Economics RBB UEA PhD How can simulation help assess the scope for anti-competitive input foreclosure in vertical mergers? Adrian Majumdar* 13 June 2008 Joint work with Jeffrey Church and Markus Baldauf

Economics RBB 13 June Norwich Topics Is the meaning of foreclosure clear in the EC Commissions non horizontal merger guidelines? Does the Commission still contemplate an efficiency offence? How can simulation shed light on the likelihood of input foreclosure in vertical mergers?

Economics RBB 13 June Norwich Non Horizontal Merger Guidelines A merger is said to result in foreclosure where actual or potential rivals access to supplies or markets is hampered or eliminated as a result of the merger, thereby reducing these companies ability and/or incentive to compete… …Such foreclosure is regarded as anti-competitive where the merging companies – and, possibly, some of its competitors as well – are as a result able to profitably increase the price charged to consumers (para 29) …for input foreclosure to lead to consumer harm… The relevant benchmark is whether the increased input costs would lead to higher prices for consumers (para 31) Is the distinction between foreclosure and anti-competitive foreclosure clear enough?

Economics RBB 13 June Norwich Vertical Arithmetic and Complete Foreclosure OSS (1990). Vertical merger: U1 and D1 Would U1 refuse to supply D2, so that U2 becomes a de facto monopolist over U2? U2 then increases D2s price (but not by so much as to cause a counter merger)? U1 forgoes profits from selling to D2, but… gains downstream profit because D2 is less competitive… do gains exceed losses? U2 D2 U1 D1

Economics RBB 13 June Norwich Problems with Complete Foreclosure Commitment problem – U1 has an incentive to supply D2, at a price just below U2s price… since if D2 is to be supplied at that price anyway, U1 may as well be the supplier… With homogenous goods and price competition (as in OSS), U1 must credibly commit not to supply D2, e.g. by making its product technically incompatible with D2s needs Are there counter-mergers that defeat the profitability of the merger, e.g. are U2 and D2 induced to merge? Do efficiencies dominate any foreclosure effect? OSS assumed away efficiencies with perfect competition upstream.

Economics RBB 13 June Norwich Partial Foreclosure U1 remains a supplier to D2 but may change its pre-merger output Literature focuses on symmetry for tractability: Upstream Cournot Downstream Bertrand (differentiated) or Cournot Formal literature: few models of partial foreclosure do not predict consumer harm (Church 2004, Church forthcoming) Lafontaine & Slade (2007) – empirical evidence supports view that vertical mergers benign

Economics RBB 13 June Norwich Partial Foreclosure – Determining the Input Price First order effect: U1s first order condition changes. At margin incentive to raise D2s cost by withdrawing output (or bidding up input price) since U1 internalises gain to D1s profit Reduced demand for input from non-integrated buyers D2 faces more competitive D1 (depends on extent of reduction of double marginalisation, input share of total costs, degree of differentiation between D1 and D2) D1s demand is withdrawn D2s input price determined by balance of FO and RD effects If input price falls – consumers gain unambiguously both D1 and D2 lower prices post merger

Economics RBB 13 June Norwich Welfare Considerations with Higher Input Price Suppose D2 faces higher input price (assume downstream Bertrand competition) D2 may still lower its price If D2 raises price, consumers may still gain due to D1s larger price cut Key to consumer gain is efficiency driving D1s lower price through eliminating double marginalisation Rise in input price sometimes called foreclosure Consumers may well still gain… beneficial partial foreclosure The term/concept may scare lawyers and confuse case team (non economists)! Lack of clarity in guidelines risks efficiency offence?

Economics RBB 13 June Norwich Simulation – vertical mergers (1) Theoretical results tend to assume symmetry Simulation techniques can test sensitivity to a wide range of asymmetries (and indeed different theoretical models) Test millions of possible parameter combinations (under different theoretical models) to generate millions of combinations of own and cross price elasticity of demand, relative market sizes, costs, etc v powerful sensitivity testing

Economics RBB 13 June Norwich Simulation – vertical mergers (2) Must filter results to give plausible pre-merger outcomes Focus on % and relative pre-merger values (e.g. margins, market shares, ratio of input in question to total cost, relative prices) – can filter millions down to thousands or hundreds Powerful technique when high share of plausible pre- merger outcomes give rise to post merger predictions that point in the same direction Achievable in time frame for Phase I

Economics RBB 13 June Norwich Preliminary Results with Asymmetries U1 and U2 set quantities, conjectural variations model D1 and D2 differentiated, Bertrand competitors Filter based on pre-merger market shares likely to concern commission Very low % of mergers harm consumers when downstream integrating firm has 30-50% share Preliminary results with asymmetries extend findings of current theory – also consistent with balance of empirical evidence Work in progress: when vertical mergers are bad?

Economics RBB 13 June Norwich Conclusions Is the meaning of foreclosure clear in the EC Commissions non horizontal merger guidelines? Not clear enough! Does the Commission still contemplate an efficiency offence? Perhaps unwittingly? How can simulation shed light on the likelihood of input foreclosure in vertical mergers? Sensitivity testing and filtering to believable pre-merger outcomes Compare simulate-filtrate with estimate-simulate approach in horizontal mergers.