Economics in the Whole Foods merger case

Last week, a federal judge refused to grant a preliminary injunction against the Whole Foods acquisition of Wild Oats (FTC website; testimony: day1 am, day1 pm, day2 am). He ruled that "premium, natural and organic supermarkets" was a not a "relevant product market." A relevant market is one in which a hypothetical, multi-store monopolist, owning all stores in the category (and eliminating competition among them), would raise price.

In his decision, the Judge cited a break-even analysis (sometimes called "critical loss") that asks how much quantity a monopolist could afford to lose and still want to raise price. With retail margins of 40% (FTC complaint, p.21), a 5% price increase would require a quantity loss of no more than 11.1% to be profitable [11.1%=5%/(5%+40%)]. Citing marketing studies showing that customers shopped at Whole Foods as well as other grocery stores, former FTC Chief Economist and colleague David Scheffman argued that the actual quantity lost would be greater than 11.1%, presumably to stores outside the category.

University of Chicago economist Kevin Murphy criticized the break-even analysis by focusing on the incentive of the merged firm to raise price. From my favorite textbook,

When you price commonly owned products, ... your concern changes from earning profit on an individual product to earning profit on both products ... Aggregate demand for a group of substitute goods is less elastic than the individual demand for the goods that comprise the group. And with a less elastic aggregate demand, the merged firm wants to raise price.

The closer substitutes the two stores are, the bigger incentive the merged has to raise price (Murphy rebuttal report).

The heavily redacted court documents refer to entry "experiments" to determine the degree of substitution between the two merging stores. We found the following on the Whole Foods website,

If we [close the Wild Oats Store right across the street], we believe approximately 50% of the volume their store does will transfer to our store, with the other 50% migrating to our other competitors (these estimates are based on our past experience with similar situations).

It is hard to believe that the diversion ratio is this big. But even at half the size, simple models of competition would predict a big enough post-merger price increase to put the two stores into a relevant market by themselves.