Do Vertical Mergers Facilitate Upstream Collusion: Evidence from selected cases in South Africa

Liberty Mncube, Lindiwe Khumalo and Mfundo Ngobese1

Abstract

The anticompetitive effects of vertical integration continue to be an active but controversial topic of research in competition policy. While the Chicago school argued that integrated firms have as much of an incentive as pure upstream firms to cut upstream prices, vertical mergers are at least competitively neutral and might even be pro-competitive. In recent years, consensus seems to have been reached that vertical mergers may indeed be anti-competitive if they allow upstream firms commit to a lower output and/or higher price, or raise their rivals’ costs. South African experience shows that a number of collusion cases have involved intermediate good, with a significant portion of these cases involving industries where one or more firms are vertically integrated. Furthermore, several of these cases have involved firms which have been prohibited from integrating vertically. Our focus in this paper is the effect of vertical mergers on upstream collusion in South Africa. Specifically does vertical integration facilitate upstream collusion and if so what lessons do we draw from recent collusion cases such as the plastic pipes and steel cartel cases.

Keywords: Vertical mergers; Collusion JEL classification: D43, L13, L23, L40

1. Introduction

The potential and incentives for anti-competitive vertical mergers depend on the situation in individual markets. This is true to a much greater extent in a country such as South Africa. Historically the state has created monopolies and used protection from competition widely as a policy instrument in South Africa. The scale of concentration has been and remains considerable coupled with extensive cross-holdings by the major firms.

There is consensus amongst competition practitioners that the presence of concentrated market structures is likely to impact adversely on price and output levels of many goods and services. There are also knock-on effects if the goods and services are used as inputs in production of other goods. In South Africa, with its highly concentrated markets, it is not uncommon for there to be a dominant firm or duopoly in the upstream and/or downstream markets.

South African competition authorities have for the past decade been wary of vertical mergers which may have the effect of shielding firms from increased competitive forces, one of the arguments being that such mergers provide an environment conducive to anti-competitive outcomes and allow firms to monitor and punish their rivals, or they increase the likelihood of coordination or its continued maintenance.

Vertical mergers involve the merger of firms that produce products at different levels in the production process of some final product.2 Ordinarily, the acquiring firm’s products will be in a different market to the target firm’s products and/or the products will be complementary in nature. An example could be; when the target firm produces an input used to produce the acquiring firms’ products. The merging parties are therefore likely to be in a customer- supplier relationship pre-merger.

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Competition policy recognises that, on one hand, a vertical merger can achieve efficiencies and eliminate double mark ups; on the other hand it remains mindful that vertical mergers can also create incentives for foreclosure or facilitate collusion. In the 1950s and 1960s, the US authorities followed the structure-conduct-performance approach. Their antitrust decisions were hostile to vertical mergers. The US, authorities were concerned that vertical integration would harm competition by removing resources from the input market thereby foreclosing competitors and leveraging monopoly from one market to another.

The Chicago School of the 1960s and 1970s rebutted these concerns by pointing out the weak microeconomic foundations of leverage theory, and explaining why vertical integration increases economic efficiency (Riordan, 2005). The Chicago school is premised on assumptions of perfect information, efficient markets (such as financial markets) and economies of scale in an essentially static framework. As pointed out in Riordan (2005), transaction cost economics of the 1970s and 1980s staked a middle ground, identifying new efficiency rationales for vertical integration, while cautioning that firms with market power may have strategic goals poorly aligned with consumer welfare.3

In recent years post Chicago theories have applied game-theoretic tools and strategic behaviour, together with the effect of imperfect information on contracting. Under such conditions there are clear incentives for firms to engage in anticompetitive behaviour in which vertical integration alters industry conduct to the detriment of competitors and consumers. Post-Chicago economics identifies a number of situations in which vertical foreclosure is a rational anticompetitive strategy. Post-Chicago theories of anticompetitive vertical mergers differ in various details, for example, assumptions about the integrated firm’s market power to raise prices above costs and to exclude rivals and the contractual arrangements between the parties involved. Riordan (2005) identifies three major theories, including the “raising rivals’ cost”, “restoring monopoly power” and the “facilitating collusion” theories.4

The “facilitating collusion” theory has deep roots in competition policy but has only recently had firm grounding in economic theory. The 1984 US Non-Horizontal Merger Guidelines anticipate the idea that vertical mergers may facilitate upstream collusion.5 These guidelines envisage two ways in which this can occur. First, a vertical merger may facilitate upstream collusion by making it easier to monitor downstream prices. The guidelines state:

A high level of vertical integration by upstream firms into the associated retail market may facilitate collusion in the upstream market by making it easier to monitor price. Retail prices are generally more visible than prices in upstream markets, and vertical mergers may increase the level of vertical integration to the point at which the monitoring effect becomes significant. Adverse competitive consequences are unlikely unless the upstream market is generally conducive to collusion and a large percentage of the products produced there are sold through vertically integrated retail outlets.6

Second, vertical integration may facilitate collusion is through the acquisition of “disruptive buyer”. The Guidelines state that a disruptive buyer must be one which is substantially different from the others; the idea being that price-cutting to this buyer is particularly attractive, so that the “removal” of this buyer from the downstream market may significantly reduce incentives to deviate from a collusive agreement. The Guidelines state:

The elimination by vertical merger of a particularly disruptive buyer in a downstream market may facilitate collusion in the upstream market. If upstream firms view sales to a particular buyer as sufficiently important, they may deviate from the terms of a collusive

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agreement in an effort to secure that business, therefore disrupting the operation of the agreement. The merger of such a buyer with an upstream firm may eliminate that rivalry, making it easier for the upstream firms to collude effectively.7

The aim is to briefly introduce the Nocke and White model as one of the economic frameworks that could be used by South African Competition authorities in assessing the effect of vertical mergers on collusion. Nocke and White (2007) analyse collusion among upstream firms who use two-part tariffs in a dynamic model. They compare the minimum discount factor required for collusion to be a sub game-perfect Nash equilibrium with integration to the standard case of vertical separation. They show that vertical integration unambiguously facilitates collusion. Generally, explicit and/or tacit collusion requires reaching an agreement, monitoring compliance, and punishing defections. Vertical integration might facilitate collusion by aiding any of these activities. South African experience shows that a number of collusion cases have involved intermediate good, with a significant portion of these cases involving industries where one or more firms are vertically integrated. Furthermore, several of these cases have involved firms which have been prohibited from integrating vertically. However, the contribution of this paper is to illustrate how much the South African Competition Commission could have benefited in its analysis of vertical mergers, if it had adopted a more economic analysis in its prohibitions of some of these mergers.

The structure of this paper will be as follows. We begin in Section 2 with a discussion of the Commission’s approach to vertical mergers. In Section 3 we describe the theoretical model. In Sections 4 and 5 we set out and analyse the relevance of “facilitating upstream collusion” theory in the context of recent international and South African cases. Section 6 concludes.

2. Commission’s approach

Before discussing the South African Competition Commission (Commission)’s approach it is useful to give an overview of the types of mergers that the competition authorities have dealt with over the past ten years. 1999 was the “transitional period”, a period when the Competition Act had just been passed. Initially there was a slow rate of merger filings due to a lack of the awareness and understanding of the new law. Merger filings have steadily increased over the years and Table 1 below shows the different types of merger filed over a ten year period.

Table 1: Percentage of mergers filed by type from 1999 to 2008

Merger type/year 2000 2001 2002 2003 2004 2005 2006 2007 2008

Horizontal 62 66 65 51 56 54 49 57 48

Vertical 9 10 6 8 9 11 8 6 9

Horizontal and vertical 5 1 4 7 8 17 13

Conglomerate 2 13 17 26 24 26 26 37 30

Management buy-out 5 11 8 8 3 9

Total 100 100 100 100 100 100 100 100 100

Source: Competition Commission’s Annual Reports

At a glance there is no clear indication of whether there has been a relative increase or decline of different types of merger; however purely horizontal mergers have declined from a high of

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66% in 2001 to a low of 48% in 2008 and there has been a slight fluctuation in purely vertical mergers with an average of 8% being finalized over the nine year period. Mergers with a mix of horizontal and vertical relationships have increased showing that firms are vertically integrating or expanding their product range and capacities. The competition authorities have of late seen steady increases in vertical mergers. The ability of these mergers to increase collusion in upstream markets will be discussed later in the paper.

Currently there are no specific provisions in the Competition Act pertaining to vertical merger analysis, however the tendency has been for the competition authorities to use the ICN Guidelines as a guide in conjunction with the substantial lessening of competition (“SLC”) test in terms of section 12 A (1) of the Competition Act. The Act sets out factors that the authorities must take into account in determining the effect on competition, which have implications for all types of mergers including horizontal, conglomerate and vertical mergers. These factors include the probability that firms will behave competitively or cooperatively after the merger, ease of entry, levels and trends of concentration and any history of collusion, degree of countervailing power, dynamic characteristics (innovation, product differentiation) and the nature and extent of vertical integration.

The Commission follows the approach of the ICN and OECD Guidelines in its analysis of vertical mergers. The OECD Guidelines8 categorically state that the competition authorities’ analysis involves checking the following:

The levels of concentration in the upstream and/ or downstream market;

The ability of the merging firms to behave anti-competitively;

Any incentives that the merging firms will have to behave anti-competitively; and

The actual effect/s on competition, and who will be affected by the behaviour.

If the largest firm’s market share is high and there are high levels of concentration in the relevant market, adverse competitive effects are likely. Further, if the merging firms have the ability to behave anti-competitively, the merger will result in an anticompetitive effect. This implies that the authorities will assess if there are other sources of competitive constraints on the merging firms which will be able to prevent the pass through of increased costs of the firms that are not integrated. In the next section we describe the theoretical model used to evaluate whether vertical mergers facilitate upstream collusion.

3. Theoretical background

A vertical merger facilitates collusion, if post-merger firms, either upstream or downstream, are able to more effectively coordinate, either because a vertical merger makes reaching a tacit agreement on the coordinated outcome easier or makes enforcement more effective. In this paper we concentrate on upstream collusion. The literature on the impact of vertical mergers on upstream collusion is fairly small and very recent. It consists of the contributions by Riordan and Salop (1995), Nocke and White (2005, 2007), and Normann (2009).9 For a discussion of this literature see Riordan (2005). In this paper, we adopt the Nocke and White model.

Nocke and White model collusion by an upstream industry as a sub game perfect equilibrium of a repeated game, at each stage of which downstream product market competition follows the negotiation of supply contracts with upstream firms. Consider a vertically related industry with

identical upstream firms, U1, U2, ..., UM, and 2N symmetric downstream firms (or

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retailers), D1, D2, ..., DN. The upstream firms produce a homogeneous intermediate good at constant marginal cost c, which for simplicity we set equal to 0, and sell this good to the downstream firms. The downstream firms transform the intermediate good into a final good on a one-to-one basis at zero marginal costs of production, and sell it to consumers. Consumers view the final good as either homogeneous or else symmetrically differentiated (by downstream firms). The M upstream firms make simultaneous and public take-it-or-leave-it two-part tariff offers to the downstream firms.

For simplicity, assume that upstream firms sustain collusion through infinite “Nash reversion”: any deviation by an upstream firm or an integrated downstream firm is followed by the infinitely repeated play of the “noncollusive equilibrium” (which is a sub game-perfect equilibrium of the stage game).10 In contrast, deviations by unintegrated downstream firms do not trigger any punishment.

The critical discount factor

is the lowest value of such that, for all

, there exists an equilibrium in which all of the monopoly rents are extracted by upstream firms. A vertical merger

facilitates upstream collusion if it reduces the critical discount factor

. The symmetric noncollusive equilibrium is the standard Bertrand equilibrium to two-part tariffs. Since each (unintegrated) upstream firm makes zero profit in this equilibrium, and any integrated firm faces downstream rivals that all obtain the input at zero cost, this equilibrium minimizes the profit of each unintegrated upstream firm and each integrated firm in the set of sub game-perfect equilibria of the stage game. The allocation in the symmetric noncollusive equilibrium is independent of the number of integrated upstream-downstream pairs. This feature the setup is useful since it focuses attention on the collusive effects of vertical integration.

Consider the collusive equilibrium when no firm is vertically integrated focusing on the collusive

equilibrium where the upstream firms jointly extract all of the monopoly rents M . The critical

discount factor under non integration (NI) is given by:1NI M

M

. (1) A deviant upstream firm can always sever the ties between its upstream rivals and the unintegrated downstream firms by slightly undercutting rival offers, allowing it to obtain (arbitrarily close to) the collusive industry profit in the period of deviation. In fact, this holds not

only for the monopoly profit M , but more generally for any upstream industry profit level

M . Under nonintegration, any positive upstream industry profit can be sustained as an

equilibrium if and only if NI

. Now turning to the collusive equilibrium when one upstream-

downstream pair, say U1–D1, is vertically integrated the integrated firm makes a per-period profit

of NC through its downstream affiliate D1. The integrated firm’s incentive constraint is thus

given by:

1 1

MM NC

(2)

The term /(1 )NC represents the punishment effect of vertical integration. It is more difficult to punish an integrated firm than an unintegrated upstream firm. Unless downstream products are homogeneous and retail competition is in prices, the integrated downstream affiliate makes

positive profits in the punishment phase, 0NC .

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The punishment effect is quite intuitive and arises because downstream firms may earn rents in the noncooperative equilibrium of the model. If an upstream firm integrates with a downstream firm, these rents now become part of the profit of the merged entity. Thus the merged entity can expect to make more profits in the non-cooperative punishment phase than the upstream firm could make alone. Conversely, absent any changes in market share, the merged entity will make the same profit as would the upstream firm alone when monopoly profits are sustained. So, for a given collusive market share, the merged entity suffers relatively less from a switch from collusive to punishment phases, and is correspondingly more tempted to cheat on any collusive agreement.

Consider now an unintegrated Ui’s incentive to deviate, 2i . There is no punishment effect for Ui since, in periods following a deviation, all unintegrated upstream firms make zero profits, as in the absence of integration. The deviant Ui will not be able to extract any profit from the integrated D1. Since D1 can obtain the intermediate input at zero marginal cost from its own upstream affiliate, U1, D1 will not accept any (deviant) contract that does not leave D1 all of the rents: it will always be at least as cheap for D1 to obtain the input from U1. Vertical integration

therefore reduces the deviation profit of an unintegrated upstream firm by /M N : the amount that it would have made from selling to D1 if D1 were not integrated. This is what we call the outlets effect of vertical integration:

(1 ) 1( 1)(1 )

MM M

M N

(3)

The outlets effect is also intuitive. The optimal way for an upstream firm to deviate is typically to undercut the fixed fees and wholesale prices of its rivals only marginally. This allows the deviant firm to steal all of its rivals’ business whilst downstream output remains close to monopoly levels and hence the deviant firm’s profits are close to monopoly profit. Such a strategy is no longer feasible when one or more downstream firms are integrated. Integrated downstream firms will always prefer to buy from their upstream affiliate at marginal cost than to buy from a deviant firm at any price which gives the latter positive profits (essentially, they would rather these profits went to their upstream affiliate than to another firm). Integrated downstream firms can be relied upon to reject any offer that would be profitable for a deviating upstream firm, which can help to enforce the collusive agreement. A deviating upstream firm cannot hope to attain the full monopoly profit from deviating if one or more downstream firms are integrated with its rivals. Vertical integration by an upstream firm reduces the number of outlets through which its rivals can sell when deviating, generally reducing their profit from cheating and thus facilitating collusion.

The critical discount factor under single integration is given by:1

( 1)

SIM NC

M

MNM

N

(4)Comparing equations (1) and (4), we obtain the main result of the Nocke and White model: In a vertically unintegrated industry, a vertical merger facilitates upstream collusion:

SI NI

(5)

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A vertical merger between an upstream and a downstream firm has two opposing effects on upstream firms’ incentives to collude. On the one hand, an unintegrated upstream firm cannot profitably deviate through a rival’s integrated downstream affiliate; this outlets effect reduces the

unintegrated firm’s deviation profit (by /M N ), and hence its incentive to deviate. On the other

hand, an integrated firm captures the profit of its downstream affiliate (which is /NC M N ) in the punishment phase, while all unintegrated upstream firms make zero profit in the punishment phase, independently of market structure.

This punishment effect increases the integrated firm’s incentive to deviate, holding fixed its market share. Following a single vertical merger, there are 1M remaining unintegrated upstream firms, and the combined outlets effect reduces overall deviation profits by ( 1) /MM N . The punishment effect increases the integrated firm’s discounted sum of profits

from deviating by /(1 )NC , holding fixed the integrated firm’s market share. Under

nonintegration, the critical discount factor is ( 1) /NI M M

. Evaluated at NI

, the

outlets effect outweighs the punishment effect since /NC M N . In a variation of the above model, Nocke and White show that two other effects, the reaction effect and the lack-of commitment effect which can also arise, depending on the timing of upstream and downstream moves.

The baseline model has upstream firms making contract offers simultaneously with downstream firms setting prices (or choosing quantities). However, in some circumstances it may be more natural to think of downstream firms setting their strategic variable after they know what input costs they will face. This new timing introduces further considerations to the dynamic game, because downstream prices (or quantities) can now potentially react to upstream deviations within the same period that they are made. The reaction effect arises from the fact that the integrated downstream firm can now react aggressively (reducing its price or increasing its quantity) during the period of deviation, reducing the profits of the deviator. Thus the reaction effect further facilitates collusion. When downstream firms can condition their retail prices on upstream firms’ contract offers, the integrated firm will suffer from a lack-of-commitment effect: its inability to commit to its own downstream price when making deviant contract offers reduces the integrated firm’s deviation profit. The lack-of-commitment effect therefore makes upstream collusion easier to sustain.

As pointed out in Rordian (2005), an important result of the Nocke and White model is that the outlet effect of a single vertical integration outweighs the punishment effect for a homogeneous-good upstream industry. However, we acknowledge that the assumption that the discount factor is low enough to enable collusion and that upstream firms set market shares in such a way as to minimise the collective incentive to deviate is quite restrictive.

4. International case law

The model discussed in the preceding section is noteworthy because it loosely relates the reaction effect to the US Non- Horizontal Merger Guidelines’ theory that vertical integration facilitates collusion by making it easier to monitor downstream prices, and the outlets effect to the US Guidelines’s disruptive buyer theory.

Cartels are inherently unstable and the cartel problem lies in finding ways to ensure adherence to a collusive agreement by devising punishment mechanisms that will make deviation from a

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collusive outcome unattractive. This problem is compounded in tacitly collusive markets since there is no communication between market participants. It should be noted that merger review seeks to avoid the creation of conditions where consciously explicit collusion, tacit collusion or even parallel behaviour is likely to occur.

Whilst tacitly and explicitly collusive conduct may be enjoined in terms of relevant antitrust enforcement provisions, conscious parallelism may not be so enjoined. Accordingly, we are using the terms coordinated conduct or coordination to refer to all of these instances. Both international and South African case law reveals that in certain circumstances vertical mergers can facilitate coordination both in the upstream and the downstream.

Recently the EC reviewed TomTom /Tele Atlas11 and Nokia/Navteq12 mergers. Tele Atlas and Navteq are the only two suppliers of navigable digital map databases with European Economic Area (EEA) coverage. Essentially the market for the supply of navigable digital map databases in the EEA is a duopoly. A digital map database is described as:

“a compilation of digital data which typically includes (i) geographic information which contains the position and shape of each feature on a map (such as roads, railways, rivers and indications of land use), (ii) attributes which contain additional information associated with features on the map (such as street names, addresses, driving directions, turn restrictions and speed limits) and (iii) display information.”

Navigable digital map databases are ultimately used as input in the production of navigation devices such as portable navigation devices (PNDs), personal digital assistants (PDAs), GPS-enabled mobile telephones and “in-dash” navigation devices. Navigable devices use navigation software which combines geographic positioning from a GPS receiver, data contained in the navigable digital database and other information in order to provide navigation functionality. There are firms that develop and supply navigation software to navigation device manufacturers. However, some navigation device producers such as TomTom have in-house software development capabilities. Therefore, the supply chain is divided into three levels, i.e. upstream production of navigable digital map databases, intermediate development of navigation software and downstream production of navigation devices. TomTom is a downstream producer of navigation devices (more specifically PNDs) and is an intermediate developer and supplier of navigation software to third parties. Nokia on the other hand produces and supplies GPS-enabled mobile phones and has an in-house navigation software development capability used solely for internal purposes.

It is essential to note as preliminary point that the three effects outlined by Nocke and White that tend to facilitate collusion (i.e. outlet, reaction and lack of commitment effects) should be placed within the context of the three elements that were outlined in the European Court of First Instance’s ("CFI") Airtours/Commission decision13 relating to a determination of whether market conditions are such that there is likely to be coordination. Firstly, market participants must possess an ability to coordinate, i.e. market participants must be able to reach terms of coordination. Secondly, once the terms of coordination are accepted coordination must be sustainable. Coordination will not be sustainable if deviations cannot be deterred. Lastly, coordination must be feasible. It is not feasible to coordinate in a market characterized by low entry barriers and buyers with countervailing power. In both Tele Atlas and Nokia cases the EC found that each of these vertical mergers was unlikely to facilitate coordination in the upstream market for navigable digital map databases. In the EC’s view there was no indication that Tele Atlas and Navteq coordinated with each other in the upstream. Investigations revealed that they

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competed in price and non-price aspects and that innovation was an important feature of this market.

In addition, the EC found that the characteristics of the market were such that coordination was unlikely to take place. In particular coordination on prices was found to be unlikely since database prices are not transparent and there was no evidence of geographic split between Tele Atlas and Navteq. The other factors that the EC considered in Tele Atlas case, which was decided before the Navteq case, was the fact that vertical integration of Tele Atlas and TomTom decreased market symmetry in the situation where Navteq is not integrated with Nokia. These market characteristics related to the ability to coordinate.

In relation to sustainability the EC noted that the database market is characterized by large and infrequent contracts which increased incentives to deviate from a collusive agreement. In addition, the EC found that high fixed costs and low marginal costs in the database industry make deviation attractive.

One of the important assumptions in the basic model of Nocke and White is the stability in the number and relative sizes of downstream firms. In order for the outlet effect to provide a strong incentive for coordination in the upstream the downstream arm of the integrated firm must one of a fixed number of outlets of fixed relative sizes. Otherwise sales that will be achieved by an undercutting non-integrated firm will not be constrained by the fact that it cannot offer its products through the downstream arm of an integrated rival. The EC noted certain aspects of both the PND market in the Tele Atlas case and GPS-enabled mobile telephones in Navteq case which indicate that in both these markets the number and/or size of market players are far from being stable. In Tele Atlas the EC found that in 2004 TomTom, Garmin, Navman and six other firms entered the market. However, the EC did note that despite a large number entrants in the PND market these have failed to capture more than marginal market shares and remain minor players. This factor will seem to favour the existence of an outlet effect particularly if the merger is taking place with an incumbent firm enjoying the first mover advantages.

Nonetheless, the EC did not give much significance to the first mover advantages in Tele Atlas case since it eventually held that there had been numerous entrants in the four years prior to the merger and that the relative sizes of PND manufacturers had not been stable. In the Navateq case the EC’s view was that the market for mobile telephones with navigation features was nascent with a high growth potential. The EC noted as follows:

“Finally, an allocation of customers would also be difficult, as in the PND market, and in the downstream mobile markets, the size of the firms is far from stable and numerous new companies regularly enter one or other of those markets.”

In the Tele Atlas case the EC made it clear that some aspects of a vertical merger may possibly increase the scope for coordination. In a summation of the outlet and punishment effects the EC noted as follows in footnote 195:

“For instance, the fact that one downstream customer is now integrated with an upstream company could reduce the possibility for the non-integrated company to deviate from a collusive agreement. However, a vertical merger also has effects that may decrease the scope for coordination. For instance, the fact that one downstream customer is now integrated diminishes the possibility to punish the integrated company if it were to deviate.”

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It should be noted the incentive to coordinate upstream can also be related to whether or not there is an incentive to foreclose rivals in the downstream market. This is due to the fact that the downstream arm of a vertically integrated firm will benefit from increased profits since higher input prices will be faced by its downstream rivals; whilst it may continue to purchase its inputs at costs from its upstream division. Thus the integrated firm’s downstream arm will be more competitive than its rivals. In Tele Atlas the EC found that databases account for less than 10% of the PND wholesale price. In addition, the extent of the retail price increase will depend on the pass-on rate of Tom Tom’s competitors. Accordingly, the EC found that a 10% price increase will only lead to a 0,5% wholesale price increase. If the PND manufacturers pass on 50% and under any reasonable own elasticity and diversion ratio such a price increase would lead to very few additional sales for the merged firm.

The EC found that the revenues that will be lost in the upstream market as a result of a partial foreclosure strategy designed to increase rivals’ costs will exceed gains from increased sales of PNDs that will be captured by the merged entity downstream. In the Navteq case the EC’s econometric analysis also indicated that the merged entity would only capture a relatively limited amount of sales downstream by increasing map database pricing to Nokia‘s competitors. It can thus be argued that the incentive to coordinate pricing upstream is lessened by the fact that the amount of sales that will be captured downstream by the integrated firm are non-existent or insignificant due to limited retail price increases by rivals.

In most vertical mergers where facilitation of coordination was a concern, the issues traversed related to the merger’s likelihood to increase the scope for coordination as result of the merger making it easier to reach terms of coordination; by making monitoring easy due to increasing the levels of market transparency in the market; or by creating a conduit for information exchange.

In the Accor/Hilton/Six Continents/JV14 merger the EC had to assess a formation of a JV between Accor, Hilton, Six Continents and WorldRes to be referred to as WorldRes Europe Ltd (WRE). Accor, Hilton and Six Continents operated in the upstream hotel accommodation market whilst WRE was to function as a computerized reservation system (CRS) or global distribution system (GDS) downstream of its parents’ activities. WRE was to provide travel agencies with information and enable them to make hotel reservations. The market investigation focused on increased flow of information between hotel parents, providing them with the incentive and ability to coordinate. In addition, the information that would have been available through WRE was not such it would have allowed parents to deduce patterns of offer and demand: the information was found to be already available in websites.

In Shell/DEA15 and BP/E.ON (Veba16) mergers the EC looked at various characteristics of the ethylene market and adopted simultaneous decisions. These mergers had both vertical and horizontal elements. The EC concluded that the two proposed transactions would result in the creation of a collective dominant position of the two new entities Shell/DEA and BP/E.ON in the upstream market for the supply of ethylene on the ARG pipeline network (ARG+). The EC found that the market had the necessary characteristics relating to ability, sustainability and feasibility of coordination. From a vertical perspective the EC noted that as the only non-vertically integrated suppliers, DEA and Veba are the main price setters in the ethylene market. The removal of these non-integrated upstream suppliers was essentially found likely to alter the ability to coordinate and incentives as the merger established downstream links that enhance the chances for coordination.

The EC found that since all ethylene suppliers will be vertically integrated they will have similar incentives regarding companies that compete with their downstream divisions in the market for

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ethylene derivatives. An incentive to make downstream non-vertically integrated rivals less competitive was going to be shared by all ethylene suppliers on the ARG+ post-merger.

In 2001, the Department of Justice (DOJ) challenged the proposed acquisition of Masonite17, one of the two major producers of “interior moulded doorskins” (doorskins) by Premdor, Inc, one of the two major producers of “interior molded doors” (doors) and a minor producer of doorskins. The DOJ alleged that doorskins and doors were separate markets, and in each market Premdor’s and Masonite’s only major competitor was vertically integrated into both doorskins and doors. Premdor had a 40% market share of the moulded door market. Its major competitor was In Door. There was also a competitive fringe consisting of nine firms, none of which had a market share greater than 5%. Masonite and In Door produced the vast majority of door skins. Masonite was the larger of the two firms with over 50% of the market and Premdor was its major customer. The third largest doorskin manufacturer with less than 10% of the market, was a joint venture that included Premdor. All of the joint venture‘s output was sold to Premdor. Both In Door and Masonite sold to the unintegrated downstream door manufacturers

The DOJ alleged that the market was susceptible to coordination: it was concentrated and the product was homogenous. There was a history of collusion in the downstream market. The DOJ alleged that the proposed vertical integration would facilitate price coordination with the existing vertically integrated firm at both levels of the supply chain, by eliminating factors that had theretofore impeded coordination. First, before the merger, any attempt by Masonite and its competitor jointly to raise the price of doorskins ran the risk of spurring Premdor to expand its production of doorskins both for its own use and for the use of other door manufacturers.

Second, absent the merger, the DOJ alleged that expansion by Premdor upstream in the door skin market constrained the ability of Masonite and In Door to coordinate in the upstream market. Post-merger, Premdor would have less incentive to expand its output upstream, since it benefits from higher upstream prices, as an integrated supplier, in the downstream market. Third, In Door constrained coordination because its lower cost structure created incentives for it to lower prices to obtain greater market share. The ability to coordinate would be enhanced because the merger would create cost parity. Masonite and Premdor would have similar costs post-merger due to the elimination of double marginalisation. Fourth, pre-merger asymmetries of information impeded coordination. Those asymmetries would be eliminated by the merger. The Department’s concerns were resolved through a package of divestitures designed to establish another competitor in the doorskin market.

5. Evidence from selected cases in south Africa

As noted above an incentive to coordinate upstream can also be related to whether or not there is an incentive to foreclose rivals in the downstream markets. When it upheld the decision of the Tribunal in Mondi/Kohler Core and Tubes (KC&T)18 the Competition Appeal Courts (CAC) clearly recognized the interdependence between input foreclosure and upstream coordination. Firstly, the CAC found that Mondi was likely to prioritise the needs of KC&T’s downstream core and tubes manufacturing business over those its competitors. In the CAC’s view the existence of an acknowledged capacity constraint faced by Mondi in the upstream production of core boards used in the downstream production of core and tubes constituted sufficient justification for a restriction of supply. This strategy was found likely to be beneficial to Mondi since Sappi, the only other supplier of core boards, will be left with an effective near monopoly over third party sales. Due to lack of other viable alternative suppliers Sappi would have been in a position to raise prices of its core boards to rival core and tube manufacturers.

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It should be noted that Mondi and Sappi were in turn also the major customers of core and tubes. The CAC found that core and tubes constituted a small proportion of the price of composite products sold by Sappi and Mondi. Accordingly, it was found that Mondi and Sappi would not have faced much resistance from their customers as a result of limited price increases of composite materials. Therefore, whilst there may have been substantial price increases in the manufacture of core and tubes this would not translate to a significant price increase of composite products. Sappi and Mondi were thus likely to gain more from coordinating over higher prices in the supply of core boards than they will lose as result of such cost increases in the downstream as these would not have been substantial and could have been passed-on with limited effects on sales. In fact, if KC&T had continued to obtain its core boards from Mondi at cost it would have been more competitive than its rivals, an additional gain for Mondi.

When looking at the facts of the KC&T case it seemed that the decision of the Tribunal, as confirmed by the CAC, can only be strengthened further by the basic model of Nocke and White. The CAC noted that KC&T was dominant in the market for the supply cores and tubes. The market appeared to be stable with limited entry. KC&T thus constituted an important customer for core boards. Thus if Sappi cheated from a collusive outcome by undercutting it may not have been able to increase its sales since in order to do so its offer would have needed to be accepted by KC&T (outlet effect). The punishment effect is unlikely to be significant because by cheating on the collusive outcome Mondi was likely to lose more profits than it would have gained: the price of core boards is a small proportion of the ultimate price of composite products.

Changes brought about by vertical integration do not provide a basis for concern unless the conditions for coordinated effects as set out in Airtours case are met and changes brought about by the merger strengthen or increase the likelihood of coordination. The CAC effectively found that the merging parties had the ability to collude and that collusion was sustainable and feasible. The merging parties themselves acknowledged that the structure of the market was susceptible to collusion even prior to the merger.

In January 2008 the Commission prohibited a vertical merger between DPI Plastics (Pty) Ltd (“DPI Plastics”) and Incledon Cape (Pty) Ltd (“Incledon Cape”). DPI Plastics is involved in the manufacturing and distribution of plastic pipes and fittings for various applications including civil building, construction, plumbing, industrial, mining and irrigation. Incledon Cape operates as a wholesaler and supplier of a wide range of products including pipes, fittings, valves, flanges, threading machines, water meters, plumbing and related products used in the engineering, civils, agriculture, plumbing and municipal industries.

At the time of the transaction there was a horizontal overlap in the activities of the merging firms in the market for the wholesale distribution of pipeline solutions. Pipeline solutions consist of a basket of products required to transfer water, including pipes, fittings, water meters, valves, pumps and other related piping products to suit the needs of the customer. The proposed transaction also resulted in vertical integration in that DPI Plastics was a manufacturer of plastic pipes and fittings while Incledon Cape is a distributor of said products. There were nine firms in the upstream market, three of which were already vertically integrated into the downstream market including DPI Plastics.

During the course of the merger investigation, the Commission uncovered information that suggested that there was collusion in the markets for the manufacture of pipeline solutions in the Western Cape. According to the information uncovered, a cartel which was mainly engaged

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in collusive tendering with various manufacturers and merchants in the region, including the merging parties, being members. On the basis of the existence of collusion (and on other grounds), the Commission prohibited the merger. Subsequent to the prohibition of the merger, DPI applied for immunity from prosecution in terms of the Commission’s corporate leniency policy. The matter has since been referred to the Tribunal for adjudication.

Although the Commission found it sufficient to prohibit the merger based on the fact that they was an existing cartel, the insights from the Nocke and White model can be relied upon to illustrate how the vertical merger could have facilitated upstream collusion.

In order to show that vertical mergers facilitate upstream collusion Nocke and White (2007) make what at first appears to be a rather strong assumption. They assume that the discount factor is low enough to make it necessary for colluding, upstream firms set market shares in such a way as to minimise the collective incentive to deviate. In other words, firms need to agree on a market share split as a necessary condition to tacitly coordinate their prices. It turns out that in the plastics pipes cartel such an agreement existed, for instance, in the Eastern Cape the manufacturers of PVC and HDPE pipes in the region held several meetings wherein it was agreed inter alia that contracts would be allocated to the individual manufacturers so as to reflect their pre-existing market shares.

As we have already established there is an outlets effects associated with each vertical integration, and this outlets effect reduces the incentives for unintegrated upstream firms to cheat. Weighing against the adverse effects of vertical integration is a punishment effect of vertical integration. The punishment effect refers to the possibility that the acquisition of a downstream firm might increase the integrated firm’s incentive to defect from upstream collusion by securing profits in the downstream market should the collusion collapse. Nocke and White (2007) acknowledge that the interplay between the outlets effects and the punishment effect may be more complicated with each vertical merger in the case of multiple integration.

When considering the number of vertical integrations that one would expect to see in an industry, Nocke and White point out that there is, in addition to the collusive motive, a market share motive for vertical mergers. One might expect to see more mergers than the number which minimizes the critical discount factor as firms may have an incentive to vertically integrate in order to obtain a larger share of the collusive pie, even when the vertical merger increases the critical discount factor. The merging parties’ post merger market share for the distribution of pipeline solutions in the Western Cape was approximately 45% with a market share accretion of 20%. Since a vertical integrated firm may have incentive to cheat, other firms may be willing to concede this increase in market share for collusion not to break down. We argue in this paper that there was both a collusive and a market share motive for the vertical merger between DPI Plastics and Incledon Cape. A vertical merger may appear to increase market share, but that does not imply that all firms in the industry should integrate as this could upset the collusive equilibrium.

The Commission blocked a few transactions in the reinforcing and fencing steel industry in 2008. Some of these transactions resulted in vertical integration and the Commission was concerned that they may have facilitated coordination both upstream and downstream. In September 2008 the Commission prohibited a merger wherein Cape Gate sought to acquire Cape Africa, Transvaal Gate and Fence and Tube.19 During its investigation the Commission found that the market for wire and wire products was cartelized. The transaction resulted in the vertical integration of various activities. Firstly, Cape Gate manufactures a range of steel, wire

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and wire products, some of which are supplied to Cape Africa (a JV between Cape Gate and Transvaal Gate), for on sale in the Limpopo Province. Secondly, Cape Gate produces galvanized wire which is utilized downstream by Transvaal Gate and by Cape Gate itself to make fencing products like commercial chain link fencing. Lastly, Fence and Tube distributes its products through Cape Africa in the Limpopo Province.

It should be noted that Cape Gate and Cape Africa were already vertically integrated and that a significant effect was brought about by the acquisition of Transvaal Gate. The Commission noted that the upstream market for the production of galvanized wire was highly concentrated with sales of the two players accounting for a significant proportion of the market. Both the upstream and downstream markets were cartelised with market players integrated both up- and downstream.

The Commission was thus of the view that not only was Transvaal gate an effective competitor that was about to be removed from the market but Transvaal Gate would effectively have been part of an existing cartel post merger. It can thus be argued that Transvaal Gate was, pre-merger, an avenue that existed for upstream manufacturers of galvanized wire to expand their sales if they were to cheat on the coordinated outcome. Post-merger this avenue would not have been available and as such this would have strengthened the already existing outlet effect. The importance of Transvaal Gate in the downstream was however not fully explored.

Various market players in the market for the supply of reinforcing steel are vertically integrated. Integration occurs from wire and rod manufacture down to bar yards that cut, bend and supply reinforcing steel to construction projects. In early September 2008 the Commission blocked a merger wherein Aveng sought to acquire Silverton Reinforcing, Koedoespoort Reinforcing, Witbank Reinforcing and Nelspruit Reinforcing bar yards. This transaction had both a horizontal and a vertical dimension. Aveng operated major bar yards in the country under the name Steeledale, hence the horizontal overlap with target firms. In addition, Aveng is involved in the upstream market for the production of mesh and wire. The target firms are downstream suppliers of mesh and wire in construction projects. During the merger investigation Aveng applied for corporate leniency in respect of the upstream market for the production and supply of mesh.

In this transaction the Commission did not find vertical integration likely to facilitate coordination. This was linked to the Commission’s finding that the proportion of mesh sourced by the target firms was very small such that the transaction was unlikely to result in customer foreclosure. Accordingly, the target firms were not sufficiently important outlets such that foreclosure of access to them was likely to make deviation by upstream rivals from the coordinated outcome unattractive.

Clearly vertical mergers in collusive markets are likely to attract attention from competition authorities and a finding the likelihood of foreclosure could exacerbate coordinated effect concerns.

6. Lessons and Conclusions

Collusion enables firms to restrict competition and raise prices by exerting market power they would not otherwise have. Fighting collusion is a major area of activity for any competition authority and this is likely to remain so in the coming years. Through the merger review regime competition authorities can prevent the emergence of industry structures that are prone to

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collusion by taking this into account when evaluation proposed mergers ex ante. They can also prohibit vertical mergers which facilitate collusion.

What is apparent from most of the steel mergers that the Commission prohibited is that the basis for prohibitions had little to do with changes brought about by the merger, but appeared to have much to do with the involvement of either or both of the merging firms in a cartel. There was thus little economic analysis in evaluating the merger on the effect of the merger on existing collusion.

Our view is that the Commission’s analysis could have been strengthened by an economic analysis of the likely effects of the mergers on collusive activity. As noted above, vertical integration by an upstream firm reduces the number of outlets through which its rivals can sell when deviating, generally reducing their profit from cheating and thus facilitating collusion. However, if an increasing number of firms integrate downstream other countervailing effects may begin to outweigh the outlet effect. In the extreme case when all firms are vertically integrated it should be noted that competition at one level of the market is eliminated and therefore, the outlet effect no longer holds.

Transactions that result in vertical integration of firms that operate in vertically integrated markets may not bring about an anticompetitive outcome from foreclosure of an outlet to upstream firms that choose to deviate from collusion. If the end product is sufficiently homogeneous the vertically integrated deviating upstream firm can capture market share from its competitors through its own vertical chain. Therefore, the punishment effect is likely to outweigh the outlet effect. Nevertheless, a merger increasing the number of vertically integrated firms may still reduce asymmetry between market players so as to make collusion easy to achieve and sustain.

7. References

MARTIN, S., NORMANN, H. T. & SNYDER, C. M. (2001) Vertical Foreclosure in Experimental

Markets. RAND Journal of Economics

NOCKE, V. & WHITE, L. (2003) Do vertical mergers facilitate upstream collusion? Penn Institute

for Economic Research Working Paper 03-033.

NOCKE, V. & WHITE, L. (2005) Do Vertical Mergers Facilitate Upstream Collusion? Penn

Institute for Economic Research Working Paper 05-013.

NOCKE, V. & WHITE, L. (2007) Do Vertical Mergers Facilitate Upstream Collusion? American

Economic Review.

NORMANN, H. T. (2009) Vertical integration, raising rivals’ costs and upstream collusion

European Economic Review.

RIORDAN, M. (2005) Competitive Effects of Vertical Integration. IN BUCCIROSSI, P. (Ed.)

Handbook of Antitrust Economics. MIT Press.

RIORDAN, M. & SALOP, G. (1995) Evaluating Vertical Mergers - A Post Chicago Approach.

Antitrust Law Journal

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WILLIAMSON, O. E. (1975) Markets and Hierarchies: Analysis and Antitrust Implications, New

York., Free Press.

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1 This paper is written in the personal capacities of the authors and does not necessarily reflect the views of the Competition Commission

2 ABA Section of Antitrust Law - Mergers and Acquisitions: Understanding the Antitrust Issues (2008).

3 See also Williamson (1975).

4 See Martin, Norman, and Snyder (2001), Hart and Tirole (1990) and Rey and Tirole (2003).

5 See also Nocke and White (2003) and Riordan (2005)

6 DOJ, 1984, Section 4.221

7 DOJ, 1984, Section 4.222

8 OECD Policy Roundtables on Vertical Mergers; (2007).

9 Normann (2007) analyzes the impact vertical integration has on upstream firms’ ability to collude when downstream firms pay a linear price for the input. As the downstream unit of the integrated firms is delivered internally at marginal cost, it benefits from a raising-rivals’-cost effect when the input market is collusive. The main result is that vertical integration facilitates upstream collusion. While Riordan and Salop (1995) sketch an informal theory of how information exchange through a vertically integrated firm facilitates upstream collusion.

10 Since we are interested in tacit collusion between upstream firms, we focus mainly on collusive equilibria that allow upstream firms to jointly extract all of the monopoly rents.

11 Case no. COMP/M.4854

12 Case no. COMP/M.4942

13 Case T-342/99

14 Case no. COMP/M.3101

15 Case no. COMP/M.2389

16 Case no. COMP/M.2533

17 United States v. Premdor, Competitive Impact Statement, Civ. Action No. 1:01CV01696 (D.D.C. filed Aug. 3, 2001) available at http://www.usdoj.gov/atr/cases/f9000/9017.htm

18 Case no. 20/CAC/Jun02

19 Case no. 2008Jun3788 (This document is confidential, but a non-confidential version can made available on request to the Competition Commission)