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[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 Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati), and Kenneth Edelson (Associate, Wilson Sonsini Goodrich & Rosati).]

So we now have 21st Century Vertical Merger Guidelines, at least in draft. Yay. Do they tell us anything? Yes! Do they tell us much? No. But at least it’s a start.

* * * * *

In November 2018, the FTC held hearings on vertical merger analysis devoted to the questions of whether the agencies should issue new guidelines, and what guidance those guidelines should provide. And, indeed, on January 10, 2020, the DOJ and FTC issued their new Draft Vertical Merger Guidelines (“Draft Guidelines”). That new guidance has finally been issued is a welcome development. The antitrust community has been calling for new vertical merger guidelines for some time. The last vertical merger guidelines were issued in 1984, and there is broad consensus in the antitrust community – despite vigorous debate on correct legal treatment of vertical mergers – that the ’84 Guidelines are outdated and should be withdrawn. Despite disagreement on the best enforcement policy, there is general recognition that the legal rules applicable to vertical mergers need clarification. New guidelines are especially important in light of recent high-visibility merger challenges, including the government’s challenge to the ATT/Time Warner merger, the first vertical merger case litigated since the 1970s. These merger challenges have occurred in an environment in which there is little up-to-date case law to guide courts or agencies and the ’84 Guidelines have been rendered obsolete by subsequent developments in economics. 

The discussion here focuses on what the new Draft Guidelines do say, key issues on which they do not weigh in, and where additional guidance would be desirable

What the Draft Guidelines do say

The Draft Guidelines start with a relevant market requirement – making clear that the agencies will identify at least one relevant market in which a vertical merger may foreclose competition. However, the Draft Guidelines do not require a market definition for the vertically related upstream or downstream market(s) in the merger. Rather, the agencies’ proposed policy is to identify one or more “related products.” The Draft Guidelines define a related product as

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

The Draft Guidelines’ most significant (and most concrete) proposal is a loose safe harbor based on market share and the percentage of use of the related product in the relevant market of interest. The Draft Guidelines suggest that agencies are not likely to challenge mergers if two conditions are met: (1) the merging company has less than 20% market share in the relevant market, and (2) less than 20% of the relevant market uses the related product identified by the agencies. 

This proposed safe harbor is welcome. Generally, in order for a vertical merger to have anticompetitive effects, both the upstream and downstream markets involved need to be concentrated, and the merging firms’ shares of both markets have to be substantial – although the Draft Guidelines do not contain any such requirements. Mergers in which the merging company has less than a 20% market share of the relevant market, and in which less than 20% of the market uses the vertically related product are unlikely to have serious anticompetitive effects.

However, the proposed safe harbor does not provide much certainty. After describing the safe harbor, the Draft Guidelines offer a caveat: meeting the proposed 20% thresholds will not serve as a “rigid screen” for the agencies to separate out mergers that are unlikely to have anticompetitive effects. Accordingly, the guidelines as currently drafted do not guarantee that vertical mergers in which market share and related product use fall below 20% would be immune from agency scrutiny. So, while the proposed safe harbor is a welcome statement of good policy that may guide agency staff and courts in analyzing market share and share of relevant product use, it is not a true safe harbor. This ambiguity limits the safe harbor’s utility for the purpose of counseling clients on market share issues.

The Draft Guidelines also identify a number of specific unilateral anticompetitive effects that, in the agencies’ view, may result from vertical mergers (the Draft Guidelines note that coordinated effects will be evaluated consistent with the Horizontal Merger Guidelines). Most importantly, the guidelines name raising rivals’ costs, foreclosure, and access to competitively sensitive information as potential unilateral effects of vertical mergers. The Draft Guidelines indicate that the agency may consider the following issues: would foreclosure or raising rivals’ costs (1) cause rivals to lose sales; (2) benefit the post-merger firm’s business in the relevant market; (3) be profitable to the firm; and (4) be beyond a de minimis level, such that it could substantially lessen competition? Mergers where all four conditions are met, the Draft Guidelines say, often warrant competitive scrutiny. While the big picture guidance about what agencies find concerning is helpful, the Draft Guidelines are short on details that would make this a useful statement of enforcement policy, or sufficiently reliable to guide practitioners in counseling clients. Most importantly, the Draft guidelines give no indication of what the agencies will consider a de minimis level of foreclosure.

The Draft Guidelines also articulate a concern with access to competitively sensitive information, as in the recent Staples/Essendant enforcement action. There, the FTC permitted the merger after imposing a firewall that blocked Staples from accessing certain information about its rivals held by Essendant. This contrasts with the current DOJ approach of hostility to behavioral remedies.

What the Draft Guidelines don’t say

The Draft Guidelines also decline to weigh in on a number of important issues in the debates over vertical mergers. Two points are particularly noteworthy.

First, the Draft Guidelines decline to allocate the parties’ proof burdens on key issues. The burden-shifting framework established in U.S. v. Baker Hughes is regularly used in horizontal merger cases, and was recently adopted in AT&T/Time-Warner in a vertical context. The framework has three phases: (1) the plaintiff bears the burden of establishing a prima facie case that the merger will substantially lessen competition in the relevant market; (2) the defendant bears the burden of producing evidence to demonstrate that the merger’s procompetitive effects outweigh the alleged anticompetitive effects; and (3) the plaintiff bears the burden of countering the defendant’s rebuttal, and bears the ultimate burden of persuasion. Virtually everyone agrees that this or some similar structure should be used. However, the Draft Guidelines’ silence on the appropriate burden is consistent with the agencies’ historical practice: The 2010 Horizontal Merger Guidelines allocate no burdens and the 1997 Merger Guidelines explicitly decline to assign the burden of proof or production on any issue.

Second, the Draft Guidelines take an unclear approach to elimination of double marginalization (EDM). The appropriate treatment of EDM has been one of the key topics in the debates on the law and economics of vertical mergers, but the Draft Guidelines take no position on the key issues in the conversation about EDM: whether it should be presumed in a vertical merger, and whether it should be presumed to be merger-specific.

EDM may occur if two vertically related firms merge and the new firm captures the margins of both the upstream and downstream firms. After the merger, the downstream firm gets its input at cost, allowing the merged firm to eliminate one party’s markup. This makes price reduction profitable for the merged firm where it would not have been for either firm before the merger. 

The Draft Guidelines state that the agencies will not challenge vertical mergers where EDM means that the merger is unlikely to be anticompetitive. OK. Duh. However, they also claim that in some situations, EDM may not occur, or its benefits may be offset by other incentives for the merged firm to raise prices. The Draft Guidelines do not weigh in on whether it should be presumed that vertical mergers will result in EDM, or whether it should be presumed that EDM is merger-specific. 

These are the most important questions in the debate over EDM. Some economists take the position that EDM is not guaranteed, and not necessarily merger-specific. Others take the position that EDM is basically inevitable in a vertical merger, and is unlikely to be achieved without a merger. That is: if there is EDM, it should be presumed to be merger-specific. Those who take the former view would put the burden on the merging parties to establish pricing benefits of EDM and its merger-specificity. 

Our own view is that this efficiency is pervasive and significant in vertical mergers. The defense should therefore bear only a burden of producing evidence, and the agencies should bear the burden of disproving the significance of EDM where shown to exist. This would depart from the typical standard in a merger case, under which defendants must prove the reality, magnitude, and merger-specific character of the claimed efficiencies (the Draft Guidelines adopt this standard along with the approach of the 2010 Horizontal Merger Guidelines on efficiencies). However, it would more closely reflect the economic reality of most vertical mergers. 

Conclusion

While the Draft Guidelines are a welcome step forward in the debates around the law and economics of vertical mergers, they do not guide very much. The fact that the Draft Guidelines highlight certain issues is a useful indicator of what the agencies find important, but not a meaningful statement of enforcement policy. 

On a positive note, the Draft Guidelines’ explanations of certain economic concepts important to vertical mergers may serve to illuminate these issues for courts

However, the agencies’ proposals are not specific enough to create predictability for business or the antitrust bar or provide meaningful guidance for enforcers to develop a consistent enforcement policy. This result is not surprising given the lack of consensus on the law and economics of vertical mergers and the best approach to enforcement. But the antitrust community — and all of its participants — would be better served by a more detailed document that commits to positions on key issues in the relevant debates. 

[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 Gregory J. Werden (former Senior Economic Counsel, DOJ Antitrust Division (ret.)) and Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Owen School of Management, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC).]

The proposed Vertical Merger Guidelines provide little practical guidance, especially on the key issue of what would lead one of the Agencies to determine that it will not challenge a vertical merger. Although they list the theories on which the Agencies focus and factors the Agencies “may consider,” the proposed Guidelines do not set out conditions necessary or sufficient for the Agencies to conclude that a merger likely would substantially lessen competition. Nor do the Guidelines communicate generally how the Agencies analyze the nature of a competitive process and how it is apt to change with a proposed merger. 

The proposed Guidelines communicate the Agencies’ enforcement policy in part through silences. For example, the Guidelines do not mention several theories that have appeared in recent commentary and thereby signal that Agencies have decided not to base their analysis on those theories. That silence is constructive, but the Agencies’ silence on the nature of their concern with vertical mergers is not. Since 1982, the Agencies’ merger guidelines have always stated that their concern was market power. Silence on this subject might suggest that the Agencies’ enforcement against vertical mergers is directed to something else. 

The Guidelines’ most conspicuous silence concerns the Agencies’ general attitude toward vertical mergers, and on how vertical and horizontal mergers differ. This silence is deafening: Horizontal mergers combine substitutes, which tends to reduce competition, while vertical mergers combine complements, which tends to enhance efficiency and thus also competition. Unlike horizontal mergers, vertical mergers produce anticompetitive effects only through indirect mechanisms with many moving parts, which makes the prediction of competitive effects from vertical mergers more complex and less certain.

The Guidelines also are unhelpfully silent on the basic economics of vertical integration, and hence of vertical mergers. In assessing a vertical merger, it is essential to appreciate that vertical mergers solve coordination problems that are solved less well, or not at all, by contracts. By solving different coordination problems, a vertical merger can generate merger-specific efficiencies or eliminate double marginalization. But solving a coordination problem need not be a good thing: Competition is the ultimate coordination problem, and a vertical merger can have anticompetitive consequences by helping to solve that coordination problem.   Finally, the Guidelines are unhelpfully silent on the fundamental policy issue presented by vertical merger enforcement: What distinguishes a vertical merger that harms competition from a vertical merger that merely harm competitors? A vertical merger cannot directly eliminate rivalry by increasing market concentration. The Supreme Court has endorsed a foreclosure theory under which the merger directly causes injury to a rival and thus proximately causes diminished rivalry. Vertical mergers also might diminish rivalry in other ways, but the proposed Guidelines do not state that the Agencies view diminished rivalry as the hallmark of a lessening of competition.   

[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 Joshua D. Wright (University Professor of Law, George Mason University and former Commissioner, FTC); Douglas H. Ginsburg (Senior Circuit Judge, US Court of Appeals for the DC Circuit; Professor of Law, George Mason University; and former Assistant Attorney General, DOJ Antitrust Division); Tad Lipsky (Assistant Professor of Law, George Mason University; former Acting Director, FTC Bureau of Competition; former chief antitrust counsel, Coca-Cola; former Deputy Assistant Attorney General, DOJ Antitrust Division); and John M. Yun (Associate Professor of Law, George Mason University; former Acting Deputy Assistant Director, FTC Bureau of Economics).]

After much anticipation, the Department of Justice Antitrust Division and the Federal Trade Commission released a draft of the Vertical Merger Guidelines (VMGs) on January 10, 2020. The Global Antitrust Institute (GAI) will be submitting formal comments to the agencies regarding the VMGs and this post summarizes our main points.

The Draft VMGs supersede the 1984 Merger Guidelines, which represent the last guidance from the agencies on the treatment of vertical mergers. The VMGs provide valuable guidance and greater clarity in terms of how the agencies will review vertical mergers going forward. While the proposed VMGs generally articulate an analytical framework based upon sound economic principles, there are several ways that the VMGs could more deeply integrate sound economics and our empirical understanding of the competitive consequences of vertical integration.

In this post, we discuss four issues: (1) incorporating the elimination of double marginalization (EDM) into the analysis of the likelihood of a unilateral price effect; (2) eliminating the role of market shares and structural analysis; (3) highlighting that the weight of empirical evidence supports the proposition that vertical mergers are less likely to generate competitive concerns than horizontal mergers; and (4) recognizing the importance of transaction cost-based efficiencies.

Elimination of double marginalization is a unilateral price effect

EDM is discussed separately from both unilateral price effects, in Section 5, and efficiencies, in Section 9, of the draft VMGs. This is notable because the structure of the VMGs obfuscates the relevant economics of internalizing pricing externalities and may encourage the misguided view that EDM is a special form of efficiency.

When separate upstream and downstream entities price their products, they do not fully take into account the impact of their pricing decision on each other — even though they are ultimately part of the same value chain for a given product. Vertical mergers eliminate a pricing externality since the post-merger upstream and downstream units are fully aligned in terms of their pricing incentives. In this sense, EDM is indistinguishable from the unilateral effects discussed in Section 5 of the VMGs that cause upward pricing pressure. Specifically, in the context of mergers, just as there is a greater incentive, under certain conditions, to foreclose or raise rivals’ costs (RRC) post-merger (although, this does not mean there is an ability to engage in these behaviors), there is also an incentive to lower prices due to the elimination of a markup along the supply chain. Consequently, we really cannot assess unilateral effects without accounting for the full set of incentives that could move prices in either direction.

Further, it is improper to consider EDM in the context of a “net effect” given that this phrase has strong connotations with weighing efficiencies against findings of anticompetitive harm. Rather, “unilateral price effects” actually includes EDM — just as a finding that a merger will induce entry properly belongs in a unilateral effects analysis. For these reasons, we suggest incorporating the discussion of EDM into the discussion of unilateral effects contained in Section 5 of the VMGs and eliminating Section 6. Otherwise, by separating EDM into its own section, the agencies are creating a type of “limbo” between unilateral effects and efficiencies — which creates confusion, particularly for courts. It is also important to emphasize that the mere existence of alternative contracting mechanisms to mitigate double marginalization does not tell us about their relative efficacy compared to vertical integration as there are costs to contracting.

Role of market shares and structural analysis

In Section 3 (“Market Participants, Market Shares, and Market Concentration”), there are two notable statements. First,

[t]he Agencies…do not rely on changes in concentration as a screen for or indicator of competitive effects from vertical theories of harm.

This statement, without further explanation, is puzzling as there are no changes in concentration for vertical mergers. Second, the VMGs then go on to state that 

[t]he 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 percent, and the related product is used in less than 20 percent of the relevant market.

The very next sentence reads:

In some circumstances, mergers with shares below the thresholds can give rise to competitive concerns.

From this, we conclude that the VMGs are adopting a prior belief that, if both the relevant product and the related product have a less than 20 percent share in the relevant market, the acquisition is either competitively neutral or benign. The VMGs make clear, however, they do not offer a safe harbor. With these statements, the agencies run the risk that the 20 percent figure will be interpreted as a trigger for competitive concern. There is no sound economic reason to believe 20 percent share in the relevant market or the related market is of any particular importance to predicting competitive effects. The VMGs should eliminate the discussion of market shares altogether. At a minimum, the final guidelines would benefit from some explanation for this threshold if it is retained.

Empirical evidence on the welfare impact of vertical mergers

In contrast to vertical mergers, horizontal mergers inherently involve a degree of competitive overlap and an associated loss of at least some degree of rivalry between actual and/or potential competitors. The price effect for vertical mergers, however, is generally theoretically ambiguous — even before accounting for efficiencies — due to EDM and the uncertainty regarding whether the integrated firm has an incentive to raise rivals’ costs or foreclose. Thus, for vertical mergers, empirically evaluating the welfare effects of consummated mergers has been and remains an important area of research to guide antitrust policy.

Consequently, what is noticeably absent from the draft guidelines is an empirical grounding. Consistent empirical findings should inform agency decision-making priors. With few exceptions, the literature does not support the view that these practices are used for anticompetitive reasons — see Lafontaine & Slade (2007) and Cooper et al. (2005). (For an update on the empirical literature from 2009 through 2018, which confirms the conclusions of the prior literature, see the GAI’s Comment on Vertical Mergers submitted during the recent FTC Hearings.) Thus, the modern antitrust approach to vertical mergers, as reflected in the antitrust literature, should reflect the empirical reality that vertical relationships are generally procompetitive or neutral.

The bottom line is that how often vertical mergers are anticompetitive should influence our framework and priors. Given the strong empirical evidence that vertical mergers do not tend to result in welfare losses for consumers, we believe the agencies should consider at least the modest statement that vertical mergers are more often than not procompetitive or, alternatively, vertical mergers tend to be more procompetitive or neutral than horizontal ones. Thus, we believe the final VMGs would benefit from language similar to the 1984 VMGs: “Although nonhorizontal mergers are less likely than horizontal mergers to create competitive problems, they are not invariably innocuous.”

Transaction cost efficiencies and merger specificity

The VMGs address efficiencies in Section 8. Under the VMGs, the Agencies will evaluate efficiency claims by the parties using the approach set forth in Section 10 of the 2010 Horizontal Merger Guidelines. Thus, efficiencies must be both cognizable and merger specific to be considered by the agencies.

In general, the VMGs also adopt an approach that is consistent with the teachings of the robust literature on transaction cost economics, which recognizes the costs of using the price system to explain the boundaries of economic organizations, and the importance of incorporating such considerations into any antitrust analyses. In particular, this literature has demonstrated, both theoretically and empirically, that the decision to contract or vertically integrate is often driven by the relatively high costs of contracting as well as concerns regarding the enforcement of contracts and opportunistic behavior. This literature suggests that such transactions cost efficiencies in the vertical merger context often will be both cognizable and merger-specific and rejects an approach that would presume such efficiencies are not merger specific because they can be theoretically achieved via contract.

While we agree with the overall approach set out in the VMGs, we are concerned that the application of Section 8, in practice, without more specificity and guidance, will be carried out in a way that is inconsistent with the approach set out in Section 10 of the 2010 HMGs.

Conclusion

Overall, the agencies deserve credit for highlighting the relevant factors in assessing vertical mergers and for not attempting to be overly aggressive in advancing untested merger assessment tools or theories of harm.

The agencies should seriously consider, however, refinements in a number of critical areas:

  • First, discussion of EDM should be integrated into the larger unilateral effects analysis in Section 5 of the VMGs. 
  • Second, the agencies should eliminate the role of market shares and structural analysis in the VMGs. 
  • Third, the final VMGs should acknowledge that vertical mergers are less likely to generate competitive concerns than horizontal mergers. 
  • Finally, the final VMGs should recognize the importance of transaction cost-based efficiencies. 

We believe incorporating these changes will result in guidelines that are more in conformity with sound economics and the empirical evidence.

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

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

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

Market definition, market shares, and concentration

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

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

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

Elimination of double marginalization and other efficiencies

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

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

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

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

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

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

Equilibrium effects

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

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

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

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

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

[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 William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division), and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP).

[Kolasky & Giordano: The authors thank Katherine Taylor, an associate at Hughes Hubbard & Reed, for her help in researching this article.]

On January 10, the Department of Justice (DOJ) withdrew the 1984 DOJ Non-Horizontal Merger Guidelines, and, together with the Federal Trade Commission (FTC), released new draft 2020 Vertical Merger Guidelines (“DOJ/FTC draft guidelines”) on which it seeks public comment by February 26.[1] In announcing these new draft guidelines, Makan Delrahim, the Assistant Attorney General for the Antitrust Division, acknowledged that while many vertical mergers are competitively beneficial or neutral, “some vertical transactions can raise serious concern.” He went on to explain that, “The revised draft guidelines are based on new economic understandings and the agencies’ experience over the past several decades and better reflect the agencies’ actual practice in evaluating proposed vertical mergers.” He added that he hoped these new guidelines, once finalized, “will provide more clarity and transparency on how we review vertical transactions.”[2]

While we agree with the DOJ and FTC that the 1984 Non-Horizontal Merger Guidelines are now badly outdated and that a new set of vertical merger guidelines is needed, we question whether the draft guidelines released on January 10, will provide the desired “clarity and transparency.” In our view, the proposed guidelines give insufficient recognition to the wide range of efficiencies that flow from most, if not all, vertical mergers. In addition, the guidelines fail to provide sufficiently clear standards for challenging vertical mergers, thereby leaving too much discretion in the hands of the agencies as to when they will challenge a vertical merger and too much uncertainty for businesses contemplating a vertical merger. 

What is most troubling is that this did not need to be so. In 2008, the European Commission, as part of its merger process reform initiative, issued an excellent set of non-horizontal merger guidelines that adopt basically the same analytical framework as the new draft guidelines for evaluating vertical mergers.[3] The EU guidelines, however, lay out in much more detail the factors the Commission will consider and the standards it will apply in evaluating vertical transactions. That being so, it is difficult to understand why the DOJ and FTC did not propose a set of vertical merger guidelines that more closely mirror those of the European Commission, rather than try to reinvent the wheel with a much less complete set of guidelines.

Rather than making the same mistake ourselves, we will try to summarize the EU vertical mergers and to explain why we believe they are markedly better than the draft guidelines the DOJ and FTC have proposed. We would urge the DOJ and FTC to consider revising their draft guidelines to make them more consistent with the EU vertical merger guidelines. Doing so would, among other things, promote greater convergence between the two jurisdictions, which is very much in the interest of both businesses and consumers in an increasingly global economy.

The principal differences between the draft joint guidelines and the EU vertical merger guidelines

1. Acknowledgement of the key differences between horizontal and vertical mergers

The EU guidelines begin with an acknowledgement that, “Non-horizontal mergers are generally less likely to significantly impede effective competition than horizontal mergers.” As they explain, this is because of two key differences between vertical and horizontal mergers.

  • First, unlike horizontal mergers, vertical mergers “do not entail the loss of direct competition between the merging firms in the same relevant market.”[4] As a result, “the main source of anti-competitive effect in horizontal mergers is absent from vertical and conglomerate mergers.”[5]
  • Second, vertical mergers are more likely than horizontal mergers to provide substantial, merger-specific efficiencies, without any direct reduction in competition. The EU guidelines explain that these efficiencies stem from two main sources, both of which are intrinsic to vertical mergers. The first is that, “Vertical integration may thus provide an increased incentive to seek to decrease prices and increase output because the integrated firm can capture a larger fraction of the benefits.”[6] The second is that, “Integration may also decrease transaction costs and allow for a better co-ordination in terms of product design, the organization of the production process, and the way in which the products are sold.”[7]

The DOJ/FTC draft guidelines do not acknowledge these fundamental differences between horizontal and vertical mergers. The 1984 DOJ non-horizontal guidelines, by contrast, contained an acknowledgement of these differences very similar to that found in the EU guidelines. First, the 1984 guidelines acknowledge that, “By definition, non-horizontal mergers involve firms that do not operate in the same market. It necessarily follows that such mergers produce no immediate change in the level of concentration in any relevant market as defined in Section 2 of these Guidelines.”[8] Second, the 1984 guidelines acknowledge that, “An extensive pattern of vertical integration may constitute evidence that substantial economies are afforded by vertical integration. Therefore, the Department will give relatively more weight to expected efficiencies in determining whether to challenge a vertical merger than in determining whether to challenge a horizontal merger.”[9] Neither of these acknowledgements can be found in the new draft guidelines.

These key differences have also been acknowledged by the courts of appeals for both the Second and D.C. circuits in the agencies’ two most recent litigated vertical mergers challenges: Fruehauf Corp. v. FTC in 1979[10] and United States v. AT&T in 2019.[11] In both cases, the courts held, as the D.C. Circuit explained in AT&T, that because of these differences, the government “cannot use a short cut to establish a presumption of anticompetitive effect through statistics about the change in market concentration” – as it can in a horizontal merger case – “because vertical mergers produce no immediate change in the relevant market share.”[12] Instead, in challenging a vertical merger, “the government must make a ‘fact-specific’ showing that the proposed merger is ‘likely to be anticompetitive’” before the burden shifts to the defendants “to present evidence that the prima facie case ‘inaccurately predicts the relevant transaction’s probable effect on future competition,’ or to ‘sufficiently discredit’ the evidence underlying the prima facie case.”[13]

While the DOJ/FTC draft guidelines acknowledge that a vertical merger may generate efficiencies, they propose that the parties to the merger bear the burden of identifying and substantiating those efficiencies under the same standards applied by the 2010 Horizontal Merger Guidelines. Meeting those standards in the case of a horizontal merger can be very difficult. For that reason, it is important that the DOJ/FTC draft guidelines be revised to make it clear that before the parties to a vertical merger are required to establish efficiencies meeting the horizontal merger guidelines’ evidentiary standard, the agencies must first show that the merger is likely to substantially lessen competition, based on the type of fact-specific evidence the courts required in both Fruehauf and AT&T.

2. Safe harbors

Although they do not refer to it as a “safe harbor,” the DOJ/FTC draft guidelines state that, 

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 percent, and the related product is used in less than 20 percent of the relevant market.[14] 

If we understand this statement correctly, it means that the agencies may challenge a vertical merger in any case where one party has a 20% share in a relevant market and the other party has a 20% or higher share of any “related product,” i.e., any “product or service” that is supplied by the other party to firms in that relevant market. 

By contrast, the EU guidelines state that,

The Commission is unlikely to find concern in non-horizontal mergers . . . where the market share post-merger of the new entity in each of the markets concerned is below 30% . . . and the post-merger HHI is below 2,000.[15] 

Both the EU guidelines and the DOJ/FTC draft guidelines are careful to explain that these statements do not create any “legal presumption” that vertical mergers below these thresholds will not be challenged or that vertical mergers above those thresholds are likely to be challenged.

The EU guidelines are more consistent than the DOJ/FTC draft guidelines both with U.S. case law and with the actual practice of both the DOJ and FTC. It is important to remember that the raising rivals’ costs theory of vertical foreclosure was first developed nearly four decades ago by two young economists, David Scheffman and Steve Salop, as a theory of exclusionary conduct that could be used against dominant firms in place of the more simplistic theories of vertical foreclosure that the courts had previously relied on and which by 1979 had been totally discredited by the Chicago School for the reasons stated by the Second Circuit in Fruehauf.[16] 

As the Second Circuit explained in Fruehauf, it was “unwilling to assume that any vertical foreclosure lessens competition” because 

[a]bsent very high market concentration or some other factor threatening a tangible anticompetitive effect, a vertical merger may simply realign sales patterns, for insofar as the merger forecloses some of the market from the merging firms’ competitors, it may simply free up that much of the market, in which the merging firm’s competitors and the merged firm formerly transacted, for new transactions between the merged firm’s competitors and the merging firm’s competitors.[17] 

Or, as Robert Bork put it more colorfully in The Antitrust Paradox, in criticizing the FTC’s decision in A.G. Spalding & Bros., Inc.,[18]:

We are left to imagine eager suppliers and hungry customers, unable to find each other, forever foreclosed and left languishing. It would appear the commission could have cured this aspect of the situation by throwing an industry social mixer.[19]

Since David Scheffman and Steve Salop first began developing their raising rivals’ cost theory of exclusionary conduct in the early 1980s, gallons of ink have been spilled in legal and economic journals discussing and evaluating that theory.[20] The general consensus of those articles is that while raising rivals’ cost is a plausible theory of exclusionary conduct, proving that a defendant has engaged in such conduct is very difficult in practice. It is even more difficult to predict whether, in evaluating a proposed merger, the merged firm is likely to engage in such conduct at some time in the future. 

Consistent with the Second Circuit’s decision in Fruehauf and with this academic literature, the courts, in deciding cases challenging exclusive dealing arrangements under either a vertical foreclosure theory or a raising rivals’ cost theory, have generally been willing to consider a defendant’s claim that the alleged exclusive dealing arrangements violated section 1 of the Sherman Act only in cases where the defendant had a dominant or near-dominant share of a highly concentrated market — usually meaning a share of 40 percent or more.[21] Likewise, all but one of the vertical mergers challenged by either the FTC or DOJ since 1996 have involved parties that had dominant or near-dominant shares of a highly concentrated market.[22] A majority of these involved mergers that were not purely vertical, but in which there was also a direct horizontal overlap between the two parties.

One of the few exceptions is AT&T/Time Warner, a challenge the DOJ lost in both the district court and the D.C. Circuit.[23] The outcome of that case illustrates the difficulty the agencies face in trying to prove a raising rivals’ cost theory of vertical foreclosure where the merging firms do not have a dominant or near-dominant share in either of the affected markets.

Given these court decisions and the agencies’ historical practice of challenging vertical mergers only between companies with dominant or near-dominant shares in highly concentrated markets, we would urge the DOJ and FTC to consider raising the market share threshold below which it is unlikely to challenge a vertical merger to at least 30 percent, in keeping with the EU guidelines, or to 40 percent in order to make the vertical merger guidelines more consistent with the U.S. case law on exclusive dealing.[24] We would also urge the agencies to consider adding a market concentration HHI threshold of 2,000 or higher, again in keeping with the EU guidelines.

3. Standards for applying a raising rivals’ cost theory of vertical foreclosure

Another way in which the EU guidelines are markedly better than the DOJ/FTC draft guidelines is in explaining the factors taken into consideration in evaluating whether a vertical merger will give the parties both the ability and incentive to raise their rivals’ costs in a way that will enable the merged entity to increase prices to consumers. Most importantly, the EU guidelines distinguish clearly between input foreclosure and customer foreclosure, and devote an entire section to each. For brevity, we will focus only on input foreclosure to show why we believe the more detailed approach the EU guidelines take is preferable to the more cursory discussion in the DOJ/FTC draft guidelines.

In discussing input foreclosure, the EU guidelines correctly distinguish between whether a vertical merger will give the merged firm the ability to raise rivals’ costs in a way that may substantially lessen competition and, if so, whether it will give the merged firm an incentive to do so. These are two quite distinct questions, which the DOJ/FTC draft guidelines unfortunately seem to lump together.

The ability to raise rivals’ costs

The EU guidelines identify four important conditions that must exist for a vertical merger to give the merged firm the ability to raise its rivals’ costs. First, the alleged foreclosure must concern an important input for the downstream product, such as one that represents a significant cost factor relative to the price of the downstream product. Second, the merged entity must have a significant degree of market power in the upstream market. Third, the merged entity must be able, by reducing access to its own upstream products or services, to affect negatively the overall availability of inputs for rivals in the downstream market in terms of price or quality. Fourth, the agency must examine the degree to which the merger may free up capacity of other potential input suppliers. If that capacity becomes available to downstream competitors, the merger may simple realign purchase patterns among competing firms, as the Second Circuit recognized in Fruehauf.

The incentive to foreclose access to inputs: 

The EU guidelines recognize that the incentive to foreclose depends on the degree to which foreclosure would be profitable. In making this determination, the vertically integrated firm will take into account how its supplies of inputs to competitors downstream will affect not only the profits of its upstream division, but also of its downstream division. Essentially, the merged entity faces a trade-off between the profit lost in the upstream market due to a reduction of input sales to (actual or potential) rivals and the profit gained from expanding sales downstream or, as the case may be, raising prices to consumers. This trade-off is likely to depend on the margins the merged entity obtains on upstream and downstream sales. Other things constant, the lower the margins upstream, the lower the loss from restricting input sales. Similarly, the higher the downstream margins, the higher the profit gain from increasing market share downstream at the expense of foreclosed rivals.

The EU guidelines recognize that the incentive for the integrated firm to raise rivals’ costs further depends on the extent to which downstream demand is likely to be diverted away from foreclosed rivals and the share of that diverted demand the downstream division of the integrated firm can capture. This share will normally be higher the less capacity constrained the merged entity will be relative to non-foreclosed downstream rivals and the more the products of the merged entity and foreclosed competitors are close substitutes. The effect on downstream demand will also be higher if the affected input represents a significant proportion of downstream rivals’ costs or if it otherwise represents a critical component of the downstream product.

The EU guidelines recognize that the incentive to foreclose actual or potential rivals may also depend on the extent to which the downstream division of the integrated firm can be expected to benefit from higher price levels downstream as a result of a strategy to raise rivals’ costs. The greater the market shares of the merged entity downstream, the greater the base of sales on which to enjoy increased margins. However, an upstream monopolist that is already able to fully extract all available profits in vertically related markets may not have any incentive to foreclose rivals following a vertical merger. Therefore, the ability to extract available profits from consumers does not follow immediately from a very high market share; to come to that conclusion requires a more thorough analysis of the actual and future constraints under which the monopolist operates.

Finally, the EU guidelines require the Commission to examine not only the incentives to adopt such conduct, but also the factors liable to reduce, or even eliminate, those incentives, including the possibility that the conduct is unlawful. In this regard, the Commission will consider, on the basis of a summary analysis: (i) the likelihood that this conduct would be clearly be unlawful under Community law, (ii) the likelihood that this illegal conduct could be detected, and (iii) the penalties that could be imposed.

Overall likely impact on effective competition: 

Finally, the EU guidelines recognize that a vertical merger will raise foreclosure concerns only when it would lead to increased prices in the downstream market. This normally requires that the foreclosed suppliers play a sufficiently important role in the competitive process in the downstream market. In general, the higher the proportion of rivals that would be foreclosed in the downstream market, the more likely the merger can be expected to result in a significant price increase in the downstream market and, therefore, to significantly impede effective competition. 

In making these determinations, the Commission must under the EU guidelines also assess the extent to which a vertical merger may raise barriers to entry, a criterion that is also found in the 1984 DOJ non-horizontal merger guidelines but is strangely missing from the DOJ/FTC draft guidelines. As the 1984 guidelines recognize, a vertical merger can raise entry barriers if the anticipated input foreclosure would create a need to enter at both the downstream and the upstream level in order to compete effectively in either market.

* * * * *

Rather than issue a set of incomplete vertical merger guidelines, we would urge the DOJ and FTC to follow the lead of the European Commission and develop a set of guidelines setting out in more detail the factors the agencies will consider and the standards they will use in evaluating vertical mergers. The EU non-horizontal merger guidelines provide an excellent model for doing so.


[1] U.S. Department of Justice & Federal Trade Commission, Draft Vertical Merger Guidelines, available at https://www.justice.gov/opa/press-release/file/1233741/download (hereinafter cited as “DOJ/FTC draft guidelines”).

[2] U.S. Department of Justice, Office of Public Affairs, “DOJ and FTC Announce Draft Vertical Merger Guidelines for Public Comment,” Jan. 10, 2020, available at https://www.justice.gov/opa/pr/doj-and-ftc-announce-draft-vertical-merger-guidelines-public-comment.

[3] See European Commission, Guidelines on the assessment of non-horizontal mergers under the Council Regulation on the control of concentrations between undertakings (2008) (hereinafter cited as “EU guidelines”), available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52008XC1018(03)&from=EN.

[4] Id. at § 12.

[5] Id.

[6] Id. at § 13.

[7] Id. at § 14. The insight that transactions costs are an explanation for both horizontal and vertical integration in firms first occurred to Ronald Coase in 1932, while he was a student at the London School of Economics. See Ronald H. Coase, Essays on Economics and Economists 7 (1994). Coase took five years to flesh out his initial insight, which he then published in 1937 in a now-famous article, The Nature of the Firm. See Ronald H. Coase, The Nature of the Firm, Economica 4 (1937). The implications of transactions costs for antitrust analysis were explained in more detail four decades later by Oliver Williamson in a book he published in 1975. See Oliver E. William, Markets and Hierarchies: Analysis and Antitrust Implications (1975) (explaining how vertical integration, either by ownership or contract, can, for example, protect a firm from free riding and other opportunistic behavior by its suppliers and customers). Both Coase and Williamson later received Nobel Prizes for Economics for their work recognizing the importance of transactions costs, not only in explaining the structure of firms, but in other areas of the economy as well. See, e.g., Ronald H. Coase, The Problem of Social Cost, J. Law & Econ. 3 (1960) (using transactions costs to explain the need for governmental action to force entities to internalize the costs their conduct imposes on others).

[8] U.S. Department of Justice, Antitrust Division, 1984 Merger Guidelines, § 4, available at https://www.justice.gov/archives/atr/1984-merger-guidelines.

[9] EU guidelines, at § 4.24.

[10] Fruehauf Corp. v. FTC, 603 F.2d 345 (2d Cir. 1979).

[11] United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[12] Id. at 1032; accord, Fruehauf, 603 F.2d, at 351 (“A vertical merger, unlike a horizontal one, does not eliminate a competing buyer or seller from the market . . . . It does not, therefore, automatically have an anticompetitive effect.”) (emphasis in original) (internal citations omitted).

[13] AT&T, 419 F.2d, at 1032 (internal citations omitted).

[14] DOJ/FTC draft guidelines, at 3.

[15] EU guidelines, at § 25.

[16] See Steven C. Salop & David T. Scheffman, Raising Rivals’ Costs, 73 AM. ECON. REV. 267 (1983).

[17] Fruehauf, supra note11, 603 F.2d at 353 n.9 (emphasis added).

[18] 56 F.T.C. 1125 (1960).

[19] Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself 232 (1978).

[20] See, e.g., Alan J. Meese, Exclusive Dealing, the Theory of the Firm, and Raising Rivals’ Costs: Toward a New Synthesis, 50 Antitrust Bull., 371 (2005); David T. Scheffman and Richard S. Higgins, Twenty Years of Raising Rivals Costs: History, Assessment, and Future, 12 George Mason L. Rev.371 (2003); David Reiffen & Michael Vita, Comment: Is There New Thinking on Vertical Mergers, 63 Antitrust L.J. 917 (1995); Thomas G. Krattenmaker & Steven Salop, Anticompetitive Exclusion: Raising Rivals’ Costs to Achieve Power Over Price, 96 Yale L. J. 209, 219-25 (1986).

[21] See, e.g., United States v. Microsoft, 87 F. Supp. 2d 30, 50-53 (D.D.C. 1999) (summarizing law on exclusive dealing under section 1 of the Sherman Act); id. at 52 (concluding that modern case law requires finding that exclusive dealing contracts foreclose rivals from 40% of the marketplace); Omega Envtl, Inc. v. Gilbarco, Inc., 127 F.3d 1157, 1162-63 (9th Cir. 1997) (finding 38% foreclosure insufficient to make out prima facie case that exclusive dealing agreement violated the Sherman and Clayton Acts, at least where there appeared to be alternate channels of distribution).

[22] See, e.g., United States, et al. v. Comcast, 1:11-cv-00106 (D.D.C. Jan. 18, 2011) (Comcast had over 50% of MVPD market), available at https://www.justice.gov/atr/case-document/competitive-impact-statement-72; United States v. Premdor, Civil No.: 1-01696 (GK) (D.D.C. Aug. 3, 2002) (Masonite manufactured more than 50% of all doorskins sold in the U.S.; Premdor sold 40% of all molded doors made in the U.S.), available at https://www.justice.gov/atr/case-document/final-judgment-151.

[23] See United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[24] See Brown Shoe Co. v. United States, 370 U.S. 294, (1962) (relying on earlier Supreme Court decisions involving exclusive dealing and tying claims under section 3 of the Clayton Act for guidance as to what share of a market must be foreclosed before a vertical merger can be found unlawful under section 7).

[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 Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC).

[Nuechterlein: I represented AT&T in United States v. AT&T, Inc. (“AT&T/Time Warner”), and this essay is based in part on comments I prepared on AT&T’s behalf for the FTC’s recent public hearings on Competition and Consumer Protection in the 21st Century. All views expressed here are my own.]

The draft Vertical Merger Guidelines (“Draft Guidelines”) might well leave ordinary readers with the misimpression that U.S. antitrust authorities have suddenly come to view vertical integration with a jaundiced eye. Such readers might infer from the draft that vertical mergers are a minefield of potential competitive harms; that only sometimes do they “have the potential to create cognizable efficiencies”; and that such efficiencies, even when they exist, often are not “of a character and magnitude” to keep the merger from becoming “anticompetitive.” (Draft Guidelines § 8, at 9). But that impression would be impossible to square with the past forty years of U.S. enforcement policy and with exhaustive empirical work confirming the largely beneficial effects of vertical integration. 

The Draft Guidelines should reflect those realities and thus should incorporate genuine limiting principles — rooted in concerns about two-level market power — to cabin their highly speculative theories of harm. Without such limiting principles, the Guidelines will remain more a theoretical exercise in abstract issue-spotting than what they purport to be: a source of genuine guidance for the public

1. The presumptive benefits of vertical integration

Although the U.S. antitrust agencies (the FTC and DOJ) occasionally attach conditions to their approval of vertical mergers, they have litigated only one vertical merger case to judgment over the past forty years: AT&T/Time Warner. The reason for that paucity of cases is neither a lack of prosecutorial zeal nor a failure to understand “raising rivals’ costs” theories of harm. Instead, in the words of the FTC’s outgoing Bureau of Competition chief, Bruce Hoffman, the reason is the “broad consensus in competition policy and economic theory that the majority of vertical mergers are beneficial because they reduce costs and increase the intensity of interbrand competition.” 

Two exhaustive papers confirm that conclusion with hard empirical facts. The first was published in the International Journal of Industrial Organization in 2005 by FTC economists James Cooper, Luke Froeb, Dan O’Brien, and Michael Vita, who surveyed “multiple studies of vertical mergers and restraints” and “found only one example where vertical integration harmed consumers, and multiple examples where vertical integration unambiguously benefited consumers.” The second paper is a 2007 analysis in the Journal of Economic Literature co-authored by University of Michigan Professor Francine LaFontaine (who served from 2014 to 2015 as Director of the FTC’s Bureau of Economics) and Professor Margaret Slade of the University of British Columbia. Professors LaFontaine and Slade “did not have a particular conclusion in mind when [they] began to collect the evidence,” “tried to be fair in presenting the empirical regularities,” and were “therefore somewhat surprised at what the weight of the evidence is telling us.” They found that:

[U]nder most circumstances, profit-maximizing vertical-integration decisions are efficient, not just from the firms’ but also from the consumers’ points of view. Although there are isolated studies that contradict this claim, the vast majority support it. (p. 680) 

Vertical mergers have this procompetitive track record for two basic reasons. First, by definition, they do not eliminate a competitor or increase market concentration in any market, and they pose fewer competitive concerns than horizontal mergers for that reason alone. Second, as Bruce Hoffman noted, “while efficiencies are often important in horizontal mergers, they are much more intrinsic to a vertical transaction” and “come with a more built-in likelihood of improving competition than horizontal mergers.”

It is widely accepted that vertical mergers often impose downward pricing pressure by eliminating double margins. Beyond that, as the Draft Guidelines observe (at § 8), vertical mergers can also play an indispensable role in “eliminate[ing] contracting frictions,” “streamlin[ing] production, inventory management, or distribution,” and “creat[ing] innovative products in ways that would have been hard to achieve through arm’s length contracts.”

2. Harm to competitors, harm to competition, and the need for limiting principles

Vertical mergers do often disadvantage rivals of the merged firm. For example, a distributor might merge with one of its key suppliers, achieve efficiencies through the combination, and pass some of the savings through to consumers in the form of lower prices. The firm’s distribution rivals will lose profits if they match the price cut and will lose market share to the merged firm if they do not. But that outcome obviously counts in favor of supporting, not opposing, the merger because it makes consumers better off and because “[t]he antitrust laws… were enacted for the protection of competition not competitors.” (Brunswick v Pueblo Bowl-O-Mat). 

This distinction between harm to competition and harm to competitors is fundamental to U.S. antitrust law. Yet key passages in the Draft Guidelines seem to blur this distinction

For example, one passage suggests that a vertical merger will be suspect if the merged firm might “chang[e] the terms of … rivals’ access” to an input, “one or more rivals would [then] lose sales,” and “some portion of those lost sales would be diverted to the merged firm.” Draft Guidelines § 5.a, at 4-5. Of course, the Guidelines’ drafters would never concede that they wish to vindicate the interests of competitors qua competitors. They would say that incremental changes in input prices, even if they do not structurally alter the competitive landscape, might nonetheless result in slightly higher overall consumer prices. And they would insist that speculation about such slight price effects should be sufficient to block a vertical merger. 

That was the precise theory of harm that DOJ pursued in AT&T/Time Warner, which involved a purely vertical merger between a video programmer (Time Warner) and a pay-TV distributor (AT&T/DirecTV). DOJ ultimately conceded that Time Warner was unlikely to withhold programming from (“foreclose”) AT&T’s pay-TV rivals. Instead, using a complex economic model, DOJ tried to show that the merger would increase Time Warner’s bargaining power and induce AT&T’s pay-TV rivals to pay somewhat higher rates for Time Warner programming, some portion of which the rivals would theoretically pass through to their own retail customers. At the same time, DOJ conceded that post-merger efficiencies would cause AT&T to lower its retail rates compared to the but-for world without the merger. DOJ nonetheless asserted that the aggregate effect of the pay-TV rivals’ price increases would exceed the aggregate effect of AT&T’s own price decrease. Without deciding whether such an effect would be sufficient to block the merger — a disputed legal issue — the courts ruled for the merging parties because DOJ could not substantiate its factual prediction that the merger would lead to programming price increases in the first place. 

It is unclear why DOJ picked this, of all cases, as its vehicle for litigating its first vertical merger case in decades. In an archetypal raising-rivals’-costs case, familiar from exclusive dealing law, the defendant forecloses its rivals by depriving them of a critical input or distribution channel and so marginalizes them in the process that it can profitably raise its own retail prices (see, e.g., McWane; Microsoft). AT&T/Time Warner could hardly have been further afield from that archetypal case. Again, DOJ conceded both that the merged firm would not foreclose rivals at all and that the merger would induce the firm to lower its retail prices below what it would charge if the merger were blocked. The draft Guidelines appear to double down on this odd strategy and portend more cases predicated on the same attenuated concerns about mere “chang[es in] the terms of … rivals’ access” to inputs, unaccompanied by any alleged structural changes in the competitive landscape

Bringing such cases would be a mistake, both tactically and doctrinally

“Changes in the terms of inputs” are a constant fact of life in nearly every market, with or without mergers, and have almost never aroused antitrust scrutiny. For example, whenever a firm enters into a long-term preferred-provider agreement with a new business partner in lieu of merging with it, the firm will, by definition, deal on less advantageous terms with the partner’s rivals than it otherwise would. That outcome is virtually never viewed as problematic, let alone unlawful, when it is accomplished through such long-term contracts. The government does not hire a team of economists to pore over documents, interview witnesses, and run abstruse models on whether the preferred-provider agreement can be projected, on balance, to produce incrementally higher downstream prices. There is no obvious reason why the government should treat such preferred provider arrangements differently if they arise through a vertical merger rather than a vertical contract — particularly given the draft Guidelines’ own acknowledgement that vertical mergers produce pro-consumer efficiencies that would be “hard to achieve through arm’s length contracts.” (Draft Guidelines § 8, at 9).

3. Towards a more useful safe harbor

Quoting then-Judge Breyer, the Supreme Court once noted that “antitrust rules ‘must be clear enough for lawyers to explain them to clients.’” That observation rings doubly true when applied to a document by enforcement officials purporting to “guide” business decisions. Firms contemplating a vertical merger need more than assurance that their merger will be cleared two years hence if their economists vanquish the government’s economists in litigation about the fine details of Nash bargaining theory. Instead, firms need true limiting principles, which identify the circumstances where any theory of harm would be so attenuated that litigating to block the merger is not worth the candle, particularly given the empirically validated presumption that most vertical mergers are pro-consumer.

The Agencies cannot meet the need for such limiting principles with the proposed “safe harbor” as it is currently phrased in the draft Guidelines: 

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 percent, and the related product is used in less than 20 percent of the relevant market.” (Draft Guidelines § 3, at 3). 

This anodyne assurance, with its arbitrarily low 20 percent thresholds phrased in the conjunctive, seems calculated more to preserve the agencies’ discretion than to provide genuine direction to industry. 

Nonetheless, the draft safe harbor does at least point in the right direction because it reflects a basic insight about two-level market power: vertical mergers are unlikely to create competitive concerns unless the merged firm will have, or could readily obtain, market power in both upstream and downstream markets. (See, e.g., Auburn News v. Providence Journal (“Where substantial market power is absent at any one product or distribution level, vertical integration will not have an anticompetitive effect.”)) This point parallels tying doctrine, which, like vertical merger analysis, addresses how vertical arrangements can affect competition across adjacent markets. As Justice O’Connor noted in Jefferson Parish, tying arrangements threaten competition 

primarily in the rare cases where power in the market for the tying product is used to create additional market power in the market for the tied product.… But such extension of market power is unlikely, or poses no threat of economic harm, unless…, [among other conditions, the seller has] power in the tying-product market… [and there is] a substantial threat that the tying seller will acquire market power in the tied-product market.

As this discussion suggests, the “20 percent” safe harbor in the draft Guidelines misses the mark in three respects

First, as a proxy for the absence of market power, 20 percent is too low: courts have generally refused to infer market power when the seller’s market share was below 30% and sometimes require higher shares. Of course, market share can be a highly overinclusive measure of market power, in that many firms with greater than a 30% share will lack market power. But it is nonetheless appropriate to use market share as a screen for further analysis.

Second, the draft’s safe harbor appears illogically in the conjunctive, applying only “where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.” That “and” should be an “or” because, again, vertical arrangements can be problematic only if a firm can use existing market power in a “related products” market to create or increase market power in the “relevant market.” 

Third, the phrase “the related product is used in less than 20 percent of the relevant market” is far too ambiguous to serve a useful role. For example, the “related product” sold by a merging upstream firm could be “used by” 100 percent of downstream buyers even though the firm’s sales account for only one percent of downstream purchases of that product if the downstream buyers multi-home — i.e., source their goods from many different sellers of substitutable products. The relevant proxy for “related product” market power is thus not how many customers “use” the merging firm’s product, but what percentage of overall sales of that product (including reasonable substitutes) it makes. 

Of course, this observation suggests that, when push comes to shove in litigation, the government must usually define two markets: not only (1) a “relevant market” in which competitive harm is alleged to occur, but also (2) an adjacent “related product” market in which the merged firm is alleged to have market power. Requiring such dual market definition is entirely appropriate. Ultimately, any raising-rivals’-costs theory relies on a showing that a vertically integrated firm has some degree of market power in a “related products” market when dealing with its rivals in an adjacent “relevant market.” And market definition is normally an inextricable component of a litigated market power analysis.

If these three changes are made, the safe harbor would read: 

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 30 percent, or the related product sold by one of the parties accounts for less than 30 percent of the overall sales of that related product, including reasonable substitutes.

Like all safe harbors, this one would be underinclusive (in that many mergers outside of the safe harbor are unobjectionable) and may occasionally be overinclusive. But this substitute language would be more useful as a genuine safe harbor because it would impose true limiting principles. And it would more accurately reflect the ways in which market power considerations should inform vertical analysis—whether of contractual arrangements or mergers.

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

This post is authored by Herbert Hovenkamp (James G. Dinan University Professor, University of Pennsylvania School of Law and the Wharton School).]

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

1. What the Guidelines contain

a. “Relevant markets” and “related products”

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

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

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

b. 20% market share threshold

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

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

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

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

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

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

c. Unilateral effects

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

 The Draft Guidelines note:

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

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

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

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

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

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

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

d. Elimination of double marginalization

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

e. Coordinated effects

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

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

2. Conclusion: An increase in economic sophistication

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

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

The 2020 Draft Joint Vertical Merger Guidelines:

What’s in, what’s out — and do we need them anyway?

February 6 & 7, 2020

Welcome! We’re delighted to kick off our two-day blog symposium on the recently released Draft Joint Vertical Merger Guidelines from the DOJ Antitrust Division and the Federal Trade Commission. 

If adopted by the agencies, the guidelines would mark the first time since 1984 that U.S. federal antitrust enforcers have provided official, public guidance on their approach to the increasingly important issue of vertical merger enforcement. 

As previously noted, the release of the draft guidelines was controversial from the outset: The FTC vote to issue the draft was mixed, with a dissent from Commissioner Slaughter, an abstention from Commissioner Chopra, and a concurring statement from Commissioner Wilson.

As the antitrust community gears up to debate the draft guidelines, we have assembled an outstanding group of antitrust experts to weigh in with their initial thoughts on the guidelines here at Truth on the Market. We hope this symposium will provide important insights and stand as a useful resource for the ongoing discussion.

The scholars and practitioners who will participate in the symposium are:

  • Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division)
  • Steven Cernak (Partner, Bona Law PC; former antitrust counsel, GM)
  • Eric Fruits (Chief Economist, ICLE; Professor of Economics, Portland State University)
  • Herbert Hovenkamp (James G. Dinan University Professor of Law, University of Pennsylvania)
  • Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati) and Kenneth Edelson (Associate, Wilson Sonsini Goodrich & Rosati)
  • William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division) and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP)
  • Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics) and Kristian Stout (Associate Director, ICLE)
  • Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC)
  • Sharis A. Pozen (Partner, Clifford Chance; former Vice President of Global Competition Law and Policy, GE; former Acting Assistant Attorney General, DOJ Antitrust Division), Timothy Cornell (Partner, Clifford Chance), Brian Concklin (Counsel, Clifford Chance), and Michael Van Arsdall (Counsel, Clifford Chance)
  • Jan Rybnicek (Counsel, Freshfields Bruckhaus Deringer; former attorney adviser to Commissioner Joshua D. Wright, FTC)
  • Steven C. Salop (tent.) (Professor of Economics and Law, Georgetown University; former Associate Director, FTC Bureau of Economics)
  • Scott A. Sher (Partner, Wilson Sonsini Goodrich & Rosati) and Matthew McDonald (Associate, Wilson Sonsini Goodrich & Rosati)
  • Margaret Slade (Professor Emeritus, Vancouver School of Economics, University of British Columbia)
  • Gregory Werden (former Senior Economic Counsel, DOJ Antitrust Division) and Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC)
  • Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division)
  • Joshua D. Wright (University Professor of Law, George Mason University; former Commissioner, FTC), Douglas H. Ginsburg (Senior Circuit Judge, US Court of Appeals for the DC Circuit; Professor of Law, George Mason University; former Assistant Attorney General, DOJ Antitrust Division), Tad Lipsky (Assistant Professor of Law, George Mason University; former Acting Director, FTC Bureau of Competition; former chief antitrust counsel, Coca-Cola; former Deputy Assistant Attorney General, DOJ Antitrust Division), and John M. Yun (Associate Professor of Law, George Mason University; former Acting Deputy Assistant Director, FTC Bureau of Economics)

The first of the participants’ initial posts will appear momentarily, with additional posts appearing throughout the day today and tomorrow. We hope to generate a lively discussion, and expect some of the participants to offer follow up posts and/or comments on their fellow participants’ posts — please be sure to check back throughout the day and be sure to check the comments. We hope our readers will join us in the comments, as well.

Once again, welcome!

The DOJ and 20 state AGs sued Microsoft on May 18, 1998 for unlawful maintenance of its monopoly position in the PC market. The government accused the desktop giant of tying its operating system (Windows) and its web browser (Internet Explorer). Microsoft had indeed become dominant in the PC market by the late 1980s:

Source: Asymco

But after the introduction of smartphones in the mid-2000s, Microsoft’s market share of personal computing units (including PCs, smartphones, and tablets) collapsed:

Source: Benedict Evans

Steven Sinofsy pointed out why this was a classic case of disruptive innovation rather than sustaining innovation: “Google and Microsoft were competitors but only by virtue of being tech companies hiring engineers. After that, almost nothing about what was being made or sold was similar even if things could ultimately be viewed as substitutes. That is literally the definition of innovation.”

Browsers

Microsoft grew to dominance during the PC era by bundling its desktop operating system (Windows) with its productivity software (Office) and modularizing the hardware providers. By 1995, Bill Gates had realized that the internet was the next big thing, calling it “The Internet Tidal Wave” in a famous internal memo. Gates feared that the browser would function as “middleware” and disintermediate Microsoft from its relationship with the end-user. At the time, Netscape Navigator was gaining market share from the first browser to popularize the internet, Mosaic (so-named because it supported a multitude of protocols).

Later that same year, Microsoft released its own browser, Internet Explorer, which would be bundled with its Windows operating system. Internet Explorer soon grew to dominate the market:

Source: Browser Wars

Steven Sinofsky described how the the browser threatened to undermine the Windows platform (emphasis added):

Microsoft saw browsers as a platform threat to Windows. Famously. Browsers though were an app — running everywhere, distributed everywhere. Microsoft chose to compete as though browsing was on par with Windows (i.e., substitutes).

That meant doing things like IBM did — finding holes in distribution where browsers could “sneak” in (e.g., OEM deals) and seeing how to make Microsoft browser work best and only with Windows. Sound familiar? It does to me.

Imagine (some of us did) a world instead where Microsoft would have built a browser that was an app distributed everywhere, running everywhere. That would have been a very different strategy. One that some imagined, but not when Windows was central.

Showing how much your own gravity as a big company can make even obvious steps strategically weak: Microsoft knew browsers had to be cross-platform so it built Internet Explorer for Mac and Unix. Neat. But wait, the main strategic differentiator for Internet Explorer was ActiveX which was clearly Windows only.

So even when trying to compete in a new market the strategy was not going to work technically and customers would immediately know. Either they would ignore the key part of Windows or the key part of x-platform. This is what a big company “master plan” looks like … Active Desktop.

Regulators claimed victory but the loss already happened. But for none of the reasons the writers of history say at least [in my humble opinion]. As a reminder, Microsoft stopped working on Internet Explorer 7 years before Chrome even existed — literally didn’t release a new version for 5+ years.

One of the most important pieces of context for this case is that other browsers were also free for personal use (even if they weren’t bundled with an operating system). At the time, Netscape was free for individuals. Mosaic was free for non-commercial use. Today, Chrome and Firefox are free for all users. Chrome makes money for Google by increasing the value of its ecosystem and serving as a complement for its other products (particularly search). Firefox is able to more than cover its costs by charging Google (and others) to be the default option in its browser. 

By bundling Internet Explorer with Windows for free, Microsoft was arguably charging the market rate. In highly competitive markets, economic theory tells us the price should approach marginal cost — which in software is roughly zero. As James Pethokoukis argued, there are many more reasons to be skeptical about the popular narrative surrounding the Microsoft case. The reasons for doubt range across features, products, and markets, including server operating systems, mobile devices, and search engines. Let’s examine a few of them.

Operating Systems

In a 2007 article for Wired titled “I Blew It on Microsoft,” Lawrence Lessig, a Harvard law professor, admits that his predictions about the future of competition in computer operating systems failed to account for the potential of open-source solutions:

We pro-regulators were making an assumption that history has shown to be completely false: That something as complex as an OS has to be built by a commercial entity. Only crazies imagined that volunteers outside the control of a corporation could successfully create a system over which no one had exclusive command. We knew those crazies. They worked on something called Linux.

According to Web Technology Surveys, as of April 2019, about 70 percent of servers use a Linux-based operating system while the remaining 30 percent use Windows.

Mobile

In 2007, Steve Ballmer believed that Microsoft would be the dominant company in smartphones, saying in an interview with USA Today (emphasis added):

There’s no chance that the iPhone is going to get any significant market share. No chance. It’s a $500 subsidized item. They may make a lot of money. But if you actually take a look at the 1.3 billion phones that get sold, I’d prefer to have our software in 60% or 70% or 80% of them, than I would to have 2% or 3%, which is what Apple might get.

But as Ballmer himself noted in 2013, Microsoft was too committed to the Windows platform to fully pivot its focus to mobile:

If there’s one thing I regret, there was a period in the early 2000s when we were so focused on what we had to do around Windows that we weren’t able to redeploy talent to the new device form factor called the phone.

This is another classic example of the innovator’s dilemma. Microsoft enjoyed high profit margins in its Windows business, which caused the company to underrate the significance of the shift from PCs to smartphones.

Search

To further drive home how dependent Microsoft was on its legacy products, this 2009 WSJ piece notes that the company had a search engine ad service in 2000 and shut it down to avoid cannibalizing its core business:

Nearly a decade ago, early in Mr. Ballmer’s tenure as CEO, Microsoft had its own inner Google and killed it. In 2000, before Google married Web search with advertising, Microsoft had a rudimentary system that did the same, called Keywords, running on the Web. Advertisers began signing up. But Microsoft executives, in part fearing the company would cannibalize other revenue streams, shut it down after two months.

Ben Thompson says we should wonder if the case against Microsoft was a complete waste of everyone’s time (and money): 

In short, to cite Microsoft as a reason for antitrust action against Google in particular is to get history completely wrong: Google would have emerged with or without antitrust action against Microsoft; if anything the real question is whether or not Google’s emergence shows that the Microsoft lawsuit was a waste of time and money.

The most obvious implications of the Microsoft case were negative: (1) PCs became bloated with “crapware” (2) competition in the browser market failed to materialize for many years (3) PCs were less safe because Microsoft couldn’t bundle security software, and (4) some PC users missed out on using first-party software from Microsoft because it couldn’t be bundled with Windows. When weighed against these large costs, the supposed benefits pale in comparison.

Conclusion

In all three cases I’ve discussed in this series — AT&T, IBM, and Microsoft — the real story was not that antitrust enforcers divined the perfect time to break up — or regulate — the dominant tech company. The real story was that slow and then sudden technological change outpaced the organizational inertia of incumbents, permanently displacing the former tech giants from their dominant position in the tech ecosystem. 

The next paradigm shift will be near-impossible to predict. Those who know which technology — and when — it will be would make a lot more money implementing their ideas than they would by playing pundit in the media. Regardless of whether the future winner will be Google, Facebook, Amazon, Apple, Microsoft, or some unknown startup company, antitrust enforcers should remember that the proper goal of public policy in this domain is to maximize total innovation — from firms both large and small. Fetishizing innovation by small companies — and using law enforcement to harass big companies in the hopes for an indirect benefit to competition — will make us all worse off in the long run.

The case against AT&T began in 1974. The government alleged that AT&T had monopolized the market for local and long-distance telephone service as well as telephone equipment. In 1982, the company entered into a consent decree to be broken up into eight pieces (the “Baby Bells” plus the parent company), which was completed in 1984. As a remedy, the government required the company to divest its local operating companies and guarantee equal access to all long-distance and information service providers (ISPs).

Source: Mohanram & Nanda

As the chart above shows, the divestiture broke up AT&T’s national monopoly into seven regional monopolies. In general, modern antitrust analysis focuses on the local product market (because that’s the relevant level for consumer decisions). In hindsight, how did breaking up a national monopoly into seven regional monopolies increase consumer choice? It’s also important to note that, prior to its structural breakup, AT&T was a government-granted monopoly regulated by the FCC. Any antitrust remedy should be analyzed in light of the company’s unique relationship with regulators.

Breaking up one national monopoly into seven regional monopolies is not an effective way to boost innovation. And there are economies of scale and network effects to be gained by owning a national network to serve a national market. In the case of AT&T, those economic incentives are why the Baby Bells forged themselves back together in the decades following the breakup.

Source: WSJ

As Clifford Winston and Robert Crandall noted

Appearing to put Ma Bell back together again may embarrass the trustbusters, but it should not concern American consumers who, in two decades since the breakup, are overwhelmed with competitive options to provide whatever communications services they desire.

Moreover, according to Crandall & Winston (2003), the lower prices following the breakup of AT&T weren’t due to the structural remedy at all (emphasis added):

But on closer examination, the rise in competition and lower long-distance prices are attributable to just one aspect of the 1982 decree; specifically, a requirement that the Bell companies modify their switching facilities to provide equal access to all long-distance carriers. The Federal Communications Commission (FCC) could have promulgated such a requirement without the intervention of the antitrust authorities. For example, the Canadian regulatory commission imposed equal access on its vertically integrated carriers, including Bell Canada, in 1993. As a result, long-distance competition developed much more rapidly in Canada than it had in the United States (Crandall and Hazlett, 2001). The FCC, however, was trying to block MCI from competing in ordinary long-distance services when the AT&T case was filed by the Department of Justice in 1974. In contrast to Canadian and more recent European experience, a lengthy antitrust battle and a disruptive vertical dissolution were required in the U.S. market to offset the FCC’s anti-competitive policies. Thus, antitrust policy did not triumph in this case over restrictive practices by a monopolist to block competition, but instead it overcame anticompetitive policies by a federal regulatory agency.

A quick look at the data on telephone service in the US, EU, and Canada show that the latter two were able to achieve similar reductions in price without breaking up their national providers.

Source: Crandall & Jackson (2011)

The paradigm shift from wireline to wireless

The technological revolution spurred by the transition from wireline telephone service to wireless telephone service shook up the telecommunications industry in the 1990s. The rapid change caught even some of the smartest players by surprise. In 1980, the management consulting firm McKinsey and Co. produced a report for AT&T predicting how large the cellular market might become by the year 2000. Their forecast said that 900,000 cell phones would be in use. The actual number was more than 109 million.

Along with the rise of broadband, the transition to wireless technology led to an explosion in investment. In contrast, the breakup of AT&T in 1984 had no discernible effect on the trend in industry investment:

The lesson for antitrust enforcers is clear: breaking up national monopolies into regional monopolies is no remedy. In certain cases, mandating equal access to critical networks may be warranted. Most of all, technology shocks will upend industries in ways that regulators — and dominant incumbents — fail to predict.

Truth on the Market is pleased to announce its next blog symposium:

The 2020 Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?

February 6 & 7, 2020

Symposium background

On January 10, 2020, the DOJ Antitrust Division and the Federal Trade Commission released Draft Joint Vertical Merger Guidelines for public comment. If adopted by the agencies, the guidelines would mark the first time since 1984 that U.S. federal antitrust enforcers have provided official, public guidance on their approach to the increasingly important issue of vertical merger enforcement: 

“Challenging anticompetitive vertical mergers is essential to vigorous enforcement. The agencies’ vertical merger policy has evolved substantially since the issuance of the 1984 Non-Horizontal Merger Guidelines, and our guidelines should reflect the current enforcement approach. Greater transparency about the complex issues surrounding vertical mergers will benefit the business community, practitioners, and the courts,” said FTC Chairman Joseph J. Simons.

As evidenced by FTC Commissioner Slaughter’s dissent and FTC Commissioner Chopra’s abstention from the FTC’s vote to issue the draft guidelines, the topic is a contentious one. Similarly, as FTC Commissioner Wilson noted in her concurring statement, the recent FTC hearing on vertical mergers demonstrated that there is a vigorous dispute over what new guidelines should look like (or even if the 1984 Non-Horizontal Guidelines should be updated at all).

The agencies have announced two upcoming workshops to discuss the draft guidelines and have extended the comment period on the draft until February 26.

In advance of the workshops and the imminent discussions over the draft guidelines, we have asked a number of antitrust experts to weigh in here at Truth on the Market: to preview the coming debate by exploring the economic underpinnings of the draft guidelines and their likely role in the future of merger enforcement at the agencies, as well as what is in the guidelines and — perhaps more important — what is left out.  

Beginning the morning of Thursday, February 6, and continuing during business hours through Friday, February 7, Truth on the Market (TOTM) and the International Center for Law & Economics (ICLE) will host a blog symposium on the draft guidelines. 

Symposium participants

As in the past (see examples of previous TOTM blog symposia here), we’ve lined up an outstanding and diverse group of scholars to discuss these issues, including:

  • Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division)
  • Steven Cernak (Partner, Bona Law PC; former antitrust counsel, GM)
  • Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC)
  • Eric Fruits (Chief Economist, ICLE; Professor of Economics, Portland State University)
  • Douglas H. Ginsburg (Senior Circuit Judge, US Court of Appeals for the DC Circuit; Professor of Law, George Mason University; former Assistant Attorney General, DOJ Antitrust Division)
  • Herbert Hovenkamp (James G. Dinan University Professor of Law, University of Pennsylvania)
  • Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati)
  • William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division)
  • Tad Lipsky (Assistant Professor of Law, George Mason University; former Acting Director, FTC Bureau of Competition; former chief antitrust counsel, Coca-Cola; former Deputy Assistant Attorney General, DOJ Antitrust Division) 
  • Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics)
  • Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC)
  • Sharis A. Pozen (Partner, Clifford Chance; former Vice President of Global Competition Law and Policy, GE; former Acting Assistant Attorney General, DOJ Antitrust Division) 
  • Jan Rybnicek (Counsel, Freshfields Bruckhaus Deringer; former attorney adviser to Commissioner Joshua D. Wright, FTC)
  • Steven C. Salop (tent.) (Professor of Economics and Law, Georgetown University; former Associate Director, FTC Bureau of Economics)
  • Scott A. Sher (Partner, Wilson Sonsini Goodrich & Rosati)
  • Margaret Slade (Professor Emeritus, Vancouver School of Economics, University of British Columbia)
  • Kristian Stout (Associate Director, ICLE)
  • Gregory Werden (former Senior Economic Counsel, DOJ Antitrust Division)
  • Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division)
  • Joshua D. Wright (University Professor of Law, George Mason University; former Commissioner, FTC)
  • John M. Yun (Associate Professor of Law, George Mason University; former Acting Deputy Assistant Director, FTC Bureau of Economics)

We want to thank all of these excellent panelists for agreeing to take time away from their busy schedules to participate in this symposium. We are hopeful that this discussion will provide invaluable insight and perspective on the Draft Joint Vertical Merger Guidelines.

Look for the first posts starting Thursday, February 6!

The Department of Justice began its antitrust case against IBM on January 17, 1969. The DOJ sued under the Sherman Antitrust Act, claiming IBM tried to monopolize the market for “general-purpose digital computers.” The case lasted almost thirteen years, ending on January 8, 1982 when Assistant Attorney General William Baxter declared the case to be “without merit” and dropped the charges. 

The case lasted so long, and expanded in scope so much, that by the time the trial began, “more than half of the practices the government raised as antitrust violations were related to products that did not exist in 1969.” Baltimore law professor Robert Lande said it was “the largest legal case of any kind ever filed.” Yale law professor Robert Bork called it “the antitrust division’s Vietnam.”

As the case dragged on, IBM was faced with increasingly perverse incentives. As NYU law professor Richard Epstein pointed out (emphasis added), 

Oddly, enough IBM was able to strengthen its antitrust-related legal position by reducing its market share, which it achieved through raising prices. When the suit was discontinued that share had fallen dramatically since 1969 from about 50 percent of the market to 37 percent in 1982. Only after the government suit ended did IBM lower its prices in order to increase market share.

Source: Levy & Welzer

In an interview with Vox, Tim Wu claimed that without the IBM case, Apple wouldn’t exist and we might still be using mainframe computers (emphasis added):

Vox: You said that Apple wouldn’t exist without the IBM case.

Wu: Yeah, I did say that. The case against IBM took 13 years and we didn’t get a verdict but in that time, there was the “policeman at the elbow” effect. IBM was once an all-powerful company. It’s not clear that we would have had an independent software industry, or that it would have developed that quickly, the idea of software as a product, [without this case]. That was one of the immediate benefits of that excavation.

And then the other big one is that it gave a lot of room for the personal computer to get started, and the software that surrounds the personal computer — two companies came in, Apple and Microsoft. They were sort of born in the wake of the IBM lawsuit. You know they were smart guys, but people did need the pressure off their backs.

Nobody is going to start in the shadow of Facebook and get anywhere. Snap’s been the best, but how are they doing? They’ve been halted. I think it’s a lot harder to imagine this revolutionary stuff that happened in the ’80s. If IBM had been completely unwatched by regulators, by enforcement, doing whatever they wanted, I think IBM would have held on and maybe we’d still be using mainframes, or something — a very different situation.

Steven Sinofsky, a former Microsoft executive and current Andreessen Horowitz board partner, had a different take on the matter, attributing IBM’s (belated) success in PCs to its utter failure in minicomputers (emphasis added):

IBM chose to prevent third parties from interoperating with mainframes sometimes at crazy levels (punch card formats). And then chose to defend until the end their business model of leasing … The minicomputer was a direct threat not because of technology but because of those attributes. I’ve heard people say IBM went into PCs because the antitrust loss caused them to look for growth or something. Ha. PCs were spun up because IBM was losing Minis. But everything about the PC was almost a fluke organizationally and strategically. The story of IBM regulation is told as though PCs exist because of the case.

The more likely story is that IBM got swamped by the paradigm shift from mainframes to PCs. IBM was dominant in mainframe computers which were sold to the government and large enterprises. Microsoft, Intel, and other leaders in the PC market sold to small businesses and consumers, which required an entirely different business model than IBM was structured to implement.

ABB – Always Be Bundling (Or Unbundling)

“There’s only two ways I know of to make money: bundling and unbundling.” – Jim Barksdale

In 1969, IBM unbundled its software and services from hardware sales. As many industry observers note, this action precipitated the rise of the independent software development industry. But would this have happened regardless of whether there was an ongoing antitrust case? Given that bundling and unbundling is ubiquitous in the history of the computer industry, the answer is likely yes.

As the following charts show, IBM first created an integrated solution in the mainframe market, controlling everything from raw materials and equipment to distribution and service. When PCs disrupted mainframes, the entire value chain was unbundled. Later, Microsoft bundled its operating system with applications software. 

Source: Clayton Christensen

The first smartphone to disrupt the PC market was the Apple iPhone — an integrated solution. And once the technology became “good enough” to meet the average consumer’s needs, Google modularized everything except the operating system (Android) and the app store (Google Play).

Source: SlashData
Source: Jake Nielson

Another key prong in Tim Wu’s argument that the government served as an effective “policeman at the elbow” in the IBM case is that the company adopted an open model when it entered the PC market and did not require an exclusive license from Microsoft to use its operating system. But exclusivity is only one term in a contract negotiation. In an interview with Playboy magazine in 1994, Bill Gates explained how he was able to secure favorable terms from IBM (emphasis added):

Our restricting IBM’s ability to compete with us in licensing MS-DOS to other computer makers was the key point of the negotiation. We wanted to make sure only we could license it. We did the deal with them at a fairly low price, hoping that would help popularize it. Then we could make our move because we insisted that all other business stay with us. We knew that good IBM products are usually cloned, so it didn’t take a rocket scientist to figure out that eventually we could license DOS to others. We knew that if we were ever going to make a lot of money on DOS it was going to come from the compatible guys, not from IBM. They paid us a fixed fee for DOS. We didn’t get a royalty, even though we did make some money on the deal. Other people paid a royalty. So it was always advantageous to us, the market grew and other hardware guys were able to sell units.

In this version of the story, IBM refrained from demanding an exclusive license from Microsoft not because it was fearful of antitrust enforcers but because Microsoft made significant concessions on price and capped its upside by agreeing to a fixed fee rather than a royalty. These economic and technical explanations for why IBM wasn’t able to leverage its dominant position in mainframes into the PC market are more consistent with the evidence than Wu’s “policeman at the elbow” theory.

In my next post, I will discuss the other major antitrust case that came to an end in 1982: AT&T.