WHAT line of business are you in? It is hard for a lot of people to answer this question with a straight face. As tasks become more specialised and firms occupy ever-smaller market niches, job titles and business categories can sound comically obscure. It is a source of embarrassment for antitrust agencies, too. To assess whether there is a enough competition in a market, trustbusters must first decide what the market is. The results can be risible. For instance, Britain's Office of Fair Trading (OFT) said this month that the purchase of a job-lot of theatres by the Ambassador Theatre Group did not raise competition concerns. The OFT's definition of the relevant market in this case (the “provision of regional theatres for medium-scale national touring productions”) is unlikely to be found on anyone's business card.

Some economists doubt whether defining a market is useful at all when judging marriages between very specialist firms. The issue has a growing saliency because America's trustbusters are currently rewriting the guidelines for “horizontal” mergers (tie-ups between firms that offer the same sorts of products). The update is partly an exercise in good housekeeping: the current guidelines were written in 1992 and do not reflect advances in economic theory and changes to actual practice since then. It is also an opportunity for American policymakers to shift the analysis of mergers away from an obsession with “structure”—the size of the combined market share of merging firms—to focus instead on how big a constraint each firm is on the other's pricing.

The emphasis on structure in the current guidelines is a legacy from another era. Trustbusters used to worry most about the scope for firms making standardised products in concentrated markets to arrive at an unspoken agreement on prices. In principle a merger in such a market supplied by, say, just five firms might harm competition. After the tie-up the four remaining firms would find it much easier to monitor the others' prices than before. This could lead to a cosy arrangement where each firm is less inclined to compete on price.

In practice, the conditions for such tacit collusion are quite rare. Incumbents would have to be safe from challenge by new entrants. They would also have to sell similar products at similar margins. Otherwise there is the temptation for the firm with the lowest costs, or the best products, to break ranks and steal market share from others. Because these conditions are so specific, trustbusters fret less and less about the “co-ordinated effects” of mergers and more about the “unilateral effects”—the loss of competition between merging partners.

The focus on market definition has nevertheless made it harder for trustbusters to stand in the way of some mergers. In June 2007 America's Federal Trade Commission (FTC) applied to the courts to stop the tie-up between Whole Foods and Wild Oats, two upmarket food retailers. At the time Whole Foods and Wild Oats had around 300 shops, a small fraction of the 34,000 supermarkets across America. The FTC argued that the relevant market was “premium, natural and organic supermarkets”. The court thought that definition was much too narrow: didn't less fancy outlets, such as Safeway, also sell organic food? It denied the FTC's request. The appeals court later ruled that the two firms were far closer competitors with each other than with more humdrum stores, but by then the merger had been consummated.

The case highlights a flaw in using a market definition to frame a competition concern. The FTC's narrow definition played up the likely effect on prices from the loss of that rivalry but ignored the more distant challenge from ordinary supermarkets. But defining the market broadly as “all supermarkets” would have exaggerated the pressures faced by both firms.

If market-share analysis can be a poor guide to the likely effect of mergers on prices, what might be put in its place? One suggestion* comes from Joseph Farrell and Carl Shapiro, two professors at the University of California, Berkeley, who happen also to be the chief economists at the FTC and the antitrust arm of the Department of Justice (DoJ) respectively. They advocate a measure of “upward pricing pressure” (UPP) as a screen for judging the probable impact of a merger.

Their gauge provides an estimate of the benefits of keeping the two merger candidates apart. These benefits depend on how many consumers switch between the two firms when one of them cuts prices (the diversion ratio). They also depend on how fat the profit margins are in the firm that loses custom, since that determines how much each consumer gains from switching. Multiplying the diversion ratio by the profit margin gives a measure of the lost benefits of competition should the firms merge. If this benefit is greater than a plausible estimate of the efficiency savings from the merger, then it should be halted.

Upp and away

This sort of approach, which is already used by Britain's OFT, has its critics. One concern is that diversion ratios are hard to measure in practice: trustbusters sometimes have to rely on consumer surveys, which can be unreliable. Another fear is that the use of UPP and the like will give trustbusters too much leeway to block mergers that might benefit consumers. A third worry is that the UPP gauge ignores the effect of third parties who may be only slightly less close competitors to the merging firms than they are to each other. The market-share measure of competitive pressure also has all the advantages of incumbency: American legal precedents are built upon it and judges find it a useful check. But changes are needed and the horizontal-merger guidelines, the most cited antitrust document of all, are the best place to start.

* “Antitrust Evaluation of Horizontal Mergers: An Economic Alternative to Market Definition” by Joseph Farrell and Carl Shapiro, February 2010. http://faculty.haas.berkeley.edu/shapiro/alternative.pdf