lecture at sydney university - mergers and vertical restraints
TRANSCRIPT
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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
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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
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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
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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
51
Manufacturer A Manufacturer B
Retailer A Retailer B
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Risk of vertical restraints being anti-competitive increases with market power
52
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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