UPP, which stands for Upward Pricing Pressure, is a measure used in merger analysis to determine whether a given merger will result in higher prices for consumers.
It was introduced in 2010 by economists Joseph Farrell and Carl Shapiro and bases itself on the idea that two merged firms may have an incentive to raise prices because they no longer compete with each other.
UPP is based on two factors: the diversion ratio and the profit margins.
Diversion is the percent of sales that would be diverted to the other merging firm if one firm raised it prices.
Furthermore, the higher the profit margins, the greater the incentive firms have to raise prices post-merger.
The formula for UPP is thus as follows:
UPP = D*Π
If it is easier to understand, Π = P - C
- D = diversion from one merging firm to the other
- Π = profit margin
- P = price of the product
- C = marginal cost of producing the product
Let’s run through a few examples:
Example 1
Firm A and Firm B are merging. The diversion ratio from Firm A to Firm B is .4, the price of the product is $100, and the marginal cost is $60. The UPP is:
0.4*(100–60) = 0.4*40 = $16
This indicates that the merger creates an incentive for the merged firm to raise prices by $16.
Example 2
Firm A and Firm B are merging. The diversion ratio from Firm A to Firm B is .4, the price of the product is $200, and the marginal cost is $60. The UPP is:
0.4*(200–60) = 0.4*140 = $56
Here, since the profit margin was larger, prices are raised even higher.
Example 3
Firm A and Firm B are merging. The diversion ratio from Firm A to Firm B is .2, the price of the product is $100, and the marginal cost is $60. The UPP is:
.2*(100–60) = .2*40 = 8
Here, lower diversion means less market power and a smaller price increase.
That’s all for our introduction to the UPP! Let me know in the comments if you would like to see any additions to this article, or further articles on similar subjects.
