The Role Of Undertakings In Regulatory Decisionmaking*

The Role of Undertakings in Regulatory DecisionMaking* by

Teresa Fels, Joshua S. Gans and Stephen P. King** University of Melbourne

th July, 1998 First Draft: 29 This Version: 20th November, 1998

The Australian Competition and Consumer Commission (ACCC) has powers under the Trade Practices Act to accept undertakings from industry participants interested in taking actions, such as mergers, that may potentially be anti-competitive. This paper conducts an economic analysis of the role of such undertakings. Focussing on the special case of horizontal mergers, we demonstrate how undertakings can provide an imperfectly informed regulator with a credible signal of the positive social benefits of a proposed merger. In particular, if the merged parties undertake not to reduce their output following the merger, then it can be demonstrated that a merger will only be proposed if results in net social benefits. There are practical issues involved in implementing a behavioural undertaking such as a minimum quantity commitment. However, we argue that these are no less difficult than other regulatory activities currently pursued by the ACCC. Journal of Economic Literature Classification Numbers: L41, L50 Keywords.undertaking, competition policy, mergers, signalling.

*

We thank Ian Harper, Donald Robertson and Philip Williams for helpful discussions. Of course, responsibility for all views expressed lies with the authors. ** Department of Economics, Department of Economics and Melbourne Business School, respectively. All correspondence to Joshua Gans, Melbourne Business School, 200 Leicester Street, Carlton, Victoria 3053; E-mail: [email protected]. The latest version of this paper is available at http://www.mbs.unimelb.edu.au/home/jgans.

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I.

Introduction The problem of asymmetric information is at the heart of regulatory

economics. A regulator, when attempting to make socially desirable decisions, must rely on information provided by regulated parties. Those parties often have an incentive to distort the information they provide to protect their private interests, and the regulator must take account of the distortion when attempting to use this information. In general, it becomes 1 impossible for the regulator to formulate a first best solution.

The ability of regulators to elicit and use accurate information may be constrained or expanded by legislation. In 1993, the Australian Competition and Consumer Commission (ACCC) was given additional powers that allow it to accept enforceable undertakings when firm behaviour might lead to violations of the Trade Practices Act (1974); hereafter TPA. For example, suppose two firms wish to merge but are concerned that this merger will be deemed illegal under the TPA as it may substantially lessen competition. The firms might offer enforceable undertakings as part of an informal clearance or authorisation of the merger. The undertakings might ensure that the merger does not substantially lessen competition or that, even if competition is affected, there are sufficient offsetting public benefits. By offering enforceable undertakings, firms can address ACCC concerns. This provides the firms with regulatory certainty and can allow mergers to go ahead when, otherwise, they would have been opposed by the ACCC. To date, the ACCC has shown a strong preference for structural rather than behavioural undertakings. Structural undertakings are once off actions that alter entry conditions or either vertical or horizontal relationships in an industry. Most notably, structural undertakings involve a relevant firm selling some critical assets to either a current competitor or a potential new entrant, even though the selling firm may not find the sale profit maximising.

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There is a large economics literature that considers this general problem and potential solutions. Baron (1989) and Laffont and Tirole (1992) provide useful survey of this literature.

3 In contrast, a behavioural undertaking involves a commitment by a relevant firm to act in a particular way in the future, even though such an action may not be consistent with profit maximisation. Behavioural undertakings require some on-going price monitoring or other form of regulation. The on-going nature of behavioural undertakings has concerned the ACCC. We argue that behavioural undertakings might provide benefits that more than outweigh the on-going monitoring costs. Behavioural undertakings can help regulators make better decisions, leading to improved efficiency and social welfare. This is because firms can use behavioural undertakings to credibly signal that the public benefit of their proposed arrangement outweighs any anti-competitive detriment, in terms of dead-weight losses that might be realised. Below, we illustrate our argument focussing on a merger between two firms in the same industry. Such a merger may lead to a substantial reduction in competition, in which case it would contravene section 50 of the TPA. The ACCC may authorise the merger if there are public benefits that outweigh these anticompetitive effects. For example, the merger may result in synergies between the operations of the two firms, leading to cost savings and more efficient production. If these savings are large enough to offset the (potential) dead weight loss from diminished competition, then the merger will raise social welfare.2 The regulator, however, faces a dilemma. How does it know that cost reductions will be sufficiently large to lead to a positive social outcome? Relying on the information of industry participants is at best imperfect, and at worst potentially misleading. Consultants’ reports commissioned by the merging firms that show large cost reductions are, by themselves, unlikely to be useful. Given a lack of credible information, a

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The ACCC may consider cost savings as a ‘public benefit’. However, it has stated that if cost savings are retained by the relevant firms and not passed on to consumers then they are likely to be given less importance in evaluating the net public benefit or detriment from a merger, compared with the same situation where the cost savings are passed on to consumers. See the ACCC’s merger guidelines (Australian Competition and Consumer Commission, 1996), paragraphs 6.43 and 6.44. In the parlance of economics, this means that a merger is more likely to be authorised if it not only raises social welfare but also ensures that some of the welfare gain is passed on to consumers.

4 cautious regulator may be to refuse to authorise many mergers that might otherwise result in social benefits. Undertakings can help resolve the information asymmetry between the firms and the regulator. An appropriate undertaking can act like a guarantee that information is accurate. Again, if we consider a potential merger, if the regulator is concerned that the merger will lead to a reduction in quantity (increase in price), an undertaking by the merged firm not to reduce its output post-merger performs a signalling role. If the merger is expected to lead to such large cost savings that the merged firms would raise (aggregate) output, leading to lower industry prices, then the guarantee not to lower postmerger output will not bind. The merger is clearly socially desirable and the firms are happy to offer the quantity guarantee. If cost savings are smaller, but the merger is socially efficient then, as we show below, the merged firms would still prefer to offer a quantity based undertaking rather than forgo the merger. In fact, only in those situations where the merger leads to a reduction in social welfare will the parties to the merger prefer not to offer a quantity guarantee. Given that a private merger goes ahead, despite the output guarantee, is a signal that the merger is socially efficient. The intuition underlying our analysis is quite simple. If parties wish to engage in an activity that potentially violates the TPA, but, in the opinion of the relevant parties themselves, will lead to an increase in social welfare, then it is often possible for the parties to present an undertaking that guarantees that social welfare will not fall. If two firms are seeking a vertical merger and there is a fear of foreclosure, then this may be assuaged by an undertaking guaranteeing third party access at the same terms and conditions as are currently available. If a firm wishes to charge prices that may be claimed to be predatory by competitors, then the firm can offset this by committing not to raise prices for at least a period of time sufficiently long to offset any predatory concerns. Firms can offer these undertakings because, if an activity raises social welfare, then the firms can afford to either share some of these gains while still raising profits, or at least commit not to undertake any secondary actions (such as lowering output post-merger) that may harm

5 consumers. A gain in social welfare creates a potential benefit to both the relevant firms and consumers, and a behavioural undertaking can signal these mutual benefits to the regulator. We illustrate our argument in detail below, focussing on the case of a horizontal merger. We begin by outlining the legal process of authorisations and undertakings and reporting on some examples of how these have been applied to date. We note that the ACCC has accepted many undertakings with respect to mergers but that the vast majority of these have been structural rather than behavioural in nature. Section III then constructs the problem facing the regulator in merger analysis. In section IV, we demonstrate how a quantity undertaking can provide a perfect signal about the social efficiency of a merger. Indeed, we demonstrate there that such a signal might also lead to socially beneficial mergers taking place that might otherwise have been privately unprofitable.Section V discusses the practical problems involved with behavioural undertakings that may concern the ACCC. We argue that these concerns are misplaced given that half of the TPA and role of the ACCC is about on-going regulation . A final section concludes.

II.

The Current Legal Status of Undertakings Before examining the economic role of undertakings, it is useful to

discuss briefly their current legal status and their relationship to merger laws. Section 50 of the TPA prohibits mergers or acquisitions that have the effect or likely effect of substantially lessening competition in a substantial market, unless authorised by the ACCC under section 88 of the Act. Prior to 1993, the then Trade Practices Commission often faced an all or nothing choice when examining mergers under section 50 – the Commission either opposed the merger or it did not. Any conditions that it wished to impose on the merger through a deed of settlement were difficult to enforce. To enforce an agreement, the Commission would have been required to take action in a Supreme Court, a process subject to lengthy delays.

6 Alternatively, mergers could be dealt with under the more flexible authorisation process. This has always allowed for authorisations to be 3 If the conditions granted subject to conditions being imposed by the ACCC.

were not met, the authorisation lapsed and the ACCC could seek divestiture of the merger under section 81 of the Act for up to three years after the merger had taken place. At first glance, it may appear that conditions provided the ACCC with a powerful regulatory tool. In practice, however, conditions were often problematic. The sanction of divestiture was not often credible because of the practical difficulties in separating an integrated entity. In fact, the divestiture sanction has never been sought by the ACCC or by any private party pursuant to a lapsed authorisation and there remains some doubt that it would be granted by a Court. Partly in response to these problems, section 87B was enacted in 1993. Section 87B provides for the ACCC to accept legally enforceable undertakings in relation to mergers dealt with under either a section 50 analysis or under 4 the authorisation process.

Section 87B undertakings have various legal features.

First, the

relevant party must offer written undertakings. They cannot be imposed by the ACCC. However, the ACCC has the power to reject undertakings and is in a strong bargaining position when negotiating undertakings because it may otherwise oppose a merger. Secondly, undertakings are not reviewable on their merits by a Court. However, when undertakings are offered under an authorisation process it now appears that, if the decision is appealed, the Australian Competition Tribunal can accept or reject undertakings. It is not yet clear whether the Tribunal can vary undertakings. Thirdly, undertakings

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Mergers examined under section 50 will contravene the TPA if they have the (likely) effect of substantially lessening competition in a substantial market. However, mergers dealt with under the authorisation process will be allowed notwithstanding an anticompetitive effect so long as it can be shown that the merger will produce a net public benefit. The main benefits likely to be given weight by the ACCC are cost efficiencies and factors leading to an increase in international competitiveness. Therefore, the types of undertakings parties will make under each process are quite different. 4 Section 87B undertakings can also be accepted by the ACCC in the exercise of all its powers (except Part X) of the TPA.

7 can be varied or subsequently withdrawn by mutual agreement between the ACCC and the relevant parties. Although undertakings are legally enforceable, to date, the ACCC has preferred parties to fix any concerns it has about a merger before the mergers takes place. When accepting undertakings, the ACCC has shown a strong preference for structural rather than behavioural undertakings. The ACCC has stated that it is unlikely to accept price, output, quality and service guarantees on their own. This reflects a traditional antitrust view. In its merger guidelines the ACCC has stated that behavioural undertakings are “extremely difficult to make certain and workable in detail, … require continuing monitoring, and where breaches are detected they are often 5 dependent on enforcement after the event.”

The ACCC’s guidelines also state that behavioural undertakings are not favoured because they are inflexible to market changes such as contractions in demand. The ACCC also questions the optimal duration of 6 behavioural undertakings.

The most common type of structural undertaking accepted by the ACCC when considering a merger involves the divestiture of assets. Divestiture undertakings usually have the effect of averting a substantial lessening of competition. For example in the Sigma-QDL merger (two wholesale distributors of pharmaceutical products), examined under section 50, the ACCC concluded that the merger was only likely to substantially lessen competition in one state market. Sigma agreed to sell off the Victorian

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See Australian Competition and Consumer Commission (1996) paragraph 7.11. Clearly behavioural undertakings raise regulatory issues despite being offered by the relevant firm(s). Prior to the ACCC making a decision about a merger, firms will often be relatively willing to offer undertakings. However, once the ACCC has decided not to oppose a merger and the merger has been implemented, firms’ incentives to implement the undertakings are sharply reduced and a significant degree of monitoring by the ACCC is often required. However, the same problems also arise to some degree with structural undertakings. For example, if the undertaking involves asset sales, it may be difficult for the ACCC to guarantee that the assets actually sold are the same as specified in the undertaking. Further, the sale will usually only occur if the firm receives a reasonable price. But this may be a source of dispute. 6 See Australian Competition and Consumer Commission (1996) paragraph 7.10.

8 assets it would acquire after the merger, thereby avoiding the anticompetitive effects of the merger. The Ampol-Caltex merger also involved a structural undertaking. The ACCC concluded that the proposed merger would breach section 50 by reducing the number of oil companied from five to four. The parties offered undertakings that had the effect inter alia of facilitating import competition that would not otherwise have occurred. In this instance the undertaking to increase import competition was regarded as balancing the reduced competition in the domestic market. Despite the strong statements in the merger guidelines, the ACCC will accept behavioural undertakings so long as they are coupled with structural undertakings. In theCaltex-Ampol merger ,the parties agreed not to deal exclusively, thereby relieving concerns about the vertical aspects of the merger. The parties also guaranteed supply of petrol at a competitive price during a transition phase. Similarly in the Westpac-Bank of Melbourne merger the parties agreed to provide access to third parties of its ATMs at agreed upon access prices. Behavioural undertakings have also been used in authorisations to ensure that there are sufficient public benefits from a merger. In the DavidsComposite Buyers case, the ACCC accepted undertakings regarding the terms and conditions between Davids and retail consumers. Presumably, this undertaking was accepted to guarantee that private benefits, in the form of cost savings to Davids, were (at least in part) passed on to retail consumers. These undertakings were later withdrawn and the Tribunal authorised the merger without such undertakings. While the ACCC largely dismisses behavioural undertakings as unworkable, they do not consider the potential benefits that might flow from behavioural undertakings. As we demonstrate, these benefits might be substantial.

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III. The Regulator’s Problem in Merger Analysis Horizontal mergers are a concern for regulators because, all other things being equal, they are likely to be anti-competitive. That is, they result in price increases, output reductions and, consequently, a deadweight loss of social surplus. But if mergers alter the cost structure of the industry, they may raise social welfare. Demsetz (1974) argued that mergers might lead to industry-wide production rationalisation. While the merger might reduce industry output, it also may result in that output being produced with a lower average cost. Indeed, it is even possible that a merger between duopolists might be welfare improving.7 Williamson (1968) noted that a merger might reduce production costs through synergies (lower marginal costs) or the elimination of duplicated investments (lower fixed costs) for the merged firms. Again this can mean 8 that a merger raises social welfare despite increasing market power.

In theory, if a regulator had sufficient information, it could examine the costs and benefits of a merger and evaluate the net effect of the merger on social welfare. Farrell and Shapiro (1990) model this evaluation for a homogenous good Cournot oligopoly. Their argument has been graphically summarised by Ziss (1998) and we utilise his framework here. Suppose that two firms in an industry are considering merging. Their initial marginal costs identical and equal to c.9 If the firms merge, the merged firm’s marginal cost is reduced belowc by ∆ > 0. The pre-merger industry price and output are Q0 and P0 respectively. After the merger these will

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Suppose that market (inverse) demand is given by P = 10 – (q 1 + q2). Firm 1 has a (constant) marginal cost of 0 while 2’s is c. The firms initially compete as Cournot duopolists. If c > 25/11and merger rationalises production to 1’s assets, then a merger raises the sum of consumer and producer surplus. This is because the merger reduces average industry costs be a sufficient amount to overcome deadweight losses associated with the merged firm’s market power. Such efficiency improvements from the removal of smaller firms can also occur in contestable markets (see Gans and Quiggin, 1997). 8 While Demsetz (1974) notes that a merger may remove an inefficient competitor, Williamson (1968) notes that a merger can create a new more efficient firm. 9 The assumption of constant marginal costs is made without loss in generality. All the arguments below extend to the case of increasing (or indeed, decreasing) marginal costs, although this would complicate the graphical analysis.

10 change to Q1 and P1. If the cost reduction, ∆ , is large enough, it could be the case that P1 < P0 so that the merger is pro-competitive rather than anticompetitive. Alternatively, it could be the case that P1 > P0. Social welfare will fall due to the reduction in industry sales after the merger. But this will be at least partially offset by gains in producer surplus due to more efficient production. Determining the net effect of the merger on social welfare requires explicit analysis, as depicted in Figure 1. Suppose that the merged firms reduce their combined output from q0 to q1. The area E represents the increment to profits from the cost reductions achieved by the merging firms while B – D is the net increment in the merged firm’s profits from a greater ability to exercise market power. However, the merged firms lose A to other firms who expand 10 Those firms also gain F production in response to the rise in industry price.

as a result of the price rise. The total change in industry producer surplus as a result of the merger is B + E – D + 11F.The merger will be privately profitable for the relevant firms if B + E – A – D is positive. B + C + F represents the loss in consumer surplus as a result of the merger. Therefore, the merger will be socially beneficial if B + E – D + F exceeds B + C + F, or E > C + D.

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Our conclusions in this paper about the desirability of minimum quantity undertakings rest on three relatively weak assumptions about firm interaction. First, we assume that if there is an increase (no change) in the total output of one subset of firms then the best response by all other firms leads to an increase (no change) in total industry output ceteris paribus. In other words, if a subset of firms raises their output, other firms may lower output but not to such a degree that total industry output falls. This is a standard assumption and is satisfied, for example, by a standard Cournot model. Also, if there is no change in the output of a subset of firms then, in the absence of any other change, total industry output is unchanged. This means that simply the act of merger with no change in the output of the merged firms cannot change the behaviour of other firms in the industry. This will normally be satisfied so long as firms make independent strategic decisions. Secondly, we assume that there is a unique well-defined equilibrium in the industry both premerger and post-merger. This assumption is for convenience as it enables us to ignore issues of multiple equilibria. Thirdly, we assume that if a subset of firms face an increase in production costs then its equilibrium output cannot increase ceteris paribus. This rules out the intuitively implausible case where a merger raises the merged firms’ costs, the merged firms increase output, industry output rises and consumer prices fall, but social welfare falls because of the rise in the merged firms’ costs. The diagrammatic analysis presented in this paper is based on a standard Cournot model but this is purely for exposition. 11 A is simply a transfer among firms and does not affect industry producer surplus.

11 Given the potential for cost reductions, the regulator faces a difficult problem when evaluating a merger. A particular merger proposal may be predominantly motivated by a reduction in competition (B – D – A) or by cost reductions for the firms (E). However, evidence on cost reductions comes from the merging firms themselves. If those firms know that a regulator is more likely to authorise a merger if there is favourable evidence on cost reductions then the firms are likely to present such evidence. Unfortunately, this information may be distorted and unreliable. While the merging firms know the true underlying motivation for the merger and the expected extent of any cost reductions that are likely to be achieved, there is an asymmetry of information between the regulator and firms. The regulator may try and reduce this asymmetry by conducting further investigations but it will inevitably need to rely on information provided by parties who have a vested interest in the merger. It will be difficult for the regulator to verify information provided to it. After all, the regulator is not trying to determine cost reductions that have already been achieved but rather the merging firms’ beliefs about potential savings and the true reason behind the merger. So the regulator must look upon the information provided by parties with a sceptical eye and potentially might refuse some mergers that would be socially beneficial.12 The regulator may try and gather other information about the proposed merger that is less open to distortion and manipulation. Swan (1995) argues that competitors’ responses to the merger provide relevant information to regulators. As a matter of logic, rivals should unambiguouslysupportmergers which are anti-competitive but will do their best toprevent mergers which promote synergies and cost reductions. To the extent that the merger has elements of both anti-competitive effects and synergistic cost reductions, the net balance between these two offsetting effects should determine the attitude of rivals towards the merger. Rivals are likely to have a better idea than any group outside the industry, no matter how knowledgeable, as to whether a proposed merger is on balance pro- or anti-competitive in its effect. The more that synergistic cost reductions outweigh anti-competitive effects, the more likely rivals are to oppose the merger. (Swan, 1995, pp.88-89; the italics in original)

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See Milgrom and Roberts (1986) for a discussion of the optimality of such scepticism.

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In the context of our discussion, Swan’s argument concerns the value of F + A, the change in profits realised by the merging firms’ competitors. F + A will be less than 0, and competitors will be harmed by the merger, only if0 >P P1. In this case, the merger is pro-competitive. Swan argues that if competitors object to a merger, they are signalling to a regulator that F + A < 0 and, as a result, the regulator should infer that such a merger is socially beneficial and allow it go ahead. On the other hand, if rivals do not oppose a merger, this indicates that F + A≥ 0 and the case for the merger depends on the magnitude of cost reductions. Swan’s argument appears to give the regulator a means of evaluating a merger without determining the extent of cost reductions. However, it has two serious limitations. First, if competitors’ reactions did provide a perfect signal of F + A, then this tells the regulator about the potential for the merger to result in lower prices. But social welfare may improve even if0 P < P1. The information reduces the regulator’s information problem but does not solve it. More importantly, the “reactions” of rivals may be manipulated, so that any systematic attempt by the regulator to use this information would undermine its value. To see this, imagine that a regulator adopts a rule that if rivals object it approves the merger. Then rivals will have an incentive to act strategically in their response to a merger proposal. If it really is the case that F + A ≤ 0, they should keep silent or perhaps publicly support the merger. On the other hand, if it is the case that F + A > 0, they should publicly decry the merger. It cannot be an equilibrium for the information provided by rivals’ objections (or otherwise) to be useful to regulators. Farrell and Shapiro (1990) suggest an alternative approach to help 13 The fact that a merger is proposed at all alleviate the regulator’s problem.

indicates that it is privately profitable so that B + E > A + D. A merger is socially desirable if and only if E > C + D. Hence, if A > B + C, it must be the

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Similar, more specific analyses are provided by Levin (1990) and McAfee and Williams (1992).

13 14 In case that any privately profitable merger is socially desirable as well.

effect, the Farrell and Shapiro test evaluates the net benefits to agents other than the merging firms. These are the other firms in the industry (who get F + A) and consumers who lose (F + B + C). This external effect is positive if A > B + C. The Farrell and Shapiro test reduces the regulator’s reliance on information supplied by the merging firms because the components A, B and C do not directly depend on the degree of cost savings. A relates to the aggressiveness of competing firms’ responses to output reductions. B depends on the market share of the merging firms. C relates to the elasticity of market demand. Farrell and Shapiro (1990) provide some simple tests that are based only on pre-merger market shares and demand elasticity that indicate when a privately profitable merger will be socially profitable. These tests, however, suffer from several difficulties. First, they require specific knowledge of market and technological conditions. Second, they are only sufficient conditions. Hence, some socially profitable mergers may not pass the tests. Finally, the tests rely on private profitability. Regulatory rules based 15 on them do not ensure that every socially profitable merger takes place.

The Farrell and Shapiro approach offers a way for regulators to tradeoff the anti-competitive and cost reducing effects of a merger. But it is far from perfect. As we will discuss in the next section, effective undertakings may help regulators to evaluate mergers without having to obtain detailed knowledge of the industry structure and of the magnitude of potential cost reductions.

IV.

Undertakings as Signals How can a behavioural undertaking improve regulatory decision-

making on mergers? Suppose a merger is both privately profitable and 14

A merger is privately profitable if E – D > A – B and socially beneficial if E – D > C. The private condition is more stringent than the social condition if A – B > C. 15 Ziss (1998) also demonstrates that when output decisions are delegated within a corporation, the tests are limited in their applicability.

14 socially desirable, but in the absence of an undertaking, the merger will both violate section 50 of the TPA and fail to be authorised by the ACCC. Then the firms that wish to merge have an incentive to assuage the regulator’s concerns by presenting a behavioural undertaking. The behavioural undertaking must credibly signal the regulator that the merger will raise social welfare and, to the degree that the regulator weights consumer surplus more highly than firm profits, must signal that consumers will not lose from the merger. Assume that the regulator can observe the pre-merger output of the firms, q0. Recall that a reduction in social welfare can only occurQif1 < Q0. As outside firms’ costs do not change following the merger, their market share will be unchanged ifq1 = q0, and will tend to fall ifq1 > q0. This means that so long as q1 ≥ q0, Q1 must be at least equal to Q 0. Hence, if the merger proposal involves an undertaking thatq1 ≥ q0, social welfare cannot fall as a result of the merger. If an undertaking is made to at least maintain pre-merger total output, how does this change the relevant firms’ incentives to merge? If ∆ is sufficiently large, the merged firm’s equilibrium output will rise as a result of the merger. In this case, the undertaking will not bind and the private profitability of the merger will be unchanged. On the other hand, if ∆is small, so that in the post-merger equilibrium the quantity undertaking binds the merged firms, the private incentive to merger changes from B + E – A – D to E + G + H. But this new private gain is precisely the social benefit from any cost reduction, given the pre-merger oligopolistic behaviour. While consumer surplus is unchanged, the merged firm receives higher profits from the cost reduction. The undertaking that guarantees that post-merger output will not fall below pre-merger output precisely aligns the private and social incentives for a merger. Finally, what if ∆is zero or negative. In this case, the merger was only proposed to raise profits and was socially undesirable. The minimum quantity undertaking prevents the merged firms from seizing any increased

15 industry profits so firms that seek to merge when there are no cost savings 16 would not be willing to make such an undertaking.

In brief, a minimum quantity undertaking is a credible signal that the merger involves expected cost savings and guarantees that those cost savings will not be more than offset by a fall in consumer surplus due to diminished post-merger competition. There are several things to emphasise about the minimum quantity undertaking. First, the regulator does not need to know anything about the industry, the magnitude of∆, or the level of concentration in the industry. All it needs to know isq0. While determiningq0 may be difficult in practice it will often present the regulator with significantly less difficulty than determining likely cost savings or potential competitive reactions. Secondly, it is well known that socially beneficial mergers may not be privately profitable in a Cournot oligopoly (Salant, Switzer and Reynolds, 1983). This is because the merged firm loses A to other firms in the industry. If A is large, it is possible that a socially beneficial merger is not privately profitable.17 However, with the undertaking, the merged firm does not lose A as a result of the merger. The minimum quantity undertaking aligns private and social incentives and encourages mergers that are socially desirable but, in the absence of a minimum quantity undertaking, would not have been privately profitable. This is possible because the undertaking changes the post-merger equilibrium in the industry. It can help the merged firms maintain higher output when this is in both their own and society’s interest but, in the absence of the undertaking, would not be credible. Finally, note that the undertaking actually improves the efficiency of the merger. Without an undertaking, the regulator could approve a merger if

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Formally, to see that these conclusions follow from our three assumptions on firm behaviour presented in footnote 12, the second assumption means that we can avoid multiple equilibria. If ∆ < 0, then the quantity undertaking must bind by the third assumption, so the merged firms will make a loss. The merger is socially and privately unprofitable. If ∆ ≥ 0 and the quantity undertaking does not bind, then industry output must rise by the first assumption so the merger is socially profitable if it is privately profitable. If the quantity undertaking binds, then by the first assumption, industry output will be unchanged and the merger is socially desirable if it is privately profitable. 17 Note that the social benefits from a merger are greater than the private benefits if A – B > C.

16 it believed E > C + D. However, with the undertaking, there is no loss in consumer surplus from the merger but any cost reductions are still achieved (and, in fact, spread over a larger quantity). The undertakings procedure, besides improving decision-making, also raises socially efficiency. In principle, a maximum price undertaking can achieve the same result as a minimum quantity undertaking. This is obvious from Figure 1. If the merged firm gave an undertaking not to price aboveP0 then it could only achieve this in equilibrium by selling at least q units. A price undertaking, 0 however, seems an indirect way to guarantee that a merger does not have anticompetitive effects. The anticompetitive potential of a merger arises because the merged firms might have an incentive to restrict quantity to raise the market price. It is the quantity restriction that is the original cause of the anticompetitive effect and it seems reasonable to target an undertaking at the quantity restriction rather than the price that flows from the quantity restriction.18 Further, unlike the situation when regulating a monopoly, the merged firm will generally not be the sole producer in the market after the merger. The merged firm cannot, by itself control the industry price. Rather the equilibrium price will reflect the strategic decisions of all firms. A price undertaking by the merged firm may alter the strategic interactions in the 19 industry in an undesirable way.

V.

Designing a Minimum Quantity Underta king. An undertaking by the parties to a merger that they will retain their

output after the merger to at least the pre-merger level(s) theoretically

18

To see why quantity rather than price undertakings directly address the competitive concerns, consider the following simple example. Suppose a merged firm made a price undertaking then sold on its operations to create another company. The ‘shell’ of the merged companies can trivially satisfy the price restriction and simultaneously sell nothing. The new company would be free of the price restriction and can set its production to maximise profit. This could not occur under a minimum quantity restriction as the ‘shell’ would still have to meet the outcome target or face a penalty. 19 For example, the industry may move to a new equilibrium where the merged firm reduces production but other firms raise production so that industry output and price remain unchanged. This outcome satisfies the price undertaking but, to the degree that the merged firm has lower production costs, this outcome represents a less efficient mix of production than under a quantity undertaking.

17 performs a perfect signalling role. There are, however, a number of practical issues that need to be considered. Measuring the initial quantity In order to accept a quantity undertaking, the regulator must have a good idea of the output levels of the relevant firms before the merger. The regulator may have difficulty determining these levels, particularly if the firms produce a variety of products with different specifications and qualities that appeal to different groups of customers. However, the regulator does not have to determine these quantities for themselves. Rather, the parties seeking the merger must convince the regulator that the quantity undertaking is sufficiently stringent to prevent the merger from being anticompetitive. While the regulator will need to rely on information supplied by the merging firms and these firms have an incentive to distort and manipulate this information, the relevant data is historic and to a large degree can be confirmed by market inquiries. This stands in sharp contrast to claims of future cost savings that may be uncertain and highly speculative. It could also be argued that firms would have an incentive to reduce aggregate output before seeking a merger in order to reduce the effect of a quantity undertaking. If the firms can agree to lower q0 prior to the merger then they can legitimately claim that they will sustain after q 0 the merger while still having an anticompetitive effect. This problem, however, is easily overstated. First, it is clearly illegal for firms to collude in this way before a merger. The firms, if detected, could be prosecuted under section 45 of the TPA. The penalties for anticompetitive collusion are severe. Secondly, if a firm acted unilaterally to restrict its quantity in order to prepare itself for a possible future merger, it would suffer a loss of profits. The firm would be trading off its short-term profits for the potential of gaining more effective market power after a possible future merger. To sustain this action for any significant period of time, the firm would have to be relatively certain of a successful merger in the near future. It seems unlikely that such unilateral action would be profitable except in the relatively short term. To the degree

18 that the regulator can judge an appropriate quantity undertaking on the basis of outputs over a number of years, it is unlikely that unilateral preparation for merger would represent a major problem. When using historic data to judge an appropriate quantity undertaking, the regulator will need to allow for a variety of factors that may alter output over time. These same issues arise when placing the quantity undertaking in a dynamic context, and are discussed below. The nature of a quantity undertaking In many ways, the practical issues surrounding a minimum quantity undertaking are the same as apply to monopoly price caps. A price cap (or CPI-X regulation) is a rule that limits the changes in output prices allowed to a monopoly. The rule is adjusted for general increases in input prices, as well as industry specific factors. If one particular input is crucially important then the monopoly may be allowed to immediately pass price changes in that input through to customers. The price cap rule can allow for changes in demand and product mix by applying to a bundle of outputs. A similar approach can be used to implement a minimum quantity undertaking. The undertaking can be adjusted for cyclical changes in economy-wide demand by using a GNP measure or an alternative index. Specific factors that are crucial to demand in the relevant market, such as world oil prices for car demand, can also be built into the minimum output rule. Supply-side factors, such as changes in critical input prices, can also be considered. The minimum quantity undertaking may be based on a well-defined bundle of outputs. These can be designed to allow the firm flexibility to adjust the output mix in the face of changes in product-specific costs or demands. There has been significant work on price cap regulation that provides the 20 basis for analysing appropriate quantity undertakings.

20

For example, Armstrong, Cowan and Vickers (1994) presents a useful overview of price caps including regulatory experience in the UK.

19 In some ways, a quantity undertaking has significant advantages over traditional price cap regulation. First, under price cap regulation an outside authority often imposes the rule on the firm. In contrast, under a quantity undertaking the firms that are seeking the merger and who gain the benefits from the merger also design the quantity rule. They must then convince the regulator that the rule is appropriate. This has a number of benefits. Unlike a standard regulated firm that has interests directly opposed to the regulator, the interests of the merging firms and the regulator are partially aligned. To the degree that the merger is efficient, both sides gain from the merger going ahead. In fact, as noted above, an effective minimum quantity undertaking can improve the profitability of a merger so both the merging firms and the regulator may gain from the undertaking process. Secondly, the merging firms can make subjective judgements about the degree of adjustment to build into the undertaking. The firms are in the best position to evaluate future risks from a quantity undertaking. If they adjust for future changes in the undertaking rule, they must convince the regulator that the rule is appropriate. The firms can trade off the market risk with the regulatory risk. Finally, unlike price cap regulation, a quantity undertaking will usually have a fixed and finite life. The quantity undertaking is designed to prevent anticompetitive abuse of market power by merged firms in the short to medium term. A minimum quantity undertaking is not meant to be a long term solution to potential market power. Rather, it is a regulatory tool that can be used in the medium term to prevent potential abuse of market power. In the longer term, competition could usually be expected to mute or eliminate anticompetitive market power. Penalties and enforcement A quantity undertaking would include penalties for any breach. It is clearly not credible for these penalties to involve the reversal of the merger. However, they could involve a severe monetary penalty for the merged firm. The ability to enforce the undertaking will depend on the clarity of the quantity constraint. If the quantity constraint is poorly specified and is based

20 on an index of output that is easily manipulated by the merged firm then it will clearly be ineffective. But experience with price caps and other regulatory tools can be brought to bear to design clear, well functioning quantity undertakings. Further, before the merger actually takes place, both the firms seeking the merger and the regulator have an incentive to find a mutually satisfactory quantity undertaking. Anticompetitive spillovers from an undertaking Could a quantity undertaking be used in a socially undesirable way? There may be concerns that a quantity undertaking could be used to limit future entry into the industry. Future potential entrants know that they will face an aggressive competitor, in the sense that the merged firm will be forced to maintain output even after successful new entry. This, in turn, may make entry less profitable and less likely to succeed. This problem may be faced directly through the quantity undertaking. If there is new entry in the industry, and this leads to a substantial change in the output of other firms, then the regulator may retain the discretion to lower or remove the quantity undertaking on the merged firms. Such a revision makes perfect sense. After all, the reason for the undertaking was that the merger was likely to substantially lessen competition. If new entry occurs and this raises competition then the anticompetitive effects of the merger are reduced. If the new entrant is well funded and likely to be a long term success, then the regulator can reduce the quantity undertaking to accommodate this new entry or even remove the undertaking completely. Secondly, while an undertaking may make entry more risky in the short term, it need not have this effect in the longer term. A quantity undertaking generally will have a finite life. A potential new entrant can plan for the end of the undertaking adjusting its entry strategy to coincide with this time. Alternatively, it is theoretically possible for quantity undertakings to encourage inefficient mergers for strategic reasons. Two firms might find it mutually profitable to be able to commit to raise output. By merging and

21 providing a quantity undertaking that exceeds the sum of their pre-merger quantities, the firms can commit to act aggressively. Even if the merger offers no cost efficiencies and is costly, such a credible commitment, enforced by the ACCC, may be strategically valuable. Clearly, it is not desirable to encourage inefficient mergers. But it seems unlikely and unnecessary for the firms to merge to offer such a commitment. There is nothing stopping firms from forming a joint venture where they agree to maintain a high level of total output. So long as such an agreement was not ‘predatory’ it would not violate the TPA. In other words, the firms could write a standard enforceable contract to raise output and do not need the assistance of the ACCC.

VI.

Behavioural Undertakings and the ACCC The ACCC’s unwillingness to accept behavioural undertakings is

understandable. From a traditional antitrust perspective, competition laws establish rules against socially undesirable behaviour by firms. But beyond these laws, the authorities do not interfere in the day-to-day activities of the market place. Behavioural undertakings, by contrast, require on-going supervision and monitoring. In this sense, they are closer to tools of regulation rather than antitrust. This simple division between antitrust laws and regulation is clearly outdated in Australia. The ACCC is not simply a body that enforces a set of market rules. Unlike the U.S. Department of Justice, the ACCC has a variety of roles that involve on-going regulation. The ACCC was formed on November 6, 1995 when the Trade Practices Commission and the Prices Surveillance Authorities merged. Under the Prices Surveillance Act 1983, the Commission has a mandate to monitor specified prices, to vet proposed price rises for certain firms and to investigate pricing practices when requested by the federal treasurer. The ACCC arbitrates and determines access terms and conditions under Part IIIA of the TPA. Further, the ACCC regulates prices for

22 aeronautical charges at privatised airports and for a variety of telecommunications services. The ACCC also has a role in monitoring service quality, for example, when regulating airports. Put simply, the ACCC has significant experience with the type of on-going monitoring that would be needed for a successful behavioural undertaking. As noted above, the willingness of the ACCC to accept structural rather than behavioural undertakings may reflect a simplistic belief about the ease of enforcement of the former relative to the latter. Structural undertakings may be difficult to formulate. The ACCC will often require more information when judging a structural undertaking compared with, say, a quantity undertaking. For example, if the merging firms undertake to divest certain assets, then the ACCC must know if these assets will be sufficient to allow either improved competition by current competitors or for new firms to enter. It will often be difficult for the ACCC to judge the appropriateness of the relevant assets. Structural undertakings also have rather uncertain consequences. While some assets may be sold under an undertaking, this is not the same thing as ensuring that potential competitors buy these assets and then successfully enter the relevant industry. In contrast, behavioural undertakings, such as the quantity undertaking discussed above, may be relatively easy. While the actual quantity rule may be complex, there is significant experience in formulating similar rules. More importantly, behavioural undertakings can be specific to the underlying competitive problem. The problem with a merger is that the merged firms might lower total output to use their increased market power. A behavioural undertaking based on quantity directly addresses this issue, unlike a structural undertaking. Further, subject to issues of enforcement, the quantity undertaking discussed above acted as a perfect mechanism to separate socially desirable and undesirable mergers. In contrast, an undertaking to, say, sell certain assets, may prevent socially desirable mergers if such a sale raises the merged firm’s costs of operation. Conversely, it may allow undesirable mergers to continue. The asset sale may remove some of

23 the merged firm’s ability to exploit market power but still leave it with the ability to raise prices and limit output after the merger.

VII. Conclusion The ability of the ACCC to accept undertakings under section 87B of the TPA, has the potential to improve merger analysis. As shown above, a simple quantity undertaking made by the merging firms provides a strong signal that the merger is, on the whole, beneficial to society. Further, the undertaking can change the distribution of the gains from a merger, making sure that consumers do not face higher prices and may even raise the merger benefits. To date, however, the ACCC has shown a reluctance to accept this type of behavioural undertaking. In part, this reflects fallacious reasoning. It is far from clear that behavioural undertakings are particularly difficult to formulate or enforce, as the ACCC has claimed, particularly when compared with structural undertakings that the ACCC has been willing to accept. In fact, there are strong arguments that the ACCC, with its extensive regulatory experience, is uniquely placed to enforce behavioural undertakings. In many ways these undertakings are easier to design and implement because, at least at the initial stage of the undertaking, both the firms seeking cost-reducing a merger and the ACCC have similar objectives. The reluctance on the part of the ACCC to accept behavioural undertakings means that much of the potential benefit of undertakings may be lost. The simple model presented above shows that a quantity undertaking, when perfectly enforceable, is a perfect signal about the social desirability of a merger. Given our (relatively weak) assumptions about competition, firms will only be willing to offer such an undertaking if the merger leads to net cost savings in the absence of any increase in market power. In contrast, if the main force driving the merger is the anticompetitive intention to use market power to restrict output after the merger, then the relevant firms will not be willing to offer a quantity undertaking.

24 Clearly behavioural undertakings, such as a quantity guarantee, are not perfectly enforceable. But given the potential benefits that they offer, and the ACCC’s significant practical experience with other regulatory schemes, it is undesirable to dismiss behavioural undertakings as unworkable.

25 Figure 1

P

P1 P0

F

B

A

C D c

H

E

G

c-∆

q1

P(Q)

q0

Q1

Q0

Q

26

References Armstrong, M., S. Cowan and J.Vickers (1994),Regulatory Reform , MIT Press: Cambridge (MA). Australian Competition and Consumer Commission (1996) Merger Guidelines: a guide to the Commission’s administration of the merger provisions ss 50, ( 50A) of the Trade Practices Act , Canberra. Baron, D.P. (1989), “Design of Regulatory Mechanisms and Institutions,” in R. Schmalensee and R. Willig (eds.), Handbook of Industrial Organization , Vol.II, North Holland: Amsterdam, Chapter 24. Daughety, A.F. (1990), “Beneficial Concentration,” American Economic Review , 80 (5), pp.1231-1237. Demsetz, H. (1974), “Two Systems of BeliefAbout Monopoly,” in H. Goldschmid et.al. (eds.), Industrial Concentration: The New Learning, Little Brown: Boston, pp.164-184. Farrell, J. and C. Shapiro (1990), “Horizontal Mergers: An Equilibrium Analysis,” American Economic Review , 80 (1), pp.107-123. Gans, J.S. and J.Quiggin (1997), “A Technological and Organisation Explanation of the Size Distribution of Firms,” Working Paper , Melbourne Business School. Laffont, J-J.and J. Tirole (1992), The Theory of Incentives in Procurement and Regulation, MIT Press: Cambridge (MA). Levin, D. (1990), “Horizontal Mergers: The 50-Percent Benchmark,” American Economic Review, 80 (5), pp.1238-1245. McAfee, R.P. and M.A. Williams (1992), “Horizontal Mergers and Antitrust Policy,” Journal of Industrial Economics, 40 (2), pp.181-187. Milgrom, P. and J. Roberts (1986), “Relying on the Information of Interested Parties,”Rand Journal of Economics , 17 (1), pp.18-32. Salant, S.W., S. Switzer and R.J. Reynolds (1983), “Losses from Horizontal Merger: the Effects of an Exogenous Change in Industry Structure on Cournot-Nash Equilibrium,” Quarterly Journal of Economics, 98 (1), pp.185-199. Swan, P. (1995), “What is Behind the Mergers Between Australian Independent Grocery Wholesalers?” in M. Richardson and P.L. Williams (eds.),The Law and the Market, Federation Press: Sydney.

27 Williamson, O.E. (1968), “Economies as an Anti-trust Defense,” American Economic Review, 58 (1), pp.18-34. Williamson, O.E. (1977), “Predatory Pricing: A Strategic and Welfare Analysis,” Yale Law Journal, 87 (284), December, pp.284-340. Ziss, S. (1998), “Horizontal Mergers and Delegation,” mimeo., Sydney.