Vertical Merger Guidelines

The cognitive map of contract set out in Chapter 1 (Figure 1-2) identifies two main approaches to the study of contract: monopoly and efficiency. Of the two, the monopoly approach was the more fully developed and more widely favored through the early 1970s (Coase, 1972). Vertical integration is one of the areas to which the monopoly branch of contract was thought to have relevance.

Leverage theory and entry barrier arguments were especially prominent. Vertical integration was believed to permit monopoly power in one area to be magnified through acquisition of another (the leverage theory hypothesis) or to impair the condition of entry (the entry”barrier hypothesis). Lacking a “physical or technical aspect” (Bain, 1968, p. 381), whereupon technological cost savings were plausibly associated with vertical integration anticompetitive purpose was thought to be the driving force. It was easy therefore, to conclude that public policy concern was warranted whenever vertical integration involved an ‘‘appreciable degree of market control at even one stage of the production process” (Stigler, 1955, p. 183). Specifically, Stigler stated that when a firm had at least 20 percent of an industry’s output its acquisition of more than 5 percent of the output capacity of firms to which it sells or from which it buys can be presumed to violate the antitrust laws (Stigler, 1955, pp 183-84).

The 1968 Vertical Merger Guidelines, which set the limits on acquiring firm and acquired firm market shares at 10 and 6 percent respectively were plainly in this monopoly/technological spirit. The Guidelines were either informed by and reflected this line of scholarship, or the correspondence between the two is a remarkable coincidence. Given the prevailing firm-as- production-function framework, an affirmative rationale for vertical integration that did have technological origins was not evident. There being no transaction cost economies to realize, even the slightest degree of monopoly power was thought to be responsible for decisions to integrate. The threshold level for imputing monopoly power and purpose to the acquiring firm was set at 20 percent by Stigler and was subsequently reduced to 10 percent in the 1968 Guidelines.

Transaction cost economics takes issue with that in two respects. First the possibility that vertical integration is driven by transaction cost economies needs to be taken into account where parties are operating in a bilateral trading context. Second, the slightest degree of monopoly power will not elicit integration if, as developed more fully in Chapter 6, internal organization is beset by incentive difficulties. Slight degrees of monopoly power at one stage are not, without more, sufficient to warrant internal procurement.

This is not to say that vertical integration is wholly unproblematic in antitrust respects, however. To the contrary, integration by dominant firms can place smaller rivals at a strategic disadvantage. Interestingly, such anticompetitive effects also have transaction cost origins.

Entry impediments of two types can arise where the leading firms in stage I integrate (backward or forward) into what could otherwise be a competitively organized stage II activity. For one thing, the residual (noninte- grated) sector of the market may be so reduced that only a few firms of efficient size can service the stage II market. Firms that would otherwise be prepared to enter stage I may be discouraged from coming in by the prospect of having to engage in small- numbers bargaining, with all the hazards this entails, with those few nonintegrated stage II firms. Additionally, if prospective stage I entrants lack experience in stage II related activity, and thus would incur high capital costs were they to enter both stages themselves, integrated entry may be rendered unattractive. The integration of stages I and II by leading firms is then anticompetitive, in entry aspects at least, if severing the vertical connections would permit a competitive (large-numbers) stage II activity to develop without loss of scale economies.

Vertical integration in industries with low or moderate degrees of con- centration does not, however, pose the same problems. Here a firm entering into either stage can expect to strike competitive bargains with firms in the other stage whether they are integrated or nonintegrated. The reasons are that no single integrated firm enjoys a strategic advantage with respect to such transactions and that collusion by the collection of integrated firms (in supply or demand respects) is difficult to effectuate. Vertical integration rarely poses an antitrust issue, therefore, unless the industry in question is highly concentrated or, in less concentrated industries, collective refusals to deal are observed. But for such circumstances, vertical integration is apt to be of the efficiency promoting kind.

The 1982 Merger Guidelines hold that vertical mergers are unlikely to pose troublesome antitrust issues unless the Herfindahl index in the acquired Firm’s market exceeds 1800 (this corresponds,.roughly, to a four-firm concentration ratio of 70 percent) and the market share of the acquired firm exceeds 5 percent. The presumption is that nonintegrated stage I firms can satisfy their stage II requirements by negotiating competitive terms with stage II fimiswhere the HH1 is below 1800. The 1982 Vertical Merger Guidelines thus focus exclusively on the monopolistic subset, which is congruent with transaction cost reasoning. It is furthermore noteworthy that the anticompetitive concerns to which the Guidelines refer—regarding costs of capital,41 (contrived) scale diseconomies, and the use of vertical integration to evade rate regulation—are all consonant with transaction cost reasoning.42 Also, the 1982 Guidelines expressly acknowledge that investments in the secondary market are risky in the degree to which “capital assets in the secondary market are long-lived and specialized to that market.” This core proposition plainly has transaction cost economics origins.

Despite this striking correspondence, the 1982 Guidelines are not fully consonant with transaction cost reasoning throughout. The transaction cost rationale for challenging a 5 percent acquisition whenever the HHI exceeds 1800 is not transparent. Furthermore, it was not until 1984 that the Guidelines made provision for an economies defense. To be sure, there are hazards in allowing an economies defense, especially if economic evidence must be presented in court. These hazards can be mitigated, however, if the Justice Department declines to bring cases where economies are clearly driving organizational outcomes (Kauper, 1983, pp. 519-22).

Whatever is decided in economies defense respects, the fact is that the 1982/1984 Vertical Merger Guidelines reflect a genuine sensitivity to transaction cost features—and are much more permissive than their predecessors as a consequence. Although there are those who counsel otherwise (Schwartz, 1983), public policy is arguably more informed and has been made more consonant with the public interest.

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

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