Antitrust Enforcement: Merger Policy

Changes in public policy toward vertical and conglomerate mergers have been described in Chapters 4 and 11. They do not require repeating here. The proposition that public policy toward mergers had undergone significant transformation is difficult to appreciate, however, without a statement of specifics. I attempt to give some background here.

1. The 1960s 

The 1960s was (he era when market power analysis flourished. Partly that was due to recent theoretical, empirical, and policy studies in which the importance of barriers to entry was featured. But it was also because antitrust economics was sorely lacking in two other respects. First, there was a general undervaluation of the social benefits of efficiency. Second, there was a widespread tendency to regard efficiency very narrowly—mainly in technological terms. ‘An awareness of transaction costs, much less a sensitivity to the importance of economizing thereon, had scarcely surfaced. Instead, the firm was held to be a production function to which a profit maximization objective had been assigned.1 The efficient boundaries of firms were thought to be determined by technology. Accordingly, efforts to reconfigure firm and market structures that violated those “natural” boundaries were believed to have market power origins.

The prevailing state of affairs is indicated by the Federal Trade Commis- sion’s opinion in Foremost Dairies, where the Commission ventured the view that necessary proof of violation of Section 7 “consists of types of evidence showing that the acquiring firm possesses significant power in some markets or that its over-all organization gives it a decisive advantage in efficiency over its smaller rivals. 2 Although Donald Turner, among others, was quick to label that as bad law and bad economics (1965, p. 1324), in that it protects competitors rather than promoting the welfare benefits of competition, the Commission carried its reasoning forward in Procter & Gamble and linked it with barriers to entry in the following way:

In stressing as we have the importance of advantages of scale as a factor heightening the barriers to new entry into the liquid bleach industry, we reject, as specious in law and unfounded in fact, the argument that the Commission ought not, for the sake of protecting the “inefficient” small firms in the industry, proscribe a merger so productive of “efficiencies.” The short answer to this argument is that, in a proceeding under Section 7, economic efficiency or any other social benefit resulting from a merger is pertinent only insofar as it may tend to promote or retard the vigor of competition.

The emphasis on entry barriers and the low regard accorded to economies also appear in the Supreme Court’s opinion. Thus the Court observed Procter’s acquisition of Clorox may have the tendency of raising the barriers to new entry. The major competitive weapon in the successful marketing of bleach is advertising. Clorox was limited in this area by its relatively small budget and its inability to obtain substantial discounts. By contrast, Procter’s budget was much larger; and, although it would not devote its entire budget to advertising Clorox, it could divert a large portion to meet the short-term threat of a new entrant. Procter would be able to use its volume discounts to advantage in advertising Clorox. Thus, a new entrant would be much more reluctant to face the giant Procter than it would have been to face the smaller Clorox.

Possible economies cannot be used as a defense to illegality.

The low opinion and perverse regard for economies went so far that beleaguered respondents disclaimed efficiency gains. Thus Procter & Gamble insisted that its acquisition of Clorox was unobjectionable because the govern- ment was unable definitively to establish that any efficiencies would result:

[The Government is unable to prove] any advantages in the procurement or price of raw materials or in the acquisition or use of needed manufacturing facilities or in the purchase of bottles or in freight costs… [T]here is no proof of any savings in any aspect of manufacturing. There is no proof that any additional manufacturing facilities would be usable for the production of Clorox. There is no proof that any combination of manufacturing facilities would effect any savings, even if such combination were feasible.

This upside-down assessment of economies was bound to change, and it did—but not before Justice Stewart, in a dissenting opinion in 1966, recorded that the “sole consistency that I can find is that in [merger] litigation under Section 7, the Government always wins.”

2. Subsequent Developments 

The reforms of antitrust enforcement in the 1970s had their origins in critiques of the 1960s. Those include (1) the insistence of the “Chicago School” that antitrust issues be studied through the lens of price theory; (2) related critiques of the entry barrier approach; (3) application of the partial equilibrium welfare economics model to assess the tradeoffs between market power and efficiency; and (4) a reformulation ot the theory of the modern corporation whereby transaction cost economizing considerations were brought to the fore. An additional contributing factor was the reorganization of the economics staff of the Antitrust Division. Whereas previously the staff economists were used almost exclusively to support the legal staff in the preparation and litigation of cases, it was now asked to assess the economic merits of cases before they were filed.

The Chicago School approach has been set out by Richard Posner (1979) elsewhere. Although it is possible to quibble with Posner’s rendition of Harvard versus Chicago (as these were viewed in the 1960s), it is nevertheless clear that the leverage theory approach to nonstandard contracting has progressively given way to the price discrimination interpretation favored by Aaron Director (and his students and colleagues).

The preoccupation of merger policy with entry barriers was also criticized by Chicago. Objectives of two kinds were registered. The first held that the basic entry barrier model, as set out by Bain (1956) and elaborated by Franco Modigliani (1958), purported to be but did not qualify as an oligopoly model. As Stiglcr put it, the entry barrier models solved the oligopoly problems by murder: “The ability of the oligopolists to agree upon and police the limit price is apparently independent of the sizes and numbers of oligopolists” (1968, p. 21). Put differently, the model did not address itself to the mechanics by which collective action was realized. Instead, it simply assumed that the requisite coordination to effect a limit price result would appear. As discussed below, recent models in the entry barrier tradition have avoided that problem by explicitly casting the analysis in a “sitting monopolist”/duopoly framework. Addressing the issues of entry in this more limited context has analytical advantages, but applications outside of the dominant firm context are appropriate only upon a showing that the necessary preconditions to effect oligopolistic coordination are satisfied.

The other objection to entry barrier analysis relates to public policy misuses of entry barrier reasoning. That the condition of entry is impeded is neither here nor there if no superior structural configuration—expressed in welfare terms—can be described. However obvious that may be on reflection, it was not always the case. Rather, there was a widespread tendency to regard barriers of all kinds as contrary to the social interest. But as Robert Bork has put it, “The question for antitrust is whether there exist artificial entry barriers. These must be barriers that are not forms of superior efficiency and which yet prevent the forces of the market . . . from operating to erode market positions not based on efficiency” (1978, p. 311; emphasis added).

The distinction  between remediable  and irremediable  entry impediments thus becomes the focus of attention. Little useful public policy purpose is served, and a considerable risk of public policy mischief results, when conditions of an irremediable kind are brought under fire. Mistaken treatment of economies of scale illustrates what is at stake. Thus suppose that economies of scale exist and that the market is of sufficient size to support the larger of two technologies. Since superior outcomes will be attributable to the less efficient technology only in very unusual conditions, net social benefits ought presumably to be attributed to the scale economy conditions. To describe such economies as “barriers to entry,” however, does not invite that conclusion; to the contrary, mistaken welfare judgments are encouraged.

That efficiency benefits were held in such low regard in the 1960s is partly explained by the widespread opinion that, as between two structural alternatives— one of which simultaneously presents greater market power and greater efficiency than the other—the more competitive structure is invariably to be preferred. That view was supported by the implicit assumption that even small anticompetitive effects would surely swamp efficiency benefits in arriving at a net valuation. The FTC opinion that “economic efficiency or any other social benefit [is) pertinent only insofar as it may tend to promote or retard the vigor of competition”7—where competition is defined in structural terms—is a clear indication of such thinking.

Application of the basic partial equilibrium welfare economics model to an assessment of market power versus economies tradeoffs disclosed that to sacrifice economies for reduced market power came at a high cost (Williamson, 1968). Although the merits of that framework remain open to dispute (Posner, 1975, p. 821), the general approach, if not the framework itself, has since been employed by others. Bain was among the first to acknowledge the merits of an economies defense in assessing mergers (1968, p. 658). Wesley Liebeler (1978), Robert Bork (1978), and Timothy Mûris (1979) have all made extensive use of the partial equilibrium tradeoff model in their insistence that antitrust enforcement that proceeds heedless of tradeofls is uninformed and contrary to the social interest.

A common argument against tradeoff analysis is that the courts arc poorly suited to assess economic evidence and arguments of this kind (Bork. 1978). In tact, however, a simple sensitivity to the merits of economies is sufficient to avoid the inverted reasoning of Foremost Dairies. And although «tors of the Schwinn kind are avoided only upon recognizing that economies Cta take transaction cost as well as technological forms, the mistakes of the “inhospitably tradition” also become less likely once that step has been taken. The upside-down assessment of economies in the 1960s appears thoroughly to have been vanquished by the economies as an antitrust defense literature (Fisher and Lande, 1983).

Indeed, not only are economies no longer regarded as an anticompetitive feature, but the 1984 Merger Guidelines of the Department of Justice expressly declare that “some mergers that the Department otherwise might challenge may be reasonably necessary to achieve significant net efficiencies. If the parties to the merger establish by clear and convincing evidence that a merger will achieve such efficiencies, the Department will consider those efficiencies in deciding to challenge the merger” (U.S. Department of Justice, 1984, Sec. 3.5). In effect, firms that are proposing a merger are now invited to present evidence of efficiencies as support for the merger—rather than suppress such evidence (the market power standard) or deny that any efficiencies exist (the perverse condition to which merger enforcement had fallen in the 1960s). Economies of both technological and transaction cost kinds will be entertained (Sec. 3.5 and 4.24).

Although such an approach to merger enforcement accords what some may regard as excessive discretion to an administrative branch of the government, there are no costless choices. Only time will tell whether the lawyers and economists in the Antitrust Division will be able to sort real from contrived claims of efficiency and thus permit the merger statutes to be enforced with net social gains. I am nevertheless cautiously optimistic of such a result.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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