Mergers and acquisitions spark ongoing controversy in the economics profession

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1 Economic Perspectives Volume 1, Number 2 Fall 1987 Pages 3 12 Symposium on Mergers and Antitrust Steven C. Salop Mergers and acquisitions spark ongoing controversy in the economics profession and in society at large. This is not surprising. Billion dollar deals not only involve a great deal of money, but they often raise economic issues implicating capital and labor markets as well as the markets for the products sold by the merger partners. Because of this, merger enforcement is probably the most widely known area of antitrust. However, economists who do not specialize in industrial organization generally have little understanding of the type of competitive analysis that forms the basis for merger enforcement by the antitrust authorities and the courts. This is unfortunate. Not only does this analysis have important social implications, but when formulated rigorously, the analytic model used in antitrust represents a simple, yet quite sophisticated, microeconomic model of competition. In the past ten years, economics and economists have become far more important in antitrust. The so-called "Chicago school" of antitrust has provided the intellectual rationale for a considerable loosening of antitrust law. Its intellectual leaders, for example, Robert Bork, Richard Posner, and Frank Easterbrook, have become judges and soon may ascend to (or already have joined) the Supreme Court. Economists like James Miller and George Douglas have become Federal Trade Commissioners, and the staff economists at the Commission and the Department of Justice have gained considerable influence. Steven C. Salop is Professor of Economics at the Georgetown University Law Center, Washington, D.C.

2 4 Economic Perspectives The Journal of Economic Perspectives organized this symposium to provide economists who do not specialize in industrial organization and policy makers now considering reform proposals with a better sense of the type of competitive analysis carried out in evaluating mergers and the controversies involved in proposals to reform merger law. The Journal asked three mainstream industrial organization economists to comment on both current merger enforcement and merger reform proposals: Lawrence White, Franklin Fisher, and Richard Schmalensee. Lawrence White was one of the authors of the 1982 Department of Justice Merger Guidelines that now provide the basic analytic framework for mergers, if not all of antitrust regulation. White was the Federal Trade Commission's expert economist in the recent litigation that blocked the proposed acquisition of Dr Pepper by Coca-Cola. He is currently a board member of the Federal Home Loan Bank Board. Franklin Fisher is a former Clark Award recipient in econometrics who now specializes in industrial organization. In antitrust, he is probably best known for his spirited defense of IBM in the various antitrust cases brought against it. Richard Schmalensee has written extensively about industrial organization and antitrust, including important papers on advertising, brand reputation and market power. He has been an expert economist in a number of cases, including the Federal Trade Commission's case against Kellogg and other major cereal companies. U.S. Merger Policy United States merger policy is mainly carried out by the Department of Justice (DOJ) and Federal Trade Commission (FTC). Under the Hart-Scott-Rodino Pre- Merger Notification Act, an acquiring firm with assets or sales in excess of $100 million must report all proposed acquisitions of assets valued in excess of $15 million to these agencies. A merger cannot be consummated until one of the agencies has evaluated its likely effects on competition. If a problem is found, the merging parties can either withdraw the proposal, negotiate a method of alleviating the agency's concern (for example, by selling off a plant or an entire division), or litigate the acquisition's legality. Very few cases are litigated. Between 1982 and 1986, the FTC and DOJ brought enforcement actions against only 56 mergers out of the more than 7700 reported. 1 Mergers are evaluated under Section 7 of the Clayton Act. A merger is considered illegal if it "substantially decreases competition or tends to create a monopoly." Thus, Section 7 is concerned with market power in its incipiency. This "incipiency standard" is controversial because it could be, and in the past was, interpreted very broadly. For example, in the 1962 Brown Shoe case, the government blocked a merger 1 See Antitrust & Trade Regulation Reporter, March 5, 1987, vol. 52, page 452. Private parties (customers, suppliers or competitors) and states also can sue to block a proposed merger. Because of the federal government's primary role in the process, however, private and state litigation generally has little significance. However, more cases are being brought by private parties, often successfully, since the government has so relaxed its merger enforcement.

3 Salop 5 between Brown Shoe and Kinney Shoe. Brown and Kinney were ranked third and eighth in the industry. Although the firms' market shares were low, the Supreme Court was concerned that, "if a merger achieving 5% control were now approved, we might be required to approve future merger efforts by Brown's competitors seeking similar market shares. The oligopoly Congress sought to avoid would then be furthered and it would be difficult to dissolve the combinations previously approved." Both Brown and Kinney were retailers as well as manufacturers. The Court also was concerned about the trend to both horizontal consolidation and vertical integration and treated the potential efficiency benefits of the merger as a rationale for blocking it. Four years later in the Von's Grocery case, the Supreme Court held illegal the merger of Von's Grocery and Shopping Bag, the third and sixth largest supermarket chains in the Los Angeles area. The firms had a combined market share of only 7.5 percent. Yet the Court was concerned with the "trend towards concentration" in the market, as indicated by the fact that the number of owners of single ("mom and pop") stores fell from approximately 5300 in 1950 to 3600 in In Justice Stewart's dissent, in which he concluded that there were no substantial entry barriers into grocery retailing, he wrote: "The sole consistency that I can find is that in litigation under Section 7, the Government always wins." Reflecting this concern about incipient market power, the 1968 Merger Guidelines stated the intention of the Department of Justice to attack mergers in concentrated markets where the combined share of the parties was as low as 8 percent. These market share standards were controversial even then. The trend cited by Justice Stewart was reversed beginning with the 1974 General Dynamics case. 2 In that decision, in permitting the merger, the Court opened the door to detailed analysis of variables other than concentration and market shares. In 1982, the Department of Justice issued new Merger Guidelines to reflect the current state of the law. However, the 1982 Guidelines made a more fundamental contribution than simply updating the market share standards. 3 They also set out a unified conceptual framework for analyzing the competitive effects of horizontal mergers, a framework that reflects industrial organization economics more closely. While important aspects of the Guidelines are quite controversial among economists, most economists agree that the basic framework is an exceedingly useful analytical tool, not just for merger policy, but for much of industrial organization economics. 4 2 This case involved the merger of two coal companies, one of which had already contractually committed itself to sell the bulk of its reserves. The coal companies argued that calculating market shares and concentration without taking into account the fact that most of the reserves already were committed gave a misleading impression of the power of the two firms. The Supreme Court agreed, holding that market share and concentration statistics may be rebutted with other evidence. 3 The Guidelines were revised again in 1984, although not dramatically. Some of the most significant revisions are discussed later in this introduction. 4 The Department of Justice's far more controversial Vertical Merger Guidelines, issued at the same time, are not discussed in the Symposium. For a recent critique of these standards, see Krattenmaker, Thomas, and Steven C. Salop, "Anticompetitive Exclusion: Raising Rivals' Costs to Gain Power over Price," Yale Law Journal, December 1986, 96,

4 6 Economic Perspectives The Merger Guidelines only reflect Department of Justice enforcement policy, not the law itself. They do not represent legal precedent, even though they do influence courts. The Reagan Administration has proposed amending the Clayton Act to alter substantive merger law. The amendment would have two main effects. First, it would require analysis of variables other than concentration, notably entry barriers and efficiency benefits. This change is intended to mandate by statute the basic approach taken in the Merger Guidelines. Second, the amendment would eliminate the "incipiency standard" of illegality by deleting the "tend to create a monopoly" language of Section 7 of the Clayton Act. This change would raise the evidentiary standard for proving market power above the levels of Von's Grocery and Brown Shoe. The amendment is apparently also intended to mandate enforcement at the current or at a somewhat more permissive level. Perhaps most significantly, it is intended to permit potential cost savings to justify increases in market power. The purpose of this symposium is to evaluate current merger policy and reform proposals and to set out economists' "best practice" of merger evaluation. To this end, the symposium participants analyze the Department of Justice Guidelines and the proposals for reforming them. The symposium also highlights the issues on which policy makers should focus in judging reform proposals. Basic Merger Analysis The Department of Justice Horizontal Merger Guidelines are not concerned with aggregate industrial concentration as measured, for example, by the share of the economy's assets owned by the largest 500 corporations. They focus only on the likelihood that a merger may create or increase market power: that is, the ability to set price above the competitive level. The Guidelines are built on the premise that collusion, either in the form of a "hotel room" conspiracy or tacit coordination, is less likely to succeed in less concentrated markets, in markets where few entry barriers exist, and in markets where competitive price cuts are more difficult for rivals to detect rapidly. The Guidelines are premised on the recognition that significant cost savings can flow from mergers and acquisitions, and enforcement standards governing concentration and ease of entry should be set accordingly. The degree to which potential cost savings should count as an offset and therefore permit mergers that create or increase market power is more controversial. To evaluate the possible competitive impact of a horizontal merger, the Guidelines set out a five-part protocol. First, a relevant market is determined for evaluating competitive effects. Second, concentration in the market is calculated, using the Herfindahl-Hirshman Index (HHI). The HHI is defined as the sum of squared market shares of the firms in the market, where market shares are treated as whole numbers, not fractions. The possible values for the HHI range from zero for an industry with an infinite number of tiny firms to 10,000 for a single firm monopoly

5 Symposium on Mergers and Antitrust 7 market. 5 Third, the likelihood of entry into the market is evaluated. Fourth, other competitive factors that might affect the likelihood of successful collusion are evaluated, including producer information exchanges and contracting practices. Fifth, any efficiency benefits, primarily cost savings, are analyzed. These five elements then are balanced. Most economists agree that this five-part protocol is a reasonable way, in the words of Franklin Fisher, to organize the data. It is the weights the Guidelines place on these factors in this balancing, and the methodology by which to measure the factors, that are disputed. The Guidelines measure market concentration and ease of entry in the context of a "relevant antitrust market," defined on the basis of the own-price elasticity for a set of products (and geographic area). In particular, a relevant antitrust market is defined as a set of products and geographic area, such that if all the production capacity in the set were owned by a single firm (a "hypothetical monopolist"), that firm profitably could raise price by at least some percentage (for example, 5 percent or 10 percent) above the current (not necessarily competitive) level for a "significant non-transitory" time period. This methodology is referred to as the "5 percent (or 10 percent) test" and is the key concept of the Guidelines. In evaluating the profitability of a price rise, the Guidelines evaluate the potential for substitution by buyers to other products ("demand substitution") and capacity switchovers by sellers of other products ("supply substitution"), as well as substitution to producers whose plants are located in other places ("geographic diversion") that would occur within 12 months in response to the price increase. The Guidelines evaluate "ease of entry" in a similar way. Entry is considered "easy" if, in response to the hypothetical price increase, enough new capacity would be brought on line within 24 months to render the price rise unprofitable. By defining market power as the ability to raise prices, the administration reform proposal would support this approach to market definition and ease of entry. According to the Guidelines, ease of entry and market concentration are given the most weight. Indeed, in the 1982 Guidelines, efficiencies and other factors were treated as "tiebreakers" that only came into play in otherwise "close" cases. Ease of entry could be considered the primary variable, in that "easy entry" can justify even merger to an apparent monopoly, where the "monopolist" is actually constrained by many potential entrants; consider a merger between the only two taxicab companies in a town where no medallion or reputation is required to compete. If entry is not "easy," primary focus then is placed on market concentration. Once markets are defined, concentration is relatively easy to measure, and according to many economists, higher concentration raises the likelihood of successful (tacit or 5 For example, if an industry is comprised of one firm with 80 percent and two firms with 10 percent each, the HHI would equal 6600 (that is, (80) 2 + (10) 2 + (10) 2 ). For an industry comprised of N equal-sized firms, the HHI = 10,000 N. The Herfindahl-Hirshman Index replaced the Four- and Eight-Firm Concentration Ratios (that is, the aggregate market share held by the top four or eight firms) used in the 1968 Guidelines and major court decisions. In practice, these concentration indices are highly correlated.

6 8 Economic Perspectives express) collusion. According to the DOJ Guidelines, if the post-merger HHI remains below 1000, the DOJ threshold for an "unconcentrated" market, all mergers are permitted, despite entry barriers or other factors. In the parlance of enforcers, the HHI of 1000 is a "safe harbor." A post-merger HHI of 1800 defines the threshold of a "highly concentrated" market. If the post-merger HHI exceeds 1800 and entry is not "easy," the DOJ "generally" will attempt to block mergers that increase the HHI by at least 50 points, and will attempt to block mergers that increase the HHI by more than 100 points, except in "extraordinary cases." 6 Mergers with HHI's in the "gray area" between 1000 and 1800 will only be blocked if they would raise the HHI by at least 100 points. In this gray area, ease of entry and other factors are given the most weight. Even if concentration and entry barriers both are high, noncompetitive pricing is not a certainty. Sophisticated buyers may utilize long term contracts to destabilize collusive agreements, and product heterogeneity and the potential for secret price cuts may reduce the likelihood of successful collusion. On the other hand, information exchanges among producers and (ironically named) "buyer protection" clauses such as most-favored-customer and meeting competition provisions may increase the likelihood that oligopolistic pricing coordination will succeed. In the Guidelines, these "plus" and "minus" factors are taken into account in "close" cases. Some observers claim that, in recent practice, merger policy has been made some what more permissive by giving more weight to those "minus" factors that reduce the likelihood of successful coordination. The administration bill, by eliminating the "incipiency standard," would tend to increase further the weight placed on the "minus" factors. Finally, under the 1984 revisions of the Guidelines, mergers likely to raise prices will be permitted nonetheless if the parties can demonstrate by "clear and convincing evidence" that the merger is "reasonably necessary" to create significant cost savings or other efficiency benefits. These benefits include achieving economies of scale as well as direct technological improvements. By the "reasonably necessary" standard, the Guidelines will not consider efficiencies achievable by means short of merger. In that case, a competitively troublesome merger need not be permitted because the cost savings will be achieved anyway. Where a merger is reasonably necessary for achieving efficiencies, the Guidelines do not state how cost savings and monopoly price increases should be balanced. This balancing issue is important and quite controversial. Even modest cost decreases would swamp any short run deadweight losses from monopoly pricing, if the Department of Justice were indifferent to the distribution of the gains between consumers and stockholders and cared only about total social welfare. In the parlance of antitrust, the issue is a matter of interpreting "consumer welfare" (and "competition") either to mean the welfare of purchasers of the products or to mean aggregate 6 The Guidelines also contain a "leading firm proviso." No acquisition of a firm with a market share exceeding 1 percent is permitted for the leading firm in the industry, if the market share of the leading firm exceeds 35 percent.

7 Salop 9 economic efficiency. 7 The controversy has become sharper because the administration leans to the latter interpretation, while most courts seem generally to favor the former. Issues for Analysis This conceptual framework raises two difficult questions. How should these variables be measured and, once measured, how should they be weighted? In practice, what might appear initially to be purely a measurement issue also may imply an enforcement standard, which creates a significant problem for the policy maker. For example, by defining a relevant antitrust market according to the degree of substitution within twelve months rather than six months, markets will be defined more broadly and this expansion of the market definition will, as a general matter, tend to permit more mergers. 8 That permissiveness can be offset, of course, by tightening either the concentration or entry standards. This choice raises a difficult balancing issue. What is the correct mix: to define markets tightly and set high concentration thresholds or vice versa? These basic issues are the ones that face economists and policy makers in evaluating merger enforcement and merger reform. These are the controversies the participants were asked to address. To focus their analysis, we also posed a number of specific questions. These questions provide a framework for analysis. They may well be useful to readers in forming their own opinions and organizing their own thoughts. 9 Market Definition 1. How should relevant antitrust markets be defined? What initial price should be used as the benchmark in the test? The Guidelines' use of the current price as the benchmark has been criticized as preventing deterioration of the competitive environment, but placing no weight at all on the potential for increased competition in the future. 10 This issue also forms part of the question of the appropriate legal standard for evaluating the likelihood of anticompetitive effects. 7 By training, economists might lean to the aggregate efficiency standard, at least initially. After all, economics purports to have little insight into the "proper" distribution of wealth. But simply because economic theory has little to contribute does not mean that society should be indifferent to the distribution, where losers are not compensated for their losses by winners. For example, consider a worker who steals $100 from a capitalist and invests the proceeds at a higher return than the capitalist earned. Would the higher social return justify the involuntary transfer? 8 Lawrence White stresses the exceptions to this generalization in his article. 9 Also, teachers may wish to use these questions to organize class discussion or formulate examination questions. 10 In this regard, the Guidelines are accused of committing the "cellophane fallacy." In the 1956 case against Du Pont, the Supreme Court held that cellophane was not a relevant market, and Du Pont had no market power, because at current prices, any further cellophane price rises would be constrained by competition from other flexible wrappings. This conclusion was fallacious, of course. The fact that no further price rises were possible does not mean that the market was competitive. Rather, perhaps Du Pont could raise price no further because it already was charging the monopoly price. The DOJ's use of the current price as the benchmark arises from a policy judgment that merger policy only should prevent

8 10 Economic Perspectives 2. Some commentators claim that while the "5 percent test" approach looks good on paper, it has failed in practice for two reasons. First, it is so hypothetical (hypothetical buyers and competitors with perfect information responding to a price rise by a hypothetical monopolist) that the result generally will be entirely subjective. As a result, it gives the agency enormous discretion. This is, of course, in striking contrast to the concreteness of the HHI levels. Put another way, the apparent concreteness of the HHIs is dissolved by the mushiness of the 5 percent test. Second, and based on the first point, critics have claimed that the agencies have administered the test in practice to broaden markets far beyond practical boundaries by accepting weak subjective evidence of potential substitution instead of insisting on "hard evidence" of actual substitution. Have the DOJ and the FTC been defining markets too narrowly or too broadly? Has the evidentiary standard been too low? Should the agencies be constrained to use only "hard evidence" of actual or very likely substitution? 3. The 1982 Guidelines specified a 5 percent price test. The 1984 Guidelines contemplate larger price increases as well. It has been suggested that, in practice, the Department of Justice has now increased the price percentage to 10 percent, instead of 5 percent. In general, this change would broaden markets and lead to less enforcement. Which is the better test, 10 percent or 5 percent? 4. How should foreign competition be included in the merger analysis? At one extreme, some commentators would ignore foreign capacity altogether on the grounds that the potential for exogenous exchange rate changes and the chance of tariffs and quotas make the prospects for increased foreign competition too risky. At the other extreme, some argue that if the domestic market has any imports at all, then the entire foreign capacity could be diverted to the United States if prices rose to noncompetitive levels. Should imports be treated identically with domestic capacity, if no quotas exist? If quotas do exist, how should foreign capacity be included in the analysis? Market Concentration 5. Some economists conclude that the "new industrial organization learning" demonstrates that although market concentration may be easy to calculate, it has no predictive value. They say that absolutely no weight should be placed on concentration, that it should be ignored in evaluating mergers. How should concentration enter the analysis? 6. Market definition and concentration are related, of course. As a practical matter, the broader the market definition, the lower market concentration will tend to be. What threshold concentration levels for enforcement guidelines are implied by the optimal market definition? 7. Some evidence suggests that the enforcement agencies in the current administration have brought almost no cases where the HHI is below 1800, the threshold defining "highly concentrated" markets. Is this a beneficial policy change? additional market power and not serve also to preserve the possibility of dissipating already exercised market power.

9 Symposium on Mergers and Antitrust 11 Ease of Entry 8. The DOJ Guidelines do not discuss the determinants of ease of entry in any detail. How should ease of entry be measured in merger analysis? George Stigler defined an entry barrier as limited to costs that entrants (but not incumbents) must bear, while Joe Bain's definition includes the potential entry-deterring effects of "post-entry" price competition. In particular, should the presence of significant scale economies and sunk costs that are identical for all firms be treated as impediments or barriers to entry? What about advertising and reputation? 9. Similarly, despite the weight placed on ease of entry in the Guidelines, the Justice Department did not attempt to devise a method for grading ease of entry into categories (such as low, moderate and high barriers), comparable to the current grading system for market concentration. Should such a grading system be designed to facilitate quantitative analysis of this crucial variable? 10. In evaluating the likelihood of unilateral output reductions and tacit collusion, how much weight should be placed on ease of entry? Should merger to monopoly be permitted in those situations where entry is "very" easy? "Plus" and "Minus" Factors 11. Should evidence about competitive factors relating to contracting practices and information be used as "tiebreakers," or should these factors be weighted more or less heavily? In the extreme, could it be argued that the use of long term contracts by industrial buyers should make any merger short of a true single firm monopoly permissible, regardless of concentration or even ease of entry, on the grounds that sophisticated buyers can devise means of maintaining competition even if only two firms are bidding? Efficiencies 12. How should cost savings and other efficiency benefits be reckoned into merger analysis, if at all? Should cost savings be evaluated in each case or should likely cost savings (on average) be used only in setting overall enforcement thresholds? Can sufficiently credible cost savings information be generated during the short pre-merger screening period to make case-by-case evaluation useful? What should be the evidentiary standard on the merger partners? What should be the benchmark for defining when a merger is "reasonably necessary" to achieve cost efficiencies a comparison with the unmerged status quo or some less restrictive hypothetical alternative like licensing, alternative merger partners, or a joint venture? 13. In specifying the general standard for evaluating claims of cost savings, should the criterion be indifferent to wealth transfers from purchasers to stockholders? That is, should a merger likely to produce cost savings be permitted even if it also leads to market power and higher prices, if the cost savings exceed the deadweight loss triangle? How should considerations of dynamic rent-seeking and innovation incentives be included in the analysis?

10 12 Economic Perspectives Balancing 14. In summary, do the DOJ Guidelines place the correct relative weights on the five factors? Should more or less weight be placed on some of the variables? What are the appropriate enforcement thresholds? Stated another way, what are optimal Merger Guidelines? Should the "incipiency standard" be eliminated altogether or simply interpreted less expansively than in Brown Shoe and Von's Grocery? 15. Current merger policy clearly is more permissive than in previous administrations. As a general matter, has the current administration gone too far or not far enough in loosening merger enforcement? Using these questions as a basic framework, each participant was asked to set out his own analysis. The drafts then were circulated among the participants so they could sharpen their disagreements or achieve consensus in their revisions. Note Many economists may be unfamiliar with the court cases and legal citations that recur throughout this introduction and symposium. Probably the easiest way to collect the relevant material is by using an antitrust casebook. One good example is Handler, et al., Trade Regulation: Cases and Materials. 2nd ed. Mineola, NY: Foundation Press, This book (like other such casebooks), contains the text of the Clayton Act, the Department of Justice Merger Guidelines, and key court cases like Brown Shoe, Von's Grocery, General Dynamics, and Du Pont. Thomas Krattenmaker and the symposium participants provided helpful comments.