The Use of Simulations to Assess the Effect of Vertical Mergers

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Michael G. Baumann is a Senior Vice President at Economists Incorporated. He has extensive experience in analyzing mergers and using empirical methods in merger analysis. Matthew B. Wright is a Corporate Vice President and Principal at Economists Incorporated. He also has a wide range of experience evaluating both horizontal and vertical mergers and analyzing the competitive effects of vertical restraints. Both were part of the team that helped analyze and develop merger simulation models for the Toyota-Cascade transaction.

In recent years, U.S. competition authorities have extensively scrutinized non-horizontal mergers. Prominent examples include Comcast-NBC and Google-ITA. In both cases, concern about potential input foreclosure was both a significant focus of the merger investigation and a major element of the antitrust remedy. Experience in a recent investigation suggests that simulation models may play an increasingly important role in assessing the competitive effects of vertical mergers.

Competitive concerns regarding input foreclosure arise because a vertical merger can affect the incentives of the merging parties. For example, an upstream input supplier that formerly had an incentive to sell to all downstream buyers on comparable terms may face different incentives after the merger, because it now accounts for the impact of its actions on the profitability of its merger partner. If the downstream merger partner would benefit from the upstream merger partner’s refusing to sell to rival downstream firms (a “total foreclosure” strategy), or supplying downstream rivals at prices above pre-merger levels (a “partial foreclosure” strategy), then the potential for input foreclosure may exist.

For input foreclosure to cause competitive harm, three conditions must hold. First, the merged firm must have the abilityto foreclose its rivals. If the merged firm cannot effectively raise input prices to its rivals or deny its rivals access to the input, then foreclosure cannot occur. Second, the merged firm must have an incentive to foreclose. If attempted foreclosure would not be profitable, then foreclosure should not be a competitive concern. Third, foreclosure must harmconsumers, not just competitors. If, despite any potential foreclosure, consumers benefit because of efficiencies specific to the merger, then the merger would not harm competition and should not be challenged.

Economists have found that vertical mergers raise competitive concerns only under limited circumstances. Indeed, because significant efficiencies may result, vertical mergers have considerable potential to produce competitive benefits. For example, consumers may benefit from the elimination of double marginalization. Double marginalization occurs when both the upstream and downstream firms have some market power and each prices at a markup over marginal cost. A vertical merger can eliminate one of the markups and increase output. Identifying the rare instances in which vertical mergers might raise competitive concerns is an important and difficult task for the competition agencies.

To aid their analysis, competition agencies have begun using quantitative approaches to analyze the incentive to foreclose and the likely competitive effects of foreclosure. For instance, enforcement agencies have used “vertical arithmetic” to consider the incentive for merging parties to engage in input foreclosure. Vertical arithmetic can be used to compare the likely costs to the potential benefits of foreclosure for the merging parties. The cost and benefits depend on many factors, including the relative margins of the merging firms, the magnitude of lost upstream sales resulting from the foreclosure, and the likely increase in the downstream merger partner’s sales due to the foreclosure strategy. Vertical arithmetic is most useful when considering the potential effect of total foreclosure. It is much less helpful in assessing incentives for partial foreclosure because it does not address the incentives to change input prices.

The potential competitive effects of partial foreclosure might instead be evaluated through merger simulation. While merger simulation has frequently been used to analyze horizontal mergers, its use to analyze vertical mergers is less common and more complicated. As in horizontal contexts, vertical merger simulation faces substantial challenges, including the need to assume the form of competitive behavior, to estimate relevant demand elasticities (or diversion patterns), to account for relevant cost savings, and to assume a particular functional form of the demand curve. Vertical merger simulation not only faces those issues but also requires assumptions about the willingness of consumers to switch from one combination of upstream and downstream products to another, about the competitive interactions between the upstream and downstream firms, and about the manner in which vertical integration affects these interactions. Changes in the merged firm’s pricing incentives, including the elimination of double marginalization, also present challenges to modeling vertical merger effects.

DOJ recently employed merger simulation in its analysis of a vertical transaction, the acquisition of Cascade Corporation, a lift-truck attachment manufacturer, by Toyota Industries Corporation, a lift truck manufacturer. Lift truck attachments include forks and specialized attachments, such as clamps and rotators, used for specific applications. DOJ’s review focused in part on whether the transaction might lead Cascade to engage in partial input foreclosure when supplying specialized attachments for use with lift truck brands that compete against Toyota.

As part of its analysis, DOJ developed a merger simulation model to predict the likely competitive effects of the transaction. Given the absence of data about several important inputs for the simulation exercise, DOJ made several simplifying assumptions. These assumptions included that diversions in response to relative price changes would be in proportion to current shares, that pricing decisions about lift truck attachments and lift trucks were made sequentially rather than simultaneously, and that each lift truck brand could only be paired with one brand of lift truck attachment.

That DOJ made many (and in some cases, unrealistic) assumptions reflects the difficulty in calibrating the model and highlights the challenges with using simulations to estimate the effects of vertical mergers. In response to DOJ’s modeling effort, the parties’ economic consultants developed their own simulation model that relaxed some of the most restrictive DOJ assumptions. For instance, the parties’ model allowed for simultaneous pricing decisions by attachment and lift truck manufacturers and permitted purchasers of any lift truck brand to pair the lift truck with any attachment brand. When merger-specific efficiencies (such as elimination of double marginalization) were accounted for, the parties’ model suggested that under most scenarios average prices to consumers would fall after the transaction. After the model’s findings were presented to DOJ, DOJ permitted the merger to proceed without any conditions.

The antitrust agencies are likely to increase their scrutiny of vertical mergers and employ increasingly sophisticated merger simulation models. While these models may help focus merger analysis, it is important to understand their limitations and to ensure that the assumptions that underlie any model are well suited to the merger being analyzed.