what role does the price elasticity of demand play in determining the short run

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The more competition there is ex post, the more the cost savings will be passed on to consumers. For example, if competition is very intense, a reduction of marginal cost by €1 would lead to a reduction of the price by €1. If the merger creates a monopoly (and if demand is very price insensitive) the price may essentially be unaffected by the cost savings. Third, pass-on also depends on the exact “shape” of the demand function. In particular, if the price elasticity of demand is higher at higher price levels, then the effect of a reduction in cost on price tends to be small (everything else equal). Fourth, In a collusive market, all three aspects mentioned above are still crucial. In order to estimate the degree of post merger competition, it is also necessary to estimate the degree of post merger collusion. The more collusion there is, the less a given reduction in cost will be passed on to consumers (much like the non-collusive case). It may be more difficult to assess the effect of efficiencies on the price level in a collusive market. The reason is that cost savings may reduce the likelihood that collusion is successful. 68 However, economic theory is not well developed to analyse these issues. Third, assume that there is imperfect competition. In this case firms may have incentives to absorb cost changes by adjusting their markups. The degree of markup absorption depends on the curvature of the price elasticity of demand. To see this, note that percentage markups over marginal costs are given by the inverse of the price elasticity of demand. If the price elasticity of demand is constant, then percentage markups will also be constant. In this case there is no markup absorption of cost changes. If, in contrast, the price elasticity of demand is increasing in price, then firms find it optimal to reduce their markups when costs increase, and increase their markups when costs decrease. Consequently, pass-on is incomplete.92 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 markup 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 markup absorption to the firms market shares. For example, Feenstra, Gagnon and Knetter (1994) show that the degree of markup absorption depends on the market share of the firms according to a U-shaped pattern.All one needs to know is the market share of each partner before the merger, and the market elasticity of demand. Intuitively, as the market share of either firm A or firm B increases, or as the price elasticity of market demand decreases, the required percentage cost reduction increases.96 One may distinguish between two extreme cases. On the one hand, if the market share of firm B becomes very small, then the required reduction in the marginal cost below the low cost firm A’s pre-merger marginal cost can be very small. The acquisition of a small firm thus puts very low MREs. On the other hand, if the joint market share of the merging firms exceeds the price elasticity of market demand (sA+sB>e), then the merger can never reduce price, even if the marginal cost would drop to zero after the merger.97 In less extreme cases, the threshold efficiency level needs to be computed. For example, if firm A and B have a market share of 30 percent and 10 percent, and if the price elasticity of market demand equals one, then the required percentage reduction in A’s marginal cost is 33 percent; if the merging firms’ joint market share of 40 percent is evenly distributed (i.e. each firm has 20 percent), then the required marginal cost reduction is 25 percent.From a practical perspective, it is necessary to compute the firms' market shares and the price elasticity of market demand. A prerequisite to both is a proper definition of what constitutes the relevant market. In the previous sub-section we discussed how the relevant market is defined according to the Commission's notice.98 To compute the price elasticity of demand (once the market is defined), one may follow an econometric approach after gathering historical information on prices, total market demand and other variables such as income. In many cases, price elasticities of market demand may also be available from academic publications or from industry sources. If none of these possibilities is available, reasonable values for elasticities may be assumed and the robustness regarding alternative assumptions will need to be assessed.

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