Archives For Efficiencies

The American Choice and Innovation Online Act (previously called the Platform Anti-Monopoly Act), introduced earlier this summer by U.S. Rep. David Cicilline (D-R.I.), would significantly change the nature of digital platforms and, with them, the internet itself. Taken together, the bill’s provisions would turn platforms into passive intermediaries, undermining many of the features that make them valuable to consumers. This seems likely to remain the case even after potential revisions intended to minimize the bill’s unintended consequences.

In its current form, the bill is split into two parts that each is dangerous in its own right. The first, Section 2(a), would prohibit almost any kind of “discrimination” by platforms. Because it is so open-ended, lawmakers might end up removing it in favor of the nominally more focused provisions of Section 2(b), which prohibit certain named conduct. But despite being more specific, this section of the bill is incredibly far-reaching and would effectively ban swaths of essential services.

I will address the potential effects of these sections point-by-point, but both elements of the bill suffer from the same problem: a misguided assumption that “discrimination” by platforms is necessarily bad from a competition and consumer welfare point of view. On the contrary, this conduct is often exactly what consumers want from platforms, since it helps to bring order and legibility to otherwise-unwieldy parts of the Internet. Prohibiting it, as both main parts of the bill do, would make the Internet harder to use and less competitive.

Section 2(a)

Section 2(a) essentially prohibits any behavior by a covered platform that would advantage that platform’s services over any others that also uses that platform; it characterizes this preferencing as “discrimination.”

As we wrote when the House Judiciary Committee’s antitrust bills were first announced, this prohibition on “discrimination” is so broad that, if it made it into law, it would prevent platforms from excluding or disadvantaging any product of another business that uses the platform or advantaging their own products over those of their competitors.

The underlying assumption here is that platforms should be like telephone networks: providing a way for different sides of a market to communicate with each other, but doing little more than that. When platforms do do more—for example, manipulating search results to favor certain businesses or to give their own products prominence —it is seen as exploitative “leveraging.”

But consumers often want platforms to be more than just a telephone network or directory, because digital markets would be very difficult to navigate without some degree of “discrimination” between sellers. The Internet is so vast and sellers are often so anonymous that any assistance which helps you choose among options can serve to make it more navigable. As John Gruber put it:

From what I’ve seen over the last few decades, the quality of the user experience of every computing platform is directly correlated to the amount of control exerted by its platform owner. The current state of the ownerless world wide web speaks for itself.

Sometimes, this manifests itself as “self-preferencing” of another service, to reduce additional time spent searching for the information you want. When you search for a restaurant on Google, it can be very useful to get information like user reviews, the restaurant’s phone number, a button on mobile to phone them directly, estimates of how busy it is, and a link to a Maps page to see how to actually get there.

This is, undoubtedly, frustrating for competitors like Yelp, who would like this information not to be there and for users to have to click on either a link to Yelp or a link to Google Maps. But whether it is good or bad for Yelp isn’t relevant to whether it is good for users—and it is at least arguable that it is, which makes a blanket prohibition on this kind of behavior almost inevitably harmful.

If it isn’t obvious why removing this kind of feature would be harmful for users, ask yourself why some users search in Yelp’s app directly for this kind of result. The answer, I think, is that Yelp gives you all the information above that Google does (and sometimes is better, although I tend to trust Google Maps’ reviews over Yelp’s), and it’s really convenient to have all that on the same page. If Google could not provide this kind of “rich” result, many users would probably stop using Google Search to look for restaurant information in the first place, because a new friction would have been added that made the experience meaningfully worse. Removing that option would be good for Yelp, but mainly because it removes a competitor.

If all this feels like stating the obvious, then it should highlight a significant problem with Section 2(a) in the Cicilline bill: it prohibits conduct that is directly value-adding for consumers, and that creates competition for dedicated services like Yelp that object to having to compete with this kind of conduct.

This is true across all the platforms the legislation proposes to regulate. Amazon prioritizes some third-party products over others on the basis of user reviews, rates of returns and complaints, and so on; Amazon provides private label products to fill gaps in certain product lines where existing offerings are expensive or unreliable; Apple pre-installs a Camera app on the iPhone that, obviously, enjoys an advantage over rival apps like Halide.

Some or all of this behavior would be prohibited under Section 2(a) of the Cicilline bill. Combined with the bill’s presumption that conduct must be defended affirmatively—that is, the platform is presumed guilty unless it can prove that the challenged conduct is pro-competitive, which may be very difficult to do—and the bill could prospectively eliminate a huge range of socially valuable behavior.

Supporters of the bill have already been left arguing that the law simply wouldn’t be enforced in these cases of benign discrimination. But this would hardly be an improvement. It would mean the Federal Trade Commission (FTC) and U.S. Justice Department (DOJ) have tremendous control over how these platforms are built, since they could challenge conduct in virtually any case. The regulatory uncertainty alone would complicate the calculus for these firms as they refine, develop, and deploy new products and capabilities. 

So one potential compromise might be to do away with this broad-based rule and proscribe specific kinds of “discriminatory” conduct instead. This approach would involve removing Section 2(a) from the bill but retaining Section 2(b), which enumerates 10 practices it deems to be “other discriminatory conduct.” This may seem appealing, as it would potentially avoid the worst abuses of the broad-based prohibition. In practice, however, it would carry many of the same problems. In fact, many of 2(b)’s provisions appear to go even further than 2(a), and would proscribe even more procompetitive conduct that consumers want.

Sections 2(b)(1) and 2(b)(9)

The wording of these provisions is extremely broad and, as drafted, would seem to challenge even the existence of vertically integrated products. As such, these prohibitions are potentially even more extensive and invasive than Section 2(a) would have been. Even a narrower reading here would seem to preclude safety and privacy features that are valuable to many users. iOS’s sandboxing of apps, for example, serves to limit the damage that a malware app can do on a user’s device precisely because of the limitations it imposes on what other features and hardware the app can access.

Section 2(b)(2)

This provision would preclude a firm from conditioning preferred status on use of another service from that firm. This would likely undermine the purpose of platforms, which is to absorb and counter some of the risks involved in doing business online. An example of this is Amazon’s tying eligibility for its Prime program to sellers that use Amazon’s delivery service (FBA – Fulfilled By Amazon). The bill seems to presume in an example like this that Amazon is leveraging its power in the market—in the form of the value of the Prime label—to profit from delivery. But Amazon could, and already does, charge directly for listing positions; it’s unclear why it would benefit from charging via FBA when it could just charge for the Prime label.

An alternate, simpler explanation is that FBA improves the quality of the service, by granting customers greater assurance that a Prime product will arrive when Amazon says it will. Platforms add value by setting out rules and providing services that reduce the uncertainties between buyers and sellers they’d otherwise experience if they transacted directly with each other. This section’s prohibition—which, as written, would seem to prevent any kind of quality assurance—likely would bar labelling by a platform, even where customers explicitly want it.

Section 2(b)(3)

As written, this would prohibit platforms from using aggregated data to improve their services at all. If Apple found that 99% of its users uninstalled an app immediately after it was installed, it would be reasonable to conclude that the app may be harmful or broken in some way, and that Apple should investigate. This provision would ban that.

Sections 2(b)(4) and 2(b)(6)

These two provisions effectively prohibit a platform from using information it does not also provide to sellers. Such prohibitions ignore the fact that it is often good for sellers to lack certain information, since withholding information can prevent abuse by malicious users. For example, a seller may sometimes try to bribe their customers to post positive reviews of their products, or even threaten customers who have posted negative ones. Part of the role of a platform is to combat that kind of behavior by acting as a middleman and forcing both consumer users and business users to comply with the platform’s own mechanisms to control that kind of behavior.

If this seems overly generous to platforms—since, obviously, it gives them a lot of leverage over business users—ask yourself why people use platforms at all. It is not a coincidence that people often prefer Amazon to dealing with third-party merchants and having to navigate those merchants’ sites themselves. The assurance that Amazon provides is extremely valuable for users. Much of it comes from the company’s ability to act as a middleman in this way, lowering the transaction costs between buyers and sellers.

Section 2(b)(5)

This provision restricts the treatment of defaults. It is, however, relatively restrained when compared to, for example, the DOJ’s lawsuit against Google, which treats as anticompetitive even payment for defaults that can be changed. Still, many of the arguments that apply in that case also apply here: default status for apps can be a way to recoup income foregone elsewhere (e.g., a browser provided for free that makes its money by selling the right to be the default search engine).

Section 2(b)(7)

This section gets to the heart of why “discrimination” can often be procompetitive: that it facilitates competition between platforms. The kind of self-preferencing that this provision would prohibit can allow firms that have a presence in one market to extend that position into another, increasing competition in the process. Both Apple and Amazon have used their customer bases in smartphones and e-commerce, respectively, to grow their customer bases for video streaming, in competition with Netflix, Google’s YouTube, cable television, and each other. If Apple designed a search engine to compete with Google, it would do exactly the same thing, and we would be better off because of it. Restricting this kind of behavior is, perversely, exactly what you would do if you wanted to shield these incumbents from competition.

Section 2(b)(8)

As with other provisions, this one would preclude one of the mechanisms by which platforms add value: creating assurance for customers about the products they can expect if they visit the platform. Some of this relates to child protection; some of the most frustrating stories involve children being overcharged when they use an iPhone or Android app, and effectively being ripped off because of poor policing of the app (or insufficiently strict pricing rules by Apple or Google). This may also relate to rules that state that the seller cannot offer a cheaper product elsewhere (Amazon’s “General Pricing Rule” does this, for example). Prohibiting this would simply impose a tax on customers who cannot shop around and would prefer to use a platform that they trust has the lowest prices for the item they want.

Section 2(b)(10)

Ostensibly a “whistleblower” provision, this section could leave platforms with no recourse, not even removing a user from its platform, in response to spurious complaints intended purely to extract value for the complaining business rather than to promote competition. On its own, this sort of provision may be fairly harmless, but combined with the provisions above, it allows the bill to add up to a rent-seekers’ charter.

Conclusion

In each case above, it’s vital to remember that a reversed burden of proof applies. So, there is a high chance that the law will side against the defendant business, and a large downside for conduct that ends up being found to violate these provisions. That means that platforms will likely err on the side of caution in many cases, avoiding conduct that is ambiguous, and society will probably lose a lot of beneficial behavior in the process.

Put together, the provisions undermine much of what has become an Internet platform’s role: to act as an intermediary, de-risk transactions between customers and merchants who don’t know each other, and tweak the rules of the market to maximize its attractiveness as a place to do business. The “discrimination” that the bill would outlaw is, in practice, behavior that makes it easier for consumers to navigate marketplaces of extreme complexity and uncertainty, in which they often know little or nothing about the firms with whom they are trying to transact business.

Customers do not want platforms to be neutral, open utilities. They can choose platforms that are like that already, such as eBay. They generally tend to prefer ones like Amazon, which are not neutral and which carefully cultivate their service to be as streamlined, managed, and “discriminatory” as possible. Indeed, many of people’s biggest complaints with digital platforms relate to their openness: the fake reviews, counterfeit products, malware, and spam that come with letting more unknown businesses use your service. While these may be unavoidable by-products of running a platform, platforms compete on their ability to ferret them out. Customers are unlikely to thank legislators for regulating Amazon into being another eBay.

The language of the federal antitrust laws is extremely general. Over more than a century, the federal courts have applied common-law techniques to construe this general language to provide guidance to the private sector as to what does or does not run afoul of the law. The interpretive process has been fraught with some uncertainty, as judicial approaches to antitrust analysis have changed several times over the past century. Nevertheless, until very recently, judges and enforcers had converged toward relying on a consumer welfare standard as the touchstone for antitrust evaluations (see my antitrust primer here, for an overview).

While imperfect and subject to potential error in application—a problem of legal interpretation generally—the consumer welfare principle has worked rather well as the focus both for antitrust-enforcement guidance and judicial decision-making. The general stability and predictability of antitrust under a consumer welfare framework has advanced the rule of law. It has given businesses sufficient information to plan transactions in a manner likely to avoid antitrust liability. It thereby has cabined uncertainty and increased the probability that private parties would enter welfare-enhancing commercial arrangements, to the benefit of society.

In a very thoughtful 2017 speech, then Acting Assistant Attorney General for Antitrust Andrew Finch commented on the importance of the rule of law to principled antitrust enforcement. He noted:

[H]ow do we administer the antitrust laws more rationally, accurately, expeditiously, and efficiently? … Law enforcement requires stability and continuity both in rules and in their application to specific cases.

Indeed, stability and continuity in enforcement are fundamental to the rule of law. The rule of law is about notice and reliance. When it is impossible to make reasonable predictions about how a law will be applied, or what the legal consequences of conduct will be, these important values are diminished. To call our antitrust regime a “rule of law” regime, we must enforce the law as written and as interpreted by the courts and advance change with careful thought.

The reliance fostered by stability and continuity has obvious economic benefits. Businesses invest, not only in innovation but in facilities, marketing, and personnel, and they do so based on the economic and legal environment they expect to face.

Of course, we want businesses to make those investments—and shape their overall conduct—in accordance with the antitrust laws. But to do so, they need to be able to rely on future application of those laws being largely consistent with their expectations. An antitrust enforcement regime with frequent changes is one that businesses cannot plan for, or one that they will plan for by avoiding certain kinds of investments.

That is certainly not to say there has not been positive change in the antitrust laws in the past, or that we would have been better off without those changes. U.S. antitrust law has been refined, and occasionally recalibrated, with the courts playing their appropriate interpretive role. And enforcers must always be on the watch for new or evolving threats to competition.  As markets evolve and products develop over time, our analysis adapts. But as those changes occur, we pursue reliability and consistency in application in the antitrust laws as much as possible.

Indeed, we have enjoyed remarkable continuity and consensus for many years. Antitrust law in the U.S. has not been a “paradox” for quite some time, but rather a stable and valuable law enforcement regime with appropriately widespread support.

Unfortunately, policy decisions taken by the new Federal Trade Commission (FTC) leadership in recent weeks have rejected antitrust continuity and consensus. They have injected substantial uncertainty into the application of competition-law enforcement by the FTC. This abrupt change in emphasis undermines the rule of law and threatens to reduce economic welfare.

As of now, the FTC’s departure from the rule of law has been notable in two areas:

  1. Its rejection of previous guidance on the agency’s “unfair methods of competition” authority, the FTC’s primary non-merger-related enforcement tool; and
  2. Its new advice rejecting time limits for the review of generally routine proposed mergers.

In addition, potential FTC rulemakings directed at “unfair methods of competition” would, if pursued, prove highly problematic.

Rescission of the Unfair Methods of Competition Policy Statement

The FTC on July 1 voted 3-2 to rescind the 2015 FTC Policy Statement Regarding Unfair Methods of Competition under Section 5 of the FTC Act (UMC Policy Statement).

The bipartisan UMC Policy Statement has originally been supported by all three Democratic commissioners, including then-Chairwoman Edith Ramirez. The policy statement generally respected and promoted the rule of law by emphasizing that, in applying the facially broad “unfair methods of competition” (UMC) language, the FTC would be guided by the well-established principles of the antitrust rule of reason (including considering any associated cognizable efficiencies and business justifications) and the consumer welfare standard. The FTC also explained that it would not apply “standalone” Section 5 theories to conduct that would violate the Sherman or Clayton Acts.

In short, the UMC Policy Statement sent a strong signal that the commission would apply UMC in a manner fully consistent with accepted and well-understood antitrust policy principles. As in the past, the vast bulk of FTC Section 5 prosecutions would be brought against conduct that violated the core antitrust laws. Standalone Section 5 cases would be directed solely at those few practices that harmed consumer welfare and competition, but somehow fell into a narrow crack in the basic antitrust statutes (such as, perhaps, “invitations to collude” that lack plausible efficiency justifications). Although the UMC Statement did not answer all questions regarding what specific practices would justify standalone UMC challenges, it substantially limited business uncertainty by bringing Section 5 within the boundaries of settled antitrust doctrine.

The FTC’s announcement of the UMC Policy Statement rescission unhelpfully proclaimed that “the time is right for the Commission to rethink its approach and to recommit to its mandate to police unfair methods of competition even if they are outside the ambit of the Sherman or Clayton Acts.” As a dissenting statement by Commissioner Christine S. Wilson warned, consumers would be harmed by the commission’s decision to prioritize other unnamed interests. And as Commissioner Noah Joshua Phillips stressed in his dissent, the end result would be reduced guidance and greater uncertainty.

In sum, by suddenly leaving private parties in the dark as to how to conform themselves to Section 5’s UMC requirements, the FTC’s rescission offends the rule of law.

New Guidance to Parties Considering Mergers

For decades, parties proposing mergers that are subject to statutory Hart-Scott-Rodino (HSR) Act pre-merger notification requirements have operated under the understanding that:

  1. The FTC and U.S. Justice Department (DOJ) will routinely grant “early termination” of review (before the end of the initial 30-day statutory review period) to those transactions posing no plausible competitive threat; and
  2. An enforcement agency’s decision not to request more detailed documents (“second requests”) after an initial 30-day pre-merger review effectively serves as an antitrust “green light” for the proposed acquisition to proceed.

Those understandings, though not statutorily mandated, have significantly reduced antitrust uncertainty and related costs in the planning of routine merger transactions. The rule of law has been advanced through an effective assurance that business combinations that appear presumptively lawful will not be the target of future government legal harassment. This has advanced efficiency in government, as well; it is a cost-beneficial optimal use of resources for DOJ and the FTC to focus exclusively on those proposed mergers that present a substantial potential threat to consumer welfare.

Two recent FTC pronouncements (one in tandem with DOJ), however, have generated great uncertainty by disavowing (at least temporarily) those two welfare-promoting review policies. Joined by DOJ, the FTC on Feb. 4 announced that the agencies would temporarily suspend early terminations, citing an “unprecedented volume of filings” and a transition to new leadership. More than six months later, this “temporary” suspension remains in effect.

Citing “capacity constraints” and a “tidal wave of merger filings,” the FTC subsequently published an Aug. 3 blog post that effectively abrogated the 30-day “green lighting” of mergers not subject to a second request. It announced that it was sending “warning letters” to firms reminding them that FTC investigations remain open after the initial 30-day period, and that “[c]ompanies that choose to proceed with transactions that have not been fully investigated are doing so at their own risk.”

The FTC’s actions interject unwarranted uncertainty into merger planning and undermine the rule of law. Preventing early termination on transactions that have been approved routinely not only imposes additional costs on business; it hints that some transactions might be subject to novel theories of liability that fall outside the antitrust consensus.

Perhaps more significantly, as three prominent antitrust practitioners point out, the FTC’s warning letters states that:

[T]he FTC may challenge deals that “threaten to reduce competition and harm consumers, workers, and honest businesses.” Adding in harm to both “workers and honest businesses” implies that the FTC may be considering more ways that transactions can have an adverse impact other than just harm to competition and consumers [citation omitted].

Because consensus antitrust merger analysis centers on consumer welfare, not the protection of labor or business interests, any suggestion that the FTC may be extending its reach to these new areas is inconsistent with established legal principles and generates new business-planning risks.

More generally, the Aug. 6 FTC “blog post could be viewed as an attempt to modify the temporal framework of the HSR Act”—in effect, an effort to displace an implicit statutory understanding in favor of an agency diktat, contrary to the rule of law. Commissioner Wilson sees the blog post as a means to keep investigations open indefinitely and, thus, an attack on the decades-old HSR framework for handling most merger reviews in an expeditious fashion (see here). Commissioner Phillips is concerned about an attempt to chill legal M&A transactions across the board, particularly unfortunate when there is no reason to conclude that particular transactions are illegal (see here).

Finally, the historical record raises serious questions about the “resource constraint” justification for the FTC’s new merger review policies:

Through the end of July 2021, more than 2,900 transactions were reported to the FTC. It is not clear, however, whether these record-breaking HSR filing numbers have led (or will lead) to more deals being investigated. Historically, only about 13 percent of all deals reported are investigated in some fashion, and roughly 3 percent of all deals reported receive a more thorough, substantive review through the issuance of a Second Request. Even if more deals are being reported, for the majority of transactions, the HSR process is purely administrative, raising no antitrust concerns, and, theoretically, uses few, if any, agency resources. [Citations omitted.]

Proposed FTC Competition Rulemakings

The new FTC leadership is strongly considering competition rulemakings. As I explained in a recent Truth on the Market post, such rulemakings would fail a cost-benefit test. They raise serious legal risks for the commission and could impose wasted resource costs on the FTC and on private parties. More significantly, they would raise two very serious economic policy concerns:

First, competition rules would generate higher error costs than adjudications. Adjudications cabin error costs by allowing for case-specific analysis of likely competitive harms and procompetitive benefits. In contrast, competition rules inherently would be overbroad and would suffer from a very high rate of false positives. By characterizing certain practices as inherently anticompetitive without allowing for consideration of case-specific facts bearing on actual competitive effects, findings of rule violations inevitably would condemn some (perhaps many) efficient arrangements.

Second, competition rules would undermine the rule of law and thereby reduce economic welfare. FTC-only competition rules could lead to disparate legal treatment of a firm’s business practices, depending upon whether the FTC or the U.S. Justice Department was the investigating agency. Also, economic efficiency gains could be lost due to the chilling of aggressive efficiency-seeking business arrangements in those sectors subject to rules. [Emphasis added.]

In short, common law antitrust adjudication, focused on the consumer welfare standard, has done a good job of promoting a vibrant competitive economy in an efficient fashion. FTC competition rulemaking would not.

Conclusion

Recent FTC actions have undermined consensus antitrust-enforcement standards and have departed from established merger-review procedures with respect to seemingly uncontroversial consolidations. Those decisions have imposed costly uncertainty on the business sector and are thereby likely to disincentivize efficiency-seeking arrangements. What’s more, by implicitly rejecting consensus antitrust principles, they denigrate the primacy of the rule of law in antitrust enforcement. The FTC’s pursuit of competition rulemaking would further damage the rule of law by imposing arbitrary strictures that ignore matter-specific considerations bearing on the justifications for particular business decisions.

Fortunately, these are early days in the Biden administration. The problematic initial policy decisions delineated in this comment could be reversed based on further reflection and deliberation within the commission. Chairwoman Lina Khan and her fellow Democratic commissioners would benefit by consulting more closely with Commissioners Wilson and Phillips to reach agreement on substantive and procedural enforcement policies that are better tailored to promote consumer welfare and enhance vibrant competition. Such policies would benefit the U.S. economy in a manner consistent with the rule of law.

For a potential entrepreneur, just how much time it will take to compete, and the barrier to entry that time represents, will vary greatly depending on the market he or she wishes to enter. A would-be competitor to the likes of Subway, for example, might not find the time needed to open a sandwich shop to be a substantial hurdle. Even where it does take a long time to bring a product to market, it may be possible to accelerate the timeline if the potential profits are sufficiently high. 

As Steven Salop notes in a recent paper, however, there may be cases where long periods of production time are intrinsic to a product: 

If entry takes a long time, then the fear of entry may not provide a substantial constraint on conduct. The firm can enjoy higher prices and profits until the entry occurs. Even if a strong entrant into the 12-year-old scotch market begins the entry process immediately upon announcement of the merger of its rivals, it will not be able to constrain prices for a long time. [emphasis added]

Salop’s point relates to the supply-side substitutability of Scotch whisky (sic — Scotch whisky is spelt without an “e”). That is, to borrow from the European Commission’s definition, whether “suppliers are able to switch production to the relevant products and market them in the short term.” Scotch is aged in wooden barrels for a number of years (at least three, but often longer) before being bottled and sold, and the value of Scotch usually increases with age. 

Due to this protracted manufacturing process, Salop argues, an entrant cannot compete with an incumbent dominant firm for however many years it would take to age the Scotch; they cannot produce the relevant product in the short term, no matter how high the profits collected by a monopolist are, and hence no matter how strong the incentive to enter the market. If I wanted to sell 12-year-old Scotch, to use Salop’s example, it would take me 12 years to enter the market. In the meantime, a dominant firm could extract monopoly rents, leading to higher prices for consumers. 

But can a whisky producer “enjoy higher prices and profits until … entry occurs”? A dominant firm in the 12-year-old Scotch market will not necessarily be immune to competition for the entire 12-year period it would take to produce a Scotch of the same vintage. There are various ways, both on the demand and supply side, that pressure could be brought to bear on a monopolist in the Scotch market.

One way could be to bring whiskies that are being matured for longer-maturity bottles (like 16- or 18-year-old Scotches) into service at the 12-year maturity point, shifting this supply to a market in which profits are now relatively higher. 

Alternatively, distilleries may try to produce whiskies that resemble 12-year old whiskies in flavor with younger batches. A 2013 article from The Scotsman discusses this possibility in relation to major Scottish whisky brand Macallan’s decision to switch to selling exclusively No-Age Statement (NAS — they do not bear an age on the bottle) whiskies: 

Experts explained that, for example, nine and 11-year-old whiskies—not yet ready for release under the ten and 12-year brands—could now be blended together to produce the “entry-level” Gold whisky immediately.

An aged Scotch cannot contain any whisky younger than the age stated on the bottle, but an NAS alternative can contain anything over three years (though older whiskies are often used to capture a flavor more akin to a 12-year dram). For many drinkers, NAS whiskies are a close substitute for 12-year-old whiskies. They often compete with aged equivalents on quality and flavor and can command similar prices to aged bottles in the 12-year category. More than 80% of bottles sold bear no age statement. While this figure includes non-premium bottles, the share of NAS whiskies traded at auction on the secondary market, presumably more likely to be premium, increased from 20% to 30% in the years between 2013 and 2018.

There are also whiskies matured outside of Scotland, in regions such as Taiwan and India, that can achieve flavor profiles akin to older whiskies more quickly, thanks to warmer climates and the faster chemical reactions inside barrels they cause. Further increases in maturation rate can be brought about by using smaller barrels with a higher surface-area-to-volume ratio. Whiskies matured in hotter climates and smaller barrels can be brought to market even more quickly than NAS Scotch matured in the cooler Scottish climate, and may well represent a more authentic replication of an older barrel. 

“Whiskies” that can be manufactured even more quickly may also be on the horizon. Some startups in the United States are experimenting with rapid-aging technology which would allow them to produce a whisky-like spirit in a very short amount of time. As detailed in a recent article in The Economist, Endless West in California is using technology that ages spirits within 24 hours, with the resulting bottles selling for $40 – a bit less than many 12-year-old Scotches. Although attempts to break the conventional maturation process are nothing new, recent attempts have won awards in blind taste-test competitions.

None of this is to dismiss Salop’s underlying point. But it may suggest that, even for a product where time appears to be an insurmountable barrier to entry, there may be more ways to compete than we initially assume.

[TOTM: The following is part of a symposium by TOTM guests and authors marking the release of Nicolas Petit’s “Big Tech and the Digital Economy: The Moligopoly Scenario.” The entire series of posts is available here.

This post is authored by Nicolas Petit himself, the Joint Chair in Competition Law at the Department of Law at European University Institute in Fiesole, Italy, and at EUI’s Robert Schuman Centre for Advanced Studies. He is also invited professor at the College of Europe in Bruges
.]

A lot of water has gone under the bridge since my book was published last year. To close this symposium, I thought I would discuss the new phase of antirust statutorification taking place before our eyes. In the United States, Congress is working on five antitrust bills that propose to subject platforms to stringent obligations, including a ban on mergers and acquisitions, required data portability and interoperability, and line-of-business restrictions. In the European Union (EU), lawmakers are examining the proposed Digital Markets Act (“DMA”) that sets out a complicated regulatory system for digital “gatekeepers,” with per se behavioral limitations of their freedom over contractual terms, technological design, monetization, and ecosystem leadership.

Proponents of legislative reform on both sides of the Atlantic appear to share the common view that ongoing antitrust adjudication efforts are both instrumental and irrelevant. They are instrumental because government (or plaintiff) losses build the evidence needed to support the view that antitrust doctrine is exceedingly conservative, and that legal reform is needed. Two weeks ago, antitrust reform activists ran to Twitter to point out that the U.S. District Court dismissal of the Federal Trade Commission’s (FTC) complaint against Facebook was one more piece of evidence supporting the view that the antitrust pendulum needed to swing. They are instrumental because, again, government (or plaintiffs) wins will support scaling antitrust enforcement in the marginal case by adoption of governmental regulation. In the EU, antitrust cases follow each other almost like night the day, lending credence to the view that regulation will bring much needed coordination and economies of scale.

But both instrumentalities are, at the end of the line, irrelevant, because they lead to the same conclusion: legislative reform is long overdue. With this in mind, the logic of lawmakers is that they need not await the courts, and they can advance with haste and confidence toward the promulgation of new antitrust statutes.

The antitrust reform process that is unfolding is a cause for questioning. The issue is not legal reform in itself. There is no suggestion here that statutory reform is necessarily inferior, and no correlative reification of the judge-made-law method. Legislative intervention can occur for good reason, like when it breaks judicial inertia caused by ideological logjam.

The issue is rather one of precipitation. There is a lot of learning in the cases. The point, simply put, is that a supplementary court-legislative dialogue would yield additional information—or what Guido Calabresi has called “starting points” for regulation—that premature legislative intervention is sweeping under the rug. This issue is important because specification errors (see Doug Melamed’s symposium piece on this) in statutory legislation are not uncommon. Feedback from court cases create a factual record that will often be missing when lawmakers act too precipitously.

Moreover, a court-legislative iteration is useful when the issues in discussion are cross-cutting. The digital economy brings an abundance of them. As tech analysist Ben Evans has observed, data-sharing obligations raise tradeoffs between contestability and privacy. Chapter VI of my book shows that breakups of social networks or search engines might promote rivalry and, at the same time, increase the leverage of advertisers to extract more user data and conduct more targeted advertising. In such cases, Calabresi said, judges who know the legal topography are well-placed to elicit the preferences of society. He added that they are better placed than government agencies’ officials or delegated experts, who often attend to the immediate problem without the big picture in mind (all the more when officials are denied opportunities to engage with civil society and the press, as per the policy announced by the new FTC leadership).

Of course, there are three objections to this. The first consists of arguing that statutes are needed now because courts are too slow to deal with problems. The argument is not dissimilar to Frank Easterbrook’s concerns about irreversible harms to the economy, though with a tweak. Where Easterbook’s concern was one of ossification of Type I errors due to stare decisis, the concern here is one of entrenchment of durable monopoly power in the digital sector due to Type II errors. The concern, however, fails the test of evidence. The available data in both the United States and Europe shows unprecedented vitality in the digital sector. Venture capital funding cruises at historical heights, fueling new firm entry, business creation, and economic dynamism in the U.S. and EU digital sectors, topping all other industries. Unless we require higher levels of entry from digital markets than from other industries—or discount the social value of entry in the digital sector—this should give us reason to push pause on lawmaking efforts.

The second objection is that following an incremental process of updating the law through the courts creates intolerable uncertainty. But this objection, too, is unconvincing, at best. One may ask which of an abrupt legislative change of the law after decades of legal stability or of an experimental process of judicial renovation brings more uncertainty.

Besides, ad hoc statutes, such as the ones in discussion, are likely to pose quickly and dramatically the problem of their own legal obsolescence. Detailed and technical statutes specify rights, requirements, and procedures that often do not stand the test of time. For example, the DMA likely captures Windows as a core platform service subject to gatekeeping. But is the market power of Microsoft over Windows still relevant today, and isn’t it constrained in effect by existing antitrust rules?  In antitrust, vagueness in critical statutory terms allows room for change.[1] The best way to give meaning to buzzwords like “smart” or “future-proof” regulation consists of building in first principles, not in creating discretionary opportunities for permanent adaptation of the law. In reality, it is hard to see how the methods of future-proof regulation currently discussed in the EU creates less uncertainty than a court process.

The third objection is that we do not need more information, because we now benefit from economic knowledge showing that existing antitrust laws are too permissive of anticompetitive business conduct. But is the economic literature actually supportive of stricter rules against defendants than the rule-of-reason framework that applies in many unilateral conduct cases and in merger law? The answer is surely no. The theoretical economic literature has travelled a lot in the past 50 years. Of particular interest are works on network externalities, switching costs, and multi-sided markets. But the progress achieved in the economic understanding of markets is more descriptive than normative.

Take the celebrated multi-sided market theory. The main contribution of the theory is its advice to decision-makers to take the periscope out, so as to consider all possible welfare tradeoffs, not to be more or less defendant friendly. Payment cards provide a good example. Economic research suggests that any antitrust or regulatory intervention on prices affect tradeoffs between, and payoffs to, cardholders and merchants, cardholders and cash users, cardholders and banks, and banks and card systems. Equally numerous tradeoffs arise in many sectors of the digital economy, like ridesharing, targeted advertisement, or social networks. Multi-sided market theory renders these tradeoffs visible. But it does not come with a clear recipe for how to solve them. For that, one needs to follow first principles. A system of measurement that is flexible and welfare-based helps, as Kelly Fayne observed in her critical symposium piece on the book.

Another example might be worth considering. The theory of increasing returns suggests that markets subject to network effects tend to converge around the selection of a single technology standard, and it is not a given that the selected technology is the best one. One policy implication is that social planners might be justified in keeping a second option on the table. As I discuss in Chapter V of my book, the theory may support an M&A ban against platforms in tipped markets, on the conjecture that the assets of fringe firms might be efficiently repositioned to offer product differentiation to consumers. But the theory of increasing returns does not say under what conditions we can know that the selected technology is suboptimal. Moreover, if the selected technology is the optimal one, or if the suboptimal technology quickly obsolesces, are policy efforts at all needed?

Last, as Bo Heiden’s thought provoking symposium piece argues, it is not a given that antitrust enforcement of rivalry in markets is the best way to maintain an alternative technology alive, let alone to supply the innovation needed to deliver economic prosperity. Government procurement, science and technology policy, and intellectual-property policy might be equally effective (note that the fathers of the theory, like Brian Arthur or Paul David, have been very silent on antitrust reform).

There are, of course, exceptions to the limited normative content of modern economic theory. In some areas, economic theory is more predictive of consumer harms, like in relation to algorithmic collusion, interlocking directorates, or “killer” acquisitions. But the applications are discrete and industry-specific. All are insufficient to declare that the antitrust apparatus is dated and that it requires a full overhaul. When modern economic research turns normative, it is often way more subtle in its implications than some wild policy claims derived from it. For example, the emerging studies that claim to identify broad patterns of rising market power in the economy in no way lead to an implication that there are no pro-competitive mergers.

Similarly, the empirical picture of digital markets is incomplete. The past few years have seen a proliferation of qualitative research reports on industry structure in the digital sectors. Most suggest that industry concentration has risen, particularly in the digital sector. As with any research exercise, these reports’ findings deserve to be subject to critical examination before they can be deemed supportive of a claim of “sufficient experience.” Moreover, there is no reason to subject these reports to a lower standard of accountability on grounds that they have often been drafted by experts upon demand from antitrust agencies. After all, we academics are ethically obliged to be at least equally exacting with policy-based research as we are with science-based research.

Now, with healthy skepticism at the back of one’s mind, one can see immediately that the findings of expert reports to date have tended to downplay behavioral observations that counterbalance findings of monopoly power—such as intense business anxiety, technological innovation, and demand-expansion investments in digital markets. This was, I believe, the main takeaway from Chapter IV of my book. And less than six months ago, The Economist ran its leading story on the new marketplace reality of “Tech’s Big Dust-Up.”

More importantly, the findings of the various expert reports never seriously contemplate the possibility of competition by differentiation in business models among the platforms. Take privacy, for example. As Peter Klein reasonably writes in his symposium article, we should not be quick to assume market failure. After all, we might have more choice than meets the eye, with Google free but ad-based, and Apple pricy but less-targeted. More generally, Richard Langlois makes a very convincing point that diversification is at the heart of competition between the large digital gatekeepers. We might just be too short-termist—here, digital communications technology might help create a false sense of urgency—to wait for the end state of the Big Tech moligopoly.

Similarly, the expert reports did not really question the real possibility of competition for the purchase of regulation. As in the classic George Stigler paper, where the railroad industry fought motor-trucking competition with state regulation, the businesses that stand to lose most from the digital transformation might be rationally jockeying to convince lawmakers that not all business models are equal, and to steer regulation toward specific business models. Again, though we do not know how to consider this issue, there are signs that a coalition of large news corporations and the publishing oligopoly are behind many antitrust initiatives against digital firms.

Now, as is now clear from these few lines, my cautionary note against antitrust statutorification might be more relevant to the U.S. market. In the EU, sunk investments have been made, expectations have been created, and regulation has now become inevitable. The United States, however, has a chance to get this right. Court cases are the way to go. And unlike what the popular coverage suggests, the recent District Court dismissal of the FTC case far from ruled out the applicability of U.S. antitrust laws to Facebook’s alleged killer acquisitions. On the contrary, the ruling actually contains an invitation to rework a rushed complaint. Perhaps, as Shane Greenstein observed in his retrospective analysis of the U.S. Microsoft case, we would all benefit if we studied more carefully the learning that lies in the cases, rather than haste to produce instant antitrust analysis on Twitter that fits within 280 characters.


[1] But some threshold conditions like agreement or dominance might also become dated. 

From Sen. Elizabeth Warren (D-Mass.) to Sen. Josh Hawley (R-Mo.), populist calls to “fix” our antitrust laws and the underlying Consumer Welfare Standard have found a foothold on Capitol Hill. At the same time, there are calls to “fix” the Supreme Court by packing it with new justices. The court’s unanimous decision in NCAA v. Alston demonstrates that neither needs repair. To the contrary, clearly anti-competitive conduct—like the NCAA’s compensation rules—is proscribed under the Consumer Welfare Standard, and every justice from Samuel Alito to Sonia Sotomayor can agree on that.

In 1984, the court in NCAA v. Board of Regents suggested that “courts should take care when assessing the NCAA’s restraints on student-athlete compensation.” After all, joint ventures like sports leagues are entitled to rule-of-reason treatment. But while times change, the Consumer Welfare Standard is sufficiently flexible to meet those changes.

Where a competitive restraint exists primarily to ensure that “enormous sums of money flow to seemingly everyone except the student athletes,” the court rightly calls it out for what it is. As Associate Justice Brett Kavanaugh wrote in his concurrence:

Nowhere else in America can businesses get away with agreeing not to pay their workers a fair market rate on the theory that their product is defined by not paying their workers a fair market rate.  And under ordinary principles of antitrust law, it is not evident why college sports should be any different.  The NCAA is not above the law.

Disturbing these “ordinary principles”—whether through legislation, administrative rulemaking, or the common law—is simply unnecessary. For example, the Open Markets Institute filed an amicus brief arguing that the rule of reason should be “bounded” and willfully blind to the pro-competitive benefits some joint ventures can create (an argument that has been used, unsuccessfully, to attack ridesharing services like Uber and Lyft). Sen. Amy Klobuchar (D-Minn.) has proposed shifting the burden of proof so that merging parties are guilty until proven innocent. Sen. Warren would go further, deeming Amazon’s acquisition of Whole Foods anti-competitive simply because the company is “big,” and ignoring the merger’s myriad pro-competitive benefits. Sen. Hawley has gone further still: calling on Amazon to be investigated criminally for the crime of being innovative and successful.

Several of the current proposals, including those from Sens. Klobuchar and Hawley (and those recently introduced in the House that essentially single out firms for disfavored treatment), would replace the Consumer Welfare Standard that has underpinned antitrust law for decades with a policy that effectively punishes firms for being politically unpopular.

These examples demonstrate we should be wary when those in power assert that things are so irreparably broken that they need a complete overhaul. The “solutions” peddled usually increase politicians’ power by enabling them to pick winners and losers through top-down approaches that stifle the bottom-up innovations that make consumers’ lives better.

Are antitrust law and the Supreme Court perfect? Hardly. But in a 9-0 decision, the court proved this week that there’s nothing broken about either.

The recent launch of the international Multilateral Pharmaceutical Merger Task Force (MPMTF) is just the latest example of burgeoning cooperative efforts by leading competition agencies to promote convergence in antitrust enforcement. (See my recent paper on the globalization of antitrust, which assesses multinational cooperation and convergence initiatives in greater detail.) In what is a first, the U.S. Federal Trade Commission (FTC), the U.S. Justice Department’s (DOJ) Antitrust Division, offices of state Attorneys General, the European Commission’s Competition Directorate, Canada’s Competition Bureau, and the U.K.’s Competition and Market Authority (CMA) jointly created the MPMTF in March 2021 “to update their approach to analyzing the effects of pharmaceutical mergers.”

To help inform its analysis, in May 2021 the MPMTF requested public comments concerning the effects of pharmaceutical mergers. The MPMTF sought submissions regarding (among other issues) seven sets of questions:   

  1. What theories of harm should enforcement agencies consider when evaluating pharmaceutical mergers, including theories of harm beyond those currently considered?
  2. What is the full range of a pharmaceutical merger’s effects on innovation? What challenges arise when mergers involve proprietary drug discovery and manufacturing platforms?
  3. In pharmaceutical merger review, how should we consider the risks or effects of conduct such as price-setting practices, reverse payments, and other ways in which pharmaceutical companies respond to or rely on regulatory processes?
  4. How should we approach market definition in pharmaceutical mergers, and how is that implicated by new or evolving theories of harm?
  5. What evidence may be relevant or necessary to assess and, if applicable, challenge a pharmaceutical merger based on any new or expanded theories of harm?
  6. What types of remedies would work in the cases to which those theories are applied?
  7. What factors, such as the scope of assets and characteristics of divestiture buyers, influence the likelihood and success of pharmaceutical divestitures to resolve competitive concerns?

My research assistant Andrew Mercado and I recently submitted comments for the record addressing the questions posed by the MPMTF. We concluded:

Federal merger enforcement in general and FTC pharmaceutical merger enforcement in particular have been effective in promoting competition and consumer welfare. Proposed statutory amendments to strengthen merger enforcement not only are unnecessary, but also would, if enacted, tend to undermine welfare and would thus be poor public policy. A brief analysis of seven questions propounded by the Multilateral Pharmaceutical Merger Task Force suggests that: (a) significant changes in enforcement policies are not warranted; and (b) investigators should employ sound law and economics analysis, taking full account of merger-related efficiencies, when evaluating pharmaceutical mergers. 

While we leave it to interested readers to review our specific comments, this commentary highlights one key issue which we stressed—the importance of giving due weight to efficiencies (and, in particular, dynamic efficiencies) in evaluating pharma mergers. We also note an important critique by FTC Commissioner Christine Wilson of the treatment accorded merger-related efficiencies by U.S. antitrust enforcers.   

Discussion

Innovation in pharmaceuticals and vaccines has immensely significant economic and social consequences, as demonstrated most recently in the handling of the COVID-19 pandemic. As such, it is particularly important that public policy not stand in the way of realizing efficiencies that promote innovation in these markets. This observation applies directly, of course, to pharmaceutical antitrust enforcement, in general, and to pharma merger enforcement, in particular.

Regrettably, however, though general merger-enforcement policy has been generally sound, it has somewhat undervalued merger-related efficiencies.

Although U.S. antitrust enforcers give lip service to their serious consideration of efficiencies in merger reviews, the reality appears to be quite different, as documented by Commissioner Wilson in a 2020 speech.

Wilson’s General Merger-Efficiencies Critique: According to Wilson, the combination of finding narrow markets and refusing to weigh out-of-market efficiencies has created major “legal and evidentiary hurdles a defendant must clear when seeking to prove offsetting procompetitive efficiencies.” What’s more, the “courts [have] largely continue[d] to follow the Agencies’ lead in minimizing the importance of efficiencies.” Wilson shows that “the Horizontal Merger Guidelines text and case law appear to set different standards for demonstrating harms and efficiencies,” and argues that this “asymmetric approach has the obvious potential consequence of preventing some procompetitive mergers that increase consumer welfare.” Wilson concludes on a more positive note that this problem can be addressed by having enforcers: (1) treat harms and efficiencies symmetrically; and (2) establish clear and reasonable expectations for what types of efficiency analysis will and will not pass muster.

While our filing with the MPMTF did not discuss Wilson’s general treatment of merger efficiencies, one would hope that the task force will appropriately weigh it in its deliberations. Our filing instead briefly addressed two “informational efficiencies” that may arise in the context of pharmaceutical mergers. These include:

More Efficient Resource Reallocation: The theory of the firm teaches that mergers may be motivated by the underutilization or misallocation of assets, or the opportunity to create welfare-enhancing synergies. In the pharmaceutical industry, these synergies may come from joining complementary research and development programs, combining diverse and specialized expertise that may be leveraged for better, faster drug development and more innovation.

Enhanced R&D: Currently, much of the R&D for large pharmaceutical companies is achieved through partnerships or investment in small biotechnology and research firms specializing in a single type of therapy. Whereas large pharmaceutical companies have expertise in marketing, navigating regulation, and undertaking trials of new drugs, small, research-focused firms can achieve greater advancements in medicine with smaller budgets. Furthermore, changes within firms brought about by a merger may increase innovation.

With increases in intellectual property and proprietary data that come from the merging of two companies, smaller research firms that work with the merged entity may have access to greater pools of information, enhancing the potential for innovation without increasing spending. This change not only raises the efficiency of the research being conducted in these small firms, but also increases the probability of a breakthrough without an increase in risk.

Conclusion

U.S. pharmaceutical merger enforcement has been fairly effective in forestalling anticompetitive combinations while allowing consumer welfare-enhancing transactions to go forward. Policy in this area should remain generally the same. Enforcers should continue to base enforcement decisions on sound economic theory fully supported by case-specific facts. Enforcement agencies could benefit, however, by placing a greater emphasis on efficiencies analysis. In particular, they should treat harms and efficiencies symmetrically (as recommend by Commissioner Wilson), and fully take into account likely resource reallocation and innovation-related efficiencies. 

The slew of recent antitrust cases in the digital, tech, and pharmaceutical industries has brought significant attention to the investments many firms in these industries make in “intangibles,” such as software and research and development (R&D).

Intangibles are recognized to have an important effect on a company’s (and the economy’s) performance. For example, Jonathan Haskel and Stian Westlake (2017) highlight the increasingly large investments companies have been making in things like programming in-house software, organizational structures, and, yes, a firm’s stock of knowledge obtained through R&D. They also note the considerable difficulties associated with valuing both those investments and the outcomes (such as new operational procedures, a new piece of software, or a new patent) of those investments.

This difficulty in valuing intangibles has gone somewhat under the radar until relatively recently. There has been progress in valuing them at the aggregate level (see Ellen R. McGrattan and Edward C. Prescott (2008)) and in examining their effects at the level of individual sectors (see McGrattan (2020)). It remains difficult, however, to ascertain the value of the entire stock of intangibles held by an individual firm.

There is a method to estimate the value of one component of a firm’s stock of intangibles. Specifically, the “stock of knowledge obtained through research and development” is likely to form a large proportion of most firms’ intangibles. Treating R&D as a “stock” might not be the most common way to frame the subject, but it does have an intuitive appeal.

What a firm knows (i.e., its intellectual property) is an input to its production process, just like physical capital. The most direct way for firms to acquire knowledge is to conduct R&D, which adds to its “stock of knowledge,” as represented by its accumulated stock of R&D. In this way, a firm’s accumulated investment in R&D then becomes a stock of R&D that it can use in production of whatever goods and services it wants. Thankfully, there is a relatively straightforward (albeit imperfect) method to measure a firm’s stock of R&D that relies on information obtained from a company’s accounts, along with a few relatively benign assumptions.

This method (set out by Bronwyn Hall (1990, 1993)) uses a firm’s annual expenditures on R&D (a separate line item in most company accounts) in the “perpetual inventory” method to calculate a firm’s stock of R&D in any particular year. This perpetual inventory method is commonly used to estimate a firm’s stock of physical capital, so applying it to obtain an estimate of a firm’s stock of knowledge—i.e., their stock of R&D—should not be controversial.

All this method requires to obtain a firm’s stock of R&D for this year is knowledge of a firm’s R&D stock and its investment in R&D (i.e., its R&D expenditures) last year. This year’s R&D stock is then the sum of those R&D expenditures and its undepreciated R&D stock that is carried forward into this year.

As some R&D expenditure datasets include, for example, wages paid to scientists and research workers, this is not exactly the same as calculating a firm’s physical capital stock, which would only use a firm’s expenditures on physical capital. But given that paying people to perform R&D also adds to a firm’s stock of R&D through the increased knowledge and expertise of their employees, it seems reasonable to include this in a firm’s stock of R&D.

As mentioned previously, this method requires making certain assumptions. In particular, it is necessary to assume a rate of depreciation of the stock of R&D each period. Hall suggests a depreciation of 15% per year (compared to the roughly 7% per year for physical capital), and estimates presented by Hall, along with Wendy Li (2018), suggest that, in some industries, the figure can be as high as 50%, albeit with a wide range across industries.

The other assumption required for this method is an estimate of the firm’s initial level of stock. To see why such an assumption is necessary, suppose that you have data on a firm’s R&D expenditure running from 1990-2016. This means that you can calculate a firm’s stock of R&D for each year once you have their R&D stock in the previous year via the formula above.

When calculating the firm’s R&D stock for 2016, you need to know what their R&D stock was in 2015, while to calculate their R&D stock for 2015 you need to know their R&D stock in 2014, and so on backward until you reach the first year for which you have data: in this, case 1990.

However, working out the firm’s R&D stock in 1990 requires data on the firm’s R&D stock in 1989. The dataset does not contain any information about 1989, nor the firm’s actual stock of R&D in 1990. Hence, it is necessary to make an assumption regarding the firm’s stock of R&D in 1990.

There are several different assumptions one can make regarding this “starting value.” You could assume it is just a very small number. Or you can assume, as per Hall, that it is the firm’s R&D expenditure in 1990 divided by the sum of the R&D depreciation and average growth rates (the latter being taken as 8% per year by Hall). Note that, given the high depreciation rates for the stock of R&D, it turns out that the exact starting value does not matter significantly (particularly in years toward the end of the dataset) if you have a sufficiently long data series. At a 15% depreciation rate, more than 50% of the initial value disappears after five years.

Although there are other methods to measure a firm’s stock of R&D, these tend to provide less information or rely on stronger assumptions than the approach described above does. For example, sometimes a firm’s stock of R&D is measured using a simple count of the number of patents they hold. However, this approach does not take into account the “value” of a patent. Since, by definition, each patent is unique (with differing number of years to run, levels of quality, ability to be challenged or worked around, and so on), it is unlikely to be appropriate to use an “average value of patents sold recently” to value it. At least with the perpetual inventory method described above, a monetary value for a firm’s stock of R&D can be obtained.

The perpetual inventory method also provides a way to calculate market shares of R&D in R&D-intensive industries, which can be used alongside current measures. This would be akin to looking at capacity shares in some manufacturing industries. Of course, using market shares in R&D industries can be fraught with issues, such as whether it is appropriate to use a backward-looking measure to assess competitive constraints in a forward-looking industry. This is why any investigation into such industries should also look, for example, at a firm’s research pipeline.

Naturally, this only provides for the valuation of the R&D stock and says nothing about valuing other intangibles that are likely to play an important role in a much wider range of industries. Nonetheless, this method could provide another means for competition authorities to assess the current and historical state of R&D stocks in industries in which R&D plays an important part. It would be interesting to see what firms’ shares of R&D stocks look like, for example, in the pharmaceutical and tech industries.

Last Thursday and Friday, Truth on the Market hosted a symposium analyzing the Draft Vertical Merger Guidelines from the FTC and DOJ. The relatively short draft guidelines provided ample opportunity for discussion, as evidenced by the stellar roster of authors thoughtfully weighing in on the topic. 

We want to thank all of the participants for their excellent contributions. All of the posts are collected here, and below I briefly summarize each in turn. 

Symposium Day 1

Herbert Hovenkamp on the important advance of economic analysis in the draft guidelines

Hovenkamp views the draft guidelines as a largely positive development for the state of antitrust enforcement. Beginning with an observation — as was common among participants in the symposium — that the existing guidelines are outdated, Hovenkamp believes that the inclusion of 20% thresholds for market share and related product use represent a reasonable middle position between the extremes of zealous antitrust enforcement and non-enforcement.

Hovenkamp also observes that, despite their relative brevity, the draft guidelines contain much by way of reference to the 2010 Horizontal Merger Guidelines. Ultimately Hovenkamp believes that, despite the relative lack of detail in some respects, the draft guidelines are an important step in elaborating the “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.”

Finally, he notes that, while the draft guidelines leave the current burden of proof in the hands of challengers, the presumption that vertical mergers are “invariably benign, particularly in highly concentrated markets or where the products in question are differentiated” has been weakened.

Full post.

Jonathan E. Neuchterlein on the lack of guidance in the draft vertical merger guidelines

Neuchterlein finds it hard to square elements of the draft vertical merger guidelines with both the past forty years of US enforcement policy as well as the empirical work confirming the largely beneficial nature of vertical mergers. Related to this, the draft guidelines lack genuine limiting principles when describing speculative theories of harm. Without better specificity, the draft guidelines will do little as a source of practical guidance.

One criticism from Neuchterlein is that the draft guidelines blur the distinction between “harm to competition” and “harm to competitors” by, for example, focusing on changes to rivals’ access to inputs and lost sales.

Neuchterlein also takes issue with what he characterizes as the “arbitrarily low” 20 percent thresholds. In particular, he finds the fact that the two separate 20 percent thresholds (relevant market and related product) being linked leads to a too-small set of situations in which firms might qualify for the safe harbor. Instead, by linking the two thresholds, he believes the provision does more to facilitate the agencies’ discretion, and little to provide clarity to firms and consumers.

Full post.

William J. Kolasky and Philip A. Giordano discuss the need to look to the EU for a better model for the draft guidelines

While Kolasky and Giordano believe that the 1984 guidelines are badly outdated, they also believe that the draft guidelines fail to recognize important efficiencies, and fail to give sufficiently clear standards for challenging vertical mergers.

By contrast, Kolasky and Giordano believe that the 2008 EU vertical merger guidelines provide much greater specificity and, in some cases, the 1984 guidelines were better aligned with the 2008 EU guidelines. Losing that specificity in the new draft guidelines sets back the standards. As such, they recommend that the DOJ and FTC adopt the EU vertical merger guidelines as a model for the US.

To take one example, the draft guidelines lose some of the important economic distinctions between vertical and horizontal mergers and need to be clarified, in particular with respect to burdens of proof related to efficiencies. The EU guidelines also provide superior guidance on how to distinguish between a firm’s ability and its incentive to raise rivals’ costs.

Full post.

Margaret Slade believes that the draft guidelines are a step in the right direction, but uneven on critical issues

Slade welcomes the new draft guidelines and finds them to be a good effort, if in need of some refinement.  She believes the agencies were correct to defer to the 2010 Horizontal Merger Guidelines for the the conceptual foundations of market definition and concentration, but believes that the 20 percent thresholds don’t reveal enough information. She believes that it would 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.”

Slade also takes issue with the way the draft guidelines deal with EDM. Although she does not believe that EDM should always be automatically assumed, the guidelines do not offer enough detail to determine the cases where it should not be.

For Slade, the guidelines also fail to include a wide range of efficiencies that can arise from vertical integration. For instance “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 important considerations that the draft guidelines should acknowledge.

Slade also advises caution when simulating vertical mergers. They are much more complex than horizontal simulations, which means 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.”

Full post.

Joshua D. Wright, Douglas H. Ginsburg, Tad Lipsky, and John M. Yun on how to extend the economic principles present in the draft vertical merger guidelines

Wright et al. commend the agencies for highlighting important analytical factors while avoiding “untested merger assessment tools or theories of harm.”

They do, however, offer some points for improvement. First, EDM should be clearly incorporated into the unilateral effects analysis. The way the draft guidelines are currently structured improperly leaves the role of EDM in a sort of “limbo” between effects analysis and efficiencies analysis that could confuse courts and lead to an incomplete and unbalanced assessment of unilateral effects.

Second, Wright et al. also argue that the 20 percent thresholds in the draft guidelines do not have any basis in evidence or theory, nor are they of “any particular importance to predicting competitive effects.”

Third, by abandoning the 1984 guidelines’ acknowledgement of the generally beneficial effects of vertical mergers, the draft guidelines reject the weight of modern antitrust literature and fail to recognize “the empirical reality that vertical relationships are generally procompetitive or neutral.”

Finally, the draft guidelines should be more specific in recognizing that there are transaction costs associated with integration via contract. Properly conceived, the guidelines should more readily recognize that efficiencies arising from integration via merger are cognizable and merger specific.

Full post.

Gregory J. Werden and Luke M. Froeb on the the conspicuous silences of the proposed vertical merger guidelines

A key criticism offered by Werden and Froeb in their post is that “the proposed Guidelines do not set out conditions necessary or sufficient for the agencies to conclude that a merger likely would substantially lessen competition.” The draft guidelines refer to factors the agencies may consider as part of their deliberation, but ultimately do not give an indication as to how those different factors will be weighed. 

Further, Werden and Froeb believe that the draft guidelines fail even to communicate how the agencies generally view the competitive process — in particular, how the agencies’ views regard the critical differences between horizontal and vertical mergers. 

Full post.

Jonathan M. Jacobson and Kenneth Edelson on the missed opportunity to clarify merger analysis in the draft guidelines

Jacobson and Edelson begin with an acknowledgement that the guidelines are outdated and that there is a dearth of useful case law, thus leading to a need for clarified rules. Unfortunately, they do not feel that the current draft guidelines do nearly enough to satisfy this need for clarification. 

Generally positive about the 20% thresholds in the draft guidelines, Jacobson and Edelson nonetheless feel that this “loose safe harbor” leaves some problematic ambiguity. For example, the draft guidelines endorse a unilateral foreclosure theory of harm, but leave unspecified what actually qualifies as a harm. Also, while the Baker Hughes burden shifting framework is widely accepted, the guidelines fail to specify how burdens should be allocated in vertical merger cases. 

The draft guidelines also miss an important opportunity to specify whether or not EDM should be presumed to exist in vertical mergers, and whether it should be presumptively credited as merger-specific.

Full post.

Symposium Day 2

Timothy Brennan on the complexities of enforcement for “pure” vertical mergers

Brennan’s post focused on what he referred to as “pure” vertical mergers that do not include concerns about expansion into upstream or downstream markets. Brennan notes the highly complex nature of speculative theories of vertical harms that can arise from vertical mergers. Consequently, he concludes that, with respect to blocking pure vertical mergers, 

“[I]t is not clear that we are better off expending the resources to see whether something is bad, rather than accepting the cost of error from adopting imperfect rules — even rules that imply strict enforcement. Pure vertical merger may be an example of something that we might just want to leave be.”

Full post.

Steven J. Cernak on the burden of proof for EDM

Cernak’s post examines the absences and ambiguities in the draft guidelines as compared to the 1984 guidelines. He notes the absence of some theories of harm — for instance, the threat of regulatory evasion. And then moves on to point out the ambiguity in how the draft guidelines deal with pleading and proving EDM.

Specifically, the draft guidelines are unclear as to how EDM should be treated. Is EDM an affirmative defense, or is it a factor that agencies are required to include as part of their own analysis? In Cernak’s opinion, the agencies should be clearer on the point. 

Full post.

Eric Fruits on messy mergers and muddled guidelines

Fruits observes that the attempt of the draft guidelines to clarify how the Agencies think about mergers and competition actually demonstrates how complex markets, related products, and dynamic competition actually are.

Fruits goes on to describe how the nature of assumptions necessary to support the speculative theories of harm that the draft guidelines may rely upon are vulnerable to change. Ultimately, relying on such theories and strong assumptions may make market definition of even “obvious” markets and products a fraught exercise that devolves into a battle of experts. 

Full post.

Pozen, Cornell, Concklin, and Van Arsdall on the missed opportunity to harmonize with international law

Pozen et al. believe that the draft guidelines inadvisably move the US away from accepted international standards. The 20 percent threshold in the draft guidelines   is “arbitrarily low” given the generally pro competitive nature of vertical combinations. 

Instead, DOJ and the FTC should consider following the approaches taken by the EU, Japan and Chile by favoring a 30 percent threshold for challenges along with a post-merger  HHI measure below 2000.

Full post.

Scott Sher and Mattew McDonald write about the implications of the Draft Vertical Merger Guidelines for vertical mergers involving technology start-ups

Sher and McDonald describe how the draft Vertical guidelines miss a valuable opportunity to clarify speculative theories harm based on “potential competition.” 

In particular, the draft guidelines should address the literature that demonstrates that vertical acquisition of small tech firms by large tech firms is largely complementary and procompetitive. Large tech firms are good at process innovation and the smaller firms are good at product innovation leading to specialization and the realization of efficiencies through acquisition. 

Further, innovation in tech markets is driven by commercialization and exit strategy. Acquisition has become an important way for investors and startups to profit from their innovation. Vertical merger policy that is biased against vertical acquisition threatens this ecosystem and the draft guidelines should be updated to reflect this reality.

Full post.

Rybnicek on how the draft vertical merger guidelines might do more harm than good

Rybnicek notes the common calls to withdraw the 1984 Non-Horizontal Merger Guidelines, but is skeptical that replacing them will be beneficial. Particularly, he believes there are major flaws in the draft guidelines that would lead to suboptimal merger policy at the Agencies.

One concern is that the draft guidelines could easily lead to the impression that vertical mergers are as likely to lead to harm as horizontal mergers. But that is false and easily refuted by economic evidence and logic. By focusing on vertical transactions more than the evidence suggests is necessary, the Agencies will waste resources and spend less time pursuing enforcement of actually anticompetitive transactions.

Rybicek also notes that, in addition to the 20 percent threshold “safe harbor” being economically unsound, they will likely create a problematic “sufficient condition” for enforcement.

Rybnicek believes that the draft guidelines minimize the significant role of EDM and efficiencies by pointing to the 2010 Horizontal Merger Guidelines for analytical guidance. In the horizontal context, efficiencies are exceedingly difficult to prove, and it is unwarranted to apply the same skeptical treatment of efficiencies in the vertical merger context.

Ultimately, Rybnicek concludes that the draft guidelines do little to advance an understanding of how the agencies will look at a vertical transaction, while also undermining the economics and theory that have guided antitrust law. 

Full post.

Lawrence J. White on the missing market definition standard in the draft vertical guidelines

White believes that there is a gaping absence in the draft guidelines insofar as they lack an adequate  market definition paradigm. White notes that markets need to be defined in a way that permits a determination of market power (or not) post-merger, but the guidelines refrain from recommending a vertical-specific method for drawing market definition. 

Instead, the draft guidelines point to the 2010 Horizontal Merger Guidelines for a market definition paradigm. Unfortunately, that paradigm is inapplicable in the vertical merger context. The way that markets are defined in the horizontal and vertical contexts is very different. There is a significant chance that an improperly drawn market definition based on the Horizontal Guidelines could understate the risk of harm from a given vertical merger.

Full post.

Manne & Stout 1 on the important differences between integration via contract and integration via merger

Manne & Stout believe that there is a great deal of ambiguity in the proposed guidelines that could lead either to uncertainty as to how the agencies will exercise their discretion, or, more troublingly, could lead courts to take seriously speculative theories of harm. 

Among these, Manne & Stout believe that the Agencies should specifically address the alleged equivalence of integration via contract and integration via merger. They  need to either repudiate this theory, or else more fully explain the extremely complex considerations that factor into different integration decisions for different firms.

In particular, there is no reason to presume in any given situation that the outcome from contracting would be the same as from merging, even where both are notionally feasible. It would be a categorical mistake for the draft guidelines to permit an inference that simply because an integration could be achieved by contract, it follows that integration by merger deserves greater scrutiny per se.

A whole host of efficiency and non-efficiency related goals are involved in a choice of integration methods. But adopting a presumption against integration via merger necessary leads to (1) an erroneous assumption that efficiencies are functionally achievable in both situations and (2) a more concerning creation of discretion in the hands of enforcers to discount the non-efficiency reasons for integration.

Therefore, the agencies should clarify in the draft guidelines that the mere possibility of integration via contract or the inability of merging parties to rigorously describe and quantify efficiencies does not condemn a proposed merger.

Full post.

Manne & Stout 2 on the problematic implication of incorporating a contract/merger equivalency assumption into the draft guidelines

Manne & Stout begin by observing that, while Agencies have the opportunity to enforce in either the case of merger or contract, defendants can frequently only realize efficiencies in the case of merger. Therefore, calling for a contract/merger equivalency amounts to a preference for more enforcement per se, and is less solicitous of concerns about loss of procompetitive arrangements. Moreover, Manne & Stout point out that there is currently no empirical basis for justifying the weighting of enforcement so heavily against vertical mergers. 

Manne & Stout further observe that vertical merger enforcement is more likely to thwart procompetitive than anticompetitive arrangements relative to the status quo ante because we lack fundamental knowledge about the effects of market structure and firm organization on innovation and dynamic competition. 

Instead, the draft guidelines should adopt Williamson’s view of economic organizations: eschew the formal orthodox neoclassical economic lens in favor of organizational theory that focuses on complex contracts (including vertical mergers). Without this view, “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.”

Critically, Manne & Stout argue that the guidelines focus on market share thresholds leads to an overly narrow view of competition. Instead of looking at static market analyses, the Agencies should include a richer set of observations, including those that involve “organizational decisions made to facilitate the coordination of production and commercialization when they are dependent upon intangible assets.”

Ultimately Manne & Stout suggest that the draft guidelines should be clarified to guide the Agencies and courts away from applying inflexible, formalistic logic that will lead to suboptimal enforcement.

Full post.

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.   

[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 Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics ); and Kristian Stout (Associate Director, ICLE).]

As many in the symposium have noted — and as was repeatedly noted during the FTC’s Hearings on Competition and Consumer Protection in the 21st Century — there is widespread dissatisfaction with the 1984 Non-Horizontal Merger Guidelines

Although it is doubtless correct that the 1984 guidelines don’t reflect the latest economic knowledge, it is by no means clear that this has actually been a problem — or that a new set of guidelines wouldn’t create even greater problems. Indeed, as others have noted in this symposium, there is a great deal of ambiguity in the proposed guidelines that could lead either to uncertainty as to how the agencies will exercise their discretion, or, more troublingly, could lead courts to take seriously speculative theories of harm

We can do little better in expressing our reservations that new guidelines are needed than did the current Chairman of the FTC, Joe Simons, writing on this very blog in a symposium on what became the 2010 Horizontal Merger Guidelines. In a post entitled, Revisions to the Merger Guidelines: Above All, Do No Harm, Simons writes:

My sense is that there is no need to revise the DOJ/FTC Horizontal Merger Guidelines, with one exception…. The current guidelines lay out the general framework quite well and any change in language relative to that framework are likely to create more confusion rather than less. Based on my own experience, the business community has had a good sense of how the agencies conduct merger analysis…. If, however, the current administration intends to materially change the way merger analysis is conducted at the agencies, then perhaps greater revision makes more sense. But even then, perhaps the best approach is to try out some of the contemplated changes (i.e. in actual investigations) and publicize them in speeches and the like before memorializing them in a document that is likely to have some substantial permanence to it.

Wise words. Unless, of course, “the current [FTC] intends to materially change the way [vertical] merger analysis is conducted.” But the draft guidelines don’t really appear to portend a substantial change, and in several ways they pretty accurately reflect agency practice.

What we want to draw attention to, however, is an implicit underpinning of the draft guidelines that we believe the agencies should clearly disavow (or at least explain more clearly the complexity surrounding): the extent and implications of the presumed functional equivalence of vertical integration by contract and by merger — the contract/merger equivalency assumption.   

Vertical mergers and their discontents

The contract/merger equivalency assumption has been gaining traction with antitrust scholars, but it is perhaps most clearly represented in some of Steve Salop’s work. Salop generally believes that vertical merger enforcement should be heightened. Among his criticisms of current enforcement is his contention that efficiencies that can be realized by merger can often also be achieved by contract. As he discussed during his keynote presentation at last year’s FTC hearing on vertical mergers:

And, finally, the key policy issue is the issue is not about whether or not there are efficiencies; the issue is whether the efficiencies are merger-specific. As I pointed out before, Coase stressed that you can get vertical integration by contract. Very often, you can achieve the vertical efficiencies if they occur, but with contracts rather than having to merge.

And later, in the discussion following his talk:

If there is vertical integration by contract… it meant you could get all the efficiencies from vertical integration with a contract. You did not actually need the vertical integration. 

Salop thus argues that because the existence of a “contract solution” to firm problems can often generate the same sorts of efficiencies as when firms opt to merge, enforcers and courts should generally adopt a presumption against vertical mergers relative to contracting:

Coase’s door swings both ways: Efficiencies often can be achieved by vertical contracts, without the potential anticompetitive harms from merger

In that vertical restraints are characterized as “just” vertical integration “by contract,” then claimed efficiencies in problematical mergers might be achieved with non-merger contracts that do not raise the same anticompetitive concerns. (emphasis in original)

(Salop isn’t alone in drawing such a conclusion, of course; Carl Shapiro, for example, has made a similar point (as have others)).

In our next post we explore the policy errors implicated by this contract/merger equivalency assumption. But here we want to consider whether it makes logical sense in the first place

The logic of vertical integration is not commutative 

It is true that, where contracts are observed, they are likely as (or more, actually)  efficient than merger. But, by the same token, it is also true that where mergers are observed they are likely more efficient than contracts. Indeed, the entire reason for integration is efficiency relative to what could be done by contract — this is the essence of the so-called “make-or-buy” decision. 

For example, a firm that decides to buy its own warehouse has determined that doing so is more efficient than renting warehouse space. Some of these efficiencies can be measured and quantified (e.g., carrying costs of ownership vs. the cost of rent), but many efficiencies cannot be easily measured or quantified (e.g., layout of the facility or site security). Under the contract/merger equivalency assumption, the benefits of owning a warehouse can be achieved “very often” by renting warehouse space. But the fact that many firms using warehouses own some space and rent some space indicates that the make-or-buy decision is often unique to each firm’s idiosyncratic situation. Moreover, the distinctions driving those differences will not always be readily apparent, and whether contracting or integrating is preferable in any given situation may not be inferred from the existence of one or the other elsewhere in the market — or even in the same firm!

There is no reason to presume in any given situation that the outcome from contracting would be the same as from merging, even where both are notionally feasible. The two are, quite simply, different bargaining environments, each with a different risk and cost allocation; accounting treatment; effect on employees, customers, and investors; tax consequence, etc. Even if the parties accomplished nominally “identical” outcomes, they would not, in fact, be identical.

Meanwhile, what if the reason for failure to contract, or the reason to prefer merger, has nothing to do with efficiency? What if there were no anticompetitive aim but there were a tax advantage? What if one of the parties just wanted a larger firm in order to satisfy the CEO’s ego? That these are not cognizable efficiencies under antitrust law is clear. But the adoption of a presumption of equivalence between contract and merger would — ironically — entail their incorporation into antitrust law just the same — by virtue of their effective prohibition under antitrust law

In other words, if the assumption is that contract and merger are equally efficient unless proven otherwise, but the law adopts a suspicion (or, even worse, a presumption) that vertical mergers are anticompetitive which can be rebutted only with highly burdensome evidence of net efficiency gain, this effectively deputizes antitrust law to enforce a preconceived notion of “merger appropriateness” that does not necessarily turn on efficiencies. There may (or may not) be sensible policy reasons for adopting such a stance, but they aren’t antitrust reasons.

More fundamentally, however, while there are surely some situations in which contractual restraints might be able to achieve similar organizational and efficiency gains as a merger, the practical realities of achieving not just greater efficiency, but a whole host of non-efficiency-related, yet nonetheless valid, goals, are rarely equivalent between the two

It may be that the parties don’t know what they don’t know to such an extent that a contract would be too costly because it would be too incomplete, for example. But incomplete contracts and ambiguous control and ownership rights aren’t (as much of) an issue on an ongoing basis after a merger. 

As noted, there is no basis for assuming that the structure of a merger and a contract would be identical. In the same way, there is no basis for assuming that the knowledge transfer that would result from a merger would be the same as that which would result from a contract — and in ways that the parties could even specify or reliably calculate in advance. Knowing that the prospect for knowledge “synergies” would be higher with a merger than a contract might be sufficient to induce the merger outcome. But asked to provide evidence that the parties could not engage in the same conduct via contract, the parties would be unable to do so. The consequence, then, would be the loss of potential gains from closer integration.

At the same time, the cavalier assumption that parties would be able — legally — to enter into an analogous contract in lieu of a merger is problematic, given that it would likely be precisely the form of contract (foreclosing downstream or upstream access) that is alleged to create problems with the merger in the first place.

At the FTC hearings last year, Francine LaFontaine highlighted this exact concern

I want to reemphasize that there are also rules against vertical restraints in antitrust laws, and so to say that the firms could achieve the mergers outcome by using vertical restraints is kind of putting them in a circular motion where we are telling them you cannot merge because you could do it by contract, and then we say, but these contract terms are not acceptable.

Indeed, legal risk is one of the reasons why a merger might be preferable to a contract, and because the relevant markets here are oligopoly markets, the possibility of impermissible vertical restraints between large firms with significant market share is quite real.

More important, the assumptions underlying the contention that contracts and mergers are functionally equivalent legal devices fails to appreciate the importance of varied institutional environments. Consider that one reason some takeovers are hostile is because incumbent managers don’t want to merge, and often believe that they are running a company as well as it can be run — that a change of corporate control would not improve efficiency. The same presumptions may also underlie refusals to contract and, even more likely, may explain why, to the other firm, a contract would be ineffective.

But, while there is no way to contract without bilateral agreement, there is a corporate control mechanism to force a takeover. In this institutional environment a merger may be easier to realize than a contract (and that applies even to a consensual merger, of course, given the hostile outside option). In this case, again, the assumption that contract should be the relevant baseline and the preferred mechanism for coordination is misplaced — even if other firms in the industry are successfully accomplishing the same thing via contract, and even if a contract would be more “efficient” in the abstract.

Conclusion

Properly understood, the choice of whether to contract or merge derives from a host of complicated factors, many of which are difficult to observe and/or quantify. The contract/merger equivalency assumption — and the species of “least-restrictive alternative” reasoning that would demand onerous efficiency arguments to permit a merger when a contract was notionally possible — too readily glosses over these complications and unjustifiably embraces a relative hostility to vertical mergers at odds with both theory and evidence

Rather, as has long been broadly recognized, there can be no legally relevant presumption drawn against a company when it chooses one method of vertical integration over another in the general case. The agencies should clarify in the draft guidelines that the mere possibility of integration via contract or the inability of merging parties to rigorously describe and quantify efficiencies does not condemn a proposed merger.

[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 Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division).]

The DOJ/FTC Draft Vertical Merger Guidelines establish a “safe harbor” of a 20% market share for each of the merging parties. But the issue of defining the relevant “market” to which the 20% would apply is not well addressed.

Although reference is made to the market definition paradigm that is offered by the DOJ’s and FTC’s Horizontal Merger Guidelines (“HMGs”), what is neglected is the following: Under the “unilateral effects” theory of competitive harm of the HMGs, the horizontal merger of two firms that sell differentiated products that are imperfect substitutes could lead to significant price increases if the second-choice product for a significant fraction of each of the merging firms’ customers is sold by the partner firm. Such unilateral-effects instances are revealed by examining detailed sales and substitution data with respect to the customers of only the two merging firms.

In such instances, the true “relevant market” is simply the products that are sold by the two firms, and the merger is effectively a “2-to-1” merger. Under these circumstances, any apparently broader market (perhaps based on physical or functional similarities of products) is misleading, and the “market” shares of the merging parties that are based on that broader market are under-representations of the potential for their post-merger exercise of market power.

With a vertical merger, the potential for similar unilateral effects* would have to be captured by examining the detailed sales and substitution patterns of each of the merging firms with all of their significant horizontal competitors. This will require a substantial, data-intensive effort. And, of course, if this effort is not undertaken and an erroneously broader market is designated, the 20% “market” share threshold will understate the potential for competitive harm from a proposed vertical merger.

* With a vertical merger, such “unilateral effects” could arise post-merger in two ways: (a) The downstream partner could maintain a higher price, since some of the lost profits from some of the lost sales could be recaptured by the upstream partner’s profits on the sales of components to the downstream rivals (which gain some of the lost sales); and (b) the upstream partner could maintain a higher price to the downstream rivals, since some of the latter firms’ customers (and the concomitant profits) would be captured by the downstream partner.

[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 Jan Rybnicek (Counsel at Freshfields Bruckhaus Deringer US LLP in Washington, D.C. and Senior Fellow and Adjunct Professor at the Global Antitrust Institute at the Antonin Scalia Law School at George Mason University).]

In an area where it may seem that agreement is rare, there is near universal agreement on the benefits of withdrawing the DOJ’s 1984 Non-Horizontal Merger Guidelines. The 1984 Guidelines do not reflect current agency thinking on vertical mergers and are not relied upon by businesses or practitioners to anticipate how the agencies may review a vertical transaction. The more difficult question is whether the agencies should now replace the 1984 Guidelines and, if so, what the modern guidelines should say.

There are several important reasons that counsel against issuing new vertical merger guidelines (VMGs). Most significantly, we likely are better off without new VMGs because they invariably will (1) send the wrong message to agency staff about the relative importance of vertical merger enforcement compared to other agency priorities, (2) create new sufficient conditions that tend to trigger wasteful investigations and erroneous enforcement actions, and (3) add very little, if anything, to our understanding of when the agencies will or will not pursue an in-depth investigation or enforcement action of a vertical merger.

Unfortunately, these problems are magnified rather than mitigated by the draft VMGs. But it is unlikely at this point that the agencies will hit the brakes and not issue new VMGs. The agencies therefore should make several key changes that would help prevent the final VMGs from causing more harm than good.

What is the Purpose of Agency Guidelines? 

Before we can have a meaningful conversation about whether the draft VMGs are good or bad for the world, or how they can be improved to ensure they contribute positively to antitrust law, it is important to identify, and have a shared understanding about, the purpose of guidelines and their potential benefits.

In general, I am supportive of guidelines. In fact, I helped urge the FTC to issue its 2015 Policy Statement articulating the agency’s enforcement principles under its Section 5 Unfair Methods of Competition authority. As I have written before, guidelines can be useful if they accomplish two important goals: (1) provide insight and transparency to businesses and practitioners about the agencies’ analytical approach to an issue and (2) offer agency staff direction as to agency priorities while cabining the agencies’ broad discretion by tethering investigational or enforcement decisions to those guidelines. An additional benefit may be that the guidelines also could prove useful to courts interpreting or applying the antitrust laws.

Transparency is important for the obvious reason that it allows the business community and practitioners to know how the agencies will apply the antitrust laws and thereby allows them to evaluate if a specific merger or business arrangement is likely to receive scrutiny. But guidelines are not only consumed by the public. They also are used by agency staff. As a result, guidelines invariably influence how staff approaches a matter, including whether to open an investigation, how in-depth that investigation is, and whether to recommend an enforcement action. Lastly, for guidelines to be meaningful, they also must accurately reflect agency practice, which requires the agencies’ analysis to be tethered to an analytical framework.

As discussed below, there are many reasons to doubt that the draft VMGs can deliver on these goals.

Draft VMGs Will Lead to Bad Enforcement Policy While Providing Little Benefit

 A chief concern with VMGs is that they will inadvertently usher in a new enforcement regime that treats horizontal and vertical mergers as co-equal enforcement priorities despite the mountain of evidence, not to mention simple logic, that mergers among competitors are a significantly greater threat to competition than are vertical mergers. The draft VMGs exacerbate rather than mitigate this risk by creating a false equivalence between vertical and horizontal merger enforcement and by establishing new minimum conditions that are likely to lead the agencies to pursue wasteful investigations of vertical transactions. And the draft VMGs do all this without meaningfully advancing our understanding of the conditions under which the agencies are likely to pursue investigations and enforcement against vertical mergers.

1. No Recognition of the Differences Between Horizontal and Vertical Mergers

One striking feature of the draft VMGs is that they fail to contextualize vertical mergers in the broader antitrust landscape. As a result, it is easy to walk away from the draft VMGs with the impression that vertical mergers are as likely to lead to anticompetitive harm as are horizontal mergers. That is a position not supported by the economic evidence or logic. It is of course true that vertical mergers can result in competitive harm; that is not a seriously contested point. But it is important to acknowledge and provide background for why that harm is significantly less likely than in horizontal cases. That difference should inform agency enforcement priorities. Potentially due to this the lack of framing, the draft VMGs tend to speak more about when the agencies may identify competitive harm rather than when they will not.

The draft VMGs would benefit greatly from a more comprehensive approach to understanding vertical merger transactions. The agencies should add language explaining that, whereas a consensus exists that eliminating a direct competitor always tends to increase the risk of unilateral effects (although often trivially), there is no such consensus that harm will result from the combination of complementary assets. In fact, the current evidence shows such vertical transactions tend to be procompetitive. Absent such language, the VMGs will over time misguidedly focus more agency resources into investigating vertical mergers where there is unlikely to be harm (with inevitably more enforcement errors) and less time on more important priorities, such as pursuing enforcement of anticompetitive horizontal transactions.

2. The 20% Safe Harbor Provides No Harbor and Will Become a Sufficient Condition

The draft VMGs attempt to provide businesses with guidance about the types of transactions the agencies will not investigate by articulating a market share safe harbor. But that safe harbor does not (1) appear to be grounded in any evidence, (2) is surprisingly low in comparison to the EU vertical merger guidelines, and (3) is likely to become a sufficient condition to trigger an in-depth investigation or enforcement. 

The draft VMGs state:

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

But in the very next sentence the draft VMGs render the safe harbor virtually meaningless, stating:

In some circumstance, mergers with shares below the threshold can give rise to competitive concerns.

This caveat comes despite the fact that the 20% threshold is low compared to other jurisdictions. Indeed, the EU’s guidelines create a 30% safe harbor. Nor is it clear what the basis is for the 20% threshold, either in economics or law. While it is important for the agencies to remain flexible, too much flexibility will render the draft VMGs meaningless. The draft VMGs should be less equivocal about the types of mergers that will not receive significant scrutiny and are unlikely to be the subject of enforcement action.

What may be most troubling about the market share safe harbor is the likelihood that it will establish general enforcement norms that did not previously exist. It is likely that agency staff will soon interpret (despite language stating otherwise) the 20% market share as the minimum necessary condition to open an in-depth investigation and to pursue an enforcement action. We have seen other guidelines’ tools have similar effects on agency analysis before (see, GUPPIs). This risk is only exacerbated where the safe harbor is not a true safe harbor that provides businesses with clarity on enforcement priorities.

3. Requirements for Proving EDM and Efficiencies Fails to Recognize Vertical Merger Context

The draft VMGs minimize the significant role of EDM and efficiencies in vertical mergers. The agencies frequently take a skeptical approach to efficiencies in the context of horizontal mergers and it is well-known that the hurdle to substantiate efficiencies is difficult, if not impossible, to meet. The draft VMGs oddly continue this skeptical approach by specifically referencing the standards discussed in the horizontal merger guidelines for efficiencies when discussing EDM and vertical merger efficiencies. The draft VMGs do not recognize that the combination of complementary products is inherently more likely to generate efficiencies than in horizontal mergers between competitors. The draft VMGs also oddly discuss EDM and efficiencies in separate sections and spend a trivial amount of time on what is the core motivating feature of vertical mergers. Even the discussion of EDM is as much about where there may be exceptions to EDM as it is about making clear the uncontroversial view that EDM is frequent in vertical transactions. Without acknowledging the inherent nature of EDM and efficiencies more generally, the final VMGs will send the wrong message that vertical merger enforcement should be on par with horizontal merger enforcement.

4. No New Insights into How Agencies Will Assess Vertical Mergers

Some might argue that the costs associated with the draft VMGs nevertheless are tolerable because the guidelines offer significant benefits that far outweigh their costs. But that is not the case here. The draft VMGs provide no new information about how the agencies will review vertical merger transactions and under what circumstances they are likely to seek enforcement actions. And that is because it is a difficult if not impossible task to identify any such general guiding principles. Indeed, unlike in the context of horizontal transactions where an increase in market power informs our thinking about the likely competitive effects, greater market power in the context of a vertical transaction that combines complements creates downward pricing pressure that often will dominate any potential competitive harm.

The draft VMGs do what they can, though, which is to describe in general terms several theories of harm. But the benefits from that exercise are modest and do not outweigh the significant risks discussed above. The theories described are neither novel or unknown to the public today. Nor do the draft VMGs explain any significant new thinking on vertical mergers, likely because there has been none that can provide insight into general enforcement principles. The draft VMGs also do not clarify changes to statutory text (because it has not changed) or otherwise clarify judicial rulings or past enforcement actions. As a result, the draft VMGs do not offer sufficient benefits that would outweigh their substantial cost.

Conclusion

Despite these concerns, it is worth acknowledging the work the FTC and DOJ have put into preparing the draft VMGs. It is no small task to articulate a unified position between the two agencies on an issue such as vertical merger enforcement where so many have such strong views. To the agencies’ credit, the VMGs are restrained in not including novel or more adventurous theories of harm. I anticipate the DOJ and FTC will engage with commentators and take the feedback seriously as they work to improve the final VMGs.