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Mergers and Vertical Restraints

The application of economics to examine the

competitive effect of mergers and vertical restraints

Dr Luke Wainscoat

Senior Economist, HoustonKemp

University of Sydney

6 October 2016

© 2016

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MergersHow economics can help assess the effect of a

merger on competition

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Outline

• How economists can help assess the competitive

effect of mergers

• How does the market function?

• Coordinated effects

• Barriers to entry

• Unilateral effects (firms set quantity)

• Unilateral effects (firms set prices)

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Mergers can be very valuable for the economy

• ACCC assessed 322 mergers in 2014-15, conducting

public reviews of 42

• Cost synergies estimated to be 3-4% of transaction

value, on average

• Value of mergers estimated to be US$1.3 trillion in

Asia-Pacific region in 2015

• BUT, some mergers can reduce competition, driving

up prices

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Economics is only relevant if it can assist in the assessment of conduct with reference to the law

• Section 50 of the Competition and Consumer Act

(CCA) prohibits mergers that…

‘would have the effect, or be likely to have the effect,

of substantially lessening competition [SLC] in any

market’

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Economics can help determine whether there has been a SLC

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How does the market function?

What are the credible theories of harm?

Does the evidence support a credible

theory of harm?

• What information is needed?

• Market definition

• Use qualitative and quantitative

evidence

• What is the likely effect of the

merger?

• Theories of harm need to be

consistent with how market operates

• Under what conditions would theory

of harm be true?

SLC • Relate back to competition law

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How does the market function?

• Strategic environment

› Price setting

› Quantity/capacity setting

› Auction

› Bargaining

• Type of products

› Homogenous or

differentiated?

› Substitutes

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• Entry/expansion› Capacity constraints

• Market structure› Concentration (over time)

› Vertical relationships

• Type of customers› Small

› Large

• Others› Two-sided market

› Network effects

› Innovation

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What are the credible theories of harm?

• Vertical mergers

› Similar arguments for vertical restraints

• Horizontal mergers

› Coordinated effects

Collusion becomes more likely/stable

› Unilateral effects

Firms act independently

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Firm A Firm B

Firm C Firm D

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Coordinated effects

• Three conditions necessary for collusion to take

place

› Firms reach agreement as to conduct

› Collusive agreement is internally stable

› Collusive agreement is externally stable

• Merger may affect first two conditions

› Easier to reach agreement with fewer firms (in particular if

merge with maverick)

› Reduced incentive to cheat in more concentrated market

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Three main sources of constraint to unilateral conduct

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Firms in the

market

Potential entrants

Customers

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Contestable markets and barriers to entry

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• Perfectly contestable market› One supplier

› Technology/knowhow for production available to all

› Fixed, but no sunk costs

• Outcome› Price=average costs

› Mergers have no effect

• But › Fixed costs often sunk – no

‘hit and run’ entry

› New entrants may have highervariable costs

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Barriers to entry allow incumbents to set prices above the competitive level without entry occurring

• Some disagreement on exact definition• Something that allows the incumbents to earn above-normal

profits

• A cost of producing that must be borne by an entrant but not incumbents

• Additional profit earned as a sole consequence of being established in the industry

• Barriers to entry allow firms to have market power

• Extent to which the threat of entry restricts market power depends upon› Likelihood of entry

› Timeliness of entry

› Impact of entry on the incumbents

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Unilateral effects when firms set quantities

• Cournot model

› Firms independently and simultaneously decide their own

quantity/capacities

› Products are homogeneous

› Prices determined by total amount supplied by all firms

• Examples

› Airlines

› Farms

› Mining

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Herfindahl-Hirschman Index (HHI)

• HHI is the sum of the squared market shares

› 𝐻𝐻𝐼 = 𝑠𝑖2

• Eg

› Market shares, 20%, 30% and 50%

› HHI = 202+302+502=3,800

• Take into account

› HHI post merger

› change in HHI as a result of the merger

• ‘The ACCC will generally be less likely to identify horizontal

competition concerns when the post-merger HHI is:

› less than 2000, or

› greater than 2000 with a delta less than 100.’

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Greater Herfindahl-Hirschman Index (HHI) leads to higher prices

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𝜋𝑖 = 𝑥𝑖𝑃 𝑋 − 𝐶 𝑥𝑖 𝑃 + 𝑥𝑖 𝑃 𝑋 − 𝐶 𝑥𝑖 = 0Profit for firm i FOC

𝜀 =1

𝑃 𝑋

𝑃

𝑋

𝑚𝑖 ≡𝑃 − 𝐶 𝑥𝑖

𝑃Price cost margin

Elasticity of

demand𝑃 − 𝐶 𝑥𝑖

𝑃=−𝑥𝑖 𝑃 𝑋

𝑃

𝑚𝑖 =−𝑥𝑖 𝑃 𝑋

𝑃

Greater HHI

More elastic

demandLower prices

Higher prices

𝑠𝑖𝑚𝑖 =−𝑠𝑖

2

𝜀 𝑠𝑖𝑚𝑖 = −

1

𝜀 𝑠𝑖

2

𝑚 = −𝐻𝐻𝐼

𝜀

Profit max

=−𝑥𝑖𝑋

𝑃 𝑋 𝑋

𝑃=−𝑠𝑖𝜀

𝑠𝑖 = 𝑥𝑖 𝑋 Market share

Share

weighted

margin

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Limitations of Herfindahl-Hirschman Index

• Post merger market shares will not be sum of pre

merger market shares if the merger is anticompetitive

• Industry average marginal cost will change if there

are efficiencies and/or if market shares change

• Need to consider possibility of entry

• Requires market shares of all firms

• Only applies to Cournot competition

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Unilateral effects when firms set prices and sell differentiated products

• Bertrand competition

› Firms set prices

› Products are differentiated – they are imperfect substitutes

› Eg, differentiation may be

Brand

Quality

Location of stores

• Examples

› Restaurants/ coffee shops

› Retail

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Store A Store B Store C

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Merger simulation for differentiated products

• Use model calibrated to observed features of market

to predict the effects of a merger

› Estimate cost and demand parameters

Assume form of demand

› Calibrate demand system to give prices and market shares actually observed

› Specify model of competition – Bertrand in this case

› Re-estimate model with new market structure, and

potentially, efficiencies

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Drawbacks of merger simulation

• Assume form of competition, demand system and

functional form of marginal cost unchanged by

merger

• Assumes no supply side response

• Data availability

• May not provide precise result

• Time intensive

• Results can appear to be opaque

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Simplified merger simulation – pricing pressure tests

• Number of assumptions have been suggested

› Hold prices of third party firms constant

Only need price elasticities and cross-price elasticities of merging

firms

› Use Lerner index to determine own-price elasticities from

mark-ups

› Use diversion rations instead of cross price elasticities

› Demand curvature

Assume linear or constant elasticity of demand

Assess effects at current prices

• Leads to a variety of different tests

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Upwards Pricing Pressure (UPP) test

Merger

Merger

Merger

Merger

Merger

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The economic intuition behind UPP

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Price

Output

Revenue RevenuePrice

Output

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The economic intuition behind UPP

23

Pricerises

Quantity falls Quantity Increases

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The economic intuition behind UPP

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Pricerises

Quantity falls Quantity Increases

Significance of this incentive

depends upon:

• Quantity of sales that switches

(closeness of competition)

• Profit margin for silver (benefit

from each switched sale)

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The economic intuition behind UPP

25

Output

$

Demand

Marginal

Revenue

Marginal

Cost

Q

P

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The economic intuition behind UPP

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Output

$

Demand

Marginal

Revenue

Marginal

Cost

Q

P

P

Q

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Calculating UPP

• Calculating profit maximising prices involves

determining the FOC and setting this equal to 0

• Upward pricing pressure when FOC>0

• So UPP only measures direction of effect

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Calculating UPP (firm 1)

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Pressure for prices to rise Pressure for prices to fall

Marginal cost reduction (firm 1)

as fraction of the price

e1 =∆𝑐1

𝑝1

Profit margin (firm 2)

p2−c2

p2

Diversion ratio (from 1 to 2)

D12 = −ε21

ε1×

Q2

Q1

𝑝2

𝑝1

p2−c2

p2× 𝐷12 − 𝑒1

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Sales Volume 10 15 30

Price 120 115 80

Marginal Cost 90 85 75

Margin 0.25 0.2609 0.0625

Market Share 23% 32% 45%

UPP vs concentration measures

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3,578Pre-merger HHI

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Using a market share approach

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55% 68%

Post merger HHI: 5,050

Change in HHI: 1,472

Post merger HHI: 5,648

Change in HHI: 2,070

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Using UPP

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𝑝2𝑝1

p2 − c2p2

∗ 𝐷12 − 𝑒1

DGS = 0.5

UPPG = 0.025

UPP =115

120∗ 0.261 ∗ 0.5 − 0.1 = 0.025

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Using UPP

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𝑝2𝑝1

p2 − c2p2

∗ 𝐷12 − 𝑒1

DGS = 0.5

UPPG = 0.025

UPP =120

115∗ 0.258 ∗ 0.4 − 0.1 = 0.0043

D𝑆𝐺 = 0.4

UPPS = 0.0043

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Using UPP

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DGS = 0.5

UPPG = 0.025

UPP =80

120∗ 0.0625 ∗ 0.25 − 0.1 = −0.0896

D𝑆𝐺 = 0.4

UPPS = 0.0043

DG𝑃 = 0.25

UPPG = −0.0896

𝑝2𝑝1

p2 − c2p2

∗ 𝐷12 − 𝑒1

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Using UPP

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DGS = 0.5

UPPG = 0.025

UPP =120

80∗ 0.25 ∗ 0.15 − 0.1 = −0.0438

D𝑆𝐺 = 0.4

UPPS = 0.0043

DG𝑃 = 0.25

UPPG = −0.0896

UPP𝑃 = −0.0438

D𝑃𝐺 = 0.15

𝑝2𝑝1

p2 − c2p2

∗ 𝐷12 − 𝑒1

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Market share and UPP approaches give different results

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68%DG𝑃 = 0.25

UPPG = −0.0896

UPP𝑃 = −0.0438

D𝑃𝐺 = 0.15

Post merger HHI: 5,648

Change in HHI: 2,070

Market share UPP

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Benefits and limitations of using UPP

• Benefits

› UPP is relatively easy to calculate

› Does not rely on market definition

• Limitations

› Assumptions about functional form for demand

› Does not account for

supply-side response (entry and repositioning)

multi-product nature of firms (eg effect on complementary

products)

response to price changes by other firms

› Often relies on surveys or switching analysis for diversion ratios

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Vertical restraintsHow economics can help assess the effect of

vertical restraints on competition

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Outline

• What are vertical restraints?

• How economists can help to assess the competitive

effects of vertical restraints

• Pro-competitive effects of vertical restraints

• Anti-competitive effects of vertical restraints

• Overall assessment

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What are vertical restraints?

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Coca-Cola

Coles Downstream

Upstream

Supply agreement

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Common vertical restraints

• Selective distribution

• Exclusive distribution

• Exclusive supply

• Single branding

• Quantity forcing

• Restraints to prices

› Resale price maintenance

› Most favoured nation contracts

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Vertical restraints are important in the economy

• Vertical restraints are common

› Includes lots of types of conduct

• Can be pro and anti competitive

• Topical issue

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Vertical restraints can be prohibited under the Competition and Consumer Act

• Anti-competitive agreements (s 45)

› SLC test

• Misuse of market power (s 46)

› Substantial market power

› Take advantage of market power

› Damage an actual or potential competitor

• Exclusive dealing (s 47)

› Parts per se, parts subject to SLC test

• Resale price maintenance (s 48)

› Per se offence

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Economics can help determine whether there has been a substantial lessening of competition

43

How does the market function?

What are the credible theories of harm

and benefit?

Does the evidence support a credible

theory of harm or benefit?

• What additional information is

needed?

• Market definition

• Use qualitative and quantitative

evidence

• What is the likely net effect of the

conduct?

• Theories of harm need to be

consistent with how market operates

• Under what conditions would theory

of harm be true?

SLC • Relate back to competition law

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Vertical restraints prevent double markup

44

Coca-Cola

Coles

Consumers

= (Manufacturing cost *Markup)*Markup

Wholesale price = Manufacturing cost *Markup

*MarkupWholesale price Retail Price =

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Vertical restraints can prevent free-riding

45

Manufacturer

High quality

retailer

Discount Store

Customer visits

store

Customer

purchases product

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Vertical restraints can prevent hold-up

46

Manufacturer

Retailer

1. Investment in crates

2. Refuses to pay for crates (hold up)

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Vertical foreclosure can restrict competition

47

Manufacturer A

Retailer A Retailer B

Manufacturer B

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Vertical restraints can facilitate downstream collusion

48

Manufacturer A

Retailer A Retailer B

Agree retail price Agree retail price

Agree to

collude using

vertical

restraints

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Vertical restraints can facilitate collusion upstream

49

Manufacturer A

Retailer A

Agree retail price Agree retail price

Manufacturer B

Collusion

over

wholesale

prices

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Vertical restraints can solve a monopolist’s commitment problem

50

Franchise A

FranchisorNew Town

Franchise B

Franchise C

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Vertical restraints can soften competition

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Manufacturer A Manufacturer B

Retailer A Retailer B

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Risk of vertical restraints being anti-competitive increases with market power

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Risk of anti-competitive effect increasing

No

market

power

Downstream

market

power only

Upstream

and

downstream

market

power

Upstream

market

power only

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Assessing vertical conduct

Do any of the firms involved

have significant market power?

Is there an anti-competitive

theory of harm that is consistent with the facts?

Is there a pro-competitive theory that is

consistent with the facts?

Weigh up pro and anti-

competitive effects

53

NoNo

SLC

Yes, significant benefit,

and little harm

No

SLC

Yes

Small, or no

significant benefit

NoNo

SLC

Yes

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