Merger

Diagonal Merger
Author(s): RICHARD S. HIGGINS

Source: Review of Industrial Organization, Vol. 12, No. 4 (August 1997), pp. 609-623
Published by: Springer
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Review of Industrial Organization 12: 609-623,1997.
© 1997 Kluwer Academic Publishers. Printed in the Netherlands.
Diagonal Merger
RICHARD S. HIGGINS*
Capital Economics, 1299 Pennsylvania Avenue, NW, Washington, DC 20004, U.S.A.
Abstract. Diagonal merger combines the assets of an input supplier and a downstream rival of t
input demander that does not use the input. Diagonal mergers are likely to be overlooked by federal
antitrust authorities as they are neither vertical nor horizontal mergers. Diagonal mergers are show
to be nearly as anticompetitive as comparable horizontal mergers and, like horizontal mergers, th
welfare effects of diagonal mergers are predicted in the first instance by a modified HHI calculation
Key words: Merger, antitrust, Herfindahl Index.
I. Introduction
Recently, several articles have claimed to provide an analytical basis for anticom-
petitive vertical integration, including Salinger (1989, 1991); Ordover et al. (1990)
[O-S-S]; and Hart and Tiróle (1990). None of these attempts succeeds sufficiently
to justify invigorating federal antitrust enforcement of vertical merger as urged by
Riordan and Salop (1994). Both Salinger and O-S-S assume firm conduct that is
irrational or, at least, which has not been demonstrated to be individually rational
Specifically, Salinger assumes vertically integrated input suppliers do not sell in
the merchant market, and O-S-S similarly assume commitment to a downstream
price by the vertically integrated input suppliers.1 There are only two potential-
ly anticompetitive bases for vertical integration: (1) price discrimination; and (2)
variable proportions. In the first case, as is true for price discrimination in gener-
al, the effect on economic welfare-and even output- is ambiguous depending on
higher order demand curvature.2 Similarly, with variable proportions the effect of
vertical integration is ambiguous. Finally, in neither case, is pre-merger marke
* I wish to thank Raymond A. Jacobsen, Jr., David P. Kaplan, Paul H. Rubin, Marc G. Schildkraut,
and especially Gregory J. Werden for helpful comments on an earlier draft of this paper. I also wish to
thank the Center for the Study of Public Choice for inviting me to present this paper and the member
of its Wednesday Seminar for their critical comments.
Reiffen and Vita (1995) provide an excellent analysis of the Post-Chicago vertical integration
literature, except for the Hart and Tiróle paper, which they do not address. Also, see Reififen (1992),
which specifically criticizes Ordover, Saloner and Salop, and see Ordover, Saloner and Salop's reply
(1992).
The justification for rejecting the Hart and Tiróle analysis as a basis for antitrust enforcement of
vertical merger is that Hart and Tiróle unrealistically assume contingent and multi-part price contracts
which effectively eliminate all but the anticompetitive gains from vertical integration.
2 See Joan Robinson (1933) and Ekelund et al. (1981).
6 1 0 RICHARD S. HIGGINS
concentration predictive of th
most antitrust economists wo
Post-Chicago analysis demonst

cal mergers. By itself, howev
review of these transactions
requires a reliable link betw
performance. This link hasy
This conclusion is also approp

(1986) theory of raising rivals
this light, it is difficult to ex
alies which are likely to misg
Graphics , Silicon Graphics, In
ics workstation' market propo
software suppliers in the wor
Inc.4 Instead of challenging th
likely be lessened in the 'enter
challenged the acquisition bas
the Commission evinced conce
to software providers or that
expanding workstation supplie
one of the software provider
order' designed to assure that
software rivals of Alias and W
will deal fairly with burgeoni
While an explanation for the
probably lies with the econom
is a direct implication of the
been overlooked. The theory
vertical merger that is likely
hybrid is potentially anticomp
related to the magnitude of p
become obvious, I call such m
stylized illustration. Brass is
with steel in several applicatio
and steel are interdependent. If
Horizontal Merger Guidelines
sales,
steel may or may not be
steel disciplines the price of b
price of steel. If there were a s
3 See Reiffin and Vita ( 1 995, p. 92 1

4 See, 'Complaint, Order and Analys
Inc., FTC, File No. 951-0064, July 5
DIAGONAL MERGER 6 1 1
as the unintegrated zinc mon

lose sales on at least two accou
from zinc to the extent othe
alloys to make a brass-equiva
to steel (or, more realistically
fabrications). 5
Typical application of the G
would be highly unlikely to
even if the cross elasticity o
In particular, zinc customers
commonly relied on in merger
definition, not would certainly
market containing zinc may c
alloying metal. Just as obvio
at most, brass-îot zinc- wou
merger between the zinc mon
to be classified as a horizonta
Guidelines market definition te
implementation. However, be
fail to place steel in the relev
diagonal merger between zin
effect.6 Such a merger would
monopolist does not supply a
merger is diagonal , as it ent
from a competitive standpoin
potential for anticompetitive
merger one or more stages re
zinc input monopolist to captu
the supply of zinc. In the abse
gain on the steel industry whic
an investment-only interest in
raise the price of zinc. Under
equilibrium price of zinc is h
incentive for zinc producers t
5 Of course, to the extent the mix of

the properties of the brass output, c
zinc are primarily complementary, n
6 The analysis herein ignores the rol
Diagonal merger is a special case of
an input or other exclusionary beha
competitor relative to its rivals to the
a diagonal merger, the relevant down
no increased input cost as the price o
612 RICHARD S. HIGGINS
In Section H, I demonstrate
a comparison with horizonta
quantity-setting behavior. I
effect of a diagonal merger w
a comparable horizontal mer
from diagonal merger may
mergers are more likely to
althogether than their hori
antitrust investigations of m
least, could be described p
Section IV.
Analysis of Diagonal Merg
Ultimately I will show that

that of horizontal merger.8
between competing produce
interdependent demands.
1 . HHI Analysis of Horizontal Merger with Interdependent Demands
First, consider two horizontally-related markets A and B containing n and m

Cournot competitors, respectively. To simplify matters, I assume uniform constant
marginal cost within a market. The demands for A and B are interdependent.
Specifically, in A , MC = ca and pdA = pa Œ)n Qt* QB ) *n MC = cb and
pdB=PB(QA,ZmQF)-
Prior to merger with all firms independently owned and operated, the weighted-
average price/cost margins in A and B are
( PA - CA)/pa = -HHIo £AA, 0a)
and
(pb - cb)/pb = -mn$eBB.9 (ib)

In (1), the HHIs for A and B are based on shares within A
The en are the inverse own elasticities of demand. These
8 HHI is a measure of concentration. The HHI and HHI change th

related to welfare changes through an appropriately chosen oligopoly
simplest such model is Cournot quantity setting. By HHI analysis I m
merger's effect on concentration in the context of a simple Cournot mod
constitutes a welfare analysis of merger.
9 The Lerner Index is not an unambiguous measure of market imperfe
simplicity. See Landes and Posner (1981).
Of course, in the case of constant uniform marginal cost, HHI = 1
equal to the monopoly percen

single product demand funct
reciprocals of the ordinary o
denominators as divisors of t
the inverse elasticities cannot
appear in the numerators as m
are weighted by the dollar sh
Lerner Index for A and B :
L$B = -SAASA HHtf -£BB( 1 - SA) HHI£.13 (2)
If firm 1 in A merged with firm 1 in B , the marginal conditions would be altered

and the Lerner Index would then be
L'B - LqB - Sa'Sb'{SB£BA + sazab)' 14'15 (3)
With symmetry ( sbSba = s as ab'
A LAB - -2SA'SB'SA£AB
= -(2SA'SB'/sasb)SAÂB
= -{2saisb'/SB)(-£AB)' (4)
If A and B were perfect substitutes, -sa

elasticity of demand for A and B combined.
(-e), the familiar HHI change formula. Alterna
between A and B , A LAB = 0. Even if there w
A and B , it may not be sufficient to place A an
1 1 The monopoly markup is overstated by e a except

linear demand curves, for example, demand elasticity is h
the monopoly price inverse elasticity is lower.
12 Here, transforming direct own and cross elasticit
elasticities and vice versa requires that a 2 x 2 mat
Sjj/{£AASBB - sabeba ), and Tjij = - SijlD , where D i
elasticities.
13 The lower case shares indicate shares of total dolla
14 The upper case shares indicate dollar shares of A a
is given in Mathematical Appendix A.
15 The analysis presented herein is not an equilibrium a
(1990). That is, merger leads not just to different prices (
while in general, the simple comparison of pre- and p
shares, is incorrect, it is often used in antitrust analysis
Also, use of the Lemer Index as an indicator of market
incorrect. See Landes and Posner (1981). But, again, the c
by such simplifying assumptions.
according to (4), AL may be

merger may fall outside the
2. Hffl Analysis of Diagonal Merger
Again, I assume two downstream markets, A and B, interrelated through deman

In each market there are n and m Cournot competitors, respectively. Marginal co
is assumed to be uniform within a market and constant. Specifically, MC a = ca an
MCb = cb + kpz, and pdA =pA (£„ Q?, QB) and pdB =pB(QA, £m Qf ), wher
pz is the price of the input, Z, used to make B, and A; is a constant input/outpu
ratio.17 The input, Z, which is used by producers of B , but not A, is produced b
r Cournot competitors at constant, uniform marginal cost, cz- Thus, the model
based on competitive, or noncooperative behavior, not collusion.
Because, by assumption, market power is exhibited at each of the two levels o
production, B and Z , either the buyers or the sellers must be price takers in ord
to avoid a bargaining situation with indeterminate results. I assume that produce
in B take the price, pz, as given. A choice of price determination models still
remains. Among static models, the producers in the A , B and Z markets may
choose output simultaneously or sequentially and, among the sequential models
there are several options (see Salinger, 1989). Notably, if each of the producers
chose output simultaneously, diagonal merger would not alter the incentives of
producers to restrict output.18 Thus, a two-stage, static game is analyzed here.
Specifically, in stage 2, the producers in B maximize profit, taking QA and p
as given. This establishes a relationship between the quantity demanded of QB (o
Z) and pz and QA - in terms of inverses, between pz and QA and Z. In stage 1,
quantity-setters in A and Z maximize profit given the output chosen by the othe
Thus, the producers in both A and Z are Stackelberg leaders with respect to B. 19
16 This is the issue Greg Werden (1982) addressed in his paper on semihorizontal mergers. A
semihorizontal merger is a merger like that between Al and B 1 in which sxy /syy is significantly
greater than zero but not sufficient to place B in the market with A (or vice versa). Werden appear
to be concerned that semihorizontal mergers involving a dominant firm would go unchallenged.
can be seen from (4) above, the merger in question need not involve a dominant firm to result in a
substantial increase in the HHI.
17 With no loss of generality k = 1. Also, the assumption that there is a fixed input-output ratio
simplifies analysis, but it is not a critical assumption for the sequential decision-making mode
analyzed below.
18 A simultaneous decision model would assume that the Z producers choose outputs (and henc
input price), given aggregate B output, and that B producers choose their outputs given the pri
or output of Z and the output in A. In this case, with fixed proportions in By the output choic
would be trivial given Z usage. With either variable or fixed proportions, the profit of Z producers
independent of A's price or output, and A producers' profit is independent of the price or output o
Z when outputs are chosen simultaneously.
19 It may seem more natural to let A and B producers select quantities simultaneously and to allow
Z producers alone to be the Stackelberg leaders. This specification yields results similar to tho
presented in the text, while the algebra is messier.
Before merger, each produce

ated. The marginal conditions
Lerner Indexes for A and for
merger is assumed between Z
HHI is derived.
Pre-Merger
In stage 2, the marginal conditions are
Qf(dpß/dQB) + pb(QB, QA) - ( cB + pz) = 0, for i = 1 - m. (5)
Since Qf = Qf for all i and j , (5) can be solved for pz to yield:
Pz = Pb(Z, QA)[(eBB/m) + 1] - cB = pz(Z, QA). (6)

In deriving (6) from (5), second order effects are assumed to be zero, and individual
shares of B firms are uniformly equal to 1/m = Sbí = HHIfî.20
In stage 1, A producers and Z producers anticipate their impact on and each
maximizes, respectively,
Q?'Pa(QA,Z)-ca], (7a)
and
ZjIp^Q^-cz].21 (7b)
Based on the marginal conditions a
HHIs in A and EnândHHI«
Z are computed: =£
H
Post-Merger
Assuming that firm 1 in Z and firm

are derived. Unlike its rivals, firm
Zl:
QÎ'pa(Qa , Z) - ca] + Zl'pz(Z, Qa) - cz] (8)

Based on (8), firm 1 has different incentives than before merger, while its riv
profit functions remain unchanged. Specifically, it has greater incentive to re
output in Z because it now captures runoff of sales diverted from B to A.
20 In general, one would solve (5) for QB in terms of pz and QA and then invert to get pd
(QA* Z).
21 Recall that pA (QA, QB) = pa (Qa, Z/k) = pA ( QA , Z).
consequence the weighted-aver

now given by:
{PA - CA)/PA = $Ai£A

n
- £AA) - [{S'Z'S'A')IS'A'£ZA, (â)

and
( Pz - cz)Ipz = HHI %{-£zz) - Sz'{s'A'ls'z)eAz

= HHJ°z(-£ZZ) - l(s'Als'zl)/s%eAZ.22 (9b)
Based on (9),
&LAZ = -ezA{s'Z's'A'ls'A) - £az(S'Z'S'A'Is'Z)

- '{S'A'S'Z')KS'AS'Z)][~S'Z£ZA - S'A£AZ'
= SAISZÌ(-S'ZSZA - S'A£AZ) (10)
To compare A LAZ to A LAB, A-Z elasticities must first be
B elasticities. Based on (6), ezA = [{EBB/™) + 1] • £ BA !n
oí = Pz/PB < 1 and 0 < p = ess/m + 1 < 1, and eA z = £ab •
into (10), (10) becomes
A LAZ = SA'SZ'[{-S'ZP£BA/<X) - S'A£AB] (11)

To take advantage of the demand symmetry assumption {sasab = sb£ba)>
(11) has to be restated in terms of s .4 and Sß. Thus, (11) becomes
A Laz = SA'SZ'SB£BA[{-s'zp/asB) - S'a/ SA], (12)

and
ALAZ/ALAB = {-SA'SZ'SA€AB/ - 1SA'SB'SA£AB)

■[{s'zPhBa) + s'a/ sa]
= {'/2)[{SaS'zP + s'AsBa)lsASBoi'
= sAs'z{' +p)/2asBSA
= s'z{l + p)/2asB
= ( PaQA +PbQB){ i + p)/2{paQA +PzZ)7i (13)
22 The apostrophes are used to distinguish sa = paQa/(paQa + PbQb) from s'A =

PaQa /(paQa +PzZ ), and sb from s'7.
23 The derivation of (13) is illustrated more fully in Mathematical Appendix B.
If the ratio in (13) were m

resulting market size - weigh
(p+l)/2 = [(eM/m)+2]/2. (14)

This ratio in (14) governs the relative competi
diagonal and horizontal mergers (i.e., Sb' = Szi)
since 'ebb' is at most 100 percent and m is at l
merger is at least half as harmful to consumer
merger. Note that when the B industry is per
horizontal merger are equally harmful. In this cas
from horizontal merger is zero. When m = 1 an
half as harmful as horizontal merger but, in th
competitive harm from both horizontal and diag
The upshot is that a diagonal merger cannot e
a comparable horizontal merger. However, diag
conditions reduce welfare substantially when th
input-using industry.
In the next section I present the conditions und
separate antitrust markets based on the Guidelin
challenge based on horizontal merger principles
relevant market containing B 1 would also conta
an antitrust challenge.
3. Market Definition in B and in Z
In the Introduction, I asserted that diagonal mergers of competitive significance

would be likely to slip through the Guidelines enforcement screen. Specifically,
I maintained that market definition analysis as presently implemented would be
unlikely to place product A in the relevant antitrust market containing input Z and,
as a result, a merger between Ai and Z' would create no horizontal overlap. The
truth or falsity of this assertion is not as interesting as whether or not the horizontal
merger Guidelines market definition test when properly implemented would fail to
capture a significant diagonal merger. I finally address this issue.
The Guidelines market definition test requires a comparison of the markup, and
hence price, that a hypothetical monopolist in Z would charge (viz., -ezz * 10, 000)
and the safe-harbor price- cost margin, -ezz * 1 » 000. The percentage price increase
in this hypothetical is
iPz -p°z)/p°z = K - - mlz)

= [(-ezz)/(l +*zz)][(10,000- 1,000)/10,000]. (15)
If (1 5) is at least 5 percent, Z is a relevant antitrust market. Thus, whether or not Z
alone is a market depends entirely on its demand elasticity. Based on (15), if -ezz
> 5/95, Z alone is a market.

alone is a market.24 This inequ
greater is m. That is, the less i
the more inelastic the demand
more competitive the downstre
A comparison defini of market
to market definition for Z, th
its own market definition (i.e.,
pricing is used as the competitiv
increase. In fact, since 'but for
the B market is the more likely
A, as in the case of Z market
test is only likely to overlook
of the input is small relative t
for sufficiently low a, Z alone
market based on B also contains A.
For example, assume that -£bb is sufficiently small that B alone is not a
relevant market-say, - ebb = 5 (<5/95) percent.25 Also assume that the next-best
substitute is A. Assume that sales revenue Ra = $200 million and Rb = $200
million. Further assume that there are five equal-sized firms in each of the A and
B markets. Finally, assume that Rz = $50 million.
By assumption, the elasticity of demand for B is just a tad too large for B
alone to be a market. And, since A is the next-best substitute, the relevant market
containing B must also contain A. In contrast, under the circumstances, Z alone is
a relevant market since, based on (5) and (6), -ezz = - {£bb/&)[{£bb /™) + 1]
= (20%) [1- 5%/5], which is greater than 5/95%.
Thus, a diagonal merger between A' and Z' would not be challenged under
the (horizontal merger) Guidelines, whereas a horizontal merger between A' and
B 1 may be. Moreover, as the example will further illustrate, between comparable
horizontal and diagonal mergers, the diagonal merger may be nearly as harmful to
competition as the horizontal merger.
Based on (14), above, the weighted ratio of delta Lerner indices is ( €bb/™> +
2) /2, which in the example is 1 .99/2 « 1 . Thus, the welfare effects of the illustrative
diagonal merger would lessen competition almost as much as the horizontal merger.
Notwithstanding the near equality of the respective anticompetitive effects of
the diagonal and the horizontal mergers in the example, the diagonal merger would
24 The input demand elasticity also depends in general on the elasticity of marginal cost in B with
respect to B's output. When marginal cost is not constant, contrary to what is assumed here, the
more inelastic marginal cost is, the more likely Z alone would be a relevant market. Of course, it is
also true that the more inelastic is marginal cost in B , the less impact an increase in Z's price would
ultimately have in the A market.
25 Critical elasticities of this magnitude are implied because marginal cost is flat. Typically, A
would be in the relevant market based on B for inverse demand elasticities much higher than 5
percent.
not be challenged by the fede

Guidelines because, under the
contains Z.
in. Diagonal Mergers at th
1 . PepsiCo/General Cinema Beverages
In 1989, PepsiCo provisionally agreed to buy General Cinema's carbonated soft

drink bottling operations (GCB).26 Many of the General Cinema bottlers were Pep-
siCo franchisee-owned bottlers or FOBOs. Thus, PepsiCo sought through acquisi-
tion to vertically integrate, in order to correct inefficiencies resulting from bottler
territories that no longer matched natural market or media areas, among others and,
in light of General Cinema's decision to sell its bottler subsidiaries, to assure that
the ultimate bottler franchisees would meet with PepsiCo 's approval.
In two instances, however, the planned acquisition of GCB subsidiaries would
have conveyed a Seven Up bottler to PepsiCo in a territory in which a PepsiCo
FOBO also operated. In Broward County, Florida, for example, the GCB subsidiary
bottled non-Pepsi brands and competed with a PepsiCo FOBO. The proposed merg-
er was not strictly horizontal because PepsiCo did not own the Pepsi bottler there.
However, the close relationship between PepsiCo and its FOBOs created a near-
horizontal overlap in Broward County, which ex-Director of the FTC Bureau of
Competition, Tim Muris, dubbed a "diagonal overlap". Presumably, Muris created
this term because in Broward County the proposed acquisition had both vertical
and horizontal elements.
Muris' concept of diagonal overlap is similar but not identical to that of diagonal
merger defined here in this paper. To see this, note that without the relationship
between PepsiCo and its FOBO, it is unlikely that the Commission would have
objected to PepsiCo's pure vertical acquisition of GCB's Miami subsidiary. The
apparent justification for the Commission's objection rests on a theory that col-
lusion between bottlers would be enhanced by the acquisition. In contrast, in the
diagonal mergers analyzed herein, a competitive problem arises potentially even
when the upstream acquirer has only arms' length dealings with downstream firms.
Moreover, the theory of anticompetitive effect explained herein is different. In a
diagonal merger, there is concern that incentives upstream to collude or to raise
price unilaterally would be enhanced.27
26 See "Complaint, Order and Analysis to Aid Public Comment", in the Matter of PepsiCo, Inc.
and General Cinema Corporation, FTC, File no. 891-0030, March 1989.
Of course, the anticompetitive theory of diagonal merger presented here does not provide a real-
istic basis for anticompetitive effect in the PepsiCo/GCB case, unless concentrate price discrimination
across bottler territories is profitable.
2. Hughes/Itek
The closest, recent examples of "diagonal merger" investigations have involved

teaming agreements in the defense industry. Specifically, in Hughes/Itek , Hughes
Electronics and Lockheed Martin Corporation (LMC) were first tier electronics
contractors teamed respectively with airframe primes, Rockwell and Boeing, to
develop the concept design for the Air Force's Airborne Laser Program (ABL).28
The ABL program would use a customized 747 aircraft to locate and destroy
incoming short-range ballistic missiles during their launch or boost phase so that
they fall back on the enemy's own territory. Critical to the ABL program are
components, called "deformable mirrors", which allow for atmospheric distortions.
Itek and Xinetics are apparently the only two firms capable of building these
deformable mirrors. Itek had an exclusive contract with the Boeing/Lockheed
Martin team and Xinetics had an exclusive contract with the Rockwell/Hughes
team.
There are several ways to analyze the proposed acquisition of Itek by Hughes.
First, analogizing the PepsiCo/Seven Up bottler diagonal overlap, the acquisition
would raise the incentives for Itek (the "Seven Up bottler") and Xinetics ("The
FOBO") to collude. This theory makes no sense in the all-or-nothing bid context
that Itek and Xinetics were in, however. When analyzed as a diagonal merger, a
different theory of effect would be applicable.29
A direct application of the diagonal merger model would address the likelihood
that competition between Hughes and Lockheed Martin would be reduced. There
are two mechanisms by which the reduction in competition may be effected. First,
to the extent that bidding between Hughes and LMC resembles a sealed-bid auction
with private cost information ("Cournot" competition), Hughes' ownership of Itek
would alter Hughes' objective function in such a way that higher bids from both
Hughes and LMC would result.30 Put simply, since Hughes "wins" even if the
Boeing/LMC team is awarded the contract, its incentive to bid higher increases.
Second and, probably more important, is a diagonal merger theory tailored to the all-
or-nothing aspect of most competitive bidding in the defense industry. Specifically,
as a subsidiary of Hughes, Itek may have the incentive to raise price to Lockheed
Martin in order to throw the competition to the Rockwell/Hughes/Xinetics team.
Unlike the diagonal merger analyzed in the text, in which the upstream firms jointly
28 See "Complaint, Order and Analysis to Aid Public Comment", in the Matter of Hughes Danburg
Optical Systems, Inc., Hughes Electronics Corp. and General Motors Corporation, FTC, file no.
961-0018, 1996.
29 The proposed acquisition is superficially vertical, but the fact that there are exclusive agreements
between Xinetics and Hughes and between Itek and Lockheed Martin makes the merger more
diagonal. That is, like the zinc supplier in my introductory example, Itek does not sell to Hughes,
who is the analog of the downstream steel producer.
30 It is unclear, however, whether or not the 1992 Horizontal Merger Guidelines accept the
"Cournot" version of bid models. Specifically, the Guidelines' emphasis on the first and second-
best situated rivals suggests that these auction models may have been rejected as a basis for predicting
the effect of merger between rival bidders for defense contracts.
DIAGONAL MERGER 62 1
benefit from a price increas

Thus, the Hughes/Itek acquis
the gains to Hughes from w
of the losing team.
IV. Conclusion
Mergers between input suppliers and downstream competitors of the input users
are likely to pass through the screens of both the horizontal and vertical merger
Guidelines. Moreover, these diagonal mergers are as likely as horizontal mergers
to raise price above marginal cost significantly in appropriately defined relevant
markets. As a result of diagonal merger, the rivals in the input market have height-
ened incentives to restrict output either cooperatively or noncooperatively. Also,
investment- only stakes between firms in diagonally-related industries may cause
a similar significant change in incentives to restrict output.
Mathematical Appendix A. Derivation of the Post-Horizontal-Merger Lerner

Index with Interdependent Demands
Upon merger of firms A 1 and Bl, the combined firm chooses QAl and Qm to
maximize
'PA(QA,Qb)-Ca)Qai + 'pb(QA,Qb)-Cb)QBI. (Al)

The marginal conditions are
Saiâa + ™}M + ( sBi/sa)£ba = 0 (A2a)

Sb'£bb + ™>b' + {sa'/sb)£ab = 0 (A2b)
The marginal conditions for the remaining A and B competito
least to the first order). These are
mAj = Saj£aa (A3a)

and
mBj = Sßj£BB, (A3b)

for all Aj and Bj not equal to Al and
Based on (2) and (3) the Lerner Inde
L' = HHIo (-£aa) - (Sa'sb'/sa)sba (A4a)

and
Lxb = HHIq (-£bb){Sbisa'/sb)£ab- (A4b)
Weighting L' and LlB by sa a
LXAB = L'b - Sa'SB'cb

= L°ab - ( SA'SB'SB/SB)
= L°AB ~ SAISbisb^BA - SA'SB'SA£AB • (A5)
With symmetry ( sa£ab = sB£ba),
A.Lab = (2SMSBI)(-S1£ij)
= ( 2saisbi/sb){~£ab )
= (2saisbi/sa)(~£ba) (A6)
Mathematical Appendix B. Derivation of
The second line of (13) in the text is
ALaz/ALab = {'/2){{sAsxzp + sxAsBa)lsASBa' (Bl)

This expression can be written as
( 'I2sasbq){'paQaI(paQA +PbQB)]'pzZ/(paQa + PzZ)]p

+'PaQA/(paQA + PzZ)]'pBQBa/{pAQA + PbQB)}}
= ( 1/2sasboi)'paQA/(paQA +PbQB)]{'pzZ/(paQa + PzZ)]p
+[apBQB /(p aQA +PzZ )]}
= ( 1/2sasb<x)sa{s'z(p+ 1)}
= sAs'z{l +p)/2sasbol
= s'z( 1 +p)/2asB
= [0 + P)/2]'PZZ/(PAQA +PZZ)]/'PZZ/(PAQA +PBQB)]
= [(1 + p)/2}'paQA +PbQB]/'PAQA +PzZ ] (B2)
References
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DIAGONAL MERGER 623
FTC and DOJ Horizontal Merger

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Merger

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Merger

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Diagonal Merger

Author(s): RICHARD S. HIGGINS

Key words: Merger, antitrust, Herfindahl Index.

Post-Chicago analysis demonst

This conclusion is also approp

3 See Reiffin and Vita ( 1 995, p. 92 1

as the unintegrated zinc mon

5 Of course, to the extent the mix of

Analysis of Diagonal Merg

Ultimately I will show that

1 . HHI Analysis of Horizontal Merger with Interdependent Demands

First, consider two horizontally-related markets A and B containing n and m

( PA - CA)/pa = -HHIo £AA, 0a)

(pb - cb)/pb = -mn$eBB.9 (ib)

8 HHI is a measure of concentration. The HHI and HHI change th

equal to the monopoly percen

L$B = -SAASA HHtf -£BB( 1 - SA) HHI£.13 (2)

If firm 1 in A merged with firm 1 in B , the marginal conditions would be altered

L'B - LqB - Sa'Sb'{SB£BA + sazab)' 14'15 (3)

With symmetry ( sbSba = s as ab'

If A and B were perfect substitutes, -sa

1 1 The monopoly markup is overstated by e a except

according to (4), AL may be

2. Hffl Analysis of Diagonal Merger

Again, I assume two downstream markets, A and B, interrelated through deman

Before merger, each produce

In stage 2, the marginal conditions are

Qf(dpß/dQB) + pb(QB, QA) - ( cB + pz) = 0, for i = 1 - m. (5)

Since Qf = Qf for all i and j , (5) can be solved for pz to yield:

Pz = Pb(Z, QA)[(eBB/m) + 1] - cB = pz(Z, QA). (6)

Assuming that firm 1 in Z and firm

QÎ'pa(Qa , Z) - ca] + Zl'pz(Z, Qa) - cz] (8)

consequence the weighted-aver

{PA - CA)/PA = $Ai£A

- £AA) - [{S'Z'S'A')IS'A'£ZA, (^a)

( Pz - cz)Ipz = HHI %{-£zz) - Sz'{s'A'ls'z)eAz

&LAZ = -ezA{s'Z's'A'ls'A) - £az(S'Z'S'A'Is'Z)

A LAZ = SA'SZ'[{-S'ZP£BA/<X) - S'A£AB] (11)

A Laz = SA'SZ'SB£BA[{-s'zp/asB) - S'a/ SA], (12)

ALAZ/ALAB = {-SA'SZ'SA€AB/ - 1SA'SB'SA£AB)

22 The apostrophes are used to distinguish sa = paQa/(paQa + PbQb) from s'A =

If the ratio in (13) were m

(p+l)/2 = [(eM/m)+2]/2. (14)

3. Market Definition in B and in Z

In the Introduction, I asserted that diagonal mergers of competitive significance

iPz -p°z)/p°z = K - - mlz)

> 5/95, Z alone is a market.

not be challenged by the fede

in. Diagonal Mergers at th

1 . PepsiCo/General Cinema Beverages

In 1989, PepsiCo provisionally agreed to buy General Cinema's carbonated soft

The closest, recent examples of "diagonal merger" investigations have involved

benefit from a price increas

Mathematical Appendix A. Derivation of the Post-Horizontal-Merger Lerner

'PA(QA,Qb)-Ca)Qai + 'pb(QA,Qb)-Cb)QBI. (Al)

Sai^aa + ™}M + ( sBi/sa)£ba = 0 (A2a)

mAj = Saj£aa (A3a)

mBj = Sßj£BB, (A3b)

L' = HHIo (-£aa) - (Sa'sb'/sa)sba (A4a)

Lxb = HHIq (-£bb){Sbisa'/sb)£ab- (A4b)

Weighting L' and LlB by sa a

LXAB = L'b - Sa'SB'cb

Mathematical Appendix B. Derivation of