Why the Effects of Cross-Price Elasticity of Demand Are Important in Contract Management

The concept of cross-price elasticity of demand is essential to competitor identification and market definition because the cross-price elasticity of demand measures the degree to which products substitute for each other, that is whether they are competitors in the same industry.

Given product X and Y, then the cross-price elasticity of demand measures the percentage change in demand for good Y that results from a 1% percent change in the price of good X. In the other hand, the own elasticity of demand is essential to competitor identification and market definition because it illustrates the implications of the firm’s pricing decision when its demand curve has alternative shapes.

Having an understanding of each firm’s demand curve within an industry allows a data analyst, government regulator, or financial analyst to come up with an aggregate demand curve and process the market implications of the price movements from the different firms in the industry.

When to Use Firm-Level Versus Industry-Level Price Elasticity of Demand

Own-price elasticity reflects the extent to which customers have substitutes for the product (or service) that you sell. A high price elasticity means that your customers can easily switch to other products if you raise your price. Conversely, a low price elasticity means that customers will not switch if you raise the price. High elasticity is a reflection of a more competitive environment. Cross-price elasticity defines whether two products are substitutes. If there is a positive cross price elasticity, then the products are substitutes. The higher that cross price elasticity, the more the products are substitutes.

The firm-level price elasticity of demand shapes the opportunities for making profit in an industry because firm-level elasticities are often higher than industry-level elasticities because consumers can purchase from other firms when only one firm raises its price.  It is up to companies to decide whether to use an industry-level or firm-level elasticity of demand when assessing the impact of a price change because it all depends on what the firm expects its rivals to do.  In a price-competitive industry, the industry-level elasticity is a savvy choice; while in an industry where the firm is a price-leader, the firm-level elasticity is a more appropriate choice.

How to Measure Price Elasticity

There is a systematic relationship between seller concentration and price in any market.  The market structure, the number and distribution of firms in a market, provides a quick assessment of the likely nature of competition (e.g. price) in a market.

The Herfindahl-Hirschman Index  (HHI) measures the nature of competition in a market, which in turn measures the intensity of price competition.

HHI = s1^2 + s2^2 + s3^2 + … + sn^2 (where sn is the market share of the nth firm).

Holding all other variables constant, a perfect competitive market should offer fierce price competitions, and a monopoly should offer light price competitions (unless threatened by entry).  However, this is not a 100% accurate measure because some markets with only two competitors might be very price competitive, while price competition might be nonexistent in markets with various firms.  It is important to assess all of the circumstances surrounding the competitive interaction of firms to make appropriate conclusions about the intensity of price competition.

Application of HHI in Contract Management

While the HHI may seem a foreign concept to most of us, it is widely used. The U.S. Department of Justice uses the HHI to evaluate the competitiveness of an industry, which is a necessary step during investigations about antitrust concerns.

According to U.S. Department of Justice, regulatory agencies use the following guidelines:

  • HHI of 1,000 or less is considered to be a competitive
  • HHI is between 1,500 and 2,500 points: moderately concentrated market
  • HHI is in excess of 2,500 points: highly concentrated market
  • HHI of 10,000 points: monopoly

Another important point to consider is that mergers and acquisitions  that increase the HHI by more than 200 points in highly concentrated markets are presumed likely to enhance market power under the Horizontal Merger Guidelines issued by the Department of Justice and the Federal Trade Commission.

This means that when drafting contracts for M&A transactions a best practice is to include a section of clauses that  detail the calculation of the HHI, provide explanation of the calculations, and highlight potential issues if a transaction increases the HHI by more than 200 points in a highly concentrated market. By including a discussion of the HHI in your contract, you can demonstrate your due diligence and prepare for any potential questioning from regulatory agencies. Another important issue to consider is the prevention of hidden value leakage in M&A transactions.