Wednesday, September 30, 2009

Reconciling the Opposing Views of Critical Elasticity

Posted by D. Daniel Sokol

Michael Baumann (Economists Incorporated) & Paul Godek (Compass Lexecon) make an attempt at Reconciling the Opposing Views of Critical Elasticity.

ABSTRACT: Market definition is the core of antitrust analysis, and the concepts of “critical elasticity” and “critical loss” have often been applied to the task of defining relevant antitrust markets, in both differentiated-product and homogenous-product scenarios. The critical elasticity is that elasticity of demand that is just high enough to prevent a hypothetical monopolist from profitably increasing price by a threshold “small but significant” amount; critical loss is the fraction of sales lost by the hypothetical monopolist, as implied by the critical elasticity. Evidence that the actual demand elasticity exceeds the critical elasticity indicates that the product in question is not a relevant market.

In recent articles, several researchers have offered an alternative approach to the issue of critical elasticity. Their view is that the traditional application of the concept is flawed and that critical elasticity calculations contain information about actual elasticities of demand. We believe that alternative view to be half wrong. While it offers a misleading interpretation of critical elasticity analysis, the alternative view does reveal a flaw in the conventional approach—a flaw that proponents of the conventional approach have failed to recognize. Here we present a revised and more general critical elasticity model, one that might reconcile the competing arguments. The new model also implies substantially higher critical elasticities than previous models would indicate.

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