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Review of Professor Church’s Report on the Impact of Vertical and
Conglomerate Mergers on Competition
By James Cooper1, Luke Froeb2, Daniel O’Brien3, and Michael Vita4
ABSTRACT: In this article, and the rejoinder that follows, Professor Church’s report to
the European Commission on the effects of vertical restraints and mergers is discussed.
While thorough and accurate, the report could be misinterpreted by practitioners.
I. Background
In 2003 the European Commission’s Merger Task Force commissioned a study on
the Impact of Vertical and Conglomerate Mergers on Competition. The purpose of the
report was to synthesize the relevant economic literature and to provide a foundation for
an appropriate antitrust policy. The contract was awarded to Professor Jeffrey Church of
the University of Calgary who finished the report September of 2004. It was published
on DG Comp’s website in February of 2005.5
About six months later, the European Commission published a report from the
antitrust subgroup of the Economic Advisory Group for Competition Policy6, a "group of
distinguished academic economists” advising DG Comp who argued for an “economic”
approach to enforcement of Article 82 based on the effects of the practice, rather than on
its form (for example, exclusive dealing, tying, etc.). The report came with a disclaimer
that it does not “present DG COMP’s position.”
In September of 2005, Commissioner Nellie Kroes gave a speech7 at the Fordham
Conference in New York in which she appeared to endorse an “effects” based reform of
Article 82. The speech was immediately hailed in the Financial Times and the Wall St.
Journal as a long overdue change in policy towards protecting “competition rather than
competitors,” but Commissioner Kroes explicitly stated that it was not her intention to
propose a radical shift in enforcement policy.
Commission watchers are eagerly anticipating the announced “review” of Article
82. What form this review will take is not clear, but it would presumably draw on
Professor Church’s report and on the report of the Economic Advisory Group. In this
article, and the rejoinder that follow, we discuss Professor Church’s review of the
academic literature on the effects of vertical restraints and mergers and its implications
for policy.
II. Critique of Church Report
1
Attorney, Office of Policy Planning, US Federal Trade Commission.
William Oehmig Associate Professor of Management, Vanderbilt University.
3
Chief,Regulatory Section, Economic Analysis Group, Antitrust Division, US Dept. of Justice
4
Associate Director, Bureau of Economics, US Federal Trade Commission
5
http://europa.eu.int/comm/competition/mergers/others/#study
6
http://europa.eu.int/comm/competition/publications/studies/eagcp_july_21_05.pdf
7
http://europa.eu.int/rapid/pressReleasesAction.do?reference=SPEECH/05/537
2
1
Professor Church’s Report provides a great service by reviewing thoroughly the
theoretical literature on non-horizontal mergers. The Executive Summary, at over 50
pages, is itself a fairly comprehensive survey of the literature. The entire report (over
300 double-spaced pages) covers the literature in greater detail and could easily be made
into a monograph on non-horizontal mergers. In addition to reviewing the literature,
Professor Church also sets out a framework for the antitrust analysis of the competitive
effects of non-horizontal mergers.
Although we believe that Professor Church offers a thorough and accurate review
of the literature, we are concerned that some antitrust practitioners— for example,
attorneys who lack a strong economic background—may interpret (or more accurately,
misinterpret) the policy implications of the report. In particular, we believe that the
report could benefit from clarifying three basic principles: (1) vertical integration
presents a possible antitrust concern only if it reduces welfare (total or consumer); (2)
welfare can be reduced only if market power (discussed in greater detail below) is
present; and (3) there exist efficiencies intrinsic to vertical integration in many settings
where vertical integration is viewed as potentially harmful to welfare.
The remainder of this comment is organized as follows. In Section II we
summarize Professor Church’s review of the literature. In Section III we discuss his
definition of “antitrust concern,” and in Section IV we examine his proposed framework
for analyzing non-horizontal mergers. Section V concludes.
II. Professor Church’s Review of the Literature
Professor Church reviews dozens of theoretical papers that identify potential
sources of competitive harm (and, necessarily, competitive benefit) from non-horizontal
mergers. A nice feature of the review is that he discusses the theories in depth, in many
cases with a simplified set of equations to assist in the exposition.8 He also highlights
some of the theories in the executive summary. We recommend the main body of the
review to anyone seeking insight into the intricacies of the various theories. A reader
interested in the key ideas, but not the fine details of the specific theories, can read the
executive summary. The “Frequently Asked Questions” section also does a good job
providing information about the effects of non-horizontal mergers.
Professor Church begins his discussion of vertical mergers by summarizing the
old “Chicago” contention that concerns about the competitive implications of vertical
mergers are misplaced (i.e., that “there is only one monopoly profit”). He notes correctly
that this conclusion rests on restrictive assumptions, and that vertical mergers can reduce
welfare when these assumptions do not hold (e.g., if inputs are used in variable rather
than fixed proportions, or if there are multiple downstream uses of the product
(motivating pricing discrimination)). He argues, however, that “these situations . . . did
not suggest a compelling rationale for widespread concern over the competitive effects of
vertical mergers.” (p. v)
8
In this manner, Professor Church’s report resembles Tirole’s (1988) IO text.
2
Professor Church then turns to more recent theories that analyze vertical mergers
when competition is imperfect at both the upstream and downstream levels, arguably a
more realistic setting than the pure monopoly upstream/perfect competition downstream
assumptions employed in earlier analyses. In a useful distinction, he classifies
anticompetitive theories as involving “raising rivals costs” (RRC), which typically
involves input foreclosure, and “reducing rivals revenues” (RRR), which typically
involves customer foreclosure. In what follows, we focus on his review of RRC models.
Professor Church divides the RRC theories according to whether the downstream
market is characterized by strategic complements (e.g., differentiated Bertrand) or
strategic substitutes (e.g., homogeneous Cournot).9 He lists the implications of the RRC
theories for strategic substitutes, highlighting the tradeoff between the elimination of
double marginalization and the (possible) incentive to supply less to unintegrated rivals.
10
Specifically, he notes that the welfare effects of vertical mergers depend on the
credibility of complete foreclosure, which occurs when the integrated firm sells nothing
to unintegrated rivals. He notes that complete foreclosure might be credible if integration
allows for adoption of a specific technology. Professor Church observes that the
profitability of adoption of the specific technology is ambiguous, but he states that if the
downstream market is concentrated, “the trade-off favors foreclosure.” He also states
that “if complete foreclosure is not credible, then increasing the extent of vertical
integration is efficiency-enhancing and leads to lower prices for consumers.” For this
statement he has in mind papers like Gaudet & Long (1996), which relaxes Salinger’s
(1988) assumption that downstream firms are price-takers in the input market. In this
case, complete foreclosure does not occur, and vertical integration turns out to enhance
welfare. On the other hand, in models like Salinger’s, where complete foreclosure
occurs, vertical integration can be either harmful or beneficial.
Professor Church further writes “when complete foreclosure is credible and entry
is not an issue, the welfare effects are in general ambiguous and difficult to assess ex
ante.” The problem is the tradeoff between the benefits of eliminating double mark ups
and the harm that occurs if price rises to unintegrated rivals.11 He observes that welfaredecreasing integration “is only profit maximizing if it results in the elimination of the
wholesale market and exclusion of unintegrated downstream firms and only then if there
are relatively many such firms which are excluded.” Professor Church also notes that
Strategic complements and substitutes are the “normal” cases for Bertrand and Cournot competition,
respectively.
9
10
The reviewed literature started with Salinger (1988) and includes Gaudet & Long (1996), Schrader and
Martin (1998), Higgins (1999) and Avenel and Barlet (2000).
11
The price rivals pay for the input may rise or fall (e.g., Salinger). If it falls, the effective input price paid
by all downstream firms falls, and welfare necessarily rises. If the price charged rivals rises but not by
much, welfare will still rise. Only if the price charged rivals rises by enough to offset the elimination of the
double mark-up will welfare fall.
3
rivals may counter-integrate, meaning that an initial vertical merger may set off a wave of
vertical mergers that make the initial merger unprofitable.
Professor Church discusses in some detail the sole RRC model with downstream
strategic substitutes in which the effects of integration are unambiguously bad for
consumers. In Avenel & Bartlett (2000), vertical integration deters upstream entry. 12
The model considers an incumbent upstream monopolist threatened by entry. Under very
specific conditions, vertical integration can profitably deter entry and reduce consumer
welfare. These conditions are: (1) vertical integration allows the firm to adopt a specific
technology that precludes its participation in the upstream market; (2) the downstream
market is concentrated; (3) the integrated firm’s lack of participation reduces a potential
upstream firm’s scale by an amount sufficient to make entry into that market
unprofitable; and (4) two-level entry or integration with unintegrated downstream firms is
not possible for an upstream entrant.13
Professor Church also discusses the case of strategic complements downstream.
He notes that the same essential tradeoff (double marginalization vs. possible higher
prices to unintegrated rivals) exists here, as it does in the case of strategic substitutes. He
states: “The literature suggests that if there is existing market power upstream, then a
vertical merger leading to the elimination of double marginalization is likely beneficial
for consumers and efficiency” (p. x). As with his treatment of downstream Cournot
players, Professor Church focuses on the commitment problem with downstream
Bertrand competitors, discussing extensions of Ordover et al. (1990) by Choi and Yi
(2000) and Chen (2001). In the main body, he notes that the Ordover et al. analysis is
controversial because it assumed that the integrated firm can commit to withhold supplies
from rivals while unintegrated firms cannot. The lack of commitment prior to integration
leads to marginal cost pricing between homogenous Bertrand players in the upstream
market. The post-merger commitment induces the integrated firm to raise price to
unintegrated rivals. Since there is no elimination of double marginalization, welfare falls.
Choi and Yi and Chen both provide mechanisms (investment in specific assets) by which
the integrated firm may gain commitment power, and thereby recover an anticompetitive
effect from vertical integration similar to that found by Ordover et al.
Regarding Choi and Yi, Professor Church observes, “A showing that foreclosure
will be harmful to consumers requires a plausible case that the effects of raising rivals’
12
This discussion is somewhat out of place, as the model is about entry deterrence, whereas the other
literature (e.g., Salinger, Ordover et al., Reiffen & Vita) are static and ignore entry. Professor Church does
not classify models by whether they are static or dynamic, although we believe that the distinction is
important; the argument that prices will rise because competition is “softened” is very different than the
argument that prices will rise because entry will be deterred. Further, in models of entry deterrence, the
possibility of harm necessarily is more speculative than in static models, and for that reason should be
given less weight against known benefits. In the analysis of horizontal mergers, for example, likely shortrun losses from either unilateral or coordinated effects are given more weight than effect than future
benefits, simply because the benefits are less certain and occur further off in the future.
13
While vertical integration reduces consumer welfare under these assumptions, it may or may not reduce
total welfare, depending on the nature of upstream scale economies.
4
costs and enhancing cost asymmetry dominate the elimination of double
marginalization.” He notes that their model is “difficult to apply since it depends
critically on the extent of cost correlation, and assessing empirically the extent of cost
correlation is likely to be difficult.” Regarding Chen, he observes that “the welfare
effects in Chen’s model depend on the size of the switching cost [relative to the degree of
substitutability among products].” The effects of integration are anticompetitive if the
integrating upstream firm has an efficiency advantage, this advantage is small so that the
integrating firm chooses to raise price, switching costs are large, and downstream firms
are strategic complements.
Viewed in its entirety, Professor Church’s description of the RRC literature does
not support an aggressive stance against vertical mergers. Professor Church does not state
this conclusion explicitly, however, and instead simply describes the possible
implications of the theories and lets the reader draw their own policy conclusions This
may have been a mistake. There is a substantial risk that some antitrust practitioners may
rationalize aggressive enforcement policies towards vertical integration because it has
been now shown that circumstances exist in which vertical mergers can be
anticompetitive. This regrettable (and doubtless unintended) outcome could have been
avoided had the monograph included a short paragraph in which the policy implications
of this literature were addressed more explicitly. Such a paragraph might, for example,
have made explicit the special nature of the models surveyed. In many of these models,
for example, vertical integration reduces welfare only when competition is modeled as a
two stage games with linear pricing; the results are reversed when nonlinear pricing is
permitted. Because nonlinear pricing is common in many intermediate good markets and
the motivation for, and effects of, vertical integration are different with nonlinear
contracts, considerable caution is warranted in attempting to use the models Professor
Church reviews to inform competition policy.14
III.
When Does Vertical Integration Raise an Antitrust Concern?
After defining non-horizontal mergers in his executive summary, Professor
Church discusses the antitrust issues they might raise. He notes:
Antitrust concerns typically arise only if a non-horizontal merger results in an
increase in market power. Just as in a horizontal merger, a non-horizontal merger
can result in an increase in market power because of either a unilateral or a
coordinated effect. A unilateral effect occurs in a non-horizontal merger if
products of other producers post-merger are no longer as attractive substitutes as
they were pre-merger, thereby creating market power for the merging firm. This
might result because the products of the competitors post-merger have lower
14
There is a significant literature on two-stage game models of vertical control in which upstream and
downstream firms can write non-linear contracts. The results in this literature depend in subtle ways on the
details of the oligopoly game, such as whether downstream decision variables are strategic substitutes or
complements and whether firms observe their rivals’ contracts. For more on the issues, see Cooper, James,
Froeb Luke, O’Brien, Dan, and Michael Vita, “Vertical Antitrust Policy as a Problem of Inference,”
International Journal of Industrial Organization, 23 (2005) 639– 664 and the references cited therein.
5
quality or higher prices, or because competitors are excluded or prevented from
entry. A coordinated effect occurs if, post-merger, it is easier for the remaining
firms, or some subset, to enhance coordination and the collective exercise of
market power. The literature on the anticompetitive rationales and effect of nonhorizontal mergers surveyed in this report are based on identifying how the
transaction changes incentives and/or constraints on the merged, firm, thereby
enhancing market power. (p. ii).
Unfortunately, this seemingly simple statement embodies much of what can (and often
does) go wrong with the antitrust policy of non-horizontal mergers. We wish Professor
Professor Church had emphasized that an “increase in market power” is a necessary, but
not sufficient, condition for a non-horizontal merger to raise antitrust concerns.15 This is
an important principle – indeed, one might say that it is central policy message of the
entire report. Increases in “market power,” as the term is defined by Professor Church,
do not necessarily translate into a reduction in either consumer or total welfare – as
Professor Church’s comprehensive survey demonstrates, these increases often will yield
increased consumer surplus. The problem is that many antitrust practitioners often, if not
invariably, interpret the term “increases market power” as “harms consumers,” which is
in turn treated as a sufficient condition for antitrust intervention.16
To illustrate, Professor Church’s discussion of the antitrust implications of
vertical integration does not distinguish pro-competitive from anti-competitive means by
which a merger makes rivals’ products “less attractive.” Do rival products become less
attractive because of some cost-raising strategy facilitated by the merger, or because the
merged firm improves its product or lowers its cost? The former effect obviously has the
15
In the main body of the report, Professor Church provides a more careful definition of “market
power”: “The concern here is not with market power as conventionally defined by economists—the ability
to raise price above marginal cost—but with antitrust market power. Antitrust market power is significant
and durable, where significant means prices exceed average cost and durable means that these prices can be
sustained in the long run.” Professor Church focuses on average cost instead of marginal cost, but both the
marginal and average cost margins of the downstream firm can rise when successive monopolists merge,
even though market power clearly does not increase in this case. The accepted legal definition of “market
power”—“the ability to raise prices above those that would be charged in a competitive market”— does not
appear to have any grounding in a reduction of welfare, but rather focuses on a departure of price from
marginal cost. NCAA v. Board of Regents, 468 U.S. 85, 198 n.38 (1984). Similarly the FTC and DOJ
define “market power” in the Horizontal Merger Guidelines as “the ability profitably to maintain prices
above competitive levels for a significant period of time.” Horizontal Merger Guidelines at § 0.1 See also
Kodak, 504 U.S. at 464 (“Market power is the power ‘to force a purchaser to do something that he would
not do in a competitive market.’”) (quoting Jefferson Parish Hosp. Dist. No. 4 v. Hyde, 466 U.S. 1, 14
(1984)) (“It has been described as ‘the ability of a single seller to raise price and restrict output.’”) (quoting
Fortner II, 394 U.S. at 503). Some, however, have argued that a focus on own-price elasticity departs
from a proper reading of courts’ interpretations of market power, which typically means the ability to affect
market-wide price, not merely one’s own price. See, e.g, Benjamin Klein, Market Power in Antitrust:
Economic Analysis After Kodak, 3 S. CT. ECON. REV. 43, 71–85 (1993).
For example, a reasonable reading of Professor Church’s definition could lead to an antitrust challenge of
a vertical merger that creates a competitive advantage for the merging parties due to the elimination of the
double mark-up problem and other vertical externalities.
16
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potential to raise greater concerns than the latter. Again, our concern here goes well
beyond semantics. For example, if a merged firm can offer one-stop shopping for two
previously independent products while a rival cannot, then the merger has a unilateral
effect of creating market power according to Professor Church’s definition.17 This may
allow the merged firm to charge a higher price than independent firms. However, unless
rival firms exit, competition will ensure that the merged firm’s premium is no higher than
the benefits of one-stop shopping.18 In this example, the merger increases market power
in an economic sense (the merged firm’s margin rises), and in Professor Church’s sense
(price rises relative to average cost and the increase is durable), but overall welfare is
increased, not reduced.
We wish to make clear that we do not believe that Professor Church intends such
a result; the discussion contained in the main body of his report demonstrates
persuasively that he does not. Unfortunately, however, there is great possibility for
miscommunication in the very short, but critical, section in the Executive Summary titled
“Antitrust Concerns” (p. ii). The Executive Summary is 50 pages long; our experience in
the antitrust community leads us to predict that most practitioners will not read beyond it
(indeed, if they read that much). And even if they read more, similar language appears in
the main body in Section 2.1, titled “Antitrust Concerns.” (p. 4,5). Thus, the possibility
for misinterpretation is high.
IV.
A Framework for Analyzing Non-Horizontal Mergers
Is it possible to distill enforcement Guidelines from the economic theory of
vertical integration and restraints? Guidelines require great care in interpreting the
theory in light of the types of evidence the typical antitrust practitioner is likely to have
available. Professor Church’s report does a careful job outlining the assumptions
theorists must make to obtain equilibrium reductions in welfare from vertical integration.
He may be a little more optimistic than we are about using existing theory for Guidelines,
but he is quick to highlight the difficulties.
He concludes (correctly in our view) that the literature does not provide the basis
for “structural guidelines” that, like the current U. S. Horizontal Merger Guidelines,
would “define the circumstances when a non-horizontal merger is presumed to raise
antitrust concern and when it is not” (p. iii). He reasons (also correctly, in our view) that
theory does not make it possible to “map the structural variables into enforcement policy”
(p. iii).19
17
This is true as long as consumers prefer one-stop shopping.
18
If consumers have different preferences for one-stop shopping and firms cannot price discriminate, some
consumers may benefit and some may lose. The net effect on consumers will be ambiguous.
19
See also the discussion in the main body of the paper, pages 5-8. Professor Church notes:
“Unfortunately, it does not appear to be possible to provide such a mapping [between key variables that con
be observed and implications] for vertical mergers” (p. 8). This is quite consistent with the view we
articulate in Cooper et al. (2005) that the theory in this area is too sensitive and relies on too many variables
that are hard to observe to provide a practical basis policy.
7
On the other hand, Professor Church does conclude that “the economics literature
can be used to inform guidelines . . .” “The literature can be used to identify
circumstances where antitrust analysis of a non-horizontal merger is warranted” (p. iii).
He suggests that Guidelines based on this approach “would consist of a framework for
analysis and the [identification of] circumstances which raise concerns.” Specifically, he
suggests a three-stage approach:
i) apply a market power screen; ii) identify a coherent theory of anticompetitive
harm (profit-maximizing behavior in theory) and its factual relevance (profit
maximizing behavior in practice); and iii) assess the nature and magnitude of
efficiencies. This last stage involves a balancing exercise and would be relevant
only if the first two stages indicate a potential competitive problem. (p. iv).
By “market power screen,” he means that market power is necessary for any risk
of competitive harm from non-horizontal mergers. Except in cases where vertical
mergers are used to create horizontal market power by, for example, monopolizing a
critical input market (e.g., Timothy Brennan, Saving Section II, working paper), which
are easily analyzed under the usual horizontal market power screens, this is
uncontroversial and useful; provided, of course, that practitioners and courts are careful
not to transform market power from a necessary condition into a sufficient condition for
competitive harm.
We agree strongly that stage (ii), identifying and assessing a coherent theory of
harm, should be requirement of any antitrust intervention. However, where vertical
practices are concerned, this is extremely difficult to do in practice. Given imperfect
competition pre-merger, almost anything is possible. Greater specificity is required. But
as we have emphasized, the conditions necessary for the particular (anticompetitive)
equilibria of (particular) theories to arise typically are subtle, difficult to describe, and
very difficult to verify empirically.
A fundamental criticism of Professor Church’s antitrust framework is that it treats
efficiencies (stage iii) as wholly separate from the analysis in stage (ii), paralleling
(perhaps deliberately) the mode of inquiry used in horizontal merger analysis. If
Professor Church means to include efficiencies such as the elimination of doublemarginalization in the analysis of stage (ii)—as it appears from the analysis that follows,
stage (iii) efficiencies presumably would be things like production cost savings that also
are considered in a separate step in the Horizontal Merger Guidelines. As a theoretical
matter, it really does not have a bearing where any of these efficiencies are evaluated, as
long as they are evaluated. As a practical matter, however, the order of consideration in
Professor Church’s framework may very well have an effect on how it is implemented.
The issue is that certain transactions, particularly vertical mergers (but also
conglomerate mergers that might facilitate bundling), generally have efficiencies that are
intrinsic to the transaction and do not result from production cost savings. The biggest
example is double marginalization, which is attenuated in a vertical merger. Professor
Church, however, follows antitrust terminology in calling the analysis in stage (ii) the
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identification of a “theory of harm.” As he clearly notes throughout his report, whether
most vertical theories are theories of harm or benefit in a given case depends on the
relative magnitudes of the benefits (eliminating the double mark-up) and the costs (a
potentially higher input price to unintegrated rivals). Thus, implicit in stage (ii) is a
“netting out” of these two effects. This notwithstanding, our experience suggests that
practitioners often think that they have satisfied step (ii) when they have merely
identified a theory that predicts the possibility of harm. Practitioners may well ignore the
efficiencies intrinsic to vertical integration, and conclude that if certain characteristics of
a merger satisfy some of the assumptions of a given theory, and also yield no obvious
production cost efficiencies, harm to competition is likely. Even if the practitioner were
to recognize that a vertical merger might generate efficiencies such as the elimination of
the double mark-up or other vertical externalities, because “efficiencies” are a final and
separate step in the analysis, Professor Church’s framework may inadvertently place the
burden of proof on the merging parties to show these efficiencies. And given the nature
of antitrust enforcement in the U.S, firms likely will be reluctant to argue strongly the
existence of a double-markup efficiency, since doing so requires them to assert the
existence of substantial pre-merger market power. This is a highly risky strategy.
In fairness to Professor Church, his analysis of vertical mergers in the body of the
report is very clear that there is a tradeoff between any raising-rivals-cost-like effects and
the benefits of eliminating double mark-ups. In fact, he states: “The literature suggests
that, if anything, there are too few vertical mergers when complete foreclosure is not
credible.” Indeed, our criticism is about potential misinterpretation rather than about
misstatement. But authors must take into account the intended audience will read and
interpret their analysis. Professor Church’s Report would provide clearer guidance to
practitioners if it stated explicitly that efficiencies intrinsic to the transaction, such as the
elimination of double-marginalization, are treated in step (ii). Finally, it would be worth
emphasizing – this cannot be repeated enough -- that an important factor distinguishing
horizontal from non-horizontal mergers are the latter’s intrinsic efficiencies.
V.
Conclusion
Overall, Professor Church has produced a thorough and accurate survey of the
literature on non-horizontal mergers. Our concern is not with the thoroughness or
balance of the review – it is to be commended on both counts – but with the possibility
that economically unsophisticated antitrust practitioners may attempt to use it to
rationalize or justify unsound policies. We wish that he articulated more forcefully the
fact that market power is only a necessary condition for harm to competition, and that
most vertical merger that presents the possibility of competitive harm also presents
economic efficiencies that are intrinsic to the integration.
9