Yesterday, Lina Khan’s FTC released their long-awaited draft merger guidelines for public comment. Regrettably yet not unsurprisingly, the new guidelines are a radical departure from established case law and antitrust thinking. They’re marked by a failure to account for the role of efficiencies in the competitive process, and a failure to distinguish between the implications of generally pro-competitive vertical mergers and horizontal mergers. If the FTC’s 0-4 losing track record in merger litigation so far is any indication, then they’re likely to be struck down by courts nationwide.
On July 19, the District Court for the Northern District of California denied the FTC’s bid to enjoin Microsoft’s vertical acquisition of video game publisher Activision. The court rejected the FTC’s theory of harm, namely that the merger could lessen competition since Microsoft may force Activision to offer popular games, like the Call of Duty franchise, exclusively on Microsoft’s own game platforms, such as Xbox Live. Instead, it recognized evidence that Microsoft had already signed agreements to make Activision’s games available on other platforms. The court accepted the propositions that vertical mergers typically benefit consumers by creating pro-competitive efficiencies, and that a vertical merger virtually never poses a threat to competition when undertaken in competitive markets.
The court found that the merged entity lacked an incentive to foreclose its rivals from access to Activision’s game titles, since cross-platform play is important to the games’ profitability. After all, a bigger community of gamers means more challenges and opportunities to play and compete. For that reason, the court also noted that the efficiencies and leverage that the merged entity would possess make it likely that the games will reach more gamers and find a broader audience, benefiting consumers while increasing competition. Microsoft is one of the few big players in the emerging cloud gaming space. For this and other reasons, it poses a challenge to another major gaming giant, Sony, of Playstation fame. As the court noted:
Sony opposes the merger; its opposition is understandable. Before the merger Sony paid Activision for exclusive marketing rights that allowed Sony to market Call of Duty on PlayStation, but restricted Xbox’s ability to do the same. (Dkt. No. 282, 6/22/23 Tr. (Bond) at 162:19-165:8.) After the merger, the combined firm presumably will not agree to such restrictions. Before the merger, a consumer wanting to play a Call of Duty console game had to buy a PlayStation or an Xbox. After the merger, consumers can utilize the cloud to play on the device of choice, including, it is intended, on the Nintendo Switch. Perhaps bad for Sony. But good for Call of Duty gamers and future gamers.
In other words, the vertical merger would fuse two firms that don’t compete head-to-head, forging a more powerful entity that can efficiently leverage the products of one firm with the resources and greater access to novel markets of the other. This increased market penetration would mean more competition on the very metric that gamers care about- a better gaming experience resulting from a larger community of players. Moreover, rather than resulting in exclusive dealing arrangements that foreclose rivals, the deal will likely end an exclusive dealing arrangement that already exists by challenging the power of Microsoft’s competitor to extract favorable terms from Activision.
The efficiencies aren’t just an indicator that the merger could benefit consumers. They are the very metric that demonstrates competition in the market. And rejecting these efficiencies means destroying competition.
A theory of vertical mergers and efficiency
Increased efficiencies due to its greater resources and scale of operations could lead to improvements in a vertically merged firm’s product quality and output relative to price. But economist Ronald Coase also noted that firms tend to vertically integrate to reduce the cost of repeatedly coordinating and contracting with each other on the open market. In a competitive market where the firms aren’t direct competitors, the integrated entity would have incentives to pass these cost savings to consumers to bid customers away from rivals. This differs from the case of horizontal mergers between direct competitors, where a merger-specific increase in market concentration could potentially (at least in theory) enhance the ease of anticompetitive coordination among firms in the market, or allow the merging firms to achieve anticompetitive unilateral effects (where the merging parties offer close substitutes).. allow the merged entity to restrict output relative to price since it faces fewer rivals than before, provided that this wouldn’t attract the entry of new players to erode their profit margins. This is why courts and agencies like the FTC and DOJ have historically taken a more critical view of arguments that a merged entity will pass on the savings created by its efficiencies to consumers in horizontal merger cases than vertical ones.
The FTC’s war on efficiency
Current FTC and DOJ leadership are applying an increasingly skeptical and critical view of efficiencies regardless of their context. Antitrust enforcers are certainly justified in carefully scrutinizing efficiencies claims, given the self-interest that motivates them. However, the Biden administration has seen FTC and DOJ management take a much harder and more skeptical line on the very idea that efficiencies could be beneficial in any antitrust context. Consider the following statement from Commissioner Bedoya in September 2022:
I think we need to step back and question the role of efficiency in antitrust enforcement. If efficiency is so important in antitrust, then why doesn’t that word, “efficiency,” appear anywhere in the antitrust statutes that Congress actually wrote and passed? If efficiency is the goal of antitrust, then why am I charged by statute with stopping unfair methods of competition, and not “inefficient” ones? We cannot let a principle that Congress never wrote into law trump a principle that Congress made a core feature of that law. I think it is time to return to fairness.
Bedoya is right that the word efficiency doesn’t appear in the Clayton Act, Sherman Act, Robinson-Patman Act, or any other major antitrust statute. But the term “competition” is explicit, and so too is the Clayton Act’s requirement that for a merger to be unlawful, it must “substantially reduce competition.” But competition for what? In any commercial field, it can only ever refer to competing for customers’ and consumers’ dollars. And if efficiency is the very thing that enables the production of goods and services that attract customers from other businesses, then punishing efficiency for contravening “fairness” makes as much sense as punishing Tom Brady for throwing the ball better than the opposite team’s quarterback.
Outside of mergers, the FTC’s “war on efficiency” has manifested itself in the promise of renewed enforcement of the Robinson-Patman Act (RPA). The RPA is a 1936-era anti-price discrimination statute designed to punish large, more efficient sellers for negotiating exclusive discounts from their suppliers, despite longstanding bipartisan consensus that enforcing it would be likely to hurt consumers and lower American living standards by raising prices. For a comprehensive analysis of the FTC’s plans to enforce the RPA and its likely consequences across healthcare, beverage, retail and other sectors, see the RPA issues brief that I co-authored with my Mercatus Center colleague Alden Abbott.
FTC vs Amazon’s integration into logistics
Microsoft and Activision haven’t been the FTC’s only targets in policing vertical integration. Chair Khan has long singled out Amazon for the tech giant’s vertical integration across multiple lines of business, including retail shopping, online marketplace platform, Prime delivery and logistics, Prime media streaming, and more. Even though this integration has allowed Amazon to improve its offerings and attract scores of customers through greater access to goods and services, Khan takes the view that these efficiencies have instead allowed Amazon to extract more from customers by using its leverage and foreclosing rivals to restrict competition. Under her leadership, the FTC reportedly plans to sue Amazon to force the divestiture of its logistics business.
In her 2018 paper, Amazon’s Antitrust Paradox, she summarizes the leverage and foreclosure arguments against vertical integration as follows:
Leverage reflects the idea that a firm can use its dominance in one line of business to establish dominance in another. Because ‘horizontal power in one market or stage of production creates ‘leverage’ for the extension of the power to bar entry at another level’” vertical integration combined with horizontal market power ‘can impair competition to a greater extent than could the exercise of horizontal power alone.’ Foreclosure, meanwhile, occurs when a firm uses one line of business to disadvantage rivals in another line. A flour mill that also owned a bakery could hike prices or degrade quality when selling to rival bakers—or refuse to do business with them entirely. In this view, even if an integrated firm did not directly resort to exclusionary tactics, the arrangement would still increase barriers to entry by requiring would-be entrants to compete at two levels.
Khan expresses skepticism about jurist Robert Bork and the Chicago school’s arguments that these theoretical harms are unlikely to manifest. Specifically, a vertically integrated entity would preference its downstream business arm over rivals in the downstream market only if it was more cost-efficient for it to do so, and any attempt to do so to foreclose rivals and increase prices to customers would ultimately drive the entry of new rivals seeking to erode those profit margins- thus, making foreclosure an ineffective and inefficient business strategy.
This isn’t to say that vertical mergers or integration can never lead to anti-competitive consequences, that vertical mergers shouldn’t be analyzed or subjected to scrutiny at all, or that Bork and the Chicago school’s arguments aren’t without critiques. His theories don’t cover the full multitude of situations and markets where specific circumstances make strategic anti-competitive behavior more lucrative and feasible. For instance, a large firm with few rivals conceivably could gain dominance in a downstream market by purchasing an upstream market monopolist or oligopolist firm that controls one of its industry’s production inputs. It could thus theoretically harm competition by raising the prices of the input and thus raising its rivals’ costs, which would make it harder for those firms to compete for customers cost-effectively. Purchasing the patent-holding firm for a crucial technological input that is necessary for complying with a global standard for the downstream firm’s technology product might be an example of this. Complex highly speculative game-theoretic tales of potential competitive harm achieved through vertical contracts and full vertical integration abound.
However, these are situations that reflect niche or particular circumstances that can only be ascertained through comprehensive quantitative analysis of the relevant market, current and likely conduct of the firms involved, rather than by default assumption. Merely positing theoretical possibilities of harm (which often rely on highly stylized models) is a far cry from demonstrating actual harm. Even in situations where there is a reasonable possibility that the integrated firm will have both the ability and incentive to raise its rivals’ costs or foreclose competition, remedies such as contractually binding consent decrees whereby the merged entity guarantees that it will deal with and sell inputs to its downstream rivals under fair, reasonable and non-discriminatory terms, would suffice to mitigate the harm to competition. In situations involving already integrated firms like Amazon, material evidence of the anti-competitive conduct in question could be adduced to justify sanctions rather than forcing vertical disintegration through a forced divestiture of the downstream business. In other words, what matters is a rigorous empirical examination and economic analysis of the relevant market and firms’ conduct within it. Theoretically-based assumptions being made about the anti-competitive nature of the vertical integration or conduct that it has enabled do not suffice.
So what does the evidence indicate about Amazon? Amazon operates a digital marketplace platform where it is both a seller competing with third-party sellers who use its platform to reach customers, and the platform’s owner. As a seller, Amazon has drastically expanded the scale and volume of its operations. Due to high shipping volume, it’s thus able to negotiate steep discounts of 70% or more for shipping its products from third-party shipping firms like UPS and FedEx. Additionally, it has vertically integrated and expanded into the logistics business on its own as part of increasing cost-efficiencies in shipping and improving shipping reliability. It has invested in hiring 400,000 drivers, purchasing 40,000 semi-trucks, 30,000 vans and over 70 planes, and opening a $1.5 billion Kentucky-based air hub. For a price, it also offers third-party sellers on its platform Fulfilment By Amazon (FBA), a program whereby Amazon handles the shipping, storage, processing and customer service for their products alongside benefits such as free shipping on certain orders.
Khan claimed that Amazon’s ability to negotiate steep discounts from third-party shippers like UPS and FedEx for its own products has resulted in these companies charging higher prices for shipping to other sellers on Amazon’s marketplace to compensate for the difference. She claims that the FBA program pressures third-party retailers to partner with their competitor to secure lower shipping rates and that even retailers who participate in FBA face discrimination in delivery services relative to Amazon’s own retail products. Furthermore, due to the favorable shipping rates that Amazon secures using high product volumes enabled by the efficiencies of integrating retail and logistics, potential competitors in the retail space are barred from entering the market, since the favorable shipping rate arrangement that already exists with Amazon prevents them from profitably undertaking both shipping and logistics on their own. In a nutshell, the dominance allowed by Amazon’s vertical integration of marketplace, retail, and logistics operations, creates entry barriers for rivals in all three markets and allows Amazon to discriminate against sellers on its own platform.
These theories of harm around price discrimination enabled by market dominance may seem plausible at face value, but the evidence, including data cited by Khan herself, contradict the claims. As noted by Information Technology and Innovation Foundation (ITIF) president Robert Atkinson and University of Texas at Arlington economics professor Dr. Michael Ward:
[Khan’s cited data] merely shows that low-volume shippers receive less-generous discounts than do high-volume shippers. It does not show that third-party delivery companies raised prices to compensate for discounts to Amazon. Furthermore, in 2016, “about 560 shippers … spent in the range of $100 million annually on shipping could qualify for discounts of more than 80% on overnight shipments, and up to 60% on residential delivery by ground.” That is, more than 500 other shippers were able to obtain shipping discounts similar to those obtained by Amazon due to their high shipping volumes. This suggests that there is nothing unique about the discounts provided to Amazon.
Vertical integration leads to efficiencies. Efficiencies lead to more cost-effective delivery of goods and services. This enables Amazon to outcompete less efficient rivals. Punishing Amazon for this efficient course of conduct would amount to constraining competition- the opposite of the FTC’s stated objectives.
What about the theory that Amazon has an incentive to discriminate against retail sellers on its own platform, through its logistics division’s favoring Amazon’s retail offerings over theirs?
For some portion of the products available in its store, Amazon certainly competes with Marketplace sellers. However, the extent of this competition is far less than anecdotal evidence might suggest. One motivation for opening Amazon’s retail store to third-party sellers was to increase product selection for customers. If third-party products are intended to fill gaps in product selection, then we should expect limited competition between Amazon’s offerings and the offerings of third-party sellers. Analyzing data from Germany, Crawford et al. (2022) found that over 60 percent of sales on Amazon are of products for which Amazon does not have a first-party offering. And only about 8 percent of sales were of products where Amazon entered into competition with a Marketplace seller during the period of their study (i.e., Amazon was not the incumbent seller of the product). This is consistent with an analysis of U.S. data by Zhu and Liu (2018), who found that Amazon entered into competition with Marketplace sellers for only 3 percent of products during the period of their study.
Speculative theories of harm aside, the evidence indicates that Bork and the Chicago school economists were right. Hagiu et al. (2022) find that platforms that offer sales offerings from both the owner-operator and third-party sellers only preference the owner-operator’s products over those of third-party sellers where the expected margin from selling them exceeds the expected commission gains from third-party sales, or when consumers tend to leave the platform and purchase directly from the third-party sellers after discovering their products on the platform.
Evidence also suggests that third-party sellers choose to participate in FBA when they believe it suits their circumstances, rather than because there are no viable, profitable alternatives. An investigation by Italy’s national competition authority found that 40-45% of third-party retailers who use Amazon Italy’s marketplace platform don’t opt for FBA, and that of the 100 top products sold on the platform, 40 of them aren’t shipped by Amazon logistics or using FBA. Lazar Radic and Geoffrey Manne note that if retailers who don’t use FBA are forced to cut their own prices to compete with FBA-sold products, then this only benefits consumers and demonstrates that competition is vigorous and working as it’s supposed to.
Dire consequences
The trial court’s rejection of a preliminary injunction in the Microsoft-Activision merger, the 0-4 losing track record for the Lina Khan FTC in merger cases, and economic data that undermine potential FTC antitrust claims against Amazon, demonstrate that the agency is likely to fail in future efforts to police vertical mergers that are likely to boost efficiency and are pro-competitive. However, this doesn’t mean that the agency’s efforts won’t harm consumers, competition, and the taxpayers who foot the bill for the Commission’s failed litigation efforts.
At a recent House Judiciary Committee hearing where Khan was questioned on her running of the FTC, she rejected the notion that the FTC should only pursue cases where it’s likely to succeed in court. She instead said that the FTC under her leadership pursues cases where it thinks it’s right about a law violation, implying that it would do so even when courts are likely to rule otherwise. She cited examples of mergers that didn’t proceed after the FTC announced that it would challenge them. These could theoretically include cases where the facts would have supported the FTC’s theory of harm. However, they’re likely to include cases where otherwise pro-competitive or non-anti-competitive mergers were blocked due to the prospect of expensive litigation. Large companies like Amazon, Microsoft, Google and others may have the resources to weather these challenges, but less-resourced firms may not. This style of merger enforcement by the antitrust agencies also sends signals to future parties against potentially pro-competitive conduct, including vertical integration.
If the FTC does ultimately succeed in undoing a Microsoft-Activision merger, the result will be a lower quality gaming experience and less competition for Microsoft’s rival, Sony. If it succeeds in forcing Amazon to divest its logistics arm, then this would likely destroy Amazon Prime, sacrificing billions of dollars in value for consumers, while deterring similar pro-competitive examples of vertical integration.
Deterring competition and efficiency-boosting vertical mergers doesn’t just mean that we could end up paying more for goods and services, or lose access to ones we value. It can even cost human lives. Earlier this year, the FTC ordered DNA sequencing provider Illumina Inc. to divest GRAIL Inc., producers of a multi-cancer early detection (MCED) test. It claimed, without evidence, that competition would be stifled in the American MCED test market, due to Illumina’s discrimination against GRAIL’s future competitors, despite contractually binding assurances from Illumina that it would make its testing platform available to third-parties on non-discriminatory terms. In doing so, the FTC ignored evidence regarding Illumina’s ability to use its superior resources in securing expensive regulatory clearances that could bring GRAIL’s tests to market more quickly, thus saving more lives. Even if a federal appeals court overturns the FTC’s decision, this still wouldn’t undo the damage caused by the delay. The saga means that pioneering start-ups with novel, lifesaving technology may find that it’s more difficult to get acquired by larger companies with the resources that enable them to navigate regulatory barriers. What’s more, because Illumina originally owned GRAIL and spun it off to facilitate the small firm’s focus on blood cancer research, the FTC’s actions may tend to chill other firms’ analogous efficiency-seeking spinoffs.
Conclusion
Since 1914, Congress has tasked the FTC with preserving and promoting competition. Decades of economic and judicial learning and experience have revealed that efficiency and competition are almost always intimately linked and are often indistinguishable from each other, as the generation of efficiencies is crucial to providing innovative goods and services that transform our lives in a cost-effective manner. The FTC would do well to return to economic learning regarding the effects of vertical mergers, if it wants to preserve competition, stop losing in court, and succeed in requests for more funding from Congress.
It might also consider one of the main reasons why vertical integration and consolidation is most ubiquitous in heavily-regulated sectors, such as healthcare. Government regulations come with high fixed costs related to firms’ establishment of internal regulatory compliance mechanisms. This means that larger firms are more capable of spreading the fixed costs, thereby reducing their impact on per-unit prices of their products. This also means that government regulations impose relatively higher costs on smaller firms than larger ones. It’s unsurprising, then, that higher regulatory costs and more regulation in an industry drives consolidation and vertical integration to offset the cost impact, while shutting out competition from smaller players or forcing them to get bought out.
If the FTC wants to see less vertical integration, then it ought to address these issues by conducting a cost-benefit analysis of government regulations and their impact on competition, barriers to entry, and pressures to consolidate, as part of its competition advocacy role. This would be a far more productive use of taxpayer resources than pursuing failed cases against mergers that are likely to benefit consumers based on unsubstantiated theories of harm, or promulgating merger guidelines that are likely to be laughed out of court rather than giving merging parties meaningful guidance about the legal consequences of their actions.
Satya Marar is a Visiting Postgraduate Fellow at the Mercatus Center at George Mason University.