Vertical mergers are not necessarily competition law friendly

The vertical integration of producers of complementary products or services results in no loss of direct competition as they operate at different levels of the supply chain. On the one hand, vertical mergers are likely to produce efficiency gains because they give rise to a direct incentive to reduce prices and/or improve quality. On the other hand, they can create market power, either by coordinated or unilateral effects, which may result in detriment to consumers. Competitive and anticompetitive effects of a vertical merger arise from the same source: the creation of cost asymmetries between the integrated firm and its rivals. Whether the deal will result in detriment to consumers, it depends on whether it will be greater the market power increase or the reduction in cost of the integrated firm.

Substitution vs. complementarity

Horizontal mergers involve producers of substitute products and are likely to cause anticompetitive effects because substitute products have a positive cross-price elasticity: if product A’s price increases, the demand of product B will rise as some customers will switch to the latter. Because post-merger some of the lost sales are internalised, a horizontal merger creates an incentive to raise prices.
Conversely, the relationship between complementary products is characterised by a negative cross-price elasticity: the sales of both products will increase following the reduction of either’s price. If producers of complementary products merge, this beneficial effect is internalised providing an additional incentive to lower prices. This externality effect is not restricted to prices: any improvements of quality, promotion or distribution will produce a positive effect. Because the integrated firm will act to maximise profits across the two lawyers of the chain, prices will decrease and output will rise. Vertical mergers are presumed to be pro-competitive; indeed, the main rational behind a vertical merger is the achievement of efficiencies rather than the increase of market power. However, in limited circumstances the cost asymmetries produced by the integration can result in the foreclosure of competitors and eventually lead to higher prices. The competition concerns created by vertical mergers are similar to those put forward in abuse of dominance cases: the integrated firm might have the ability to foreclose rivals in downstream and/or upstream markets, might act to raise rivals’ costs or weaken their offering by bundling, discriminating or refusing to supply.

Anti-competitive effects of vertical mergers

Efficiencies can create cost asymmetries between the merged firm and its non-integrated rivals, which can eventually lead to an increase of the integrated firm’s market power as a result of:
(i) the loss of attractiveness as a substitute of rivals’ products, either because they are of lower quality, more expensive or because competitors are excluded from the market or prevented entry (unilateral effect); or
(ii) the increased likelihood of coordinated conduct (coordinated effects).

The change of incentives and constraints following the vertical integration can rise rivals’ costs (input foreclosure) or reduce their revenues (customer foreclosure). Moreover, vertical integration can make it easier for firms to coordinate or evade regulatory obligations.

Input foreclosure
To engage in anticompetitive input foreclosure, a firm needs to have the ability and the incentive to foreclose and its behaviour must result in detriment to consumers.
The merged entity will be able to engage in input foreclosure only if it controls an important input to downstream rivals. If it will either stop supplying competing downstream firms or will do so at a higher price, the cost of downstream rivals may be negatively affected and, as a consequence, their prices will increase. The restriction could also prevent a new entry, and hence the vertically integrated firm will preserve significant market power upstream. The downstream prices will either increase or fall, depending on whether dominates the cost or the market power effect of integration. In conclusion, the overall effect on consumers is ambiguous.

However, engaging in a foreclosure strategy involves a profit sacrifice, i.e. the lost margins on the sales of products to downstream competitors that are not made post-merger. Only if the benefits outweigh the costs, the integrated firms will have the incentives to engage in foreclosure. The empirical analysis assessing the trade-off between costs and benefits involves, inter alia, the assessment of upstream and downstream margins as well as the propensity of consumers to switch and the reaction of competitors.

If, as a result of the foreclosure, rivals’ price increases, costumers will switch to the integrated firm’s product: the greater the switching rate, the greater the benefits will be since the merged entity will earn both the wholesale and the retail margin on those additional sales. However, the merger will harm consumers and, hence will be considered anticompetitive, only if it allows for a price increase possible given the reduced competition.

The merger will not cause anticompetitive effects unless the competing upstream firms are capacity-constrained, or less efficient, or if branding is important since, in these cases, the downstream firms may find it difficult to obtain equivalent input at pre-merger price. Competition concerns are unlikely to arise also if the upstream product represents only a small proportion of the overall retail price because, in these instances, even a substantive price increase would be unlikely to affect the final price. Similarly, the greater is the incentive for the downstream firms to absorb the price increase, the less effective will be a foreclosure strategy.

Customer foreclosure
If before the merger the downstream firm was a significant market player, and following the integration it stops purchasing from upstream rivals, the latter’s average costs of supply might increase because of the reduction in sales. If customer foreclosure results in exit (from higher average costs) or reduced competitive vigour (from increased marginal costs), the competitive constraints that upstream competitors exert on the upstream division of the integrated firm will be reduced, leading to greater market power upstream and higher input prices. It is a concern only when the vertical merger involves a firm that is an important customer that enjoys significant market power in the downstream market, i.e. it has the ability to foreclose.

Only in certain instances consumers are harmed. There are competition concerns, only if, by denying access, the wholesale price to non-integrated downstream firms increases leading to reduced competition downstream and hence higher retail margins. Competition concerns may also arise when the integrated firm is successfully winning sales from its upstream competitors and the upstream market is characterised by significant economies of scale, since customer foreclosure can lead to higher input prices. In general, customer foreclosure is anticompetitive only if there is a significant customer in the downstream market with large market share, the input suppliers are subject to significant economies of scale, and the upstream firms are not able to expand sales to other downstream firms.

Enhanced likelihood of collusion
Vertical mergers can make it easier for firms to engage in tacit or express collusion since it might facilitate the exchange of pricing and other competitively sensitive information in either the input or output market, or it can eliminate a disruptive buyer or enhance market transparency. The greater the benefit of the downstream division from raising the costs of its rivals, the greater the incentive for the integrated firm to coordinate pricing upstream. However, the coordinated effects are likely to be significant only if either the upstream or the downstream market is conducive to coordination.

Evading price regulation
If the upstream market is regulated, but the downstream market is not, by integrating, the upstream monopolist can realise its monopoly profit in the downstream market. This is possible by either discriminating other downstream players or engaging in cost misallocation. At the same time, a downstream monopolist active in a regulated market could integrate and use transfer pricing to evade its regulatory constraint and earn the monopolist profit upstream. If the integrated firm engages in discrimination, it will disadvantage its downstream rivals by reducing the quality of the input or raising competitors’ costs. This relaxes the competitive constraints played by downstream competitors and hence, the integrated firm will be able to increase prices. If the regulated price upstream is cost-based, the integrated firm will have the incentive to have its downstream costs attributed to its upstream division so that it relaxes the price constraints in the upstream market and increases its profits downstream. As it occurs with cost misallocation, the market power and profits are realised by the unregulated entity. These strategies are of concern because they result in greater exercise of market power and produce inefficiencies.

Pro-competitive effects of vertical mergers

Vertical integration enhances coordination between the upstream and downstream firms. The most evident positive effect of vertical integration is that the merged entity will no longer pay a wholesale price that includes a mark-up over marginal cost: it will transfer the input internally at only marginal cost. Hence, vertical integration solves the problem of double marginalisation and can allow for an immediate price reduction.
Efficiency gains are not limited to costs and price reductions; they also include improvements in quality, increased variety, and innovation leading to new products.

From an empirical point of view, those efficiencies are found to outweigh possible anticompetitive effects in most contexts. However, in limited circumstances, vertical mergers can indirectly generate anticompetitive concerns as a result of changes in constraints and incentives.

***

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010.

Church, J., The Impact of Vertical and Conglomerate Mergers on Competition, European Commission, 2006, available at: http://bookshop.europa.eu/en/the-impact-of-vertical-and-conglomerate-mergers-on-competition-pbKD7105158/.

Church, J., Vertical Mergers, in Issues in Competition Law and Policy, Vol. 2, p. 1455, ABA Section of Antitrust Law, 2008, available at SSRN: https://ssrn.com/abstract=1280505.

Gunnar, N., Jenkins, H., and Kavanagh, J., Economics for Competition Lawyers, Oxford University Press, 2016.

RBB, The efficiency-enhancing effects of non-horizontal mergers, 2005, available at: http://ec.europa.eu/DocsRoom/documents/3667/attachments/1/translations/en/renditions/native.

Rosengren, E.S., and Meehan, J.W., Antitrust policy and vertical mergers, in New England Economic Review, 1995, pp. 27-38.

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