A Critical Analysis of Critical Loss Analysis

Critical loss analysis is often used to argue that firms with large margins have more to lose from a reduction in sales and hence are less likely to increase prices. This argument ignores the fact that profit-maximizing competitors who do not coordinate their pricing only have large margins if their customers are not very price sensitive. In this paper, we explore the implications of critical loss analysis using an internally consistent model of oligopoly. We show that, under the assumptions made in the standard critical loss analysis, firms with larger pre-merger margins are more likely to raise prices than are firms with smaller margins, other things equal. This reinforces the traditional view that mergers are more likely to harm consumers when the merging firms have greater market power, as measured by their margins. We also derive internally consistent formulas for evaluating the profitability of price increases when defining markets and evaluating unilateral competitive effects.