Vertical And Conglomerate Effects
Vertical and ConglomerateEffectsMiguel de la Mano*Chief Economist Team, European Commission*The views expressed are those of the author and do not necessarily reflect those of DGCOMP or the European Commission
Outline1.2.IntroductionVertical mergersnn3.Good thingsBad thingsn input foreclosuren customer foreclosureConglomerate mergersn4.foreclosure concerns of tying/bundling/portfolio effectsConcluding remarks
1. IntroductionDefinitions:hHorizontal merger hVertical merger ha merger between companies are actual or potential competitors inin the same relevant marketa merger between companies that have an actual or potential suppliersupplier--customer relationshipConglomerate merger: a merger that is neither purely horizontal or purely vertical
2. Vertical mergershExamples of a vertical relationship:––––hproducer and retailercar parts producer and car producercement producer and concrete producerelectricity producer and distributorVertical mergers have implications which differ from horizontalmergers: a horizontal merger is a merger between competitors,whereas a vertical merger is a merger between players that arecomplementary
Theory of the firmnnWhat decides the boundaries of a firm?To get a final product/service to the final customer requires a number ofsubproducts and subservices.nnR&D, Raw materials, Combining the raw materials, Feeding the employees,Cleaning the factory, Distribution, Advertising, AccountingWhich of these activities should a firm do themselves and which should beleft to the market?Market based transactionInternal transfer
Vertical mergershAdvantages of being independent:hhhhhExternal pressure from competition keeps eachentity “on their toes”Easier to handle smaller entitiesBetter focus on core activities .Advantages of being integratedhhEasier to align activitiesInternalize externalities
Does it pay to increase prices?PriceDemand?Marginal costLeavingcustomersQuantity
A downstream monopolistPriceDemandUpstreammarkupMarginal costMarginal revenueQuantity
Mobile telephonyDomestic on-net callDomestic off-net callInternational callOrigination Termination SubscriptionTerminationOriginationOrigination SubscriptionTerminationSubscription
Aligned incentivesnM. 3868 DONG/Elsam/E2/KE/FEnDONG receives gas in a steady flownnnbut customers mainly need the gas in the wintersolution: storageElsam and E2 use gas to produce electricitynnnBut they also use other fuels (coal, oil, wood-pellets and straw)Merger potential: use power plants as virtual storageBy using gas in the summer and other fuels in the winter
Vertical mergershThere are many reasons why vertical mergers may be good forconsumershhhhInternal transfers may be better than market based transfersIncentives may be better alignedDouble mark-ups may be eliminatedSo what could possibly be wrong with a verticalmerger?
ForeclosurehVertical mergers may foreclose competition by–raising the costs at which competitors can operate on a downstreammarket (raising rivals’ cost); typically associated with input foreclosure–and/or lowering the expected revenue streams of upstream competitors(reducing rivals’ revenues); typically associated with customer foreclosureè may affect the ability or incentive of competitors to compete,and thereby negatively affect consumers
Input foreclosureNo reason to offer different pricesto the two downstream firmsMonopolistElimination of double mark-upLower downstream pricesBut what about also increasingprices to red?Net effect?Higher downstream prices
There is only one monopoly profit!MonopolistExcept if:n The monopolist is regulatedn Two-level entry is moredifficult than one-level entryn Entry from one level to theother level is easier thanentry for a complete outsidern There is some competitionupstream
Example EDP/GDPnAcquisition of joint controlby ENI and EDP (electricity incumbent)over GDP (gas incumbent)
Vertical effectsnA vertically integrated quasi-monopoly could raise entrybarriers by:n increasing the price of gas or reducing quality ofsupply to Turbogas and new entrants (inputforeclosure)n by not purchasing gas from other suppliers thanGDP thus depriving them of incentives to enterbecause of lack of scale economies and ofprofitability of entry (customer foreclosure)
GASCoalGDPTejoEDPEDPConsumersPETG
15%EDPTG10-20%EDPhigherpriceshereConsumers
Input foreclosure may be a concernnWhen the merged entity has the ability to raise rivals cost;nnnHas the incentive to do so;nnnnInput must be importantMerged entity must have significant market power in the input marketDownstream profits should be significantUpstream prices should translate into higher downstream pricesThe rival should be a close competitorThe effect on downstream consumers would be significantnnThe rivals whose cost are raised should constitute an importantcompetitive forceThe effect on entry barriers should be significant
Customer foreclosurehExample:U1U2D1D2consumers(U1 mergeswith D1)
Customer foreclosurennnnnUpstream firm threatened by entry. But entry is only profitable if MES isachievedThe perspective of reduced revenue streams may reduce the incentive toinvest (e.g. in product or process innovation) and remain active, therebyleading to lower competitive pressure in the futureIntegration or exclusive dealing with downstream firm precludes entry andintroduces a cost asymmetry downstreamConditionsn Soft competition downstreamn If entrant is more efficient: Incumbent must have a first moveradvantage in negotiationsCompetitive harm generally more delayed and more uncertain: may dependon a sequence of events (absence of counter-strategies, reduced investmentlevels, .).
Restoring monopoly powernA non-integrated upstream monopolist has a serious self-discipline (i.ecommitment) problem which limits its ability to exploit its monopoly power(analogous to durable good monopolies).nnnnIt cannot commit to abstain from secretly discounting to any downstream firm, ina form of post-contractual opportunism.Thus the source of this problem is contractual incompleteness(no contracts contingent on profitability measures and no exclusivity)Through vertical integration a monopolist acquires a direct stake ondownstream profits which allow it to credibly commit not to offer secretdiscounts to rivals.Integration only imperfectly solves this commitment problem because themonopolist cannot commit not to favour its downstream units whenindependent units exist.
Policy relevance of RMPnnVertical integration helps the upstream monopolist to circumvent itscommitment problem and to (credibly) maintain monopoly prices.Empirical validity requires:nnnWeaknesses:nnnnNon-linear pricing is assumed to exclude gains from eliminating doublemarginalisation. Is this always realistic?Contract incompletenessMultiple equilibriaNo explanation of how vertical integration might foreclose an equally efficientcompetitor. This narrows its scope.Vertical integration is not necessary: Exclusive agreements also circumvent theproblem. Implications for policy.Also note that the merger does not restrict competition. It allows the mergedentity to commit to a strategy. It is questionable this should be challengedprovided the monopoly was achieved legitimately.
Conglomerate MergersnnParties are not actual or potential competitorsand they have no actual or potential customersupplier relationshipFocus: significant degree of commonality interms of buyers served. (e.g. complementaryproducts – i.e. more valuable to the buyer whenconsumed together)
Pro-competitive effectsnnnConglomerate mergers generally have no negativeeffects on competition.Due to specialization through division of labour it isoften more efficient that certain components aremarketed together rather than separately.More generally bundling or tying can lead to:nnnCost savings derive from some form of economy of scope(either on the production or the consumption side (e.g. onestop-shop).Value enhancements can result from better compatibility andquality assurance of complementary componentsBut such efficiencies must be merger specific!
Conglomerates are more likely to be neutralthan Horizontal Mergers nBut two reasons to be cautious:Conglomerate effects are more difficult to assessthan horizontal effects.n It also follows that the deterrence effect is lesserthan in horizontal mergers*n*(e.g. assume 50% of HM and 10% of CM are anti-competitive. Mergingparties expect most anticompetitive HM will be challenged so only 10% ofanticompetitive HM are notified. This implies the proportion of notified HMand CG that are anticompetitive is the same (10%)
Anti-competitive effectsnIncreased ability or incentive to:price discriminate (through self-sorting) and therebyextract rents from consumersn engage in exclusionary practices (e.g. foreclosurethrough tying or bundling)nnExample: a conglomerate merger could facilitatebundling and tying or closely analogouspractices such as exclusive dealing or full-lineforcing.
What is Bundling?nSelling two products together in fixedproportions.Pure bundling: products are available only as abundle (technical or commercial)n Mixed bundling, the products are available both on astandalone basis and bundled at a discount(consumers can mix and match components ofdifferent competitors as long as they are compatible).n
What is Tying?nnSelling one product (the tying product) conditional onthe purchase of another product (the tied product).Tying differs from bundling in that:nnnproducts are consumed in variable proportions andit is left to the buyer to decide on the respective quantities(thus the tied good is also available on a stand-alone basis).(e.g.) a requirements tie-in which occurs whenconsumers have to purchase all of their tied goodrequirements in order to buy the tying product. Therequirement might be contractual, or technical.
Rent extraction from consumers(Bundling)nnnBundling enables firms to obtain more consumersurplus from consumers who place different valuationson the separate goodsBy offering a bundle as part of the overall mix ofoptions offered to consumers, a firm may be able tosmooth out variability in demand and capture moreconsumer surplus.This effect is strongest when consumers’ values of theproducts are negatively correlated
Pattern of valuations
ExampleC am eraP rin terB u n d lennnnW illin gness to payN eelie P hilip L o w ri302520101520404040E m il103040If the monopolist sells each product separately it maximizes profits by setting the priceof cameras at 20 and the price of printers at 15.Total profit is 20x3 15x3 105.However it can do much better by selling a bundle at 40. In this case all customerspurchase the bundle and the monopolist efficiently extracts the whole consumersurplus and makes 160.Note the demand curve for each component is clearly downward sloping but thedemand curve for the bundle is perfectly elastic
Rent extraction from consumers(Tying)nnnTying can serve as a metering device (e.g. durable goodthat requires supplies that vary with usage).By marking-up the variable inputs above marginal cost,the seller can price discriminate against intense users ofthe durable good with the sale of variable inputs as ametering or monitoring device for the intensity of use.In most cases of "metering", the tying and tied goodsare complements.
Effects on consumersnNot possible to determine whether in general bundlingor tying for price discrimination reasons harms orbenefits consumers.nnConsumers with relatively inelastic demand will likely face ahigher price if price discrimination occursBut it may increase output by serving consumers that wouldotherwise have been excluded from the marketEast Theaters West TheatersTitanic80003000Star Wars25007000
The Cournot effect(internalizing a pricing externality)ÊÊÊÊBundling is more profitable than offering each componentseparately: lowering the price of one component increases thesale of its own complementary component and not that of rivalmanufacturers.Does not depend on form of demand or cost functionIt does not require for goods to be perfect complementsImplicit assumption: There are linear prices (reflectinguncertainty about customers’ willingness to pay)
Internalising a pricing externality(the Cournot effect)
Importance of the Cournot EffectnCournot effect is larger (i.e. static incentives to bundle increase)ÊÊÊIf system demand is relatively inelastic (but not perfectly)As the size of the bundle increases (and/or components have similar weights)With higher levels of uncertainty about customer valuationsIt is difficult to measure this kind of uncertainty but it is likely to be nonnegligible: No incentive for customers to reveal their willingness to pay duringduring a negotiationPreferences are affected by multiple factors which differ in intensityintensity and relevance indifferent situationsExogenous and unpredictable events as well as innovation continuouslycontinuously alter suchpreferencesHowever because there are rival firms, there will also be a response to a pricecut (in equilibrium). This response may offset the potential gain to themerging firms. (i.e. cross price elasticities matter)
So is bundling anti-competitive?nnNot if there is fierce competition in the market for onecomponent.Chicago School argument in a nutshell:nnnnnthe monopoly price of good A on its own is mthe competitive price of good B is c.If the monopolist were to earn higher profits at price x for a bundle of Aand B, then consider the implied monopoly price m x –c.Since good B is available at c, anyone who buys the bundle is willing topay an incremental price of x-c for A.Were the monopolist to charge x-c for A alone and eliminate the bundle,its demand and, hence, its profits would be at least as large (as there maybe some consumers who do not value good B even at its cost c).
Foreclosure mechanisms oftying/bundlingnnnnCommitment to compete aggressivelySoften competition by enhancing productdifferentiationPrevent sequential entry into the tied and tyingmarketReduce rivals revenues thereby inducing exitor prevent entry
Commitment to compete aggressively and deterentry or induce exitnnnTechnical bundling of a monopolised product with another (the tied good) isa commitment to sell in the future only in a bundled form.This may increase the intensity of competition with future rivals because themerged entity must sell the bundle in order to make profits on themonopolised product.Potential or actual competitor may be unable to reach the necessary scale tooperate profitably in the tied good marketnnnConsumers may be worse off:nnwhen scale economies in the tied good are large enough relative to the market andbundling or tying make the difference between achieving or not adequate scalewhen tied market rivals exit, prices may rise and the level of variety availablenecessarily falls.But commitment (i.e. technical bundling) is necessary as it leads to toughercompetition if foreclosure fails.nIf the competitor has already paid the sunk cost of entry and there is no avoidablefixed cost, bundling cannot be a profitable strategy.
Stark examplenAssumme:ÄÄÄÄnIf the monopolist sells both goods individually, he will cease tosell good B after entry has occurred.ÄnConsumers are homogenous buy a single unitDemand for the two goods A and B is not interrelatedA monopolist can realise profits (rA-cA) (rB-cB)A potential entrant can produce good B at zero marginal costs, whilecB 0 for the monopolist.The entrant's profits are then just cB.Suppose the monopolist offers only a bundle of A and B.ÄÄÄAfter entry he will prepared to offer the whole bundle for a price as lowas cA cB.If the entrant chooses to sell at all, he will realise only the profit cB-(rAcA).By reducing the entrant's profits, bundling makes entry less profitable andthus less likely
Soften competition by enhancing productdifferentiationnnnTechnical bundling may be a way for two competing firms tobetter differentiate their products.Bundling provides a partitioning mechanism to sortheterogeneous consumers into groups with different willingnessto pay.This can lead to price increases in the tying market or in both thetied and the tying market if both markets are imperfectlycompetitive.nnnnE.g. Flight tickets in-flight meals / Fixed phone ADSL / Skis BindingsPositive correlation in valuations strengthens the differentiationeffect of bundling.The competition-mitigating effect of bundling is morepronounced the more items are bundled together.Consumers that mix-and-match may be harmed as the price oftheir most preferred system increases.
Pure Bundling of complementary productsnnnnnAssume a primary good and a complementary goodEntry in the primary market is dependent on the success of entryin a complementary market.While an incumbent monopolist benefits from a competitordeveloping a better component, he will try to avoid thereplacement of the whole system.Technical bundling can reduce the sales of a rival entrant’scomplement.If there are economies of scale this will impede the emergence ofserious competitive threats in the primary market
Pure Bundling of complementary products IInExamples:nnnif consumers’ valuations for the complementary good are anincreasing function of the number of other users (directnetwork effects) then bundling can allow the incumbentimpose the standard in that market.when the value of the tying good in increasing in the numberof varieties of the tied good (indirect network effects)technical bundling can reduce the incentives for rivals tosupply varieties of the tied good compatible with independentsuppliers of the tying good.Consumer welfare may fall if bundling excludes a rivalwith a cheaper or more valuable good.
Mixed bundling of complementary goodsnnnnnMixed bundling of complementary goods may allow the merged firm toexpand market share relative to the situation prior to the merger byinternalising the Cournot effect.Consumers with a preference for the components of the merging firms maygain in the short run as they pay less for the bundle.The merging firms will have an incentive to increase prices of stand-alonecomponents since some consumers will switch from mix-ant-match systemsto the bundled system.Independent rivals would cut price in order to retain some market share.However, they would not cut their prices as much as the merged firm (i.e.their system will remain more expensive than the bundled system of themerged firm).Mixed bundling can thus reduce the profits of rivals unable to counter-mergeor team-up to offer a counter-bundle.
Mixed bundling of complementary goods IInMixed bundling may also be used strategically as a lesscostly means to predate.nnA commitment to pure bundle can also be a powerful meansto predate since it has a stronger negative impact on rivalsprofits.Moreover after a predatory period the merging partiesshall be able to recoup the initial sacrifice by increasingprices significantly, quickly and durably.nOnly then may the short-run benefits to consumers in theform of lower prices be more than offset by future priceincreases in the event of foreclosure.
ChallengesnNeed to show:nnnnnAnti-competitive effect must follows directly from themerger (i.e. it is merger specific). The merger can changeconduct (i.e. merger specificity – e.g. merger creates bundlingopportunity)Future conduct is profitable (i.e. credible & thus likely)Competition is foreclosed or mitigatedConsumers are worse off than in the absence of the mergerUnfortunately there does not exist a set of observablefactors in a constant and robust association with eachof the above steps.
Necessary conditions 1.2.3.4.5.6.7.Market power in at least one of the components in the tie or bundle (tyinggood)The market for the other component (tied good) has basic conditions that areconducive to market power. For example it might be imperfectly competitivedue to economies of scale.There must be a common pool of customers that is large relative to the poolof buyers for either the tying or the tied good separately.The size and profit margins of the tying and tied markets are comparable.The merged entity enjoys a product line unmatched by any competitor.There are no opportunities to resale individual components previouslypurchased as a bundle or tie.Competitors are unable or unwilling to match the tie or bundle either bycounter-merger or teaming-up with each other.
Even then, need to develop a theoryof harmnFollowing the Courts it must be shown on the basis ofconvincing evidence thatnnnThe means and capacities brought together by the transactionmay immediately create conditions allowing the merged entityto engage in exclusionary practices.As a result of the merger, the merged entity has an incentiveto engage in exclusionary practices. This involves showingthat the alleged anti-competitive conduct is profitable for themerged entity, taking relevant incentives and disincentivesinto account.These practices would in the relatively near futuresignificantly impede effective competition in one or more ofthe markets concerned leading to consumer harm
What is convincing evidence?nnnEvidence of past conduct (but this can not as a rule bedeterminativeInternal documents attesting to the intentions toengage in exclusionary practicesAn economic assessment showing that such behaviourwould objectively have been in the merged entity’scommercial interestsnConsider (costs; differentiation among rivals, correlation anddispersion in valuations in both tying and tied good markets;commitment mechanism; dynamics (network or learningeffects, information asymmetries, innovation incentives etc)
Example GE/Honeywell1.Naked predation 2.Honeywell’s product range would benefit from GE Capital’s financial strength tosecure exclusive positionsPost-merger GE’s aircraft leasing arm (GECAS) would buy only (or at leastheavily favor) Honeywell productsMixed bundling of an unrivalled range of complementary products ÊÊIf profitable in a static equilibrium (i.e. no strategic profit sacrifice)Predatory mixed bundling (i.e. short term profit sacrifice)Honeywell would become a dominant supplier of avionics, a market in which italready enjoyed a leading position.The foreclosure effects would allow GE to strengthen its dominant position in thelarge and regional engine markets.
Extent and ability to bundle nRelative to its competitors GE-Honeywell’s ability tobundle is unmatched in terms of:nnnnSize: The combined range of aircraft componentsconstitutes about 1/3 of the price of an aircraftNumber of components: over which the merged firmwould hold a dominant or near-dominant positionAdditional services: GE-Honeywell can further extendthe range of the bundle by adding financial and aftermarket servicesBundling can take various forms (technical orcommercial; pure or mixed)
Two Incentives (Strategies)nnStatic vs. non-strategicDynamic, predatory strategynexplicitly taking into account the likely impact ofcurrent behavior on future market structure(intensity of product market competition, abilityand incentives to invest in R&D)
Static Equilibrium Mixed BundlingEffects§On prices and demandÊʧPrices of mixed bundle and outside system decreases (demandincreases).Price of GE/HW individual components increases (demandfor mix-and-match systems falls)On rival profitability: All rivals in all affected marketslose market share to GE-Honeywell. This is a robustresult.
Predatory mixed bundlingIncentivesnnGE-HW can sacrifice short-term profits by offeringdiscounted bundles to induce rivals to withdraw andstifle competitionNecessary steps to establish incentives:nnnLikely Exclusion: Rivals will exit the market if the mergedentity predatesLikely Recoupment: GE/HW will then increase the price of themixed bundle and thereby recoup the initial sacrificeThe decision contains all the elements but these are notarticulated together.n(in particular predatory mixed bundling and naked predationreinforce each other)
(ii) Withdrawal of rivals aggravates the negative effects on consumer welfare.
Likely ExclusionnFinance is important in the aircraft manufacturing industry:Ê Capital markets do not work efficiently due to asymmetric information (aboutthe likely returns of the proposed investment).Ê In this case a firm’s ability to raise external funding depends on having a sufficientlevel of retained earnings (see §204), §403 asymmetric informationThere are significant differences among competitors in terms of their internalfinancing capabilities. GE has a comparatively much stronger financialpositionÊ large up-front sunk costs, long lead times (see also §110), informationalasymmetryGenerates about USD 15bn annually in cash, Triple A rating, GE capital is notregulated in the same way as other financial and banking institutions, PW (§180183 & § 190); RR(§200-205) ; RC (§302-304) ; HS (§ 323-324)GE-Honeywell can endogenously reduce the funds available to its rivals by (§354) :ÊÊFurther reducing the price of the bundle and/orResorting to (pure) technical bundling (mainly for new generations of productssuch as Electric Aircraft Engine project)
Likely Recoupment(counter-strategies)nCompetitors: It cannot be expected that rivals would be either able or have theincentive to counter-bundle by teaming-up (or counter-merging)No AbilitynnnTransaction cost in defining rentrent-sharing agreement between bundling partnersUnmatchable range of productsLimited number of uncommitted partnersNo IncentivennnCustomers:nnnWith a low market demand elasticity countercounter-bundling is not profitable. There is noprisoners’ dilemma. Instead, a merger confers a firstfirst-movermover-advantage.A counter merger may make no overall commercial senseNeither Airlines nor aircraft manufacturers can be expected to paypay for the public good ofmaintaining competition.Cost pressures and a tough competitive environment make cooperationcooperation difficult andunsustainable.The benefits from increased market power are long-lasting given the low-risk ofnew or re-entry and thus likely to compensate for any (likely small andtemporary) sacrifice in profits.
Vertical mergers h Examples of a vertical relationship: – producer and retailer – car parts producer and car producer – cement producer and concrete producer – electricity producer and distributor h Vertical mergers have implications which differ from horizo
(1) Portfolio effects in conglomerate mergers include potential pro- and anti-competitive effects that might arise due to a merger uniting complementary products in which one or more parties enjoy significant market power. The complementarities featured in conglomerate mergers displaying portfolio effects extend beyond classic economic .
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conglomerate companies is an important form of organizing business in emerging markets. Study of La Porat and others from in 1999, indicates that in the 27 richest countries, with a market capitalization exceeding 500 million, 50% of companies are controlled by families and 40% are in
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