COMMENTS OF THE AMERICAN ANTITRUST INSTITUTE

ON

## HORIZONTAL MERGER ANALYSIS 

AND THE ROLE OF CONCENTRATION

IN THE MERGER GUIDELINES

February 10, 2004

Albert A. Foer, President

# **Introduction**

Market concentration has often played a controversial role in merger law
and policy. In the past, some have argued that "big is bad" and the
government must use its antitrust tools to stop all trends toward
concentration. On the opposite extreme, others have argued that
concentration is never a problem as long as government is not creating
or supporting entry barriers, because new competitors are always waiting
in the wings, forcing even an apparent monopolist to behave in a
competitive manner. Although debates about antitrust have moved beyond
these older views, merger enforcement today has been criticized for
giving concentration either too little or too much weight. A
"post-Chicago" position on the proper role of seller concentration[^1]
and related issues in horizontal merger analysis that relies heavily on
recent advances in empirical economic analysis has not yet clearly
crystallized. The American Antitrust Institute[^2] offers this
Statement, based on extensive conversations and debate within the AAI
Advisory Board, as a contribution toward crystallization. While the
document attempts to reflect a consensus, it cannot and should not be
expected that every member of the Advisory Board necessarily agrees with
every word or even with all of the general positions taken.

1.  **Concerns with Mergers.**

(a.) Horizontal mergers can raise competitive concerns for a number of
reasons. A merger may create opportunities and incentives for unilateral
price increases, express collusion or tacit coordination and strategic
behavior that artificially disadvantages rivals or suppliers. These
effects may lead to higher prices, which are harmful because they
transfer income away from consumers and undermine allocative efficiency.
They may also lead to higher costs, including the possible creation of
so-called x-inefficiency.

(b.) Mergers can also reduce competition along other dimensions,
including quality, service, the development of new and better products
and other areas that significantly affect consumer choice. In an
industry with differentiated products, a horizontal merger may also lead
to a reduction in the variety of products, which can also harm
consumers.

(c.) Economic research indicates that monopoly slows the pace of
innovation. Incumbents may ignore or discourage the development of new
products and technologies, particularly radical innovations, and both
market and technological uncertainties make it likely that innovations
will be forthcoming more rapidly when there are multiple, independent
sources of initiative. Enhanced opportunities for express or tacit
collusion associated with higher levels of concentration can lead to a
reduction in the incentives for innovation and may channel investment by
fringe firms or prospective entrants away from projects that would
compete against the leading firms.

2.  **Concentration**.

(a.) Since the Supreme Court's decisions in cases like *Philadelphia
National Bank*, the level of market concentration has played a central
role in merger analysis. However, the economics literature of that era
that related measures of concentration to profits has been criticized
for its over-reliance on questionable measures of profits and its
failure to account for factors other than anticompetitive behavior that
could explain the correlation between profits and concentration across
industries.

(b.) The consensus conclusion from more recent studies using more
sophisticated research tools is that increased concentration, at high
levels, is associated with higher prices, and is therefore a suitable
proxy, at least in the first instance, for an expectation of market
power. In particular, as an empirical matter, high seller concentration
in a properly defined market with significant barriers to entry is
associated with higher prices, all other things being equal, and
increases in concentration, particularly substantial ones in markets
that are already highly concentrated, may precipitate large price
increases.

(c.) Even if one is not persuaded by the economic literature alone,
where the literature is inconclusive (as is often the case) it is
appropriate to take into account the underlying policies of the
antitrust laws, as manifested in legislative history and more than a
century of judicial explication, reflecting a preference for open
markets and more than a handful of competitors, all other things being
equal; and a trust in openness, diversity, and forces of competition.

3.  **Presumptions Regarding Concentration**.

(a.) Neither economic theory nor empirical economic research supports a
single "bright line" level of concentration that separates
anticompetitive from benign mergers in all or even most industries.
Nonetheless, empirical results are generally consistent with current
merger law: namely, that in general a substantial increase in an already
high level of seller concentration creates a *rebuttable* presumption
that a merger transaction is likely to have anticompetitive effects.
These empirical results also support the appropriateness of a flexible
sliding scale approach. That is, the higher the degree of concentration
and the larger the magnitude of increase in concentration, the stronger
the rebuttal evidence that should be required to overcome the
presumption of consumer harm.

(b.) As an empirical matter, small mergers producing a low level of
concentration generally are unlikely to be associated with consumer
harm. In this regard, cases like *Von's Grocery Company* obviously no
longer reflect appropriate merger policy, despite the statute's
incipiency mandate. Even though the Guidelines\' statements that
low-concentration mergers within their safe harbor are \"unlikely\" to
have anticompetitive effects and \"ordinarily\" require no further
analysis are correct, increased guidance could be provided by specifying
those rare circumstances where a challenge might nevertheless be
appropriate. These exceptions should be made explicit and transparent,
and should be limited to situations involving an industry with a history
of collusion, or mergers that involve the elimination of a maverick or a
weakening of a maverick\'s behavioral incentives.

(c.) Another reason why presumptions drawn from high concentration
should be rebuttable is the fact that market definition is an imperfect
procedure and, as a related point, certain common market definition
procedures create the potential for systematic errors in defining
markets. Procedures deserving reconsideration include: the use of the
prevailing price as the pricing benchmark for the *ssnip* test \["small
but significant and nontransitory increase in price"\] for measuring
cross-elasticity of demand; the use of critical loss analysis; and the
principle that the agencies will adopt the smallest market definition
that satisfies the *ssnip* test. The smallest market principle should be
deleted from the Guidelines entirely. The validity of the use of the
prevailing price in the *ssnip* test and critical loss analysis should
not be assumed, but rather should be carefully evaluated in every merger
investigation.[^3]

(d.) Though empirical research admittedly does not support a single
"bright line" level of concentration or market share for determining
when mergers are anticompetitive, the public identification of
rebuttable threshold presumptions has served as a useful policy guide,
channeling enforcement discretion and yielding an important degree of
predictability for business planning. Recognizing that predictability is
limited by the inherent vagaries of market definition and the
difficulties of forecasting such factors as future market entry and
competitive effects, merger analysis should be not so much a scientific
endeavor as an administrable process of applying educated judgment to
careful fact-finding within a commonly accepted, albeit ultimately
imprecise, methodological framework.

4.  **Incipiency.**

(a.) Merger enforcement, while emphasizing microeconomic analysis, must
be carried out in light of the intent behind the antimerger statutes,
and it is clear that Congress intended this enforcement to embody an
incipiency doctrine. While the Sherman Act blocks mergers likely to lead
to monopoly power or the dangerous probability of monopoly power, the
Clayton Act is designed to block mergers the effect of which \"may be
substantially to lessen competition or to tend to create a monopoly.\"
This means that increases in concentration should be prohibited even if
the anticompetitive effects might not be quite large enough or certain
enough to constitute Sherman Act violations.

(b.) This statutory language and the intent behind the Clayton Act as
well as Supreme Court precedent, also require a degree of careful,
economically informed prediction on the part of enforcers and the
courts. Under the circumstances, errors of both over-enforcement and
under-enforcement are inevitable, and the underlying facts and economics
will often be inconclusive. The incipiency doctrine means that in close
cases decision makers should resolve doubts on the side of blocking
mergers that might lead to a reasonable probability of market power.

(c.) Preserving multiple competitors is likely to be an efficient
administrative rule in otherwise close cases because mergers, once
consummated, are rarely undone. Enforcement policy almost never gets a
chance to undo a merger that should not have taken place, but there
almost surely will be future opportunities to permit consolidation in
the industry in question.

(d.) In the absence of an \"incipiency\" policy, firms in an industry
that might be contemplating consolidation may be induced into merging
prematurely. When other large firms in an industry are merging, the firm
that waits runs the risk of its later merger becoming the proposed
merger that finally triggers agency opposition \--even though in
principle it is no worse or different from those mergers that preceded
and thus got in under the wire. Enforcement decisions ought to take into
consideration the likely strategic responses to a consummated merger by
rivals and potential rivals.

5.  **Coordinated Effects.**

(a.) At one time, the analysis of coordinated effects in mergers relied
too heavily on the level and change in concentration. Expanding the
analysis to include other factors has refined the analysis and made it
more reliable. Further refinement of this analysis, including analysis
of the pre- and post-merger competitive role of mavericks and other
merger-induced changes in the likelihood of coordination, would improve
predictions of likely merger effects.

(b.) This is not to say that coordinated effects prediction in the
merger context should be identical with analysis of cartel incentives in
a price-fixing context. The purpose of merger intervention is to prevent
a situation that *may* be conducive to coordination from occurring in
the future, not to demonstrate that coordination will inevitably occur.

(c.) With respect to potential coordinated effects, heightened concern
has historically arisen around the point at which there will no longer
be at least five strong competitors or when a dominant firm may enhance
its price leadership role through a merger. We see no reason to revise
this general benchmark at this time.

6.  **Unilateral Effects.**

(a.) With respect to unilateral effects, the market shares of the
merging firms can sometimes be used as a rough proxy of the closeness of
substitution between the brands of the merging firms. However, market
shares are at best a rough indicator of substitution and generally are
inferior to careful factual and empirical analysis, including estimates
of cross-elasticities.

(b.) The apparent minimization of unilateral effects analysis by the
current federal enforcement agencies represents a step backwards.
Unilateral effects analysis has a substantial history in industrial
organization economics and represents a rigorous analytic approach.
While there may be some basis for concern about over-reliance on
simulation models in their current state of development, as a particular
method of demonstrating the magnitude of unilateral effects, there is no
good basis for

skepticism of unilateral effects analysis itself.

(c.) With respect to unilateral effects, heightened concern has
historically arisen around the point at which the leading firm's market
share is at least 35%. We see no reason to change this benchmark level
at this time.

7.  **Burden Shifting.**

(a.) When high market shares and concentration resulting from merger
create a presumption of consumer harm, the burden should shift onto
merger proponents to demonstrate one or more of the following
factors[^4]:

> (1.) Other reasons exist that demonstrate the inadequacy of measured
> market shares as a predictor of future competition;
>
> (2.) Sufficient new entry or fringe expansion is likely to occur
> within a reasonable time to reverse or deter the probable competitive
> consequences of the merger;
>
> (3.) The premerger degree of rivalry in the market is likely to be
> sustained or increased and the incentives of the merged firm to
> compete with incumbents are unlikely to be reduced;
>
> (4.) The merger will permit cognizable efficiencies yielding potential
> benefits that outweigh the harms threatened by the transaction and
> thereby eliminate the likelihood of consumer harm.

(b.) If one or more of the above is established, the burden should shift
to the government or other plaintiff to show that the merger would
likely generate a net anticompetitive effect, taking into account all
relevant evidence.

8.  **Contestable Markets.**

There is reason to doubt the empirical significance of the strongest
version of the 'contestable market' theory, which holds that potential
entry can cause even a monopolist benefiting from significant economies
of scale to price competitively. This theory wrongly assumes both that
entry requires no significant sunk costs (i.e., the entrant's
expenditures on inputs can be fully recovered if entry fails) and that
the monopolist's price response to entry is delayed.

9.  **Potential Entry**.

(a.) Despite the very limited applicability of the pure contestable
market model to real world settings, the more general potential entry
concept nonetheless is an important element in the analysis of the
likely competitive effects of a merger. On the one hand, potential
entrants can reduce the likelihood of anticompetitive effects from a
merger, particularly where efficient small scale entry by multiple firms
is possible and where entry can be secret or sponsored by large buyers.
On the other hand, mergers between an incumbent and a potential entrant
can cause anticompetitive harm. Accordingly, competitive concerns may
arise from mergers that remove significant potential entry, both
perceived and likely actual potential entrants. This is a particular
concern in high technology markets, where significant competition may
occur well before products are sold to consumers.

(b.) Because of the competitive importance of potential entry in many
industries, merger policy should place more emphasis on preventing
mergers that reduce potential competition. This is an area where the
case law has moved too far in the direction of laissez-faire. Federal
and state enforcement agencies should undertake greater efforts to bring
appropriate enforcement actions, refine the analysis and educate the
courts.

10. **Efficiency from Mergers.**

(a.) National merger policy since 1981 has rested on the assumption that
most mergers generate important efficiencies and therefore significantly
contribute to consumer welfare. This is reflected in the fact that,
typically, only 2-3% of mergers large enough to require federal
pre-notification are pursued to the second request level of
investigation. Yet, respected economic research has found that many,
perhaps most, mergers do not lead to significant reductions in cost,
although a small proportion of horizontal mergers have led to very
significant efficiencies. Many of the predicted efficiencies of mergers
have failed to materialize.

(b.) The practical importance of this research is that it is time to
re-examine the underlying assumption that allows such a high proportion
of significant horizontal mergers to be consummated.

(c.) In the meantime, in specific investigations, claims of efficiency
benefits arising from a merger should be viewed skeptically. This is
particularly true of theoretical arguments for gains arising from
consolidated management and marketing. Moreover, the empirical evidence
supporting claims of efficiency gains should be based on the specific
cost structure and technology of the firms, and should be accompanied by
further evidence that demonstrates how these cost reductions will
benefit consumers.

(d.) To be cognizable, efficiencies must be non-speculative,
merger-specific, and provide substantial direct benefit to customers.
Only efficiencies net of any higher costs caused by the merger represent
potential consumer benefits. Claimed benefits that will only arise in
the long run are often more uncertain and for that reason should be
given less weight.

(e.) Because a high proportion of mergers fail to provide the benefits
that were predicted by their proponents and because there are large
costs for society when anticompetitive mergers occur, Congress should
provide federal antitrust enforcers additional resources to permit more
detailed scrutiny of more proposed mergers than is possible today.
Enforcers should be encouraged to scrutinize more mergers that might
currently be deemed marginal.

11. **Research Topics.**

Recognition of the failure of so many mergers to produce their predicted
benefits suggests that more research be devoted to examination of:

(a.) consummated mergers to evaluate whether or not they led to
significant savings and/or price increases;

(b.) proposed mergers that were stopped or restructured as a result of
antitrust intervention in order to evaluate the effectiveness of the
government's intervention, including the sufficiency of remedies
utilized;

(c.) the effects of merger enforcement on innovation, including both the
extent to which innovation concerns played a role in past enforcement
decisions, and the extent to which merger enforcement and
non-enforcement has affected various types of innovation; and

(d.) merger dynamics in network industries, where predictions of
merger-enhanced tipping effects may deter entry by potential
competitors.

12. **Transparency and Evolution.**

Greater transparency on the part of the government is a necessary
foundation for the beneficial evolution of antitrust policy. Although
the government has recently made positive strides toward increased
transparency, there remains a need for more detailed explanations of the
agencies' reasoning with respect to actions taken (and, in certain
instances, not taken); for projects like the joint FTC/DOJ compilation
of data on completed investigations; and for other initiatives that will
facilitate research by the government and by academics. The history of
antitrust should not be characterized as pendulum-like, but rather as an
on-going dialogue, continually evolving toward a better understanding of
markets and competition within the context of a politically-determined
legal framework.

[^1]: We have not focused in this statement on concentration at the
    buyer level, which will be the subject of an AAI conference on June
    22, 2004, exploring ways in which buyer power may differ from seller
    power.

[^2]: The AAI is an independent education, research, and advocacy
    organization, described on the Internet at
    www.antitrustinstitute.org. The drafting of this document has been a
    nine-month iterative process featuring very heavy input by a
    drafting committee of seven and repeated circulations to the full
    Advisory Board for comment. The author and the Board of Directors
    bear responsibility for the final version.

[^3]: The AAI will conduct a symposium on "Combining Horizontal and
    Vertical Analysis in Antitrust: Implications of the Work of Robert
    L. Steiner" on June 21, 2004. This will explore whether the role of
    retailers gross margin is given adequate consideration in market
    definition and other merger-related issues that arise in the
    consumer goods sector.

[^4]: Merger case law and the Horizontal Merger Guidelines also properly
    recognize a narrow failing firm defense.