Rivals’ exit from a market due to a vertical merger can fundamentally alter vertical merger evaluation. The reason is simple: An exit-inducing vertical merger reduces product variety to consumers and the number of competitors that would otherwise exert downward pricing pressure. An exit-inducing vertical merger might reduce welfare even if it is a welfare-enhancing vertical merger absent exit. Therefore, the possibility for rivals’ exit should be incorporated into the guidelines for vertical merger evaluation, write Javier D. Donna and Pedro Pereira in new research.

On June 30, 2020, the Federal Trade Commission and Department of Justice issued the Vertical Merger Guidelines (VMGs). A significant innovation was the inclusion of a theory of anticompetitive harm. Notably, this theory was absent in its predecessor, the 1984 Guidelines.

On September 15, 2021, the FTC rescinded the VMGs and associated commentary. While the DOJ did not, both agencies jointly launched a public inquiry asking for “public input […] to modernize federal merger guidelines […].”

We responded to the inquiry by providing a framework for exit-inducing vertical mergers. The Agencies should incorporate these insights into the Guidelines.

To be sure, we do not argue that vertical mergers are intrinsically anticompetitive. Nor do we argue that all vertical mergers induce rivals’ exit. We argue that a vertical merger that induces rivals’ exit might be very harmful. This feature has been long recognized in the economics and antitrust literatures. The Supreme Court and the Agencies have also long recognized that the possibility of rivals’ exit might substantially lessen competition, which violates Section 7 of the Clayton Act.

Vertical mergers

Vertical mergers are notoriously complex. In contrast to horizontal mergers, vertical mergers feature an intrinsic efficiency, the elimination of double marginalization (EDM). The EDM has a procompetitive effect and causes price reductions, which increase social welfare if there is no exit.

But vertical mergers also have anticompetitive effects. The vertically integrated firms might increase the price or lower the quality of the inputs, raising rivals’ costs (RRC). The vertically integrated firms might also refuse to supply the inputs altogether (foreclosure).

While some vertical mergers may enhance welfare, others stifle competition and harm consumers. It is complicated to distinguish ex ante which vertical mergers are welfare enhancing.

Exit is not required to establish harm. Nevertheless, if exit occurs, harm might increase substantially. Exit might fundamentally alter the welfare analysis of a vertical merger because it reduces a product variety (Donna et al. 2022). Exit also reduces the competitive pressures that active rivals can impose on large suppliers.

Hence, the EDM, one of the redeeming aspects of a vertical merger, might have anticompetitive consequences in certain instances. This important consideration is not properly reflected in the VMGs, aside from an example reference using the usual exclusionary harm theories (VMGs, section 4a):

“By altering the terms by which it provides a related product to one or more of its rivals, the merged firm would likely be able to cause those rivals […] to lose significant sales in the relevant market (for example, if they are forced out of the market; […].” (Emphasis added.)

An old idea

The idea that vertical integration might induce rivals’ exit is not new. Mainstream antitrust and economic scholars have repeatedly emphasized that vertical mergers and vertical schemes may harm horizontal rivals (Areeda and Hovenkamp 1978; Bork 1978; Motta 2004; Rey and Tirole 2007). In the opening paragraph of Steven C. Salop and David T. Scheffman’s classic article, the authors state:

“Conduct that unreasonably excludes competitors from the marketplace is a concern of antitrust law. Predatory pricing doctrine focuses on conduct that lowers revenues. Alternatively, a firm can induce its rivals to exit the industry by raising their costs. Some nonprice predatory conduct can best be understood as action that raises competitors’ costs.” (Emphasis added.)

A vertical merger might induce a rival to exit the market by precluding the rival from covering its operational costs. This concept is embedded in the economic theory of exclusive dealing (Segal and Whinston, 2000; Bernheim and Whinston, 1998; Fumagalli and Motta, 2006). It is backed up by economic theory, antitrust literature, and jurisprudence.

Therefore, while the possibility that a vertical merger might induce a rival out of the market is not new, the insight that vertical mergers which induce exit might be particularly harmful has been absent in the Guidelines.

Vertical merger, horizontal harm

Incorporating this idea allows for a simple, unified approach for the evaluation of these vertical mergers using horizontal-merger criteria, as sought by Robert H. Bork (1978): “Whether or not one believes in the law’s foreclosure theory, therefore, all so-called vertical merger cases should be handled through the application of horizontal merger standards.” (Emphasis in original.)

To understand why a vertical merger that induces exit might be particularly harmful, consider its horizontal harm. Start by considering a potential anticompetitive horizontal merger. Instead, suppose that a vertical merger induces the exit of the corresponding rival in the mentioned anticompetitive horizontal merger. Such a vertical merger could be very harmful to consumers and social welfare due to the effects discussed above. The elimination of a rival following a vertical merger can, therefore, be seen as horizontal harm. Such vertical mergers are more likely to be problematic and might merit a particularly thorough evaluation by the Agencies.

An old example

In Brown Shoe Co. v. U.S. (1962), the Supreme Court’s main objection against the vertical merger between Brown and Kinney was that it would likely induce the exit of unintegrated rivals, particularly small, independent shoe manufacturers who supplied Kinney prior to the merger, a Section 7 violation of the Clayton Act:

“[A] significant aspect of this merger is that it creates a large national chain which is integrated with a manufacturing operation. The retail outlets of integrated companies, by eliminating wholesalers and by increasing the volume of purchases from the manufacturing division of the enterprise, can market their own brands at prices below those of competing independent retailers. […] Their expansion is not rendered unlawful by the mere fact that small independent stores may be adversely affected. It is competition, not competitors, which the Act protects. But we cannot fail to recognize Congress’ desire to promote competition through the protection of viable, small, locally owned businesses.” (Emphasis added.)

Another old example

FTC v. Procter & Gamble Co. (1967) was a product-extension merger, not a vertical merger. Nevertheless, the same principles apply to the complementary-nature of the merger. This feature is reflected in one of the concerns raised by the Supreme Court. Favorably quoting the FTC’s “painstaking and illuminating report,” the Supreme Court’s Opinion summarized the first anticompetitive concern in the FTC’s report by saying that the acquisition may affect the structure of the industry by driving small fringe producers out of the market, which may substantially lessen competition:

“[t]he practical tendency of the … merger … is to transform the liquid bleach industry into an arena of big business competition only, with the few small firms that have not disappeared through merger eventually falling by the wayside, unable to compete with their giant rivals.” (Emphasis added.)

Final thoughts

Several questions might arise. In which vertical mergers might exit be a concern? How might the Agencies evaluate rivals’ exit probability? Could re-entry mitigate or reverse the harmful effects of exit on welfare?  Does the exit of inefficient firms create a more efficient production reallocation, as emphasized by Schumpeter (1942)? We discuss these questions and other examples in Donna and Pereira (2023).

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.