Question

Consider the following potential merger between Firm A and Firm B. Firm A sells its product for $100 with a marginal cost of $60, selling 100 units. Firm B sells its product for $80 with a marginal cost of $40, selling 100 units. Cross price elasticity is 0.5. Calculate the value of diverted sales expected if these firms merge. What is the GUPPI? Is this merger likely to receive additional scrutiny for potential unilateral effects? If the merger is likely to generate efficiencies, give an example of potential cost savings significant enough to alleviate concerns of unilateral price effect.

Answer 1

To calculate the value of diverted sales and GUPPI, we use the given cross price elasticity and margins of both Firm A and Firm B. The merger may be scrutinized for unilateral effects, but potential cost savings from economies of scale could alleviate concerns.

Step-by-step explanation:

To calculate the value of diverted sales expected if Firm A and Firm B merge, we first need to understand that diverted sales represent the percentage of Firm A's sales that would transfer to Firm B if Firm A were to raise its price by a small amount, and vice versa. This concept is closely related to cross price elasticity, which measures the responsiveness of the quantity demanded for one good when the price of another good changes. Given the cross price elasticity is 0.5, if Firm A raises its price by $1 (1% of $100), the quantity demanded for Firm B's product would increase by 0.5% (0.5 units given their 100-unit sales).

The gross upward pricing pressure index (GUPPI) is a measure used to evaluate the potential price increase resulting from a merger between competing firms, without accounting for cost efficiencies that may result from the merger. To calculate GUPPI, we would use the formula: GUPPI = (Diverted Sales) / (Margin), where the margin is the difference between price and marginal cost.

For Firm A, the margin is $100 - $60 = $40 per unit, and for Firm B, the margin is $80 - $40 = $40 per unit. Accordingly, if Firm A raises its price by 1% or $1, Firm B's sales increase by 0.5 units, leading to diverted sales worth 0.5% x $80 = $0.40. The GUPPI for Firm A would be $0.40 / $40 = 0.01 or 1%. Similarly, if Firm B raises its price by 1%, the GUPPI for Firm B would also be 1%.

This merger may receive additional scrutiny for potential unilateral effects, particularly if the combined market shares of the firms are significant and the cross price elasticities indicate a substantial number of diverted sales between them. If the merger is likely to generate efficiencies, an example of potential cost savings might be economies of scale, where the merged firm might be able to produce the same quantity at a lower cost due to spreading overheads over a larger output.