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Vertical mergers in the technology, media and telecom sector – SLADE – June 2019 OECD discussion

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This presentation by Margaret SLADE, Professor emeritus at the Vancouver School of Economics at the University of British Columbia, was made during the discussion “Vertical mergers in the technology, media and telecom sector” held at the 131st meeting of the OECD Competition Committee on 7 June 2019. More papers and presentations on the topic can be found out at oe.cd/vmtm

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Vertical mergers in the technology, media and telecom sector – SLADE – June 2019 OECD discussion

  1. 1. VERTICAL INTEGRATION AND MERGERS: Efficiencies and Competitive Harm Margaret Slade Vancouver School of Economics, The University of British Columbia, Canada OECD Competition Committee Meeting Panel on Vertical Mergers in the Technology, Media, and Telecom Sectors Paris, France, June 7, 2019
  2. 2. SOME CLAIMS • Most vertical mergers are efficient but there is a small number that deserves close scrutiny. As a consequence, there is a need for efficient screening • Compared to horizontal, production and distribution efficiencies are less apt to motivate vertical mergers. Instead, the transfer of intangibles, the mitigation of contracting costs, and the provision of incentives are more common motives • Relative to other sorts of vertical efficiencies, the elimination of double marginalization has been overemphasized in theory and practice • Vertical relationships are more complex than horizontal. Whereas horizontal mergers involve one market, vertical mergers involve two, one up and one downstream, and an interface between the two • Techniques that are routinely used to screen horizontal mergers are much less apt to be useful vertical screens
  3. 3. MOTIVES: Vertical Integration and Mergers • Atalay, Hortascu and Syverson (2013) found that one half of upstream manufacturing establishments do not ship to their integrated downstream divisions. • The median internal shipment is 0.4% (equally weighted) or 0.1% (value weighted). • When no vertical shipments occur, it lessens the strength of certain motives, for example, the elimination of double marginalization and foreclosure • Then why do firms integrate, what are their motives? Four Nobel Prize winners have looked at this • Mitigating of contracting, renegotiation, and holdup costs, Facilitating specific investments in physical and human capital, Providing effort incentives, Allocating risk efficiently • In the context of perfect competition or monopoly
  4. 4. SOME FACTS: Vertical Mergers • OECD countries have moved from industrial economies, with giant firms like Standard Oil, US Steel, American Tobacco Company, to knowledge economies with giant firms like Amazon, Microsoft, Google, Facebook. Intangibles and networks have become much more important. • The worldwide web was initiated in 1991, which facilitated that transition. • Salop and Culley (2018) document all US vertical merger actions between 1994 and 2018 • One can use this data to look at levels and trends in vertical mergers in the technology, media, and telecom (TMT) sectors
  5. 5. US VERTICAL MERGER ACTIONS 1994-JULY 2018 1994-2000 2001-2009 2010-2018 All years # of challenged vertical mergers 31 10 18 59 # of challenged in TMT sectors 19 6 12 37 Ratio TMT/VM 0.61 0.60 0.67 0.63 Challenges per year 4.4 1.1 2.1 2.4 US President Clinton GW Bush Obama Years in office 1993-2000 2001-2008 2009-2017
  6. 6. THE EX POST EVIDENCE: Vertical Efficiencies • Most studies compare vertical integration to separation • One cannot always apply the insights from studies of vertical integration to vertical mergers • Many of the studies involve workably competitive industries (fast food, hotels, apparel) • Some benefits cannot be achieved through integration (i.e., those related to geographic location) • Many studies assess only efficiencies or competitive harm when a tradeoff between the two is relevant • However, there are lessons that one can learn from this work
  7. 7. THE EX POST EVIDENCE: Vertical Efficiencies Elimination of Double Marginalization • Elimination of double marginalization (EDM) tends to dominate the (antitrust) discussion • Not a true efficiency, one that lowers input/output ratios or increases productivity; it is a pricing externality • EDM need not be beneficial. (Salinger 1991) showed that, with multiproduct firms, when the integrated product price falls: • Nonintegrated product prices can rise • The average price can rise • This can happen in practice • Luco and Marshal (2018) show that when Coke and Pepsi acquired their bottlers, Dr Pepper prices rose • Average soft drink price rose • Many studies of EDM find that prices are lower under VI (e.g., Chipty 2001; Gill 2015) • This is consistent with EDM but is not a direct test (Crawford et. al. is an exception)
  8. 8. THE EX POST EVIDENCE: Vertical Efficiencies (cont.) • Other efficiencies: facilitation of knowledge flows; alignment of incentives; elimination of contracting costs; coordination of design, production, distribution, and marketing • More difficult to test • Acemoglu et. al. (2010) provide indirect evidence in the context of an incomplete contracts model • Predict that upstream technology intensity lowers the probability of VI whereas downstream intensity raises it • Who should make the important decisions • Find support in their study of UK manufacturing
  9. 9. THE EX POST EVIDENCE: Vertical Efficiencies (cont.) • Many authors have assessed other consequences of vertical integration • Lafontaine and Slade (2007) summarize the effects on, for example, cost, price, investment, and quality • More investment in healthcare services, Ciliberto (2005, doctors and hospitals) • Provision of higher quality video games (Gil and Warzynski 2014, game developers and distributors) • Lowers movie release date clustering (Corts 2001, production and distribution) • Increases movie run lengths (Gil 2006, production and distribution) • In summary, most studies find benefits
  10. 10. THE EX POST EVIDENCE: Competitive Harm Foreclosure • Foreclosure, which involves the restriction of output in one market through the use of market power in another, has received most attention in the empirical literature • Many empiricists do not assess foreclosure directly; they examine whether the vertically integrated firm favors its integrated products, which is consistent with foreclosure • (Waterman and Weiss 1996, Chipty 2001, Chen and Waterman 2007, Suzuki 2009, Bilotkach and Huselrath 2013) • If vertical integration lowers production or transaction costs or if it eliminates double marginalization, any firm will favor its integrated products, regardless of market structure or foreclosure intensions
  11. 11. THE EX POST EVIDENCE: Competitive Harm Foreclosure (cont.) • A merger that results in foreclosure need not be detrimental • A merger can lead to foreclosure while at the same time eliminating preexisting foreclosure • Suzuki (2009) examines the Turner Broadcasting Time Warner merger and finds that • After the merger, unintegrated channels were foreclosed (e.g., Fox News and Disney) • Prior to the merger, many Turner channels were foreclosed by Time Warner and the merger eliminated this • The net effect is empirical
  12. 12. THE EX POST EVIDENCE: Competitive Harm Foreclosure (cont.) • Much of the evidence of foreclosure pertains to cable TV • (Chipty 2001, Chen and Waterman 2007, Suzuki 2009, Crawford et. al. 2018) • Those studies find evidence of foreclosure and efficiencies and the net effect on welfare is positive • However, Crawford et. al. find that there is considerable heterogeneity in outcomes (some positive and some negative net effects) that can depend on the regulatory regime • Regulation and antitrust policy are complements • Some problems are better handled by regulation
  13. 13. THE EX POST EVIDENCE: Competitive Harm Marker Structure • Some recent studies that examine market structure effects are less optimistic • Nishiwaki (2016) finds that integration of cement and concrete facilitates collusion among upstream firms due to an increase in unintegrated concentration • Lee (2013) examines exclusivity in video games and concludes that it is associated with lower sales due to the lack of competition that results from incompatibility • In an experimental setting, Norman (2017) finds that markets with a vertically integrated firm are less competitive • McGowan (2017) finds that an increase in competition in coal markets leads to less vertical integration • When output increases due to more competition, prices fall and VI is less profitable
  14. 14. EX ANTE FORECASTING • The studies examined so far are retrospective; there is a need for forward looking methods -prediction of merger effects using premerger data • Many techniques are routinely used to forecast horizontal merger effects • Gross upward pricing pressure (GUPP) and horizontal merger simulations • It is tempting to extend those techniques to the vertical context • However, there are pitfalls • Since the vertical assessment methods are extension of horizontal, I discuss the horizontal cases first
  15. 15. EX ANTE FORECASTING: Horizontal UPP • The GUPPI (Farrell and Shapiro 2010) is not a predictor of post merger prices; it predicts the direction of price changes --- the incentive to change price • The GUPPI from 1 to 2 is a measure of substitution between the two (the diversion ratio) times the profit margin of 2, evaluated at premerger prices • It is the value of diverted sales, a first order effect • Advantages: • Simple to calculate; does not require information on nonmerging parties; no need for market definition • Disadvantages: • Does not consider rival response to changed prices or passthrough from cost to price • Empirical assessments: • Miller et. al. (2017) find that GUPPI predictions are not less accurate than those from misspecified merger simulations • Garmon (2017) finds that GUPPIs are better flags of anticompetitive mergers than concentration ratios
  16. 16. EX ANTE FORECASTING: Vertical UPP • Moresi and Salop (2013) propose three vertical measures (vGUPPIs) that are incentives to raise: • The input price that the merged firm charges a downstream rival (vGUPPIu) • The downstream rival’s price in response to its input price increase (vGUPPIr) • The merged firm’s output price (vGUPPId) • Disadvantages: • All of the horizontal disadvantages • Instead of one now there are three measures • They require information on nonmerging firms, the targeted rivals • Must decide which rivals are targeted, perhaps all, which is like defining a market • Requires more diversion ratios (e.g., between merging and nonmerging products) and information on cost passthrough • The vGUPPIu always predicts a price increase to unintegrated rivals (evaluated at premerger prices – no EDM)
  17. 17. EX ANTE FORECASTING: Vertical UPP (cont.) • Domenenko and Sibley (2018) use Monte Carlo simulations to compare predictions from vGUPPIs to those from the simulations and find that • The vGUPPIu always predicts a price increase to rivals even though that price can rise or fall in the simulation • The vGUPPIu is not an accurate predictor of the sign of a price change – it is wrong in 59% of the cases • The vGUPPId performs better – it is accurate in 82% of the cases) • In my view, vGUPPIs will not be useful screening tools • The informational (data) requirements are too high • There is a need to combine the three so that EDM can be considered • The merged firm makes a take-it-or-leave-it offer to the rival; there is no possibility of bargaining • It could be a useful tool for analyzing contested mergers; the vGUPPIu is a worse case scenario
  18. 18. EX ANTE FORECASTING: Horizontal merger simulations • A horizontal merger simulation predicts post merger prices • It requires: • Estimates of product demands • A set of marginal costs • An assumption about the market game (usually differentiated products Bertrand) • Given these, one can obtain each firm’s profit function and the first order conditions for profit maximization • The n first order conditions can be solved for n post merger prices, where n is the number of products It can go wrong if any of these is misspecified
  19. 19. EX ANTE FORECASTING: Horizontal merger simulations (cont.) • Retrospective analysis of horizontal merger simulation models find that they have not predicted well • (Peters 2006, Weinberg 2011, Weinberg and Hosken 2013, Bjornstedt and Verboven 2016) • Merger simulations are sensitive to the specification of demand • (Slade 2009) • Marginal costs are often obtained as those that rationalize the chosen demand and game • If demand or the game is misspecified, so are the costs • With nonconstant returns, marginal costs will vary with changes in output (Grieco, Pinkse and Slade 2018 consider IRTS) • The game might change post merger • Miller and Weinberg (2017) find that the beer market became more collusive post merger • If the model assumptions are consistent with the market, a simulation can be a useful merger evaluation tool
  20. 20. EX ANTE FORECASTING: Vertical merger simulations • Much more complex than horizontal merger simulations • Two markets, one up and one downstream, both games must be specified • The link between the two must also be specified • Could be two Bertrand games with the internal input price set at marginal cost and the external price determined by the upstream game • Firms could bargain over the external input price with a separate negotiation for each up/downstream pair • The internal price need not be set at marginal cost, e.g., if divisions make separate decisions • The timing of moves matters • Could be simultaneous up and downstream games • The upstream firm could move first and have a first-mover advantage
  21. 21. EX ANTE FORECASTING: Vertical merger simulations Bargaining • The most tractable bargaining model is Nash in Nash (Horn and Wolinsky1988) • Simultaneous upstream Nash bargaining and downstream Nash market games • Applications: • Gowrisankaran, Nevo, and Town (2015) find that bargaining between hospitals and MCOs leads to lower prices • Consumers are insensitive to prices because they only pay part of the cost → demand elasticities are small and Bertrand markups are unreasonably large • Crawford et. al. (2018) simulate mergers between regional sports networks and programming distributors • Bargaining is reasonable in their application • Much less academic work on vertical merger simulations
  22. 22. EX ANTE FORECASTING: Summary • Tools that are often used to forecast horizontal merger outcomes are more complex in a vertical context • Inaccurate predictions are therefore more likely • One size fits all and other simple models will not be useful • It is necessary to pay careful attention to the institutional details • If properly applied those tools can be useful complements to more traditional analysis of contested mergers, probably not as screening devices