Investment Incentives and Merger-Specific Efficiencies

Economists Ink: A Brief Analysis of Policy and Litigation


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Richard T. Shin has worked on a number of merger and price-fixing cases before the Korea Fair Trade Commission, including the SK-ICO merger. He has experience in demand estimation and merger simulation in various industries including energy, telecommunications, retail, manufacturing, health care, high-tech, and airlines. Kwang Soo Cheong is an associate professor of the Johns Hopkins University Carey Business School and an affiliate with Economists Incorporated. He also worked on the SK-ICO merge.

The efficiencies potentially available from a merger may be an important factor both in the companies’ decision to merge and in the antitrust authorities’ decision whether to challenge the transaction. Efficiency gains will reduce costs and hence increase profits. Whether these gains will also reduce price and increase consumer welfare is another matter. In evaluating merger efficiencies, the antitrust authorities should recognize that improvements in investment incentives may be important efficiencies that increase consumer welfare.

This interest in consumer welfare has led the antitrust authorities to focus on efficiencies that reduce marginal costs. Reductions in fixed cost can also encourage investment and thus increase output and consumer welfare. Such efficiencies gains are likely to be cognizable under the revised Merger Guidelines. The Guidelines state that “certain types of efficiencies are more likely to be cognizable and substantial than others. For example, efficiencies resulting from shifting production among facilities formerly owned separately, which enable the merging firms to reduce the marginal cost of production, are more likely to be susceptible to verification, merger-specific, and substantial, or may be cognizable for other reasons.” If a merger enables an expansion of capacity at one of the merged firm’s facilities, that will enable production to be shifted to that facility. Such a shift in production may result in savings that are readily cognizable according to the Merger Guidelines.

The oil refining industry requires substantial fixed investments to increase capacity, and two merging oil refineries in Korea claimed increased investments would result in substantial efficiency gains. This claim was assessed using a game-theoretic model that specifically recognized the sequential nature of merger and investment decisions. The model was used to analyze the investment decisions likely to be made by market participants and then evaluate the total fixed cost for the market and the marginal cost for each firm both with and without the merger.

This modeling approach was applied to evaluate the merger-specific efficiencies from a proposed merger between the largest refinery in Korea, SK Corporation (SK), and the smallest refinery in Korea, Inchon Oil (ICO). This merger was subject to review by the Korea Fair Trade Commission (KFTC), which is often said to judge merger efficiencies using standards that are comparable to those used by the U.S. authorities. SK planned to make substantial investments in ICO if the merger were allowed. Efficiencies resulting from these investments would be cognizable only if these investments would not take place without the merger. Therefore, a critical examination of efficiency claims should address the following questions:

•  Would an alternative buyer invest in ICO in a way that would be similar to the planned investments by SK?

•  Would SK make similar investments in other facilities were it unable to acquire ICO?

Alternative buyers would likely not have made the same investment in ICO that SK planned. The most likely alternative buyer for ICO’s assets was a consortium of foreign investors. Those investors would make necessary investments to continue ICO’s operations, but had no incentives to make a long-term strategic investment to improve ICO’s refining capability or efficiency. The other possible alternative purchasers were the other oil refineries in Korea: GS Caltex, Hyundai Oilbank, and S-Oil; however, they expressed no interest in acquiring ICO. Any potential buyer except SK would have been reluctant to invest in ICO because there was already an overall excess capacity in oil refining for the Korean market. Compared to the other Korean refineries, SK had the largest network of foreign buyers and already had a presence in China selling refined products. SK projected that China’s demand for refined products would far outstrip Chinese domestic refining capacity. Thus, SK had greater incentives to invest in refining capacity in order to export to China as well as meet the domestic demand in Korea. Furthermore, in comparison with other potential buyers, SK’s extensive experience acquired in the process of improving and updating its own refineries would be readily transferable to improve ICO’s refineries.

Suppose SK was unable to acquire ICO. It is then unlikely that SK would have expanded refining capacity in its existing facilities. To increase its capacity, it must expand its existing facilities by acquiring adjacent real estate, and acquiring the necessary neighboring real estate was deemed to be prohibitively expensive. So, had SK invested in its own facilities, much of the investment would have gone to acquiring real estate, and the increase in productive capacity would have been much less than would have resulted from the same level of investment in the ICO facilities. Therefore, acquiring ICO would allow a more profitable investment for SK than investing in its own facilities.

Besides the increase in capacity, other efficiencies would also result from SK’s acquisition of ICO. SK could use its superior technical know-how to greatly enhance ICO’s productive efficiency. Moreover, the use of SK’s network for ICO products would reduce the cost of importing crude oil and exporting refined products. A substantial portion of these efficiencies would be marginal cost reductions that would be readily passed on to the Korean consumers.

In assessing the effects of a merger, it may be important to ask how the merger will affect investment incentives and the growth of industry capacity. A game-theoretic analysis of the SK’s acquisition of ICO finds that the merger would put the acquired firm’s assets in the hands of a company with greater ability and incentives to expand productive capacity than any other potential buyer, thereby generating cognizable efficiency gains. These efficiencies would likely reduce prices and increase consumer welfare. Largely because of these cognizable efficiencies and competitive constraints from the world oil market, the KFTC did not challenge the merger.