The empirical literature on pass-on is large, and is scattered over various fields in economics, see section (4.3.3) for a more detailed discussion. The general empirical finding from this literature is that pass-on is indeed incomplete. The examples cited above suggest that the pass-on parameter β roughly varies between 30% and 70%. Yet we stress that a more detailed study is necessary to obtain a more complete picture. If the conclusions would turn out to be robust, then one could conclude that the efficiency standard for price to increase would vary between 7% and 17% if a 5% rule for defining the relevant market is used; it would vary between 14% and 33% if a 10% rule is used. One may note that these numbers are rather high. The reason is that they come from the worst case scenario. Nevertheless, there are mergers that may meet such high requirements.
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If the dominance test entails a tolerance level for price increases of, say, 2%, then the number 2% corresponds to the threshold L in figure 2 above.
122 Full pass-on means that that the pass-on parameter β=1. No pass-on means that β=0. Partial pass-on
means that β is some number between 0 and 1. More than full pass-on, which is possible at least in theory, means that β>1. Negative pass-on is inconsistent with most models of firm behaviour.
The more confidence one would obtain regarding the estimate of the pass-on parameter across sectors, the easier it would be for the merger authority to revert to a general presumptions approach regarding the MREs (though not necessarily of course regarding actual efficiencies). For example, if it would be found from empirical studies that it is fairly safe to assume a pass-on parameter of 50%, then the efficiency standard would simply amount to twice the hypothetical joint price increase that was used when defining the relevant market. If, in contrast, a detailed review of the literature would point out that the pass-on parameter varies substantially across sectors, then the merger authority may prefer to do a case-by-case analysis in the second step for determining the pass-on parameter. The following considerations may be taken into account under such a case- by-case investigation.
(1) Previous empirical results on pass-on may be used if these are available for the sector in which the merger takes place.
(2) The merging firms may be requested to provide the necessary information for estimating pass-on based on historical data. A descriptive empirical approach to estimating past pass-on behaviour would require fairly standard econometric procedures based on data that the firms should have readily available.
(3) A qualitative analysis may be undertaken on the likelihood that pass-on in the sector of the merging firms will deviate from the mean pass-on parameter in the economy. Such a qualitative analysis may be based on several theoretical arguments.
Theory predicts that the importance of the following three variables in determining the degree of pass-on of a marginal cost reduction into consumer prices: the slope of marginal costs, the intensity of competition and the curvature of the price elasticity of demand. First, assume there is perfect competition and marginal costs are constant. In this case marginal cost changes will be fully passed on into consumer prices (β=100%). Second, assume there is still perfect competition but that marginal costs are increasing (reflecting capacity constraints). In this case pass-on will be incomplete, provided at least that industry demand is not perfectly inelastic (β<100%). Intuitively, suppose that the competitive firms decide to lower their prices by the extent of the reduction in marginal costs. This price increase would raise industry demand (unless it is perfectly inelastic). In order to meet the increased demand the firms would need to produce more. When marginal cost are increasing due to capacity constraints, this requires firms to charge a higher price than the original decreased price, so that pass-on is incomplete.
Third, assume that there is imperfect competition. In this case firms may have incentives to absorb cost changes by adjusting their mark-ups. The degree of mark-up absorption depends on the curvature of the price elasticity of demand. To see this, note that percentage mark-ups over marginal costs are given by the inverse of the price elasticity of demand. If the price elasticity of demand is constant, then percentage mark-ups will also be constant. In this case there is no mark-up absorption of cost changes. If, in contrast, the price elasticity of demand is increasing in price, then firms find it optimal to reduce their mark-ups when costs increase, and increase their mark-ups when costs decrease. Consequently, pass-on is incomplete.123
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To see this intuitively, suppose the firm would fully pass on a cost decrease in a price decrease, hence keeping mark-ups constant. The result would be that the elasticity of demand is reduced at this lower prices. But according to the inverse elasticity rule this would imply it is no longer optimal to charge
These theoretical considerations teach us that pass-on is expected to be weak when the industry is characterised by increasing marginal costs (capacity constraints), when there is a significant degree of market power, and when there is mark-up absorption due to an increasing price elasticity of demand. The first two conditions are intuitive and possibly relatively easy to observe variables. The third condition seems more difficult. Nevertheless, even for this case there are some interesting theoretical results that suggest to link the degree of mark-up absorption to the firms market shares. For example, Feenstra, Gagnon and Knetter (1994) show that the degree of mark-up absorption depends on the market share of the firms according to a U-shaped pattern.