Network Effects and the Efficiency Defense in Mergers among Two-Sided Platforms

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1 Network Effects and the Efficiency Defense in Mergers among Two-Sided Platforms Lapo Filistrucchi University of Florence and TILEC, Tilburg University CRESSE Heraklion,

2 What is a two-sided platform? A firm that acts as a platform and sells two different products or services to two different groups of customers taking into account that demand from at least one group of customers depends on demand from the other group of customers (so that these are not externalities for the firm) while customers of the two groups do not take these indirect network effects into account (so that these are in fact externalities for buyers) So that a two-sided platform - is a particular two-product firm - is different from a firm selling complement products

3 A two-sided platform - II An additional condition is that customers on one side should not be able to pass through completely to customers on the other side an increase in the price they are asked by the platform for the service.

4 Network effects and the efficiency defense in two-sided markets-i Is checking for the incentives to raise prices enough in assessing mergers among two-sided platforms? In a two-sided market, even if prices increase as a result of the merger, consumer welfare might be higher because of the internalization of the (indirect) network effects Network effects work differently than cost efficiencies: cost efficiencies work through prices, network effects increase willingness to pay From an economic point of view one would wish to clear a merger which leads to higher concentration and higher prices but higher consumer welfare So the decision should not be based on a lessening of competition (at least in a traditional interpretation of the word competition) but on a consumer surplus (or total welfare standard) From a legal point of view this does not look at first sight easy as such a merger might indeed seem to lead to less competition.

5 Network effects and the efficiency defense in twosided markets-ii Consider a merger among newspapers Assume you expect the price of an advertising page to increase A simple way is to solve the problem is not to stop at whether the price of an ad will rise or not but ask whether the price per reader would decline As the price per reader takes into account the network effect, this type of efficiency is taken into account when looking at the price per reader Merger between Dutch Yellow Pages in the NL cleared on this ground However, this amounts to assuming a restriction of the demand function. Although the restriction seems justified by business practice in some media markets, it may not apply to other two-sided markets. The issue is whether one could take into account the efficiency from the network effect more generally

6 Network effects and the efficiency defense in two-sided markets-iii Recital 29 of the EU Merger Regulation acknowledges the importance of taking efficiencies into account in the assessment of mergers: In order to determine the impact of a concentration on competition in the common market, it is appropriate to take account of any substantiated and likely efficiencies put forward by the undertakings concerned. It is possible that the efficiencies brought about by the concentration counteract the effects on competition, and in particular the potential harm to consumers, that it might otherwise have and that, as a consequence, the concentration would not significantly impede effective competition, in the common market or in a substantial part of it, in particular as a result of the creation or strengthening of a dominant position.

7 Network effects and the efficiency defense in twosided markets-iv The EU 2010 horizontal merger guidelines at 76: It is possible that efficiencies brought about by a merger counteract the effects on competition and in particular the potential harm to consumers that it might otherwise have.. while at 80: Mergers may bring about various types of efficiency gains that can lead to lower prices or other benefits to consumers. So the EU merger regulation (and horizontal merger guidelines), although not written with two-sided markets in mind, would seem to leave room to take efficiencies from network effects into account. (note however that both in the EU merger regulation and in the EU horizontal merger guidelines there is an assumption that a loss in competition harms consumers)

8 Network effects and the efficiency defense in twosided markets-v Similarly, in the 2010 US horizontal merger guidelines, at 10, provide that: To make the requisite determination, the Agency considers whether cognizable efficiencies likely would be sufficient to reverse the merger s potential to harm consumers in the relevant market, e.g., by preventing price increases in that market It was the same in the 1997 US horizontal merger guidelines, at 4, approved when the literature on two-sided markets was not around yet. So also the US merger guidelines would seem leave room to take efficiencies from network effects into account. Both for the EU and for the US: - Is it the same for direct or indirect network effects?

9 Welfare standard - I Since there are two sides of the market and two groups of customers, there are two producers welfare (e.g. newspaper publishers) two consumers welfares (e.g. readers and advertisers) which are linked. Hence What if the merger leads to lower readers prices and higher advertisers prices? What if the resulting higher amount of readers is not enough to compensate advertisers for the higher prices?

10 Welfare standard - II The EU 2004 Horizontal Merger guidelines provide that: The relevant benchmark in assessing efficiency claims is that consumers will not be worse off as a result of the merger. For that purpose, efficiencies should be substantial and timely, and should, in principle, benefit consumers in those relevant markets where it is otherwise likely that competition concerns would occur. So the benefit should be in the same market where the loss is. It is not possible to trade off (consumer) benefits in one market with a loss in another. Since in a two-sided non transaction market, theory and good practice (Filistrucchi et al. 2014) require that two interrelated relevant markets are defined, the guidelines would require that not the sum of consumer welfare (total welfare) on the two sides but consumer (total) welfare on each side increases This is rather strict. Is it desirable? Does it change matter whether a competition authority has a total welfare standard or a consumer welfare standard?

11 Welfare standard - III Both the 1997 and 2010 US horizontal merger guidelines, at 4 and 10 respectively, provide that: To make the requisite determination, the Agency considers whether cognizable efficiencies likely would be sufficient to reverse the merger s potential to harm consumers in the relevant market, e.g., by preventing price increases in that market So there would seem to be the same problem. However, in both versions there is a note, 36 and 14 respectively: [ ] In some cases, however, the Agencies in their prosecutorial discretion will consider efficiencies not strictly in the relevant market, but so inextricably linked with it that a partial divestiture or other remedy could not feasibly eliminate the anticompetitive effect in the relevant market without sacrificing the efficiencies in the other market(s).[..] This seems to fit well two-sided markets But what about case law?

12 Mastercard 2007: Cardholders versus merchants-1 In the EU a stance on these issues has been taken explicitly, up to the higher court level, in the 2007 Mastercard case COM: There is no reason to assume from the outset that an interchange fee paid by acquirers to issuers increases the utility of the payment card system to both groups of consumers alike. The Commission does not dispute that merchants may benefit through enhanced network effects from the issuing side, but this does not necessarily offset their losses which result from paying inflated merchant fees. In setting a MIF the member banks of a card scheme must guarantee a fair share of the benefits to all customers, not only those that are on the side of the scheme which receives the MIF. In a scheme where the MIF is paid by the acquirer to the issuer, the efficiencies must in particular counterbalance the restrictive effects to the detriment of merchants (and subsequent purchasers). Mastercard has not submitted evidence inthis respect.

13 Mastercard 2007: Cardholders versus merchants-2 GC: It must be concluded therefore that, in the absence of proof of a sufficiently close link between the MIF and the objective advantages enjoyed by merchants, the fact that the MIF may contribute to the increase in MasterCard system output is not, in itself, capable of establishing that the first condition laid down under Article 81(3) EC is satisfied. The applicants also criticise the Commission for failing to take into account the advantages to cardholders that arise from the MIF and, moreover, for acting as a price regulator in respect of the MIF.

14 Mastercard 2007: Cardholders versus merchants-3 With regard to the first criticism, it is indeed settled case-law that the appreciable objective advantages to which the first condition of Article 81(3) EC relates may arise not only for the relevant market but also for every other market on which the agreement in question might have beneficial effects, and even, in a more general sense, for any service the quality or efficiency of which might be improved by the existence of that agreement... However, as merchants constitute one of the two groups of users affected by payment cards, the very existence of the second condition of Article 81(3) EC necessarily means that the existence of appreciable objective advantages attributable to the MIF must also be established in regard to them.

15 Mastercard 2007: Cardholders versus merchants-4 AG : It is the consumers that suffer the harm caused by the restrictive effects of the agreement at issue that must, in principle, be allowed, as compensation for that harm, the fair share of the benefit resulting from the agreement referred to in Article 81(3) EC. In fact, if it were possible to take into consideration the advantages resulting from an agreement for one category of consumers of certain services in order to counterbalance the negative effects on another category of consumers of other services on a different market, that would amount to allowing the former category of consumers to be favoured to the detriment of the latter category. However, distributive logic of that type seem to me, in principle, to have no connection with the practical scope of competition law.

16 Mastercard 2007: Cardholders versus merchants-5 Competition law is intended to protect the structure of the market, and thus competition, in the interest of competitors and, ultimately, consumers in general. Conversely, it is not intended to favour one category of consumers to the detriment of a different category. In that regard, I must further observe that those considerations are not necessarily inconsistent with the settled case-law of the General Court, according to which it is not excluded that it may be possible to take into consideration the advantages resulting from the agreement that occur on a different market from that on which the agreement produces the restrictive effects. Such advantages may be taken into consideration where, for example, the category of consumers affected by the agreement on the two separate markets is the same.

17 Mastercard 2007: Cardholders versus merchants-6 ECJ: [ ] it must be held that, in the light of what has been stated in paragraphs 234 to 236 of the present judgment, the General Court was, in principle, required, when examining the first condition laid down in Article 81(3) EC, to take into account all the objective advantages flowing from the MIF, not only on the relevant market, namely the acquiring market, but also on the separate but connected issuing market. It follows from this that, should the General Court have found that there were appreciable objective advantages flowing from the MIF for merchants, even if those advantages did not in themselves prove sufficient to compensate for the restrictive effects identified pursuant to Article 81(1) EC, all the advantages on both consumer markets in the MasterCard scheme, including therefore on the cardholders market, could, if necessary, have justified the MIF if, taken together, those advantages were of such a character as to compensate for the restrictive effects of those fees.

18 Mastercard 2007: Cardholders versus merchants-7 ECJ: [ ] it must be held that, in the light of what has been stated in paragraphs 234 to 236 of the present judgment, the General Court was, in principle, required, when examining the first condition laid down in Article 81(3) EC, to take into account all the objective advantages flowing from the MIF, not only on the relevant market, namely the acquiring market, but also on the separate but connected issuing market. It follows from this that, should the General Court have found that there were appreciable objective advantages flowing from the MIF for merchants, even if those advantages did not in themselves prove sufficient to compensate for the restrictive effects identified pursuant to Article 81(1) EC, all the advantages on both consumer markets in the MasterCard scheme, including therefore on the cardholders market, could, if necessary, have justified the MIF if, taken together, those advantages were of such a character as to compensate for the restrictive effects of those fees.

19 Mastercard 2007: Cardholders versus merchants-8 ECJ: However, as is recalled in paragraph 234 of the present judgment, examination of the first condition laid down in Article 81(3) EC raises the question whether the advantages derived from the measure at issue are of such a character as to compensate for the disadvantages resulting therefrom. Thus, where, as in the present case, restrictive effects have been found on only one market of a two-sided system, the advantages flowing from the restrictive measure on a separate but connected market also associated with that system cannot, in themselves, be of such a character as to compensate for the disadvantages resulting from that measure in the absence of any proof of the existence of appreciable objective advantages attributable to that measure in the relevant market, in particular, as is apparent from paragraphs 21 and 168 to 180 of the judgment under appeal, where the consumers on those markets are not substantially the same.

20 Mastercard 2007: Cardholders versus merchants-9 ECJ: In the present case, and without any distortion having been claimed in that regard, the General Court concluded in paragraph 226 of the judgment under appeal that there was no proof of the existence of objective advantages flowing from the MIF and enjoyed by merchants. In those circumstances, it was not necessary to examine the advantages flowing from the MIF for cardholders, since they cannot, by themselves, be of such a character as to compensate for the disadvantages resulting from those fees.

21 Welfare standard - IV According to the ECJ ruling on Mastercard, some benefits should be in the same market where the damage is when the category of consumers is not the same or when the consumers are not substantially the same In some cases defining customers on the two-sides as of different categories may be more problematic (e.g. night clubs or virtual market places) In fact, think of the aggregation implicit in the definition of consumers surplus (e.g. Bill Gates and me) It seems however that, according to the ECJ, while benefits should be present on both sides of the market, they need not compensate the harm on each side of the market (quite ambiguous) In the payment card case it may not be so relevant if market definition is correctly carried out (i.e. a single market is defined as mentioned above) Hence the ECJ decision, despite referring to the payment card case, should be seen as mainly relevant for media markets and other two-sided non-transaction markets

22 Conclusions The EU seems to have adopted a strict approach for taking into account efficiencies from indirect network effects (though maybe not as strict as often claimed) The US instead seems to have adopted a less strict one However, also in the EU, despite the ECJ decision on Mastercard, efficiencies from indirect network effects may be taken into account more often than it seems at first sight if market definition is correctly carried out Also because there is a strong economic incentive to move towards transaction platforms also in the media markets and the futher development of digital technologies (consumers tracking and algorithms) may help to move in this direction