Invigorating Vertical Merger Enforcement.

• Author: Salop, Steven C.
• Position: Symposium: Unlocking Antitrust Enforcement

INTRODUCTION

Chicago School economics and laissez-faire ideology have intentionally targeted vertical merger enforcement. This assault has been largely successful. Enforcement has been infrequent, and remedies have been limited. However, in our modern market system, vigorous vertical merger enforcement is a necessity, particularly in markets where economies of scale and network effects lead to barriers to entry and durable market power. This Feature explains why and how vertical merger enforcement should be invigorated. This would involve a more balanced approach to the evaluation of potential competitive harms and benefits, rather than presuming that efficiency benefits are highly likely while competitive harms are unlikely or speculative.

Vertical merger enforcement was attacked as economically irrational by Chicago School commentators, notably by Robert Bork, on three principal grounds. (1) First, while a competitive concern of vertical mergers is that they will lead to rivals being "foreclosed" from inputs or customers, leading to market power by the merged firm, Bork argued that the alleged foreclosure was illusory, seeing instead merely a neutral rearrangement of supplier-customer relations. (2) Second, Bork viewed competitive harm as implausible because there was only a "single monopoly profit" that would be unaffected by the merger (except under rare circumstances). (3) Third, Bork offered the affirmative argument that vertical mergers were invariably highly efficient: for example, they inevitably reduce downstream prices by "eliminating double marginalization" of the cost of the upstream merging firm on sales by the downstream merging firm. (4) In sum, for these commentators, competitive harm was seen as implausible, and substantial competitive benefits were seen as virtually inevitable. It followed from this logic that there should be a nearly conclusive presumption that vertical mergers are procompetitive, regardless of the market shares of the merging firms in their respective markets. The spirit (although not the letter) of these critiques was reflected in the 1984 Non-Horizontal Merger Guidelines, which set out narrow conditions for vertical merger challenges. (5)

This Feature disputes the Chicago School account outlined above and explains instead that some (but not all) vertical mergers raise substantial competitive concerns. This analysis proceeds in three Parts: Part I reviews the history and explains the economic flaws in the Chicago School theories. Part II presents a more balanced approach to the potential competitive effects of vertical mergers. Part III outlines the next steps that might be taken to modernize enforcement policy and the law.

1. THE LIMITED ECONOMIC RELEVANCE OF THREE CHICAGO SCHOOL ASSUMPTIONS UNDERLYING THE VERTICAL ENFORCEMENT LANDSCAPE

   A major consequence of the Chicago School commentators' flawed economic theories with respect to vertical merger enforcement is that this body of law has remained undeveloped for the past forty years. Consider the following data points : The last vertical merger case analyzed by the Supreme Court was the 1972 merger between Ford and Autolite. (6) There has been very little private litigation. (7) The last vertical merger case litigated to conclusion by the Federal Trade Commission (FTC) dates back to 1979, which the FTC lost because it was unable to prove probable anticompetitive effects. (8) Since that time, vertical merger challenges have been infrequent. (9) From 1994 to 2016, U.S. agencies have challenged only fifty-two mergers that involved vertical integration, and some of these also involved horizontal overlaps. (10) In merger enforcement involving mergers with both vertical and horizontal components, the FTC and the Department of Justice (DOJ) typically focused only on the horizontal overlaps. (11)

   Within this general dearth of litigation, some more specific trends can be observed. Enforcement has varied across administrations. (12) Reduced enforcement by the Bush Administration was consistent with its more minimal concerns about exclusionary conduct, as reflected in the DOJ's Section 2 report. (13) That report was withdrawn by the Obama DOJ in 2009, (14) which showed increased interest in vertical merger concerns. (15) While perhaps unexpected, the Trump DOJ issued a complaint in November 2017 to block the proposed AT&T-Time Warner vertical merger. This merger raised similar concerns as the Comcast-NBC Universal (NBCU) merger, but unlike in that matter, the DOJ apparently refused to accept a proffered conduct remedy. (16) The outcome of the trial and whether the current DOJ and FTC will continue to follow this course of increased enforcement remain open questions at the time of this writing.

   This increase in vertical merger enforcement during the Obama Administration and the AT&T-Time Warner complaint are encouraging because the Chicago School's skepticism toward both the competitive risks of vertical mergers and foreclosure more generally has proved to be misguided. That skepticism rests on three main claims: (1) foreclosure is illusory because vertical mergers simply realign vertical relationships rather than reduce supply; (2) anticompetitive foreclosure generally would not be profitable; and (3) vertical mergers are invariably efficient, particularly because of elimination of double marginalization. However, modern economic analysis demonstrates that these theories do not provide a valid basis for such limited enforcement. Instead, modern analysis shows that competitive harm can in fact result from vertical mergers when markets are imperfectly competitive. (17) As discussed in the next Sections, the first two claims never had a strong economic basis and have been steadily and powerfully debunked by economists, while the third cannot carry the burden to support nonenforcement.

   1. Foreclosure as Illusory

      Most fundamentally, Bork argued that vertical mergers do not foreclose, but rather realign, vertical relationships. Brown Shoe is a much studied and much maligned vertical and horizontal merger ruling by the Supreme Court, addressing the Brown Shoe Company's attempted purchase of G.R. Kinney Company, another shoe manufacturer and retailer. (18) Applied to that case, the Chicago School critique is that while the Brown Shoe Company may supply more of the shoes that it produces to Kinney stores and fewer to competing stores, Kinney may purchase fewer shoes from rival manufacturers but more from Brown. Rather than eliminating rivals' opportunities, the retailers no longer buying from Brown can benefit from the manufacturers no longer selling to Kinney. Thus, there is not real foreclosure. This reasoning famously led Bork to quip about a later case that the FTC should have hosted an "industry social mixer" instead of challenging the merger. (19)

      While this criticism may have been applicable to Brown Shoe--where Brown and Kinney had very low market shares in unconcentrated markets--it is not true in dominant firm or oligopoly markets with entry impediments. (20) For example, suppose that Brown was one of only three large shoe manufacturers selling differentiated products and Kinney had a substantial retail market share. If Brown were to raise prices or refuse to sell to Kinney's downstream rivals, that foreclosure may reduce the total supply available to rivals. It also may incentivize Brown's two manufacturing competitors to raise their prices to Kinney's rivals in response, either unilaterally or through coordinated interaction. Unintegrated downstream rivals thus can be disadvantaged, and the merging firm can achieve or enhance market power in one or both markets. This explains why foreclosure is real.

      In the proposed AT&T-Time Warner merger, for example, a foreclosure concern is that the merged firm will raise prices of Time Warner content to AT&T's rival video distributors or threaten to withhold that content in order to obtain higher prices. Because video content is not fungible, the concern is that the other distributors cannot simply drop Time Warner content and replace it with other programming without losing some subscribers to AT&T and others. Nor is entry of equally popular competing programming easy. Similar foreclosure issues arose in the Comcast-NBCU merger. (21) Moreover, the foreclosure concern is now enhanced because Comcast and AT&T would have similar foreclosure incentives and might coordinate their actions. Thus, foreclosure concerns cannot simply be dismissed in oligopoly markets. Instead, a rational vertical merger policy would analyze the likely ability and incentives of the merging firms to engage in various types of foreclosure conduct.

   2. Single Monopoly Profit

      A second core Chicago School claim is that an unregulated monopolist can obtain only a single monopoly profit, so it would gain no additional market power from foreclosure through tying or vertical merger. (22) This theory has gained some judicial acceptance. In her Jefferson Parish concurrence advocating elimination of the per se rule against tying, Justice O'Connor opined that "[c]ounterintuitive though [the single monopoly profit theory] may seem, it is easily demonstrated and widely accepted." (23) In Jefferson Parish, it was alleged that East Jefferson Hospital would force patients solely to use the Roux anesthesiology group, and this tying arrangement would harm consumers and competition in the local anesthesiology services market. But the single monopoly profit theory would claim that even if the hospital had market power in its hospital market, it had no anticompetitive incentive to leverage that power into the anesthesiology market. (24) It would gain no incremental market power or profits by doing so.

      Similarly, in Doman, a Second Circuit panel (including then-Judge So-tomayor) alluded to the theory in dismissing a complaint against an exclusive distributorship awarded by a lumber supplier (Doman) to a distributor (Sherwood)...