Slade: The Draft Vertical Merger Guidelines Are a Step in the Right Direction, But Uneven on Critical Issues

Margaret Slade —  6 February 2020 — Leave a comment

[TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

This post is authored by Margaret E. Slade (Professor Emeritus, Vancouver School of Economics, The University of British Columbia).]

A revision of the DOJ’s Non-Horizontal Merger Guidelines is long overdue and the Draft Vertical Merger Guidelines (“Guidelines”) takes steps in the right direction. However, the treatment of important issues can be uneven. For example, the discussions of market definition and shares are relatively thorough whereas the discussions of anti-competitive harm and pro-competitive efficiencies are more vague.

Market definition, market shares, and concentration

The Guidelines are correct in deferring to the Horizontal Merger Guidelines for most aspects of market definition, market shares, and market concentration. The relevant sections of the Horizontal Guidelines are not without problems. However, it would make no sense to use different methods and concepts to delineate horizontal markets that are involved in vertical mergers compared to those that are involved in horizontal mergers.  

One aspect of market definition, however, is new: the notion of a related product, which is a product that links the up and downstream firms. Such products might be inputs, distribution systems, or sets of customers. The Guidelines set thresholds of 20% for the related product’s share, as well as the parties’ shares, in the relevant market. 

Those thresholds are, of course, only indicative and mergers can be investigated when markets are smaller. In addition, mergers that fail to meet the share tests need not be challenged. It would therefore be helpful to have a list of factors that could be used to determine which mergers that fall below those thresholds are more likely to be investigated, and vice versa. For example, the EU Vertical Merger Guidelines list circumstances, such as the existence of significant cross-shareholding relationships, the fact that one of the firms is considered to be a maverick, and suspicion that coordination is ongoing, under which mergers that fall into the safety zones are more apt to be investigated.

Elimination of double marginalization and other efficiencies

Although the elimination of double marginalization (EDM) is a pricing externality that does not change unit costs, the Guidelines discuss EDM as the principal `efficiency’ or at least they have more to say about that factor. Furthermore, after discussing EDM, the Guidelines note that the full EDM benefit might not occur if the downstream firm cannot use the product or if the parties are already engaged in contracting. The first factor is obvious and the second implies that the efficiency is not merger specific. In practice, however, antitrust and regulatory policy has tended to apply the EDM argument uncritically, ignoring several key assumptions and issues.

The simple model of EDM relies on a setting in which there are two monopolists, one up and one downstream, each produces a single product, and production is subject to fixed proportions. This model predicts that welfare will increase after a vertical merger. If these assumptions are violated, however, the predictions change (as John Kwoka and I discuss in more detail here). For example, under variable proportions the unintegrated downstream firm can avoid some of the adverse effects of the inflated wholesale price by substituting away from use of that product, and the welfare implications are ambiguous. Moreover, managerial considerations such as independent pricing by divisions can lead to less-than-full elimination of double marginalization.  

With multi-product firms, the integrated firm’s average downstream prices need not fall and can even rise when double marginalization is eliminated. To illustrate, after EDM the products with eliminated margins become relatively more profitable to sell. This gives the integrated firm incentives to divert demand towards those products by increasing the prices of its products for which double marginalization was not eliminated. Moreover, under some circumstances, the integrated downstream price can also rise.

Since violations of the simple model are present in almost all cases, it would be helpful to include a more complete list of factors that cause the simple model — the one that predicts that EDM is always welfare improving — to fail.

Unlike the case of horizontal mergers, with vertical mergers, real productive efficiencies on the supply side are often given less attention. Those efficiencies, which include economies of scope, the ability to coordinate other aspects of the vertical chain such as inventories and distribution, and the expectation of productivity growth due to knowledge transfers, can be important

Moreover, organizational efficiencies, such as mitigating contracting, holdup, and renegotiation costs, facilitating specific investments in physical and human capital, and providing appropriate incentives within firms, are usually ignored. Those efficiencies can be difficult to evaluate. Nevertheless, they should not be excluded from consideration on that basis.

Equilibrium effects

On page 4, the Guidelines suggest that merger simulations might be used to quantify unilateral price effects of vertical mergers. However, they have nothing to say about the pitfalls. Unfortunately, compared to horizontal merger simulations, there are many more assumptions that are required to construct vertical simulation models and thus many more places where they can go wrong. In particular, one must decide on the number and identity of the rivals; the related products that are potentially disadvantaged; the geographic markets in which foreclosure or raising rivals’ costs are likely to occur; the timing of moves: whether up and downstream prices are set simultaneously or the upstream firm is a first mover; the link between up and downstream: whether bargaining occurs or the upstream firm makes take-it-or-leave-it offers; and, as I discuss below, the need to evaluate the raising rivals’ costs (RRC) and elimination of double marginalization (EDM) effects simultaneously.

These choices can be crucial in determining model predictions. Indeed, as William Rogerson notes (in an unpublished 2019 draft paper, Modeling and Predicting the Competitive Effects of Vertical Mergers Due to Changes in Bargaining Leverage: The Bargaining Leverage Over Rivals (BLR) Effect), when moves are simultaneous, there is no RRC effect. This is true because, when negotiating over input prices, firms take downstream prices as given. 

On the other hand, bargaining introduces a new competitive effect — the bargaining leverage effect — which arises because, after a vertical merger, the disagreement payoff is higher. Indeed, the merged firm recognizes the increased profit that its downstream integrated division will earn if the input is withheld from the rival. In contrast, the upstream firm’s disagreement payoff is irrelevant when it has all of the bargaining power.

Finally, on page 5, the Guidelines describe something that sounds like a vertical upward pricing pressure (UPP) index, analogous to the GUPPI that has been successfully employed in evaluating horizontal mergers. However, extending the GUPPI to a vertical context is not straightforward

To illustrate, Das Varma and Di Stefano show that a sequential process can be very misleading, where a sequential process consists of first calculating the RRC effect and, if that effect is substantial, evaluating the EDM effect and comparing the two. The problem is that the two effects are not independent of one another. Moreover, when the two are determined simultaneously, compared to the sequential RRC, the equilibrium RRC can increase or decrease and can even change sign (i.e., lowering rival costs).What these considerations mean is that vertical merger simulations have to be carefully crafted to fit the markets that are susceptible to foreclosure and that a one-size-fits-all model can be very misleading. Furthermore, if a simpler sequential screening process is used, careful consideration must be given to whether the markets of interest satisfy the assumptions under which that process will yield approximately reasonable results.

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