Topic 12: Horizontal Mergers and the analysis of competitive effects Antitrust Economics 2013 David S. Evans University of Chicago, Global Economics Group Elisa Mariscal CIDE, Global Economics Group Topic 12| Part 1 10 October 2013 Date

Overview Part 1 Part 2 Legal and Economic Background of Mergers Merger Screening Unilateral Effects: Economic Theory Part 2 Coordinated Effects: Economic Theory and Evidence Two-Sided Platforms Empirical Methods

Key Issues Mergers can generate various efficiencies but can also increase market power and ultimately harm consumers. Merger to monopoly is an extreme example. Economics can assess whether a merger is likely to harm consumers by estimating price and other effects Merger assessment is difficult because it makes predictions about the future and economists (and the authorities) often lack good data and the time (given time schedules) to analyze it.

Legal and Economic Background on Mergers

Definition of Mergers Merger results in transfer of ownership and control of a company (or a part of a company) “Merger”: A and B agree to combine to form C “Acquisition”: B sells to A which combines B into A “Takeover”: A buys control of B from shareholders against wishes of management Different types of combinations Use the term “merger” for convenience to refer to mergers, acquisitions, and takeovers without referring to an “acquirer” and “target” (A and B respectively in the example above) .

Horizontal vs. Vertical Mergers Horizontal merger of B and C in market of A, B, and C which have substitutable products C A B f e Vertical merger of A and f where f supplies a downstream service to A.

Possible Benefits of Mergers Permit the exchange of property to higher valued uses; ultimately mergers are about selling property. (Why is Nokia selling and Microsoft buying Nokia’s handset unit?) Acquirer finds it cheaper to buy than to build (Why did Facebook buy Instagram?) Mergers can generate economies of scale and scope; reduce duplicative costs; create synergies through complementary technologies. (One of the arguments for EU efforts to break down national boundaries e.g. in capital markets.) Encourage innovation and investment because an acquisition provides major potential source of reward for the target. (eBay just bought processor Braintree for $800 million providing exit for Braintree’s entrepreneurs and investors.) Mergers and takeovers—and the mere threat of them—can discipline corporate management and thereby solve separation of ownership and control problem (CEO loses job in takeover and would like to avoid that.) AP: At the end, the efficiencies generated are related with economies of scope and scale

Possible Harm from Mergers Mergers could increase prices and reduce output through increased concentration. Merger to monopoly is the extreme case. Mergers could also reduce innovation, service, and other desirable non-price aspects of competition. Mergers could increase entry barriers and thereby result in durable market power. Vertical mergers could facilitate the extension of market power from one market to another or help maintain market power through control of essential suppliers.

The Policymaker’s Error Cost Conundrum If competition authorities block too many mergers, the potential for efficiency gains will be lost. If competition authorities allow too many mergers the merged firms may be able to exploit market power and thereby harm consumers. In both cases merger policy will affect how companies decide to invest and innovate. Merger policy can be seen as application of “error-cost approach.” It balances false positives and false negatives in applying merger screens and tests.

Merger Screening

Many Countries Have Legal Frameworks for Clearing Mergers Only “economically” significant mergers are reviewed where the acquirer or target firm or both are large enough (reach certain thresholds). Screening measures are then used to quickly approve “non-problematic mergers” (HHI and change in HHI). Mergers are blocked if they lead to “significant impediment to efficient competition” (EC) or “substantial lessening of competition” (e.g. UK, US). These legal frameworks are consistent with the view that mergers are presumed to be procompetitive unless there are reasons to believe otherwise.

The HHI Is A Common Method of Screening Herfindahl-Hirschman Index (HHI) is calculated by squaring the market share of each firm competing in a market, and then summing the resulting numbers. HHI = S12 + S22 + S32 + ... + Sn2 ; e.g. 302 + 302 + 402 =3400 The HHI can range from a minimum of close to 0 (a perfectly competitive industry) to a maximum of 10,000 (a perfectly monopolistic industry) if calculated by squaring percentages (like 10%) or between 0 and 1 if calculated by squaring fractional shares like 0 .1 (so 3400 or .34 in the example above).

Change in HHI Indicates Change in Concentration Suppose firms 1 and 2 merge HHIpost = (S1 + S2 )2 + S32 + ... + Sn2 HHIpre = S12 + S22 + S32 + ... + Sn2 ∆HHI = HHIpost – HHIpre= 2 S1S2

Example of Calculating HHI and Change in HHI Pre-Merger Firm Share A 50% B 25% C 15% D 10% HHI 3450 Post-Merger Firm Share A 50% B+D 35% C 15% HHI 3950 Change in HHI=2 x 25 x 10 = 500

OFT’s Merger Guidelines HHI Investigate? < 1,000 NO > 1,000 and <1,800 YES IF  HHI > 100 NO OTHERWISE > 1,800 YES IF  HHI > 50 HHI and Change in HHI Serve as Screening Devices

Is the HHI Screen Based on Economics? The HHI framework is based on theory that assumes Cournot competition and homogeneous goods. These assumptions are unlikely for many mergers. The HHI framework also does not have significant empirical support. The HHI framework also requires the definition of a market. As we’ve seen, economics does not support defining hard market boundaries. Errors in market definition could result in too many or too few mergers passing screen. Difficulties with HHI and market definition have lead some economists to argue in favor of taking a preliminary look at competitive effects. That has its own problems. See Upward Pricing Pressure Tests later. Best practice is to use a variety of evidence to assess whether a merger is sufficiently likely to cause problems that warrant more investigation.

Key Steps in Regulatory Analysis of Mergers Define markets Assess overlaps between products of merging firms Apply HHI (or other) screens and continue only if there is a possible problem Determine whether overlaps result in significant harm to competition such as significant price increases Consider remedies that could eliminate competitive problems through divestitures Decide whether to block a merger or approve possibly with remedies

Unilateral vs. Coordinated Effects Unilateral effects: The acquiring firm may raise price because the merger gives it more market power. Coordinated effects: The merger either strengthens or makes possible tacit collusion among firms thereby leading to an increase in price. A given merger could involve either or both types of effects. AP: Coordinated effects are known in the EU as “pro-collusive effects” or “joint dominance”

Commonly Used Economic Framework for Analysis of Mergers Market definition based on hypothetical monopolist test Estimation of change in prices as a result of the merger, ignoring efficiency effects using diversion ratios, demand estimation, natural experiments, or company documents. Estimation and consideration of efficiency effects (in practice this is often not taken seriously). Assessment of whether prices increase by small and significant non-transitory amount after accounting for change in competitive conditions and efficiencies or whether benefits of efficiencies outweigh harm from increased prices. AP: It is important to highlight the information asymmetry that exist between the Authority and the merging parties. The authority could consider the opinion of competitors of the merging parties, because if they oppose the mergers, it means they are going to be harmed by it, therefore there are possible efficiencies from it. It they don´t complain about it, it is possible that they are benefited from the merger, so there is possible there aren´t efficiencies from it.

Mergers are presumed to be pro-competitive Mergers are commonplace in the market economy. Most are not examined by competition authorities because they do not involve large enough acquirers or targets. Most mergers that are examined by competition authorities are cleared without conditions. A few are cleared after the divestiture of some overlapping products. Mergers are an integral part of the market process and are presumed to foster competition and innovation. In practice, merger prohibitions are a small fraction of all mergers—but without rules there would likely be many more problematic mergers. Firms seldom propose 3-2 mergers, for example.

Most Mergers before EC Are Cleared Most mergers are cleared quickly in Phase I. Most mergers that go into Phase II are cleared although often subject to some divestitures. Only mergers that are large enough to be “noticed” under the guidelines are considered here. So an even larger fraction of all mergers are approved.

Unilateral Effects: Economic Theory

Internalization of Price Effects Is Key Issue Suppose Firms A and B sell two products that compete with each other When Firm A raises its price it loses some sales and profits to Firm B. In effect Firm B partly benefits when Firm A raises its price because some customers are going to switch to it and Firm B makes profits from them instead of Firm A. Now suppose Firm A buys Firm B but operates A and B as separate divisions. The new firm will capture the benefits of profits from a higher price from both A and B so the benefits from raising prices increase. The same logic applies to B raising its price. The new owner of A+B will find that it can make more money by raising the prices of both A and B because it is also capturing the “spillover” effects between the products. Economists say the acquirer and target “internalize” the full spillovers between each other.

Limitations on Raising Price Virtually all models of market behavior show that when Firms A and B sell substitute products their combination will always tend to increase price. The only question is whether there are factors that will limit that increase (in addition to efficiencies considered later). Factors include: Degree of substitution between the products (close or distant?) Availability of substitutes of other products (in practice market shares provides a proxy for substitutes) Change in supply of substitutes through entry or expansion (could new suppliers come in?) Countervailing buyer power (a big buyer like Tesco has greater ability to prevent price increases than does a small business or consumer) Efficiencies that offset tendency to raise price (e.g. a firm passes through enough of the cost savings to offset the price effect).

Merger of Firms in an Oligopoly Industry with Homogeneous Demand In an oligopoly industry (with Cournot competition) market price is lower than a monopolist would charge, but higher than the competitive price so each firm has some degree of market power Deadweight loss is also lower than that in the monopoly case in the same market, but still positive qC D(P) COMPETITION COURNOT MONOPOLY Q Q COURNOT qMA,B MC P PM PCOURNOT

The Price-Cost Margin for Industry Increases With Concentration Under Cournot Competition Homogenous product industry with Cournot competition and symmetric costs: Where: Si is the share of firm (i) in the market m is the percentage markup of price over marginal cost m is the average percent markup for all firms in the market EM is the elasticity of demand facing the market This can be used for back of the envelope calculations on the effects of mergers. Change in price-cost margin equals change in HHI divided by market demand

Consequences of a Reduction in the Number of Firms with Homogeneous Products Basic economic theory shows that reducing the number of firms results in higher prices (Cournot Model) MC P PM After a merger, we see: Higher prices Lower output But: How significant is the effect? Is it counteracted by efficiencies? D(P) MONOPOLY N = 2 N = 3 N = 4 COMPETITION qM qC Q

Mergers of Firms that Produce Differentiated products Key issue is how substitutable the merging products are — we are obviously more concerned with the combination of two small car producers products than we would be with the merger of small car producer with a large car producer. The “diversion ratio” — the portion of sales that gets “diverted” between the merging parties rather than to non-merging rivals —and the cross-elasticity of demand are critical although related measures of substitution to consider. Market shares are less informative for this analysis since the market will ordinarily include products that vary in their degree of substitution with the merging products. Adding apples and oranges or at least McIntonish and Golden Delicious apples. With differentiated products shares should be based on “value” rather than units because at least “value” takes quality differences into account.

Example of differentiated products In differentiated products, the closeness of competition matters In the event of a 5% price rise, firm A loses 20% of its customers The post-merger firm A+B only loses 10% of its customers after a price rise because it captures 10% through common ownership If the critical loss for A is between 10-20%, a merger with B will make profitable a price rise which would not have been profitable pre-merger If the critical loss is between 16-20%, a merger with C will also make a price rise profitable, and so on Overall market shares matter less than the diversion ratio Can result in a small but significant price increase even if modest change in HHI Response of customers of Firm A to a 5% price rise Stay with firm A 80% Switch to B 10% C 4% D 2% E F

Back of the Envelope Merger Analysis for Differentiated Products It is possible to estimate the price change for firm A from a proposed merger from the diversion ratio between firm A and B (D) and the price-cost margin of firm A (m) Percent price change = mD/(2(1-D)) In the case of linear demand with constant unit costs. If margin is 20% and diversion ratio is10% then the price change is: .2x.1/2x.9=.02/1.8=.0111 or 1.1%. If the margin is 50% and the diversion ratio is 20%. Then the price change is .5x.2/2x.8=.0625 or 6.3% Can derive similar formulas with different assumptions and factor in efficiency effects. Can also extend to accounting for increasing prices for both products

Upward Pricing Pressure Test Farrell and Shapiro have proposed the use of a variant of this to assess whether a merger should be given more scrutiny. The basic idea is to give some credit for possible efficiencies (E) and measure whether given these efficiencies there will be a tendency for prices to rise. If there is, then further scrutiny is warranted. One version of the test is if Dm – E(1-m) > 0 then the merger is subject to scrutiny where D is the symmetric diversion ratio between the two firms, m is the common price margin, and E is efficiencies as a percent of cost. If the efficiency credit is 10% then with a diversion ratio of 10% and a margin of 50% the equation yields .1 x .5 - .1 x .5 = 0 so there is no pricing pressure. If the diversion ratio was greater than 10% or the margin was greater than 50% the merger would be subject to scrutiny.

Efficiencies and Merger to Monopoly The firms in a competitive industry with p=MC are all bought up and merged into monopoly. Surplus transferred from consumers to producers Consider also when marginal cost decreases from $3.00 to $2.50 Surplus from cost savings Dead Weight Loss PPost Pre-merger Marginal Cost PPre Post-merger Marginal Cost I’ve added a piece to the title, because the correct benchmark shouldn’t be P=MC… Demand QPost QPre MR In this example price to consumers increases and social welfare declines less than consumer welfare because of efficiencies.

Efficiencies and Merger to Monopoly In this example price increases, consumer welfare declines, but social welfare increases because the efficiency benefits outweigh the deadweight losses to society. Surplus transferred from consumers to producers Consider also when marginal cost decreases from $3.00 to $1.50 Surplus from cost savings Dead Weight Loss PPost Pre-merger Marginal Cost PPre Post-merger Marginal Cost I’ve added a piece to the title, because the correct benchmark shouldn’t be P=MC… Demand QPost QPre MR

End of Part 1, Next Class Part 2 Legal and Economic Background of Mergers Merger Screening Unilateral Effects: Economic Theory Part 2 Coordinated Effects: Economic Theory and Evidence Two-Sided Platforms Empirical Methods