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The Upward Pricing Pressure Test for Merger Analysis: An Empirical Examination

 |  November 11, 2013

Posted by D. Daniel Sokol

Lydia Cheung (Department of Economics, Faculty of Business and Law, Auckland University of Technology) discusses The Upward Pricing Pressure Test for Merger Analysis: An Empirical Examination

ABSTRACT: The Upward Pricing Pressure (UPP) test developed by antitrust economists Joseph Farrell and Carl Shapiro marks a new era in antitrust and provides an alternative to the traditional concentration-based tests in merger analysis. In addition to being free of market definition, the UPP’s appeal lies in its ease of use: one simple formula indicates whether a merging firm has an incentive to increase prices postmerger. This paper first establishes the theoretical relationship between the UPP and the standard structural merger simulation, namely, that the UPP is a singleproduct merger simulation” that ignores the re-equilibration of all other endogenous variables except that product’s own price. To assess the consequence of this simplification, I compute “true” UPP values for a cross-section of airline markets using structurally estimated price elasticities, and confront them with the gold standard” of a merger simulation. I examine the predictive accuracy of both the sign and magnitude of the UPP. I find that it gives wrong sign predictions to an average 10% of the observations, and its value has an average correlation of 0:92 with the structurally simulated price changes. However, since this test is meant to bypass a complicated demand estimation, I then use the example of a simple logit demand to illustrate the consequence of using inaccurate demand-side inputs in the UPP: the test will give a wrong sign prediction over a much larger range of cost synergies. Lastly, I discuss the pass-through conditions for Farrell and Shapiro’s proposition, demonstrate empirically that they are not innocuous, and show that their violation can lead to false positive results (type I errors) in the UPP.