The Role of Undertakings in Regulatory DecisionMaking*

8/14/2019 The Role of Undertakings in Regulatory DecisionMaking*

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The Role of Undertakings in Regulatory Decision-

Making*

by

Teresa Fels, Joshua S. Gansand Stephen P. King**

University of Melbourne

First Draft: 29th July, 1998

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 demonstratehow 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

impossible for the regulator to formulate a first best solution.1

The ability of regulators to elicit and use accurate information may beconstrained 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.

1 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.


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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-goingnature 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 signalthat 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

2 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 ACCCs 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.


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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 guaranteethat 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 post-

merger 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


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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 ahorizontal 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.


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Alternatively, mergers could be dealt with under the more flexible

authorisation process. This has always allowed for authorisations to be

granted subject to conditions being imposed by the ACCC.3 If the conditions

were not met, the authorisation lapsed and the ACCC could seek divestitureof 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

the authorisation process.4

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

3 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.


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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 mergerstakes 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

dependent on enforcement after the event.5

The ACCCs 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

behavioural undertakings.6

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

5 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.


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assets it would acquire after the merger, thereby avoiding the anti-

competitive effects of the merger.

The Ampol-Caltex merger also involved a structural undertaking. The

ACCC concluded that the proposed merger would breach section 50 byreducing the number of oil companied from five to four. The parties offered

undertakings that had the effectinter 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 theWestpac-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 Davids-

Composite 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 Regulators 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

that a merger raises social welfare despite increasing market power.8

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 ahomogenous 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 toc.9 If the firms merge, the merged

firms marginal cost is reduced belowc by > 0. The pre-merger industry

price and output areQ0 and P0 respectively. After the merger these will

7 Suppose that market (inverse) demand is given by P = 10 (q1 + q2). Firm 1 has a (constant)

marginal cost of 0 while 2s is c. The firms initially compete as Cournot duopolists. Ifc > 25/11and

merger rationalises production to 1s 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 firms 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.


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change to Q1 andP1. If the cost reduction, , is large enough, it could be the

case that P1 < P0 so that the merger is pro-competitive rather than anti-

competitive.

Alternatively, it could be the case thatP1 >P0. Social welfare will falldue 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 firms profits from a greater ability to exercise

market power. However, the merged firms lose A to other firms who expand

production in response to the rise in industry price.10 Those firms also gain F

as a result of the price rise. The total change in industry producer surplus as a

result of the merger is B + E D + F.11 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.

10 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 pre-

merger 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.


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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 comesfrom 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 italicsin

original)

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


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In the context of our discussion, Swans 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 ifP0 >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.

Swans 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 ifP0 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

alleviate the regulators problem.13 The fact that a merger is proposed at all

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

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


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

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 regulators 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

on them do not ensure that every socially profitable merger takes place.15

The Farrell and Shapiro approach offers a way for regulators to trade-

off 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.


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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 regulators concerns

by presenting a behavioural undertaking. The behavioural undertaking mustcredibly 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 occur ifQ1 < 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 q1q0, Q1 must be at least equal to Q0. 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 firms 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, ifis 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 ifis 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


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industry profits so firms that seek to merge when there are no cost savings

would not be willing to make such an undertaking.16

In brief, a minimum quantity undertaking is a credible signal that the

merger involves expected cost savings and guarantees that those cost savingswill 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 andReynolds,

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 societys 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

16 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.


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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 q0units. A price undertaking,

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

industry in an undesirable way.19

V. Designing a Minimum Quantity Undertaking.

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.


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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 lowerq0 prior to the merger

then they can legitimately claim that they will sustain q0after 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


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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 quantityundertaking, 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

basis for analysing appropriate quantity undertakings.20

20 For example, Armstrong, Cowan and Vickers (1994) presents a useful overview of price caps

including regulatory experience in the UK.


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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 benefitsfrom 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


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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 firmsseeking 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


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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 ACCCThe ACCCs 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 thePrices

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


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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 beneeded 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 firms costs of operation. Conversely, it may

allow undesirable mergers to continue. The asset sale may remove some of


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the merged firms 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 mergerbenefits.

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 acost-reducing

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.


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Clearly behavioural undertakings, such as a quantity guarantee, are

not perfectly enforceable. But given the potential benefits that they offer, and

the ACCCs significant practical experience with other regulatory schemes, it

is undesirable to dismiss behavioural undertakings as unworkable.


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Figure 1

P1

P0

P

Q0Q1 Q

P(Q)

c

F

E

D

CB

A

q0

q1

Gc -

H


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Documents

The Role of Undertakings in Regulatory DecisionMaking*