The "diversion ratio analysis" is a basic tool used to simulate the effects of a merger between firms producing differentiated products. It measures in the case of an increase in price the loss of sales of a product towards another product.
The method consists of a four-step procedure (described in the context of a merger between brand A and brand B):
- Estimate the fraction of brand A´s sales that would be diverted to brand B as a result of a price increase in brand A. This is the diversion ratio. This ratio can be obtained by econometric estimation of elasticities, consumer survey data, or other documents concerning consumers’ first and second brand choices. Furthermore, market shares are often used as a criterion to determine the proportion of sales diverted from one brand to the other (this refers to the assumption of proportionality).
- Use the estimated diversion ratio, along with pre-merger margins, to predict post-merger prices, ignoring cost savings, or a rival’s response.
- Take into account the product repositioning and potential market entry.
- Allow for potential efficiency gains likely to ensure as a result of the merger.
In general, the diversion ratio provides a rough estimate of post-merger prices. Its accuracy is limited by the extent to which the proportionality assumption holds in reality. Furthermore, there is great uncertainty about post-merger product repositioning and market entry which may introduce a bias in the estimation of the merger's unilateral effects. A diversion ratio analysis complements the analysis but does not replace merger modelling.