On October 11, 2000, the European Commission approved the proposed merger between America Online (AOL) and Time Warner, after the two companies agreed to cut their ties with certain European companies. Many are puzzled as to why the merger between two American companies needs approval from a regulatory authority outside the United States. The answer lies in the fact that these firms compete in Europe as well as the United States. With the fast pace of economic globalization in recent years, many transnational corporations operate all over the world and are therefore subject to the antitrust laws of several countries.

Because of overlapping jurisdiction, American antitrust agencies have been negotiating antitrust cooperation agreements with foreign countries. Indeed, the United States has been negotiating such an agreement with the European Commission for about ten years. Moreover, today, antitrust cooperation is on the agenda of the World Trade Organization (WTO). As Joel Klein, the departing antitrust chief at the United States Department of Justice, put it at a recent antitrust conference in Brussels, "Never has [antitrust] been a more important component of the global economic machinery." (Joel Klein, "Time for A Global Competition Initiative?" September 14, 2000)

Are these trends irrelevant to China? No. Transnational mergers and acquisitions are already happening in China. For example, in early 1998, Kodak acquired several Chinese photo film producers, effectively making the Chinese photo film market a triopoly (with Fuji and Le Kai being the other two producers).

China has laws for countering unfair competition, but these laws are hardly sufficient to deal with a broad range of competition issues. For example, the existing laws address very few antitrust issues related to mergers and acquisitions, which are an important part of American antitrust enforcement.

With no clear rules, market players often behave in an anti-competitive way. For example, after the "price war" in China's color TV market heated up in June of this year, nine domestic TV producers conferred in Shenzhen and set up a cartel to limit price decreases. Although this collusion was widely criticized by academics and even some government agencies, no real action was taken and no punishment was imposed on those companies. Another example is the telecom market, well documented and analyzed in Zhang Weiying and Sheng Hong's "Antimonopoly Problem in China: An Analysis of Telecom Industry" (author's translation). In their article, Zhang Weiying and Sheng Hong described how China Telecom, controlled by the former Ministry of Posts and Telecommunications, now the Ministry of the Information Industry, harmed China Unicom in various anti-competitive ways in the early years of China Unicom's development.

To aid its domestic economic restructuring and to prepare for its entry into the WTO, China needs to have a complete set of pro-competition regulatory policies, not just to assure foreign investors, but also to protect domestic firms from unfair competition of all sorts. Moreover, a set of well-defined domestic competition policies will also provide a basis for negotiating antitrust cooperation agreements with other countries in the future.

In order to make sound competition policies for China, it is helpful to understand the economic basis for antitrust and how it works in a country with more complete laws and more enforcement experience. This article provides an overview of the basic analytical approaches used in antitrust enforcement in the United States.

1. The Basics of Antitrust Analysis

At the center of antitrust economics is the concept of market power. Market power is deemed to exist if, for a sustained period, a firm or several firms have the ability to raise prices profitably above the levels that would be charged in a competitive market. A competitive market is one with a sufficiently large number of firms competing with one another that prices are kept at levels that reflect social costs. Since market power usually leads to high prices and/or low quality, and often stifles future innovations, it hurts consumers and should be restricted.

There are numerous ways to obtain market power. If there are only a few firms in a market, concentration is high, and each firm will have some market power to charge a high price. When the market is highly concentrated, it is also easier for firms to coordinate their pricing behavior so that a high level of prices can be maintained. Market power may also exist even with many small firms in the market, if there is a single dominant firm.

A common way of obtaining more market power is through mergers and acquisitions. This is why recent proposed megamergers like AOL/Time Warner and WorldCom/Sprint have caused so much antitrust concern in the United States and Europe. Market power can be extended from one market to another through tying. In the Microsoft case, tying Internet Explorer to the Windows operating system is alleged to be an attempt by Microsoft to monopolize the web browser market by leveraging its monopoly power in the operating system market.

Entry barriers are required for there to be sustained market power. Where there is high difficulty of market entry, incumbents are able to set high prices and to enjoy high profits, without fear that new firms might enter and induce competition. Government regulations may limit entry. In addition, structural characteristics of markets may deter entry. For example, entry barriers are high when entry requires a huge sunk cost and when there is significant economy of scale in the production. This phenomenon has been seen in, for example, some parts of the energy and telecommunications markets, where networks (such as pipelines or cable networks) require very high initial capital outlays.

In virtually any antitrust analysis, the first step is to define the "relevant market" (the term was first introduced in 1948, in a merger case named United States v. Columbia Steel Co.). There are two dimensions that define a market: product market and geographic market. Products have to be substitutable enough to be included in the same market. There is little doubt that Coke and Pepsi are substitutable enough to be included in the same market. But should Sunkist, an orange juice product, be included in the same market? In American antitrust practice, substitutability is often determined by the so-called "5% rule": if a group of firms in a particular category of products all increase their price by 5% and their profits increase significantly, then those firms compete in a well-defined product market. For example, if Coke, Pepsi and other soft drink producers all increase their prices by 5% and gain higher profits, then the market would not include other beverages. However, if the 5% price increase leads to lower profits because sales are lost to other beverages, the market definition should be broader than just soft drinks. Perhaps Sunkist should be included in this broader market. But this expanded market again should be tested by the 5% rule. The relevant product market is the smallest market that satisfies the 5% rule.

The geographic market is determined in pretty much the same way. Start with the geographic locations of merging firms' business operations and perform successive iterations of the 5% price increase test. Expand to include more locations, until this hypothetical price increase leads to higher profits. Then the group of locations already included is deemed to be one market. Since the 5% rule is based on a hypothetical price increase, more information about the product and the market is needed to determine whether profits would indeed rise. Demand elasticity is often a key element in such estimates.

Once the relevant market is defined, further analysis depends on the nature of the problem at hand. In merger analysis, the next step would be to calculate the market shares of the parties involved and the concentration level of the market. When measuring concentration, the Herfindahl-Hirschman Index (HHI) is often used by American antitrust agencies. The HHI is the sum of the squared market shares of all the participants. For example, if there are three firms in the market, with market shares of 50%, 30%, and 20%, respectively, then the HHI is: 50^2+30^2+20^2=3,800. As a result, a monopoly market has an HHI equal to 10,000. A competitive market has an HHI that is low. Unlike other indices (for example, the four-firm concentration ratio), the HHI assigns greater weights to the market shares of the larger firms, in accordance with their relative importance in the market.

A market may be characterized as unconcentrated (HHI below 1,000), moderately concentrated (HHI between 1,000 and 1,800), or highly concentrated (HHI above 1,800). To get a sense of these thresholds, an HHI of 1,000 corresponds to ten firms of equal size, and an HHI of 1,800 corresponds to five and half firms of equal size. Although the exact numerical cutoff does not have a precise justification, the use of HHIs provides a broad framework for further analysis. For example, if there is ease of entry, then a seemingly concentrated market can behave competitively. On the other hand, since mergers may increase firms' operating efficiency and the cost reduction can be translated into price reduction, they should be analyzed on a case-by-case basis. In practice, American antitrust authorities usually do not challenge a merger that would result in an HHI below 1,800, unless the change in the HHI from the pre-merger level is very dramatic and there is other evidence that suggests that a post-merger price increase is likely. Such analysis linking market concentration to market power is often called structural analysis.

Antitrust analysis has evolved over time with the development of economic theories and empirical methods. For example, antitrust analysis has been extended from possible collusive behavior to the evaluation of possible unilateral effects. Unilateral effects occur when a firm can increase prices without the collusive support of others in the same market. Unilateral effects theories arise from modern Industrial Organization models that describe competition in differentiated product markets. Advances in econometric techniques, the improvement of computer software, and better data availability (for example, the emergence of scanned data) has led to more extensive use of econometrics and simulation methods in antitrust analysis, which has in turn provided empirical support for unilateral effects theories.

2. Antitrust Enforcement in the United States

In the United States, the Antitrust Division of the Department of Justice and the Federal Trade Commission have primary responsibility for antitrust enforcement. Various other agencies are also involved, depending on the industry. For example, the acquisition of MediaOne, a large cable company, by AT&T, required approval from the Federal Communications Commission. The current merger between two commercial banks, JP Morgan and Chase Manhattan, will require approval from the Securities and Exchange Commission and the Federal Reserve. The attorney generals of individual states may be involved, too. For example, the Texas Attorney General recently participated in the review of natural gas pipeline mergers because the State of Texas has the right to go to the U.S. District Court to stop a merger. In addition, state regulators like public utilities commissions may review some aspects of mergers.

Antitrust has a long history in the United States. The first antitrust act, the Sherman Act, was passed in 1890 to reduce anti-competitive behavior. It made price-fixing and attempts to monopolize illegal. The Sherman Act was used to break up the oil giant Standard Oil in 1911. Over the years, it has been used in numerous cases involving famous companies such as the American Tobacco Company, AT&T, IBM, and Microsoft. While the Sherman Act deals with existing monopoly power, the Clayton Act, passed in 1914, prevents monopolies from forming through mergers. It has been used to block mergers that would create significant market power.

Merger and acquisition activities have been especially active in the recent decades. The enforcement policy that is often relied on today is set forth in the 1992 Horizontal Merger Guidelines. The Guidelines contain a detailed discussion of market definition, measurement of concentration, potential adverse effects of mergers, and entry and exit issues in a market. The Guidelines also recognize potential efficiency gains from a merger.

The issues and markets that have been the focus of antitrust analysis change over time with changes in market structure and technologies. For example, recent developments in e-commerce have raised antitrust concerns. Recently, the Federal Trade Commission investigated a joint venture of online airline ticket reservations among several airlines. A joint venture among five automotive manufacturer-General Motors, Ford, DaimlerChrysler, Renault, and Nissan-to operate an Internet-based Business to Business (B2B) supply chain service, has also been reviewed carefully. To clarify certain issues, the Federal Trade Commission issued a staff report on October 26 of this year entitled "Entering the 21st Century: Competition Policy in the World of B2B Electronic Marketplaces." The report recognizes the potentially substantial cost savings and enhanced competition such marketplaces provide, but also points out the antitrust issues B2B may raise. The report concludes that these issues are not new and "B2Bs are amenable to traditional antitrust analysis."

3. Conclusion

There is a clear trend that antitrust is going global. Cooperative antitrust enforcement among countries is needed to reduce inefficiencies resulting from overlapping investigations by the antitrust authorities in different countries. Given the structure of the Chinese economy in the past, China has not been particularly active in the area of antitrust. Since the Law for Countering Unfair Competition was passed in 1993, China has been in a process of drafting the first anti-monopoly law. This process should be accelerated. With its domestic restructuring progressing and its entry into the WTO approaching, it is time for China to put antitrust on the agenda.

(Su Sun is a Senior Economist at Economists Incorporated. The author would like to thank Dr. Phil Nelson at Economists Incorporated for his proof-reading of the article and helpful comments.)