Competition Law and Policy in the United States (and Ukraine). Part 4. Vertical Mergers

Vertical mergers, unlike horizontal mergers, do not by their nature reduce the number of competitors in any particular market. Furthermore, it has been one of the real success stories of economic theory in the past fifty years that economists and enforcers have come to better understand the rationale for, and welfare benefits from, vertical integration, and, by extension, vertical mergers. Nonetheless, vertical mergers may reduce competition and lead to welfare losses under certain circumstances.

Vertical mergers, unlike horizontal mergers, do not by their nature reduce the number of competitors in any particular market. Furthermore, it has been one of the real success stories of economic theory in the past fifty years that economists and enforcers have come to better understand the rationale for, and welfare benefits from, vertical integration, and, by extension, vertical mergers. Nonetheless, vertical mergers may reduce competition and lead to welfare losses under certain circumstances. In particular, and in exactly the same way as contractual vertical restraints, vertical mergers may create or enhance the ability of a firm with market power to protect that power from competition from other firms. In this sense, the most serious potential negative consequence of a vertical merger, as with a vertical restraint, is the entrenchment of a dominant or monopolistic position in a market.

Consider, for example, a firm with a dominant position in a particular product market – call it “steel”, and assume that steel is a product market – in a particular country – call it “Ukraine”, and assume that Ukraine is a geographic market for the product market “steel”. Consider the reaction of the dominant steel-producing firm to the threat of entry by a new firm – perhaps a multinational steel producer – on the Ukrainian market.

One possible strategy might be for the incumbent dominant firm to merge, or sign a long-term exclusive supply contract with, a producer of an important input into the production of steel, for example iron ore. There may be a variety of procompetitive and proefficiency rationales for a manufacturer to merge with, or sign a long-term contract with, one of its suppliers. But suppose this iron ore company is the only supplier of iron ore on the Ukrainian market. Then a vertical merger between the incumbent dominant steel company and the incumbent monopolistic iron ore supplier might make it more difficult for a new firm to begin producing steel in Ukraine. Unless the entrant were confident that the merged firm would supply iron ore on exactly the same terms to a non-integrated rival as to an integrated sister company, the entrant would likely seek out other sources of iron ore, and these – as evidenced by the hypothesized fact that they were not in the market before – might be less reliable or more expensive or of lower quality. Thus through its purchase of a raw material supplier – a vertical merger – the dominant firm could make entry (or expansion) into the market by competitors more difficult, “entrenching” its dominant position.

Such a strategy would not, it is true, be particularly effective in preventing entry into the market by producers located elsewhere and seeking to ship their steel into Ukraine. To guard against market entry of this form, the domestic incumbent might seek a vertical merger with a downstream firm, that is, a supplier of wholesaling or distribution services. If, for example, it is not difficult to ship steel to a Ukrainian port city of Odessa or Mariopol, or to an import facility on the Polish or Slovak border, but it is necessary to have an extensive network of steel warehouses (sometimes called “service centers”) if one is to compete for business and serve customers effectively, a possible defensive strategy of the domestic incumbent might be a vertical merger (or, again, a long-term exclusive contract) with a company owning a dominant or monopolistic steel warehouse network. Again, unless a prospective entrant were confident that the merged firm would supply warehousing services on exactly the same terms to a non-integrated rival as to an integrated sister company, the prospective entrant would likely seek out other sources – for example, warehouses currently stocking other construction materials but not steel – or be forced to enter the Ukrainian market on a larger financial scale by creating its own warehouse network. Again, the vertical merger has the potential to make entry into the market – this time by a prospective importer – more difficult, thus entrenching the dominant position of the incumbent.

It is important to note just how fact-specific are the above anticompetitive scenarios for vertical mergers, however. The US and EU enforcement agencies do not have formal guidelines for the analysis of vertical mergers, but a close reading of the previous two paragraphs will confirm that many of the same steps are involved. There cannot be much worry about the possible entrenchment of a dominant firm until one is satisfied that there is a dominant firm, and a firm can be dominant (or, equivalently in the US, possess market power) only in a particular product and geographic market. Thus in the two scenarios suggested above, we are already requiring product and geographic market definition in both markets subject to the vertical merger, as well as market share and entry analysis. To revisit only the final section of the second scenario, if an investigation reveals that it would be trivially easy for a network of warehouses of other construction materials to begin serving as a wholesaler of steel, and if there exists such a network of warehouses of construction materials with a sufficient geographic reach to allow a steel importer to compete effectively with an incumbent steel producer, then the hypothesized vertical merger of the incumbent with the warehouse network would not in fact entrench the dominant position of the incumbent, and it should not be challenged on such grounds.

As with the case of horizontal merger analysis, enforcement agencies and adjudicative bodies will typically consider the possible efficiencies from a vertical merger and seek to balance those against the possible harms from a loss of competition. The most important of these economies are often related to the improved economic understanding mentioned at the beginning of this section: they relate to the reduction in transactions costs that may take place when two independent, vertically related firms are joined into one, and their interfirm, market-mediated transactions are transformed into intrafirm transactions[2]. In addition, a vertical merger between two firms that both possess market power may improve allocative efficiency by causing these intrafirm transactions to take place at marginal rather than average cost[3].

One interesting wrinkle concerning efficiencies in vertical mergers turned up in a recent EU merger decision, that blocking the GE/Honeywell merger. Recall that the standard for legality of a merger under the EU and similar statutes and regulations was whether the merger would be likely to create or strengthen a dominant position in a market (versus the US-style standard of a substantial lessening of competition, or SLC). What if a merger would create substantial efficiencies, but they would all accrue to a dominant firm? Under a US-style standard, the substantial efficiencies would be counted as a benefit of the merger, as they would increase producer surplus and, under many circumstances, increase consumer surplus as well by leading to lower prices. (Even a monopolist typically finds it in its interest to lower its price in response to lower costs.) However, under the old EU-style standard, the very efficiencies may be counted on the harm side of the ledger if they strengthen a dominant position in a market. Even if prices are lowered in the short run, the fear is that in the longer term the firm in the position of strengthened dominance would abuse that position. This issue seems to have become probably the single most important point of disagreement and incongruence between antitrust enforcement in the US and in Europe.

Conclusion

Most mergers are unlikely to harm competition, and most competition agencies routinely permit most mergers to occur without challenge or even extensive investigation. However, under particular circumstances, both horizontal and vertical mergers may threaten the vitality of competition in particular markets, and most competition agencies have the authority to seek to block such mergers, or to insist upon structural measures that protect competition before the merger is consummated. When particular countries have had competition laws that did not include merger jurisdiction – for example, the US before the passage of the Clayton Act, or Argentina during the 1990’s – this has come to be recognized as a serious deficiency in the ability of the authority to protect competition in the market, and it has usually been rectified. Sensible, economics-literate merger enforcement is one important component of an effective competition policy regime.

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