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How US and EU Competition Law Differ

Sam Bowman, Dirk Auer & Geoffrey Manne —  9 August 2021

[This post adapts elements of “Should ASEAN Antitrust Laws Emulate European Competition Policy?”, published in the Singapore Economic Review (2021). Open access working paper here.]

U.S. and European competition laws diverge in numerous ways that have important real-world effects. Understanding these differences is vital, particularly as lawmakers in the United States, and the rest of the world, consider adopting a more “European” approach to competition.

In broad terms, the European approach is more centralized and political. The European Commission’s Directorate General for Competition (DG Comp) has significant de facto discretion over how the law is enforced. This contrasts with the common law approach of the United States, in which courts elaborate upon open-ended statutes through an iterative process of case law. In other words, the European system was built from the top down, while U.S. antitrust relies on a bottom-up approach, derived from arguments made by litigants (including the government antitrust agencies) and defendants (usually businesses).

This procedural divergence has significant ramifications for substantive law. European competition law includes more provisions akin to de facto regulation. This is notably the case for the “abuse of dominance” standard, in which a “dominant” business can be prosecuted for “abusing” its position by charging high prices or refusing to deal with competitors. By contrast, the U.S. system places more emphasis on actual consumer outcomes, rather than the nature or “fairness” of an underlying practice.

The American system thus affords firms more leeway to exclude their rivals, so long as this entails superior benefits for consumers. This may make the U.S. system more hospitable to innovation, since there is no built-in regulation of conduct for innovators who acquire a successful market position fairly and through normal competition.

In this post, we discuss some key differences between the two systems—including in areas like predatory pricing and refusals to deal—as well as the discretionary power the European Commission enjoys under the European model.

Exploitative Abuses

U.S. antitrust is, by and large, unconcerned with companies charging what some might consider “excessive” prices. The late Associate Justice Antonin Scalia, writing for the Supreme Court majority in the 2003 case Verizon v. Trinko, observed that:

The mere possession of monopoly power, and the concomitant charging of monopoly prices, is not only not unlawful; it is an important element of the free-market system. The opportunity to charge monopoly prices—at least for a short period—is what attracts “business acumen” in the first place; it induces risk taking that produces innovation and economic growth.

This contrasts with European competition-law cases, where firms may be found to have infringed competition law because they charged excessive prices. As the European Court of Justice (ECJ) held in 1978’s United Brands case: “In this case charging a price which is excessive because it has no reasonable relation to the economic value of the product supplied would be such an abuse.”

While United Brands was the EU’s foundational case for excessive pricing, and the European Commission reiterated that these allegedly exploitative abuses were possible when it published its guidance paper on abuse of dominance cases in 2009, the commission had for some time demonstrated apparent disinterest in bringing such cases. In recent years, however, both the European Commission and some national authorities have shown renewed interest in excessive-pricing cases, most notably in the pharmaceutical sector.

European competition law also penalizes so-called “margin squeeze” abuses, in which a dominant upstream supplier charges a price to distributors that is too high for them to compete effectively with that same dominant firm downstream:

[I]t is for the referring court to examine, in essence, whether the pricing practice introduced by TeliaSonera is unfair in so far as it squeezes the margins of its competitors on the retail market for broadband connection services to end users. (Konkurrensverket v TeliaSonera Sverige, 2011)

As Scalia observed in Trinko, forcing firms to charge prices that are below a market’s natural equilibrium affects firms’ incentives to enter markets, notably with innovative products and more efficient means of production. But the problem is not just one of market entry and innovation.  Also relevant is the degree to which competition authorities are competent to determine the “right” prices or margins.

As Friedrich Hayek demonstrated in his influential 1945 essay The Use of Knowledge in Society, economic agents use information gleaned from prices to guide their business decisions. It is this distributed activity of thousands or millions of economic actors that enables markets to put resources to their most valuable uses, thereby leading to more efficient societies. By comparison, the efforts of central regulators to set prices and margins is necessarily inferior; there is simply no reasonable way for competition regulators to make such judgments in a consistent and reliable manner.

Given the substantial risk that investigations into purportedly excessive prices will deter market entry, such investigations should be circumscribed. But the court’s precedents, with their myopic focus on ex post prices, do not impose such constraints on the commission. The temptation to “correct” high prices—especially in the politically contentious pharmaceutical industry—may thus induce economically unjustified and ultimately deleterious intervention.

Predatory Pricing

A second important area of divergence concerns predatory-pricing cases. U.S. antitrust law subjects allegations of predatory pricing to two strict conditions:

  1. Monopolists must charge prices that are below some measure of their incremental costs; and
  2. There must be a realistic prospect that they will able to recoup these initial losses.

In laying out its approach to predatory pricing, the U.S. Supreme Court has identified the risk of false positives and the clear cost of such errors to consumers. It thus has particularly stressed the importance of the recoupment requirement. As the court found in 1993’s Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., without recoupment, “predatory pricing produces lower aggregate prices in the market, and consumer welfare is enhanced.”

Accordingly, U.S. authorities must prove that there are constraints that prevent rival firms from entering the market after the predation scheme, or that the scheme itself would effectively foreclose rivals from entering the market in the first place. Otherwise, the predator would be undercut by competitors as soon as it attempts to recoup its losses by charging supra-competitive prices.

Without the strong likelihood that a monopolist will be able to recoup lost revenue from underpricing, the overwhelming weight of economic evidence (to say nothing of simple logic) is that predatory pricing is not a rational business strategy. Thus, apparent cases of predatory pricing are most likely not, in fact, predatory; deterring or punishing them would actually harm consumers.

By contrast, the EU employs a more expansive legal standard to define predatory pricing, and almost certainly risks injuring consumers as a result. Authorities must prove only that a company has charged a price below its average variable cost, in which case its behavior is presumed to be predatory. Even when a firm charges prices that are between its average variable and average total cost, it can be found guilty of predatory pricing if authorities show that its behavior was part of a plan to eliminate a competitor. Most significantly, in neither case is it necessary for authorities to show that the scheme would allow the monopolist to recoup its losses.

[I]t does not follow from the case‑law of the Court that proof of the possibility of recoupment of losses suffered by the application, by an undertaking in a dominant position, of prices lower than a certain level of costs constitutes a necessary precondition to establishing that such a pricing policy is abusive. (France Télécom v Commission, 2009).

This aspect of the legal standard has no basis in economic theory or evidence—not even in the “strategic” economic theory that arguably challenges the dominant Chicago School understanding of predatory pricing. Indeed, strategic predatory pricing still requires some form of recoupment, and the refutation of any convincing business justification offered in response. For example, ​​in a 2017 piece for the Antitrust Law Journal, Steven Salop lays out the “raising rivals’ costs” analysis of predation and notes that recoupment still occurs, just at the same time as predation:

[T]he anticompetitive conditional pricing practice does not involve discrete predatory and recoupment periods, as in the case of classical predatory pricing. Instead, the recoupment occurs simultaneously with the conduct. This is because the monopolist is able to maintain its current monopoly power through the exclusionary conduct.

The case of predatory pricing illustrates a crucial distinction between European and American competition law. The recoupment requirement embodied in American antitrust law serves to differentiate aggressive pricing behavior that improves consumer welfare—because it leads to overall price decreases—from predatory pricing that reduces welfare with higher prices. It is, in other words, entirely focused on the welfare of consumers.

The European approach, by contrast, reflects structuralist considerations far removed from a concern for consumer welfare. Its underlying fear is that dominant companies could use aggressive pricing to engender more concentrated markets. It is simply presumed that these more concentrated markets are invariably detrimental to consumers. Both the Tetra Pak and France Télécom cases offer clear illustrations of the ECJ’s reasoning on this point:

[I]t would not be appropriate, in the circumstances of the present case, to require in addition proof that Tetra Pak had a realistic chance of recouping its losses. It must be possible to penalize predatory pricing whenever there is a risk that competitors will be eliminated… The aim pursued, which is to maintain undistorted competition, rules out waiting until such a strategy leads to the actual elimination of competitors. (Tetra Pak v Commission, 1996).

Similarly:

[T]he lack of any possibility of recoupment of losses is not sufficient to prevent the undertaking concerned reinforcing its dominant position, in particular, following the withdrawal from the market of one or a number of its competitors, so that the degree of competition existing on the market, already weakened precisely because of the presence of the undertaking concerned, is further reduced and customers suffer loss as a result of the limitation of the choices available to them.  (France Télécom v Commission, 2009).

In short, the European approach leaves less room to analyze the concrete effects of a given pricing scheme, leaving it more prone to false positives than the U.S. standard explicated in the Brooke Group decision. Worse still, the European approach ignores not only the benefits that consumers may derive from lower prices, but also the chilling effect that broad predatory pricing standards may exert on firms that would otherwise seek to use aggressive pricing schemes to attract consumers.

Refusals to Deal

U.S. and EU antitrust law also differ greatly when it comes to refusals to deal. While the United States has limited the ability of either enforcement authorities or rivals to bring such cases, EU competition law sets a far lower threshold for liability.

As Justice Scalia wrote in Trinko:

Aspen Skiing is at or near the outer boundary of §2 liability. The Court there found significance in the defendant’s decision to cease participation in a cooperative venture. The unilateral termination of a voluntary (and thus presumably profitable) course of dealing suggested a willingness to forsake short-term profits to achieve an anticompetitive end. (Verizon v Trinko, 2003.)

This highlights two key features of American antitrust law with regard to refusals to deal. To start, U.S. antitrust law generally does not apply the “essential facilities” doctrine. Accordingly, in the absence of exceptional facts, upstream monopolists are rarely required to supply their product to downstream rivals, even if that supply is “essential” for effective competition in the downstream market. Moreover, as Justice Scalia observed in Trinko, the Aspen Skiing case appears to concern only those limited instances where a firm’s refusal to deal stems from the termination of a preexisting and profitable business relationship.

While even this is not likely the economically appropriate limitation on liability, its impetus—ensuring that liability is found only in situations where procompetitive explanations for the challenged conduct are unlikely—is completely appropriate for a regime concerned with minimizing the cost to consumers of erroneous enforcement decisions.

As in most areas of antitrust policy, EU competition law is much more interventionist. Refusals to deal are a central theme of EU enforcement efforts, and there is a relatively low threshold for liability.

In theory, for a refusal to deal to infringe EU competition law, it must meet a set of fairly stringent conditions: the input must be indispensable, the refusal must eliminate all competition in the downstream market, and there must not be objective reasons that justify the refusal. Moreover, if the refusal to deal involves intellectual property, it must also prevent the appearance of a new good.

In practice, however, all of these conditions have been relaxed significantly by EU courts and the commission’s decisional practice. This is best evidenced by the lower court’s Microsoft ruling where, as John Vickers notes:

[T]he Court found easily in favor of the Commission on the IMS Health criteria, which it interpreted surprisingly elastically, and without relying on the special factors emphasized by the Commission. For example, to meet the “new product” condition it was unnecessary to identify a particular new product… thwarted by the refusal to supply but sufficient merely to show limitation of technical development in terms of less incentive for competitors to innovate.

EU competition law thus shows far less concern for its potential chilling effect on firms’ investments than does U.S. antitrust law.

Vertical Restraints

There are vast differences between U.S. and EU competition law relating to vertical restraints—that is, contractual restraints between firms that operate at different levels of the production process.

On the one hand, since the Supreme Court’s Leegin ruling in 2006, even price-related vertical restraints (such as resale price maintenance (RPM), under which a manufacturer can stipulate the prices at which retailers must sell its products) are assessed under the rule of reason in the United States. Some commentators have gone so far as to say that, in practice, U.S. case law on RPM almost amounts to per se legality.

Conversely, EU competition law treats RPM as severely as it treats cartels. Both RPM and cartels are considered to be restrictions of competition “by object”—the EU’s equivalent of a per se prohibition. This severe treatment also applies to non-price vertical restraints that tend to partition the European internal market.

Furthermore, in the Consten and Grundig ruling, the ECJ rejected the consequentialist, and economically grounded, principle that inter-brand competition is the appropriate framework to assess vertical restraints:

Although competition between producers is generally more noticeable than that between distributors of products of the same make, it does not thereby follow that an agreement tending to restrict the latter kind of competition should escape the prohibition of Article 85(1) merely because it might increase the former. (Consten SARL & Grundig-Verkaufs-GMBH v. Commission of the European Economic Community, 1966).

This treatment of vertical restrictions flies in the face of longstanding mainstream economic analysis of the subject. As Patrick Rey and Jean Tirole conclude:

Another major contribution of the earlier literature on vertical restraints is to have shown that per se illegality of such restraints has no economic foundations.

Unlike the EU, the U.S. Supreme Court in Leegin took account of the weight of the economic literature, and changed its approach to RPM to ensure that the law no longer simply precluded its arguable consumer benefits, writing: “Though each side of the debate can find sources to support its position, it suffices to say here that economics literature is replete with procompetitive justifications for a manufacturer’s use of resale price maintenance.” Further, the court found that the prior approach to resale price maintenance restraints “hinders competition and consumer welfare because manufacturers are forced to engage in second-best alternatives and because consumers are required to shoulder the increased expense of the inferior practices.”

The EU’s continued per se treatment of RPM, by contrast, strongly reflects its “precautionary principle” approach to antitrust. European regulators and courts readily condemn conduct that could conceivably injure consumers, even where such injury is, according to the best economic understanding, exceedingly unlikely. The U.S. approach, which rests on likelihood rather than mere possibility, is far less likely to condemn beneficial conduct erroneously.

Political Discretion in European Competition Law

EU competition law lacks a coherent analytical framework like that found in U.S. law’s reliance on the consumer welfare standard. The EU process is driven by a number of laterally equivalent—and sometimes mutually exclusive—goals, including industrial policy and the perceived need to counteract foreign state ownership and subsidies. Such a wide array of conflicting aims produces lack of clarity for firms seeking to conduct business. Moreover, the discretion that attends this fluid arrangement of goals yields an even larger problem.

The Microsoft case illustrates this problem well. In Microsoft, the commission could have chosen to base its decision on various potential objectives. It notably chose to base its findings on the fact that Microsoft’s behavior reduced “consumer choice.”

The commission, in fact, discounted arguments that economic efficiency may lead to consumer welfare gains, because it determined “consumer choice” among media players was more important:

Another argument relating to reduced transaction costs consists in saying that the economies made by a tied sale of two products saves resources otherwise spent for maintaining a separate distribution system for the second product. These economies would then be passed on to customers who could save costs related to a second purchasing act, including selection and installation of the product. Irrespective of the accuracy of the assumption that distributive efficiency gains are necessarily passed on to consumers, such savings cannot possibly outweigh the distortion of competition in this case. This is because distribution costs in software licensing are insignificant; a copy of a software programme can be duplicated and distributed at no substantial effort. In contrast, the importance of consumer choice and innovation regarding applications such as media players is high. (Commission Decision No. COMP. 37792 (Microsoft)).

It may be true that tying the products in question was unnecessary. But merely dismissing this decision because distribution costs are near-zero is hardly an analytically satisfactory response. There are many more costs involved in creating and distributing complementary software than those associated with hosting and downloading. The commission also simply asserts that consumer choice among some arbitrary number of competing products is necessarily a benefit. This, too, is not necessarily true, and the decision’s implication that any marginal increase in choice is more valuable than any gains from product design or innovation is analytically incoherent.

The Court of First Instance was only too happy to give the commission a pass in its breezy analysis; it saw no objection to these findings. With little substantive reasoning to support its findings, the court fully endorsed the commission’s assessment:

As the Commission correctly observes (see paragraph 1130 above), by such an argument Microsoft is in fact claiming that the integration of Windows Media Player in Windows and the marketing of Windows in that form alone lead to the de facto standardisation of the Windows Media Player platform, which has beneficial effects on the market. Although, generally, standardisation may effectively present certain advantages, it cannot be allowed to be imposed unilaterally by an undertaking in a dominant position by means of tying.

The Court further notes that it cannot be ruled out that third parties will not want the de facto standardisation advocated by Microsoft but will prefer it if different platforms continue to compete, on the ground that that will stimulate innovation between the various platforms. (Microsoft Corp. v Commission, 2007)

Pointing to these conflicting effects of Microsoft’s bundling decision, without weighing either, is a weak basis to uphold the commission’s decision that consumer choice outweighs the benefits of standardization. Moreover, actions undertaken by other firms to enhance consumer choice at the expense of standardization are, on these terms, potentially just as problematic. The dividing line becomes solely which theory the commission prefers to pursue.

What such a practice does is vest the commission with immense discretionary power. Any given case sets up a “heads, I win; tails, you lose” situation in which defendants are easily outflanked by a commission that can change the rules of its analysis as it sees fit. Defendants can play only the cards that they are dealt. Accordingly, Microsoft could not successfully challenge a conclusion that its behavior harmed consumers’ choice by arguing that it improved consumer welfare, on net.

By selecting, in this instance, “consumer choice” as the standard to be judged, the commission was able to evade the constraints that might have been imposed by a more robust welfare standard. Thus, the commission can essentially pick and choose the objectives that best serve its interests in each case. This vastly enlarges the scope of potential antitrust liability, while also substantially decreasing the ability of firms to predict when their behavior may be viewed as problematic. It leads to what, in U.S. courts, would be regarded as an untenable risk of false positives that chill innovative behavior and create nearly unwinnable battles for targeted firms.

In Antitrust & Competition, Broadband, Cartels, Constitutional Law, Economic Theory, European Union, Exclusionary Conduct, Exclusive Dealing, Health Care, Intellectual Property, International, International Trade, Pharmaceuticals, Platforms, Price Discrimination, Resale Price Maintenance, Supreme Court, Telecommunications, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
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The DOJ’s Antitrust Case Against Google: A Tough Slog, but Maybe an Intriguing Possibility?

Lawrence White —  14 January 2021

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

The U.S. Department of Justice’s (DOJ) antitrust case against Google, which was filed in October 2020, will be a tough slog.[1] It is an alleged monopolization (Sherman Act, Sec. 2) case; and monopolization cases are always a tough slog.

In this brief essay I will lay out some of the issues in the case and raise an intriguing possibility.

What is the case about?

The case is about exclusivity and exclusion in the distribution of search engine services; that Google paid substantial sums to Apple and to the manufacturers of Android-based mobile phones and tablets and also to wireless carriers and web-browser proprietors—in essence, to distributors—to install the Google search engine as the exclusive pre-set (installed), default search program. The suit alleges that Google thereby made it more difficult for other search-engine providers (e.g., Bing; DuckDuckGo) to obtain distribution for their search-engine services and thus to attract search-engine users and to sell the online advertising that is associated with search-engine use and that provides the revenue to support the search “platform” in this “two-sided market” context.[2]

Exclusion can be seen as a form of “raising rivals’ costs.”[3]  Equivalently, exclusion can be seen as a form of non-price predation. Under either interpretation, the exclusionary action impedes competition.

It’s important to note that these allegations are different from those that motivated an investigation by the Federal Trade Commission (which the FTC dropped in 2013) and the cases by the European Union against Google.[4]  Those cases focused on alleged self-preferencing; that Google was unduly favoring its own products and services (e.g., travel services) in its delivery of search results to users of its search engine. In those cases, the impairment of competition (arguably) happens with respect to those competing products and services, not with respect to search itself.

What is the relevant market?

For a monopolization allegation to have any meaning, there needs to be the exercise of market power (which would have adverse consequences for the buyers of the product). And in turn, that exercise of market power needs to occur in a relevant market: one in which market power can be exercised.

Here is one of the important places where the DOJ’s case is likely to turn into a slog: the delineation of a relevant market for alleged monopolization cases remains as a largely unsolved problem for antitrust economics.[5]  This is in sharp contrast to the issue of delineating relevant markets for the antitrust analysis of proposed mergers.  For this latter category, the paradigm of the “hypothetical monopolist” and the possibility that this hypothetical monopolist could prospectively impose a “small but significant non-transitory increase in price” (SSNIP) has carried the day for the purposes of market delineation.

But no such paradigm exists for monopolization cases, in which the usual allegation is that the defendant already possesses market power and has used the exclusionary actions to buttress that market power. To see the difficulties, it is useful to recall the basic monopoly diagram from Microeconomics 101. A monopolist faces a negatively sloped demand curve for its product (at higher prices, less is bought; at lower prices, more is bought) and sets a profit-maximizing price at the level of output where its marginal revenue (MR) equals its marginal costs (MC). Its price is thereby higher than an otherwise similar competitive industry’s price for that product (to the detriment of buyers) and the monopolist earns higher profits than would the competitive industry.

But unless there are reliable benchmarks as to what the competitive price and profits would otherwise be, any information as to the defendant’s price and profits has little value with respect to whether the defendant already has market power. Also, a claim that a firm does not have market power because it faces rivals and thus isn’t able profitably to raise its price from its current level (because it would lose too many sales to those rivals) similarly has no value. Recall the monopolist from Micro 101. It doesn’t set a higher price than the one where MR=MC, because it would thereby lose too many sales to other sellers of other things.

Thus, any firm—regardless of whether it truly has market power (like the Micro 101 monopolist) or is just another competitor in a sea of competitors—should have already set its price at its profit-maximizing level and should find it unprofitable to raise its price from that level.[6]  And thus the claim, “Look at all of the firms that I compete with!  I don’t have market power!” similarly has no informational value.

Let us now bring this problem back to the Google monopolization allegation:  What is the relevant market?  In the first instance, it has to be “the provision of answers to user search queries.” After all, this is the “space” in which the exclusion occurred. But there are categories of search: e.g., search for products/services, versus more general information searches (“What is the current time in Delaware?” “Who was the 21st President of the United States?”). Do those separate categories themselves constitute relevant markets?

Further, what would the exercise of market power in a (delineated relevant) market look like?  Higher-than-competitive prices for advertising that targets search-results recipients is one obvious answer (but see below). In addition, because this is a two-sided market, the competitive “price” (or prices) might involve payments by the search engine to the search users (in return for their exposure to the lucrative attached advertising).[7]  And product quality might exhibit less variety than a competitive market would provide; and/or the monopolistic average level of quality would be lower than in a competitive market: e.g., more abuse of user data, and/or deterioration of the delivered information itself, via more self-preferencing by the search engine and more advertising-driven preferencing of results.[8]

In addition, a natural focus for a relevant market is the advertising that accompanies the search results. But now we are at the heart of the difficulty of delineating a relevant market in a monopolization context. If the relevant market is “advertising on search engine results pages,” it seems highly likely that Google has market power. If the relevant market instead is all online U.S. advertising (of which Google’s revenue share accounted for 32% in 2019[9]), then the case is weaker; and if the relevant market is all advertising in the United States (which is about twice the size of online advertising[10]), the case is weaker still. Unless there is some competitive benchmark, there is no easy way to delineate the relevant market.[11]

What exactly has Google been paying for, and why?

As many critics of the DOJ’s case have pointed out, it is extremely easy for users to switch their default search engine. If internet search were a normal good or service, this ease of switching would leave little room for the exercise of market power. But in that case, why is Google willing to pay $8-$12 billion annually for the exclusive default setting on Apple devices and large sums to the manufacturers of Android-based devices (and to wireless carriers and browser proprietors)? Why doesn’t Google instead run ads in prominent places that remind users how superior Google’s search results are and how easy it is for users (if they haven’t already done so) to switch to the Google search engine and make Google the user’s default choice?

Suppose that user inertia is important. Further suppose that users generally have difficulty in making comparisons with respect to the quality of delivered search results. If this is true, then being the default search engine on Apple and Android-based devices and on other distribution vehicles would be valuable. In this context, the inertia of their customers is a valuable “asset” of the distributors that the distributors may not be able to take advantage of, but that Google can (by providing search services and selling advertising). The question of whether Google’s taking advantage of this user inertia means that Google exercises market power takes us back to the issue of delineating the relevant market.

There is a further wrinkle to all of this. It is a well-understood concept in antitrust economics that an incumbent monopolist will be willing to pay more for the exclusive use of an essential input than a challenger would pay for access to the input.[12] The basic idea is straightforward. By maintaining exclusive use of the input, the incumbent monopolist preserves its (large) monopoly profits. If the challenger enters, the incumbent will then earn only its share of the (much lower, more competitive) duopoly profits. Similarly, the challenger can expect only the lower duopoly profits. Accordingly, the incumbent should be willing to outbid (and thereby exclude) the challenger and preserve the incumbent’s exclusive use of the input, so as to protect those monopoly profits.

To bring this to the Google monopolization context, if Google does possess market power in some aspect of search—say, because online search-linked advertising is a relevant market—then Google will be willing to outbid Microsoft (which owns Bing) for the “asset” of default access to Apple’s (inertial) device owners. That Microsoft is a large and profitable company and could afford to match (or exceed) Google’s payments to Apple is irrelevant. If the duopoly profits for online search-linked advertising would be substantially lower than Google’s current profits, then Microsoft would not find it worthwhile to try to outbid Google for that default access asset.

Alternatively, this scenario could be wholly consistent with an absence of market power. If search users (who can easily switch) consider Bing to be a lower-quality search service, then large payments by Microsoft to outbid Google for those exclusive default rights would be largely wasted, since the “acquired” default search users would quickly switch to Google (unless Microsoft provided additional incentives for the users not to switch).

But this alternative scenario returns us to the original puzzle:  Why is Google making such large payments to the distributors for those exclusive default rights?

An intriguing possibility

Consider the following possibility. Suppose that Google was paying that $8-$12 billion annually to Apple in return for the understanding that Apple would not develop its own search engine for Apple’s device users.[13] This possibility was not raised in the DOJ’s complaint, nor is it raised in the subsequent suits by the state attorneys general.

But let’s explore the implications by going to an extreme. Suppose that Google and Apple had a formal agreement that—in return for the $8-$12 billion per year—Apple would not develop its own search engine. In this event, this agreement not to compete would likely be seen as a violation of Section 1 of the Sherman Act (which does not require a market delineation exercise) and Apple would join Google as a co-conspirator. The case would take on the flavor of the FTC’s prosecution of “pay-for-delay” agreements between the manufacturers of patented pharmaceuticals and the generic drug manufacturers that challenge those patents and then receive payments from the former in return for dropping the patent challenge and delaying the entry of the generic substitute.[14]

As of this writing, there is no evidence of such an agreement and it seems quite unlikely that there would have been a formal agreement. But the DOJ will be able to engage in discovery and take depositions. It will be interesting to find out what the relevant executives at Google—and at Apple—thought was being achieved by those payments.

What would be a suitable remedy/relief?

The DOJ’s complaint is vague with respect to the remedy that it seeks. This is unsurprising. The DOJ may well want to wait to see how the case develops and then amend its complaint.

However, even if Google’s actions have constituted monopolization, it is difficult to conceive of a suitable and effective remedy. One apparently straightforward remedy would be to require simply that Google not be able to purchase exclusivity with respect to the pre-set default settings. In essence, the device manufacturers and others would always be able to sell parallel default rights to other search engines: on the basis, say, that the default rights for some categories of customers—or even a percentage of general customers (randomly selected)—could be sold to other search-engine providers.

But now the Gilbert-Newbery insight comes back into play. Suppose that a device manufacturer knows (or believes) that Google will pay much more if—even in the absence of any exclusivity agreement—Google ends up being the pre-set search engine for all (or nearly all) of the manufacturer’s device sales, as compared with what the manufacturer would receive if those default rights were sold to multiple search-engine providers (including, but not solely, Google). Can that manufacturer (recall that the distributors are not defendants in the case) be prevented from making this sale to Google and thus (de facto) continuing Google’s exclusivity?[15]

Even a requirement that Google not be allowed to make any payment to the distributors for a default position may not improve the competitive environment. Google may be able to find other ways of making indirect payments to distributors in return for attaining default rights, e.g., by offering them lower rates on their online advertising.

Further, if the ultimate goal is an efficient outcome in search, it is unclear how far restrictions on Google’s bidding behavior should go. If Google were forbidden from purchasing any default installation rights for its search engine, would (inert) consumers be better off? Similarly, if a distributor were to decide independently that its customers were better served by installing the Google search engine as the default, would that not be allowed? But if it is allowed, how could one be sure that Google wasn’t indirectly paying for this “independent” decision (e.g., through favorable advertising rates)?

It’s important to remember that this (alleged) monopolization is different from the Standard Oil case of 1911 or even the (landline) AT&T case of 1984. In those cases, there were physical assets that could be separated and spun off to separate companies. For Google, physical assets aren’t important. Although it is conceivable that some of Google’s intellectual property—such as Gmail, YouTube, or Android—could be spun off to separate companies, doing so would do little to cure the (arguably) fundamental problem of the inert device users.

In addition, if there were an agreement between Google and Apple for the latter not to develop a search engine, then large fines for both parties would surely be warranted. But what next? Apple can’t be forced to develop a search engine.[16] This differentiates such an arrangement from the “pay-for-delay” arrangements for pharmaceuticals, where the generic manufacturers can readily produce a near-identical substitute for the patented drug and are otherwise eager to do so.

At the end of the day, forbidding Google from paying for exclusivity may well be worth trying as a remedy. But as the discussion above indicates, it is unlikely to be a panacea and is likely to require considerable monitoring for effective enforcement.

Conclusion

The DOJ’s case against Google will be a slog. There are unresolved issues—such as how to delineate a relevant market in a monopolization case—that will be central to the case. Even if the DOJ is successful in showing that Google violated Section 2 of the Sherman Act in monopolizing search and/or search-linked advertising, an effective remedy seems problematic. But there also remains the intriguing question of why Google was willing to pay such large sums for those exclusive default installation rights?

The developments in the case will surely be interesting.

[1] The DOJ’s suit was joined by 11 states.  More states subsequently filed two separate antitrust lawsuits against Google in December.

[2] There is also a related argument:  That Google thereby gained greater volume, which allowed it to learn more about its search users and their behavior, and which thereby allowed it to provide better answers to users (and thus a higher-quality offering to its users) and better-targeted (higher-value) advertising to its advertisers.  Conversely, Google’s search-engine rivals were deprived of that volume, with the mirror-image negative consequences for the rivals.  This is just another version of the standard “learning-by-doing” and the related “learning curve” (or “experience curve”) concepts that have been well understood in economics for decades.

[3] See, for example, Steven C. Salop and David T. Scheffman, “Raising Rivals’ Costs: Recent Advances in the Theory of Industrial Structure,” American Economic Review, Vol. 73, No. 2 (May 1983), pp.  267-271; and Thomas G. Krattenmaker and Steven C. Salop, “Anticompetitive Exclusion: Raising Rivals’ Costs To Achieve Power Over Price,” Yale Law Journal, Vol. 96, No. 2 (December 1986), pp. 209-293.

[4] For a discussion, see Richard J. Gilbert, “The U.S. Federal Trade Commission Investigation of Google Search,” in John E. Kwoka, Jr., and Lawrence J. White, eds. The Antitrust Revolution: Economics, Competition, and Policy, 7th edn.  Oxford University Press, 2019, pp. 489-513.

[5] For a more complete version of the argument that follows, see Lawrence J. White, “Market Power and Market Definition in Monopolization Cases: A Paradigm Is Missing,” in Wayne D. Collins, ed., Issues in Competition Law and Policy. American Bar Association, 2008, pp. 913-924.

[6] The forgetting of this important point is often termed “the cellophane fallacy”, since this is what the U.S. Supreme Court did in a 1956 antitrust case in which the DOJ alleged that du Pont had monopolized the cellophane market (and du Pont, in its defense claimed that the relevant market was much wider: all flexible wrapping materials); see U.S. v. du Pont, 351 U.S. 377 (1956).  For an argument that profit data and other indicia argued for cellophane as the relevant market, see George W. Stocking and Willard F. Mueller, “The Cellophane Case and the New Competition,” American Economic Review, Vol. 45, No. 1 (March 1955), pp. 29-63.

[7] In the context of differentiated services, one would expect prices (positive or negative) to vary according to the quality of the service that is offered.  It is worth noting that Bing offers “rewards” to frequent searchers; see https://www.microsoft.com/en-us/bing/defaults-rewards.  It is unclear whether this pricing structure of payment to Bing’s customers represents what a more competitive framework in search might yield, or whether the payment just indicates that search users consider Bing to be a lower-quality service.

[8] As an additional consequence of the impairment of competition in this type of search market, there might be less technological improvement in the search process itself – to the detriment of users.

[9] As estimated by eMarketer: https://www.emarketer.com/newsroom/index.php/google-ad-revenues-to-drop-for-the-first-time/.

[10] See https://www.visualcapitalist.com/us-advertisers-spend-20-years/.

[11] And, again, if we return to the du Pont cellophane case:  Was the relevant market cellophane?  Or all flexible wrapping materials?

[12] This insight is formalized in Richard J. Gilbert and David M.G. Newbery, “Preemptive Patenting and the Persistence of Monopoly,” American Economic Review, Vol. 72, No. 3 (June 1982), pp. 514-526.

[13] To my knowledge, Randal C. Picker was the first to suggest this possibility; see https://www.competitionpolicyinternational.com/a-first-look-at-u-s-v-google/.  Whether Apple would be interested in trying to develop its own search engine – given the fiasco a decade ago when Apple tried to develop its own maps app to replace the Google maps app – is an open question.  In addition, the Gilbert-Newbery insight applies here as well:  Apple would be less inclined to invest the substantial resources that would be needed to develop a search engine when it is thereby in a duopoly market.  But Google might be willing to pay “insurance” to reinforce any doubts that Apple might have.

[14] The U.S. Supreme Court, in FTC v. Actavis, 570 U.S. 136 (2013), decided that such agreements could be anti-competitive and should be judged under the “rule of reason”.  For a discussion of the case and its implications, see, for example, Joseph Farrell and Mark Chicu, “Pharmaceutical Patents and Pay-for-Delay: Actavis (2013),” in John E. Kwoka, Jr., and Lawrence J. White, eds. The Antitrust Revolution: Economics, Competition, and Policy, 7th edn.  Oxford University Press, 2019, pp. 331-353.

[15] This is an example of the insight that vertical arrangements – in this case combined with the Gilbert-Newbery effect – can be a way for dominant firms to raise rivals’ costs.  See, for example, John Asker and Heski Bar-Isaac. 2014. “Raising Retailers’ Profits: On Vertical Practices and the Exclusion of Rivals.” American Economic Review, Vol. 104, No. 2 (February 2014), pp. 672-686.

[16] And, again, for the reasons discussed above, Apple might not be eager to make the effort.

In Antitrust & Competition, Antitrust Division, Apple, European Union, Exclusive Dealing, Federal Trade Commission, Google, Health Care, Intellectual Property, International, Justice Department, Market Definition, Monopolization, Patent, Pharmaceuticals, Platforms, Symposia, Symposium on the Future of American Antitrust: The Google Lawsuits, Telecommunications, Truth on the Market, Wireless , , , , , , , , , , , , , , , , , , , , , ,
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Why the Federal Government’s Antitrust Case Against Google Should—and Likely Will—Fail

Thom Lambert —  18 December 2020

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

On October 20, 2020, the U.S. Department of Justice (DOJ) and eleven states with Republican attorneys general sued Google for monopolizing and attempting to monopolize the markets for general internet search services, search advertising, and “general search text” advertising (i.e., ads that resemble search results).  Last week, California joined the lawsuit, making it a bipartisan affair.

DOJ and the states (collectively, “the government”) allege that Google has used contractual arrangements to expand and cement its dominance in the relevant markets.  In particular, the government complains that Google has agreed to share search ad revenues in exchange for making Google Search the default search engine on various “search access points.” 

Google has entered such agreements with Apple (for search on iPhones and iPads), manufacturers of Android devices and the mobile service carriers that support them, and producers of web browsers.  Google is also pursuing default status on new internet-enabled consumer products, such as voice assistants and “smart” TVs, appliances, and wearables.  In the government’s telling, this all amounts to Google’s sharing of monopoly profits with firms that can ensure its continued monopoly by imposing search defaults that users are unlikely to alter.

There are several obvious weaknesses with the government’s case.  One is that preset internet defaults are super easy to change and, in other contexts, are regularly altered.  For example, while 88% of desktop and laptop computers use the Windows operating system, which defaults to a Microsoft browser (Internet Explorer or Edge), Google’s Chrome browser commands a 69% market share on desktops and laptops, compared to around 13% for Internet Explorer and Edge combined.  Changing a default search engine is as easy as changing a browser default—three simple steps on an iPhone!—and it seems consumers will change defaults they don’t actually prefer.

A second obvious weakness, related to the first, is that the government has alleged no facts suggesting that Google’s search rivals—primarily Bing, Yahoo, and DuckDuckGo—would have enjoyed more success but for Google’s purportedly exclusionary agreements.  Even absent default status, people likely would have selected Google Search because it’s the better search engine.  It doesn’t seem the challenged arrangements caused Google’s search dominance.

Admittedly, the standard of causation in monopolization cases (at least those seeking only injunctive relief) is low.  The D.C. Circuit’s Microsoft decision described it as “edentulous” or, less pretentiously, toothless.  Nevertheless, the government is unlikely to prevail in its action against Google—and that’s a good thing.  Below, I highlight the central deficiency in the government’s Google case and point out problems with the government’s challenges to each of Google’s purportedly exclusionary arrangements.   

The Lawsuit’s Overarching Deficiency

We’ve all had the experience of typing a query only to have Google, within a few key strokes, accurately predict what we were going to ask and provide us with exactly the answer we were looking for.  It’s both eerie and awesome, and it keeps us returning to Google time and again.

But it’s not magic.  Nor has Google hacked our brains.  Google is so good at predicting our questions and providing responsive search results because its top-notch algorithms process gazillions of searches and can “learn” from users’ engagement.  Scale is thus essential to Google’s quality. 

The government’s complaint concedes as much.  It acknowledges that “[g]reater scale improves the quality of a general search engine’s algorithms” (¶35) and that “[t]he additional data from scale allows improved automated learning for algorithms to deliver more relevant results, particularly on ‘fresh’ queries (queries seeking recent information), location-based queries (queries asking about something in the searcher’s vicinity), and ‘long-tail’ queries (queries used infrequently)” (¶36). The complaint also asserts that “[t]he most effective way to achieve scale is for the general search engine to be the preset default on mobile devices, computers, and other devices…” (¶38).

Oddly, though, the government chides Google for pursuing “[t]he most effective way” of securing the scale that concededly “improves the quality of a general search engine’s algorithms.”  Google’s efforts to ensure and enhance its own product quality are improper, the government says, because “they deny rivals scale to compete effectively” (¶8).  In the government’s view, Google is legally obligated to forego opportunities to make its own product better so as to give its rivals a chance to improve their own offerings.

This is inconsistent with U.S. antitrust law.  Just as firms are not required to hold their prices high to create a price umbrella for their less efficient rivals, they need not refrain from efforts to improve the quality of their own offerings so as to give their rivals a foothold. 

Antitrust does forbid anticompetitive foreclosure of rivals—i.e., business-usurping arrangements that are not the result of efforts to compete on the merits by reducing cost or enhancing quality.  But firms are, and should be, free to make their products better, even if doing so makes things more difficult for their rivals.  Antitrust, after all, protects competition, not competitors.    

The central deficiency in the government’s case is that it concedes that scale is crucial to search engine quality, but it does not assert that there is a “minimum efficient scale”—i.e., a point at which scale economies are exhausted.  If a firm takes actions to enhance its own scale beyond minimum efficient scale, and if its efforts may hold its rivals below such scale, then it may have engaged in anticompetitive foreclosure.  But a firm that pursues scale that makes its products better is simply competing on the merits.

The government likely did not allege that there is a minimum efficient scale in general internet search services because returns to scale go on indefinitely, or at least for a very long time.  But the absence of such an allegation damns the government’s case against Google, for it implies that Google’s efforts to secure the distribution, and thus the greater use, of its services make those services better.

In this regard, the Microsoft case, which the government points to as a model for its action against Google (¶10), is inapposite.  Inthat case, the government alleged that Microsoft had entered license agreements that foreclosed Netscape, a potential rival, from the best avenues of browser distribution: original equipment manufacturers (OEMs) and internet access providers.  The government here similarly alleges that Google has foreclosed rival search engines from the best avenues of search distribution: default settings on mobile devices and web browsers.  But a key difference (in addition to the fact that search defaults are quite easy to change) is that Microsoft’s license restrictions foreclosed Netscape without enhancing the quality of Microsoft’s offerings.  Indeed, the court emphasized that the challenged Microsoft agreements were anticompetitive because they “reduced rival browsers’ usage share not by improving [Microsoft’s] own product but, rather, by preventing OEMs from taking actions that could increase rivals’ share of usage” (emphasis added).  Here, any foreclosure of Google’s search rivals is incidental to Google’s efforts to improve its product by enhancing its scale.

Now, the government might contend that the anticompetitive harms from raising rivals’ distribution costs exceed the procompetitive benefits of enhancing the quality of Google’s search services.  Courts, though, have generally been skeptical of claims that exclusion-causing product enhancements are anticompetitive because they do more harm than good.  There’s a sound reason for this: courts are ill-equipped to weigh the benefits of product enhancements against the costs of competition reductions resulting from product-enhancement efforts.  For that reason, they should—and likely will—stick with the rule that this sort of product-enhancing conduct is competition on the merits, even if it has the incidental effect of raising rivals’ costs.  And if they do so, the government will lose this case.     

Problems with the Government’s Specific Challenges

Agreements with Android OEMs and Wireless Carriers

The government alleges that Google has foreclosed its search rivals from distribution opportunities on the Android platform.  It has done so, the government says, by entering into exclusion-causing agreements with OEMs that produce Android products (Samsung, Motorola, etc.) and with carriers that provide wireless service for Android devices (AT&T, Verizon, etc.).

Android is an open source operating system that is owned by Google and licensed, for free, to producers of mobile internet devices.  Under the terms of the challenged agreements, Google’s counterparties promise not to produce Android “forks”—operating systems that are Android-based but significantly alter or “fragment” the basic platform—in order to get access to proprietary Google apps that Android users typically desire and to certain application protocol interfaces (APIs) that enable various functionalities.  In addition to these “anti-forking agreements,” counterparties enter various “pre-installation agreements” obligating them to install a suite of Google apps that use Google Search as a default.  Installing that suite is a condition for obtaining the right to pre-install Google’s app store (Google Play) and other must-have apps.  Finally, OEMs and carriers enter “revenue sharing agreements” that require the use of Google Search as the sole preset default on a number of search access points in exchange for a percentage of search ad revenue derived from covered devices.  Taken together, the government says, these anti-forking, pre-installation, and revenue-sharing agreements preclude the emergence of Android rivals (from forks) and ensure the continued dominance of Google Search on Android devices.

Eliminating these agreements, though, would likely harm consumers by reducing competition in the market for mobile operating systems.  Within that market, there are two dominant players: Apple’s iOS and Google’s Android.  Apple earns money off iOS by selling hardware—iPhones and iPads that are pre-installed with iOS.  Google licenses Android to OEMs for free but then earns advertising revenue off users’ searches (which provide an avenue for search ads) and other activities (which generate user data for better targeted display ads).  Apple and Google thus compete on revenue models.  As Randy Picker has explained, Microsoft tried a third revenue model—licensing a Windows mobile operating system to OEMs for a fee—but it failed.  The continued competition between Apple and Google, though, allows for satisfaction of heterogenous consumer preferences: Apple products are more expensive but more secure (due to Apple’s tight control over software and hardware); Android devices are cheaper (as the operating system is ad-supported) and offer more innovations (as OEMs have more flexibility), but tend to be less secure.  Such variety—a result of business model competition—is good for consumers. 

If the government were to prevail and force Google to end the agreements described above, thereby reducing the advertising revenue Google derives from Android, Google would have to either copy Apple’s vertically integrated model so as to recoup its Android investments through hardware sales, charge OEMs for Android (a la Microsoft), or cut back on its investments in Android.  In each case, consumers would suffer.  The first option would take away an offering preferred by many consumers—indeed most globally, as Android dominates iOS on a worldwide basis.  The second option would replace Google’s business model with one that failed, suggesting that consumers value it less.  The third option would reduce product quality in the market for mobile operating systems. 

In the end, then, the government’s challenge to Google’s Android agreements is myopic and misguided.  Competition among business models, like competition along any dimension, inures to the benefit of consumers.  Precluding it as the government is demanding would be silly.       

Agreements with Browser Producers

Web browsers like Apple’s Safari and Mozilla’s Firefox are a primary distribution channel for search engines.  The government claims that Google has illicitly foreclosed rival search engines from this avenue of distribution by entering revenue-sharing agreements with the major non-Microsoft browsers (i.e., all but Microsoft’s Edge and Internet Explorer).  Under those agreements, Google shares up to 40% of ad revenues generated from a browser in exchange for being the preset default on both computer and mobile versions of the browser.

Surely there is no problem, though, with search engines paying royalties to web browsers.  That’s how independent browsers like Opera and Firefox make money!  Indeed, 95% of Firefox’s revenue comes from search royalties.  If browsers were precluded from sharing in search engines’ ad revenues, they would have to find an alternative source of financing.  Producers of independent browsers would likely charge license fees, which consumers would probably avoid.  That means the only available browsers would be those affiliated with an operating system (Microsoft’s Edge, Apple’s Safari) or a search engine (Google’s Chrome).  It seems doubtful that reducing the number of viable browsers would benefit consumers.  The law should therefore allow payment of search royalties to browsers.  And if such payments are permitted, a browser will naturally set its default search engine so as to maximize its payout.  

Google’s search rivals can easily compete for default status on a browser by offering a better deal to the browser producer.  In 2014, for example, search engine Yahoo managed to wrest default status on Mozilla’s Firefox away from Google.  The arrangement was to last five years, but in 2017, Mozilla terminated the agreement and returned Google to default status because so many Firefox users were changing the browser’s default search engine from Yahoo to Google.  This historical example undermines the government’s challenges to Google’s browser agreements by showing (1) that other search engines can attain default status by competing, and (2) that defaults aren’t as “sticky” as the government claims—at least, not when the default is set to a search engine other than the one most people prefer.

In short, there’s nothing anticompetitive about Google’s browser agreements, and enjoining such deals would likely injure consumers by reducing competition among browsers.

Agreements with Apple

That brings us to the allegations that have gotten the most attention in the popular press: those concerning Google’s arrangements with Apple.  The complaint alleges that Google pays Apple $8-12 billion a year—a whopping 15-20% of Apple’s net income—for granting Google default search status on iOS devices.  In the government’s telling, Google is agreeing to share a significant portion of its monopoly profits with Apple in exchange for Apple’s assistance in maintaining Google’s search monopoly.

An alternative view, of course, is that Google is just responding to Apple’s power: Apple has assembled a giant installed base of loyal customers and can demand huge payments to favor one search engine over another on its popular mobile devices.  In that telling, Google may be paying Apple to prevent it from making Bing or another search engine the default on Apple’s search access points.

If that’s the case, what Google is doing is both procompetitive and a boon to consumers.  Microsoft could easily outbid Google to have Bing set as the default search engine on Apple’s devices. Microsoft’s market capitalization exceeds that of Google parent Alphabet by about $420 billion ($1.62 trillion versus $1.2 trillion), which is roughly the value of Walmart.  Despite its ability to outbid Google for default status, Microsoft hasn’t done so, perhaps because it realizes that defaults aren’t that sticky when the default service isn’t the one most people prefer.  Microsoft knows that from its experience with Internet Explorer and Edge (which collectively command only around 13% of the desktop browser market even though they’re the defaults on Windows, which has a 88% market share on desktops and laptops), and from its experience with Bing (where “Google” is the number one search term).  Nevertheless, the possibility remains that Microsoft could outbid Google for default status, improve its quality to prevent users from changing the default (or perhaps pay users for sticking with Bing), and thereby take valuable scale from Google, impairing the quality of Google Search.  To prevent that from happening, Google shares with Apple a generous portion of its search ad revenues, which, given the intense competition for mobile device sales, Apple likely passes along to consumers in the form of lower phone and tablet prices.

If the government succeeds in enjoining Google’s payments to Apple for default status, other search engines will presumably be precluded from such arrangements as well.  After all, the “foreclosure” effect of paying for default search status on Apple products is the same regardless of which search engine does the paying, and U.S. antitrust law does not “punish” successful firms by forbidding them from engaging in competitive activities that are open to their rivals. 

Ironically, then, the government’s success in its challenge to Google’s Apple payments would benefit Google at the expense of consumers:  Google would almost certainly remain the default search engine on Apple products, as it is most preferred by consumers and no rival could pay to dislodge it; Google would not have to pay a penny to retain its default status; and Apple would lose revenues that it likely passes along to consumers in the form of lower prices.  The courts are unlikely to countenance this perverse result by ruling that Google’s arrangements with Apple violate the antitrust laws.

Arrangements with Producers of Internet-Enabled “Smart” Devices

The final part of the government’s case against Google starkly highlights a problem that is endemic to the entire lawsuit.  The government claims that Google, having locked up all the traditional avenues of search distribution with the arrangements described above, is now seeking to foreclose search distribution in the new avenues being created by internet-enabled consumer products like wearables (e.g., smart watches), voice assistants, smart TVs, etc.  The alleged monopolistic strategy is similar to those described above: Google will share some of its monopoly profits in exchange for search default status on these smart devices, thereby preventing rival search engines from attaining valuable scale.

It’s easy to see in this context, though, why Google’s arrangements are likely procompetitive.  Unlike web browsers, mobile phones, and tablets, internet-enabled smart devices are novel.  Innovators are just now discovering new ways to embed internet functionality into everyday devices. 

Putting oneself in the position of these innovators helps illuminate a key beneficial aspect of Google’s arrangements:  They create an incentive to develop new and attractive means of distributing search.  Innovators currently at work on internet-enabled devices are no doubt spurred on by the possibility of landing a lucrative distribution agreement with Google or another search engine.  Banning these sorts of arrangements—the consequence of governmental success in this lawsuit—would diminish the incentive to innovate.

But that can be said of every single one of the arrangements the government is challenging. Because of Google’s revenue-sharing with search distributors, each of them has an added incentive to make their distribution channels desirable to consumers.  Android OEMs and Apple will work harder to produce mobile devices that people will want to use for internet searches; browser producers will endeavor to improve their offerings.  By paying producers of search access points a portion of the search ad revenues generated on their platforms, Google motivates them to generate more searches, which they can best do by making their products as attractive as possible. 

At the end of the day, then, the government’s action against Google seeks to condemn conduct that benefits consumers.  Because of the challenged arrangements, Google makes its own search services better, is able to license Android for free, ensures the continued existence of independent web browsers like Firefox and Opera, helps lower the price of iPhones and iPads, and spurs innovators to develop new “Internet of Things” devices that can harness the power of the web. 

The Biden administration would do well to recognize this lawsuit for what it is: a poorly conceived effort to appear to be “doing something” about a Big Tech company that has drawn the ire (for different reasons) of both progressives and conservatives.  DOJ and its state co-plaintiffs should seek dismissal of this action.  

In Apple, Google, Justice Department, Platforms, Symposia, Symposium on the Future of American Antitrust: The Google Lawsuits, Telecommunications, Truth on the Market, Wireless , , , , , , , , , ,
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It’s Not So Simple Who Owns “Your” Data

Peter Klein —  22 October 2020
[TOTM: The following is part of a symposium by TOTM guests and authors marking the release of Nicolas Petit’s “Big Tech and the Digital Economy: The Moligopoly Scenario.” The entire series of posts is available here.

This post is authored by Peter Klein (Professor of Entrepreneurship, Baylor University).]

Nicolas Petit’s insightful and provocative book ends with a chapter on “Big Tech’s Novel Harms,” asking whether antitrust is the appropriate remedy for popular (and academic) concerns about privacy, fake news, and hate speech. In each case, he asks whether the alleged harms are caused by a lack of competition among platforms – which could support a case for breaking them up – or by the nature of the underlying technologies and business models. He concludes that these problems are not alleviated (and may even be exacerbated) by applying competition policy and suggests that regulation, not antitrust, is the more appropriate tool for protecting privacy and truth.

What kind of regulation? Treating digital platforms like public utilities won’t work, Petit argues, because the product is multidimensional and competition takes place on multiple margins (the larger theme of the book): “there is a plausible chance that increased competition in digital markets will lead to a race to the bottom, in which price competition (e.g., on ad markets) will be the winner, and non-price competition (e.g., on privacy) will be the loser.” Utilities regulation also provides incentives for rent-seeking by less efficient rivals. Retail regulation, aimed at protecting small firms, may end up helping incumbents instead by raising rivals’ costs.

Petit concludes that consumer protection regulation (such as Europe’s GDPR) is a better tool for guarding privacy and truth, though it poses challenges as well. More generally, he highlights the vast gulf between the economic analysis of privacy and speech and the increasingly loud calls for breaking up the big tech platforms, which would do little to alleviate these problems.

As in the rest of the book, Petit’s treatment of these complex issues is thoughtful, careful, and systematic. I have more fundamental problems with conventional antitrust remedies and think that consumer protection is problematic when applied to data services (even more so than in other cases). Inspired by this chapter, let me offer some additional thoughts on privacy and the nature of data which speak to regulation of digital platforms and services.

First, privacy, like information, is not an economic good. Just as we don’t buy and sell information per se but information goods (books, movies, communications infrastructure, consultants, training programs, etc.), we likewise don’t produce and consume privacy but what we might call privacy goods: sunglasses, disguises, locks, window shades, land, fences and, in the digital realm, encryption software, cookie blockers, data scramblers, and so on.

Privacy goods and services can be analyzed just like other economic goods. Entrepreneurs offer bundled services that come with varying degrees of privacy protection: encrypted or regular emails, chats, voice and video calls; browsers that block cookies or don’t; social media sites, search engines, etc. that store information or not; and so on. Most consumers seem unwilling to sacrifice other functionality for increased privacy, as suggested by the small market shares held by DuckDuckGo, Telegram, Tor, and the like suggest. Moreover, while privacy per se is appealing, there are huge efficiency gains from matching on buyer and seller characteristics on sharing platforms, digital marketplaces, and dating sites. There are also substantial cost savings from electronic storage and sharing of private information such as medical records and credit histories. And there is little evidence of sellers exploiting such information to engage in price discrimination. (Aquisti, Taylor, and Wagman, 2016 provide a detailed discussion of many of these issues.)

Regulating markets for privacy goods via bans on third-party access to customer data, mandatory data portability, and stiff penalties for data breaches is tricky. Such policies could make digital services more valuable, but it is not obvious why the market cannot figure this out. If consumers are willing to pay for additional privacy, entrepreneurs will be eager to supply it. Of course, bans on third-party access and other forms of sharing would require a fundamental change in the ad-based revenue model that makes free or low-cost access possible, so platforms would have to devise other means of monetizing their services. (Again, many platforms already offer ad-free subscriptions, so it’s unclear why those who prefer ad-based, free usage should be prevented from doing so.)

What about the idea that I own “my” data and that, therefore, I should have full control over how it is used? Some of the utilities-based regulatory models treat platforms as neutral storage places or conduits for information belonging to users. Proposals for data portability suggest that users of technology platforms should be able to move their data from platform to platform, downloading all their personal information from one platform then uploading it to another, then enjoying the same functionality on the new platform as longtime users.

Of course, there are substantial technical obstacles to such proposals. Data would have to be stored in a universal format – not just the text or media users upload to platforms, but also records of all interactions (likes, shares, comments), the search and usage patterns of users, and any other data generated as a result of the user’s actions and interactions with other users, advertisers, and the platform itself. It is unlikely that any universal format could capture this information in a form that could be transferred from one platform to another without a substantial loss of functionality, particularly for platforms that use algorithms to determine how information is presented to users based on past use. (The extreme case is a platform like TikTok which uses usage patterns as a substitute for follows, likes, and shares, portability to construct a “feed.”)

Moreover, as each platform sets its own rules for what information is allowed, the import functionality would have to screen the data for information allowed on the original platform but not the new (and the reverse would be impossible – a user switching from Twitter to Gab, for instance, would have no way to add the content that would have been permitted on Gab but was never created in the first place because it would have violated Twitter rules).

There is a deeper, philosophical issue at stake, however. Portability and neutrality proposals take for granted that users own “their” data. Users create data, either by themselves or with their friends and contacts, and the platform stores and displays the data, just as a safe deposit box holds documents or jewelry and a display case shows of an art collection. I should be able to remove my items from the safe deposit box and take them home or to another bank, and a “neutral” display case operator should not prevent me from showing off my preferred art (perhaps subject to some general rules about obscenity or harmful personal information).

These analogies do not hold for user-generated information on internet platforms, however. “My data” is a record of all my interactions with platforms, with other users on those platforms, with contractual partners of those platforms, and so on. It is co-created by these interactions. I don’t own these records any more than I “own” the fact that someone saw me in the grocery store yesterday buying apples. Of course, if I have a contract with the grocer that says he will keep my purchase records private, and he shares them with someone else, then I can sue him for breach of contract. But this isn’t theft. He hasn’t “stolen” anything; there is nothing for him to steal. If a grocer — or an owner of a tech platform — wants to attract my business by monetizing the records of our interactions and giving me a cut, he should go for it. I still might prefer another store. In any case, I don’t have the legal right to demand this revenue stream.

Likewise, “privacy” refers to what other people know about me – it is knowledge in their heads, not mine. Information isn’t property. If I know something about you, that knowledge is in my head; it’s not something I took from you. Of course, if I obtained or used that info in violation of a prior agreement, then I’m guilty of breach, and I use that information to threaten or harass you, I may be guilty of other crimes. But the popular idea that tech companies are stealing and profiting from something that’s “ours” isn’t right.

The concept of co-creation is important, because these digital records, like other co-created assets, can be more or less relationship specific. The late Oliver Williamson devoted his career to exploring the rich variety of contractual relationships devised by market participants to solve complex contracting problems, particularly in the face of asset specificity. Relationship-specific investments can be difficult for trading parties to manage, but they typically create more value. A legal regime in which only general-purpose, easily redeployable technologies were permitted would alleviate the holdup problem, but at the cost of a huge loss in efficiency. Likewise, a world in which all digital records must be fully portable reduces switching costs, but results in technologies for creating, storing, and sharing information that are less valuable. Why would platform operators invest in efficiency improvements if they cannot capture some of that value by means of proprietary formats, interfaces, sharing rules, and other arrangements?  

In short, we should not be quick to assume “market failure” in the market for privacy goods (or “true” news, whatever that is). Entrepreneurs operating in a competitive environment – not the static, partial-equilibrium notion of competition from intermediate micro texts but the rich, dynamic, complex, and multimarket kind of competition described in Petit’s book – can provide the levels of privacy and truthiness that consumers prefer.

In Amazon, Antitrust & Competition, Apple, Platforms, Price Discrimination, Symposia, Symposium on Big Tech and the Digital Economy: The Moligopoly Scenario, Truth on the Market, Twitter , , , , , , , ,
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Sher: Implications of the Draft Vertical Merger Guidelines for Vertical Mergers Involving Technology Start-Ups

Scott Sher —  7 February 2020

[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 Scott Sher (Partner, Wilson Sonsini Goodrich & Rosati) and Matthew McDonald (Associate, Wilson Sonsini Goodrich & Rosati).]

On January 10, 2020, the United States Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”) (collectively, “the Agencies”) released their joint draft guidelines outlining their “principal analytical techniques, practices and enforcement policy” with respect to vertical mergers (“Draft Guidelines”). While the Draft Guidelines describe and formalize the Agencies’ existing approaches when investigating vertical mergers, they leave several policy questions unanswered. In particular, the Draft Guidelines do not address how the Agencies might approach the issue of acquisition of potential or nascent competitors through vertical mergers. As many technology mergers are motivated by the desire to enter new industries or add new tools or features to an existing platform (i.e., the Buy-Versus-Build dilemma), the omission leaves a significant hole in the Agencies’ enforcement policy agenda, and leaves the tech industry, in particular, without adequate guidance as to how the Agencies may address these issues.

This is notable, given that the Horizontal Merger Guidelines explicitly address potential competition theories of harm (e.g., at § 1 (referencing mergers and acquisitions “involving actual or potential competitors”); § 2 (“The Agencies consider whether the merging firms have been, or likely will become absent the merger, substantial head-to-head competitors.”). Indeed, the Agencies have recently challenged several proposed horizontal mergers based on nascent competition theories of harm. 

Further, there has been much debate regarding whether increased antitrust scrutiny of vertical acquisitions of nascent competitors, particularly in technology markets, is warranted (See, e.g., Open Markets Institute, The Urgent Need for Strong Vertical Merger Guidelines (“Enforcers should be vigilant toward dominant platforms’ acquisitions of seemingly small or marginal firms and be ready to block acquisitions that may be part of a monopoly protection strategy. Dominant firms should not be permitted to expand through vertical acquisitions and cut off budding threats before they have a chance to bloom.”); Caroline Holland, Taking on Big Tech Through Merger Enforcement (“Vertical mergers that create market power capable of stifling competition could be particularly pernicious when it comes to digital platforms.”)). 

Thus, further policy guidance from the Agencies on this issue is needed. As the Agencies formulate guidance, they should take note that vertical mergers involving technology start-ups generally promote efficiency and innovation, and that any potential competitive harm almost always can be addressed with easy-to-implement behavioral remedies.

The agencies’ draft vertical merger guidelines

The Draft Guidelines outline the following principles that the Agencies will apply when analyzing vertical mergers:

  • Market definition. The Agencies will identify a relevant market and one or more “related products.” (§ 2) This is a product that is supplied by the merged firm, is vertically related to the product in the relevant market, and to which access by the merged firm’s rivals affects competition in the relevant market. (§ 2)
  • Safe harbor. Unlike horizontal merger cases, the Agencies cannot rely on changes in concentration in the relevant market as a screen for competitive effects. Instead, the Agencies consider measures of the competitive significance of the related product. (§ 3) The Draft Guidelines propose a safe harbor, stating 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.” (§ 3) However, shares exceeding the thresholds, taken alone, do not support an inference that the vertical merger is anticompetitive. (§ 3)
  • Theories of unilateral harm. Vertical mergers can result in unilateral competitive effects, including raising rivals’ costs (charging rivals in the relevant market a higher price for the related product) or foreclosure (refusing to supply rivals with the related product altogether). (§ 5.a) Another potential unilateral effect is access to competitively sensitive information: The combined firm may, through the acquisition, gain access to sensitive business information about its upstream or downstream rivals that was unavailable to it before the merger (for example, a downstream rival of the merged firm may have been a premerger customer of the upstream merging party). (§ 5.b)
  • Theories of coordinated harm. Vertical mergers can also increase the likelihood of post-merger coordinated interaction. For example, a vertical merger might eliminate or hobble a maverick firm that would otherwise play an important role in limiting anticompetitive coordination. (§ 7)
  • Procompetitive effects. Vertical mergers can have procompetitive effects, such as the elimination of double marginalization (“EDM”). A merger of vertically related firms can create an incentive for the combined entity to lower prices on the downstream product, because it will capture the additional margins from increased sales on the upstream product. (§ 6) EDM thus may benefit both the merged firm and buyers of the downstream product. (§ 6)
  • Efficiencies. Vertical mergers have the potential to create cognizable efficiencies; the Agencies will evaluate such efficiencies using the standards set out in the Horizontal Merger Guidelines. (§ 8)

Implications for vertical mergers involving nascent start-ups

At present, the Draft Guidelines do not address theories of nascent or potential competition. To the extent the Agencies provide further guidance regarding the treatment of vertical mergers involving nascent start-ups, they should take note of the following facts:

First, empirical evidence from strategy literature indicates that technology-related vertical mergers are likely to be efficiency-enhancing. In a survey of the strategy literature on vertical integration, Professor D. Daniel Sokol observed that vertical acquisitions involving technology start-ups are “largely complementary, combining the strengths of the acquiring firm in process innovation with the product innovation of the target firms.” (p. 1372) The literature shows that larger firms tend to be relatively poor at developing new and improved products outside of their core expertise, but are relatively strong at process innovation (developing new and improved methods of production, distribution, support, and the like). (Sokol, p. 1373) Larger firms need acquisitions to help with innovation; acquisition is more efficient than attempting to innovate through internal efforts. (Sokol, p. 1373)

Second, vertical merger policy towards nascent competitor acquisitions has important implications for the rate of start-up formation, and the innovation that results. Entrepreneurship in technology markets is motivated by the opportunity for commercialization and exit. (Sokol, p. 1362 (“[T]he purpose of such investment [in start-ups] is to reap the rewards of scaling a venture to exit.”))

In recent years, as IPO activity has declined, vertical mergers have become the default method of entrepreneurial exit. (Sokol, p. 1376) Increased vertical merger enforcement against start-up acquisitions thus closes off the primary exit strategy for entrepreneurs. As Prof. Sokol concluded in his study of vertical mergers:

When antitrust agencies, judges, and legislators limit the possibility of vertical mergers as an exit strategy for start-up firms, it creates risk for innovation and entrepreneurship…. it threatens entrepreneurial exits, particularly for tech companies whose very business model is premised upon vertical mergers for purposes of a liquidity event. (p. 1377)

Third, to the extent that the vertical acquisition of a start-up raises competitive concerns, a behavioral remedy is usually preferable to a structural one. As explained above, vertical acquisitions typically result in substantial efficiencies, and these efficiencies are likely to overwhelm any potential competitive harm. Further, a structural remedy is likely infeasible in the case of a start-up acquisition. Thus, behavioral relief is the only way of preserving the deal’s efficiencies while remedying the potential competitive harm. (Which the Agencies have recognized, see DOJ Antitrust Division, Policy Guide to Merger Remedies, p. 20 (“Stand-alone conduct relief is only appropriate when a full-stop prohibition of the merger would sacrifice significant efficiencies and a structural remedy would similarly eliminate such efficiencies or is simply infeasible.”)) Appropriate behavioral remedies for vertical acquisitions of start-ups would include firewalls (restricting the flow of competitively sensitive information between the upstream and downstream units of the combined firm) or a fair dealing or non-discrimination remedy (requiring the merging firm to supply an input or grant customer access to competitors in a non-discriminatory way) with clear benchmarks to ensure compliance. (See Policy Guide to Merger Remedies, pp. 22-24)

To be sure, some vertical mergers may cause harm to competition, and there should be enforcement when the facts justify it. But vertical mergers involving technology start-ups generally enhance efficiency and promote innovation. Antitrust’s goals of promoting competition and innovation are thus best served by taking a measured approach towards vertical mergers involving technology start-ups. (Sokol, pp. 1362–63) (“Thus, a general inference that makes vertical acquisitions, particularly in tech, more difficult to approve leads to direct contravention of antitrust’s role in promoting competition and innovation.”)

In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Federal Trade Commission, Justice Department, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Tying , , , , , , , , , , , ,
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Fruits: Messy Mergers and Muddled Guidelines (Or, “Orange You Glad I Didn’t Say Banana?”)

Eric Fruits —  7 February 2020

[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 Eric Fruits (Chief Economist, International Center for Law & Economics and Professor of Economics, Portland State University).]

Vertical mergers are messy. They’re messy for the merging firms and they’re especially messy for regulators charged with advancing competition without advantaging competitors. Firms rarely undertake a vertical merger with an eye toward monopolizing a market. Nevertheless, competitors and competition authorities excel at conjuring up complex models that reveal potentially harmful consequences stemming from vertical mergers. In their post, Gregory J. Werden and Luke M. Froeb highlight the challenges in evaluating vertical mergers:

[V]ertical 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.  

There’s a recurring theme throughout this symposium: The current Vertical Merger Guidelines should be updated; the draft Guidelines are a good start, but they raise more questions than they answer. Other symposium posts have hit on the key ups and downs of the draft Guidelines. 

In this post, I use the draft Guidelines’ examples to highlight how messy vertical mergers can be. The draft Guidelines’ examples are meant to clarify the government’s thinking on markets and mergers. In the end, however, they demonstrate the complexity in identifying relevant markets, related products, and the dynamic interaction of competition. I will focus on two examples provided in the draft Guidelines. Warning: you’re going to read a lot about oranges.

In the following example from the draft Guidelines, the relevant market is the wholesale supply of orange juice in region X and Company B’s supply of oranges is the related product: 

Example 2: Company A is a wholesale supplier of orange juice. It seeks to acquire Company B, an owner of orange orchards. The Agencies may consider whether the merger would lessen competition in the wholesale supply of orange juice in region X (the relevant market). The Agencies may identify Company B’s supply of oranges as the related product. Company B’s oranges are used in fifteen percent of the sales in the relevant market for wholesale supply of orange juice. The Agencies may consider the share of fifteen percent as one indicator of the competitive significance of the related product to participants in the relevant market.

The figure below illustrates one hypothetical structure. Company B supplies an equal amount of oranges to Company A and two other wholesalers, C and D, totalling 15 percent of orange juice sales in region X. Orchards owned by others account for the remaining 85 percent. For the sake of argument, assume all the wholesalers are the same size in which case Company B’s orchard would supply 20 percent of the oranges used by wholesalers A, C, and D.

Orange juice sold in a particular region is just one of many uses for oranges. The juice can be sold as fresh liquid, liquid from concentrate, or frozen concentrate. The fruit can be sold as fresh produce or it can be canned, frozen, or processed into marmalade. Many of these products can be sold outside of a particular region and can be sold outside of the United States. This is important in considering the next example from the draft Guidelines.

Example 3: In Example 2, the merged firm may be able to profitably stop supplying oranges (the related product) to rival orange juice suppliers (in the relevant market). The merged firm will lose the margin on the foregone sales of oranges but may benefit from increased sales of orange juice if foreclosed rivals would lose sales, and some of those sales were diverted to the merged firm. If the benefits outweighed the costs, the merged firm would find it profitable to foreclose. If the likely effect of the foreclosure were to substantially lessen competition in the orange juice market, the merger potentially raises significant competitive concerns and may warrant scrutiny.

This is the classic example of raising rivals’ costs. Under the standard formulation, the merged firm will produce oranges at the orchard’s marginal cost — in theory, the price it pays for oranges would be the same both pre- and post-merger. If orchard B does not sell its oranges to the non-integrated wholesalers C, D, and E, the other orchards will be able to charge a price greater than their marginal cost of production and greater than the pre-merger market price for oranges. The higher price of oranges used by non-integrated wholesalers will then be reflected in higher prices for orange juice sold by the wholesalers. 

The merged firm’s juice prices will be higher post-merger because its unintegrated rivals’ juice prices will be higher, thus increasing the merged firm’s profits. The merged firm and unintegrated orchards would be the “winners;” unintegrated wholesalers and consumers would be the “losers.” Under a consumer welfare standard the result could be deemed anticompetitive. Under a total welfare standard, anything goes.

But, the classic example of raising rivals’ costs is based on some strong assumptions. It assumes that, pre-merger, all upstream firms price at marginal cost, which means there is no double marginalization. It assumes all the upstream firm’s products are perfectly identical. It assumes unintegrated firms don’t respond by integrating themselves. If one or more of these assumptions is not correct, more complex models — with additional (potentially unprovable) assumptions — must be employed. What begins as a seemingly straightforward theoretical example is now a battle of which expert’s models best fit the facts and best predicts the likely outcome. 

In the draft Guidelines’ raising rivals’ costs example, it’s assumed the merged firm would refuse to sell oranges to rival downstream wholesalers. However, if rival orchards charge a sufficiently high price, the merged firm would profit from undercutting its rivals’ orange prices, while still charging a price greater than marginal cost. Thus, it’s not obvious that the merged firm has an incentive to cut off supply to downstream competitors. The extent of the pricing pressure on the merged firm to cheat on itself is an empirical matter that depends on how upstream and downstream firms react, or might react.

For example, using the figure above, if the merged firm stopped supplying oranges to rival wholesalers, then the merged firm’s orchard would supply 60 percent of the oranges used in the firm’s juice. Although wholesalers C and D would not get oranges from B’s orchards, they could obtain oranges from other orchards that are no longer supplying wholesaler A. In this case, the merged firm’s attempt at foreclosure would have no effect and there would be no harm to competition.

It’s possible the merged firm would divert some or all of its oranges to a “secondary” market, removing those oranges from the juice market. Rather than juicing oranges, the merged firm may decide to sell them as fresh produce; fresh citrus fruits account for 7 percent of Florida’s crop and 75% of California’s. This diversion would lead to a decline in the supply of oranges for juice and the price of this key input would rise. 

But, as noted in the Guidelines’ example, this strategy would raise the merged firm’s costs along with its rivals. Moreover, rival orchards can respond to this strategy by diverting their own oranges from “secondary” markets to the juice market, in which case there may be no significant effect on the price of juice oranges. What begins as a seemingly straightforward theoretical example is now a complicated empirical matter. Or worse, it may just be a battle over which expert is the most convincing fortune teller.

Moreover, the merged firm may have legitimate business reasons for the merger and legitimate business reasons for reducing the supply of oranges to juice wholesalers. For example “citrus greening,” an incurable bacterial disease, has caused severe damage to Florida’s citrus industry, significantly reducing crop yields. A vertical merger could be one way to reduce supply risks. On the demand side, an increase in the demand for fresh oranges would guide firms to shift from juice and processed markets to the fresh market. What some would see as anticompetitive conduct, others would see as a natural and expected response to price signals.Because of the many alternative uses for oranges, it’s overly simplistic to declare that the supply of orange juice in a specific region is “the” relevant market. Orchards face a myriad of options in selling their products. Misshapen fruit can be juiced fresh or as frozen concentrate; smaller fruit can be canned or jellied. “Perfect” fruit can be sold as fresh produce, juice, canned, or jellied. Vertical integration with a juice wholesaler adds just one factor to the myriad factors affecting how and where an upstream supplier sells its products. Just as there is no single relevant market, in many cases there is no single related product — a fact that is especially relevant in vertical relationships. Unfortunately the draft Guidelines provide little guidance in these important areas.

In Antitrust & Competition, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Google, International Center for Law & Economics, Justice Department, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Tying , , , , , , , , ,
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Cernak: Who Bears the Burden on Elimination of Double Marginalization in the Draft Vertical Merger Guidelines?

Steven J Cernak —  7 February 2020

[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 Steven J. Cernak (Partner, Bona Law; Adjunct Professor, University of Michigan Law School and Western Michigan University Thomas M. Cooley Law School; former antitrust counsel, GM).] 

[Cernak: This paper represents the current views of the author alone and not necessarily the views of any past, present, or future employer or client.]

What should we make of Cmr. Chopra’s and Cmr. Slaughter’s dissents?

When I first heard that the FTC and DOJ Antitrust Division issued the draft Vertical Merger Guidelines late on Friday January 10, I did not rush out and review them to form an opinion, antitrust geek though I am. The issuance was not a surprise, given that the 1984 Guidelines were more than 35 years old and described as outdated by all observers, including those at an FTC hearing more than a year earlier. So I was surprised when I saw some pundits, especially on Twitter, immediately found the new draft controversial and I learned that two of the FTC Commissioners had not supported the release. Surely nobody was a big 1984 supporter other than fans of Orwell, Bowie, and Morris, right? 

Some of my confusion dissipated as I had a chance to read and analyze the draft guidelines and the accompanying statements of Commissioners Wilson, Slaughter, and Chopra. First, Commissioners Slaughter and Chopra only abstained from the decision to release the draft for public comment. In their statements, they explained their actions as necessary to register their disagreement with the terms of this particular draft but that they too joined the chorus calling for repudiation of the 1984 Guidelines. 

But some of my confusion remained as I went over Commissioner Chopra’s statement again. Instead of objections to particular provisions of the draft guidelines, the statement is more of a litany of complaints on all that is wrong with today’s economy and antitrust policy’s role in it. Those complaints are ones we have heard from Commissioner Chopra before. They certainly should be part of the general policy debate; however, they seem to go well beyond competitive issues that might be raised by vertical mergers and that should be part of a set of guidelines. 

As the first sentence and footnote of the draft guidelines make clear, the draft guidelines are meant to “outline the principal analytical techniques, practices and enforcement policy of … the Agencies” and “reflect the ongoing accumulation of experience at the Agencies.” They are written to provide some guidance to potential merging parties and their advisers as to how the Agencies are likely to analyze a merger and, so, provide some greater level of certainty. That does not mean that the guidelines are meant to capture the techniques of the Agencies in amber forever – or even 35 years. As that same first footnote makes clear, the guidelines may be revised to “reflect significant changes in enforcement policy…or to reflect new learning.” But guidelines designed to provide some clarity on how vertical mergers have been and will be reviewed are not the forum for a broad exchange of views on antitrust policy. Those comments are more helpful in FTC hearings, speeches, or enforcement actions that the Commissioners might participate in, not guidelines for practitioners. 

Commissioner Slaughter’s statement, on the other hand, stays focused on vertical mergers and the issues that she has with these draft guidelines. She and other early commentators raise at least some questions about the current draft that I hope will be addressed in the final version. For instance, the 1984 version of the guidelines included as potential anticompetitive effects from vertical mergers 1) regulatory evasion and 2) the creation of the need for potential entrants to enter at multiple stages of the market. As Commissioner Slaughter points out, the current draft guidelines drop those two and instead focus on 1) foreclosure; 2) raising rivals’ costs; and 3) the exchange of competitively sensitive information. 

Should we take the absence of the two 1984 harms as an indication that those types of harms are no longer important to the Agencies? Or that they have not been important in recent Agency action, and so did not make this draft, but would still be considered if the correct facts were found? Some other option? While the new guidelines would become too long and unwieldy if they recited and rejected all potential theories of harm, I join Commissioner Slaughter in thinking it would be helpful to include an explanation regarding these particular changes from the prior guidance. 

Who bears the burden on elimination of double marginalization?

Finally, both Commissioner Wilson’s and Commissioner Slaughter’s statements specifically request public comments regarding certain features of the draft guidelines’ handling of the elimination of double marginalization (“EDM”). While they raise good questions, I want to focus on a more fundamental question raised by the draft guidelines and a recent speech by Assistant Attorney General Makan Delrahim. 

The draft guidelines provide a concise, cogent description of EDM, the usual analysis of it during vertical mergers, and some special factors that might make it less likely to occur. Some commentators have pointed out that EDM gets its own section of the draft guidelines, signaling its importance. I think it even more significant, perhaps, that that separate section is placed in between the sections on unilateral and coordinated competitive effects. Does that placement signal that the analysis of EDM is part of the Agencies’ analysis of the overall predicted competitive effects of the merger? That hypothesis also is supported by this statement at the end of the EDM section: “The Agencies will not challenge a merger if the net effect of elimination of double marginalization means that the merger is unlikely to be anticompetitive in any relevant market.” 

Because the Agencies would have the ultimate burden of showing in court that the effect of the proposed merger “may be substantially to lessen competition, or tend to create a monopoly,” it seems to follow that the Agencies would have the burden to factor EDM into the rest of their competitive analysis to show what the potential overall net effect of the merger would be. 

Unfortunately, earlier in the EDM section of the draft guidelines, the Agencies state that they “generally rely on the parties to identify and demonstrate whether and how the merger eliminates double marginalization.” (emphasis added) Does that statement merely mean that the parties must cooperate with the Agencies and provide relevant information, as required on all points under Hart-Scott-Rodino? Or is it an attempt to shift to the parties the ultimate burden of proving this part of the competitive analysis? That is, is it a signal that, despite the separate section placed in the middle of the discussion of competitive effects analysis, the Agencies are skeptical of EDM and plan to treat it more like a defense as they treat certain cognizable efficiencies? 

That latter position is supported by comments by AAG Delrahim in a recent speech: “as the law requires for the advancement of any affirmative defense, the burden is on the parties in a vertical merger to put forward evidence to support and quantify EDM as a defense.” So is EDM a defense to an otherwise anticompetitive vertical merger or just part of the overall analysis of competitive effects? Before getting to the pertinent but more detailed questions posed by Commissioners Wilson and Slaughter, these draft guidelines would further their goal of providing clarity by answering that more basic EDM question. 

Despite those concerns, the draft guidelines seem consistent with the antitrust community’s consensus today on the proper analysis of vertical mergers. As such, they would seem to be consistent with how the Agencies evaluate such mergers today and so provide helpful guidance to parties considering such a merger. I hope the final version considers all the comments and remains helpful – and is released on a Monday so we can all more easily and intelligently start commenting. 

In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Justice Department, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Twitter, Tying , , , , , , , , , ,
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Brennan: Guidance on Enforcement Against “Pure” Vertical Mergers: It’s Complicated

Tim Brennan —  7 February 2020

[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 Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division).] 

The DOJ Antitrust Division and the FTC have issued draft proposed Vertical Merger Guidelines (VMGs). These have been long-desired in some quarters, and long-dreaded in others. The controversy remains, although those who long desired them may dread what they got, and vice versa. 

I’ve accepted Geoff’s invitation to offer some short thoughts on this blessedly short draft. I’ll focus on what one might call “pure” vertical mergers, as opposed to those based on concerns regarding potential entry or expansion by a vertically integrated firm into its upstream or downstream market. After looking at what the draft classifies as unilateral effects, I’ll then turn briefly to coordinated effects, burden of proof, and the whether we want to go there at all. 

A notable omission

It’s useful to think of pure vertical mergers mergers in a reverse direction; that is, not the harms they would create, but the benefits of blocking the merger even if it were harmful. The usual argument against prosecuting such mergers is that one would be left with separate firms charging above-competitive prices at one end or the other — and if they do it at both ends, creating double marginalization. 

In that regard, the draft has a notable omission: a skeptical eye toward mergers when a firm with market power is unable to charge a consequently high price. The usual justification is price regulation of a monopoly. Concern about the harm of vertical integration as a means to evade such regulation was the basis for the divestiture by AT&T of its then-regulated, then-monopoly local telephone companies, the mirror image of blocking a vertical merger. This concern also formed the basis of Federal Energy Regulatory Commission orders (here and here) separating control of regulated electricity transmission lines from ownership of unregulated generation.

More controversially, one could apply this in contexts where pricing is limited by something other than explicit regulation. TOTM has recently featured a debate between Geoff Manne and Dirk Auer on one side and Mark Lemley, Doug Melamed, and Steve Salop regarding the FTC’s case against Qualcomm’s licensing practices, where the issue (I think) is about whether FRAND licensing requirements limit Qualcomm’s ability to extract the full rental value of its patents. Perhaps even more out there, I’ve suggested that transaction costs keeping Google from charging directly for search could justify concern with discrimination in favor of its offerings in other markets, without having to reject a consumer welfare standard and where “free” search could justify rather than impede an antitrust case. Whether non-regulatory restrictions on price should justify vertical concerns is, to say the least, complicated. You’ll see that word often, and I’ll come back to it at the end. 

Raising rivals’ costs and foreclosure: Why would the merger matter?

The seeming truism of raising rivals’ costs is that to raise someone’s costs, you have to raise the price of an input they use or a complement they need. If a merger (or vertical restraint) extends control over an input or complement, the competitive risk arises because that complement market is being monopolized. Accordingly, enforcers need to ensure they are looking at competition and ease of entry in the market that’s being monopolized, not the market in which the bad guy who benefits might operate. For example, in the case involving Intel’s loyalty rebates to computer makers that allegedly excluded AMD’s processing chips, the relevant market was not chips but computers, and it is necessary to explain why AMD couldn’t get new computer makers to use its chips or vertically integrate itself into computers. 

With a “pure” vertical merger, however, the raising rivals’ cost or foreclosure story depends not on the creation or expansion of market power over an input or complement. It must depend on how vertical integration leads to the exercise of power in that market that was not being exercised before. That requires that vertical integration changes the strategic interactions determining price and quality. 

If this is the story, however, the agencies should make clear that they bear an obligation to explain how vertical integration matters, rather than assume a competitive outcome otherwise. The recent (failed) Justice Department challenge to AT&T’s vertical acquisition of Time Warner programming bears this out. DOJ’s core claim was that post-merger, Time Warner program services (HBO, CNN) would strike tougher deals with other video distributors, leading to higher licensing fees, because they would know that a failed negotiation would increase subscribership to AT&T. However, once a program service licenses to any video distributor, it realizes that if other video distributors don’t take their service, it will increase subscribers and profits from its initial deal. If that change in bargaining position benefits whoever gets the first deal, distributors presumably can cut a deal to be the first, without vertical merger being necessary. 

Might vertical merger still matter? Perhaps, but plaintiffs should have to explain what transaction costs prevent such a nominally anticompetitive deal. Critics of indifference to vertical mergers, and the draft VMGs, point out that double marginalization might be eliminated without vertical integration, through use of contracts that include fixed fees and sales at marginal cost. A similar skepticism regarding the need for vertical integration to achieve anticompetitive ends is similarly appropriate. Establishing that need may be, well, complicated. 

Coordination and symmetry

I have less to say about coordinated effects. Knowing when firms decide to switch from competing to cooperating is probably a matter of psychology and sociology as much as economics. However, economics does suggest that collusion is more likely the more symmetric are the positions of the potential colluders, to help find a mutually agreeable tactic and reduce the need for side payments and the like. To the extent symmetry is relevant, a pure vertical merger will facilitate collusion only if other market participants were similarly integrated. And absent market-wide collusion to integrate, this integration of the other participants could be reasonably interpreted as evidence of efficiencies of vertical integration. This would make a coordinated effects vertical merger case, well, complicated.

The burden of proof

As part of a widely voiced dissatisfaction with the last few decades of antitrust enforcement, some commentators have suggested that vertical mergers deserve no more of a presumption of being good than horizontal mergers. I would argue that the strength of evidence necessary to block a vertical merger should remain greater than that for horizontal mergers. This is not (just) because mergers between complements are more likely to lead prices to fall — eliminating double marginalization being an example — while horizontal mergers are likely to bring about upward pricing pressure. It is that the behavior that warrants concern with horizontal mergers, joint price setting, is illegal. Thus, the horizontal merger might be the only way to enable that conduct. 

Contracting alternatives to vertical merger abound, as two-part pricing to eliminate double marginalization and sequential per-subscriber pricing in video markets illustrate. Absent regulation, the transaction costs necessary to create and exercise market power but for vertical integration will be lower than those necessary to create and exercise that power but for horizontal merger. This difference in transaction costs means that horizontal merger is more likely to be necessary for harm than vertical merger. Thus, proving that the latter are harmful should be, well, more complicated.

So, are pure vertical mergers worth the trouble to prosecute?

Vertical mergers might be problematic, but cases are necessarily going to be complicated. This raises the question of whether the benefits of prosecuting such mergers are worth the costs, at least outside the regulated industry context. These costs are not just the cost of litigation but the costs to companies of having to hire antitrust counsel and consultants to try to determine whether their merger is likely to be challenged, how much negotiation with the agencies will be entailed, and what the likelihood of loss in court will be. Some aspects of antitrust enforcement, primarily determining who competes with whom and how much, are inevitably complicated. But it is not clear that we are better off expending the resources to see whether something is bad, rather than accepting the cost of error from adopting imperfect rules — even rules that imply strict enforcement. Pure vertical merger may be an example of something that we might just want to leave be.

In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Google, Intellectual Property, Justice Department, Market Definition, Merger Guidelines, Patent, Platforms, Truth on the Market, Tying , , , , , , , , , ,
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Jacobson: Vertical Mergers 2020 — A Missed Opportunity to Clarify Merger Analysis

Jonathan M. Jacobson —  6 February 2020

[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. 

In Antitrust & Competition, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exemptions, Federal Trade Commission, Google, Justice Department, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Tying, Vertical Restraints , , , , , , , , ,
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Kolasky: The DOJ and FTC Should Revise Their Proposed Vertical Merger Guidelines to Emulate the EU’s

William J. Kolasky —  6 February 2020

[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).

In Antitrust & Competition, Antitrust Division, Barriers to Entry, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, European Union, Exclusionary Conduct, Exclusive Dealing, Exemptions, Federal Trade Commission, International, Justice Department, Law & Economics, Market Definition, Merger Guidelines, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , , , , ,
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Nuechterlein: Guidelines without Guidance on Vertical Mergers

Jonathan E. Nuechterlein —  6 February 2020

[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.

In Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Economic Theory, Exclusive Dealing, Federal Trade Commission, Justice Department, Market Definition, Merger Guidelines, Mergers & Acquisitions, Truth on the Market, Tying, Vertical Restraints , , , , , , , , ,
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Hovenkamp: The Draft Vertical Merger Guidelines Are an Important Step for the Economic Analysis of Mergers

Herbert Hovenkamp —  6 February 2020

[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.

In Amazon, Antitrust & Competition, Antitrust Division, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, Exclusive Dealing, Federal Trade Commission, Justice Department, Law & Economics, Market Definition, Merger Guidelines, Platforms, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , ,
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