrong answers in italic]
1. The main antitrust concern with “tying” is:
a. Market power in the tied market may increase unnecessarily. This is because market power
from the tying market can be translated to the tied market
b. Quality of the product/service is not guaranteed when tying occurs. Tying is actually used to
ensure quality provision.
c. Market power in the tied market can be translated to the tying market. This is the opposite of the
correct answer
d. It is more efficient (i.e. less costly) for the tying firm to sell tied products/services. This is a
business motive, not an antitrust concern.
2. Vertical mergers can create the following anticompetitive concerns:
a.
b.
c.
d.
Firms not involved in the vertical merger may be foreclosed from an essential facility
Firms not involved in the vertical merger may face higher costs
Entry for future competitors becomes more difficult
All of the above. All these concerns were mentioned in the lecture notes and in class.
3. The following criteria are used to determine whether a horizontal merger would be challenged,
except:
a. Generalized price increases (for merged and non-merged firms). Yes, these are the unilateral
effects
b. The possibility of vertical price fixing. This is resale price maintenance, unrelated to mergers
c. Price reductions due to lower costs achieved by the merged firms. Yes, this is the cost efficiency
argument.
d. Whether the merging parties have products that are sufficiently close substitutes. This is part of
the relevant market definition, necessary for HHI calculation.
4. In a manufacturer-retailer relationship, the business motives for the manufacturer to enforce minimum
resale price maintenance to its retailers include the following, except:
a. Better coordination of sales across different retailers. Yes, this is was listed in the lecture notes
b. Elimination/reduction of retailers’ free riding on other retailers’ sales effort. Yes, listed in lecture
notes
c. Avoiding unnecessary price reductions that may tarnish the brand name. Yes, in lecture notes.
d. Lower costs for the downstream firm. Resale price maintenance deals with the price that the
retailer can charge to consumers, not its costs
5. The firm that you work for has a 50% market share in the relevant market (as defined by the antitrust
authorities). The firm’s management is merging with the 5th largest competitor, which would increase
the HHI from 3600 to 3800. Based on historical precedents (i.e. prior cases we have studied in class),
which one from the following arguments would you say is the least likely to help you in court?
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a. The 5th largest competitor’s cross-price elasticity (with respect to your firm’s product) is equal to
0.05. This would be a strong argument for the merging firms, indicating they are not in the same
relevant market (or that prices after the merger will not increase significantly as one would not
be eliminating a close competitor).
b. Entry barriers in the industry are quite low as competitors have been able to enter the market with
ease in the last 5 years. Although we did not cover cases that highlighted this issue in depth, this
would be considered as a favorable argument for the merging firms.
c. Although the product manufactured by the 5th largest competitor is highly regarded by
consumers, it operates an old and inefficient facility; moving production into your firm’s
manufacturing facility would reduce manufacturing costs of the acquired product by 50%.
While this is a valid defense, all precedents in antitrust history (illustrated in several cases we
covered) indicate that this is the least successful defense.
d. The 5th largest competitor operates mostly in Washington state, where you currently have no
presence as it is very costly to transport your product there. This would help the firm argue for
being in separate geographic markets (or that prices after the merger will not increase
significantly as one would not be eliminating a close competitor)
6. LG is currently selling its TV sets through several retailers (Best Buy, Radio Shack, etc.). LG’s policy
has been to offer training to retailers’ salesmen so that they are knowledgeable about how TVs
operate and hence increase sales (through better product demonstration). However, it has come to
LG’s attention that salesmen are using this knowledge to increase sales of other TV sets (Sony, etc.).
Which of the following can LG’s management choose to eliminate/reduce this problem (assuming
these solutions are feasible)?
a. Make retailers exclusive distributors of LG TVs. If LG can convince retailers not sell other
TVs, then this would work as training retailers’ salesmen on the technical aspects of TV sets
will pay off (i.e. salesmen would not use this knowledge to sell non-LG TVs).
b. Offer exclusive territories to their retailers. This would not solve the problem, exclusive territories
are used to provide retailers with incentives to exert sales effort and prevent retailers
from free riding on each other’s efforts.
c. Tie TVs sales to sales of other LG products (e.g. Blue Ray players, cameras, phones, monitors,
etc.). Tying is used for other purposes (ensuring quality, for example).
d. Enforce minimum retail price maintenance. This is used for other purposes, see question 4
7. Vertical price fixing:
a. Should be treated as per se illegal as prices as it amounts to collusion. I repeatedly indicated that
this should not be so. See lecture notes.
b. Has always been treated under the rule of reason approach. Not true, RPM has been treated as
per se illegal until recently (2000’s)
c. Can actually benefit consumers as it can keep prices below a certain level. This is true for
minimum RPM; I explained this in class
d. Can reduce the production costs for the downstream firm. Again, RPM has nothing to do with
costs for the downstream firm.
8. Merger simulation is used to:
a. Assess the possible effects of unilateral price increases. This exercise amounts to constructing
an economic model of the industry before the merger (one that can mimic current prices and
quantities) and then modifying it to investigate how equilibrium prices would look like after the
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merger. In other words, it tries to assess how, in the new equilibrium, prices would compare
with pre-merger prices. It does not consider (typically) cost reductions by the firm, entry
barriers or collusion; therefore, its aim is at studying unilateral price increases.
b. Assess the possible effects of coordinated price increases. See above.
c. Assess the possible effects of cost reductions brought about by the merger. See above.
d. Assess the possible effects of increased entry barriers. See above.
9. New evidence in the Toys R Us case indicates that the cross-price elasticity between toys sold at Toys
R Us and toys sold at Costco is 0.03. If the case were to be revisited today, which of the following is
most likely to occur?
a. Market definition would be similar to that used in the Staples-Office Depot case. This is the
most reasonable answer as the Staples-Office Depot case defined the market using the
identity of the seller (not the product itself): office supplies sold through office super
stores (OSS). One could conceivable think that with such a low cross price elasticity the
market here could be defined as toys sold through Toys Super Stores.
b. Costco would be considered a closer competitor to Toys R Us than it was in the 1990’s. A low
cross-price elasticity would point to the contrary (that Costco is a worse substitute)
c. Entry barriers in the Toys Super Store business are lower. Cross price elasticity is not used for
this purposes.
d. A merger simulation between Toys R Us and Costco would yield large price increases. If
anything, a merger simulation would predict the opposite (low price increase). Moreover,
the case was not about a merger.
10. The type of RPM used by Oil State was unlikely to harm consumers because:
a. It guaranteed a higher quality product to consumers. Not relevant in this case
b. It reduced the price that Khan had to pay to acquire gasoline from Oil State. False, the policy
placed a cap on Khan’s margin.
c. It placed a cap on the final price paid by consumers. The case dealt with maximum resale
price maintenance thereby impeding the Khan from raising price above a maximum margin
over wholesale cost.
d. It provided incentives for Khan to exert superior sales effort. If anything, it provided Khan with
little incentive to do so as the margin was limited (i.e. Khan had no incentive to invest or offer
costly services).
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PART II: Short Answer Questions. Choose 3 of the following 4 questions to answer. 20 points each. If
you answer all, I will drop the lowest score.
[answers in italic]
1. Consider the case of franchising by Taco Bell. The franchising model currently used has the mother
company (Taco Bell) focusing on non-retail activities (e.g. advertising of the Taco Bell brand at the
national level, introduction/removal of items in the menu, etc.) while franchisees (who sign a
franchising agreement with the mother company) dedicate to the actual retail activity (i.e. selling
Taco Bell’s products). Using this example, for each of the following vertical restraints, provide: a) a
business motive for the use of such restraint, and b) an antitrust concern that may result from such
restraint.
a. Exclusive territories (i.e. assigning franchisees exclusivity for given radius around the outlet)
Business motive: it prevents free riding between franchisees’ sales effort. This means that a
franchisee is guaranteed that the return to his efforts in promoting the Taco Bell brand
are protected (in the sense that no retailer will be able to benefit from them).
Antitrust concern: reduced intrabrand competition and, as a consequence, potentially higher
prices for consumers
b. Exclusive dealing
Business motive: It prevents the franchises from diverting efforts on sales of non-Taco Bell
products. This is particularly important if the franchisor (i.e. the mother company)
invests a lot on the franchisee (for example through training, equipment provision, etc.)
or if national advertising of the Taco Bell brand is significant. In the case of advertising,
the absence of exclusive dealing will mean that consumers may end up in a Taco Bell
because the saw the ad on TV but end up buying non-Taco Bell products (really bad).
Antitrust concern: the main concern is if exclusive dealing excludes rival firms from an
essential facility. In the case of franchising this might take the form of an ideal spot
(geographically speaking) for doing business; once this spot is taken, other franchising
firms (for example a Wendy’s) may be left out of the market or simply would need to find
another (less desirable) location.
c. Maximum resale price maintenance
Business motive: the main motive has to do with the reduction/limitation of the double
marginalization problem (aka the double mark up problem). Without the double mark up,
more of the product would be sold at a lower price (a desirable thing for the upstream
firm – and for society for that matter).
Antitrust concern: the antitrust concern here is weak. It has been claimed that this practice
can “squeeze” margins of the retailer. It’s fine if you listed this one. However, the
question remains: why would a franchisor want its franchisee not to do well by squeezing
its margins?
d. Tying (i.e. forcing the franchisee to buy the equipment and food ingredients from the mother
company).
Business motive(s): The main issue has to do with quality. In order to preserve the
appropriate level of quality, the franchisor needs the franchisee to buy equipment and
ingredients from the mother company (franchisor).
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Antitrust concern: the main issue has to do with an unnecessary increase in market power in
the tied market (i.e. market power from the tying market, in this case licensing of the
Taco Bell brand name, is extended/translated to market power in the tied market).
2. Consider the sugar manufacturing business. There are currently 5 firms in the market (annual
production in tons):
a.
b.
c.
d.
Super Sweet (270,000)
Honey-Honey (190,000)
Addictive (50,000)
This Ain’t no Splenda (25,000)
Answer the following questions
a. What is the current HHI in this industry?
Total production is 535,000 tons. This means that the corresponding market shares are:
50.46%, 35.51%, 9.35% and 4.67%. Hence the pre-merger HHI is:
50.46^2+35.51^2+9.35^2+4.67^2 = 3917.37
b. Consider a potential merger between Addictive and This Ain’t no Splenda. What is the
post-merger HHI in this case? According to the horizontal merger guidelines’
concentration measures, how would this merger be treated?
The corresponding market shares of the three firms are 50.47%, 35.51% and 14.02%
(this last figure corresponds to the merged company). The corresponding HHI is:
50.47^2+35.15^2+14.02^2=4,004.72. This merger would fall into the “highly
concentrated” category. However, the increase in the HHI is less than 100 points,
which, according to the horizontal merger guidelines, would make antitrust
authorities unlikely to challenge.
c. Consider a potential merger between Super Sweet and This Ain’t no Splenda. What is the
post-merger HHI in this case? According to the horizontal merger guidelines’
concentration measures, how would this merger be treated?
The corresponding market shares of the three firms are 55.14%, 35. 51% and 9.35% (the
first figure corresponds to the merged company). The corresponding HHI is:
55.14^2+35.15^2+9.35^2=4,389.03.
This merger would fall into the “highly
concentrated” category. As opposed to the prior merger, the increase in the HHI is more
than 100 points, which, according to the horizontal merger guidelines, would make
antitrust authorities likely to challenge.
d. New evidence has just come in suggesting that artificial sweeteners (e.g. Splenda, etc.)
have a cross-price elasticity (with respect to sugar) equal to 0.75. With this information:
i.
Would your answer to part b. change substantially? If so, how?
This high cross-price elasticity suggests that artificial sweeteners are very close
substitutes to sugar, which calls for a revision of the relevant market: it
should now include artificial sweeteners. This would reduce the market
shares of sugar manufacturers and the HHI measures significantly. The
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answer to part b is unlikely to change since in b. it was argued that this
merger would probably be unchallenged.
ii.
Would your answer to part c. change substantially? If so, how?
The inclusion of artificial sweeteners in the relevant market, however, would
probably cause a revision of a potential challenge to “no challenge” since:
a) either the post HHI would fall into the less concentrated categories or b)
the increase in the HHI would be less than 100 points.
3. Consider a hypothetical merger between Honda and Toyota. Antitrust authorities are worried about
unilateral price increases as a result of this transaction. Consequently, a merger simulation has been
carried out; the simulation exercise indicates that post-merger prices (for the merging firms) would
increase by 19% (as usual, this merger simulation assumes that costs in the post-merger world remain
unchanged). On the other hand, Honda (the acquirer) argues that such transaction will be efficiency
enhancing because Toyota’s production will move into Honda’s newer assembly facility located in
China, which currently has an excess capacity of 50%. Specifically, Honda cites estimates that this
transaction will bring about a 17% cost reduction for both Honda and Toyota cars. You work at the
DOJ and your boss has asked you to debrief him about this case; in particular, he is lawyer with no
economics training. You must address the following questions:
a. What is a merger simulation?
It is a tool used by antitrust authorities that helps them understand better the possible
unilateral price increases that can result from a merger. The basic idea is to come up
with a theoretical model that fits well the industry at hand and then calibrate it (i.e.
estimate parameters) so that it reproduce the observed behavior in the market (i.e.
equilibrium prices and quantities). The model is then “perturbed” by removing a
firm from the market (i.e. the acquired firm) and the equilibrium is calculated again.
Finally, the prices that result from this prediction are compared to current prices: if
the merger predicts substantial price increases (typically more than 5%) then
antitrust authorities will question the merger.
b. Would you tell your boss that such a price increase is something to worry about?
Yes, I would tell him that this is something to worry about because a 19% price increase
is quite large.
c. How could Honda use the efficiency argument to counter the argument regarding
unilateral price increases?
The efficiency argument can be used to tell the regulatory agency that the cost savings
will be ultimately enjoyed by the consumers since part of them (or possibly all) will
be ultimately passed on to consumers.
d. Suppose the 17% cost reduction estimate is rock solid (i.e. the judge will not question it
and will accept this measure). Would your answer to part b. change if:
i.
The whole cost reduction is passed-through to the consumer (i.e 100% pass-through
rate)? Why?
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Yes, it would probably change, since 19% - 17% only means a 2% price increase,
which might be considered as too low for antitrust authorities to worry about.
ii.
The pass-through rate is 30%? Why?
Probably not since 19% - 17%*0.30 means that prices will increase by 13.9%, which
is a high price increase. In other words, the price reduction resulting from the
efficiency gains are not enough to significantly counter the large price increase.
4. You have been recently hired by Apple’s economic analysis division. Apple is currently analyzing a
wave of mergers with different companies. You have been asked to provide a brief summary of the
merger law in the US. Specifically, you need to:
a. Briefly explain the merger typology: list the three types of mergers with a brief
description of each.
b. For conglomerate mergers (the third type of merger), list the sub-types in this category
and briefly describe what they are.
c. For each of the three types of mergers (explained in a.), explain what the main antitrust
concern is (choose one if you think there is more than one).
I will not provide an answer key for this as this comes straight from the notes (and
today’s review session).
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