Economics on Demand The role of efficiencies in mergers ...compass-lexecon.s3.amazonaws.com/prod/cms-documents/d73c766e… · Deadweight loss / allocative inefficiency Quantity of

Urs Haegler and Sergey Khodjamirian

15 November 2017

Economics on Demand

The role of efficiencies in mergers and Art. 101: Good things come to those who wait?

COMPASS LEXECON 1

OUTLINE

Why are efficiencies important?

Economics of efficiencies

European Commission’s framework for assessing efficiencies

European Commission cases involving efficiencies Airline JVs

UPS/TNT

COMPASS LEXECON 2

OUTLINE





UPS/TNT

COMPASS LEXECON 3

EFFICIENCY IS INTEGRAL TO COMPETITION POLICY

Competition policy

Unrestricted competitive process

More efficient use of scarce resources

Consumer welfare improved

COMPASS LEXECON 4

EFFICIENCY DEFENCE INCREASINGLY BEING CONSIDERED

1990s

No room for efficiency defence

Merger test = dominance test

‘Efficiency offence’ Efficiencies can

increase dominance (e.g. GE/Honeywell)

2000s

Efficiencies can be taken into account

2001 Green Paper 2004 Horizontal merger guidelines

2008 Non-horizontal merger guidelines

e.g. TomTom/TeleAtlas

2010s

Consideration of efficiencies becoming more common

DB/NYSE UPS/TNT

Orange/Jazztel

UPP analysis

EC yet to clear an otherwise anti-competitive merger explicitly on efficiency grounds

COMPASS LEXECON 5

OUTLINE





UPS/TNT

COMPASS LEXECON 6

PRE-MERGER: BERTRAND DUOPOLY (HOMOGENOUS GOOD)

Price of bananas

Quantity of bananas

D

Consumer surplus

MC PriceC

Allocative efficiency

COMPASS LEXECON 7

POST-MERGER: MONOPOLY (NO EFFICIENCIES)

D

MR

PriceM

MC PriceC

Consumer surplus

Deadweight loss / allocative inefficiency

Quantity of bananas

Price of bananas

COMPASS LEXECON 8

POST-MERGER: MONOPOLY (WITH EFFICIENCIES)

D

MR

MCL

PriceM

Cost reduction offsets

price increase

MCH PriceC

Consumer surplus

Quantity of bananas

Price of bananas

COMPASS LEXECON 9

SOURCES OF EFFICIENCIES

Firm-level efficiencies

Transaction efficiencies

Dynamic efficiencies

Mergers

Restrictive agreements

Supply-side

Demand-side

Network efficiencies

Complement pricing

One-stop shopping

COMPASS LEXECON 10

SUPPLY-SIDE: FIRM-LEVEL EFFICIENCIES – ECONOMIES OF SCALE

Dodson & Fogg Bendini, Lambert & Locke

+

Achieved by expanding scale of production and spreading costs over a larger output, which leads to lower costs per unit.

COMPASS LEXECON 11

SUPPLY-SIDE: OTHER FIRM-LEVEL EFFICIENCIES

Source of efficiency

Description Example

Economies of scope

Produce different goods under same roof

Publisher producing both hardcover and paperback

editions from same manuscript

Rationalisation Move production from

high- to low-cost facility European TV manufacturer buys

Chinese factory

Synergies Integrate

“hard-to-trade” assets Combining

complementary patents

Purchasing economies

Obtain bulk discounts on raw materials

Airline buys more airline food in bulk

COMPASS LEXECON 12

SUPPLY-SIDE: TRANSACTION EFFICIENCIES

When firms adopt contracts or organisational forms that minimise certain market failures that arise in the open marketplace

Double mark-up

Free-riding

Hold-ups

Particularly relevant for vertical mergers and agreements (e.g. MFNs and RPMs)

COMPASS LEXECON 13

DEMAND-SIDE: NETWORK EFFICIENCIES

In network industries, the larger the network, the more valuable the product can be for users

More customers

More apps

COMPASS LEXECON 14

When firms invest and innovate to create better products or more efficient production methods

– R&D

– Learning-by-doing

– Entrepreneurial creativity

New, cheaper and/or better products

DYNAMIC EFFICIENCIES

COMPASS LEXECON 15

OUTLINE





UPS/TNT

COMPASS LEXECON 16

CRITERIA FOR ACCEPTING EFFICIENCIES

Horizontal merger

guidelines (“HMG”) Art. 101 (3)

Verifiability “Efficiency gains”

Merger-specificity Indispensability

Pass-on Fair share

CRITERIA ARE CUMULATIVE

COMPASS LEXECON 17

VERIFIABILITY / EFFICIENCY GAINS

“…reasonably certain that the efficiencies are likely to materialise, and be substantial enough…” (¶86 EC HMG)

Typical evidence: Internal documents on or modelling of efficiencies related to the merger or agreement

COMPASS LEXECON 18

MERGER SPECIFICITY / INDISPENSABILITY

“…no less anticompetitive, realistic and attainable alternatives of a non-concentrative nature […] than the notified merger which preserve the claimed efficiencies.” (¶85 EC HMG)

Economies of scale: Why need a merger/JV?

Merger/JV might be preferable: Quicker

If industry is static or declining

COMPASS LEXECON 19

PASS-ON / FAIR SHARE

“…to be passed on, to a sufficient degree, to the consumer.” (¶84 EC HMG)

Firm-level efficiencies

Transaction efficiencies

Dynamic efficiencies

Demand-side efficiencies

Variable-cost reductions

Fixed-cost reductions

? Clawback?

COMPASS LEXECON 20

PASS-ON OF VARIABLE COST REDUCTIONS

Variable cost reductions normally partially passed on to consumers – even under monopoly!

Degree of pass-on may depend on: Elasticity of demand

Curvature of demand (elasticity of elasticity of demand)

Elasticity of supply

Number of competitors

D

MR

MCL

PriceM

MCH

PriceC

Consumer surplus

Quantity of bananas

Price of bananas

COMPASS LEXECON 21

OUTLINE





UPS/TNT

COMPASS LEXECON 22

Transatlantic JV between Oneworld members American Airlines, British Airways and Iberia

– Commitments on 6 transatlantic routes accepted on 14 June 2010

Transatlantic JV (‘A++’) between Star Alliance members Air Canada, Continental, Lufthansa and United Airlines

– Commitments on 1 transatlantic route accepted on 23 May 2013

Transatlantic JV between Skyteam members Air France-KLM, Alitalia and Delta

– Commitments on 3 transatlantic routes accepted on 12 May 2015

JOINT VENTURES BETWEEN MEMBERS OF ALLIANCES – CONTEXT

COMPASS LEXECON 23

COMBINING AIRLINE NETWORKS

NYC FRA

AMS

Airline 2

NYC FRA

DEN Airline 1

Behind

Behind

Trunk route

AMS

Airline 2

Trunk route

Pre-JV, Airlines 1 and 2 compete on NYC – FRA.

With the JV, there is ‘seamless’ interlining

NYC FRA DEN

Behind/ Beyond

Behind/ Beyond

NYC FRA

FRA AMS NYC

FRA AMS NYC DEN

COMPASS LEXECON 24

Marginal cost (Airline 1)


Mark-up (JV)



Mark-up (JV)

OUT-OF-MARKET EFFICIENCIES (REDUCING DOUBLE MARK-UP)

Example: NYC-AMS market

Pre-JV:

– Airline 2 buys a NYC – FRA ticket from Airline 1

– Airline 2 sells a NYC – AMS ticket to the passenger

– Results in two mark-ups

With the JV:

– Airlines jointly price the entire journey as a single entity.

– Results in a single mark-up and a fare reduction

– This in turn leads to higher passenger volumes (also on the trunk route)

Rely on econometric analysis of O&D-specific fares data to estimate the extent of the fare reduction

NYC FRA

Airline 1 AMS

Airline 2



Mark-up (Airline 2)

Mark-up (Airline 1)

Fare

Passenger volume (Pre-JV)

Pre-JV Post-JV

Reduction in fare

Passenger volume (Post-JV)

COMPASS LEXECON 25

The extent to which out-of-market efficiencies are credited was an important point of contention

In the end, the Commission required:

– ‘Considerable commonality’ between the potentially harmed and the benefitting passengers (not ‘substantially the same’!).

– The benefitting passenger’s itinerary must flow over the route of concern.

Tracking individuals’ travel histories: Benefit credited?

Miss Smith

Nov 2015 [Harm] May 2016 [Benefit]

Mr Darwin

Jan 2015 [Benefit]

Mrs Allen Jul 2015 [Benefit] Feb 2016 [Harm]

‘ELIGIBLE’ BENEFICIARIES OF OUT-OF-MARKET EFFICIENCIES

NYC FRA FRA AMS NYC

NYC FRA

FRA AMS NYC

MIA FRA DEN

COMPASS LEXECON 26

8:00AM, 5:30PM

6:30AM, 7:30PM

6:30AM, 5:30PM

8:00AM, 7:30PM

7:00AM, 5:30PM

5PM

6PM

7PM

8PM

6AM 7AM 8AM 9AM

Dep

artu

re t

ime

fro

m N

ew Y

ork

Departure time for the return flight from Frankfurt

Airline 1 Airline 2 New JV options Mr Johnson

30 mins 7:00AM, 5:30PM

6:40AM, 7:30PM

6:40AM, 5:30PM

8:00AM, 7:30PM

8:00AM, 5:30PM

5PM

6PM

7PM

8PM

6AM 7AM 8AM 9AM

Dep

artu

re t

ime

fro

m N

ew Y

ork



20 mins 8:00AM, 5:30PM

6:40AM, 7:30PM

7:00AM, 6:00PM

7:00AM, 5:30PM

8:00AM, 7:30PM

6:40AM, 5:30PM

5PM

6PM

7PM

8PM

6AM 7AM 8AM 9AM

Dep

artu

re t

ime

fro

m N

ew Y

ork



0 mins

Schedule delay reductions occur on return trips on the trunk route (i.e., ‘in-market’)

Ideally, Mr Johnson would like to depart from Frankfurt at 7:00 AM and depart from New York at 5:30 PM next day (‘X’)

Pre-JV

Mr Johnson normally takes the same airline to and fro

Airline 1 (8:00AM and 5:30PM) is preferred based on Mr Johnson’s schedule

Minimum schedule delay of 60 minutes

With JV

Schedule combination: 30minutes

Schedule coordination: 20 minutes

Increased frequencies: 0 minutes

SCHEDULE DELAY REDUCTIONS

8:00AM, 5:30PM

6:30AM, 7:30PM

7:00AM, 5:30PM

5PM

6PM

7PM

8PM

6AM 7AM 8AM 9AM

Dep

artu

re t

ime

fro

m N

ew Y

ork


Airline 1 Airline 2 Mr Johnson

60 mins

COMPASS LEXECON 27

Economies of density in the airline industry can rise from the ability of an operator to :

Carry more passengers on the same aircraft (i.e., to increase load factor)

Optimise the size of aircraft deployed (‘up-gauging’)

Increased frequencies of service on a given route.

Increasing the number of passengers on existing aircrafts and optimising the size of new aircrafts reduces the average variable costs per passenger.

Reductions in the costs feed into reduced fares for passengers depending on the pass-through rate.

ECONOMIES OF DENSITY

Slope: AVC Pre

Number of passengers

Variable cost

Pre - JV JV

Slope: AVC Post

COMPASS LEXECON 28

Is an in-depth JV necessary to generate schedule delay reductions or economies of density, i.e., is there not a realistic and less restrictive alternative agreement (‘RALRA’) delivering the same efficiencies?

Standard code-sharing is less restrictive but does not generate a significant reduction in double marginalisation, nor does it deliver schedule delay reductions or economies of density to the same extent.

Code-sharing with two-part tariffs:

– Operating carrier charges a fixed fee + marginal cost for each unit purchased by the marketing carrier.

– Arrangement does not exist in practice

– Not commercially realistic, because demand and cost uncertainty exposes airlines to risk

‘Carve-out’ of O&D passengers does not deliver the same level of efficiency gains

‘Carve-out’ of all passengers does not deliver the same level of efficiency gains either.

INDISPENSABILITY

COMPASS LEXECON 29

OUTLINE


The economics of efficiencies

European Commission framework for assessing efficiencies


UPS/TNT

COMPASS LEXECON 30

The relevant market

International express deliveries of small packages in the EEA.

Focus on global integrators:

‘Global integrators’ logistics services combining trucks and planes, which can guarantee overnight express deliveries.

Extensive aircraft fleet to send packages quickly over long distances and ground networks of road vehicles and sorting centres.

There are 4 operators (DHL, UPS, TNT and FedEx):

DHL is leader in EEA;

UPS makes a strong second;

TNT is a ‘maverick’; and

FedEx is a smaller competitor.

Significance of the case

First merger with efficiencies crucial in eliminating competition concerns.

Balancing of efficiencies with the anticompetitive effects.

UPS/TNT – CONTEXT

COMPASS LEXECON 31

Three-step ‘balancing’ analysis:

1. Price-Concentration Analysis (‘PCA’) – estimate likely impact of the merger on prices (before efficiencies);

2. Efficiencies – estimate likely efficiencies and assess whether these efficiencies outweigh the likely price effects; and

3. Assess market conditions in countries where the efficiencies did not clearly outweigh the estimated price increases.

UPS/TNT – COMMISSION’S ANALYSIS

COMPASS LEXECON 32

PCA – How prices of intra-EEA express services varied on number of competitors across lanes (“O&D pairs”).

Econometric analysis considers following factors as potentially influencing price per kg:

Cost;

Distance;

Market size;

Customer size; and

Presence of competitors.

Price effects predicted for 25 EEA countries:

Light red (12) ⇒ price increase >5%;

Light orange (13) ⇒ price increase <5%

[NB. No PCA in remaining 5 EEA countries (orange)]

UPS/TNT – STEP 1: LIKELY PRICE EFFECTS (BEFORE EFFICIENCIES)

COMPASS LEXECON 33

UPS/TNT – STEP 2: EFFICIENCIES

Criteria for efficiencies to be credited:

Cost savings in intra-Europe air network and ground handling costs.

Effective within 3 years after the merger.

Allocated overall cost savings to individual lanes:

Origin and destination within the EEA;

Proportional to each lane's share of UPS’ total European air transport costs;

Applied a pass-through rate of [60-70]% (from PCA).

In ‘green’ countries efficiencies outweigh price effects.

In these 10 countries with likely net price reductions, the Commission found that FedEx was a significant player.

These intra-EEA express markets (including previously light-red Greece) were found not to be problematic.

The remaining ‘red’ countries (15 in total) required detailed country-level analysis.

COMPASS LEXECON 34

UPS/TNT – STEP 3: DETAILED COUNTRY-LEVEL ANALYSIS

In 9 countries, the Commission found a clear positive net price effect, i.e., it deemed the merger to be problematic without further analysis. (DARKER RED)

For the other 6 countries (FI, DK, NL, CZ, HU, SL) net price effect was found to be negligible, neutral or even negative (LIGHTER RED).

Performed overall assessment of market conditions

Found that other market factors pointed towards a likely SIEC.

The Commission considered that in these markets FedEx would not exert a significant market pressure to counteract the price increases.

COMPASS LEXECON 35

Concluding remarks

COMPASS LEXECON 36

CONCLUDING REMARKS

Efficiency benefits can be used to offset restrictive effects identified in merger control or in the review of agreements:

These efficiencies need to be verifiable, merger-specific/indispensable, and to a significant extent passed on to consumers

Variable cost reductions can be expected to be at least partly passed on in most cases

Efficiencies can be of a ‘non-cost’ nature (e.g., improved product quality) – this is particularly relevant in network industries, or where the merger/agreement improves investment incentives.

Efficiencies as part of the ‘business rationale’ can positively affect authorities’ view of a merger or an agreement

COMPASS LEXECON 37

Thank you

Dr. Urs Haegler, Vice President, London Sergey Khodjamirian, Senior Economist, London

Documents

Economics on Demand The role of efficiencies in mergers ...compass-lexecon.s3.amazonaws.com/prod/cms-documents/d73c766e… · Deadweight loss / allocative inefficiency Quantity of