Manne & Stout 2: Against Incorporating a Contract/Merger Equivalency Assumption in Vertical Merger Guidelines

In our first post, we discussed the weaknesses of an important theoretical underpinning of efforts to expand vertical merger enforcement (including, possibly, the proposed guidelines): the contract/merger equivalency assumption.

In this post we discuss the implications of that assumption and some of the errors it leads to — including some incorporated into the proposed guidelines.

There is no theoretical or empirical justification for more vertical enforcement

Tim Brennan makes a fantastic and regularly overlooked point in his post: If it’s true, as many claim (see, e.g., Steve Salop), that firms can generally realize vertical efficiencies by contracting instead of merging, then it’s also true that they can realize anticompetitive outcomes the same way. While efficiencies have to be merger-specific in order to be relevant to the analysis, so too do harms. But where the assumption is that the outcomes of integration can generally be achieved by the “less-restrictive” means of contracting, that would apply as well to any potential harms, thus negating the transaction-specificity required for enforcement. As Dennis Carlton notes:

There is a symmetry between an evaluation of the harms and benefits of vertical integration. Each must be merger-specific to matter in an evaluation of the merger’s effects…. If transaction costs are low, then vertical integration creates neither benefits nor harms, since everything can be achieved by contract. If transaction costs exist to prevent the achievement of a benefit but not a harm (or vice-versa), then that must be accounted for in a calculation of the overall effect of a vertical merger. (Dennis Carlton, Transaction Costs and Competition Policy)

Of course, this also means that those (like us) who believe that it is not so easy to accomplish by contract what may be accomplished by merger must also consider the possibility that a proposed merger may be anticompetitive because it overcomes an impediment to achieving anticompetitive goals via contract.

There’s one important caveat, though: The potential harms that could arise from a vertical merger are the same as those that would be cognizable under Section 2 of the Sherman Act. Indeed, for a vertical merger to cause harm, it must be expected to result in conduct that would otherwise be illegal under Section 2. This means there is always the possibility of a second bite at the apple when it comes to thwarting anticompetitive conduct. 

The same cannot be said of procompetitive conduct that can arise only through merger if a merger is erroneously prohibited before it even happens. 

Interestingly, Salop himself — the foremost advocate today for enhanced vertical merger enforcement — recognizes the issue raised by Brennan: 

Exclusionary harms and certain efficiency benefits also might be achieved with vertical contracts and agreements without the need for a vertical merger…. It [] might be argued that the absence of premerger exclusionary contracts implies that the merging firms lack the incentive to engage in conduct that would lead to harmful exclusionary effects. But anticompetitive vertical contracts may face the same types of impediments as procompetitive ones, and may also be deterred by potential Section 1 enforcement. Neither of these arguments thus justify a more or less intrusive vertical merger policy generally. Rather, they are factors that should be considered in analyzing individual mergers. (Salop & Culley, Potential Competitive Effects of Vertical Mergers)

In the same article, however, Salop also points to the reasons why it should be considered insufficient to leave enforcement to Sections 1 and 2, instead of addressing them at their incipiency under Clayton Section 7:

While relying solely on post-merger enforcement might have appealing simplicity, it obscures several key facts that favor immediate enforcement under Section 7.

• The benefit of HSR review is to prevent the delays and remedial issues inherent in after-the-fact enforcement….
• There may be severe problems in remedying the concern….
• Section 1 and Section 2 legal standards are more permissive than Section 7 standards….
• The agencies might well argue that anticompetitive post-merger conduct was caused by the merger agreement, so that it would be covered by Section 7….

All in all, failure to address these kinds of issues in the context of merger review could lead to significant consumer harm and underdeterrence.

The points are (mostly) well-taken. But they also essentially amount to a preference for more and tougher enforcement against vertical restraints than the judicial interpretations of Sections 1 & 2 currently countenance — a preference, in other words, for the use of Section 7 to bolster enforcement against vertical restraints of any sort (whether contractual or structural).

The problem with that, as others have pointed out in this symposium (see, e.g., Nuechterlein; Werden & Froeb; Wright, et al.), is that there’s simply no empirical basis for adopting a tougher stance against vertical restraints in the first place. Over and over again the empirical research shows that vertical restraints and vertical mergers are unlikely to cause anticompetitive harm: 

In reviewing this literature, two features immediately stand out: First, there is a paucity of support for the proposition that vertical restraints/vertical integration are likely to harm consumers. . . . Second, a far greater number of studies found that the use of vertical restraints in the particular context studied improved welfare unambiguously. (Cooper, et al, Vertical Restrictions and Antitrust Policy: What About the Evidence?)

[W]e did not have a particular conclusion in mind when we began to collect the evidence, and we… are therefore somewhat surprised at what the weight of the evidence is telling us. It says that, under most circumstances, profit-maximizing, vertical-integration decisions are efficient, not just from the firms’ but also from the consumers’ points of view…. We therefore conclude that, faced with a vertical arrangement, the burden of evidence should be placed on competition authorities to demonstrate that that arrangement is harmful before the practice is attacked. (Francine Lafontaine & Margaret Slade, Vertical Integration and Firm Boundaries: The Evidence)

[Table 1 in this paper] indicates that voluntarily adopted restraints are associated with lower costs, greater consumption, higher stock returns, and better chances of survival. (Daniel O’Brien, The Antitrust Treatment of Vertical Restraint: Beyond the Beyond the Possibility Theorems)

In sum, these papers from 2009-2018 continue to support the conclusions from Lafontaine & Slade (2007) and Cooper et al. (2005) that consumers mostly benefit from vertical integration. While vertical integration can certainly foreclose rivals in theory, there is only limited empirical evidence supporting that finding in real markets. (GAI Comment on Vertical Mergers)

To the extent that the proposed guidelines countenance heightened enforcement relative to the status quo, they fall prey to the same defect. And while it is unclear from the fairly terse guidelines whether this is animating them, the removal of language present in the 1984 Non-Horizontal Merger Guidelines acknowledging the relative lack of harm from vertical mergers (“[a]lthough non-horizontal mergers are less likely than horizontal mergers to create competitive problems…”) is concerning.  

The shortcomings of orthodox economics and static formal analysis

There is also a further reason to think that vertical merger enforcement may be more likely to thwart procompetitive than anticompetitive arrangements relative to the status quo ante (i.e., where arrangements among vertical firms are by contract): Our lack of knowledge about the effects of market structure and firm organization on innovation and dynamic competition, and the relative hostility to nonstandard contracting, including vertical integration:

[T]he literature addressing how market structure affects innovation (and vice versa) in the end reveals an ambiguous relationship in which factors unrelated to competition play an important role. (Katz & Shelanski, Mergers and Innovation)

The fixation on the equivalency of the form of vertical integration (i.e., merger versus contract) is likely to lead enforcers to focus on static price and cost effects, and miss the dynamic organizational and informational effects that lead to unexpected, increased innovation across and within firms. 

In the hands of Oliver Williamson, this means that understanding firms in the real world entails taking an organization theory approach, in contrast to the “orthodox” economic perspective:

The lens of contract approach to the study of economic organization is partly complementary but also partly rival to the orthodox [neoclassical economic] lens of choice. Specifically, whereas the latter focuses on simple market exchange, the lens of contract is predominantly concerned with the complex contracts. Among the major differences is that non?standard and unfamiliar contractual practices and organizational structures that orthodoxy interprets as manifestations of monopoly are often perceived to serve economizing purposes under the lens of contract. A major reason for these and other differences is that orthodoxy is dismissive of organization theory whereas organization theory provides conceptual foundations for the lens of contract. (emphasis added)

We are more likely to miss it when mergers solve market inefficiencies, and more likely to see it when they impose static costs — even if the apparent costs actually represent a move from less efficient contractual arrangements to more efficient integration.

The competition that takes place in the real world and between various groups ultimately depends upon the institution of private contracts, many of which, including the firm itself, are nonstandard. Innovation includes the discovery of new organizational forms and the application of old forms to new contexts. Such contracts prevent or attenuate market failure, moving the market toward what economists would deem a more competitive result. Indeed, as Professor Coase pointed out, many markets deemed “perfectly competitive” are in fact the end result of complex contracts limiting rivalry between competitors. This contractual competition cannot produce perfect results — no human institution ever can. Nonetheless, the result is superior to that which would obtain in a (real) world without nonstandard contracting. These contracts do not depend upon the creation or enhancement of market power and thus do not produce the evils against which antitrust law is directed. (Alan Meese, Price Theory Competition & the Rule of Reason)

Or, as Oliver Williamson more succinctly puts it:

[There is a] rebuttable presumption that nonstandard forms of contracting have efficiency purposes. (Oliver Williamson, The Economic Institutions of Capitalism)

The pinched focus of the guidelines on narrow market definition misses the bigger picture of dynamic competition over time

The proposed guidelines (and the theories of harm undergirding them) focus upon indicia of market power that may not be accurate if assessed in more realistic markets or over more relevant timeframes, and, if applied too literally, may bias enforcement against mergers with dynamic-innovation benefits but static-competition costs.  

Similarly, the proposed guidelines’ enumeration of potential efficiencies doesn’t really begin to cover the categories implicated by the organization of enterprise around dynamic considerations. 

The proposed guidelines’ efficiencies section notes that:

Vertical mergers bring together assets used at different levels in the supply chain to make a final product. A single firm able to coordinate how these assets are used may be able to streamline production, inventory management, or distribution, or create innovative products in ways that would have been hard to achieve though arm’s length contracts. (emphasis added)

But it is not clear than any of these categories encompasses organizational decisions made to facilitate the coordination of production and commercialization when they are dependent upon intangible assets.

As Thomas Jorde and David Teece write:

For innovations to be commercialized, the economic system must somehow assemble all the relevant complementary assets and create a dynamically-efficient interactive system of learning and information exchange. The necessary complementary assets can conceivably be assembled by either administrative or market processes, as when the innovator simply licenses the technology to firms that already own or are willing to create the relevant assets. These organizational choices have received scant attention in the context of innovation. Indeed, the serial model relies on an implicit belief that arm’s-length contracts between unaffiliated firms in the vertical chain from research to customer will suffice to commercialize technology. In particular, there has been little consideration of how complex contractual arrangements among firms can assist commercialization — that is, translating R&D capability into profitable new products and processes….

* * *

But in reality, the market for know-how is riddled with imperfections. Simple unilateral contracts where technology is sold for cash are unlikely to be efficient. Complex bilateral and multilateral contracts, internal organization, or various hybrid structures are often required to shore up obvious market failures and create procompetitive efficiencies. (Jorde & Teece, Rule of Reason Analysis of Horizontal Arrangements: Agreements Designed to Advance Innovation and Commercialize Technology) (emphasis added)

When IP protection for a given set of valuable pieces of “know-how” is strong — easily defendable, unique patents, for example — firms can rely on property rights to efficiently contract with vertical buyers and sellers. But in cases where the valuable “know how” is less easily defended as IP — e.g. business process innovation, managerial experience, distributed knowledge, corporate culture, and the like — the ability to partially vertically integrate through contract becomes more difficult, if not impossible. 

Perhaps employing these assets is part of what is meant in the draft guidelines by “streamline.” But the very mention of innovation only in the technological context of product innovation is at least some indication that organizational innovation is not clearly contemplated.  

This is a significant lacuna. The impact of each organizational form on knowledge transfers creates a particularly strong division between integration and contract. As Enghin Atalay, Ali Hortaçsu & Chad Syverson point out:

That vertical integration is often about transfers of intangible inputs rather than physical ones may seem unusual at first glance. However, as observed by Arrow (1975) and Teece (1982), it is precisely in the transfer of nonphysical knowledge inputs that the market, with its associated contractual framework, is most likely to fail to be a viable substitute for the firm. Moreover, many theories of the firm, including the four “elemental” theories as identified by Gibbons (2005), do not explicitly invoke physical input transfers in their explanations for vertical integration. (Enghin Atalay, et al., Vertical Integration and Input Flows) (emphasis added)

There is a large economics and organization theory literature discussing how organizations are structured with respect to these sorts of intangible assets. And the upshot is that, while we start — not end, as some would have it — with the Coasian insight that firm boundaries are necessarily a function of production processes and not a hard limit, we quickly come to realize that it is emphatically not the case that integration-via-contract and integration-via-merger are always, or perhaps even often, viable substitutes.

Conclusion

The contract/merger equivalency assumption, coupled with a “least-restrictive alternative” logic that favors contract over merger, puts a thumb on the scale against vertical mergers. While the proposed guidelines as currently drafted do not necessarily portend the inflexible, formalistic application of this logic, they offer little to guide enforcers or courts away from the assumption in the important (and perhaps numerous) cases where it is unwarranted.