The economics of nonhorizontal merger guidelines

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The economics of non-horizontal merger guidelines

• Nikos Vettas
• Professor, Athens University of Economics and
  Business, Greece and
• Member, European Advisory Group in Competition
  Policy (Chief Economist Group, DG-Competition)
• Research Fellow, Centre for Economic Policy
  Research, London
• Athens, June 2 2007

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The issue non-horizontal merger guidelines

• Non-horizontal mergers
• - vertical
• - conglomerate
• EU guidelines?
• Compare to Horizontal merger guidelines
• Compare to US non-horizontal guidelines

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European Commission public consultation

• Draft merger guidelines circulated February 2007
• Public consultation
• - started February 13, 2007
• - ended May 12, 2007
• Commissioner Neelie Kroes providing clear and
  predictable guidance for businesses
• DG - Enterprise and Industry The
  Efficiency-Enhancing Effects of Non-Horizontal
  Mergers (RBB Economics report)

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EAGCP preliminary paper (advisory note)

• ? EAGCP (Economic Advisory Group in Competition
  Policy)
• ? Mergers subgroup
• Marc Ivaldi (University of Toulouse)
• Bruce Lyons (University of East Anglia)
• Monika Schnitzer (University of Munich)
• John Van Reenen (London School of Economics)
• Frank Verboven (University of Leuven)
• Nikos Vettas (Athens University of Economics and
  Business)
• Xavier Vives (IESE Business School, Barcelona)
• ? First set of (ten) general principles Spring
  2006
• First, on key economic differences between
  horizontal mergers and NHM.
• Second, on what the guidelines should achieve.
• ? Personal views

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1. The competitive impact of NHM is fundamentally
different from that of HM.

• The presumption in a horizontal merger is that it
  directly leads to increased market power and an
  ability to raise prices
• If the merging parties have market power, a
  horizontal merger will typically remove the
  competitive pricing restraints parties place on
  each other.
• This is not the case for a non-horizontal merger.
  
• Horizontal mergers are among substitutes,
  non-horizontal mergers are among complements.
• Enhancing efficiency is expected.
• Principle backed both by economic theory and some
  empirical evidence.
• The competitive effects of non-horizontal mergers
  will depend on characteristics of the situation
  examined.
• Important NHM parties often have previous
  contractual relationships, in which case the
  competitive change following a merger will be
  muted. Parties to a horizontal merger typically
  do not have prior contracts.

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2. NHM have indirect impact on competition.

• A horizontal merger can harm competition by its
  direct impact on the incentive to raise price.
• A non-horizontal merger has no direct impact on
  pricing.
• It may still cause competitive harm through a
  change in supply or procurement policy, or the
  way in which a product range is offered to
  consumers. Then, cost or demand of rivals is
  affected and their pricing changes.
• The merged firm sometimes has the incentive to
  soften price competition in the downstream market
  in order to protect its upstream profits. This
  situation may be difficult to track, since the
  downstream firm has no incentives to complain.
• The effect of non-horizontal mergers on
  competitive conditions tends to be limited, since
  NHM parties often have previous contractual
  relationship, e.g. that limits buyer or supplier
  switching, whereas HM parties usually do not have
  prior contract.
• Indirect effects of non-horizontal mergers can
  potentially impede effective competition, but
  they require a particularly careful analysis in
  order to justify a likelihood of harm.

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3. Non-horizontal mergers take many forms and
produce a variety of effects.

• There are canonical models for horizontal
  merger (Bertrand with differentiated products or
  Cournot with homogenous products and capacity
  constraints). Much more difficult to analyze
  non-horizontal mergers, there are many possible
  effects.
• The Chicago School (no harm) models for NHM
  specify conditions under which there is no loss
  of competition due to a non-horizontal merger.
• Monopoly profits can be taken only once along a
  vertically linked chain
• Vertical integration can reduce distortions by
  eliminating double marginalization.
• Vertical integration often results to production
  and organization efficiencies.
• Note the same reasoning applies to mergers
  between complements.
• The Chicago approach relies on particular
  assumptions. In practice, the appropriate theory
  of competitive harm must be carefully tuned to
  the merger in question.

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4. Market power in an existing market is a
pre-requisite for competitive harm from
foreclosure.

• This well-established fact provides an essential
  filter for screening out spurious concerts.
• Market power is a necessary, but not sufficient
  condition for foreclosure.
• When there is market power at both stages of the
  vertical chain, vertical integration helps to
  avoid double marginalization (that often exists
  in absence of sophisticated contracts) and thus
  results to efficiency gains.
• Even in the presence of market power, merging
  firms need not have the incentive to take actions
  that would reduce the market available to rivals
  and even if this is a likely consequence, it need
  not result in consumer harm.

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The main vertical externality double
marginalization

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Remarks

• Double marginalization with linear pricing, we
  obtain final prices that are too high for the
  final consumers and also for the sellers.
• Worse than VI monopoly.
• Distortion increasing with the number of stages
• This problem can be resolved with
• - vertical integration
• - nonlinear pricing a two-part tariff
• Who sets the prices? Bargaining?
• Only problem if market power at both stages.

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Adding horizontal strategic competition

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Multiple downstream

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Common Agency / bottlenecks

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Other structures

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5. Stronger efficiency arguments for
non-horizontal mergers than for horizontal
mergers.

• Modern theory of firm and empirical evidence
  inform us that firm as an institution exists due
  to incomplete contracts and transaction costs,
  which make it more efficient to carry out certain
  activities coordinated within a firm as opposed
  to through markets.
• If complete contracts could be written (at low
  cost), the need to organize economic activities
  within firms would be limited. However, contracts
  that specify a precise outcome for each possible
  future contingency are too expensive.
• The efficient range of activities carried out
  within a firm may change over time. A
  non-horizontal merger may be efficiency-enhancing.
  
• The downside of a decision error that prohibits a
  merger is likely to be much greater for NHM than
  for horizontal mergers.

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Example specific investments

• Assurance of quantity, quality and time of supply
• Specific production
• Specific assets danger of opportunistic behavior
  (hold-up) implies below optimal investment
  incentives (Coase, vertical boundaries of the
  firm Williamson Grossman-Hart)
• Solution? VI? Long-term contracts? Short-term
  contracts?
• Single sourcing (exclusivity) vs. multiple
  sources.

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6. NHM Guidelines could enhance the accuracy and
predictability of decisions.

• Major difficulties inherent in writing detailed
  guidelines.
• Difficulties based on the very nature of
  non-horizontal mergers and the multiplicity of
  forms they may take.
• Difficulties are reflected on the current state
  of the academic literature.
• Having a suitable set of principles to deal with
  NHM is important.
• They will contribute towards predictability of
  decisions and consistency.
• Predictability is important, especially to
  businesses and their advisors.
• Case handlers need guidance.
• Good guidance will be useful for authorities
  beyond DG-Competition.

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7. Guidelines should focus on competitive effects
resulting in benefit or harm to consumers (and
not to competitors).

• Efficiencies that lead to reduction in prices or
  to more attractive product offering may lead to
  reduction of competitors market share, but are
  to be welcomed as consumer benefit.
• Elimination of double-marginalization can create
  an incentive to reduce customer prices.
• Not always a double margin to be eliminated, even
  in the presence of imperfect competition, because
  parties have an incentive to contract around this
  source of inefficiency.
• Pre-merger contracts are very relevant and
  important in this context.
• Depending on the particular type of market
  structure under investigation studies, double
  marginalization does not necessarily reduce the
  profits of the firms involved.

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7. (and not to competitors).

• Particularly important to recognise the benefits
  of anticipated customer price reductions because
  competitors anticipating lost market share have a
  strong incentive to complain loudly to the
  Commission.
• An expectation of consumer harm needs very
  careful support.

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8. Guidelines should indicate the methodology of
analysis and the relevant evidence.

• For actions harmful to consumers, both the
  ability and the incentive of merged firms to take
  such actions should be established.
• Each particular scenario of harm should rely on a
  package of pre-requisites, e.g. market share,
  product differentiation, feasibility of bundling,
  margins.
• Other useful information to be considered
  existing contracts, sales practices, procurement
  methods, natural experiments.
• The assessment of the effects of a vertical
  merger must not presume consumer harm and then
  look for countervailing efficiencies. In other
  words, the model used to analyze a vertical
  merger must allow for potential efficiencies from
  the start and not for competitive harm only.

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9. Guidelines should distinguish more likely
from less likely competitive harm whenever
possible.

• Qualitative guidance may be provided on the
  relative risks of different types of harm (e.g.
  there is usually far greater concern if
  foreclosure results in exit, as opposed to
  changes in market share).
• Safe harbours might be indicated, at least in
  relation to the pre-requisite of market power.
• If none of the firms involved in a merger has
  significant market power in any of the markets,
  then there is almost always no need for a
  competition authority to scrutinize this
  particular merger.
• If after a vertical merger the upstream market is
  supplied by vertically integrated firms only,
  there is a risk that upstream firms could sustain
  higher prices for the upstream products, forcing
  (not vertically integrated) downstream firms to
  raise their final prices. Hence the number of
  firms acting in the different markets plays a
  crucial role.
• Overall, the scale of likelihood should tie
  appropriately with the required standard of proof
  for the Commission.

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10. Non-horizontal Guidelines should be
consistent with other Guidelines / Notices /
Green Papers.

• The horizontal merger guidelines can be
  interpreted to define existing market power in
  the context of a non-horizontal merger case (even
  though those guidelines deal directly with
  changes to market power, not the existence of
  market power).
• There might be some important links to Article
  82, as firms may find ways to establish vertical
  relationships among themselves (e.g. long-term
  specific contracts) that possibly replicate part
  of what would be achieved via a merger.
• There should also be consistency with notices on
  vertical restraints.

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Concluding remarks

• On the role of guidelines.
• On the role of competition policy (in the general
  mix of economic policy).
• Competition, free market!
• Rules to be clear and application of policy
  should be transparent, consistent, efficient and
  predictable.
• Regulatory cost as an entry cost.
• Entry! Innovation!