The Cellophane and Merger Guidelines Fallacies Again

Pierluigi Sabbatini1

JEL Classification: K2,L4

Abstract
The Cellophane Fallacy is a very familiar topic in antitrust literature. The
expression comes from the famous antitrust case of the 50's when the United
States Supreme Court made an overly broad definition of the relevant market,
thereby failing to detect the market power of du Pont, which held a virtual
monopoly on cellophane. In the presence of a concentrated market structure the
Merger Guidelines method (1982) also fails, leading to overestimation of the size
of the relevant market. Given these similarities the Merger Guidelines Fallacy and
the Cellophane Fallacy are generally taken to be identical. In fact, however, the
two fallacies arise for different reasons and need to be clearly distinguished. This
paper traces the origins of the two fallacies and provides a correction for the
Merger Guidelines approach.

May 24th 2001

Autorit Garante della Concorrenza e del Mercato (Italian Antitrust Agency). E-mail:
pls@agcm.it. The views expressed in this are those of the author and do not involve the
responsibility of the Italian Antitrust Agency.
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Introduction
The Cellophane Fallacy is a very familiar topic in antitrust literature. The
expression comes from the famous antitrust case of the 50's when the United
States Supreme Court made an overly broad definition of the relevant market,
thereby failing to detect the market power of du Pont, which held a virtual
monopoly on cellophane. The peculiarity of the fallacy derives from the fact that,
for reasons to be explained later, it was precisely du Pont's dominant position
which distorted the Supreme Courts analysis. The Merger Guidelines method
(1982) defines the relevant market by comparing the current price to the price
which would be set by a hypothetical monopolist. In the presence of a
concentrated market structure this method also fails, leading to overestimation of
the size of the relevant market. Given their similarities the Merger Guidelines
Fallacy (MGF) and the Cellophane Fallacy (CF) are generally taken to be
identical. This view was proposed immediately after the issue of the 1982 Merger
guidelines (Schaerr, 1985) and since then has been shared by nearly all antitrust
scholars. To quote an authoritative antitrust manual:
"The Horizontal Merger guidelines begin their analysis of mergers by
estimating cross-elasticity of demand at current market prices, just as the
Supreme Court did in the du Pont (Cellophane) decision. The result, as in du
Pont, is that markets may be defined too broadly if the firms under analysis
are already charging a monopoly price." (Hovenkamp,1999, p.132)

The presumed overlap between the two fallacies lies at the heart of recent
papers addressing the weakness of current legal standards for the detection of
dominant positions, a particularly acute problem in possible cases of
monopolization (Werden, 2000; Salop, 2000; White, 2000).
The CF and the MGF both produce the same undesirable effect: a
broadening of the definition of the relevant market directly proportional to the
level of market concentration. The causes underlying this effect are however
different and need to be clearly distinguished. In the case of the CF, the problem
derives from non-constant elasticity of demand: as market concentration increases
so, in general, does elasticity of demand. The weakness of the MGF derives, on
the other hand, from the comparison between the price that would be set by a
hypothetical monopolist and the actual price: if the actual price is already a
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monopoly price the relevant market will be deemed to be broader than would
otherwise be the case. This effect is independent of changes in the elasticity of
demand. The problems posed by the CF and the MGF are thus entirely different.
This short note will analyse and compare the two fallacies.
The Cellophane Fallacy
A number of papers (e.g. Stocking-Mueller,1954 and Turner,1956) have
already told the story of the du Pont case, which does not need to be recalled here.
It is nonetheless necessary to recall that during the years when du Pont was
supposed to be monopolising the market, the firm had progressively lowered its
price with respect to competing products and had spent a lot of money on
improving quality and reducing costs. Today, observers are unanimous that the
Supreme Court made a mistake in not detecting du Ponts dominant position. A
close examination of the firms behaviour suggests, however, the need for caution
in judging the Supreme Courts decision.
The problem brought to the Supreme Court was clearly stated: if the
relevant market included only cellophane then du Pont had to be considered a
monopolist: the only other producer of cellophane worked under a du Pont
license; the licencing agreement restricted the licensee to a very narrow market
share. If, on the other hand, the market was defined to include other wrapping and
packaging products, du Ponts market share would fall to a mere 17 percent,
eliminating the risk of anything which might be deemed, from an antitrust
viewpoint, a dominant position.
The District Court, which first tried the case, had opted for the broader
definition of the relevant market, without conducting any specific tests to ascertain
the elasticity or cross-elasticity of demand for cellophane. The Court had accepted
the arguments of the du Pont defence. These were founded chiefly on du Ponts
aggressive pricing, on the firms intense commitment to innovation and on the fact
that cellophane had a limited share of all specific segments of the market for
wrapping products (there was no specific characteristic of cellophane where the du
Pont product held an overwhelming advantage). Du Ponts defence was based on
an analysis of the companys behaviour. It was a strategy strikingly similar to the
defence Microsoft was to adopt fifty years later, (though the Microsoft strategy
proved much less successful, at least at the District Court level).
It was the Supreme Court which introduced the use of cross elasticity of
demand as a test of interchangeability between products, noting that the cross
elasticity of demand between cellophane and other similar products was so high as
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to justify the inclusion of the latter in the relevant market.. The Courts decision is
generally considered as providing the case-law for the use of cross elasticity of
demand in the definition of the relevant market (the Supreme Court decision
quotes the works of Bain,1953, and Scitovsky, 1951).
Early comments, while critical of the decision, used arguments which
differed from those later labelled as the Cellophane Fallacy. The first article
(Stocking-Mueller, 1955; SM), written before the Supreme Courts decision was
taken, does not analyse demand elasticity at all. The paper addresses the following
topics: a) product analysis; b) trends in prices and the gap vis vis competing
products (the price of cellophane had fallen sharply compared to that of most
similar products); c) du Pont profits. It should be stressed that SMs discussion of
point (b) amounted in reality to an analysis of residual demand. In their
argumentation the authors explicitly examine the issue of substitutability taking
into account the production costs of alternative products. In a subsequent article
Stocking asserts that demand elasticity is of no help in defining the relevant
market (Stocking, 1957). Turner, in an article written immediately after the
Supreme Court sentence, makes a number of moderately critical observations
similar to the objections raised by Stocking-Mueller, pointing out that any
appraisal of substitutability among products should take into account their
respective cost structures (Turner, 1956, p.311). Turners argument that the
definition of the relevant market has to be reconsidered for every specific antitrust
case appears on the one hand somewhat old-fashioned (Turner, 1956, pp.288-290),
on the other extremely modern (Salop, 2000). Areedas well-known antitrust
manual (Areeda 1978), criticises the decision on a purely empirical basis arguing
that the evidence produced during the trial could not justify the Supreme Courts
finding that demand elasticity was high. An analysis of trends in relative prices
and of shifts in the demand curve for the period examined during the trial, leads to
the conclusion that the elasticity of demand was in fact low.
Let us now come to what has been called the " Cellophane Fallacy ". As
early as 1976 Posner, referring to the du Pont case, had shown that in a
concentrated market, demand elasticity (which the Supreme Court had also failed
to compute correctly) could not be used in the definition of the relevant market. He
returned to this point subsequently in his well known paper on market power
(Landes-Posner, 1981). Posners opinions are now unanimously shared
(Salop,2000; White, 2000; Hovenkamp, 1999; Werden, 2000). Since Schaerrs
article of (1985), they have been used to identify the so-called "Cellophane
Fallacy".
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Posners argument is related to changes in demand elasticity at different points on

the demand curve. Consider the demand elasticity (e):
e = - dQ/dP * P/Q

where Q=demand and P=price

In general, if we consider a sufficient variety of demand curves, we observe that

elasticity is higher on the upper segment of the curve, where prices are high and
demand low (Marshall,1920,p.87) 2. In the case of a linear curve this result is
derived easily. On such a curve the derivative (dQ/dP) is constant; the P/Q ratio,
on the other hand, increases as prices become higher (and demand falls). It follows
that at higher levels of market concentration, with high prices and low demand, the
elasticity of demand tends to increase. In reality this tendency is not restricted to
linear curves but emerges from almost all the most common demand functions.
Obviously if the demand function is isoelastic there can be no Cellophane
Fallacy: the degree of substitutability with other products, as measured by the
demand elasticity, is constant at all points on the curve. It should be noted here
that the monopoly price is relevant for the Cellophane Fallacy story not directly
but only because it locates the point on the demand curve where we calculate
elasticity and thus the degree of substitutability with alternative products.
The Merger Guideline Fallacy
The Merger Guidelines (MG) of 1982 introduced an unusually innovative
method for defining the relevant market, based on the comparison between the
current price (at the moment of evaluation) and the monopoly price. If the
difference between these two prices exceeds an arbitrary threshold (between 5 and
10 percent), the provisional definition of the market is confirmed. If, on the other
hand, the difference is lower than the threshold, the definition of the relevant
market is broadened by including other products capable of substituting the
product under analysis. Using a narrower definition of the market, it is argued,
would make it impossible to detect the degree to which demand for the
monopolists product is affected by competition from possible substitutes.
The MG test can be expressed as follows:
(1) Pm/Pc 1+x

Also Landes-Posner (1981), pp. 942 and 960-961.

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where

Pm = monopoly price
Pc = current price
x = an arbitrary threshold for the difference
between Pm and Pc (5-10 %)

If (1) is fulfilled a monopolist would have the power to increase the price
significantly; the provisional definition of the relevant market is thus confirmed.
It is easy to see that this argument is a fallacy, leading to a broader
definition of the relevant market for less competitive than for more competitive
markets. On markets where competition is weak the current price will be very
close to the monopoly price, the inequality (1) will not be fulfilled and the
definition of the relevant market will have to be broadened. It should be noted
however that this conclusion does not depend on changes in elasticity along the
demand curve. To see why, remember that the monopoly price (Pm) has to satisfy
the following well-known relationship:
(2a) (Pm-c)/Pm= 1/em

where:

c = marginal cost
em = demand elasticity
monopoly price

at

the

This implies:
(2b) Pm = em c / (em -1)
To simplify our treatment we will consider a Cournot oligopoly where the
degree of competition is represented by an indicator of concentration in market
share (H). In a Cournot oligopoly we have:
(3a)

(Pc - c)/Pc = H / ec where

H = the Herfindhal-Hirschmann
concentration ratio
c
e = demand elasticity at the current
price

This leads to:

(3b)

Pc = ec c / (ec - H)
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Combining (1)-(3) we obtain.

(4) (m / (m -1)) * (1- H /c) 1+x
In other words the MG test is a combined test of demand elasticity at the
monopoly price (the first element on the left hand side of (4), market
concentration (H) used here as a proxy for the intensity of competition, and
demand elasticity at the current price (c).
If we suppose that the demand curve is isoelastic ( m = c) we escape from
the Cellophane Fallacy. (4) thus becomes:
where = =
m

(4a) ( / ( -1)) - H /( -1) / 1+x

This test is based on demand elasticity and on the concentration ratio. As

demand elasticity increases the ratio ( / ( -1)) on the left hand side of the equation
falls. As a consequence the size of the relevant market will be broadened. This
first element of the test is entirely satisfactory broadening the market as the
degree of substitutability increases is correct. The inclusion of the concentration
ratio is, on the contrary, highly problematic, the effect being to broaden the
definition of the relevant market precisely on those markets where firms already
enjoy market power. As a consequence the probability of detecting a dominant
position will shrink. This fallacy it must be stressed cannot be attributed to
changes in demand elasticity which in this case is constant. We cannot blame the
Cellophane Fallacy.
It has been proposed that the problem just described could be solved by
comparing the monopoly price not with the current price but with the price (equal
to marginal cost) which would prevail in a perfectly competitive environment:
(5)

Pm/c 1+x

which implies:
(6) e / (e -1) 1 + x
This remedy has been suggested by several antitrust practitioners and agencies.
According to the 1992 Merger Guidelines: the Agency will use prevailing prices
of the products (...) unless pre-merger circumstances are strongly suggestive of
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co-ordinated interaction, in which case the Agency will use a price more
reflective of the competitive forces.3
As a number of authors have already argued, however, the evaluation of
marginal cost (used to infer the price under perfect competition) is a difficult and
tricky task4. Worse, in cases where it is necessary to consider different kinds of
goods belonging to the same market (e.g. plastic and leather shoes) we have to
consider several different marginal costs; the same problem arises when different
firms have different marginal costs.5
Where the demand curve is isoelastic there exists an easier and more
pratical way of correcting the distortions arising from the MG test. The idea is to
adjust the threshold to the degree of market concentration. Applying this
correction the MG test is re-formulated as follows:
(7) Pm/Pc 1 + x (1-H)
Thus:
(8) (e - H)/(e - 1) 1 + x (1- H)
and
(9) e / (e - 1) 1 + x
This test, like the test formulated in (6), is based on the comparison between
monopoly and perfect competition prices. The advantage of the proposed
approach, which can be properly applied only if there is no Cellophane Fallacy, is
that it avoids the need to analyse marginal costs. In comparison, finding a proper
value for the concentration ratio (used to represent the intensity of competition)
seems a more affordable task. The logic of the corrected test is easily
understandable: the threshold, used to test the correct definition of the relevant
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The European Commission quite clearly detects the problem. As to the solution it shows
admirable vagueness:
Generally and in particular for the analysis of merger cases, the price to take into account will
be the prevailing market price. This might not be the case where the prevailing price has been
determined in the absence of sufficient competition. In particular for investigation of abuses of
dominant positions, the fact that the prevailing price might already have been substantially
increased will be taken into account. (European Commission, 1997).
4
Fisher (1987), Schmalensee (1987).
5
In this case how we define the relevant market ? Taking in account the costs of the efficient
firm or the inefficient ones?
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market, is lower for concentrated than for less concentrated markets. Once the
distortion caused by market concentration has been eliminated the M.G. test is
nothing more than a test of demand elasticity.
But let us now return to the general case where demand elasticity is not
constant but changes at different points along the demand curve. Given that c
(unlike H) is positively related to the value of the MG test, in this test changes in
demand elasticity play an opposite role to the one they play in the Cellophane
Fallacy. For high values of H the distortion due to the presence of H becomes less
and less important the greater is the increase in current elasticity. This correction is
not however sufficient to completely eliminate the distortion. This becomes
apparent if we use a new version of (4):
10) (m / (m -1)) * (1 - Lc) / 1+x where Lc = Lerner index at the current price
Given the presence of Lc, an indicator of market power, the corrected M.G.
test continues to contain a fallacy when applied to demand curves with nonconstant elasticity. As in the previous case it is possible to remove the distortion
by substituting the current price with the perfect competition price (equal to
marginal cost). A similar result can also be obtained by reducing the threshold
value (x ) of the test.
10a) ( / ( -1)) * (1 - Lc) / (1+x) (1 - Lc)
m

Both corrections are similar and require knowledge of marginal costs.

Conclusions
In the history of economic thought misunderstandings are often due to the
cumulative nature of the process whereby ideas gain currency. In some instances,
what in the beginning are nothing more than different perspectives, can evolve
into real mistakes, as happened with the Coase Theorem (Coase,1988,pp.13-15).
The confusion between Cellophane Fallacy and MGF is much less serious. In both
cases the distortions operate in the same direction. It is nonetheless useful to
analyse the causes underlying these distortions. This in turn requires that the two
fallacies be distinguished. The recognition of this distinction makes it possible to
evaluate their effective importance and to find the proper solutions. In this paper
we have shown that the MGF does not depend on changes in the elasticity of
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demand. On the contrary it is the result of the inclusion, in the test, of a component
(H or L) which increases in direct proportion to the market power of the firms
under examination. In the case of isoelastic demand functions (when there is no
Cellophane Fallacy) we have shown that the distortion of the MG test can be
corrected by incorporating an indicator of market competition (H) in the
calculation of the threshold. In the other, more general, case the only possible
correction is to analyse the theoretical price under perfect competition. This
may, however, be difficult to accomplish in practice.
Concluding this short note it should be pointed out that the concept of a
relevant market is difficult to apply not only because of the fallacies discussed
above, but because it suffers from the inherent limitations of structural analysis.
In particular it seems unable to properly detect the market power of a firm in the
presence of diversified products and company strategies (Sabbatini, 1999). It
should never be forgotten that the economists original concept of a market was
strongly associated with perfect competition. Given this association, the concept
may be a poor tool for analysing oligopolistic and monopolistic environments. The
proper evaluation of market power in antitrust cases requires a different
conceptual apparatus.
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