Vertical Merger Antitrust Enforcement: The Past, the Present, and the Future

Introduction

Vertical merger enforcement has seen major upheaval in the past few years. In 2020, the U.S. antitrust agencies (the Agencies) replaced the severely outdated 1984 Non-Horizontal Merger Guidelines to reflect a new wave of literature on raising rivals’ costs and market foreclosure. One year later, the Federal Trade Commission (FTC) unilaterally withdrew these 2020 Vertical Merger Guidelines and announced its intentions to replace them with even stricter ones. In what follows, I provide a broad overview of the history of vertical merger enforcement and the current economic theory on vertical integration in order to evaluate various presumptions that have been proposed in the literature that the Agencies could use to identify anticompetitive vertical mergers.

Neither economic theory nor empirical evidence provide a clear answer on how to evaluate vertical mergers, since it is generally accepted that these mergers can be both procompetitive and anticompetitive. However, certain features of a vertical merger may signify a higher likelihood of anticompetitive effects. For example, it is well-established that vertical mergers that occur in competitive industries are generally driven by efficiencies. On the other hand, when at least one of the firms merging has market power, raising rivals’ costs and foreclosure become more likely.

Introducing legal presumptions, which would “[identify] certain practices as presumptively illegal,” would make vertical merger enforcement more stable and efficient since it would provide clear guidelines and simplify merger review. Effective presumptions would balance the aims of eliminating anticompetitive mergers and minimizing the number of beneficial mergers that are eliminated. In this article, I argue that although the proposed presumptions have identified promising practices that often lead to anticompetitive outcomes, there is not enough empirical evidence to indicate that these presumptions effectively avoid eliminating beneficial mergers. Thus, more Agency experience in litigating vertical mergers and strong empirical evidence is needed to support the proposed presumptions.

Brief History of Vertical Merger Enforcement

Vertical merger policy has cycled between periods of light and heavy enforcement. Before the 1950 Clayton Act Amendments, vertical merger cases were tried under the Sherman Act and few cases were litigated. Driven by a “fear of what was considered to be a rising tide of economic concentration in the American economy,” Congress passed the 1950 Clayton Act amendments. As part of these amendments, Section 7 of the Clayton Act was extended to vertical mergers. Thus, vertical mergers that would “tend to substantially lessen competition” could now be challenged.

In response, the Court of the 1960s shifted to strict vertical merger enforcement, interpreting the Clayton Act amendments to be “intended to reach incipient monopolies and trade restraints outside the Sherman Act.” On the basis that a series of mergers could have a cumulative effect, the Court blocked several relatively harmless mergers. In doing so, it employed often erroneous rationale such as condemning procompetitive mergers involving players with small market shares or those involving procompetitive efficiencies that the Court feared would disadvantage rivals. In Brown Shoe, for example, the Court enjoined a merger between a shoe retailer and shoe producer in unconcentrated markets based on this reasoning.

In contrast, in the 1970s the Court shifted to a consumer welfare standard approach and considered not just potential anticompetitive effects, but also the benefits of vertical merger efficiencies. With an emphasis on efficiencies, vertical mergers were considered to be essentially harmless, especially by scholars associated with the Chicago School, which heavily influenced government policy at the time. The 1984 Non-Horizontal Merger Guidelines, which were replaced by the 2020 Vertical Merger Guidelines, are a reflection of these views.

Economic scholarship in the late 1980s and early 1990s that introduced models of exclusion, entry deterrence, foreclosure, and raising rivals’ costs again raised concerns about the proper treatment of vertical mergers. These concerns were slowly incorporated into merger enforcement and were present in the 2020 Vertical Merger Guidelines, which were later withdrawn by the FTC.

Starting in the late 2010s, concern for anticompetitive behavior by technology giants such as Google, Amazon, and Facebook, as well as rising healthcare costs have attracted more attention to antitrust. Capitalizing on this momentum, the Biden Administration appointed a number of Big Tech critics to the Agencies who advocate for stricter enforcement of antitrust policy, including with respect to vertical mergers. Although new vertical merger guidelines have not yet been released, it is likely that any new guidelines will be stricter than those published in 2020 given the views of the new administration.

Overview of the Vertical Merger Literature

Economists have studied vertical mergers for decades and the field has advanced significantly since the 1960s when the Court decided the Brown Shoe case. The current economics literature on vertical mergers calls for balance in enforcement since both the theory and empirical evidence suggest that vertical mergers can have both procompetitive and anticompetitive effects.

The literature points to two substantial benefits of vertical integration. First, there is elimination of double marginalization which occurs when an upstream and downstream firm with market power merge. Before integration, the downstream firm pays a markup on the upstream firm’s good that it considers when setting prices. By merging, the firms have an incentive to reduce price since doing so stimulates demand. Essentially, double marginalization is a pricing externality. By integrating, the firms can align their incentives and remove the double marginalization. This increases quantity and leads to lower prices for consumers. Elimination of double marginalization is not merger specific since firms can employ various contracts that eliminate double marginalization. But vertical integration may be efficient if it reduces costs associated with creating and maintaining a contract.

Second, vertical integration can reduce the merging firms’ transaction costs. In some cases, substantial search and bargaining costs may be incurred with transactions between two firms. Through integration, these costs are eliminated, leading to increased efficiencies which lower costs and increase social welfare. For example, vertical integration may “streamline production, inventory management, or distribution.” As a result of a manufacturer merging with a wholesaler, for example, the merged entity would be better able to respond to changes in consumer demand and would also be able to eliminate markups between the manufacturer and wholesaler. Integrated firms may also benefit from economies of scope, which occur when different goods can be produced at lower cost together than they could be separately. For example, knowledge transfers between firms could improve manufacturing processes that would boost productivity. Suppose a drug manufacturer buys packaging materials from a packaging firm. If the firms merged, the two departments could redesign the packaging and the pill to make manufacturing more efficient.

Vertical mergers may be anticompetitive if they raise rivals’ costs or lead to market foreclosure. Input foreclosure occurs when an integrated firm controls a vital input and uses its market power to disadvantage its downstream rivals. Output foreclosure occurs when an integrated firm controls a downstream market and uses its market power to disadvantage its upstream rivals.

Consider input foreclosure. Suppose an integrated firm controls a substantial share of the upstream market for a vital input. By reducing the quantity of input that it sells to its downstream rivals, the integrated firm induces a decrease in supply, which would increase the cost of the input. This raises the cost to the downstream rivals of producing their good. The downstream rivals may pass these costs on to consumers in the form of higher prices, in which case output quantity decreases and there is a social welfare loss. Meanwhile the integrated firm not only makes a higher margin on its own products, but it can also capture increased downstream market share. Such a venture is profitable for the merged firm only if the increased profits are greater than the loss in profits from reducing the input quantity sold.

The success of input foreclosure depends on the importance of the input as well as the integrated firm’s market power in the input market. If the input has many substitutes, for example, downstream rivals may turn to other suppliers. Additionally, barriers to entry in the upstream market are necessary to prevent other firms from entering and driving down the price of the input good.

For example, consider the merger of AT&T and Time Warner in 2018. Time Warner owned highly valuable video content, which had high fixed costs, low marginal costs, and, due to its digital nature, could be shared an infinite number of times. Before the merger, Time Warner would have the incentive to sell to anyone who was willing to pay marginal cost or more. Refusing to sell content would only lead to a reduction in profit. AT&T meanwhile owned DirecTV, which is a satellite broadcasting company. The merged entity may have an incentive to offer some of Time Warner’s valuable video content exclusively through DirecTV, thereby foreclosing rival cable companies. Similarly, Time Warner could charge higher prices for its video content to rival cable companies, who may pass on costs to consumers, and thereby divert demand. Although the firm would lose revenue on the foreclosed sales, it would gain profit if consumers switched to DirecTV due to the exclusive content.

Vertical mergers may also be anticompetitive if they facilitate coordinated effects. These effects occur when a merger changes an industry in such a way that it makes it easier for competing firms to coordinate. For instance, vertical mergers may facilitate coordination where a firm merges with a maverick firm, which is a firm that refuses to cooperate with other firms and therefore protects competition. For example, say that a number of firms agree to fix prices. A firm that does not join the cartel and undercuts the cartel price would be a maverick firm. The maverick firm protects competition because it forces the cartel to reduce prices in order to compete with the maverick firm. Thus, if a price-fixing firm acquires a maverick firm, price competition is reduced. Additionally, vertical mergers may allow firms to be privy to certain information about the other firm’s market which can make coordination easier.

Nishiwaki (2019) studied collusion incentives among vertically integrated firms in the cement and concrete industry. Through his research, he found that collusion among upstream firms is more likely the more widespread is integration. He concluded that this trend may derive from the fact that integration disincentivizes cheating on the coordinated agreement. When fewer unintegrated downstream firms exist, there are fewer firms that a cheating upstream firm can sell its products to. Hence, cheating is less profitable, which leads to less cheating, and therefore prolongs the life of a coordinated agreement.

Thus, economic theory supports the fact that vertical mergers can have both procompetitive effects—by eliminating double marginalization and reducing transaction costs—and anticompetitive effects—in the event of foreclosure or coordinated effects. Generally, however, anticompetitive effects are only present in markets with higher concentration. Thus, any potential presumption should focus on markets with a high level of concentration.

Empirical evidence

Empirical evidence on vertical mergers is mixed. Although Lafontaine and Slade (2007) determined that vertical mergers were generally procompetitive based on a survey of recent research, recent papers by Lafontaine and Slade (2021) and Beck and Scott Morton (2021) contest this outcome. Instead, they find mixed results: some vertical mergers are procompetitive, some are anticompetitive, and some are neutral.

Lafontaine and Slade (2007) found that vertical integration has positive effects in general. Specifically, vertical integration was marked by a number of efficiencies that benefited consumers. However, their 2007 research focused on competitive industries, which are generally not the focus of antitrust policy. In a later paper, the same authors (2021) looked at studies based on eight retrospective merger analyses and two stock events. They found mixed results—most of the studies had neutral effects which could occur when anticompetitive and procompetitive practices balance each other out—but concluded that the small sample size precluded any sort of presumptions on vertical mergers.

Scott Morton and Beck (2021) similarly found mixed evidence of the procompetitive and anticompetitive effects of vertical mergers when studying a larger collection of studies. However, they also caution that much of the empirical evidence is flawed in at least two ways. First, many of the industries studied have low quality data. Thus, any conclusions derived from the data could be unreliable. Second, some of the more egregious mergers would have been precluded by the Agencies. Thus, such studies could have a procompetitive bias.

Thus, whether, on balance, vertical mergers are procompetitive or anticompetitive is still inconclusive. The theoretical and empirical literature suggest that vertical mergers in competitive markets are generally driven by efficiencies that would benefit consumers. Meanwhile vertical mergers in industries characterized “by high concentration, economies of scale and scope, two-sided markets, and/or networks” are more likely to see legal action suggesting that there is more concern for anticompetitive effects. Unfortunately, the theoretical and empirical literature do not provide enough evidence to create strong presumptions. What is clear is that vertical mergers often have both anticompetitive and procompetitive effects. Thus, it is up to the Agencies to determine which effect is stronger, on a case-by-case basis.

Proposed Anticompetitive Presumptions

A legal presumption allows practitioners to infer an effect from a known fact and shifts the burden of proof from the plaintiffs to the defendants. For example, in the horizontal merger case, a merger is presumed to be anticompetitive if it would occur in a market with an HHI greater than 2,500 and would lead to an increase of concentration of at least 200. In these cases, the merging firms have the burden of proof and must present a persuasive case for why the merger would not be anticompetitive. Presumptions are beneficial since they provide clear guidelines for businesses, simplify merger review, and reduce the cost of litigation for the Agencies.

In order to prevent under- and over- enforcement, presumptions should be grounded in experience, economic theory, and common sense. Specifically, for vertical mergers, Lafontaine and Slade (2021) argue that valid presumptions should rely on a body of empirical evidence and should be unique to vertical integration. Baker, et al. (2019) have suggested five presumptions, which are relevant when at least one of the markets in the proposed vertical merger is concentrated.

First, Baker et al. recommend a foreclosure presumption. When an integrated firm has substantial market power in an upstream or downstream market and could thereby foreclose its downstream or upstream rivals, it should be presumed to be anticompetitive. The firms would need to prove that they would have neither the ability nor the incentive to foreclose rivals by, for example, arguing that substitutes exist or that there are few barriers to entry in the affected market.

Second, if there is a high probability that the upstream or downstream firm is poised to enter the other market, the merger should be presumed to be anticompetitive. The merger would eliminate actual entry or the fear of potential entry that could keep the market competitive. But, in some situations, it may be more efficient for a firm to merge with an existing upstream or downstream firm, than to develop its own new division. The threat of potential competition should be weighed against the potential efficiencies of the merger.

Third, if a vertical merger involves a maverick firm, i.e., a firm that by its actions has shown that it precludes coordination, then the merger should be deemed anticompetitive. After merging, it may be the case that the integrated firm no longer has an incentive to act as a maverick, which could reduce competition and thereby harm consumers.

Fourth, a merger that would allow a firm to evade price regulation should be deemed presumptively anticompetitive. For example, if the downstream firm’s maximum price is regulated, an integrated firm may attempt to misallocate costs to the downstream firm so that it could raise the regulated price. Additionally, when the integrated firm involves complementary products, it may bundle its products and associate any price increases with the unregulated product.

Fifth, a vertical merger that involves a dominant platform merging with a potential competitor or a firm in an adjacent market should be presumed to be anticompetitive. A dominant platform is a firm with market power, whose business model is one that creates value by facilitating interactions between at least two independent groups. This presumption is similar to the one involving elimination of potential entry since rivals in adjacent markets can be potential entrants.

These presumptions reflect the recent theoretical literature on the potential harms of vertical mergers. But, as Lafontaine and Slade (2021) argue, the Agencies have little experience litigating vertical mergers under these theories of harm as well as not enough empirical evidence to support their foundation as presumptions. These five principles can be used to identify potentially harmful vertical mergers, but more experience in using these theories of harm in vertical merger litigation must be gained and more high-quality empirical studies must be conducted before these principles should be considered presumptions.

Conclusion

Our understanding of vertical mergers and their potential harms has made great strides in the last few decades, which made the 1984 Nonhorizontal Guidelines obsolete. Now, it is a matter of incorporating the new theory into antitrust policy. The 2020 Vertical Merger Guidelines were an important milestone, but their subsequent withdrawal by the FTC leaves uncertainty for the business community on future vertical merger enforcement. At this time, the Agencies are drafting a new set of guidelines after a comment period that ended on March 21, 2022. These guidelines will likely be stricter and include a specific focus on digital markets.

Due to the lack of experience and empirical evidence, it is too early to rely on presumptions for vertical merger enforcement. Presumptions are beneficial because they stabilize enforcement and facilitate merger review and litigation; however, effective presumptions must be supported by both theoretical and empirical evidence. To this end, high quality empirical studies on vertical mergers are needed to support presumptions of harm and identify early warning signs of potentially anticompetitive vertical mergers.