Archives For

[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 Herbert Hovenkamp (James G. Dinan University Professor, University of Pennsylvania School of Law and the Wharton School).]

In its 2019 AT&T/Time-Warner merger decision the D.C. Circuit Court of Appeals mentioned something that antitrust enforcers have known for years: We need a new set of Agency Guidelines for vertical mergers. The vertical merger Guidelines were last revised in 1984 at the height of Chicago School hostility toward harsh antitrust treatment of vertical restraints. In January, 2020, the Agencies issued a set of draft vertical merger Guidelines for comment. At this writing the Guidelines are not final, and the Agencies are soliciting comments on the draft and will be holding at least two workshops to discuss them before they are finalized.

1. What the Guidelines contain

a. “Relevant markets” and “related products”

The draft Guidelines borrow heavily from the 2010 Horizontal Merger Guidelines concerning general questions of market definition, entry barriers, partial acquisitions, treatment of efficiencies and the failing company defense. Both the approach to market definition and the necessity for it are treated somewhat differently than for horizontal mergers, however. First, the Guidelines do not generally speak of vertical mergers as linking two different “markets,” such as an upstream market and a downstream market. Instead, they use the term “relevant market” to speak of the market that is of competitive concern, and the term “related product” to refer to some product, service, or grouping of sales that is either upstream or downstream from this market:

A related product is a product or service that is supplied by the merged firm, is vertically related to the products and services in the relevant market, and to which access by the merged firm’s rivals affects competition in the relevant market.

So, for example, if a truck trailer manufacturer should acquire a maker of truck wheels and the market of concern was trailer manufacturing, the Agencies would identify that as the relevant market and wheels as the “related product.” (Cf. Fruehauf Corp. v. FTC).

b. 20% market share threshold

The Guidelines then suggest (§3) that the Agencies would be

unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 20 percent and the related product is used in less than 20 percent of the relevant market.

The choice of 20% is interesting but quite defensible as a statement of enforcement policy, and very likely represents a compromise between extreme positions. First, 20% is considerably higher than the numbers that supported enforcement during the 1960s and earlier (see, e.g., Brown Shoe (less than 4%); Bethlehem Steel (10% in one market; as little as 1.8% in another market)). Nevertheless, it is also considerably lower than the numbers that commentators such as Robert Bork would have approved (see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself at pp. 219, 232-33; see also Herbert Hovenkamp, Robert Bork and Vertical Integration: Leverage, Foreclosure, and Efficiency), and lower than the numbers generally used to evaluate vertical restraints such as tying or exclusive dealing (see Jefferson Parish (30% insufficient); see also 9 Antitrust Law ¶1709 (4th ed. 2018)).

The Agencies do appear to be admonished by the Second Circuit’s Fruehauf decision, now 40 years old but nevertheless the last big, fully litigated vertical merger case prior to AT&T/Time Warner: foreclosure numbers standing alone do not mean very much, at least not unless they are very large. Instead, there must be some theory about how foreclosure leads to lower output and higher prices. These draft Guidelines provide several examples and illustrations.

Significantly, the Guidelines do not state that they will challenge vertical mergers crossing the 20% threshold, but only that they are unlikely to challenge mergers that fall short of it. Even here, they leave open the possibility of challenge in unusual situations where the share numbers may understate the concern, such as where the related product “is relatively new,” and its share is rapidly growing. The Guidelines also note (§3) that if the merging parties serve different geographic areas, then the relevant share may not be measured by a firm’s gross sales everywhere, but rather by its shares in the other firm’s market in which anticompetitive effects are being tested. 

These numbers as well as the qualifications seem quite realistic, particularly in product differentiated markets where market shares tend to understate power, particularly in vertical distribution.

c. Unilateral effects

The draft Vertical Guidelines then divide the universe of adverse competitive effects into Unilateral Effects (§5) and Coordinated Effects (§7). The discussion of unilateral effects is based on bargaining theory similar to that used in the treatment of unilateral effects from horizontal mergers in the 2010 Horizontal Merger Guidelines. Basically, a price increase is more profitable if the losses that accrue to one merging participant are affected by gains to the merged firm as a whole. These principles have been a relatively uncontroversial part of industrial organization economics and game theory for decades. The Draft Vertical Guidelines recognize both foreclosure and raising rivals’ costs as concerns, as well as access to competitively sensitive information (§5).

 The Draft Guidelines note:

A vertical merger may diminish competition by allowing the merged firm to profitably weaken or remove the competitive constraint from one or more of its actual or potential rivals in the relevant market by changing the terms of those rivals’ access to one or more related products. For example, the merged firm may be able to raise its rivals’ costs by charging a higher price for the related products or by lowering service or product quality. The merged firm could also refuse to supply rivals with the related products altogether (“foreclosure”).

Where sufficient data are available, the Agencies may construct economic models designed to quantify the likely unilateral price effects resulting from the merger…..

The draft Guidelines note that these models need not rely on a particular market definition. As in the case of unilateral effects horizontal mergers, they compare the firms’ predicted bargaining position before and after the merger, assuming that the firms seek maximization of profits or value. They then query whether equilibrium prices in the post-merger market will be higher than those prior to the merger. 

In making that determination the Guidelines suggest (§4a) that the Agency could look at several factors, including:

  1. The merged firm’s foreclosure of, or raising costs of, one or more rivals would cause those rivals to lose sales (for example, if they are forced out of the market, if they are deterred from innovating, entering or expanding, or cannot finance these activities, or if they have incentives to pass on higher costs through higher prices), or to otherwise compete less aggressively for customers’ business;
  2. The merged firm’s business in the relevant market would benefit (for example if some portion of those lost sales would be diverted to the merged firm);
  3. Capturing this benefit through merger may make foreclosure, or raising rivals’ costs, profitable even though it would not have been profitable prior to the merger; and,
  4. The magnitude of likely foreclosure or raising rivals’ costs is not de minimis such that it would substantially lessen competition.

This approach, which reflects important developments in empirical economics, does entail that there will be increasing reliance on economic experts to draft, interpret, and dispute the relevant economic models.

In a brief section the Draft Guidelines also state a concern for mergers that will provide a firm with access or control of sensitive business information that could be used anticompetitively. The Guidelines do not provide a great deal of elaboration on this point.

d. Elimination of double marginalization

The Vertical Guidelines also have a separate section (§6) discussing an offset for elimination of double marginalization. They note what has come to be the accepted economic wisdom that elimination of double marginalization can result in higher output and lower prices when it applies, but it does not invariably apply.

e. Coordinated effects

Finally, the draft Guidelines note (§7) a concern that certain vertical mergers may enable collusion. This could occur, for example, if the merger eliminated a maverick buyer who formerly played rival sellers off against one another. In other cases the merger may give one of the partners access to information that could be used to facilitate collusion or discipline cartel cheaters, offering this example:

Example 7: The merger brings together a manufacturer of components and a maker of final products. If the component manufacturer supplies rival makers of final products, it will have information about how much they are making, and will be better able to detect cheating on a tacit agreement to limit supplies. As a result the merger may make the tacit agreement more effective.

2. Conclusion: An increase in economic sophistication

These draft Guidelines are relatively short, but that is in substantial part because they incorporate by reference many of the relevant points from the 2010 Guidelines for horizontal mergers. In any event, they may not provide as much detail as federal courts might hope for, but they are an important step toward specifying the increasingly economic approaches that the agencies take toward merger analysis, one in which direct estimates play a larger role, with a comparatively reduced role for more traditional approaches depending on market definition and market share.

They also avoid both rhetorical extremes, which are being too hostile or too sanguine about the anticompetitive potential of vertical acquisitions. While the new draft Guidelines leave the overall burden of proof with the challenger, they have clearly weakened the presumption that vertical mergers are invariably benign, particularly in highly concentrated markets or where the products in question are differentiated. Second, the draft Guidelines emphasize approaches that are more economically sophisticated and empirical. Consistent with that, foreclosure concerns are once again taken more seriously.

  1. Yes, the Merger Guidelines should be revised; in particular:

a.  The discussion of concentration thresholds for collusion facilitating mergers must be aligned more closely with both recent case law and actual enforcement practices; otherwise they fail to provide guidance.  The current Guidelines indicate that concentrations greater than 1800 HHI and a post-merger increase exceeding 100HHI presumptively indicates a challenge. In fact, mergers with post-merger HHIs in excess of both these numbers are routinely permitted. While the standards in the current Guidelines are too aggressive, the George W. Bush administration policy was too lenient.  More fundamentally, the HHI creates an illusion of precision in coordinated effects analysis that is simply not warranted, particularly not when market definitions are ambiguous or when the merger market is subject to product differentiation.  Further, the “other factors” portion of the Guidelines tends to dominate the analysis.  A better approach is reduced reliance on the HHI and more on simpler observations about who the 3 or 4 largest firms in the market are, the effects of eliminating the acquired firm as an independent market entity, and the likely responses of rivals to an output reduction by the post-merger firm.

b.  The unilateral effects analysis requires elaboration that brings it into line with actual agency analysis.  Some of the economists would like to jettison a market definition approach and attempt to measure price increase potential more directly.  While I am sympathetic with that, there is too much water over the bridge; it could lead to courts’ simply rejecting the Guidelines.  A better approach is to write market definition criteria that permit narrower market definitions in situations where a unilateral price increase is likely.  This requires that some thought be given to situations where the merger is between one firm and its second closest rather than its closest rival.  Right now it is simply too easy for defendants to argue that the closer rival will steal sales and competition will not be affected.  So the government is currently losing cases that it should not be losing.  Finally,the Guidelines should quell discontent in lawyers’ perception about unilateral effects analysis that it is more speculative or less rigorous than traditional coordinated effects analysis.  The fact is that both types of analysis rely on many assumptions, some of which are no more than conjectures about future firm behavior.  If anything, the robustness edge belongs to the unilateral effects approach.

hovenkampHerbert Hovenkamp is Professor of Law at The University of Iowa College of Law.

One interesting aspect of the DOJ Report on Section 2 is the scant, episodic treatment of IP issues. The Report rejects the presumption of market power for patent ties (p. 81); has a very brief discussion of refusal to license patented parts in which it properly rejects the reasoning of the Ninth Circuit’s Kodak decision and aligns itself with the Federal Circuit’s Xerox decision (p. 121-122). The Walker Process case, which held that an infringement action based on an improperly acquired and unenforceable patent could violate §2, is cited in a footnote, and only for the proposition that market power is required in a §2 case (p. 25 n. 53). Finally, the Report contains a brief discussion of the presence of intellectual property in measuring incremental cost for purposes of analyzing predatory pricing (p. 63).

I suggest that the Antitrust Division and the case law develop a theory about the unreasonably exclusionary use of patents that generally divides the territory between pre-issuance and post-issuance conduct. This division has much less to do with the exclusionary power of patents than with the presence or absence of a relevant regulatory agency. The patenting process is characterized by very intensive agency regulation up to the time that a patent issues, but almost no regulation thereafter. This suggests a rather sharp line between pre-issuance and post-issuance conduct. The one exception is for pre-issuance conduct that the agency did not supervise adequately, mainly because it was never presented to the agency in the first place. This is consistent with the general theory of “implied immunity,” under which regulated conduct is immune from the antitrust laws only to the extent that it is within the jurisdiction of a federal agency, was actually made known to the agency, and assessed under criteria that took competitive conseqeunces into account. Continue Reading…

hovenkampHerbert Hovenkamp is Professor of Law at The University of Iowa College of Law.

The baseline for testing predatory pricing in the Section 2 Report is average avoidable cost (AAC), together with recoupment as a structural test (Report, p. 65). The AAC test or reasonably close variations, such as average variable cost or short-run marginal cost, seems about right. However, differences among them can become very technical and fine. The Report correctly includes in AAC those fixed costs that “were incurred only because of the predatory strategy, for example, as a result of expanding capacity to enable the predatory sales.” (Report, pp. xiv, 64-65) Such a strategy would make some sense for a predator if the fixed costs in question are easily re-deployed once the predation has succeeded – for example, in the case of an airline whose planes can be shifted to a different route. The test virtually guarantees that in industries that require heavy investment in production capacity that cannot be redployed the test will approach strict average variable cost. In cases where fixed costs are relatively high, an investment of this nature that lasted only through the predatory period and became excess capacity thereafter would not be worth it. Further, if fixed costs are low the market is almost certainly not prone to monopoly to begin with. AVC is probably underdeterrent, but it is also probably the best we can do without chilling procompetitive behavior.

However, when prices are under AVC, then a strict recoupment requirement (see Report, pp. 67-68) is unnecessarily harsh. Proving recoupment requires a prediction about the dominant firm’s prices, costs, and output over a defined future period, which in turn requires a prediction about when new entry will occur, how many firms will enter, and their growth rates. As a result recoupment is much too difficult to prove and does not serve to distinguish aggressive promotional price cuts from those that are anticompetitive. Rather, structural proof should consist of those things that are ordinarily required in a Section 2 case; namely, a dominant share of a properly defined relevant market and high entry barriers. That is, the question should be “is durable monopoly pricing in this market possible,” but not “can predation be predicted to yield a durable period of monopoly pricing with sufficient monopoly returns to pay off the investment in predation.” As a factual matter the former requirement is much more manageable and requires far less speculation. An important additional ingredient is causation in the classical tort sense – namely, can the plaintiff show that the prices below average variable cost were of sufficient magnitude and duration to cause its exit from the market? Sporadic or episodic price drops below AVC are unlikely to meet this requirement.

The biggest concern is with false positives. Are there cases in which prices were below AVC for a substantial length of time to meet the causation requirement and the structural components for monopoly were present, but where we would not want to condemn the conduct because dollars-and-cents proof of recoupment is not possible. I doubt it.

Continue Reading…