ANTITRUST

LAWJOURNAL
EVALUATING VERTICAL MERGERS:
A F’OST-CHICAGO APPROACH
MICHAEL H. RIORLWN
STEVEN c. SALOP
 EVALUATING VERTICAL MERGERS:
A POST-CHICAGO APPROACH
MICHAEL H. RIORDAN
STEVEN C. SALop*

I. INTRODUCTION
Antitrust law governsboth horizontal and vertical agreements.These
agreementsincludejoint pricing, exclusivityarrangements,and mergers.
In evaluating horizontal agreements,there is general consensushow
such agreementscan facilitate collusive pricing. The proper antitrust
treatment of vertical agreementsis far more controversial. In this area.
there is no consensusabout whetherand how anticompetitive effectscan
occur. There is perhaps no better example than in the area of vertical
price agreements,where one prominent commentator has called for
replacing per se illegality with per se legality.’
The antitrust treatment of verticalmergersalsohasbeenhighly contro-
versial.Antitrust treatment of vertical mergerswasextremely restrictive
in suchcasesasBrownS/up and Ford-Auk&. However, strong criticism
of thosecasesby Chicago Schoolcommentatorsand others led to a new
perspectivein which vertical mergerswere viewedasgenerally competi-
tively neutral or procompetitive.’

lThe awhorr are,rcrpectively,

Professor of F.conomio.
BostonUniversity and Profa-
sorof Economicsand Law,Georgetown University LawCenler.Wewould like 10 acknowl-
cd helpful comments from Douglas Bernheim. Ronald Bond, Lephen Calkim. Richard
Gil!&, W arren Grimes, James Key% Thomas Krstrenmsker. Tina Miller, Mau Reilly,
Gary R&ens, and R&n Willig. A previous version of rhea srricle was presented a1
Ihe FTC/DOJ/ABA/GULC Conference, Post-Chicago Economics: New Theories-New
Cases?. Washington. DC.. May 26-27, 1994.
’ Richard A:Posner, Tk Nat Sup in lix Anfihur Tmdmml of Rdided Dbhduliat: Pn
St Lepdity, 40 U. Cm. L. Rw. 6 (1981).
’ k&n Shoe Co. V. United Suws. 370 US. 294 (1962).
‘Ford Motor Ca. V. United Slaves. 286 F. Supp. 407 (E.D. Mich. 1968). n/Td, 405 U.S.
562 (1972).
‘Set Rosxw H. Bow.. THE ANTITRUST
PA~WX 225 (1978); Robert H. Bork CI al..
The Cc& of Atilitnul: A Did&w on Polity,65 COLUM. L. Rnv. 369 (1965); Thomas G.
Krattenmaker & Steven C. Salop, Anlicmmpttivr Exclwim: Raising Rids’ Cor(r lo Achime
Pow. Over PG. 96 YAU LJ. 209 (1966).

513
 514 ANTITRUST LAW JOURNAL [Vol. 63 EVALUATING VERTICAL MERGERS 515
19951
This more benign view formed the foundation of the 1984 Department investigated the acquisition of McCaw Communications by AT&T and
of Justice Merger Guidelines’ and 1985 Vertical Restraints Guidelines.’ the DOJ obtained a conduct-oriented consent decree.‘r In response to
It also led to a highly permissive vertical restraints policy during the a Congressional mandate, the FCC similarly is engaged in extensive
Reagan and Bush Administrations, apart from the AT&T divestiture,’ rulemaking to govern vertical integration in the cable television
For example, the Department of Justice (DOJ) under the Reagan and business.”
Bush Antitrust Divisions prevented only a single vertical merger, the
proposed combination of Showtime and The Movie Channel with a This renewed concern also reflects the current view among economists
number of film distributors.‘During the same period, the Federal Trade that vertical mergers can lead to anticompetitive effects under certain
Commission (FTC) brought one vertical merger action-the Goodrich- circumstances. The Chicago School critique of vertical merger policy has
Diamond Shamrock proposed merger.’ But both these mergers had precipitated a more refined analysis of vertical mergers. These new post-
Chicago theories neither ignore nor reject the economic analysis of the
important horizontal as well as vertical merger elements.
Chicago School. Instead, they apply the newer methodology of modern
This record on vertical integration has come under recent attack. For industrial organization theory to more realistic market structures in
example, Congressman Jack Brooks stated: which vertical mergers can have anticompetitive effects. Although this
It is not that vertical integration of production and distribution automat- scholarshio certainlv does not suggest a return to the Brown S/we view
ically poses a competitive threat of foreclosure and barriers to entry to :-
new entrants; it may not. The difficulty faced is that vertical mergers, for of vertical mergers: it does identtfy situations where vertical mergers
the past 12 years. weredeemed barely worthy of any careful competitive and other vertical restraints can raise significant competitive concerns.”
scrutiny at all by the antitrust enforcement agencies. This was a gross Paramount by QVC, an entity in which TCI has a partial ownership interest. Telc-Commu-
abdication of responsibility, and I know that such a cavalier approach nications, Inc., 58 Fed. Reg. 68.167 (Nov. 90. 1999). The ccmwnt decree was withdrawn
won’t be repeated with the current leadership at the Justice Department when QVC failed in its bid to purchase Paramount.
and FTC.‘O ” United States V, AT&T, 59 Fed. Reg. 44.156 (Aug. 26. 1994). In addition. Bell Atlantic
Attitudes like this have led to increased enforcement efforts against and Nynex wed in district court to block the acquisition. That case ultimately settled before
trial.
vertical integration. One of Assistant Attorney General Bingaman’s first
” The Cable Television Consumer Protccdon and Competition Act of 1992. Pub. L. No.
official acts was to repeal the Vertical Restraints Guidelines. The DOJ 102.865, 106 Stat. 1460 (1992): First Report and Order in the Matter of Implementation of
recently issued a complaint (and settled) a vertical tying-exclusive dealing Sections 12 and 19 of the Cable Television and Consumer Protection Act: Dcvelupment
case against Electronic Payment Systems,” the owner of the MAC ATM of Competition and Diversity in Vidcn Programming Distribution and Carriage. MM
Docket No. 92.165. released Apr. 1. 1992; Report and Order and Further Notice of
network. It also obtained a consent decree in the TCI-Liberty recombina- Proposed R&making in the Matter of Implemcntatiun al Sections I I and I8 of the Cable
tion.‘r The DOJ and the Federal Communications Commission (FCC) Television and Consumer Protection Act: Horizontal and Vertical Ownership Limits. Croas-
Ownership Limitations and Anti-Traficking Provisions, MM Docket No. 92-264. rclcased
’ U.S. Department of Justice Merger Guidelines (1964). reprinted in 4 Trade Reg. Rep. July 28, 1998; Second Repart and Order in the Matter al lmplcmenration of Sections I I
(CCH) ( 18.109. at 20,564 [hereinafter 1964 DOJ Merger Guidelines]. and 18 of the Cable Television and Consumer Protection Act: Horizontal and Vertical
Ownership Limits, MM Dacket No. 92-264. released Oct. 22. 1999.
’ U.S. Department of Justice Vertical Restraints Guidelines (1965). reprinted in 4 Trade
Reg. Rep. (CCH) (I 19.105. at 20,577 [hereinafter 1965 DOJ Vertical RcltraintlGuidclinea]. ‘) There is now an extensive literature in cctmOmic$ and law analyzing the comperilive
These Guidelines were reminded by the Clinton Administration in 1998. concerns raised by vertical mergers that goes back at least to JOE S. BAIN. BARRIERS TO
NEW COMPETITION 1-41 (1956). For a sampling of recent arlicb% see Krattcnmaker &
’ United States v. AT&T Co.. 552 F. Supp. 191 (D.D.C. 1962). #dssub nom. Maryland
Salop. rupm note 4: Janus2 A. Ordover et al.. Nonp!‘in Anticomptlilivr Behavior qV Dominant
v. United States, 460 U.S. (1988).
Firm TownrdlhcPmducnso,ConplnmrorlPraducls. m ANTITRUST AND REGULATION: ESSAYS
‘See Lawrence J. White. Antihut and Vi&o Mark&: The Merger of Showtim and The IN MEMORYOPJOHNJ. McCow.w I15-190 (Franklin Fishercd.. 1965): Michael A. Salingcr.
Movie Channel ar a Cart Study. in VIDEO MEDIA COMPETITION: Rrcuuwm. Eco~omtcs AND VetiicalMergrr~ ondh4arkrrFwrrlorurr. 77 Q.J. Ecotv. 845 (19RS): Oliver Hart &Jean Tirolc.
T~CHNOLOCV 986 (Eli M. Noam cd., 1965). Vtrtical h&-r&m ad Mark! F’ornlosurr. Baooa~~~s PAPERS ON ECONOMIC ACTIVITY 205
* B.F. Gwdrich Co., I IO F.T.C. 207 (1966). (1990); Louis Kaplow, Extmrion o/ Mon@ly, Powrr Through Ltucragr. 85 COLUM. L. REV.
” Letter from Congressman Jack Brwks. Chairman of the House Judiciary Committee, 515 (1985); Janus2 A. Ordaver CL al.. Equilibnun VmtvalFonclosure. RO Am. ECON. Rrv. 127
to DOJ Assistant Attorney Gcnrral Anne Bingaman and FTC Chairman Janet Steigcr (1990) [her&after Ordover. Equilibnun]; David Rciffen. Equilibrium Verfical Forerlmurr:
(Nov. 4. 1998). Cantnt. 62 Au. ECON. REV. 694 (1992): Janusz A. Ordovcr et al.. Equilibtiun Verlirol
Forcclorurr: &ply, 82 Au. ECON. REV. 69X (1992) [hereinafter Ordover. Heply]; Eric B.
” United States v. Electronic Payment Sys.. Inc.. Civ. No. 94-206 (D. Del. Apr. 21. 1994)
Rasmussen et al. N&d Exclwion, 81 Aoc. ECON. Rrv. ,187 (1991): Jeffrey Church &
(complaint); 59 Fed. Reg. 44.757 (Aug. 80. 1994).
Neil Gandal, Equilibrium Foreclosure and Cnmplementary Praducts (Sackler Lnrtitutc Of
I9 United States v. Telc-Communications. Inc.. 59 Fed. Reg. 24.729 (May 12. 1994). The Economics, Tel-Aviv University Working Paper No. 8-99 March 19YS). For recent surveys
FTC aim obtained a consent dccrer with TCI in the potential vertical acquisition of of the ccwwxGs literature, sec. e.g.. Martin K. Perry. Vrrfiral Inlegralion: Delrnnmanlr and
 516 ANTITRUST LAW JOURNAL [Vol. 63 EVALUATING VERTICAL MERGERS 517
I9951
Given these new attitudes toward vertical mergers among policy mak- Second, the Chicago School utilizes an oversimplified microeconomic
ers and economists, it is appropriate to distill the latest economic learning. model to conclude that vertical mergers carried out by a monopolist
This article is a step in that direction. We explain how vertical mergers calln~jt enhance monopoly power. The idea is that there is only a “single
can lead to anticompetitive effects and identify a number of factors that monopoly profit” that can be earned be the monopolist, whether or not
affect the likelihood and magnitude of those effects. We also discuss the the monopolist is vertically integrated. ’ Instead of enhancing monopoly
efficiency benefits of vertical mergers and how the net competitive impact power, the only economic motive for vertical merger is to reduce costs
can be evaluated. by achieving synergies.
Part II of the article sets out the Chicago School critique of 196Os- Post-Chicago industrial organization economics accepts, as a starting
style vertical merger law and explains how a theory of anticompetitive point, these criticisms of pre-Chicago foreclosure theory. However, it
vertical mergers is consistent with modern microeconomics. Part III has extended the economic models to more realistic assumptions that
discusses the efficiency benefits of vertical mergers and a general method- reach a more refined understanding of foreclosure. The modern indus-
ology for balancing efficiency benefits against anticompetitive harms. trial organization literature has formulated models of vertical integration
Parts IV through VI discuss three categories of anticompetitive concerns in which vertical mergers lead to real foreclosure in which the net supply
from vertical mergers: input and customer foreclosure, information ex- of inputs available to rivals is decreased. Models have been formulated
change, and evasion of regulation. in which monopoly power may be created or enhanced-and monopoly
profits thereby increased-by vertical mergers that have little or no efti-
II. THE POST-CHICAGO ANALYSIS OF VERTICAL MERGERS ciency benefits. In these post-Chicago models, some vertical mergers can
The permissive policy toward vertical mergers, derived from the Chi- be anticompetitive, although others are procompetitive.
cago School, is premised on a simple economic model. In contrast, the
Post-Chicago analysis also relaxes the restrictive assumptions upon
post-Chicago approach relies on more realistic and complex economic
which the single monopoly profit theory is based. In particular, the single
I8
analysis that facilitates the identification of anticompetitive concerns that
monopoly profit theory relies on the following four assumptions:
have less importance in the Chicago School approach.
(1) there is a monopoly input supplier, whose monopoly is protected
A. THE CHICAGO SCHOOL CRITIQUE OF 1960s VERTICAL MERGER LAW by prohibitive barriers to entry;
The Chicago School critique of Brown Shoe and other antitrust chal- (2) the monopoly is unregulated;
lenges to vertical mergers is based on two main tenets. First, the mere
fact that a vertical merger forecloses rival firms’ access to the supply of (3) there is perfect competition in the downstream output market; and
inputs produced by one input supplier does not mean that the net supply (4) the technology for producing output involves usage of all inputs
of inputs available to those rival firms has been reduced. When the rivals in fixed proportions.
lose access to the input supplies produced by one firm, they are likely
In the absence of these four assumptions, the single monopoly profit
to gain access to the input suppliers that previously supplied the merging
result no longer holds. Instead, vertical mergers may be motivated by
supplier’s downstream merger partner. In that case, according to Chi-
either monopoly power, economic efficiency concerns, or both.
cago School theory, the vertical merger does not reduce the net supply
available to rivals. Instead, it merely realigns purchase patterns among When the input market is not a monopoly, the analysis of vertical
competing firms.‘” mergers is altered. Vertical mergers in these circumstances can have
anticompetitive or procompetitive effects through a number of mecha-
Effecti, in I HANDEZWK or INDUSTRIAL ORGANIZATION 189 (Richard Schmalensee & Robert
Willig eds.. 1989); Michael L. Katz. Vcrltiol ConlrorrulR~kzdom, in I H~~osoon or INDUS- nisms. A vertical merger can create barriers to entry or expansion by
IXIAI. ORGANIZATION 655 (Richard Schmalensee & Robert Willigeds.. 1989); and the many foreclosing or disadvantaging unintegrated rivals. A vertical merger also
aniclescired therein. For analyses by andtrust lawyers schwlcd in economics. we 3 PHILLIP ~_-
Aarso~ & Do~~~oTurow,. AN.~IT.UST LAW ,, 736 (1978); H~,,sr,rr HOYENKAMP. FE”E,,A,. “Id. II 229.
ANTIRUST POLICY: THE LAW OF C”MPETI.II”N AN” ITS PRAC~CL 285-89. 929-49 (lYY4). II An analogous version would center the monopoly in the output market and pcrfcrt
“As Bork points out. the cure for such naive allegations of foreclosure could be ‘%n competition in the inp market. Relaxing those assumprions alters the results analogously
industry social mixer*’ to facilitate the realignment. Boar. supra note 4. at 232. to Ihc rcsulu discussed in Ihc text Lxlow.
 518 ANTITRUST LAW JOURNAL [Vol. 63 EVALUATING VERTICAL MERGERS 519
19951
can facilitate tacit or express pricing coordination among the competing These more realistic models of competitive behavior form the basis for
input suppliers. In either case, a vertical merger may lead to a reduction a richer analysis of vertical mergers and their potential anticompetitive or
in net,input supply to rivals, not just a supply realignment. procompetitive effects. In such a light, vertical mergers should be neither
universally condemned nor universally applauded.
Further, even if there is an input monopolist but that monopolist’s
price is regulated, a vertical merger can be used to evade price control
B. THE POST-CHICAGO APPROACH TO VERTICAL MERGERS
regulations. A vertical merger also can be used to facilitate price discrimi-
nation, where price discrimination by an unintegrated monopolist would Because many vertical mergers create vertical integration efficiencies
be constrained by regulation or a competitive output market. between purchasers and sellers, many if not most vertical mergers are
either procompetitive or competitively neutral. Potential efficiency bene-
By contrast, when there is not perfect competition in the output mar- fits involve improved coordination in prici,ng, production. and design
ket, a vertical merger has the potential to reduce costs and increase that can reduce costs and improve product quality. They also involve
efficiency by eliminating a double monopoly markup on input costs, more efficient input usage and promotion.
When the output technology is not in fixed proportions, a vertical merger
also has the potential to reduce costs by eliminating distortions in efficient Some vertical mergers, however, have the potential for anticompetitive
input usage that arise from noncompetitive input prices. effects by creating, enhancing, or facilitating the exercise of market
power. The competition affected may be in the sale of inputs produced
Although the original Chicago School commentators focused primarily by one merger partner (the “upstream” or “input” market), the sale of
on the efficiency benefits of vertical mergers, they did identify some the products produced by the other merger partner that uses these
competitive concerns. For example, they paid close attention to the poten- inputs (the “downstream” or “output” market), or in markets that are
tial for collusion and recognized evasion of regulation as a potential “ancillary” to the input and output markets.”
concern. Nevertheless, the original Chicago School approach placed little
credence in the harm from foreclosure. This rejection of foreclosure as Antitrust concerns regarding anticompetitive effects arise from three
a competitive concern has two sources in addition to those identified main sources.” First, vertical mergers can lead to exclusionary effects
earlier. First, the Chicago School approach is based on an assumption by increasing rivals’ costs of doing business. This may involve raising
their input costs by foreclosing their access to important inputs or fore-
that barriers to entry generally are low. Second, the Chicago approach
pre-dated the recent interest among economists in game theory and closing their access to a sufficient customer base. We refer to these respec-
strategic behavior. Along with other advances in economic theory, the tively as input foreclosure and customer foreclosure. This exclusionary
game theoretic analysis of strategic behavior forms the core of what has conduct may involve unilateral and/or the increased likelihood of coordi-
heen termed the post-Chicago approach.“The strategic behavior models nated conduct in the upstream and downstream markets.‘”
study the decisions of firms that take rivals’ likely reactions to their
” tnpua arc the products and services used 10 produce the goods and services aald by
conduct into account when making their decisions. These involve models firma. These include such ccmventional inputs as raw materials. imermcdlate products
of strategic oligopoly conduct rather than the models of simple monopoly which may be finished, energy. and labor. They may also include access10 product standards
and perfect competition that form the foundations of the traditional and certifications, 1s well 1% wholes& and retail distribution services. As discussed in
more detail later. distribution somedme~ can be properly viewed as an output in that the
Chicago School approach.“’ distributor may purchase the praduct from the manufacturer. whereas in other situaliom
dirwiburion can be properly viewed as an input into the production and sale of a pducl.
“These rhrec general classes of compctidvc harm are recagnizcd in the 19R4 DOJ
” See Oliver Williamson. Attlifwl E+cenwr: When It’s Been. Where II’S Going. 27 ST. Merger Guidelines, rupro ncxe 5. P 4.2. Hawever. only the mwt extre,mc cxamplc of
LOUIS U. L.J. 289 (1983): Herbert Hovenkamp. AnLifnuI Policy After Chicago. 84 MICH. L. excluaianary conduct is trcarcd in detail. The Vertical Merger Gu~dclmes focus 0” a
REV. 219. 274-80 (1985); Carl Shapiro, 7% Thmy o/Btuinrss Slrolcgy, 20 RANU J. ECON. Mlmcwhardiffcrentcxamplcof informadon exchange. Theanalysisofcvasionof reguladon
125 (1989). is similar to the authors’.
” Chicago School economist George Srigkr was a pioneer in the modern analyais of ” Unilateral conduct refers IO behavior that inwIves independent strategies by cornpet-
oligopoly theory. George J. Srigkr. A Throty of Oligopoly. 72 J. POL. ECON. 44 (1964). ing firms. Coordinated conduct refers 10 tacit understandings or agrccmcnls bclwecn
However. that work had little impact on the Chicago Schwl approach 10 monopoly conduct competing firma about what strategies IO f&w. .%I alro U.S. Department of J,usdcc and
or vertical rclatipnlips. Cf. Carl Shnpin, & David J. Teece. Syllnu Compelition ondA/temar- Federal Trade Commission 1992 Horizontal Merger Guidelines B 2. rrpnntrd rn 4 Trade
hrlr: An Ecamx Annlysir of Kodak. 39 ANTITRUST.BULL. IS5 (1994). Reg. Rep. (CCH) (I IS.104 [hcrcinaficr 1992 Horizontal Merger GuidelinesI.
 520 ANTITRUST LAW JOURNAL [Vol. 63
19951 EVALUATING VERTICAL MERGERS
Second, vertical mergers can facilitate tacit or express coordinated
conduct by facilitating the exchange of pricing and other competitively
sensitive information in either the input or output market.
Third, vertical mergers can permit a firm to evade a variety of pricing
regulation. For example, a vertical merger can help a regulated firm to
evade cost-based, maximum price regulation by setting an artificially high
transfer price on inputs sold by the upstream division to the downstream
division and, as a result, shift profits from the regulated to the unregu-
lated market. A vertical merger also can help a firm to evade statutes or
regulations that prohibit price discrimination.

C. THE FORD-AUTOLITE “HYPOTHETICAL’*

The various theories of anticompetitive harm from vertical mergers
can be illustrated and better understood in the context of a hypothetical
vertical merger. Consider a stylized variation of the Ford-Autolite
merger.*’ The acquisition involved the purchase of a spark plug manu-
facturer, Electric Auto-Lite, by Ford Motor Company in 1961. For pur-
poses of illustrating the analysis, the input and output markets are pic-
tured in the “Bubble Diagram” in Figure 1. To begin the analysis,
consider a possible input market defined as the sale of spark plugs at
the wholesale level. This input market is comprised of Autolite, Cham- MARKET
pion, and A.C. Delco, a division of General Motors, as well as a number \+-$/
of fringe producers that sold mainly in the aftermarket. These spark
plugs are sold to the domestic automobile producers (OEM@. A key
output market for analyzing the vertical merger is the sale of new auto-
mobiles containing spark plugs. The sellers in this output market are
the domestic producers, Ford, General Motors, Chrysler, and AMC, as
well as the foreign automobile manufacturers like Volkswagen that were
selling in the U.S. market at the time. In addition, as discussed below, an Figure 1. Input foreclosure Ford-Autolite “hypothetical”
ancillary market comprised of aftermarket retailers such as The PepBoys,
Sears, and so on, may be relevant to the analysis. substitution away from spark plugs in response to a noncompetitive
premerger price, or it might better align the incentives of Ford and
On the procompetitive side, the merger could reduce costs or improve
Autolite in other ways. These benefits could lead to more competition
product quality for both Ford and Autolite. The merger might permit
in the spark plug and automobile markets.
Ford and Autolite to coordinate better the design of a new generation
of spark plugs, or to coordinate production. If the spark plug market On the anticompetitive side, there are three distinct concerns. First,
is imperfectly competitive, the merger might increase efficiency by reduc- the vertical merger might harm consumers by excluding competition.
ing the transfer price Ford pays for plugs and reduce Ford’s inefficient Foreclosure in the input market would occur if the price of spark plugs
sold to Ford’s automobile competitors were raised, thereby enabling Ford
” WC will use this cast to illustrate the analytic framework. not IO evaluate the validity
of the result reached in the actual matter. To that end. we will trcu the cast more as a to raise the price of new automobiles. Customer foreclosure in the output
hypothetical than as a real CPK and alter the assumed facts for illustradvc purpmca. The market would occur if the other spark plug manufacturers-Champion,
hiamrical facts of the c=sc arc detailed in the district court opinion. Ford Mator Co. v, for example-were denied access to Ford as a customer. Such customer
United State% 286 F. Supp. 407 (E.D. Mich. 1968). @rd. 405 U.S. 562 (1972).
foreclosure might raise Champion’s variable costs or drive Champion
 522 ANTITRUST LAW JOURNAL [Vol. 63
below minimum viable scale. thereby enabling Autolite to raise the price
of spark plugs either to OEMs. aftermarket distributors, or both. Second,
the merger also might facilitate collusion or pricing coordination among
spark plug manufacturers if Champion and Delco use Ford as a conduit
for exchanging information with Autolite, and vice versa. Third, the
vertical merger might be used to evade regulations. For example, if the
automobile industry were subject to price regulation and Ford’s price
were regulated on the basis of its costs, it might attempt to evade the
regulation by having Autolite increase the price of spark plugs it sells
to Ford.
Using the hypothetical as background, a detailed framework for evalu-
ating vertical mergers and balancing procompetitive against anticompeti-
tive concerns can be developed. Because vertical mergers generally are
evaluated by the enforcement authorities before they are consummated,
in this article we follow the approach of evaluating proposed vertical
mergers.
III. EFFICIENCY BENEFITS FROM VERTICAL MERGERS
The first area to be examined involves the efficiency benefits that may
result from a vertical merger. A variety of efficiency benefits that can
reduce costs, improve product quality, and reduce prices may ensue
from vertical mergers.
A. THE ROLE OF EFFICIENCIES IN VERTICAL MERGER ANALYSIS
Antitrust takes the general view that cooperation among firms in a
vertical relationship in general has greater efficiency potential than d,,r:s
cooperation among horizontal competitors. It is consistent with basic
antitrust principles, therefore, to place greater weight on efficiency bene-
fits in analyzing vertical mergers than in analyzing horizontal restraints.P’
For this same reason, vertical mergers are evaluated under the rule of
reason?’
In general, efficiency benefits can be weighed in evaluating the net
competitive impact either by measuring the benefits on a case-by-case
*‘See 1992 Horizonlal Merger Guidelines. ~upm Nate 23. 5 4. One important possible
exception concerns whether vertical merger is necessary COachieve the claimed cfficiencics.
rather than utilizing a contract ion of merger that does not involve the direct sharing
of profita. Such an analysis of alternatives is carried out in the horizontal merger ccmtext
under the 1992 Horizonral Merger Guidelines.
A vertical contract short of merger ,ame,ime~ may be mom likely ,o bc sufficicn, ,o
achieve efficiency benefits, relative ,o ,he horizontal merger siuadon. One reamn is Iha,
tirmr often are wary about cwperadng wi,h their compedmrs. A second is ,ha, cwperadon
with competitors necessary to achieve the cfficiencics often will raise price-fixing concerns.
” Condnental T.V.. Inc. v. GTE Sylvania Inc.. 493 U.S. 36 (1977).
EVALUA’~~NCVERTKXL MERGERS 523
basis or by adjusting the required threshold of competitive harm or some
combination of the two.” Given that most vertical mergers generally
Icad to some efficiency benefits, it may be appropriate to adjust the
t.breshold upwards, even before any case-by-case analysis of efficiency
benefits. That is, the complaining party would be required to demon-
strate, as a threshold matter, a significant likelihood of consumer injury
even before the merging parties are faced with the need to demonstrate
positive net competitive impact on the basis of offsetting specific effi-
ciency benefits flowing from the merger. Indeed, because vertical merg-
ers often will not raise a significant likelihood of consumer harm, in
most cases it will be unnecessary to gauge the efficiency benefits of a
specific proposed merger to evaluate net competitive impact.”
Where vertical mergers both create efficiency benefits and raise sig
nificant competitive concerns, however, those conflicting effects must be
weighed and balanced, so that the net economic effect can be measured.
To &rive at the net economic impact, the sources of efficiency benefits
must be identified. Those benefits may then be weighed and balanced
against the sources of competitive harms.
B. SOURCESOF EFFICIENCY BENEPITSFROM VERTICAL MERGERS
The types of efficiency benefits flowing from vertical mergers can be
organized into several categories for purposes of illustratiotxP9
I. Coordinalion in Design and Production
Vertical mergers can facilitate better coordination between input sup-
pliers and output producers with respect to product design and produc-
tion. Design coordination can lead to lower costs, higher product quality,
and shorter lead times for new products. Feedback from buyers to sellers
” SW. e.g.. Boaw. supm now 4. a, 226; Timothy J. Muris. The E/licimq Defrnrr Under
S~cfim 7 of ht Clqra hr. 30 CASE W. RES. L. REV. 381 (1960); Gary Roberrs & Steven C.
S&p. Efficiency Benelitr in Dynamic Merger Analysir (unpublished manuscrip, on file
with author).
” Balancing efticiency bencfio agains, campe,i,ivc harms raises a number of issuer
regarding the economic welfare standard. the likelihood that CDS,%wings will diffure 10
other compe,i,ar% and whcrber a merger is rcaaonably necessary ,o aImin ,he claimed
benefi,s. These i%sucswill no, be addressed here. For a detailed diwusaion in the horizontal
merger co”,cx,, xc ltokrtr & Salop. ,upm no,e 27.
wThir discussion ia no, imended IO be exhaurdvc. although mw, efficiency claims can
bc s,a,ed in ,errm of the ca,egories K, out here. For more cx,emivc dircuarion of efficiency
bcneh,r, we Perry. rup” note 15, a, 18% 191-92. S.rr also R,c~~a” A. Poa~w. & FRANK
H. E~s~uts~ooa, ANTITRUST: CASES. EC~N~M,C NOTES AND OTHEH M*-rra,~~s 869-70
(2d cd 196,); Boas, ru,,ra now 4. a, 226-21 (1976): MILTON HANDLER LT AL.. ‘&es *ND
MA’TERIALS ON TRADE RECUUT~ON 572 (1979); Condncn,al T.V.. Inc. Y. GTE Sylvania
Inc., 433 U.S. 56. 54-57 (1977).
 524 ANTITRUST LAW JOURNAL [Vol. 63 525
I QQ5] EVALUATING VERTICAL MERGERS

can improve quality control and lead to product innovations over time.”
tioo also can alter incentives in ways that benefit competition. This effi-
Production coordination, by assuring supply or customers, for example,
ciency also is closely related to the coordination efficiencies discussed
can lead to lower costs by reducing required inventories, rationalizing
schedules to mitigate downtime and overtime inefficiencies, and optimiz- above.
ing run sizes.” Consider the impact of product promotion by the downstream firm
before the merger. Promotion can raise the profits of the firm by increas-
Such coordination may be facilitated by vertical merger in that the
ing demand for the product. Before the merger. for example, Ford
parties can better trust one another when they are pursuing a common,
would balance the costs of promotion against the increased net revenue
single-minded goal ofjoint profit maximization. In contrast, if the firms
(i.e., revenue net of costs) likely generated. Ford would not, however,
are independent, the input supplier has the incentive to compromise the
cake into account any increased net revenue flowing to its independent
needs of its multiple customers. Similarly, the buyer may fear that its input supplier, (say) Autolite before the merger, from the demand
ideas are being used to benefit its competitors in the output market. In
generated by the promotion. As a result, promotion that can lead to
short, vertical mergers can reduce the potential for opportunism.‘*
incremental joint net revenue to Ford and Autolite that exceeds their
Although these potential benefits are real, they do not Row automati- combined incremental costs may not be undertaken.”
cally from every vertical merger. In addition, in industries in which In contrast, a vertical merger will internalize the benefits to the input
technology entails only partial vertical integration, in which certain unin- supplier. In making its decisions, Ford would take into account the impact
tegrated firms are dealing with integrated rivals, some of the coordina- on Autolite. This change in the incentives of the downstream division
tion benefits necessarily may come at the expense of imposing higher will lead to increased downstream promotion that increases the profits
costs on rivals. For example, if an input must be designed to uniform
of the integrated firm. A similar analysis can be carried out for upstream
standards and the integrated firm chooses the standards preferred by promotion or other investments by either party.
the downstream division, those uniform standards may be inferior for
other unintegrated customers. A compromise standard may not be cho-
sen by the integrated firm even if it is optimal.”
When the input market is not perfectly competitive. the input price
2. Eliminating Free Riding by Intcmalizing Incentives may exceed the marginal cost level. which leads to inefficient usage
among substitutable inputs absent vertical integration. For example, sup
Vertical integration can eliminate premerger free riding by either pose imperfect competition among spark plug producers leads to non-
merger partner. This benefit occurs by coordinating the incentives of
competitive spark plug prices. In that case, automobile producers have
the merger partners to carry out actions that benefit the other. Just as
the incentive toengage in cost-reducing input substitution, such as electri-
integration can alter incentives in a way that harms competition, integra-
cal or fuel injection system changes to improve spark plug life, or a
reduced number of cylinders.
” Thomas M. Jordc & David J. Tcecc, howlion and Cwpcrotion: lmplicotionr for Compcri-
lion ondhlilrusl. 4 J. ECON. PEISP. 15 (1990) (asacrting that innovalion requires feedback
mechanisms between firms). Although this type of substitution may be cost-effective from the buy
” MICHA~.L E. PORTE.. COMPETlTlV~ STKAUTECY: T’ECHNIQULSFOI(ANALYZING l~ous~a,cs
er’s view because the input is priced high in excess of marginal cost, it
AND COMPETlmRS (1980). does not lead to economically efficient input usage. Economic efficiency
” Set Ronald Coast. ThrNohrrcof tht Fin. 4 ECONOMICA986 (1997): OLIVER E. WILLIAM- dictates that input usage be determined by marginal costs, not by prices
SON, MA~KETSANDHIERARC~IES: ANALYSI~~NDANT~TRUSTIHPLICAT.IONS(I~~~): Benjamin that exceed marginal costs. A vertical merger may eliminate this ineffi-
Klein et al.. V&ical Intcpnhon. ApPmpGblr Renti and the Carpcfitivt Conrrncling Proust. 2 I
J.L. & ECON. 297 (1978); Michael H. Riordan &Oliver E. Williamson. Aurr Sprctficiry and cient input usage when the integrated firm supplies inputs to itself.
Economic Orsvzniuuion. 3 INT’L J. INDUS. ORG. 365 (1985); David J. Tcecc. Vrrlical Inlrgrorion The integrated firm generally will transfer the input to its downstream
ad V&ml Diverlirure in the U.S. Oil Indwhy. lnaritutc for Energy Studier. Stanford Univ.
( 1976). Ed see Richard Lcvin. Vertical lntcgnrtion and Pmjitabibry in thr Oil Indwlry, 2 J,
ECON. Brw.,v. Oat. 215 (1981). sI For example. suppose that promodonal expenditures by the downstream firm of $100
lead to increased net revenue 10 the downstream firm of $80 and incrcarcd net revenue
‘*These issues arc discussed in more detail in Joseph Farrell & Garth Saloner. Sylm- to the upstream firm al $50. This promadon will be forganc before the merger because
Compeliflon Vrrsur Conponrti Cmnprlilia. Paper Presented at FT’C/DOJ/ABA Conference, costs ($100) exceed downstream benefits ($80). Hawevcr. it will be undertaken after the
P#,st-Chicago Economics: New Theories-New Cares? Wash.. DC.. May 26-27, 1994.
merger bccauac total bencfirr ($130) exceed cm@.
 ANTITRUST LAW JOURNAL
division at marginal cost, not at a price in excess of marginal cost.” As
a result, the integrated firm may be able to reduce itscosts, which provides
it with the incentive to increase its output and reduce its output price,
Although this is an efficiency-based rationale for vertical merger, the
benefits may or may not be sufficient to offset the competitive harms
from anticompetitive exclusion or other sources.~
4. Eliminating Double Markup of Costi
When both the input and output markets are imperfectly competitive,
output prices are increased above the competitive level and possibly even
above the monopoly level, as marginal input costs are marked up twice,
once by the input supplier and once by the output producer. Under these
circumstances, when the integrated firm can efficiently supply inputs to
itself, a vertical merger of a firm with a supplier of a variable input can
reduce output prices by eliminating one of the two markups. This result
occurs because the integrated firm will have the incentive to transfer the
variable input to the downstream division at a transfer price equal to
marginal cost, which then will be marked up by the downstream division,
Thus, the vertical merger can reduce output prices and increase con-
sumer and aggregate economic welfare.” In this way, a vertical merger
can be a consumer-benefiting correction to an imperfectly competitive
input market.
To evaluate the magnitude of this potential efficiency benefit, the
structure of the upstream and downstream markets must be evaluated.
” Inlernal transfer prices in cxccss of costs may bc used 10 provide incentives 10 the
upstream and downstream division in a decentralized organization struc~urc. They may
also be used in certain circumstances as a basis for management compensation 1%a mcrhod
of facilitating coordination in the downstream market. Chaim Fcrsrmann & Kenneth L.
Judd. Equilibtium lncmtiw in Oligopoly. 77 Au. ECON. RPV. 927 (1977).
s If efficiencies arc evaluated on a case-by-case basis. the conditions necessary to cause
output price to fall could. in principle, bc evaluated for this monopoly cast. To illustrale
this, consider the cxtrcmc cast in which a monopolist input supplier merges with one of
a number of competitive downstream output producers. That monopolist will have the
incemivc to engage in input foreclosure PS well as to rationalize its input usa8c at the
downstream level. Taking both incentives into account simulcaocoualy. the impact on
output prices depends on demand and cost conditions. Thus. consumer welfare and
aggregate economic welfare could fall. dcspire the efficiency benefit. For further discussion
o” mput usage, YC Parthasaradhi Mall& & Babu Nahala. The Tkwy oj Vertical Control
wzth Vati& Pwportionr. 88 J. POL. ECON. 1009 (1980); Herman C. Quirmbach. Thr Porb
o/P& Changes in Vcrlical Integralion. 94 J. POL. ECON. I I IO (1986); Michael A. Salingcr,
Vrrtical Mergers and Market Foreclosure, IO3 Q,J. ECON. $45 (1988); Frederick R. Warrcn-
Boulton. Vertical Control wilh Vakble PropooPonr. 82 J. POL. ECON. 789 (1974); Michael
Waterson. Vnlical Inlegmtion. Vatiblr Proptionr and Oligopoly. 92 ECON. J. 129 (1982);
Frederick Westfield. Vrrfical Inlrgrolion: Dorr Product Price Riw or Fall?. 7 I AM. ECON. REV.
534 (1981): src nbo Perry. so@, note 15.
” See Herbcn Spenglcr, Vmicol Inlegmlion and Anlilnul Poliry. 59 J. POL. ECON. 347
(1950); Fritz Machlup & Martha T.&r. BilnftralMonopoly. Surcrrsivc Monopoly. and Vtrtirol
EVALVATINC VERTICAL MEUCERS 527
I9951
I*- either market performs competitively before the merger, there will
be o. double markup. In that case, no efficiency benefit will occur.
Instead, this efficiency benefit is dependent upon the input market for
a variable input being imperfectly competitive. Even in this case, however,
if the downstream division of the integrated firm is a big buyer that was
able to negotiate a nearly competitive price before the merger, then the
double markup will be small and the efficiency gains will be limited
accordingly.”
Assuming that the integrated
firm can supply significant variable in-
puts to itself and markup can be eliminated, it will
a significant double
be necessary to balance these efficiency benefits against any competitive
harms identified. In some circumstances, the combination of eliminating
a double markup and foreclosure may lead to the need to balance price
reductions by the integrated firm against cost and price increases by
unintegrated competitors.
5. Efficiency Loses Suffered by Foreclosed Competitors
Where a vertical merger increases the costs to unintegrated competi-
tors, those increased costs do harm rivals. However, they do not necessar-
ily represent real efficiency losses. Real efficiency losses are involved only
to the extent that the higher costs are not simply transfers to input
suppliers but rather lead to inefficient input usage by the competitors.
There also are efficiency losses when resource use in the output market
is distorted by precluding lower-cost production by efficient competitors.
‘The competitive analysis of vertical mergers also involves an examina-
tion of the competitive concerns that can arise. These competitive con-
cerns can be classified into three categories: anticompetitive exclusion,
information exchange, and evasion of regulation. In the next three sec-
tions, we analyze those competitive theories in detail.
IV. ANTICOMPETITIVE EXCLUSION
Vertical integration by merger can increase the merged firm’s incen-
tives to engage in exclusionary conduct in its pricing, marketing, and
purchasing decisions at both the input (or upstream) and customer (or
downstream) levels. At the input level, this may involve the upstream
division raising the input price it charges to rivals of the downstream
division or refusing to supply them. At the customer level, this may
“When inputs are diffcrcndatcd. lhe inugratcd firm may suffer some incflicicncy by
supplying inputs to itself if the input produced internally is not the optimal variely.
 528 ANT~TRWT LAW JOURNAL [Vol. 63
involve refusing to purchase from rival input suppliers. This exclusionary
conduct may involve purely unilateral behavior or the vertical merger
may facilitate pricing coordination at either level. Competitors may be
harmed by having their costs raised above the premerger level or by
causing them to exit from the market. The conduct may harm competi-
tion by giving the integrated firm the power to raise or maintain input
or output prices above the competitive level.
By increasing the likelihood of anticompetitive exclusion. vertical
mergers permit the integrated firm to achieve, enhance, or maintain
market power, the essence of what is proscribed by the antitrust laws.
A finding that input foreclosure raises a real potential for harm to compe-
tition, however. does not mean that, on balance, a proposed vertical
merger necessarily is anticompetitive. Likely efficiency benefits also must
be weighed in order to gauge the likely net competitive impact of a
transaction.
A. INPUT FORECLOSURE
Input foreclosure refers to exclusionary conduct by the upstream divi-
sion of an integrated firm with the purpose of excluding rivals from
access to important inputs or raising their costs of such inputs. The
incentive for the upstream division to exclude or raise the input price
it charges to the competitors of the downstream division is easy to explain.
By raising their input costs or otherwise excluding downstream rivals,
an integrated firm can place downstream rivals at a cost disadvantage in
the downstream market. Other input suppliers may not take up the slack
because, for example, their ability to expand is limited, their effective
market power has increased, or the input foreclosure itself facilitates
coordinated pricing among input suppliers.
In these cases, if downstream rivals’ costs are raised, the integrated
firm may be able to effect an exercise of market power in the downstream
market. either unilaterally or through coordination with its competitors.
The parties to the downstream coordinated conduct may include those
competitors disadvantaged by the higher input costs or other exclusion-
ary conduct. In a sense they are induced to cooperate somewhat involun-
tarily as a result of their higher costs. In this way, the integrated firm
achieves market power. that is, the power to raise or maintain price
above the competitive level in the output market.”
“The integrated firm may nat haveclassicalunilateral market power. that is, the power
10control price by profitably restricting its own ourpul. Instead. it achieverexclusionary
market power. thal is, the power to raise price above the competitive level by excluding
competitors and forcing other market participants to raise prices.An integrated firm that
achievesexclusionarymarket power may remain a price.rakcr in a seeminglycompctitivc
529
19951 EVALUATING VERTICAL MERGERS
This exclusionary conduct harms consumers through higher down-
stream prices. Efficiency also can be reduced in two ways from this
c-onduct. First, the consumer deadweight loss involves an efficiency loss
as consumers reduce their purchases. Second, the higher cost borne by
rivals may lead those firms to utilize an inefficient input mix and the
market shares of relatively more efficient firms may also be reduced.
The input foreclosure theory can be illustrated by using the hypotheti-
cal version of the Ford-Autolite merger and the Bubble Diagram in
Figure 1. The acquisition by Ford gives Autolite the incentive to increase
its prices to Ford’s rivals in the domestic automobile market. thus giving
&Is saddled with higher costs the incentive to raise the price they
charge for automobiles or cut back their output. In this way, Ford gains
because it can increase its own price, its market share, or both. Thus,
Ford’s exclusionary conduct gives it market power-the power to raise
price above the previous, more competitive level-and consumers are
harmed by the higher automobile prices.
The merger-induced incentive to raise input prices arises because the
demand for inputs and the demand for outputs are interrelated. For
example, if the upstream division raises the input price it charges to the
rivals of the downstream division, the downstream division will be able
to sell more output at the premerger price. Before the merger, the
upstream and downstream divisions make profit-maximizing price and
output decisions without considering the effect on the other’s profits
that flow from these demand interdependencies.” After the merger,
these demand externalities can be factored in, thereby possibly increasing
the incentives of the upstream division to raise its prices to the benefit
of the downstream division.”
There are a number of economic factors that affect the incentives of
the integrated firm to raise input prices, the likely magnitude of any
increase, and the overall profitability of the strategy for the integrated
firm.
1. Four-Step Andysir of Pofdid Antimmpetitivc Harm: In Cmeral
Evaluation of the likelihood of competitive harm from input foreclo-
sure and the incentives of the integrated firm to carry out an input
foreclosure strategy involves a four-step analysis of the input and output
market. ScrThomas C. Krlltcnmaker ct al.. ManopolyPowr ad Moht Power in Antitnul
law, 76 CEO. L.J. 241, 258 (1987).
” This incentivesanalysisis foormaliud in the Appendix to this aniclc.
” The facl that incentivesare imernalizcd does no, imply that 1 vertical merger is
anticompetitive. The efficiency bencfi~ identified earlier in Put 111also arise from the
internalization of incentives.
530 ANTITRUST LAW JOURNAL [Vol. 63
markets after the proposed merger. This analysis includes evaluation of
market structure, conduct, and performance that is similar to conven-
tional analysis of horizontal mergers, but tailored to the context of the
specific competitive concerns involved in foreclosure analysis.
This four-step analysis is intended to evaluate the likelihood and mag
nitude of harm to competition, absent efficiency benefits. It also is in-
tended to evaluate harm to competitors and profitability of the strategy
to the integrated firm. This analysis then is combined with the evaluation
of efficiency benefits in order to gauge the likely net competitive impact
of the proposed vertical merger.
The first step evaluates the impact on input prices and rivals’ costs.
The inquiry here focuses on whether competitors’ costs of the foreclosed
input likely will increase after the vertical merger as a result of a change
in incentives of the newly integrated firm and its input market competi-
tors. If unintegrated rivals can substitute to equally cost-effective alterna-
tive inputs and effective input market competition is not reduced, then
there would be no competitor harm. This analysis also evaluates the
likely impact on the profits of the upstream division.
The impact on output prices Rowing from any cost increase is evaluated
in the second step. It analyzes the likely magnitude of the increase in
rivals’ costs and its implications for performance in the output market.
The inquiry here focuses on whether output market prices likely will
increase or whether, instead, rivals in the output market will maintain
the ability and incentive to compete vigorously. In this way. the second
step evaluates whether or not consumers in the output market are
harmed, assuming first that the merger raises the costs of its rivals.
The analysis in the second step also evaluates the profitability of the
downstream division.
The third step evaluates the impact on prices in any ancillary markets
relevant to the inquiry. Ancillary markets may be affected when price
discrimination in the input market is infeasible or where there are de-
mand or supply complementarities. For example, when Autolite raises
battery prices to the auto manufacturers. it also may need to raise prices
to aftermarket retailers. The inquiry here focuses on the impact on
consumers, competition from rivals, and the profitability of the inte-
grated firm.
Net anticompetitive impact is evaluated in the fourth step, in which
the relative magnitudes of efficiency benefits and anticompetitive harm
are weighed and balanced. In light of the potential for efficiency benefits
and other concerns. courts have now made it clearer that higher input
1995J EVALUATING VERTICAL MERGERS 531
costs and harm to competitors do not by themselves demonstrate injury
to competition.” The evaluation in Step 3 may demonstrate that competi-
lioL1 among downstream firms may remain vigorous so that prices do
,,ot rise relative to the relevant competitive benchmark.” In this case,
there would be no competitive harm, even if competitors are harmed
by the merger and there are no efficiency benefits. This is a stringent
standard that will permit most vertical mergers. Moreover, once the
likely efficiency benefits from a particular vertical merger are evaluated.
even fewer vertical mergers will be found to have an adverse net effect
on competition.
If a vertical merger does not cause rivals’ costs to increase, then those
excluded competitors would not be harmed. More important, the newly
merged firm would not gain market power and there would be no con-
sumer harm in output markets. In that case, the profitability and incen-
tive of the upstream division to raise its input prices or otherwise exclude
downstream rivals also would be reduced, if not eliminated.
Rivals’ costs may increase if rival input suppliers do not have the ability
or incentive to expand output at current prices and if alternative inputs
are imperfect substitutes. A number of factors are relevant in evaluating
the incentives and abilities of rivals to expand, the potential harm to
excluded competitors, the incentives of the integrated firm to carry out
an input foreclosure strategy, and the impact on consumers.
a. Availability of Substitute Inputs
If output rivals can easily substitute to other equally cost-effective
input suppliers, then those rivals will not be harmed. As a result, the
integrated firm will have no incentive to attempt input foreclosure. This
evaluation involves identifying close input demand substitutes in the
event that the upstream division of the integrated firm were to increase
the input price it charges to rivals of the downstream division. These
close substitutes include the remaining current producers of the same
input plus producers of alternative inputs that are equally cost-effective.
‘This analysis in effect identifies a narrow hypothetical relevant market
of equally cost-effective, nonforeclosed input suppliers.
“Se Eastman Kodak Co. v. Image Technical Sews.. Inc.. II2 S. Ct. 2072 (1992); stc
olro Bmokc Group Ltd. v. Brown & Williamwn Tobacco Corp.. I13 S. Ct. 2578 (1999).
“The proper competidve benchmark would be the price that would occur but for the
vertical merger. This usually would be the current price. However. in some circumatancer.
it might bc a higher or lower price.
532 ANTITRUST LAW JOURNAL [Vol. 63 VERTKXL MERGERS 533
1!495] EVALUATING

A similar analysis could identify somewhat less cost-effective nonfore- <ussed earlier, gain downstream. Similarly, if rivals have the capacity to
closed input suppliers that would participate in the market if the input expand, but the structure of the hypothetical market of nonforeclosed
price rose (e.g., by a small but significant nontransitory amount). This rival sellers is conducive to coordinated pricing, then competing input
in effect would define a broader hypothetical relevant market. This latter suI>pliers may raise their prices in response to input price increase by
analysis also would identify the magnitude of the rivals’ cost increase lhc integrated firm.” This incentive follows because they face less intense
from substituting to these less cost-effective suppliers, on the assumption competition from the integrated firm, as a result of its change in incen-
that these market participants do not increase their prices following the
tives.
merger. The larger this cost increase, the greater the potential harm to
the foreclosed rivals and the greater the potential harm to competition. Factual evaluation of these alternatives involves a detailed analysis of
the input market, similar to the DOJ/FTC analysis for horizontal mergers,
This analysis of availability of substitute inputs also is relevant for including the likely magnitude of uncommitted entry and excess capacity
gauging the profitability of the input price increase by the integrated I-elative to the magnitude of potential foreclosure by the integrated firm.
firm. The impact on profits from lost input sales is relevant to evaluating the HHI of the hypothetical relevant markets of nonforeclosed rival
the incentives for the integrated firm to attempt input foreclosure. Even input producers, ease of entry, and other relevant competitive factors.‘s
if an input price increase raises rivals’ costs, that alone does not prove c. Continued Competition by the Integrated Firm
that the price rise is profitable to the integrated firm. The upstream in the Input Market
division may lose so many input sales that the input market revenue lost
exceeds the higher revenue on input sales retained plus the increased ‘I-heanalysis in the previous section explains how a higher input price
profits to the downstream division. These losses could be significant, for set by the integrated firm facilitates coordinated input price increases
instance, if rivals do not match input price increases dollar for dollar. by non-foreclosed competing input producers. This analysis assumes, of
course, that the integrated firm does not compete by undercutting the
b. Competition in the Foreclosed Input Market input price set by the nonforeclosed input suppliers. This is a plausible
If competing input suppliers that offer equally cost-effective inputs general assumption for a fairly concentrated market, even in the absence
of formal agreements!’ After all, if the upstream division of the inte-
do not raise their prices in response to the vertically integrated firm
raising its input prices, rivals’ costs will not increase from the merger. grated firm undercuts its competitors’ input prices, that discount will
To evaluate the incentive and ability of competing input suppliers to harm its own downstream division by lowering the costs of output rivals.
In effect, the upstream division will be competing against itself. More-
compete vigorously following the merger, consider first the narrow hype
over, the discounts may set off a price war in the input market as competi-
thetical relevant market comprised solely of nonforeclosed, rival input
tors respond to the discount with price cuts of their own.”
suppliers that offer equally cost-effective inputs, as discussed above.” If
this market is both structurally competitive and participants have the ” ‘These incendvcs also may limit the input suppliers’incentives to agree to defensive
ability to expand to fulfill the increased input demand without suffering vertical integradon with a foreclosed output producer.
a significant cost penalty, then it is less likely that the competing input “I The fact that the in ut market performs compeddvcly before the merger is not a
guamwe that it will per Parm compcdtivcly after the merger. If the integrated firm fore-
suppliers will have the incentive to follow input price increases by the ~:lo~ea rivals from its input, the vertical merger can facilitate unilateral or coordinated input
integrated firm. In this case, the vertical merger simply may lead to a price increases.
realignment of supply relationships with no harm to competitors or ” We think this is a good empirical hypothesis for the case of large firms in the market
competition. for the long haul. Howwcr. it may not hold for certain static oligopoly models. For an
analysis of this point in terms of the negotiation procers for input purchasca. set Hart &
In contrast, if competitors’equally cost-effective capacity is constrained Tirolc. supro note 97: Ordover, Equilibrium. suprn note 15; Reiffen. supm note 15; Ordover,
ntpiy, rupm note 15.
so that they are unable to expand sufficiently at low cost in response to “The likelihood of successful coordination also is increased becau~ the newly integrated
a unilateral input price increase by the integrated firm, then such an upstream and downstream divisions now can communicate abour price, whereas that
input price increase would stick and the integrated firm could, as dis- ammunicarion was constrained before the merger. In addition. the integrated firm has
~XXY to lost from a price war than did the independent divisions before the merger. On
the other side, other input competiuxs may have a greater ability to undercut bccaurc
” This market would include integrated firma that sell inputs to thrmselvcr and possibly they may have less to fear from a price war after the merger. asawning that the merged
80 other hrms as well. entity has increased incendves LO raise input prices unilaterally. Of cour~c. if lhe unilateral
534 ANTITRUST LAW JOURNAL [Vol. 63
IWS] EVALUATING VERTICAL MERGERS 535

Despite this general view, in certain circumstances. it might be in is inelastic, it is a well-established principle that there is greater risk of
the interest of the upstream division of the integrated firm secretly to Collusion and pricing coordinatiow’s
undercut the prices of competing input suppliers, even if there is a
risk that it will lead to an input price war that could unravel the input e. Price Discrimination in the Sale of the Input
foreclosure strategy. This conduct would be more likely where the inte-
grated firm has more IO gain from the discounting and less to lose from The upstream division of the integrated firm sometimes will make
a price war, if one occurs. For example, in the input market, discounting input sales both to rivals of the downstream division in the output market
by the integrated firm would be more likely where the upstream division segment and to noncompeting firms in an ancillary market segment.”
would succeed in expanding its input sales by a greater magnitude than For example, Autolite sold spark plugs both to automobile OEMs that
its undercutting competitors.” Undercutting also would be more likely competed with Ford and to aftermarket retailers that sold replacement
where there is less of an effect on price in the output market from input spark plugs not in competition with Ford. The inability to price discrimi-
foreclosure, or where the downstream division only would be able to nate between these two customer groups can affect the overall profitabil-
achieve a small post-merger market share.‘O In these circumstances, the ity and welfare impact of input foreclosure in a number of complex
integrated firm has less to lose if the foreclosure unravels. As a result, WYS. S,
the merger is less likely to have anticompetitive effects, even absent
efficiency benefits. If price discrimination between rivals and nonrivals is not feasible,
then the magnitude of the price increase may be smaller, compared to
d. Elasticity of Input Demand (be situation where price discrimination is possible. For example, suppose
The likely post-merger increase in the price of the foreclosed input an unintegrated Autolite would maximize profits by charging $100 to
is constrained by the elasticity of demand for the foreclosed input. This both aftermarket and OEM purchasers. Now, suppose further that Auto-
elasticity is determined generally by producer substitution to other in- lite wishes to raise the OEM price to $1 IO following the merger with
puts, consumer substitution to other downstream products, and competi- Ford, while holding the OEM price to nonrivals at $100. If discrimination
tion among downstream producers. If the foreclosed input represents were infeasible, however. increasing the uniform price to $110 would
a small share of firms’ costs, then the derived demand for the input is not be profit-maximizing because of the lost revenue in the sale of
less price elastic.)’
12.475. If a spark plug monopalirt could charge perfecdy competitive a~” manufacwrers
If input demand is less elastic, the likelihood and magnitude of input S5.1125 for a set of spark plugs. that would imply a total cost to the auto manufacturer “I
price increases is enhanced. In the extreme, for example, if a set of I7.5lU If wholes& compctidon were perfea. then the auto price would equal marginal
~0515 of $7.500.
spark plugs is absolutely essential to the construction of an automobile, F.ven if auromobik manuf~cmrcrs are “01 perfectly compedtivc. the plug monopolist
then a spark plug monopolist could, in effect, control the automobile ~oukl charge a” extraordinary price. For example. assuming that the manufacwring co,,
market and extract all the monopoly proKts.” Moreover, when demand will be doubled. a price of plugs equal to $1.275 would imply a manufacwrcr’s cost “I
fS.750 (i.e., $1.275 + $2,475). which upon doubling yields the monopoly price of $7.500.
10 fact. the plug monopolist would charge more than this because of the double markup,
incentives to raise input prices are strong. then cwrdinatcd conduct is not necessary for
as dircusscd infm Part VI.
rivals to be harmed anyway.
“This depends on the degree of input produa differentiado” and the likelihcmd rhal ‘S POSNER & EAS~ERBROOY, supra “DW 29. al 536: George Hay & Daniel Kellcy. An
Empitical SUN~J of Price FUing Conrpiracicr. 17 J.L. & ECON. 13 (1974).
the undercutting would be rapidly detected and matched by compclilors. among other
things. These arc the MIIW faaors already examined in the analysis of the nonforeclosed ” As discussed in more detail below. output and ancillary marker sales will not consdute
input marker discussed above. ITparale andtrust markets when price discrimination is infeasible. In thal case. the term
market segmems would be more appropriaw.
‘S This set of issues is taken up in more derail in Step 2 below. If the downstream division
has a small premergcr market share and will gain lildc market share from input foreclosure. ‘I’ Thisdiwussionof pricediacriminadon al~opplicsgcncrallyt” nonpricediscrimina~ion
this reduced inccndvc to maintain the strategy also translates in,” a lesser incentive to Snd refusals to deal. Howcvcr. refusing to deal may be lc~ll cffecdvc in raising rivals’costs.
raise input prices I” begin with, just as it leads I” a grater incentive 1” undercut. Krfusing to deal may lead the upstream division 1” suffer greater input Sales losses than
would a moderate diwriminarory price increase. thereby reducing profimbility. In addition.
” In conjuncdon with the input demand elasticity and other factors. the input cost share
AS discussed in detail in Ordover. Equilitium. wpra note 15. al 194. refusing IO deal may
also can affect the magnitude of the increase in Ihe output price from a parricular increase
weale Nronger inccndvcs for defensive verrical imegntion (or variable cost reducing
in the input price. This rclawd issue is taken up in Step 2 below.
CoolracU) by the targeted rival. This is imponant because defcnsivc vertical integration
‘S This is simply the single monopoly profit analysis. For example. suppose that the $h an equally efficient input supplier somedmes could unravel the profiitability of the
monopoly wholesale price were $7,500 and that the remaining manufacturing costs wcrc l”P”l f”recl”surc s,ra,egy.
536 ANTITRUST LAW JOURNAL [Vol. 63 lon5) EVALUAT~NC VERTICAL MERGERS 537

aftermarket spark plugs.‘s Even with a uniform input price equal to (say) to laise their prices in response. Thus, it is possible without price discrimi-
$105, that price increase would sacrifice some aftermarket profits because Ilati1nl that the vertical merger might cause Autolite to lead a general
the new price is above the profit-maximizing $100 level. These lost profits I)ricc increase. Second, the vertical merger might make Autolite a more
would moderate Autolite’s incentives to raise price. Perhaps it instead willing participant in a cartel or in coordinating prices because Ford
would choose to raise the uniform price only to $102, if at all.” benefits when its competitors pay higher prices for batteries. Thus, the
wrtical merger may induce Autolite’s aftermarket competitors to raise
The reasoning (but not the result) is altered somewhat when the profit-
aftermarket prices in the belief that Autolite will follow.
maximizing price to nonrivals in the ancillary market segment (e.g.,
aftermarket sales) exceeds the optimal price to rivals (e.g., OEMs). In ‘I’his is complicated
analysis by yet another factor. Even where an
this case, if discrimination were infeasible, an increase in the uniform inability to price discriminate does moderate the input price increase,
price actually would enhance the profits earned in the ancillary market. the overall input market impact is not necessarily reduced. This is because
Even in this case, however, if price discrimination is infeasible, the opti- an input price increase now would apply to a broader class of customers.
mal input price increase is moderated. This is because the premerger absent discrimination, aftermarket purchasers also would suffer a price
price is higher to begin with. Moreover, the profits of the downstream iwrease. Suppose also that absent price discrimination the size of the
division that are taken into account after the merger are a smaller share price increase following vertical integration is proportional to the share
of the total profits of the upstream division affected by a uniform input of Autolite’s sales made in the output market segment.” In this case, the
price increase than they would be for a discriminatory price increase. xggr~gate consumer harm resulting from the vertical merger is roughly
Thus, the extra component of profits created by vertical integration indrpcndent of the aftermarket share of Autolite’s sales. For example,
would have less impact on the optimal pricing by the newly integrated suppose that aftermarket sales represent 90 percent of Autolite’s sales
firm.‘s and price would increase by $10 with price discrimination and $1 absent
price discrimination. Aggregate consumer harm would be the same,
This moderating influence of nondiscrimination on post-merger price
because a $1 increase to 100 percent of the market is equivalent to a
increases may be mitigated if the vertical merger facilitates greater pric-
$10 increase to IO percent of the market.w
ing coordination in sales to the noncompeting purchasers. First, a uni-
form price increase by Autolite may cause rival battery manufacturers In summary. the impact of an inability to price discriminate raises
c-onsiderations that complicate the analysis of input prices and rivals’
ld This ~ssurncsthat competitora do not raise their prices. an issue that is discussed costs. While very little can be concluded given our analysis to date, the
b&w.
analysis does suggest that an inability to price discriminate is a more
” For example. suppose that aftermarket buyers arc more willing to substitute among
spark plug brands than are OEMs. In that case. even a very small increase in its uniform significant constraint on the profitability of input foreclosure and less
price might cause Aulolite 10 lose virtwdly III of its aftermarket sales. Accordingly, Awolitc likely to cause large welfare harm where (I) the profit-maximizing post-
migh1 ewn choose to cominuc 10 price a1 $100. (This is an example of 1he discominuous merger price in the output market segment exceeds the prolit-maximiz-
upstream profit funcrion discussed in the Appendix.)
ing price in the ancillary market segment, were price discrimination
ss For example. in the Aulolilc hypothetical. soppow that the OEM channel accounted
for 90% of spark plug sales and the aftermarket accounted for 70% of sales. Suppose that feasible; (2) a nondiscriminatory price increase does not facilitate coordi-
if price discrimination were saiblc. the integrated firm would charge a price of $100 nated pricing in the ancillary market segment; or (3) the size of the
per case 10 the OEMs and r I IO to the ahcrmarkcr. Suppose furlher 1ha1 1hc vertical ancillary market segment dominates the size of the output market seg-
merger would induce the integrated firm 10 raise the OEM price by $10 to II IO. if price
discrimination WCTCpossible. If price discrimination were impossible. however. suppose
the prcmcrger uniform price initially wcrc set at $107. a price closer to the aftcrmarkeer ‘s If demand in the ancillary marker scgmcnt is more clasric. 1hcn a uniform price
price because rhal segment .wcounts for such a high percentage of the business. (As an mcreasc may be less 1han proportional to the shrrc of Au1alile’s sales made in char segmcm.
illustradve first approximadon. we assume 1he uniform price is a weighted average of 1hc Tbis is because 1hc los1 salts in 1hc af1ermarkct are more disciplinary. This case carrcspunds
discrimina1ory prices. with weighe equal 1o the shares of sales.) In that EPK. the mcrgcr 10 the siuation where Autolire’s preferred af1ermarkc1 price is less than i1s preferred OEM
migh1 increase the uniform price by only IS 10 $I IO. The uniform price increases by less ~wce. were discrimination possible.
bccausc the OEM segment is $107 to begin with. (Of course. unlike the first example. at ‘*I Moreover. when price discrimination is possible. only the nonirwgraad segment 01
the post-merger price of II IO. afwrmarket profits no longer arc sacrificed by rhe need lbe outpu1 mrrket cxpcricnces a price increase gecruse of [his. when rhe proportionality
10 charge a uniform price.) If the ancillary market were (ray) 90% of the business. then assumplion holds, the aggregate harm 10 consumers from a urdform price increase would
the merger might only raise the input price by $1. from $109 10 $I IO. be higher.
 538 ANTITRUST LAW JOURNAL IO95 1 EVALUATING VERTICAL MERGERS 539

merit, so that any post-merger uniform price increase would be de mi- impel a finding
of consumer injury. Competition from other down-
nimis.B’ ~rea,n whose costs are not raised and demand substitution
producers
f. Acquisition of a Disruptive Input Purchaser to other products may prevent the downstream division of the integrated
hrm from leading prices upward. This competition from nonexcluded
If the vertical merger involves a particularly disruptive input purchaser (irms generally will be a significant constraint on the ability of the newly
that competes in the output market, that may facilitate price increases merged firm to raise prices. A number of factors contribute to the evalua-
by the sellers in the input market. For example, if one input purchaser tion of the competitive impact in the output market. This analysis of the
that competes in the downstream market is able to negotiate low input uutput market also has implications for evaluating the potential gains in
prices before the merger, those low prices may cause rival input sellers prolitability to the integrated firm from implementing an input foreclo-
also to charge lower input prices to the disruptive firm’s rivals. This sure strategy and, thus. its incentives to attempt the strategy if the pro-
incentive arises from fear of losing more profitable input sales as the posed merger is consummated.
disruptive firm expands on the basis of its cost advantage. Alternatively,
if upstream firms view sales to a particular buyeras sufficiently important, a. Availability of Substitute Products
perhaps because of the size of that buyer’s aggregate purchases, they
II’ output consumers easily can substitute away from both the fore-
may deviate from the terms of coordination in an attempt to gain sales
closed competitors and the downstream division of the integrated firm
from that firm. Under certain conditions, this could disrupt a marketwide
when they raise prices of other products, without suffering a reduction
agreement.”
in welf8re or effective costs, then consumers will not be harmed by the
If such a disruptive firm merges with an upstream competitor, its input market foreclosure. This analysis in effect would identify a relevant
disruptive influence will be reduced. It will have no interest in disrupting downstream market of nonforeclosed competitors, including close de-
upstream pricing coordination directed at its rivals. It will have a greater mand substitutes and the newly integrated firm.“’
incentive to match the higher price of its downstream rivals in order to
facilitate the coordinated input pricing. Thus, in situations where the b. Post-Merger Competition in the Output Market
downstream merger partner previously had been a disruptive input
Assuming that the costs of certain downstream rivals are increased by
buyer, it is more likely that the merger will lead to input price increases
the input price increases or other input market foreclosure, the competi-
that raise rivals’ costs.
rirm provided by those rivals likely will decline. However, if other output
3. S&p2: Anlicompcliliue Impad in Ihe Outpul Market producers’ costs are not raised, including other vertically integrated
Even if the higher input price increases the costs of certain rivals that firms, competition from those firms and from producers of close substi-
are the targets of the input market foreclosure, that does not by itself tute products may prevent output prices from rising above premerger
Irvels. In this case, there would be harm to competitors, but not to
‘I In s~rne inpu, markets. it b s,a,u,ory or regulatory prohibi,ions ra,her ,han infbrma- competition.
lional and arbilragc conslraints rha, serve IO prcven, pas,-merger price discriminrdon
1 against rivals. However. ,hcse legal provisions may be inadequair constraints on ihe pricing
behavior of ,hc newly in,egra,cd firm. in light al ,he difficulty in properly evaluating “u@ note 5. a, 20.567. The Guidelines are susceptible ,o ,he cri,icbm ,ha, under ccr,ain
competidon-based and con-based jusdficaiionr for price differentials and dc,cc,ing the 8onditions the sellers migh, condnuc ,o coordinate their prices ,o buyers other than the
use of nonprice methods of discrimination. For example. after rbc merger. cornpAng disruptive buyer.
inpu, suppliers migh, rahc ,heir inpu, prices in ,he cxpectadon that ,hc upstream division ” In carrying out this cvaluatian. Ihe analys musl be careful 10 avoid lhc C~llophnnr
of ,he imcgratcd firm will raise i,s prices. In thr, case. ,hc inlcgra,ed firm might ,ry ,o “fallacy.” The an,icumpe,i,ive effects of some proposed vcrdcal mergers may no, /m&x
argue tha, i, was simply meeting compctilion when i, raised hs prices. In evaluating ,hia wiring prims abwc currem levels but, rather. prcvenling pricer from falling down ,o
claim. how will ,bc couro and regulalory authorities know which price is the “chicken” lower. rnme compe,i,ivc levels by deterring en,ry or cou rcducdons of rivals. If wo, ,hc
and which is ,hr “egg”? Moreover. even where regularion can deter, price discrimina,ion. dclerminadon of ,hc relevant markcl should be scnsilivc ,o the “price down” naiure af
permitting ,he merger would require ongG,tig rcgulamry scrutiny of ,hc merged entity ,hc allcgadon. The r&van, marke, should nag be defined by rcfcrenre ,o price increases
and may prcven, dcrcKuln,ion ,hal u,hcrwirc would be in the public imeres,. Where :I~VC ,hc currcn, level because such price increases are no, ~clcvam 10 ,hr an,icompc,i,ivc
rcgula,urs face such monimring prublcms. ICIPpower should bc a,,ribu,cd 10 an,idiscrimi- c’onccmr. For a discussion of ,hc Cdlaphanr“fallacy.” arising in United Stales v. E.I. du
ru,iun regulations. I’onl de Nemourr k Cu.. 35, U.S. 977 (1956). see Kral,enmakcr e, al.. .supm “0,~ Xl, a,
“This Ialter ilnalyrir hrms ,he basis f& %4.222 (Elimination of a Dirrup,ivc Buyer) in 256-57 n.5. and the rcfercnccr ci,ed therein. .%I obo Easmxm Kodak Cu. V. Image
rhr 19X4 Dcparlment of Juslicc Merger (Aidelines. Srr 19X4 D0.J Merger Guidclinrs. Technical Servr.. Inc.. I12 S. C,. 2072. 20X4 (19%).
542 ANTITRUST LAW JOURNAL [Vol. 63
an impact on the likely increase in the output price and many have an
impact on the likely output expansion of the downstream division as
well. For example, the degree of product differentiation also impacts
profitability, as discussed below.
d. Acquisition of a Maverick Competitor in the Output Market
A vertical merger with a downstream partner who is a maverick, that
is, a particularly vigorous and disruptive competitor in the downstream
market, may facilitate coordinated price increases in the output market
after the merger.‘O If a maverick firm merges with an upstream competi-
tor, its incentive to engage in disruptive competitive behavior will be
reduced. It will have a greater incentive to coordinate its prices with its
downstream rivals in order to facilitate coordinated input pricing that
benefits its upstream partner. Thus, in situations where the downstream
merger partner is a maverick, it is more likely that the merger will lead
to output price increases.
e. Product Differentiation in the Output Market
Where products in the output market are highly differentiated, nonco-
ordinated competition is less intense than for more homogeneous prod-
ucts. This is because demand substitution among them is limited. In that
case, higher prices charged by foreclosed competitors may not lead the
downstream division of the integrated firm to raise its own price by much
in response.” In contrast, if the products are closer substitutes, then the
integrated firm has the incentive to raise its output price by more in
response to the foreclosure induced by the merger.” Thus, the impact
on prices in the output market will be greater when the products are
somewhat closer substitutes.‘”
In addition, when the products are differentiated, the integrated firm
has less to gain from input foreclosure. This follows because the price
effect is smaller and the downstream division is unlikely to expand by
as much. This information is relevant in evaluating the integrated firm’s
incentives to raise input prices to begin with as well as its incentives to
‘“This zmalysis obviously is closely relawd to the dircusrion of dirrupdvc buyers above.
” For example. in the limiting case. if there is no demand subaitudon be~cen the firms.
the imegrntcd firm will nut have the incentive LO raise its price at all.
‘?This explains the coumerintuitive nature of the impact of product diffcrendadon.
One might expect product differendarion w increarc the likelihood of post-merger price
incrcaxs because differendadan tends to produce higher prices in markets in which pricing
is not cwrdinawd.
” Far some illustrative calculations. see Table I in Ordover. Equilibrium. ru@~ note 15.
al 137. .%I nlrn Har, & Tirolc. S”jh ““,C 37.
19951 EVALUATING VERTICAL MERGERS 543
undercut its competitors’ coordinated input price increases, as discussed
earlier.”
f. Magnitude of Increase in Rivals’ Costs
The greater the impact of the input foreclosure on rivals’ costs, the
greater will be the effect on output prices, all things being equal. As a
result, the potential harm to consumers in the output market will be
greater. In addition, the gains to the integrated firm will be greater,
which will lead to a greater incentive to undertake and stick with an
input foreclosure strategy.
Prediction of the magnitude of the likely impact of a proposed vertical
merger on rivals’ costs may be complex. This is because the magnitude
of the input demand elasticity and the cost share of the foreclosed input
are related. This relationship leads to countervailing effects on the pre-
dicted increase in rivals’ costs and downstream prices.
If the foreclosed input represents a small share of the rivals’ costs,
then any given percentage input price increase involves a smaller overall
percentage cost increase.‘” For example, if the premerger price of a set
of spark plugs were $25 out of a total manufacturing cost of $2,500,
which then was doubled to give a wholesale auto price of $5,000. then
a 100 percent increase in the price of plugs to $50 would only raise the
wholesale price to $5.050. an increase of 1 percent.‘”
However, when the foreclosed input represents a small share of rivals’
costs, then the derived demand for the input is less price elastic. This
implies that the resulting percentage increase in the input price is poten-
tially larger if a vertical merger leads to weakened input market competi-
tion.” In the extreme, if a set of spark plugs isessential to the construction
of an automobile, then a plug monopolist could, in effect, control the
automobile market and extract all the monopoly profits.” This is an
” Set in/r0 Part tV.A.4.c.
” For example. if an input rcprcscnts 10% of a firm’s costs and the price of the input
rises by 20%. then the firm’s costs will rise by 2%.
“That is. the new manufacturing cuss wauld rise to $2.525. which upon doubling gives
a wholesale price of $5.050.
” Bccauw overall costs do “01 rise by 1~ much when rhc CM share is low. a given increase
in input price will not reduce demand by ar much.
‘* For example. if the monopoly whalesale price were $7,500, a spark plug monopolist
could charge perfectly compeddve auto manufacrurcrs $5.025 for a SCI of plugs. The
remaining manufacluring c03U arc 12.475. which would imply a total CDILLOthe producer
of $7.500. If whalesale compctidon were perfect. then the wholesale price would equal
marginal costs of $7.500. Even if autamabilr manufacturers arc not perfccdy compaitivc.
the plug monopolisr could charge an extraordinary price. For example. assuming lhat the
manufacturing cost will be doubled. a price of pluga equal to $1.275 would imply a
manufxturer’r CDS~of $5.750. which upon doubling yields the monopoly price of $7.500.
 544 ANTITRUST LAW JOURNAL [Vol. 63 19951 EVALUAT~NC VERTICAL MERGERS 545

application of the general antitrust principle that there is greater risk indifferent to a spark plug cartel that had equivalent price effects. Why
of collusion and pricing coordination when demand is inelastic.‘Y should it countenance a vertical merger that acts as a facilitating practice
The net effect of the input cost in relation to the rivals’overall product simply because the price of automobiles will not rise by a large per-
cost depends on the structure of the input market. For example, in the centage?
case in which inputs are used in fixed proportions and input foreclosure One difference is that the cartel is a naked restraint whereas effects
either would leave a single remaining unintegrated input supplier or from a vertical merger are less predictable and the merger has potential
would allow multiple remaining suppliers to effectively coordinate prices, efficiency benefits. It would not make sense to sacrifice large efficiency
then low input cost share does lead to a higher percentage price increase. benefits to prevent a trivial increase in rivals’ costs and prices. Even this
Moreover, the effect on downstream rivals’overall costs actually is invari- is not so simple, however. The potential efficiency benefits likely are
ant to the input cost share.‘” In general, because inelastic demand facili- proportionally smaller for inputs that represent a small cost share. For
tates pricing coordination, there is no general reason to think that a low example, it is unlikely that the acquisition of the spark plug producer
input cost share will reduce the likelihood of input foreclosure.“’ would reduce Ford’s overall costs as much as would the acquisition of
Even when the increase in the input price is constrained, enforcement an engine plant. Thus, although consumer injury likely is low. so are
may still be warranted. For example, suppose that a vertical merger leads the likely efficiency benefits. As a result, it is hard to see why enforcement
to the price of spark plugs rising 50 percent by facilitating post-merger should be more permissive as a matter of policy rather than remaining
coordinated pricing among the spark plug producers. including the up- dependent on factual analysis of the actual balance.
stream division of the integrated firm. Suppose the price of automobiles g. Fixed Versus Variable Cost Inputs
rises by the increased spark plug price only of (say) $25 per car on an
overall automobile price of $5.000. Antitrust policy clearly would not be Certain inputs are used on a fixed cost basis, that is, where usage of the
input does not vary with the amount of output produced. For example, a
Indeed. the plug monopolist actually would want to charge more than this because it
ignores the impact of the price increase on automobile profits. as predicted by the theory machine with no practical capacity constraint and a product certification
of the double markup. from a standard setting organization are fixed cost inputs. Other inputs
“See POSNER & EASTERBROO~. ru/,ra now 29. a, 336: Hay & Kellcy. r,,pm note 53. are used on a variable cost basis, that is, where usage does vary with the
‘a For example. suppose spark plug foreclosure raises rivals’ overall input costs from a amount of output produced. For example, raw materials, fuel, and labor
premcrgcr level of $2,500 to a post.mcrger level of $3,500. as spark plug rices arc raised are variable cost inputs. It is a tenet of simple microeconomic models
from $25 to $1.025. If engines originally arc sold IO the manufacturers Por Sl.000, then
en#ne f~rcc!osurc alw will lead engine producers to raise their prices by $1,000, implying of profit-maximization that only variable (i.e., marginal) costs affect pric-
an ndentlcal mcr~ase in rivals’ overall input costs. ing in the short run. Fixed costs only affect pricing in the context of
This rcsuk makes intuitive sense. Supposc two inputs arc used in fixed proportions and long-run entry and exit.
one is supplied in a perfectly competitive market before and after the vcrdcal merger
involving rhc other. The market outcome should not depend on whether the one input
supplier purchases the other compedtively supplied mput and packages it with its own or Input foreclosure involving variable cost inputs translates directly into
whether the buyer purchases both inputs and dues the packaging. Yet the cost share of increased variable costs. These higher variable costs place direct upward
the foreclosed input will bc 100% in the first case and less than 100% in the second. pressure on rivals’ output prices. The analysis of fixed-cost inputs is
” Even where the rcsulling increase in rivals’ovcrall costs (and, as a result, downstream somewhat more complicated, depending on the time horizon of the
prices) is l?wer. there may still be a benefit to the intcgratcd firm. As discussed earlier, io
effect. the mput foreclosure may facilitate pricingcoordinarion among rhc input suppliers _. analysis.”
The integrated firm lakes its profits in the downstream market and the unintegrated fim “3
take their profits in the upstream market. Analysis of these factors determines the likelihood of anticompetitive
When the strict fixed p&portions assumption is relaxed. and a low cost share does place impact in the output market, absent efficiency benefits. This analysis
a greater limit on rivals’ overall cost increases. subsdtudon to other less cost.effecdvc then would be used in the evaluation of net competitive impact. Before
alternadvc inputs acts as the constraint on the input price increase. If factual analysis were
10 indicate that the prices of two different inputs with different shares of final output cost
- -:..-L. ^_:^__ _._1_.”
would rise by an equal percentage with vertical integration, the absolute price iocreasc ” In the short run, increases in fixed costs will have no effccc on ~~nvaw P~ULC~ AFII
(and the resul!ing incre?sc in rivals’ costs) would he larger for the more expensive input. they induce immediate exit of soroe rivals or immediately deter entry that otherwise would
For example. 11 competmon from demand substitutes prevents input price increases in have occurred. In the longer run. such fixed cost increases will have more effect on prices.
CXC~SS of (say) 10%. then the maximum input price increase for an in UI that costs $1 is They may deter entry by making entry less profitable. Where the fixed costs have not been
10 cents whereas the maximum price increase ft,r an input Ihat costs tl,OOO is SIOO. sunk at prcmerger prices. increase, in fixed cow may induce exit by established firms.
 546 ANTITRUST LAW JOURNAL [Vol. 63
Figure 2. Input foreclosure impact on ancillary market
turning to that analysis, however, we analyze the potential for anticompe-
titive effects in ancillary markets.
4. Step 3: Anficompctifive Impacl in Ancillary Marketi
The third step evaluates impact on output prices in any ancillary mar-
kets or market segments. Ancillary markets may be affected when price
discrimination in the input market is infeasible, as discussed earlier,
Other ancillary markets may be affected when there are demand or
supply side complementarities. Whatever the cause. the analysis of ancil-
lary markets focuses on the impact on consumers, competition from
rivals, and the impact on the profitability of the integrated firm.
One possible ancillary market in the Ford-Autolite case arising from
inability to price discriminate is the aftermarket illustrated in Figure 2.
As discussed earlier, when price discrimination is infeasible, a strategy
of input foreclosure, if attempted, will lead to higher prices in ancillary
market segments. For example, if Ford attempts to raise the costs of its
competitors in the automobile manufacturing market by raising the price
of spark plugs, that strategy also would increase the price of spark
plugs in the aftermarket if price discrimination is infeasible. As a result,
consumers of aftermarket spark plugs will be harmed.
Other ancillary output markets also could arise for particular demand
and supply side configurations. For example, suppose that the auto
EVALUATING VERTICAL MERGERS
manufacturers also produce another product. say electric golf carts, as
a result of technological economies of scope, and that the golf carts
do not utilize spark plugs. In this scenario, if Ford disadvantages its
automotive rivals by raising their spark plug costs, they may also suffer
cost penalties in producing golf carts. In that case, Ford may also gain
the power to raise the price of golf carts, to the detriment of consumers.
Where potential price increases in ancillary market segments occur,
they also represent competitive harms from the merger, and thus should
be factored into the analysis. In evaluating the magnitude and likelihood
of such harms, the general approach set out for Step I and Step 2 is
followed. That approach involves evaluation of the structure of the
ancillary market, including ability of consumers to substitute to other
products. market shares, concentration and competition in the ancillary
markets or market segments, ease of entry and expansion, and other
competitive factors.
5. Step 4: Evaluation of Net Compelilivc Impad
Having evaluated the potential impact of a vertical merger in the
various markets, it is necessary to describe the circumstances in which a
merger should be deemed anticompetitive under a structured rule of
reason analysis. As discussed earlier, this involves meeting a required
threshold to satisfy a standard of harm, absent any evidence of specific
efficiency benefits. As discussed earlier, it also involves meeting some
standard that governs the balancing of efficiency benefits against likely
market power harmssJ It should not be assumed that competitive harms
dominate efficiency benefits, or vice versa.
We envision the following decision-making sequence. Even before the
merging parties are required to demonstrate any specific efficiency bene-
fits, the complaining party (either the governmental enforcement agency
or a private litigant) must make a showing that the likelihood of competi-
tive harms exceeds a threshold standard of harm. Only then would the
issue of the proper balancing of efficiency benefits against potential
competitive harms become relevant.
We discuss the standard for finding competitive harm first. In analyz-
ing input foreclosure, Step I evaluates the harm suffered by the rivals
foreclosed from the input market. Step 2 and Step 3 evaluate the harm
to consumers who purchase the products sold in the output and ancillary
markets. This raises the issue of whether it is necessary to show that
output prices are likely to rise in order to conclude that the vertical
merger is anticompetitive, or whether a finding of competitor injury
 548 ANTITRUST LAW JOURNAL
should be sufficient. For the reasons discussed below, we believe that a
showing of likely consumer injury related to higher prices should be
necessary to support the conclusion that a vertical merger is anticompe-
titive.
Arguably, a conclusion that exclusionary conduct in an input market
by a vertically integrated firm is anticompetitive could rest solely on a
finding that the rivals that are potential purchasers of the input are
injured by higher input prices or a refusal to deal.@’ Injury to consumers
resulting from higher prices is not strictly necessary to demonstrate that
the exclusionary conduct is profitable to the integrated firm. Even if
prices in the output market remain constant, diversion of sales to the
integrated firm would increase its profits if its price exceeds its marginal
cost. Moreover, at least some consumer harm might occur if consumer
choice in the output market is reduced by the exit or crippling of a
competitor, or a reduction in R&D, even if prices remain fully con-
strained by competition from other firms.
[Vol. 63 EVALUATING VERTICAL MERGERS
presumption of cost savings and other efficiency benefits than are hori-
zontal price restraints and horizontal mergers. Vertical mergers involve
firms that normally have a contractual relationship to one another that
contains cooperative elements. ” This is very different from the para-
digmatic horizontal merger or horizontal price-fixing matter.
Second, complaints about specific vertical mergers often are made by
the competitors of the merging parties.” Those complaining competitors
have mixed motives. Although they are concerned about conduct that
harms consumers by raising rivals’ costs, they also are concerned about
conduct that benefits consumers by reducing the costs or improving the
products sold by the merging parties. Either way, rivals may be harmed.
Because of the resulting potential for lawsuits attempting to enjoin merg-
ers that benefit consumers, it may be necessary to require an explicit
showing of consumer injury rather than relying on an irrebuttable pre-
sumption.

In the antitrust analysis of horizontal restraints, a showing of price Third, the magnitude of harm suffered by consumers solely from
impact in a final output market in which consumers purchase is not elimination of choice and the resulting diversion of sales generally will
generally required for antitrust liability. For example, demonstrating be quite limited in situations where the merger likely will not increase
harm from higher prices to the ultimate consumers who buy the products prices. If a reduction in consumer choice flowing from the exit or crip-
manufactured and sold by input purchasers clearly would not be neces- pling of a competitor would have serious consumer welfare effects, one
sary in a price-fixing case.” Similarly, in a horizontal merger case involv- would expect that the remaining nonexcluded firms likely would gain the
ing inputs, proving solely that input prices will rise is sufficient. It is not ability to raise their prices. ” Moreover, focusing solely on the reduction in
necessary also to demonstrate that the prices of products that utilize the choice does not distinguish between actions that cause a rival to exit
inputs will rise.” Instead, there essentially is an irrebuttable presumption because the merged firm efficiently has succeeded in reducing its own
that consumers will be harmed. costs or improving its products and actions that destroy a rival by artifi-
cially and inefficiently raising its costs.
We think that this analogy to horizontal restraints, however, is insufti-
cient to eliminate the need to show consumer injury from higher prices It is for these reasons that courts generally take the approach of requir-
from input foreclosure. First, vertical mergers are entitled to a greater ing a showing of consumer injury, not simply a demonstration of compet-
itor injury, in cases involving nonprice vertical restraints, such as vertical
@’ This is. for example. essentially the position taken by Timothy Brcnnan and Joseph mergers, exclusive dealing, and unilateral refusals to deaL8” It is a maxim
Bradley. See Timothy Brcnnan. Underrlonding H&sing Rivolr’ Corb. 39 ANTITRUST BULL.
95 (1988); Joseph Bradley. Thr Economic GwLr o/ Anlirrtur: Efjcitncy. Cotuunrr We&r, and
of modern antitrust that harm to competitors is insufficient for a finding
Ttrhnolo,$o,l Progress. 62 N.Y.U. L. REV. IO20 (19R7).
” For cxamplc. in NCAA v. Board of Regents. 46X U.S. 85 (1984). the Court did not “Of coorx, as discussed earlier. this could suggest the abilby to achieve the bulk of
require analysis of the advertising market. the cfficicncy benefits by a vertical contract short of a full merger. However, for now, we
M This is a bit of an overstatement. In defining the relevant input market. the potenrial take rhc conservative approach of assuming that mergers typically are nccesrary. However.
for substitution by customers of the input purchasers is rclcvant. If that substkotion is WC would take alternadver short of merger into accouo~ in any case-by-case analyrir that
strong. lhcn the market may be defined more broadly, and as a rcsub. the merger may is carried out.
fall into the safe harbor region. See 1992 Horizontal Merger Guideliner 8 9.1. supra note u These complaints may involve claims made to the government cnforccmcn~ agencies
2% at 20.560. Howcvcr. lhe fact that the downswcam price would not rise is not rufticicnt or private lidgaiion.
to establish a broad market. For an example loc~cly bared on Aspen Skiing Co. v. Aspen ‘“Similarly. the profitability of exclusionary conduct that merely diverts sales at pre-
Highlands Skiing Corp., 472 U.S. 51% (l9llS). see Steven C. Salop. Eunluting N~hvark merger prices typically would bc significantly limited. rcladvc to the situadon where Ihe
PncinRStlf.-R~~lnfinn. in ELECTRONIC Srvwcrs Nnwua~s: A BUSINESS AND PUSLK Poucu excluding firm gains the power to raise output oricen.
CHALLENCC ES. I10 11.20 (Margaret E. Go&-Calvcrt & Steven S. Wildman eds.. 1991). w Continental T.V.. Inc. v. GTE Sylvania Inc.. 43% U.S. 36 (197: 7)
 550 ANTITRUST LAW JOURNAL [Vol. 63
of antitrust liability. It is also necessary to show harm to competition,
the buzzword for consumer injury. because antitrust is a “consumer
welfare prescription.“”
In light of this analysis, we take the approach of requiring a showing
of likely consumer injury. Moreover. we also require demonstration of
a likely price effect in either the output market or an ancillary market.
For the case of input foreclosure, it is insufficient to demonstrate merely
that input prices will rise. The significant likelihood of output price
increases also must be shown. For the reasons discussed earlier, it is
insufficient merely to demonstrate that consumer choice is reduced.
At the same time, we would not recommend that the output price
increase be required to exceed some minimum threshold, such as the
ubiquitous 5 percent of the Horizontal Merger Guidelinexg As long as
it can be shown that it is likely that output prices will rise, that finding
raises significant market power concerns. Given this showing, it then
would be necessary to balance the likely harm to consumers against the
likelihood and magnitude of specific efficiency benefits flowing from
the transaction identified. Simply because some efficiency benefits are
identified does not demonstrate that these benefits exceed the magnitude
of competitive harms. Absent proof of sufficiently offsetting efficiency
benefits, we think that the vertical merger should be judged anticompe
titive.‘”
Moreover, we think it should not be necessary for the plaintiff to prove
an immediafe price effect. Significant anticompetitive price increases may
occur, but not immediately. For example, consumer harm might result
from a reduction in R&D. However, if this is the case, then consumer
” St, Ez,w,,an Kodak Cu. v. Image Technical Sews.. Inc.. I I2 S. Ct. 2072 (1992); Brookc
t:roup Ltd. Y. Brown & Williamsan Tobacco Corp., I IS S. 0. 2578 (1993).
” Indeed, the Horizontal Merger Guidelines use of a 5% price increase in defining
rclcvant markets does “01 nccersarily imply a 5% post-merger pricing threshold. Sn Frcdcr-
irk K. Warren-Boultun. A Commrtlla~ on f/w 1992 U.S. Mtrgn Cuidrlinrs. 22 INT’L MERGER
L.. June 1992. at 14. Moreover. the IYYZ Horizontal Merger Cuidelincs do nat rilavirhly
fnllnw the 5% test in all cases. .SII 1992 Horizontal Merger tiuidclines. supra nwc 29, at
20.557 n.7 and accompanying text (explaining that a price increase larger or smaller than
5% may be used. depending upan the nature of the industry).
“I Although injury IO compcdtors alone is insufficient to condemn a vertical merger that
raises input foreclosurr concerns. our approach is nat indifferent IO the harm. As discussed
carlicr in Part III. injury tocampctitors often inwIves efficiency losses as rivali pradurdon
(osrs are aniticially’it~creascd and. as a result. industry praducdon is carried out in rn
inefticirnt manner. Thusr efficiency losxs would be included in thernalysisofnc~campc,i-
live ,impacr of the Iranrarlion. Such Insscs would have the effect of reducing the net
rllirzncy benchts that could tx claimed for a vcrdcal merger.
19951 EVALUATING VERTICAL MERGERS 551
prices are likely to be higher in the long run. but possibly not io the
short run. These harms should be cognizable.“’
B. CUSTOMER FOR~CLOSUKE
Customer foreclosure refers to exclusionary conduct by the down-
stream division of an integrated firm with the purpose and effect of
excluding rival input suppliers from access to a sufficient customer base.
By refusing to purchase from a rival input supplier. that rival may suffer
higher unit costs that make it a less formidable competitor in selling to
other customers or even force it to exit from the input market. The
conduct also may harm competition by giving the excluding firm the
power to raise or maintain input prices above the competitive level. It
also may harm competition by leading to higher prices in the primary
or ancillary output market.
The customer foreclosure theory can be illustrated with respect to the
hypothetical version of the Ford-Autolite merger. Consider the Bubble
Diagram in Figure 3: Customer foreclosure would involve denying
other spark plug manufacturers, particularly Champion, access to Ford
as a customer. If there are economies of scale or scope, this foreclosure
might drive Champion below minimum viable scale so that it is forced
to exit from the market. Alternatively, it might raise Champion’s variable
costs, thereby reducing its competitive vigor. Either way, reducing com-
petition from Champion thereby could endow Autolite with market
power in the sale of spark plugs.
Figure 3 illustrates the case in which Autolite gains market power in
aftermarket sales. This market power may involve unilateral conduct by
Autolite or it might involve coordinated pricing with the other spark
plug manufacturers.
Autolite might also gain market power in OEM sales by making it
more costly for its rivals to produce spark plugs. Figure 4 illustrates this
* For a general discussion of andtrust analysis of R&D competition. see Richard GilLxrt
& Stcvcn Sunshine. Incorporating Dynnmir Efjcbcy Conrr~ in Merger Armlysir: Thr USC of
lnnnwrion Morhrrr. rupra this issue, 6S ANTIT~ST LJ. 569 (1995).
“This Bubble Diagram obviawly is peculiar in that the OEMsof the spark plug produc-
ers are treated as inputs rather than as customers in the output market. Diagramming the
markets in this way is “01 ncccrsary. However. it dcmonatratcs the formal relationship
between the input fareclosure and cwtmxr foreclosure theories. Curtomcrs arc like an
input in the sense that a seller needs enough customers IO reach minimum viable scale in
ardcr to survive in the market. In the spark plug marke,. there actually is a rrwrc convcn-
donal sense in which the OEMs are an input inw aftermarket sales. OEM salts lead tv
addidonal aftermarket sales becaurr c~nsumcrs tended to replace wwn spark plugs with
the same brand. Ford Motor CO. v. Vniwd States. 405 U.S. 562. 565 (1972).
 552 ANTITRUST LAW JOURNAL [Vol. 69 EVALUATING VERTICAL MERGERS 553
19951

AFTERM ARK\x/

( Retailers )

Figure 3. Customer foreclosure impact on ancillary market Figure 4. Customer foreclosure impact on foreclosed customer market

case. The higher input prices in turn could lead to input foreclosure
against competing automobile manufacturers. As discussed earlier, this
could endow Ford with market power in the automobile market, either
through unilateral or coordinated conduct in that market.
The case in which Autolite gains market power in OEM sales raises
subtle conceptual issues. For example, in Figure 4, the automobile manu-
facturers are the input suppliers (selling access to the OEM market) as
well as the customers. That is, suppose Champion requires sales from
Ford in order to achieve minimum viable scale or maintain low variable
costs. In that case, if Champion has no access to Ford. its costs will be
higher or it will exit. Either way. Autolite will gain the power to raise
price to the OEMs. Despite this price increase, Champion may be unable
to recapture sufficient sales from customers like Chrysler and AMC.
For example, their sales may be insufficient to push Champion above
minimum viable scale, even at the higher price.
Evaluation of the likelihood of anticompetitive effects from customer
foreclosure involves a four-step analysis. The first step focuses on the
issue of whether unintegrated input producers will be significantly disad-
vantaged by being foreclosed from selling to the integrated firm. The
impact on the ancillary market. in which purchasers do not compete
 554 ANTITRUST LAW JOURNAL [Vol. 63 555
I9951 EVALUATING VERTICAL MERGERS
with the integrated firm. is analyzed in the second step.Y” The impact
(MVS) at premerger prices. Minimum viable scale may be significant as
on the output market in which the integrated firm competes is analyzed
a result of economies of scale and scope.
in the third step. This latter inquiry also focuses on the role of customer
foreclosure in creating input foreclosure in that output market. The MVS is the smallest average annual sales level that a firm must
persistently achieve for profitability at a given price.” The MVS can be
2. Step I: ImpOcl on RiuaLr’ Cosls and Vi&lily
utilized in conjunction with other information to gauge the likelihood
Suppose that the output division of the integrated firm refuses to that an input supplier will exit from the market following the vertical
purchase inputs from one or more rival input producers. In some cases. merger. For example, consider the input supplier that had been supply-
these lost sales can be replaced by sales to other customers. However, if ing the downstream division of the newly merged firm. Suppose that a
the integrated firm is an important customer and the foreclosed produc- particular input supplier’s premerger market share had been 15 percent
ers cannot replace the lost sales, they may be disadvantaged, If their and that 67 percent of its sales were to the merged firm. Suppose that
production is forced below minimum viable scale, they may be forced it is expected that the merged firm will supply itself with all of its input
to exit from the market altogether. Even if they do not exit, they may requirements after the merger. In this case, absent alternative customers,
face higher marginal costs that limit their ability to compete effectively. the other input supplier’s market share will fall by two-thirds to 5 percent.
Finally, as discussed below, they also may face reduced incentives to If MVS were 10 percent, then this firm would be vulnerable to failure
engage in nonprice competition. if it could not double its sales to other customers that remain available.‘w
a. Availability of Alternative Customers c. Impact on Marginal Costs and Incentives to Invest in Cost
A proposed vertical merger may alter customer relationships as the Reduction or Product Improvements
integrated firm substitutes from its revious suppliers to specialize in
Even if a foreclosed input supplier does not fall below MVS, its ability
purchases from its captive supplier. b: At the same time, unintegrated
or incentives to compete may be reduced by the foreclosure. First, the
input suppliers may gain sales from unintegrated firms that prefer not
firm’s marginal costs may rise as a result of losing the customer. This
to deal with a competitor. Defensive vertical mergers among formerly
might occur from economies of scale (in variablecosts) or from economies
unintegrated firms may be an additional source of realignment.‘* This
of scope. Second, even if marginal production costs are constant as the
realignment in supplier relationships may imply little net effect on the
output level and mix change, similar results can follow from analysis of
sales of the input suppliers. Where input suppliers are unable to replace
nonprice competition. In particular. a reduced customer base may reduce
the lost sales, however, those rivals may be harmed.
the incentives of the foreclosed firm to invest in cost reduction, product
The loss of the integrated firm as a customer is less significant if that quality. or other nonprice product dimensions. If so, its ability to provide
firm’s premerger purchases from unintegrated firms is a small share of a competitive check on the integrated firm will be reduced.
its available sales base. In that case, sufficient alternative customers are
more likely to be available. Suppose, for example. that before the merger, an input supplier was
planning to undertake a one-time investment in a new technology that
b. Minimum Viable Scale would significantly reduce its variable costs. Of course, that planned
An input supplier foreclosed from an important customer may exit reduction in variable costs would make the firm a more vigorous competi-
from the market if the foreclosure drives it below minimum viable scale tor. The return on this type of investment is larger for a firm that
produces more output. In contrast. if a firm contemplates a low scale of
*) In the case of input foreclosure. the ancillary markcl was evaluated in Step 3. Some production, its return on the investment may fall short of the rate neces-
might view Step 3 as coming logically before Step 2. WC follow the opposite order because
the analyrirof the ancillary market is simpler. Becauseof the way in which Step 9 converges
both with Step I and the evaluadon of input forcrlorore. it is less confusing to analyze ““Tbir follows the basic definition in the 1992 Horizon&d Merger Guidelines. .%I olro
the ancillary market first. Sleven C. Salop. Mtuutin~ Earr “/Entry. YI AN~.I.~RUPT BULL. 551 (19%).
” This change in inpul suppliers may bc driven by efficiency concerns. as discussed in IuJ If some potential customers are integrated. wilh no interest in buying outride or tied
more detail, supra Part III. up in long-term contracts. or if the market were shrinking. this tirm would be more
vulnerable IO failure. In contrast. it would be less vulnerable if the integrated input supplier
y See Ordovcr. Epilibtium, suprn note 15. for a discussion of thr limits of defecnsive
were expecrcd to lose sales. if long-term contracts were expiring. or if the market were
vertical mergers when foreclosure is moderate.
growing.
556 ANTITRUST LAW JOURNAL [Vol. 63
sary to justify the investment. Thus, if customer foreclosure implies a
reduced return on this investment to a level below the necessary hurdle
rate, competition will be reduced because the foreclosed firm will have
higher costs than it would otherwise.“”
An identical competitive analysis would apply to other types of invest-
ments in product quality or other nonprice dimensions of competition.
If the return on the investment increases with the level of output pro-
duced, then customer foreclosure may reduce investment incentives, and
as a result, reduce the overall competitiveness of the foreclosed input
supplier.
3. Step 2: Anticom~elitive Impact in the Ancillary Mark&
This step analyzes the impact of customer foreclosure in ancillary
markets.‘s* Ancillary markets refer to those output markets that utilize
the input but in which the integrated firm does not produce output. In
these markets, the integrated input supplier competes to sell to non-
competing customers. For example, in the Autolite hypothetical, the sale
of spark plugs to the aftermarket would constitute an ancillary market.
If one or more input suppliers are disadvantaged by customer foreclo-
sure, either because they compete less vigorously or because they exit
from the market, competition in ancillary markets may be reduced. This
analysis and the factors relevant to evaluation of the impact in the ancil-
lary market is similar to the previous analysis of the output market
discussed in the input foreclosure section. Thus. in summary, the reduc-
tion in competition in the ancillary market is more likely to occur under
the following circumstances:
(1) Customers are unable to substitute to alternative products;
(2) Post-merger competition among the input suppliers is mitigated
by the reduction in competition from the foreclosed sellers;
(3) Foreclosed rivals had been maverick competitors before the
merger;
(4) There is less product differentiation in the ancillary market.
4. Step 3: AnlicomPelilive Impacf in thr Foreclosed Cwlomer Mar&
Customer foreclosure also can create anticompetitive effects in the
output market in which the customer foreclosure occurred and in which
I” Analysis of this issue must be senridve 10 the Cdlophanr “fallacy.” .%I rupra note 69.
Forgoing an invcstmcnt may not reduce compctidan below the current level hut instead
may prevent competition from incrcaaing.
I”’ As dircusacd earlier. we analyze the impact on nncillary markctr before [he impact
in the output market to clarify our prwcntatiun.
19951 EVALUATING VERTICAL MERGERS 557
the integrated firm competes with other firms that use the input. Reduc-
ingor eliminating competition from certain unintegrated input suppliers
can facilitate input market foreclosure against the remaining uninte-
grated output producers that compete. For example, suppose that fore-
closure by Ford of an unintegrated firm like Champion were to drive
Champion below MVS. leading it to exit the market, or were to reduce
Champion’s investment incentives. In that case, Autolite may gain the
ability to raise prices to the OEMs. either unilaterally or in coordination
with the other remaining spark plug competitors. This could lead to
higher spark plug prices and also to reduced competition in the automo-
bile market as Autolite engages in input market foreclosure against Ford’s
unintegrated rivals.‘”
Evaluation of input foreclosure in this context follows the same analysis
set forth in the earlier discussion of input foreclosure. That inquiry
involves (1) the impact on input prices and rivals’ costs, (2) the impact
in the output market, and (3) the impact in any other ancillary markets.
This analysis then feeds into the evaluation of net competitive impact.
5. Step 4: Ncl Conrpclitivr Impact
In the evaluation of input foreclosure, we set out a standard for evalu-
ating net competitive impact. We take an analogous approach in analyz-
ing customer foreclosure. It is insufficient merely to prove harm in Step
1 to the competitor foreclosed from customers by the vertical merger.
It also is necessary to prove harm to competition. This can be shown in
Step 2 or Step 9 by demonstrAng the likelihood of a resulting price
effect suffered by the customers that purchase the products in those
markets.“’
V. ANTICOMPETITIVE EXCHANGE OF INFORMATION
Vertical mergers might be able to increase the likelihood of tacit or
express coordinated conduct by facilitating the exchange of pricing and
other corn titively sensitive information among the competing input
suppliers.’ ge
’ Assuming that the integrated firm does not satisfy all of its
‘“‘This scenario is unlikely on the historical facta. Champion was the largea! spark plug
producer. with 1 premcrger market share of appmximalely 50%. far in excess al Ford’s
share of purchases. Ford Motor Co. v. United States. 405 U.S. 562, 566 (1972).
l”( Thb may be a bit confusing in that the cwtmners in Srep 9 of cusmmer foreclowrc
are purchasing the product as an input. However, the kcey point in c~mmcm with the
previous analysis of input foreclosure is that injury to the foreclosed compcdtor is inrufi-
ciem for a finding that the merger is anticompedrivc.
‘O’ The 1984 DOJ Merger Guidelines offer a r&cd theory of how vertical mergers can
facilitae information exchange among compcdwrr. See 1984 DOJ Merger tiuidclincs
fi 4.221. ~uprn nmc 5. II 20.566-57 (exp$ining that a high level of vcrdcd integration by
upstream firms into the associated retail marker facilitalcs price monitoring).
 558 ANTITRUST LAW JOURNAL [Vol. 63
input requirements, but rather continues to purchase part of its require-
ments from other input suppliers, the downstream division will receive
price quotes and competitive information from rival input producers.
The downstream division can transfer this information to its upstream
division. Because it has ongoing dealings with input suppliers, the down-
stream division is well situated to transmit information from its upstream
division to rivals. In this way, the downstream division can act as a
conduit for exchanging competitive information among input suppliers,
information exchange that has the potential to increase the likelihood
of coordinated conduct.
In order for a vertical merger to raise competitive concerns regarding
information exchange, three conditions must be satisfied. First, the infor-
mation disclosed by competitors to the downstream division must be
projectable. Second, the information disclosed must be unique. Third,
the structure of the input market must be conducive to successful pricing
coordination.
A. PROJECTABILITY OF THE INFORMATION EXCHANGED
The pricing and other marketing information disclosed to the down-
stream division of the integrated firm often may not provide a reliable
basis for successful coordination. This is because the price quotes given
to the integrated firm in the normal course of business may not be
identical or even similar to the prices offered to other customers. As a
result, the information may not be projectable mother bidding situations.
Because it is integrated, the downstream division is situated differently
from other potential customers and these differences may lead input
suppliers to quote different prices than it does to other customers.
The prices quoted in the normal course of business may be higher or
lower than prices offered to other customers. On the one hand, the price
quoted may be lower in response to the fact that the integrated firm has
the incentive to transfer the input to itself at marginal cost. This means
that the competing input supplier may need to offer the integrated firm
a lower price than it quotes others in order to have a better chance of
obtaining the business. On the other hand, the input supplier might
reason that it will only get business from the integrated firm if the inputs
supplied internally are absolutely inappropriate for the downstream divi-
sion. In this case, it might feel it can quote an even higher price than it
offers other customers.
This assumes, of course, that the quotes are offered in the normal
course of business. An input supplier might behave differently if it
assumes that the price quotes were being transmitted to the upstream
559
19951 EVALUATING VERTICAL MERGERS
division with which it competes. This expectation or knowledge may lead
the input suppliers to quote the same price it offers other customers. in
order to facilitate pricing coordination by improving the information
available to the integrated firm. Of course, this reasoning assumes an
intent that may not be operating or may not be known to be operating.
Unless the rivals are confident that the integrated firm intends to coordi-
nate prices, disclosing prices offered to other customers is risky business.
The integrated firm may use the information to undercut its competitors’
prices. As a result. an input supplier might quote a deceptively high
price in the hope that it can undercut the integrated firm in the market.
Because of these complex strategic considerations, in many cases, the
integrated firm may not trust the information received from rivals. As
a result, it may undercut their price quotes in bidding for other custom-
ers. For all these reasons. the prices quoted to the integrated firm may
provide little projectable information to the integrated firm about the
prices likely quoted to other customers by its competitors.
To the extent that the firms face binding antidiscrimination regula-
tions, the information may be more reliable, of course. In this case, the
price quotes offered to the integrated firm would be the same as those
bid to others. Thus, the price information is more likely to be projectable
to other customers.
B. UNIQUENESS OF THE INFORMATION EXCHANGED
The vertical merger can facilitate pricing coordination if the merger
improves the ability of the input competitors to exchange information.
However, in order for the merger to matter, the new information channel
created must have some unique benefits. This may or may not be the
case.
Customers may facilitate the exchange of information among compet-
ing suppliers by disclosing to one supplier the prices offered by others.
Customers sometimes disclose this information in the course of at-
tempting to negotiate a better deal for themselves, despite the impact
of such disclosures on the likelihood of successful pricing coordination
by suppliers.‘M As a result. the information transmitted through the
downstream division of the integrated firm may be redundant because
it is available through other customers. The most obvious example of this
‘lb A buyer may realize that thr infwmation can facilitate cwrdinated pricing but not
Marc. I;irst. its private bendits in nqpiatinK a lower price may exceed its cxpcctcd harm
frum the small increased likelihwd of hifqher prices later un. Second. to the exent that
its rompetiaars will be forced LO pay higher prices than itself. the buyer would perceive a
knehl fwm ,faininS a cost advantaSe.
560 ANTITRUST LAW JOURNAL [Vol. 63
non-uniqueness would occur when firms price identically to all customers
from a single list price schedule.
This example suggests a fundamental tension between uniqueness and
projectability. Where the information disclosed through the integrated
firm is unique, it is less likely to be projectible to other bidding situations.
Where it is projectable, the information channel through the integrated
firm is less likely to be unique.
Despite the existence of other customers, transmitting information to
the integrated input producer through its downstream division some-
times may provide unique benefits. This may occur because the down-
stream division will accurately disclose the information it receives from
input suppliers to the upstream division. Other customers may not truth-
fully disclose prices quoted to them. Instead, they may understate the
bids they receive in order to negotiate a better price from a competitor.
However. the upstream division can trust that its downstream division
is accurately transmitting the price quotes it has received.
C. STRUCTURE OF THE INPUT MARKET
Information exchange can only facilitate successful pricing coordina-
tion if the structure of the input market otherwise is conducive to coordi-
nated conduct. For example, information exchange is unlikely to lead to
collusion in a perfectly competitive market with easy entry. Information
exchange is more likely a problem in oligopoly markets satisfying a
number of structural indicia of competitive concern.
Thus, in order to gauge the likelihood of a competitive concern from
information exchange, it is necessary to analyze the structure of the
input market. Among the factors to evaluate are the number of competi-
tors, market concentration, ease of entry, the magnitude and frequency
of contracts, whether prices are individually ne o&ted, product homo-
geneity, and other competitive analysis factors.‘0 f Only where these struc-
tural factors indicate a potential likelihood of successful coordination is
information exchange likely to raise significant concerns.‘“’
D. NET ANTICOMPETITIVE IMPACT
Suppose it is shown that a vertical merger significantly increases the
likelihood that the input suppliers will be able to coordinate their prices
“’ For a mmc d&led discussion. see 1992 Horimmal Merger Guidelines 12. rupm
nae 25. al 20.579-76. 20.579 (discussing the pacmial adverse compcridvc cffccla of
mergers,.
IM Of course. in such markcu. cxplicil information excharqcs may bc unnecessary LO
reach a coordinawd DUICO~C. Baker prescnu an intcresdng analysis uf rhe implicadons
for Ihe law of this conundrum. Jonathan Baker. Two Shrmn AnSwrim I Dikmm: Par&l
19951 561
EVALUATING VER.I.ICAI. MERCERS
successfully, as a result of information exchange. Is this sufficient for a
finding of anticompetitive impact, absent efficiency claims?
In evaluating input foreclosure, we concluded that proof that input
prices would rise is insufficient. It also is necessary to show injury to
consumers. We do not suggest that standard here. Instead, in the case
of information exchange that facilitates coordinated pricing of inputs,
we think it is sufficient merely to demonstrate a likely price effect in the
input market. We propose a more interventionist approach with respect
to information exchange because the alleged conduct is more fundamen-
tally horizontal in nature.
At the same time, we think that this horizontal nature does not suggest
the appropriateness of a per se approach. Information exchanges typi-
cally are governed by the rule of reason.lW Where the information er-
change does not arise out of a horizontal agreement but instead flows
from a vertical merger. the likelihood of valid efficiency justifications is
increased. Therefore, it seems appropriate to place the initial burden of
persuasion on the complaining party to show competitive harms before
requiring explicit efficiency justification by the merging parties.“’
VI. EVASION OF REGULATION
Vertical mergers may permit a firm to evade pricing regulation. First,
a vertical merger can help a regulated firm to evade cost-based price
regulation by setting artificially high transfer prices on inputs sold by
the unregulated upstream division to the regulated downstream division.
In this way. the integrated firm can shift profits from the regulated to
unregulated market. ” Second, a vertical merger can help a firm to evade
statutes or regulations that prohibit price discrimination.
A. EVASION OF MAXIMUM PRICE REGULATION
Vertical mergers may be used by regulated monopoly firms subject to
price regulation as a method for circumventing that regulation. Maxi-
mum price regulations could permit the regulated firm to pass on cost
increases to ourchasers by charging a higher price. After a vertical
Pricing, Thr OIip,,oly Prablm, ad Conrnnporory Ecmomic Thq. 38 ANTIXWST BULL. 145
(1999).
Is4See, e.g.. United States Y. Container Corp.. 393 U.S. 333. 337 (1969).
“‘This also raism Ihe question af remedy. Ihat is. whether a conduct remedy shon of
divestiture would permit the achievemenl of these efficiency benefio without significant
likelihd ofcompedtivc harms. That analysis of remedy is beyond the wopc of thus aniclc.
I” For a similar discussion of this issue. MC 1984 DOJ Merger Guidelines P 4.25, rupm
no,c 5. at 20.567.
562 ANTIT.RUST LAW JOURNAL [Vol. 63 19951 EVALUATING VERTICAL MERGERS 563

merger, the downstream division of an integrated firm may be able to
inflate the price it pays to its upstream division for internally supplied
inputs.“’ In this way, the firm can increase its profits.“”
Regulatory agencies such as the FCC may have difficulty in policing
these practices because of the absence of an independent market for
comparable transactions. Where there is an independent market, the
prices charged by the upstream division can be used by regulators as
an arm’s length pricing benchmark. Assuming that this benchmarking
process amounts to the maximum allowable internal transfer price equal
to the price charged to independent competitors, the ability profitably
to evade such regulations would be reduced or eliminated. However, to
the extent prices are nonetheless increased, the resulting consumer harm
would include the higher prices paid by the independent customers.“’
B. EVASION OF REGULATIONS THAT PROHI~T PRICE DISCRIMINATION
Vertical mergers may be used as a method of circumventing statutes
and regulations that prohibit or limit price discrimination in either the
input or output market. There are a number of reasons why a firm with
market power might wish to price discriminate across customers. For
example, if customers face different demand elasticities or have different
costs, the ability to price discriminate across customers can increase the
profits of the input supplier.
Vertically integrating into the output market can be a substitute for
price discrimination. For example, suppose an input monopolist would
like to sell the input at a low price to the producers in one output market
and at a higher price to the producers in a different output market.
However, suppose price discrimination is prohibited by regulation. As
an alternative, the integrated firm might raise the input price to a higher
level (appropriate for the one market) and enter the other output market
itself and set the profit-maximizing monopoly price in that other mar-
“’ In the analogous case in which Ihe input price is rcgulaled. rhc upslream division of
the regulated firm might try 10 transfer Ihe input IO its downwcnm division al an arbhrarily
low price below cost and [hen recover the losses by raising [he input prices charged LO
ucher customers.
I” Hernhcim and Willig alw p&t OUI lha this eva&n of regulation cara faciliwe input
torcclorure. An input foreclosure ~rrawgy is made even more prohmble if the revewe
slsmfall flowing frrom any 1w.t sales sacrificed by the upstream divirion is thrown into the
~-alebase and bm”e by thr COIISU~C~Iin the rcgulavd markel rather lhan by Ihe smckhold.
us of the reyula~ed firm. Sn Bernheim & Willig. q,ra rwe 53.
‘I’ Of c~urre. the c~nrurner harm is limirrd LO Ihe exlem Ihal cu~mmer~ subrdtuv LO
aherna&c inputs al premerger prices.
ket.“’ This approach would increase the profits of the integrated firm,
relative to charging a uniform price.
Similarly, suppose that it would be profitable for output producers
to charge different prices to different groups of customers. However,
suppose that output market competition prevents that discrimination.
If an input monopolist integrated forward and refused to sell to rival
output producers, it would be able to price discriminate.“’
Although vertical mergers may be used to evade regulatory or market
constraints on price discrimination, they do not necessarily reduce con-
sumer or aggregate economic welfare. It is well established that the
impact of price discrimination on output and welfare may be positive
or negative, depending on demand and supply conditions that are not
easily measured in practice. Price discrimination typically reduces the
price to some buyers while raising it to others, although there are cases
in which prices either are not increased to any buyers or are not decreased
to any buyers.“‘Thus, strict vertical merger enforcement under a balanc-
ing standard sometimes raises difficult measurement issues in order to
ensure that enforcement will be welfare-enhancing,
C. NET ANTICOMPETITIVE IMPACT
In evaluating anticompetitive evasion of maximum price regulation,
the required price showing to prove consumer injury is straightforward.
By the very nature of the theory of evasion of maximum regulation,
input price increases naturally are passed on in the form of higher output
prices.
The evaluation of net competitive impact in the case of evasion of
regulations that prohibit price discrimination is more controversial. This
“’ Bccnux Ihe unincgraled producers would be forced 10 pay Ihe higher input price.
they would b-e unable tu cwwrain Ihe imegrawd firm. of course. Ihe integrated firm
would transfer the input inamally at marginal cost.
“llSe~ George Stigler. Thr Diulsion of Labor Is Limited by thr Extml of Ihr Mark?!. 59 J. Pm..
ECON. I85 (1951); Mardn K. Perry, P&r Diwiminatiott and Fo‘onuord htI~$$m. 9 HLLL. J.
ECDN. 209 (1978); Martin K. Perry, Fnmrd Inltprion Lq Alum: IH88-IY30. 291. I~us.
ECON. 97 (1980); Michael L. Katz, Thr We&m Effm of Third Uqrrr Prim Dtirtimttmlrot~ tn
Intmrmdiolc Good Morkrti. 77 A?.,. ECDN. REV. 154 (IYH7).
I” For an example of Ihe case in which no prices are derrearcd. ruppase [here are IWO
graups of conaumer(i. a large group with Iuw willingnewto-pay and a smaller number
with high willingness-lo-pay. In that case. the uniform price would be set al the low level.
but price dircriminalicm would allow Ihe high demand Srwp 10 be rargeled. For Ihe
oppurhe rewh, reverie the sizes of the IWO groups, Sw alru,,erry A. Haunna~~ &Jeffrey
K. MacKie-Ma-n. Pncr D~cnninaliunondPa~rnr Pulrrv. 19 HANDJ. E~oN. 253( IYSH): Steven
G. Salop &Joreph E. Sdglhz. Bargain, and Ripoj/s: A M&l 0, Monopol~rtic~dly Compttilivr Prirr
Dirpmion, 44 REV. ECON. Sruur~s 493 (1977).
564 ANTITRUST. LAW JOURNAL
is because of the potential efficiency benefits that can Row from price
discrimination. On the one hand, some might take the position that
if price discrimination is illegal, then a vertical merger that facilitates
discrimination should be enjoined under the antitrust laws, irrespective
of any efficiency analysis. On the other hand, others might take the
position that the antitrust laws only should be brought to bear against
illegal conduct that also reduces economic welfare. Under this view, if
price discrimination does not reduce welfare, then the merger may facili-
tate a violation of regulations that prohibit the discrimination, but not
the Clayton Act.“’
VII. CONCLUSION
The post-Chicago approach to vertical mergers is premised on a view
that while vertical mergers often lead to efficiency benefits, they also
can lead to competitive concerns. These potential competitive concerns
involve anticompetitive foreclosure, exchange of information, and eva-
sion of regulation.
Because of the potential for efficiency benefits, it is appropriate in
many cases to adopt a decision structure that requires the complaining
party to demonstrate a significant likelihood of injury to consumers;
harm to competitors is insufficient. Where a significant likelihood of
consumer harm can be demonstrated, evaluation of net competitive im-
pact requires a balancing of the likely competitive harm against likely
efficiency benefits arising from the combination.
“‘According to this argument. a vcrdcal merger would not vi&w the andtrust
it led LOevasion of the environmental lawsor I~YSagainst racialor gender discrimination.
The 1984 Merger Guidelines did nat make the criticism of lhc USCof antitrusl to enjoin
mergers chat facilitate evasionof possiblyinefficient maximum price rcguladon.
[Vol. 63
APPENDIX
As discussed in the text, the merger-induced incentive to raise input
prices arises because the demand for inputs and the demand for outputs
are interrelated. For example, if the upstream division raises the input
price it charges to the rivals of the downstream division, the downstream
division will be able to sell more output at the premerger price. Before the
merger, the upstream and downstream divisions make profit-maximizing
price and output decisions without consideration of the effect of their
decisions on the other’s profits that Row from these demand interdepen-
dencies. After the merger, these demand externalities can be factored
in. thereby possibly increasing the incentives of the upstream division
to raise its input prices to downstream rivals in order to benefit the
downstream division.
Figure A-l formally illustrates this incentives analysis. The bottom
panel indicates the relationship between the profits of the downstream
division and the input price charged by the upstream division to its rivals,
holding constant the input price charged to the downstream division. It
is a rising curve because an increase in that input price will induce rivals
to raise their output prices, which in turn will permit the downstream
division to raise its own output prices, increase its market share at the
expense of rivals by holding its price constant and induce customers to
switch to it, or some combination of the two strategies. The middle panel
depicts the upstream division’s profits as a function of the price it charges
rivals of the downstream division. As drawn. it is a continuous curve
with a peak at pl. All three curves are drawn on the assumption of a
constant input price charged to the downstream division, both before
and after the merger.’
Prior to the merger, when the input division considers only its own
profitability. it is profit-maximizing to set the price p,. After the merger,
however. the upstream division will take into account the impact of the
profits of the downstream division as well. The top panel shows the
combined profits of the two divisions of the integrated firm, the vertical
laws if
’ In connrucdng these curves. WC do not assume that competitors’ prices arc unchanged
when p, changes. Under certain circumslances. increases in p, may induce changer in
others’ prices and the integrated firm would take these into account in setting p,.
I 566 ANTITRUST LAW JOURNAL [Vol. 63 EVALUATING VERTICAL MERGERS 567

Combln;Ul

(Ford + Autolit@

:
c
P1 P, Autollts’t Prlw to Ford’,
: : CCillpWUtOIS

Pf Pt Autollb’s Prlcs to Ford’.

Com~Ulom

,//-\

PI

Figure A-2. Impact of lost sales on Autolite’s incentives

Figure A-l. Autolite’s incentives to raise its price to Ford’s competitors

summation of the two lower panels. The profits of the combination
the merger will be maximized at a higher price, equal to p,.
Under certain circumstances, however. the profit curve may not be
a continuous function as drawn in Figure A-l. Instead, the upstream
division’s profit function may decline discontinuously at p,, and then
begin to rise from that lower level as prices increase above p,. Two
alternative shapes for the curves are illustrated in the two panels in
Figure A-2. In less technical language, the upstream division’s profits
initially might fall significantly from small price changes.
after
This is an important distinction because, in such cases, vertical integra-
tion may not lead to higher prices. Suppose that the upstream division
would lose a significant number of sales from even a very small price
increase in the input. This might occur, for instance, if a significant
group of buyers views other inputs as perfect substitutes whereas another
group does not, and the integrated firm expects that rivals will not
 568 ANTITRUST LAW JOURNAL [Vol. 63

increase their input prices by as much as does the upstream division. In

this case, if the upstream division raises its input price even slightly, it
will lose the entire first group of buyers. As it raises price, however, it
makes higher profits off the other group. If the first group is large or
if the potential increased profit from the second $oup is small, then a
post-merger price increase may not be profitable.

’ For example. sopposc that kforc the merger, the upstream division carn~ a margin
of $5 over costs on 100 units sold to output producers other than the downstream division.
Suppose that there arc two groups of buyers. such that, if the firm increarcs the input
price at all after the merger. it will IOK 50 unitr. but it will retain the remaining 50 units
ar long as it raises the price by $2 or less. Accordingly. suppose it considers raising price
by $2. thereby increasing the margin to $1. In this case. input profits would fall from $500
(i.e.. 100 units times the $5 margin) to 195tJ (i.e.. 50 units Limes the $7 margin). Under
these circumstances. this $150 rcducdon in profit might exceed any increase in profits
downstream.