Residual Demand Estimation For Market Delineation

Residual Demand Estimation for Market Delineation: Complications and Limitations
Author(s): LUKE M. FROEB and GREGORY J. WERDEN

Source: Review of Industrial Organization, Vol. 6, No. 1 (1991), pp. 33-48
Published by: Springer
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Review of Industrial Organization 6: 33-48, 1991
© 1991 Kluwer Academic Publishers. Printed in the Netherlands.
Residual Demand Estimation for Market
Delineation: Complications and Limitations

LUKE M. FROEB and GREGORY J. WERDEN*
Antitrust Division , U.S. Department of Justice, 555 Fourth Street , N.W. , Washington D.C. 20530 ,
U.S.A.
Abstract. To shed some light on market delineation in an antitrust context, many economists are
turning to estimates of residual demand elasticities. Recent papers have drawn attention to the impor-
tance of demand curve in market delineation and explained how they can be estimated. This paper
shows that there are many complications and limitations of the approach. The relationship between
the residual demand elasticity and the scope of the relevant market is complicated and depends on
behavioral assumptions. The residual demand elasticity that can be estimated is not the one on which
market delineation turns. The estimation of residual demand elasticities can be very difficult because
of the complex dynamics of consumer behavior. Finally, residual demand estimators are likely to have
a high variance because of instrument problems and this is likely to lead to widely varying estimates
depending on specification choices.
Key words. Mergers, market delineation, demand elasticities.
1. Introduction
To shed some light on market delineation in an antitrust context, many economists

are turning to estimates of residual demand elasticities. This trend has been
spurred by the Merger Guidelines of the U.S. Department of Justice and by recent
articles. The Merger Guidelines take an approach to market delineation derived
from their 'unifying theme' "that mergers should not be permitted to create or
enhance 'market power' or to facilitate its exercise."1 Because the market power
of a firm or group of firms is determined largely by the demand curve faced by
the firm or group of firms, estimating demand curves is a potentially useful way
to gain insight into market power-related issues, including market delineation
under the Merger Guidelines. Jonathan Baker and Timothy Bresnahan (1984,
1985, 1989) and Jonathan Baker (1987) have explored the estimation of the
demand curve faced by a single firm and the use of such estimation to infer the
effect on price of a merger in a differentiated product industry. David Scheffman
and Pablo Spiller (1987) considered the estimation of residual demand curves for
use in market delination under the Merger Guidelines, and Janusz Ordover and
Daniel Wall (1989) attempted to explain to lawyers how residual demand esti-
mation and other econometric methods can be used in delineating markets.
This literature draws attention to the importance of demand curves in market
34 LUKE M. FROEB AND GREGORY J. WERDEN
delineation and explains how they can be estimated, .but it says very little about
the complications and limitations of the approach. We address these issues. Section
II of the paper discusses the role of residual demand curves in the Guidlines'
approach to marked delineation. Section III identifies several limitations on the
utility of demand estimation. Section IV considers the econometrics involved in
the estimation and explores some properties of estimators. Section V offers a few
concluding remarks.
2. Residual Demand Curves and their Role in Market Delineation

under the Merger Guidelines
A. RESIDUAL DEMAND CURVES
Consider a group of products and area that might constitute a market and for
which we wish to estimate a residual demand elasticity, and call this a candidate
market. Denote the Marshallian demand for this candidate market as
qc Dc(Pc, Pa» dc),
where qc and pc are quantity and price in the candidate market; pa is a vector
containing the prices of all other goods the prices of which affect the demand in
the candidate market; and dc is a vector of demand shifters for the candidate
market. The prices of the 'affecting goods' are determined through the forces of
supply and demand and various sorts of oligopoly interactions, both among the
buyers and sellers of the affecting goods and between the sellers of the affecting
goods and the sellers in the candidate market. All of this is summarized in a best-
response function:
P a = Ra(j>c,y*a,da),
where wfl is a vector of factor prices for the affecting goods and dfl is a vector
of demand shifters for them. Substituting this best-response function into the
Marshallian demand for the candidate market yields the residual demand curve
for the candidate market:
qc = Dc(pc, wfl, dc+a).
This is the demand curve faced collectively by the firms in the candidate market
if they behave like a single, dominant firm (or, more precisely, like a Stackelberg
leader). It may be more useful than the Marshallian demand curve in delineating
markets, and it is far simpler to estimate than the Marshallian demand curve. The
reason for this is that the endogeneous prices of affecting goods on the right-hand
side of the Marshallian demand curve are replaced in the residual demand curve
by exogeneous cost and demand shifters for the affecting goods. Thus, all that is
needed for consistent estimation is an instrument for the one remaining endogen-
ous right-hand side variable, pc , and this is provided by some measure of marginal
RESIDUAL DEMAND ESTIMATION FOR MARKET DELINEATION 35
cost. The comparative simplicity of estimating a residual demand curve is an

important insight, and it was provided by Baker and Bresnahan (1984, pp. 6-10;
1988, pp. 286-89).
Using marginal cost as an instrument, an estimated residual demand elasticity
is simply a measure of the extent to which cost shocks are passed through to
prices. Cost shocks in the candidate market perform for us the critical experiment
that tests the substitution possibilities. If cost shocks are largely passed through
to price with relatively little effect on quantity sold, then we know that the residual
demand is fairly inelastic. If cost shocks are not passed on or are passed on but
quantity falls by a proportionately large amount, then we know that the residual
demand is fairly elastic.
B. THE ROLE OF RESIDUAL DEMAND ELASTICITIES IN THE GUIDELINES' APPROACH
In delineating relevant markets under the Merger Guidelines, the question posed
is: how much would a hypothetical profit-maximizing monopolist over a group of
products and area raise price?2 The question is posed in turn for a series of groups
of products and areas of increasing scope. If the price increase for a group of
products and area exceeds a significance threshold, generally taken to be five
percent, then that group of products and area are deemed a market for antitrust
purposes. The smallest group of products and area for which there would be
significant price increase generally is considered to be the relevant market and is
used in the subsequent analysis.3
Thus, market delineation under the guidelines requires a prediction about the
monopoly mark-up over the prevailing price. The demand curve that would be
faced by the hypothetical monopolist is a major determinant of the monopoly
mark-up, so estimating that demand curve can shed light on market delineation.
In most cases, it probably is reasonable to suppose that the hypothetical monopolist
would act as a dominant firm with respect to all other products and areas, if that
is the case, the monopolist's demand curve is a residual demand curve, and the
hypothetical monopolist's behavior is uniquely determined by the demand curve
and the corresponding cost curve.
Let pm be the monopoly price, c(p) be marginal cost, and e(p) be the absolute
value of the elasticity of residual demand curve for the hypothetical monopolist.
The first-order condition for profit maximization can be written
Pm - c(Pm) _ 1
Pm e(pm)'
which can be rearranged to get the less familiar but more useful expression
Pm - c(Pm) 1
c(Pm) e(Pm) - 1 '
The Merger Guidelines require a comparison of pm with the prevailing price,

Po, rather than marginal cost. If we define
d = p0lc(po ), and
4> = c(pm)lc(p0),
then by substitution and rearrangement we can get
Pm PO
Po d[e(j)m) - 1]
To estimate (pm - p0) I Po , we need to estimate, or make assumptions about, 0,

</>, and the demand curve. For example, if we assume that marginal cost is constant
and the initial equilibrium competitive (<j> = 1 and 0 = 1), and if the demand
function has constant elasticity e, then4
(Pm-Po)/Po= l/(€- 1).
In this case, an estimate of the residual demand elasticity is all that is needed for
market delineation. The assumption of constant marginal cost is reasonable in
many cases, and, in such cases, we can estimate 0 from accounting data in cases
when it is likely to be significantly greater than 1. Thus, if we have reason to assume
dominant firm behavior and that the demand function has constant elasticity, then
estimating that elasticity would be a sensible approach to the problem of market
delineation.
C. COMPLICATIONS ARISING WHEN THE RESIDUAL DEMAND ELASTICITY IS
NOT CONSTANT AND BEHAVIOR MAY NOT BE AS A DOMINANT FIRM
The difficulties arising if the demand function does not exhibit constant elasticity
and if dominant firm behavior may not be the proper assumption can be illustrated
in a very simple example in which price-setting sellers of a homogeneous product
are located at just two points, 1 and 2, and the only issue is whether these two
points are in the same relevant market. Assume that consumers are uniformly
distributed along a line segment of length d connecting Points 1 and 2 and that
one unit of the product is consumed for every unit of distance. Further assume
that consumers choose between sellers at Point 1 and sellers at Point 2 on the
basis of delivered price. Finally, assume that each seller has a constant marginal
cost of production c and that the unit transportation cost is r. Depending on the
number of price-setting sellers at each point, this model can yield four distinct
Nash, non-cooperative equilibria. With multiple sellers at either point, there is an
undifferentiated Bertrand equilibrium at that point, and price will equal marginal
cost. With one seller at each point, there is a spatially differentiated Bertrand
equilibrium for the two points. With one seller at one point and multiple sellers
at the other, the seller at the one-seller point will act as a dominant firm.
Table I. Some important characteristics of the equilibria at Point 1.
Number of sellers at Point 1 Multiple Multiple One One

Number of sellers at Point 2 Multiple One Multiple One
Nature of behavior at Point 1 Competitive Competitive Dominant Spatial
firm Bertrand
Equilibrium residual demand A A/3 1 + 2 A '

elasticity
( po - c)lc in terms of e 0 0 l/(e - 1) 1/(26 - 1)
( Pm - Po)tpo in terms of e l/2e l/3e 0 0
The Marshallian demand for sellers at Point 1 is
q i = ( dt + pz~ P')!2t,
and it has a slope of -1/2 1 for any values of p i and p2. Thus the absolute value
of the Marshallian demand elasticity, tj, is pJ2tqi. The residual demand function
is
qx = [dt + p2(pl) - pi]/2t,
where p2{pi) is the best-response function of sellers at Point 2. With multiple

sellers at Point 2, we know that p2 = c, so the best-response function has zero
slope. In this case, the absolute value of residual demand elasticity, e, also is
PiUtqi . With one seller at Point 2, the first-order condition for profit maximization
can be rearranged to give the best-response function
p2 = (dt + c + pi)/2.
Thus, e = pilAtqi.
Some important characteristics of the four possible equilibria at Point 1 are
shown in Table I, where the equilibrium/prevailing price is denoted p0i the mon-
opoly price (i.e. the price with a single seller at Point 1) is the absolute value
of residual demand elasticity is e, and À = cldt. One notable point is that the
residual demand elasticity takes different values in the four equilibria because the
slope of the residual demand curve depends on the number of sellers at Point 2
and because no two equilibria exhibit the same price and quantity combination.
With one seller at Point 1 and multiple sellers at Point 2, the seller at Point 1 acts
as a dominant firm, and we get the familiar result: (p0 - c)lc = U(e- 1), where
the residual demand elasticity in this expression is that at the monopoly price.
Suppose that there are multiple sellers at Point 1 and Point 2, and that two
sellers at Point 1 propose to merge. We need to determine whether Point 2 is in
the relevant market, and we do that by estimating the monopoly mark-up at Point
1. We could simply plug an accurate estimate of the equilibrium residual demand
elasticity into the formula l/(e - 1). If we did (and if the residual demand elasticity
exceeded 1), however, we would overestimate the monopoly mark-up by at least
100 percent because the residual demand elasticity is not constant.
With one seller at Point 1 and one at Point 2, the seller at Point 1 acts as a
spatial Bertrand duopolist, and we get (p0 - c)/c = l/(2e - 1) = 1/(17 ~ !)• Thus,
the familiar result holds for the Marshallian elasticity but not for the residual
elasticity,5 and it is easy to see from the first-order condition for profit maximizing
that this is always the case under Bertrand competition with differentiated pro-
ducts. It is not true in general, however, that 17 = 2e. That result stems from the
linearity of demand and the fact that the equilibrium is symmetric.
Suppose now that there are multiple sellers at Point 1 but only one at Point 2,
and that two sellers at Point 1 propose to merge. In this case, plugging an accurate
estimate of the equilibrium residual demand elasticity into the formula l/(e - 1)
would yield an overestimate the monopoly mark-up by at least 200 percent.
Roughly half of the error would stem from the fact that the residual demand
elasticity is not constant, and roughly half would stem from the fact that the
formula l/(e - 1) does not apply.
The moral of all of the foregoing is that residual demand elasticities are relevant,
but they do not tell anywhere near the whole story. We cannot calculate an implied
monopoly mark-up from a residual demand elasticity without making several
assumptions, and the predicted mark-up is highly sensitive to these assumptions.
The easiest case to deal with is that in which it is reasonable to suppose that a
hypothetical monopolist would act as a dominant firm and to treat marginal cost
as constant, and even in that case, we need to assume that the residual demand
elasticity is constant (or varies in a particular way) in order to calculate a monopoly
mark-up. Thus, in the best of circumstances, an accurate estimate of the residual
demand elasticity can yield only a fairly rough estimate of the monopoly mark-
up.
3. Limitations on the Utility of Estimation

A. INHERENT LIMITATIONS STEMMING FROM THE PROBLEMS OF EXTRAPOLATION
AND NONSTATIONARITY
The antitrust analysis of mergers is an attempt to peer into the future. The basic
question to be addressed is whether the merger is likely to raise prices relative to
levels that otherwise would prevail. Predicting the future is always difficult, and
two particular problems arise in using residual demand estimation to help make
predictions. One problem is extrapolation ; it is necessary to make inferences
about demand and cost conditions away from the neighborhood of the prevailing
equilibrium and probably also outside the range of historical experience. This
might not be a serious problem if demand functions exhibited constant elasticity,
but, in general, there is no reason to believe that such is the case. The other
problem is nonstationarity ; demand and cost conditions or the nature of the market
equilibrium in the future may be quite different from those historically experi-
enced. These problems present significant inherent limitations on the utility of
estimation or any inference from data.
Both of these problems are rather obvious, and we can offer no clever solution
to either. Our main point is that neither problem should simply be dismissed as
insolvable or unimportant. The significance of each problem probably is far greater
than it appears at first glance.
Consider first the extrapolation problem. Since a constant elasticity function
provides a good local approximation for any demand function and since the Merger
Guidelines consider only a fairly narrow range of prices (a small but significant
price increase above prevailing levels),6 one might be tempted to conclude extra-
polation is not a problem. However, such a conclusion would be erroneous for
two reasons. First, the neighborhood in which a constant elasticity demand func-
tion would be a good local approximation is the neighbourhood of the sample
means, which may not be close to the prevailing equilibrium. Second, and far
more important, the monopoly equilibrium normally will not be close to the
prevailing equilibrium in terms of quantities even if it is in terms of prices. Consider
the simplest possible case of linear demand, constant marginal cost, and an initially
competitive equilibrium. In this case, the monopoly quantity will be half the
competitive quantity no matter how small the monopoly price increase. If elasticity
of demand is assumed to be constant and we use an accurate estimate of the
elasticity of demand at the prevailing price to make predictions, we will overesti-
mate the price increase that a monopolist would impose by at least a hundred
percent. Under other assumptions about the true demand curve, the error may
be greater or less than this,7 but it will tend to be large because the monopoly
quantity generally will be substantially less than the prevailing quantity.
Rather than rely on a local approximation, we can use some sort of flexible
functional form to estimate the residual demand curve instead of just the residual
demand elasticity. While such an approach may be useful if history has been kind
enough to provide many observations with prices well above prevailing levels, that
certainly is not the usual case. Without such data, we would be extrapolating
into the dark, and with such data, the answer we seek may be obvious without
sophisticated econometrics.
The nonstationarity problem might be viewed as unimportant because stable
demand and cost conditions are the norm and a reasonable assumption in the vast
majority of cases. However, there are three reasons - two theoretical and one
empirical - for believing that the nonstationarity problem is more important than
it may seem. First, changing conditions may be a significant factor in causing
mergers. Mergers probably are not random events, but rather are proposed when
changes in market conditions make them seem to be profitable. Therefore, changes
in market conditions - including changes that make it more likely that market
power can be exercised - are likely to be a major cause of mergers. Second, a
merger proposal is less likely to be deterred by the mere existence of antitrust
restraints on mergers if there are changing conditions because historical data are
less likely to support any opposition to the merger by the antitrust enforcement
agencies. Thus, the proportion of proposed mergers for which there are changing
conditions is likely to be far greater than the proportion of industries in which
there are changing conditions. In addition, as an empirical matter, it is the case

that changing conditions have been a factor in three of the twelve merger cases
that were filed by the Department of Justice since the issuance of the Merger
Guidelines (June 12, 1982) and on which a district court has rendered a decision
on market delineation issues.
Two of these three cases involved mergers of hospitals in Rockford, Illinois and
Roanoke, Virginia.8 The Justice Department argued in these cases that meaningful
price competition was beginning to emerge in the hospital industry generally, and
in Rockford and Roanoke specifically. To the extent that the Justice Department
was correct, it follows that the available historical data, particularly price data,
had not been shaped very much by the forces of competition that would be
determining price in the future.9 The emergence of price competition also came
as a shock to many hospitals, and merger has been a frequent response. While
mergers may enhance efficiency, many hospital mergers likely are attempts to nip
this competition in the bud (see Jack Zwangiger, 1989), and the court found
evidence that such was the case for the Rockford merger. 10
The other Justice Department case in which changing conditions were important
involved high fructose corn syrup (HFCS), a liquid sweetener made from corn.11
HFCS became a commercial product only in the early 1970s, and, even though it
was cheaper than sugar on a sweetness equivalency basis, its adoption was gradual.
The soft drink companies are its most important users, and they did not fully
switch to it until late 1984. 12 The transaction challenged by the Justice Department
occurred in mid-1982, and it certainly is possible that the maturation of the industry
was a major factor leading to the merger. The Justice Department filed its case
in late 1982. Had the case been litigated quickly, there would have been no data
reflecting the post- 1984 world. As it happened, the litigation did not proceed
quickly, but even as of the filing of motions for summary judgment on market
delineation in late 1986 and early 1987, there were very little data reflecting the
post-1984 world.
This case also provides an excellent illustration of the problem of extrapolation.
An HFCS monopolist would raise price only up to the level of sugar prices on a
sweetness equivalency basis - an increase of 10-50 percent, depending on the
time period considered. In another paper (1990) we estimate residual demand
elasticities for HFCS and use them to infer monopoly mark-ups. The estimated
monopoly mark-ups are two to ten times the amount by which a monopolist
actually would raise price.
B. DYNAMIC COMPLICATIONS IN THE ESTIMATION OF RESIDUAL DEMAND
ELASTICITIES
In estimating demand elasticities, it is natural to conceive of every observation as

being a static equilibrium and independent of every other observation. The real
world, however, is dynamic, and each observation may actually be related to other
observations through a complicated dynamic process. The dynamics may come

from a variety of sources. For example, the product may be durable, the produc-
tion process may be characterized by learning by doing, or there may be some
sort of adjustment costs on the part of buyers or sellers.
Two scenarios reasonably likely to arise in real cases involve learning and
inventorying by buyers. Consider a model in which consumers do not know
whether an observed price change is permanent or temporary and make inferences
with Bayesian updating. Particularly if consumers can inventory, the initial re-
sponse to a price increase will be a dramatic quantity reduction. If the price
increase proves temporary, there will be another dramatic quantity response. If it
persists, the quantity response will moderate as quantity converges to a new
equilibrium. Alternatively, consider a model in which consumers are ill informed
about substitutes and would be induced to invest in information about them only
by a persistent higher price. The initial response to a price increase will be a very
small reduction in quantity. If the price increase persists, the quantity response
will increase as consumers learn and adjust. In either case, naively observing prices
and quantities for individual periods would lead to an erroneous estimate of the
relevant demand elasticity - that relating to the responsiveness of quantity to a
permanent price change. In the former case, there will be an overestimate, and
in the latter case, there will be an underestimate.
Any estimate constructed without explicitly (and correctly) accounting for the
dynamic nature of the true underlying model would actually be some sort of
weighted average of the relevant long-run elasticity and a short-run elasticity of
demand. The weights will be determined primarily by the relative amounts of
long- and short-run price variation in the data. As an extreme example, we can
assume that there is no long-run variation. Suppose demand is a function of
expected price, which is constant, but there is short-run price variation from
random sales occurring with probability 7 r. Also suppose that consumers can store
the good for only one period. If we denote the regular price, pr, and the sale
price, ps = (1 - 8)pr , it is not difficult to show that coefficient on q of the linear
conditional expectation function of p on q is -'òpr, and the absolute value of
the apparent demand elasticity evaluated at the expected values of p and q is
2(1 - ôtt)/ô. Since there is no long-run price variation, the long-run demand
elasticity can be anything between zero and infinity.
Dynamic complications do not necessarily preclude useful estimation, because
any particular, known, dynamic complication probably can be dealt with ad-
equately in the estimation. However, if one knew enough about the dynamics of
an industry to model them properly, then one probably would not need empirical
evidence to delineate markets. In practice, only very rough adjustments for dy-
namic complications are likely to be feasible. One obvious strategy is to reduce
short-run variation by using longer time periods. This will mitigate the problem
somewhat, but it is very difficult to say how long the time periods should be.
Moreover, there will be some bias with any finite period, and limited amounts of
data are likely to constrain the length of the period. Finally, temporal aggregation
introduces other problems.
4. The Estimation of Residual Demand Elasticities
A. CONSISTENT ESTIMATION WITH INSTRUMENTAL VARIABLES OR 2SLS
A residual demand curve can be estimated by OLS, but the OLS estimator
normally will be biased because the residual demand equation contains an endog-
enous right-hand side variable. From an econometric standpoint, the bias stems
from the fact that the disturbance in the equation is a determinant of both price
and quantity, so there will be a right-hand side variable that is correlated with
the disturbance. Instrumental variables or 2SLS can provide an (asymptotically)
unbiased estimator for a single equation, and they are commonly used in residual
demand estimation. In instrumental variables estimation, one or more variables
correlated with price but not with the disturbance are used as instruments for
price. The obvious instruments are elements of cost or factor prices, and they are
ones used in practice. If there is a single instrument, z , the instrumental variables
coefficient on price is Cov(<?, z)/Cov(p, z), whereas the OLS coefficient is
Co v(p, <7)/Var(p).
Either price or quantity can be used as the left-hand side variable in estimating
a residual demand curve. With instrumental variables or 2SLS, the elasticity
estimate is exactly the same in the two specifications in the case of exact identific-
ation and asymptotically the same in the case of overidentification. It appears to
be more common in practice to place price on the left-hand side and to estimate
the inverse elasticity. The reason may be that a standard one-sided hypothesis test
on the inverse elasticity coefficient is a test of the null hypothesis that the residual
demand curve is perfectly elastic, implying that a hypothetical monopolist would
not raise price at all. This test also is easily converted into a test of the null
hypothesis that the residual elasticity is any particular value.
With overidentification, the small-sample properties of 2SLS suggest a more
compelling basis for the choice of the left-hand side variable. In 2SLS the right-
hand side endogeneous variable is replaced by the fitted value of that variable
from a regression of it on the other right-hand side variables and other instruments.
If the right-hand side endogenous variable is not highly correlated with the instru-
ments, then the fitted value used in the second stage of 2SLS is basically just a
linear combination of other right-hand side variables. This creates significant
multicollinearity which increases the standard errors and makes the estimates less
reliable. This problem may be avoidable through judicious choice of the left-hand
side variable. The preferable left-hand side variable is the one with the lower
correlation with the cost instrument. If demand is very elastic, the correlation
between quantity and the cost instrument will be much greater that the correlation
between price and the cost instrument. If demand is very inelastic, the reverse is
true.
In the remainder of this section, we show that OLS has a property similar to
that of 2SLS such that placing either price or quantity on the left-hand side may
be preferable depending on the elasticity of demand. We also show that one may
choose the direction of the OLS bias by choosing which variable to place on the
left-hand side. This observation actually applies to 2SLS as well, because, in small
samples, 2SLS has a bias in the same direction as OLS.13 Finally, if quantity is
measured better than price, it is possible that placing price on the left-hand side
is desirable because it produces a less biased estimate.
The basic econometric results can be seen in a simple linear model in which
inverse demand is
p = a- ßq + e,
where p and q are price and quantity, a and ß are positive constants, and e is a
random disturbance with zero mean and variance a'. Let marginal cost be a
random variable c that is independent of e and has variance <rl. If we have a
monopoly, the equilibrium condition is marginal revenue equals marginal cost, so
we have
q = (a + € - c)/2ß
/? = (a + e + c)/2
Var(p) = (<r2e + a2c)1 4
Var (q) = + a2c)l 4ß2
Cov(p, q) = -(<t2c - <r2€)/4ß
Co v(p, c) = a2/ 2
Co v(q, c) - -a2!2ß
It follows immediately from the foregoing expectations, that the instrumental

variables estimator for a regression of price on quantity, Cov(p, c)/Cov(q, c),
equals - ß , the true value of the slope, and the instrumental variables estimator
for a regression of quantity on price, Co v(q, c)/Cov(p, c), equals -1/jS, also the
true value. By contrast both OLS coefficients are biased. They are biased toward
zero if a* c is greater than cr' , and if is greater than or equal to al, they have
the wrong sign.14 Thus, the direction of the OLS bias in the elasticity estimate
depends on the choice of the left-hand side variable, and an estimate combining
coefficients from both regressions is likely to be superior to one based on either
alone.
If the market is competitive, it is easy to show that the instrumental variables

elasticities are again unbiased, and the OLS coefficient is biased only if price is
the left-hand side. With constant marginal cost and competitive pricing, price is
uncorrected with the demand disturbance, so OLS estimates are unbiased if price
is the right-hand side variable. More generally, if the residual demand is highly
elastic, the bias from using OLS is likely to be slight if and only if quantity is on
the left-hand side. The symmetric Cournot case also is easy to solve. Again the
instrumental variables elasticities are unbiased, and the OLS elasticities are biased
toward zero. With some mild distributional assumptions, the functional form
assumptions can be dropped and all of the foregoing continues to hold locally in
the neighborhood of the sample means.
B. INSTRUMENT PROBLEMS
In practice, good instruments tend not to be readily available. Certainly marginal

cost data are not available, and even data on factor prices often will not be. As
a consequence, it generally is necessary to settle for one or more instruments that
collectively reflect a fairly small fraction of the variation in marginal costs. This
causes the instrumental variables estimator to have a higher variance than it would
if marginal cost were used as the instrument, and it may introduce a bias. A bias
is introduced if the observed component of cost is correlated with the unobserved
component of marginal cost. The variance of the estimator also will be increased
if the instrument for1 price or quantity in the candidate market is correlated with
the costs of affecting goods. Such a correlation frequently arises when one or more
of the affecting goods differ from those in the candidate market primarily on the
basis of location and various locations have correlated input costs. An illustration
is provided by the work of Spiller and Scheffman on the geographic scope of
gasoline refining markets.15 The price of crude oil is highly correlated across
regions.
These problems can be considered in the context of a simple spatial model that
is a slight variation on the one discussed in Section II. Again assume price-setting
sellers of a homogeneous product located at just two points, 1 and 2, separated
by distance d , and between which consumers are uniformly distributed along a
line segment. Also as before assume that one unit of the product is consumed for
every unit of distance and that each consumer purchases from the seller with the
lowest delivered price, where the unit transportation cost is t. As before, marginal
costs are assumed to be constant, but now cost are assumed to differ between the
two points. If firms at Point 2 act competitively, the inverse residual demand curve
faced by firms at Point 1 is
Pi = dt + c2 - 2tqi .
Finally, assume that c¡ = x¡ + yi9 with only x¡ observed, and rewrite the demand
curve as
Pi = dt + x2 - 2 tqi 4* 6,
where e = y2. If x2 is correlated with y2 , then there will be a right-hand side

variable that is correlated with the error term and for which there is no suitable
Fig. 1. Variance of instrumental variables estimator as a function of p.
instrument. Therefore, both the OLS and instrumental variables estimator will be
inconsistent. If Xi is correlated with y2 , there will be an instrument correlated with
the error term, and again the instrumental variables estimator will be inconsistent.
If each of the x¡s is uncorrected with each of the yt ?s, then the instrumental
variables estimator will be consistent, but its variance still will be adversely affected
if Xi is correlated with x2 or yx is correlated with y2. The exact effect can be easily
derived if we make a few simplifying assumptions. Let Var(ci) = Var(c2) = 1; let
A denote the proportion of the variance in costs that is observed (at both points),
and let Corrai, x2) = Corr^, y2) = p. Under these assumptions, Var(jc,-) = À,
Var^,) = 1 - A, Cov(xí9x2) = pA, Cov^, j>2) = p(l ~ A), and the variance of
the instrumental variables estimator can be shown to be
16t2(l - A)
A(l-p2) '
As the proportion of cost that is observed approaches zero, and as the corre-
lation between the costs at Points 1 and 2 approaches one, the variance approaches
infinity. Figures 1 and 2 are graphs of the variance of the instrumental variables
estimator as functions of A and p. Figure 1 shows the variance as a function of p
assuming A equals 0.5, and the vertical axis is the variance of the instrumental
variables estimator relative to the variance when p = 0.5 (i.e. it plots
0.75/(1 - p2)). If p is small or moderate, the variance is not greatly affected.
However, for values of p greater than 0.8, the variance is at least twice that for
Fig. 2. Variance of instrumental variables estimator as a function of A.
p = 0.5. Figure 2 shows the variance as a function of À for all values of p, and the
vertical axis is the variance of the instrumental variables estimator relative to the
variance when A = 0.5 (i.e. it plots (1 - A)/A). If A is fairly large, the variance is
not greatly affected by the fact that some costs are unobserved. However, for
values of A less than 0.3, the variance is at least twice that for A = 0.5.
A high variance for the instrumental variables estimator means that i-statistics
are likely to be low. In a sense, this sends exactly the right message; the data
are not strong enough to generate precise estimates. In the context of antitrust
enforcement, it is not so clear that the right message will be received. There may
be a tendency for one advocating a particular position on relevant markets to
construct a null hypothesis supporting that position and to argue that the data do
not reject it. There may also be a tendency to engage in specification searches,
which are reasonably likely to yield whatever result one advocating a particular
position on relevant markets might want. Neither exercise would be productive.
5 • Conclusion
Residual demand elasticities certainly are a relevant factor in market delineation,

but they are far from a sufficient statistic for market delineation under the Merger
Guidelines. The Guidelines' test is based on the extent to which a monopolist
would raise price, and the relationship between residual demand elasticities and
monopoly mark-ups is complicated. Normally, all we can estimate is the demand
elasticity in the neighborhood of the sample means, and there is likely to be no
basis for an assumption that the elasticity is constant. If the elasticity varies, we
must extrapolate, and there is a very large margin for error in estimating monopoly
mark-ups. Historical data also may be unable to inform predictions about future
events because structural market conditions are changing. The estimation of resid-
ual demand elasticities also can be very difficult because of the complex dynamics
of consumer behavior. From a practical standpoint, residual demand estimators
are likely to have a high variance because of instrument problems and this is likely
to lead to widely varying estimates depending on specification choices.
Analyzing data certainly can be useful, and residual demand estimation in a
sensible way in which to do it, but one should approach residual demand estimation
with a great deal of caution and skepticism.
Notes
* Economists, Antitrust Division, U.S. Department of Justice. The views expressed herein are not
purported to represent those of the U.S. Department of Justice. We thank Jonathan Baker, Dennis
Carlton, Michael Vita, and participants in seminars at the Federal Trade Commission, Department of
Justice, and meetings of the Western Economic Association for helpful comments.
U.S. Department of Justice (1984, §1.0).
2 The Guidelines state that a market
is defined as a product or group of products and a geographic area in which it is sold such that a
hypothetical, profit-maximizing firm, not subject to price regulation, that was the only present and
future seller of those products in that area would impose a "small but significant and nontransitory"
increase in price above prevailing and likely future levels.
U.S. Department of Justice (1984, §2.0). For further clarification on market delineation under the
Guidelines, see Gregory Werden (1983).
3 See U.S. Department of Justice (1984, §§2.11, 2.31). For further discussion on the concept of
relevant markets and the Smallest Market Principle, see Gregory Werden (1983, pp. 531-34; 1985,
pp. 535-36). The Smallest Market Principle is applied to the product and geographic boundaries of
market and not to firms. Scheffman and Spiller (1987, pp. 125-27) err three times in asserting that:
(1) a market under the Guidelines is a group of producers; (2) the relevant market is the smallest
group of producers that collectively would raise price by a specified amount; and (3) 'Producers with
a small supply elasticity are likely to be left out of an antitrust market.'
4 Scheffman and Spiller (1987, p. 131) neglect all of the complications and erroneously assert that the
relevant mark-up is equal to lie.
5 Baker and Bresnahan (1984, pp. 12-15) also note that the usual formula relating the monopoly
mark-up to the residual demand elasticity does not apply in general.
6 See note 2.
7 The error will be in the opposite direction if the elasticity of demand decreases as price increases.
8 The Rockford case is United States v. Rockford Memorial Corp., 717 F. Supp. 1251 (N.D. 111. 1989),
aff'd, 898 F.2d 1278 (7th Cir. 1990), and the Roanoke case is United States v. Carilion Health System,
707 F. Supp. 840 (W.D. Va. 1989), aff'd, 1989-2 Trade Cas. (CCH) 168,859 (4th Cir. 1989).
9 Historically, most patients have had indemnity insurance and little incentive to choose hospitals on
the basis of price. More recently, insurance policies have been amended to add deductibles and
copayments to induce some price sensitivity, and alternative delivery systems are increasingly used
instead of insurance plans. Alternative delivery systems take various forms, including health mainten-
ance organizations (HMOs) and preferred provider organizations (PPOs), but all feature some form
of price competition. For example, with an employer-sponsored PPO, an employer contracts directly
with hospitals to purchase care for its employees and selects the hospital(s) with which to contract
through an auction mechanism based on price. The court in the Rockford case acknowledged this
emergence of competition. See United States v. Rockford Memorial Corp., 717 F. Supp. at 1283,
1299.
10 See United States v. Rockford Memorial Corp., 717 F. Supp. at 1286-87.

11 The case is United States v. Archer-Daniels-Midland Co., 695 F. Supp. 1000 (S.D. Iowa 1987),
rev'd, 866 F.2d 242 (8th Cir. 1988). The district court relied in part on price data in holding that sugar
was in the relevant market. The court of appeals held to the contrary on the grounds that HFCS was
cheaper than sugar, it was already used instead of sugar in all uses for which the two are functional
substitutes, there would be no significant switching to sugar unless the two were comparable in price,
and that would not likely happen because of government price supports for sugar.
12 See 695 F. Supp. at 1020.
13 See Judge, et al. (1985, pp. 610-11). This fact was pointed out to us by Johathan Baker.
15 Baker and Bresnahan (1984, pp. 37-38) have a similar result.
15 Scheffman and Spiller (1987, pp. 135-45).
References
Baker, Jonathan B. (1987), 'Why Price Correlations Do Not Define Antitrust Markets: On Econometric
Algorithms for Market Definition,' Working Paper No. 149, Bureau of Economics, Federal Trade
Commission, January 1987.
Baker, Jonathan B. and Bresnahan, Timothy F. (1984), 'Estimating the Elasticity of Demand Facing
a Single Firm: Evidence on Three Brewing Firms,' Research Paper No. 54, Stanford Univ. Depart-
ment of Economics, 1984.
Baker, Jonathan B. and Bresnahan, Timothy F. (1985), 'The Gains from Merger or Collusion in
Product-Differentiated Industries, Journal of Industrial Economics 33, 427-44.
Baker, Jonathan B. and Bresnahan, Timiothy F. (1988), 'Estimating the Demand Curve Facing a
Single Firm,' International Journal of Industrial Economics 6, 283-300.
Froeb, Luke M. and Werden, Gregory J. (1990), 'Residual Demand Estimation for Market Delin-
eation: The Cellophane Fallacy Revisited,' unpublished.
Judge, George C., Griffith, W. E., Hill, R. Carter, Lütkepohl, Helmut, and Lee Tsoung-Chao (1985),
The Theory and Practice of Econometrics (2nd ed.).
Ordover, Janusz A. and Wall, Daniel W. (1989) 'Understanding Econometric Methods of Market
Definition,' Antitrust 3, 20-25.
Scheffman, David T. and Spiller, Pablo T. (1987), 'Geographic Market Definition under the U.S.
Department of Justice Merger Guidelines' , Journal of Law and Economics 30, 123-47.
U.S. Department of Justice (1984), Merger Guidelines (June 14).
Werden, Gregory J. (1983), 'Market Delineation and the Justice Department's Merger Guidelines,'
Duke Law Journal 514-79.
Werden, Gregory J. (1985), 'Is There a Principle for Defining Industries? Comment, Southern Econ-
omic Journal 52, 532-36.
Zwangiger, Jack (1989), 'A Dangerous Concentration in Hospital Markets,' Wall Street Journal June
19, p. AIO.

Residual Demand Estimation For Market Delineation

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Residual Demand Estimation for Market Delineation: Complications and Limitations

Author(s): LUKE M. FROEB and GREGORY J. WERDEN

Residual Demand Estimation for Market

Delineation: Complications and Limitations

Key words. Mergers, market delineation, demand elasticities.

To shed some light on market delineation in an antitrust context, many economists

2. Residual Demand Curves and their Role in Market Delineation

qc Dc(Pc, Pa» dc),

qc = Dc(pc, wfl, dc+a).

cost. The comparative simplicity of estimating a residual demand curve is an

B. THE ROLE OF RESIDUAL DEMAND ELASTICITIES IN THE GUIDELINES' APPROACH

The Merger Guidelines require a comparison of pm with the prevailing price,

then by substitution and rearrangement we can get

To estimate (pm - p0) I Po , we need to estimate, or make assumptions about, 0,

(Pm-Po)/Po= l/(€- 1).

C. COMPLICATIONS ARISING WHEN THE RESIDUAL DEMAND ELASTICITY IS

NOT CONSTANT AND BEHAVIOR MAY NOT BE AS A DOMINANT FIRM

Table I. Some important characteristics of the equilibria at Point 1.

Number of sellers at Point 1 Multiple Multiple One One

Equilibrium residual demand A A/3 1 + 2 A '

The Marshallian demand for sellers at Point 1 is

qx = [dt + p2(pl) - pi]/2t,

where p2{pi) is the best-response function of sellers at Point 2. With multiple

3. Limitations on the Utility of Estimation

there are changing conditions. In addition, as an empirical matter, it is the case

B. DYNAMIC COMPLICATIONS IN THE ESTIMATION OF RESIDUAL DEMAND

In estimating demand elasticities, it is natural to conceive of every observation as

observations through a complicated dynamic process. The dynamics may come

4. The Estimation of Residual Demand Elasticities

A. CONSISTENT ESTIMATION WITH INSTRUMENTAL VARIABLES OR 2SLS

It follows immediately from the foregoing expectations, that the instrumental

If the market is competitive, it is easy to show that the instrumental variables

In practice, good instruments tend not to be readily available. Certainly marginal

where e = y2. If x2 is correlated with y2 , then there will be a right-hand side

Fig. 1. Variance of instrumental variables estimator as a function of p.

Fig. 2. Variance of instrumental variables estimator as a function of A.

Residual demand elasticities certainly are a relevant factor in market delineation,

10 See United States v. Rockford Memorial Corp., 717 F. Supp. at 1286-87.

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