How to assess vertical mergers cast your vote! Miguel de la Mano* Member of the Chief Economist Team DG COMP, European Commission *The views expressed are those of the author and do not necessarily reflect those of DG COMP or the European Commission BIICL, 7th Annual Trans-Atlantic Antitrust Dialogue London, May 1 st 2007

It has long been known that the analysis of vertical mergers is much more complex than the analysis of horizontal mergers. It has long been known that the analysis of vertical mergers is much more complex than the analysis of horizontal mergers. Three good reasons for this: Three good reasons for this: A vertical merger may eliminate “double marginalization” which, other things equal, increases the incentives to increase output. A vertical merger may eliminate “double marginalization” which, other things equal, increases the incentives to increase output. vertical mergers are inherently more likely to create substantial efficiencies than horizontal mergers, in particular through the elimination of transactions costs (e.g. opportunistic behavior by one party) vertical mergers are inherently more likely to create substantial efficiencies than horizontal mergers, in particular through the elimination of transactions costs (e.g. opportunistic behavior by one party) Alternatives often exist to a vertical merger which complicate the assessment of the counterfactual Alternatives often exist to a vertical merger which complicate the assessment of the counterfactual

Most common concern: Anti-competitive foreclosure  Vertical mergers may foreclose competition by – raising the costs at which competitors can operate on a downstream market (raising rivals’ cost); typically associated with input foreclosure – and/or lowering the expected revenue streams of upstream competitors (reducing rivals’ revenues); typically associated with customer foreclosure – Either situation might lead to higher prices for consumers in the downstream market

Input foreclosure Upstream entity (market power) Downstream entity Rivals Raising rivals cost? Reduction of competitive pressure? (Efficiencies?)  Net effect on consumers ?

Customer Foreclosure Upstream entity Downstream entity (market power) Rivals downstream 1. Customer foreclosure? Reduction of competitive pressure? (Efficiencies?)  Net effect on consumers ? Rivals upstream 2. Raising rivals cost?

How should vertical mergers be assessed? Lets check the contenders…

Candidate A Anti-competitive effects may result when a vertical merger internalizes a double mark- up, resulting in the upstream affiliate raising price to the downstream affiliates rivals, thereby raising the rivals costs and rendering them less effective competitors. This could result in higher output prices. Anti-competitive effects may result when a vertical merger internalizes a double mark- up, resulting in the upstream affiliate raising price to the downstream affiliates rivals, thereby raising the rivals costs and rendering them less effective competitors. This could result in higher output prices. The risk of such a price squeeze is low if downstream rivals have alternative sources of supply competing for their input purchases. The risk of such a price squeeze is low if downstream rivals have alternative sources of supply competing for their input purchases. Vertical mergers have a stronger claim to being efficient than do horizontal mergers. By improving coordination between the merging parties and thereby mitigating problems such as double markup and moral hazard, the overwhelming majority of vertical mergers increase efficiency. Vertical mergers have a stronger claim to being efficient than do horizontal mergers. By improving coordination between the merging parties and thereby mitigating problems such as double markup and moral hazard, the overwhelming majority of vertical mergers increase efficiency. The greater the market power (in its respective market) of each party to a vertical merger, the greater the potential for their merger to increase efficiency by eliminating the double markup between them. The greater the market power (in its respective market) of each party to a vertical merger, the greater the potential for their merger to increase efficiency by eliminating the double markup between them. Theoretical models of vertical merger typically are not robust or reach ambiguous conclusions about competitive effects. Hence they offer no sound general guidance to vertical merger enforcement policy. Theoretical models of vertical merger typically are not robust or reach ambiguous conclusions about competitive effects. Hence they offer no sound general guidance to vertical merger enforcement policy.

Candidate B Vertical merger concerns are likely to arise only if market power exists or is created in one or more markets along the supply chain. Vertical merger concerns are likely to arise only if market power exists or is created in one or more markets along the supply chain. A vertical merger may lead to foreclosure when rivals lack a reasonable alternative to the vertically integrated firm. A vertical merger may lead to foreclosure when rivals lack a reasonable alternative to the vertically integrated firm. The merged entity may place rivals at a cost disadvantage by refusing to give them access to some essential facility or input It is important to consider the ability and incentives of the merged firm to foreclose in any market. A strategy to foreclose may not always be profitable. It is important to consider the ability and incentives of the merged firm to foreclose in any market. A strategy to foreclose may not always be profitable. Will use modelling and simulation techniques to assess whether foreclosure is likely to be profitable post merger. Will use modelling and simulation techniques to assess whether foreclosure is likely to be profitable post merger.

Candidate C One party to the merger, must have “strong” unilateral market power. A high market share, alone, does not demonstrate strong unilateral market power. One party to the merger, must have “strong” unilateral market power. A high market share, alone, does not demonstrate strong unilateral market power. There must be a significant and immediate threat to such dominant position from expansion or entry. There must be a significant and immediate threat to such dominant position from expansion or entry. The merger must create a credible and significant possibility of foreclosing this threat. The merger must create a credible and significant possibility of foreclosing this threat. For example, the merging party's product might provide an important potential input to a competitor. Without this input the potential new entrant would not be competitive. Need to explain why the owner of this "input" could not extract the rents from its monopoly position without a merger For example, the merging party's product might provide an important potential input to a competitor. Without this input the potential new entrant would not be competitive. Need to explain why the owner of this "input" could not extract the rents from its monopoly position without a merger Informed, representative opinions from customers downstream are very important. Informed, representative opinions from customers downstream are very important. The evidence of significant efficiencies from the merger must be weak. The evidence of significant efficiencies from the merger must be weak.

Candidate D Since vertical mergers do not lead to an addition of market shares, the agency shall focus on the question of whether or not the merger will lead to market foreclosure effects Since vertical mergers do not lead to an addition of market shares, the agency shall focus on the question of whether or not the merger will lead to market foreclosure effects Market foreclosure effects occur where, on account of its own excellent access to the supply or sales markets, a dominant company can make access to these markets difficult or even impossible for its competitors. This requires that: Market foreclosure effects occur where, on account of its own excellent access to the supply or sales markets, a dominant company can make access to these markets difficult or even impossible for its competitors. This requires that: at least one of the participating companies has a strong market position pre- merger. at least one of the participating companies has a strong market position pre- merger. the vertically integrated company gains a dominant position post-merger on one of the markets affected. the vertically integrated company gains a dominant position post-merger on one of the markets affected. In addition it has to be examined whether competitors depend on the supply or demand from the vertically integrated company. In addition it has to be examined whether competitors depend on the supply or demand from the vertically integrated company. Another aspect to be examined is the transfer of financial power, which opens up possibilities to squeeze out competitors, e.g. by lowering sales prices. Another aspect to be examined is the transfer of financial power, which opens up possibilities to squeeze out competitors, e.g. by lowering sales prices.

Candidate E The merged entity has the ability to foreclose. For example the input is important of the merged entity has market power upstream The merged entity has the ability to foreclose. For example the input is important of the merged entity has market power upstream The merger increases the profitability (incentive) of foreclosure. For example if profits upstream are low, the merged entity is dominant downstream and has no capacity constraints The merger increases the profitability (incentive) of foreclosure. For example if profits upstream are low, the merged entity is dominant downstream and has no capacity constraints The merger has an impact on competition: The merger has an impact on competition: Merger may raise rivals’ costs thereby causing an upward pressure on rivals’ prices. This may in turn allow the merged entity to raise prices Merger may raise rivals’ costs thereby causing an upward pressure on rivals’ prices. This may in turn allow the merged entity to raise prices Merger may allow merger entity to raise entry barriers Merger may allow merger entity to raise entry barriers No countervailing factors must be present (counter-mergers by rivals, downstream buyer power, entry, efficiencies (other than elimination of double margin) No countervailing factors must be present (counter-mergers by rivals, downstream buyer power, entry, efficiencies (other than elimination of double margin)

Guess who is your preferred candidate… America America Britain Britain Consultants Consultants Deutschland Deutschland EU Commission EU Commission

Does it matter who is elected? Maybe not if firms adapt to the merger enforcement environment Maybe not if firms adapt to the merger enforcement environment Lenient policy towards vertical mergers may induce firms to vertically integrate when this enhances efficiency Lenient policy towards vertical mergers may induce firms to vertically integrate when this enhances efficiency A strong policy against vertical mergers induces firms to grow organically as vertically integrated firms in the first place A strong policy against vertical mergers induces firms to grow organically as vertically integrated firms in the first place A priori it is not clear which policy is superior in terms of improving overall efficiency in the long-run A priori it is not clear which policy is superior in terms of improving overall efficiency in the long-run But the policy must be clear and consistently enforced But the policy must be clear and consistently enforced Adopting Guidelines and communicating them effectively may be more important than what the guidelines actually say! Adopting Guidelines and communicating them effectively may be more important than what the guidelines actually say!

One additional advantage… Theory must be informed by facts. Thus, the best way to approach vertical merger enforcement is through case-by-case analysis. Theory must be informed by facts. Thus, the best way to approach vertical merger enforcement is through case-by-case analysis. But fact-gathering must be informed by theory But fact-gathering must be informed by theory With guidelines in place practitioners and economists will focus on developing empirical techniques With guidelines in place practitioners and economists will focus on developing empirical techniques A solid theory of unilateral effects and the 1992 US HMG stimulated the use of merger simulation A solid theory of unilateral effects and the 1992 US HMG stimulated the use of merger simulation As regards coordinated effects a gradual consensus on an equilibrium-based assessment is generating very promising empirical methods As regards coordinated effects a gradual consensus on an equilibrium-based assessment is generating very promising empirical methods