#95 - Joint Ventures And Mergers Theoretical Articles - Competition Law

Competition law reading session 3 (theory)

Whinston and Bolton, ‘The Foreclosure Effect of Vertical Mergers’, Journal of International and Theoretical Economics

• The Chicago school says that vertical mergers should not be prohibited. Bork argues that foreclosure after a merger will never be profitable:

  • If a manufacturer (M) acquires a retailer (R), and says that R can only sell M’s products, which are more expensive or less desirable than those of rival manufacturers, any extra sales made by M will be outweighed by losses incurred by R.

• Oliver, Saloner and Salop (OSS) refute this, arguing that a vertical merger can have strong anticompetitive effects.

  • If an upstream firm merges with a downstream firm, the upstream firm has less of an incentive to cut costs and become more efficient (since it has no need to find a retailer to buy its products). As a result other upstream rivals can also start charging higher prices and remain competitive, so that the purchase price for retailers goes up and pass on higher prices to consumers.

  • Problem is that this doesn’t say why integration means a firm can afford to compete less freely. If the integrated firm is still in pursuit of profits and still has to face rivals at some point (namely at the point of sale to consumer rather than to retailer), then it will still seek efficiencies at both stages of production.

Williamson, ‘The Vertical Integration of Production: Market Failure Considerations,’ University of Pennsylvania

• Vertical Integration is an anomaly given market theory: If the cost of operating in a (perfectly competitive) market is zero (no barriers etc) then why would two firms integrate?

  • One answer might be the production for certain goods is more efficient e.g. the same/similar equipment can be used to make iron into steel so it’s more efficient to make them on the same site rather than incur the cost of transportation to a new site.

• The substitution of internal organisation for market transactions following integration is called internalisation. Market transactions are generally preferable to internal supply because market has greater rationality and there are often difficulties with internal administration following integration. However internal organisation may be preferable where the firm can deal with transaction disputes better than a firm could with a customer and has the necessary tools to give rewards and stipulate penalties for performance (promotions etc). The firm can avoid protracted bargaining or litigation where disputes arise.

• In cases of market failure, vertical integration might be rational

  • Where there’s a bilateral monopoly (monopoly buyer and seller) a merger might avoid long term negotiations on price and quantity (though a long term contract could avoid this too, and merger itself requires lengthy bargaining process).

  • Integration can avoid the problems of contracts: Long term contracts might be subject of litigation and can’t deal with new technology that leads to product redesign; short term contracts require renegotiation; ‘cost plus’ and ‘fixed price’ contracts pose uncertainty for buyer and seller respectively, so that it makes more sense to negate the risk through integration.

Furse, Competition Law of the EC and UK,’ Chapter 18:

A merger may be a better way for a firm to increase market share rather than internal expansion (since increased production can lead to lower prices across the industry, and lower profit margins). Also it’s an easier way of getting into a new market with barriers to entry etc, rather than internal expansion. It may also allow a business to spread its risk across different geographical markets so as to avoid the full force of a downturn in one of them.

The danger with vertical mergers is not that they concentrate a market (they don’t) but that they will have foreclosure effects.

J. Church, ‘The Impact of Vertical and Conglomerate Mergers on Competition,’ (2004) EU Report

• Traditional concern with vertical mergers was that a monopolist upstream could leverage its market power to obtain a monopoly downstream by vertically integrating. The Chicago school rejected this, saying that integration avoided double marginalisation (there is only one company profit, despite there being two levels of production), and as a result the company would try to be as efficient as possible to maximise this profit, regardless of whether the downstream market was competitive or monopolistic. (Unconvincing: a company with a monopoly position will make higher profits than one in a competitive market, so it is rational for a company to sacrifice short term efficiency and profitability in search of long term monopoly).

• His main point is that vertical and conglomerate mergers will have anticompetitive effect where they lead to market power/dominance AND harm to the consumer (reduction of consumer surplus etc). Vertical/conglomerate mergers should be considered in this light: Are the benefits to the consumer from efficiencies enough to outweigh any anticompetitive effects caused by the market power created/strengthened?

• (Assume a market in which there is no upstream monopoly for the following points)

• There are two hypotheses on the anticompetitive effects of vertical integration:

  • Input foreclosure can be complete (refusing to supply to downstream rivals) or partial (raising prices for downstream rivals). Either way, it has the effect of raising the cost of input for downstream competitors, causing them to raise prices. This relaxes the competitive constraints on the downstream part of the integrated firm, which can raise prices too in line with competitors and gain greater profits. This whole process causes the upstream part of the integrated firm to charge higher input prices as it recognises the effect this can have on raising downstream profits.

  • Customer foreclosure is when the downstream part of the integrated firm no longer takes supply from independent upstream firms, causing them to leave the market or have higher marginal costs (since marginal cost tends to decrease with price), reducing the competitive pressure on the upstream part of the integrated firm. The higher input prices that occur as a result (as the upstream part raises prices) can lead to the input foreclosure effect mentioned above).

• NB a vertical merger could force downstream/upstream rivals to respond in kind so as to survive any foreclosure actions. A wave of vertical integrations would make the original integration unprofitable.

• If foreclosure is not likely to occur, then vertical integration can help consumers through increased efficiency and lower prices.

• In cases where the downstream and upstream markets are competitive, it is ambiguous whether the integration will harm consumer welfare: On the one hand the merger eliminates double marginalization, reducing the costs of the merged firm, which, ceteris paribus, encourages it to produce more downstream (increased supply lowering prices). On the other hand, if the effect of the merger is to raise the price of the upstream good, this raises the costs of the unintegrated downstream firms, reducing their output. The net effect on the downstream price depends on which of these two effects is stronger: raising rivals' costs or eliminating double marginalization. Also note Chicago school objection that an integrated firm would only foreclose if the integrated firm divisions are more efficient, as otherwise it is incurring higher costs than it needs to upstream/downstream and hence is losing money. However this is a short term perspective, and in the long term greater market share might lead...