EU and UK Vertical Merger Control: What’s the State of Play?

Abstract

Recent years have seen renewed debate about the approach that competition authorities should take to vertical mergers.1 Such mergers (i.e. between firms at different levels of the supply chain) do not involve the same elimination of direct competition as horizontal mergers—but does this mean that they can be viewed more favourably? Recent years have seen renewed debate about the approach that competition authorities should take to vertical mergers. In particular, some have called for increased scepticism towards alleged efficiencies. In this article, we revisit the fundamental economics that underlies vertical mergers, including the key theories of harm, the necessary conditions for any elimination of double margins (EDM), other benefits of vertical mergers, and the role of merger specificity. We go on to look in detail at the static price effects in vertical mergers and incentives for EDM on the one hand, and raising rivals’ costs (RRC) on the other. We conclude with a discussion on the ongoing relevance of analysing static price effects in light of the advent of more dynamic theories of harm and benefit. There appears to be a change of tone from some competition authorities towards vertical mergers. In the UK, the Competition and Markets Authority (CMA) issued updated guidelines last year in which it no longer describes vertical mergers as generally benign.2 In the USA, the Federal Trade Commission (FTC), with support from a majority of the FTC Commissioners, even went so far as to revoke the 2020 vertical merger guidelines on the grounds that they contained a ‘flawed discussion of the purported procompetitive benefits’.3 In the EU, meanwhile, the most recent non-horizontal merger guidelines date back to 2008. However, it is broadly recognised that case practice has evolved since then, moving towards case-specific assessment and away from the simplistic arithmetic approach described 15 years ago.4 In addition to the changes in competition guidelines, several high-profile cases have highlighted the issues surrounding non-horizontal mergers. In the USA, the AT&T/Time Warner case has stirred up an intense debate on how to evaluate both the benefits and harms from vertical mergers—after the government conceded benefits from the ‘elimination of double-margins’ in the order of $350m without qualification.5 In the EU, the question around integrating the efficiencies resulting from internalising double margins into analysis of the effects on competition have been raised in several cases.6 These developments raise a number of questions. First, what is our current understanding of the benefits and harms of vertical mergers? Second, what role can economics play in determining future policy and guidance on such mergers? When two direct competitors merge, there is a risk that a valuable competitive constraint will be eliminated from the market. However, there is a fundamental difference between a horizontal merger such as this and a vertical merger that involves parties at different levels of the supply chain. At its core, this difference comes down to a difference between a merger of substitute products and a merger of complementary products. This in turn affects the theories of benefit and theories of harm that underlie any merger review. When firms optimise prices independently, they do not account for the pricing externality that they impose on each other. If they sell substitutes, higher own prices will increase demand for the other firm’s products. If they sell complements, higher own prices will reduce demand for the other firm’s products. Mergers allow firms to internalise such pricing externalities; hence, mergers of firms selling substitutes put upward pressure on prices, and mergers of firms selling complements put downward pressure on prices. If one firm supplies the other in a vertical supply chain, the goods are effectively complements. By charging a margin independently, both firms impose a pricing externality on each other. The efficiency is therefore described as an elimination of double margins (EDM).7 This EDM is one of the most prominent efficiency gains—as emphasised, for instance, by the European Commission in its 2008 Non-Horizontal Merger Guidelines:8 In vertical relationships for instance, as a result of the complementarity, a decrease in mark-ups downstream will lead to higher demand also upstream. A part of the benefit of this increase in demand will accrue to the upstream suppliers. An integrated firm will take this benefit into account. Vertical integration may thus provide an increased incentive to seek to decrease prices and increase output because the integrated firm can capture a larger fraction of the benefits. This is often referred to as the ‘internalisation of double mark-ups’. It is important to note that EDM is an efficiency that originates purely from the internalisation of a pricing externality. This mechanism of taking into account the effect of your pricing decision on your merging partner is the exact same mechanism that in a horizontal merger leads to an upward pricing pressure. This in turn means, conceptually, that it makes sense to integrate EDM into the general assessment of merger price effects, rather than subjecting it to the same strict standard as other efficiencies in merger assessments, which requires that the efficiency benefits consumers, is merger specific, and is verifiable.9 Irrespective of the appropriate standard of proof, the economic theory of EDM in vertical mergers has been under increased scrutiny in recent years given the adoption and subsequent revocation of the US FTC’s vertical merger guidelines. In revoking the guidelines, the majority of Commissioners issued a statement:10 The VMGs’ reliance on EDM is theoretically and factually misplaced. It is theoretically flawed because the economic model predicting EDM is limited to very specific factual scenarios: mergers that involve one single-product monopoly buying another single-product monopoly in the same supply chain, where both charge monopoly prices pre-merger and the product from one firm is used as an input by the other in a fixed-proportion production process. From an economics perspective, this statement is difficult to justify. The fundamental change resulting from a merger (whether vertical or not) is that firms take account of the externality that their pricing decisions exert on the merging partner. Double mark-ups can arise whenever there is some degree of market power upstream and downstream. Therefore, even though EDM may be more significant in monopoly settings, it may also occur in non-monopoly settings. Nevertheless, there are settings where EDM is unlikely or where it would probably be insufficient to offset potential harm.11 No pre-merger double margins—EDM cannot occur if there are no double margins before the merger. Certain contractual mechanisms can eliminate double margins, so if the parties were using such margins pre-merger, there would be no double margins to eliminate. For example, an upstream firm may license its product to a downstream firm in exchange for a fixed fee and set the per-unit price at marginal cost so as to eliminate any double margins without full vertical integration. Diagonal merger—if the upstream merging party does not supply the downstream merging party (i.e. the merger is ‘diagonal’), there is no vertical pricing externality to begin with. This was the case, for example, in Deutsche Börse/LSEG.12 Full market coverage—where the total market is unlikely to expand for the upstream firm, any increase in sales through the downstream merging firm will come at the expense of upstream sales to a downstream rival. Provided that upstream margins from supplying downstream rival(s) are not lower than the upstream margins from supplying the downstream merging party, there is no benefit to the merged entity in reducing downstream margins to increase sales. This was expected, for example, in Telia/Bonnier Broadcasting and later in LSEG/Refinitiv.13 Strong horizontal overlap—some vertical mergers may involve a firm that is already vertically integrated to a degree, such that the merger would also lead to a strong horizontal overlap between the merging parties. In such cases, horizontal upward pricing pressure may offset the vertical downward pricing pressure from EDM. This concern played a role in the recent Wieland/Aurubis EU merger prohibition.14 Moreover, there are situations in which the magnitude of EDM is reduced or even fully eliminated. For example, internal frictions may mean that the integrated firm fails to set optimal internal transfer prices between its upstream and downstream units, such that double marginalisation remains after the merger.15 However, such internal frictions also often mean that the upstream arm of the merged entity would not internalise the externality on its downstream arm from the price it charges to downstream rivals and vice versa, such that any incentive to increase rival prices (discussed in more detail below) may not be an issue in the first place. It is worth noting that—in addition to the pricing efficiency from EDM—vertical mergers can lead to other efficiencies that are potentially even more important. These include benefits from increased vertical control and security (e.g. reduced risk of ex post renegotiation of agreements and ‘hold-up’ problems), and effective vertical coordination. As recognised by the European Commission:16 […] [O]ther efforts to increase sales at one level (e.g. improve service or stepping up innovation) may provide a greater reward for an integrated firm that will take into account the benefits accruing at other levels. In theory, any vertical efficiency—including EDM—could be achieved through optimal contracting between independent companies, rather than through a vertical merger. For example, the problem of double margins disappears when the upstream firm prices a product at marginal cost while appropriating its share of the surplus with a fixed fee (i.e. non-linear contracting). This raises the question of whether any alleged efficiencies are really specific to the merger, or whether they could be achieved through other means if the merger did not go ahead. The key point here, however, is that optimal contracting may not always be feasible due to transaction costs. In particular, there may be relevant aspects of commercial relationships that are simply non-contractable—such as trust and reliability. Firms may therefore resort to mergers instead. Notwithstanding the benefits and the pro-competitive rationale for vertical mergers, it is generally recognised that vertical mergers may pose risks to competition. The theories of harm in vertical mergers focus primarily on practices that the merging parties could adopt post-merger to foreclose rivals at either level. In particular, there are two main concerns: the merged entity may have the ability and incentive to engage in input foreclosure and/or customer foreclosure. These harms are illustrated in Figure 1 Input foreclosure can occur when the merged entity raises the cost or reduces the quality of the input supplied to downstream rivals (partial input foreclosure) or when it refuses to supply them with the input altogether (total input foreclosure). This could have the effect of raising downstream rivals’ costs (RRC) by making it more expensive for them to access supplies of the input, thereby reducing the downstream rivals’ ability and/or incentive to compete. As a result, prices charged to consumers could increase and/or quality decrease. However, this practice would be effective only if the merged entity had market power over the input in question. Customer foreclosure occurs when the merged entity restricts the access of competing upstream suppliers to downstream customers, to the benefit of the merged entity’s upstream arm. If upstream rivals’ access to downstream consumers is sufficiently reduced, this may hamper their ability and/or incentive to compete upstream. If as a result the upstream rival becomes less efficient (or exits the market), this may lead to downstream rivals’ costs being raised, thereby reducing downstream rivals’ ability and/or incentive to compete. As a result, prices charged to consumers may increase. Input and customer foreclosure: Note: Input foreclosure involves U1 no longer selling a critical input to D2, whereas customer foreclosure involves D1 no longer purchasing input from (and providing a route to market to) U2. Under the European Commission’s non-horizontal merger guidelines, the accepted framework for assessing whether there is such a risk of foreclosure looks at three elements:17 the ability of the merging parties to foreclose—i.e. whether they control a critical input or route to market; the incentives of the merging parties to foreclose—i.e. whether the benefits of rivals’ foreclosure outweigh the loss in profits from a reduction in input sales to those rivals;18 the effect on competition from any foreclosure—i.e. whether the competitive process is adversely affected. Where a negative effect on competition is established, efficiency gains should be considered as a countervailing factor. Under the Commission’s practice and its merger guidelines, although the burden of proof to demonstrate anticompetitive effects lies with the competition authority, the burden of proof to substantiate any countervailing efficiency lies with the merging parties. This is also the case for efficiencies resulting from EDM, although the incentive of a merged entity to EDM and to RRC result from the same mechanics, i.e. the internalisation of the pricing externality imposed by the merging parties on each other when pricing independently. Just as raising upstream prices to rivals tends to benefit the merged downstream unit, lowering downstream prices tends to benefit the merged upstream unit. As we explain below, EDM and RRC can appreciably affect one another. This issue was recently raised, for example, in LSEG/Refinitiv. In practice, the Commission’s Non-Horizontal Merger Guidelines do not prevent the Commission and the Parties from assessing EDM and RRC together, as the Guidelines make it clear that ability, incentive, and effects are closely intertwined and often examined in an integrated way. As described above, the integrated firm may face incentives to raise its downstream rival’s input costs without fully foreclosing it, i.e. creating the upward pricing pressure. This raises an important question: how do the price effects from RRC and EDM interact, and what is the resulting net effect? One practical approach is to consider the static incentives of RRC and EDM in isolation and then compare the two to obtain a net effect. This can be done using a vertical gross upward pricing pressure index—or ‘vGUPPI’. Similarly to its established horizontal equivalent, vGUPPI aims to measure the degree to which a particular firm has an incentive to increase its prices because of the effect that this will have on its merging partner. This is done by considering the change in the ‘opportunity cost’ of a unit sale as a result of the merger—i.e. the additional profit that the other merging party would have gained if that sale did not occur.19 A positive additional opportunity cost implies that, post-merger, a merged entity would have incentives not to make those marginal sales, and so to raise its price, whereas a negative additional opportunity cost would imply incentives to make additional sales and so to lower prices. This additional opportunity cost can then be interpreted as a de facto marginal cost change, which in turn leads to higher customer prices following a full or partial pass-through of this cost increase (if positive, the same holds mutatis mutandis for cost decreases). The additional opportunity cost can then be compared against the pre-merger level of prices to obtain an index of relative price increase. This index is the vGUPPI, which provides a measure of the upward price pressure resulting from the merger both for the retail price of the downstream merging firm and for the wholesale price charged to downstream rivals of the upstream merging firm. Suppose that a single upstream firm is selling to two downstream rivals, and that the upstream firm wants to merge with one of the downstream firms. Following the merger, not selling an extra unit via the downstream merging firm due to a downstream price increase would generate additional loss for the upstream merging party in the form of unearned upstream margin on this unit—which the downstream merging party did not take into account pre-merger. However, it will, at the same time, generate an extra gain in the form of additional upstream margin earned on the sales to consumers that diverted to the downstream rival following the price increase by the downstream merging The additional opportunity cost for the downstream firm that was not for pre-merger is then given by the net when by downstream prices, the downstream this is the downstream merging party has an incentive to lower its price, which the incentives EDM. 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This additional opportunity cost of making a sale to the downstream rival can be viewed as an increase in the marginal cost to the upstream merging firm of selling to the downstream rival. 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