66 Cf. Buzzell, Robert D., et al., Market Share ... , supra; Gale/Branch, Concentration versus Market Share ... , supra; Martin, Stephen, Market, Fi rm and Economic Performance, New York 1983; and for an early work, Shepherd, The Elements of Market Structure, supra.

67 On the following study, cf. Martin, Market, Firm and Economic Performance, op. cit.

The concurring efficiency differential- and concentration collusion-hypotheses were tested by *Clarke, Davis* and *Waterson* on the basis of price-cost margins in the U.K., using a model to separate market power effects from efficiency effects.es The study is based on 147 and 155 manufacturing industries on a three digit level for the period from 1971 to 1977 respectively, using the ratio of gross profits to sales as the dependent variable. If the efficiency-differential hypothesis by *Demsetz* holds, relatively small

firms should be of lower profitability than relatively large firms, regardless of the level of industry concentration; and the profitability differences should be larger, the higher the level of concentration. However, *Demsetz'*  hypothesis is not confirmed by this study. The authors conclude that "both efficiency and market power effects are at work". 59

*Amato* and *Wilder* emphasized the relation between profitability, firm size and further structural variables for the years 1966 to 1975, including 40 manufacturing industries, classified by IRS data.7° The basic hypothesis to be tested is that, because of the separation of owne1· and management, utility maximization by managers in accordance with firm size is the correct variable. It was also tested whether profitability is a non-linear function of firm size. The result that there is no relationship between firm size and profit rate - which contradicts most of the previous studies - is supposed to be due to an improved data base. *Demsetz'* differential efficiency hypothesis is rejected and it is stated that the results of market share/profitabi I ity studies cannot be applied to firm size/profitability studies.

#### **c. The Core of the Oligopoly and other Omissions**

Although it is conceded by the current tenet that concentration facilitates collusion and that real markets are characterized by oligopolistic structures71, concentration is in fact of little importance for antitrust policy because it is argued that there is no clear theoretical basis for a general

68 Cf. Clarke, Roger, Stephen Davies and Michael Waterson, The Profitability-Concentration Relation: Market Power or Efficiency?, 32 JIE (1984), pp. 435-450.

69 Clarke/Davies/Waterson, The Profitability-Concentration Relation ... , supra, 448.

70 Cf. Amato, Louis, and Ronald P. Wilder, The Effects of Firm Size on Profit Rates in U.S. Manufacturing, 52 SEJ (1985), pp. 181-190.

71 Cf. Bork, The Antitrust Paradox, op. cit., 101 f.

oligopoly theory. 72 Due to changing conditions with regard to demand, technology, and different cost situations, collusion that is favored by oligopolistic interdependence between the firms is in practice very difficult to deal with. 73

According to this view, the fact that monopolies neither act as a collective monopoly, nor act purely competitively does not permit the conclusion that oligopolists behave uncompetitively.74

There is an exception, however, in the case of *Stigler* who was among the first to deal with problems of competition in an oligopoly. 75Though *Stigler*  is in favour of an oligopoly theory, he has not succeeded in developing a coherent economic and legal approach to oligopoly. 76

However, if we start from the more realistic assumption of market imperfections and if we assume furthermore that with increasing concentration and a decreasing number of competitors the interdependence between the firms increases, i.e., that every supplier has to take account of the behavior of his competitors as a reaction to his own behavior, then a single supplier has monopolistic discretion, which he has neither under the conditions of perfect competition (price being given) nor in a (partial) monopoly (where the fringe of the small competitors has no influence on the market activities).

However, accepting the correlation between concentration and the interdependence of firms is not enough to settle the question of whether oligopolists must behave in a competitive way or not. In order to answer this question, the existing structural conditions of the market have to be looked

72 Cf. Posner, The Chicago School ... , supra, 932.

73 Bork, The Antitrust Paradox, op. cit., 92: "Conventional oligopoly theory, however, is little more than a guess about the ways in which firms might be able to behave in a market composed of a few sellers." A different **view** is offered by *Stigler.* He accepts the existence of an authority that takes legal action against collusion, thus accepting the phenomenon as a real one. Thus he comes to the conclusion that "(t)he Sherman Act has reduced the availability of the most efficient methods of collusion and thereby reduced the amount and effects of collusion", Stigler, The Organization of Industry, op. cit., 271.

74 Cf. Bork, The Antitrust Paradox, op. cit., 102 and 104.

75 Cf. esp. Stigler, The Organization of Industry, op. cit., 39 ff.

76 For this evaluation, cf. Kirchner, Christian, "Okonomische Analyse des Rechts" und Recht der Wettbewerbsbeschrii.nkungen (antitrust law and economics), 140 ZHR ( 1980), pp. 563-588, 565.

into as well (for instance, the stage in market evolution, product homogeneity or heterogeneity, degree of information - these being factors which qualify the importance of the number of the firms). Structural conditions which lead to oligopolistic behavior cannot be established for the general case. Significant and empirically meaningful statements can be made only by showing a correlation between specific market structures and the likelihood of oligopolistic behavior. Consequently, a classification of specific oligopolistic forms of behavior restraining competition becomes necessary.77

The assertion that concentration does not necessarily lead to collusion since oligopolies are rather fragile in nature does not take into account sufficiently the fact that there is often a distinct symmetry of interest within a small group of competitors substituting for legal sanctions (e.g., penalties for breach of contract).78

This distinct symmetry of interest may be the answer to the question why firms of the oligopoly core do not seem to compete among each other on a price basis. Under the circumstances presented, positive price-cost margins should pose an incentive to expand output until competitive returns are realized and prices equal marginal costs. This would have the effect that most of the smaller and allegedly inefficient firms would have to leave the market. The fact that in reality this often does not happen, presents some evidence that superior efficiency and collusive behavior may go hand in hand.79 This makes the original reasoning become more or less **tautological** with regard to the efficiency-differential hypothesis of large firms because "comparing profitability amongst large and small firm profits is defective, in that their efficiency would Imply higher profits, but their higher profits do not necessarily imply their **efficiency",l!O** This seems to be apparent to some of the ad

77 Cf. Zohlnhofer, Werner, Wettbewerbspolitik im Oligopol: Erfahrungen der amerikanischen Antitrustpolitik, Basel and TUbingen 1968, pp. 26 ff.

78 Cf. Schmidt/Rittaler, The Chicago School of Antitrust Analysis, op. cit., 97.

79 Cf. Green, Industrial Organization Paradigms ... , supra, 493; and Greer, Industrial Organization ... , op. cit., 412 f.: "Collusion can reward an industry's big firms with excess profits and simultaneously reward its small firms with only normal profits even if the concentration fostering the collusion is not grounded on big firm efficiencies."

80 Clarke/Davies/Waterson, The Profitability-Concentration Relation ... , supra, 438.

herents of current theory, although this is not acknowledged or even accepted.81

#### **d. The Persistence of Profits In the Long Run**

The workability of the market mechanism is seen by the Chicago School in terms of a long-run realization of its basic functions: coordination, information, and allocation. However, market processes are perceived to take a certain amount of time to adjust to changing economic conditions because the relevant information has to be processed. According to this view, it is this which is responsible for temporary market frictions. However, this ought not to be mistaken for impediments to competition. Since the whole concept stands or fails with the assumption of the non-existence of impediments to competition and a long-run view of market processes (time horizon), both premises are of crucial importance. 82 We will try to find evidence for the validity of the assumption of the long-run effectiveness of the market mechanism by observing as to whether above average profitability is reduced to average competitive rates of return over time.

There is a general consensus that high profits can persist over a longer period of time when the observed enterprise has cost or related efficiency advantages, offers a superior good or holds market power in comparison to actual or potential competitors. 83 Nevertheless, sufficient competitive pressure is supposed to exercise persistent downward pressure on prices and profitability so that the ideal norm would seem to be that only costs plus a normal return on capital ought to be earned in unconcentrated industries.B-4 There is no consensus on two issues, however. First, the question remains as to whether above-average profitability is just a result of a disequilibrium

81 Cf. Demsetz, Harold, Two Systems of Belief about Monopoly, op. cit., 178; and Carter, Collusion, Efficiency and Antitrust, supra, 438 and 441, who seems to acknowledge that these results are consistent with collusion among the large firms and efficiency differentials vis-a-vis smaller firms at the same time.

82 Impediments to competition have been treated supra, showing the limited use of the assumption of ultra-free entry.

83 Cf. Mueller, Dennis C., United States' Antitrust: At the Crossroads, in: de Jong, Henk W., and William G. Shepherd (eds.), Mainstreams in Industrial Organization - Book 2, Dordrecht et al. 1986, pp. 215-241, 232.

84 Cf., e.g., Mueller, Dennis C., Profits in the Long Run, Cambridge, Mass. 1986. p. 31.

state of the market or whether there actually is a movement of above-average rates of return toward that norm and whether or not this movement occurs less quickly in more concentrated industries in comparison to less concentrated ones. 85Second, if profits are not eroded quickly in some industries this does not necessarily mean that these profits are persistent as a result of market power. They can also be persistent as a result of efficiency differences, product preferences, or as a result of a mixture of power, product preferences, and efficiency.

With regard to the first question, empirical evidence suggests that the erosion of profitability divergences in concentrated industries - if it occurs at all - takes a much longer time than it does in less concentrated indu**stries815,** regardless of whether profit margins of high and low concentration with either high or low barriers are examined87, or results of concentrated industries are treated as if they were competitive. 88

Contrary to the assertion of the current tenet, under certain circumstances profits may be an index of market power in cases in which profits are not eroded in the long-run. This is the case when profitability differences cannot be justified by persistent interfirm-efficiency differences as expressed by cost differences and when in addition the market in question may be facing impediments to competition. In this case profits can be considered an expression of market power arising from a restraint on competition. This makes it necessary to distinguish efficiency effects carefully from market power effects.89

85 Cf., e.g., Liebowitz, S.J., Measuring Industrial Disequilibria, 48 SEJ (1982), pp. 119-136.

86 Cf. MacAvoy, Paul W., John **W.** McKie and Lee E. Preston, High and Stable Concentration Levels, Profitability, and Public Policy: A Response, 14 JLE (1971 ), pp. 493-499; Mueller, Dennis C., The Persistence of Profits Above the Norm, **44** Economica (1977), pp. 369-380; Mueller, Profits in the Long Run, op, cit.; and Weiss, Leonard W., and George Pascoe, The Extent and Permanence of Market Dominance, Paper presented at the Annual EARIE Conference 1983 at Fontainebleau.

87 Cf., e.g., Qualls, P. David, Concentration, Barriers to Entry, and Long-Run Economic Profit Margins, 20 JIE (1972), pp. 146-158.

88 Cf. Marvel, Howard P., Collusion and the Pattern of Rates of Return, 47 SEJ (1980), pp. 375-387.

89 Cf. Mueller, United States' Antitrust: At the Crossroads, op. cit., 226 who emphasizes with regard to the U.S. American Fortune 500 that "'an examination of the list of persistently most profitable firms suggests that this image of efficiency does not characterize these firms."

# **m. firm Market Share as the Essential Determinant Qf Interflrro PrQfitabmty Differences**

In the following, the aforementioned line of reasoning leads us to the attempt to determine the extent to which concentration is actually justified by technical and non-technical efficiencies. The result can be considered a prima facie assumption on the threshold beyond which undue market power may be assumed to emerge. 1

# **1. Interflrm Profitability Differences: Efficiency or Market Power?**

The former tenet associated with the Harvard School does not necessarily seem to be in conflict with the new learning hypothesis, even if It seems that this former tenet as the underlying rationale for antimerger policy is in actual need of a few refinements. There is no reason why economies of scale could not be responsible for generating the intra-industry results which *Demsetz* and others offer as support for the efficiency-causes-concentration hypothesis.2

The roots of a possible complementarity lie within the role that market share as an element of market structure plays. Both the adherents to the former and the current tenet take the view that the correlation between market share and profit is much more central - even analytically more precise than the correlation between concentration and profits. 3 This seems to be largely in accordance and consistent with findings on the role of market shares. According to the view of the former tenet, however, higher profits of firms with large market shares are the result of better opportunities of making use of advantages in product differentiation and price differentiation, i.e. better opportunities of exerting Individual monopoly power and raising prices beyond the competitive level, as well as of making use of econo-

Necessari I y, the ceteris pari bus clause applies. Additional structural and behavioral aspects have to be considered depending on the individual case.

2 Cf. Scherer, The Causes and Consequences of Rising Industrial Concentration, supra; and Clarke/Davies/Waterson, The Profitability-Concentration Relation: Market Power or Efficiency?, supra, 437, who note that in the case of firms producing along a production function exhibiting scale economies "there would be a natural tendency over time for the larger firms to be more successful and for the Industry to become more concentrated",

3 Cf. Scherer, On the Current State ... , op. cit., 6; and recently, Buzzell/ Gale, The PIMS Principles ... , op. cit.

mies of scale or other cost advantages. Whereas the use of industry-wide data in former empirical studies led to spurious results due to data aggregation and thereby to a positive correlation between concentration and profit, as has been demonstrated supra (exaggeration of profits of market leaders)4, recent empirical inquiries show that the profits of the firms have to be seen primarily as a function not only of (relative) market share, but also of invested capital, market growth, life cycle stage, and product differentiation advantages:5

*l1L..l;.* Relative Market Share and Profitability Differences

~ Abell, Derek F., and John s. Ha •• ond, Strategic Market Planning: Problems and Analytical Approaches, Englewood Cliffs, U., 1979, p. 279.

These studies are based on the above mentioned PIMS-Data Base and FTC Line of Business Program, which refer to firm Information instead of industry data. They offer significant solutions to data problems due to Industry aggregation, and tend to throw quite a different light on the new learning-

4 Cf. Scherer, On the Current State ••• , op. cit., 6. The structural Importance of market shares was emphasized as early as 1972, cf. primarily Buzzell/ Gale/Sultan, Market Share - A Key to Profitability, supra; and Shepherd, The Elements of Market Structure, supra, but an extreme data Insufficiency problem remained that made It difficult If not Impossible to test the Importance of market shares.

5 Cf. esp. Ravenscraft, Structure-Profit Relationships at the Line of Business and Industry Level, supra, where product differentiation Is measured by the amount of advertising and a patents-to-sales ratio; and Abell/ Hammond, Strategic Market Planning .•• , op. cit., 289: "PIMS-flndlngs Indicate that Investment Intensity, market share, industry growth rate, life cycle position, and marketing expense/sales ratios are among the most Important factors affecting ROI and cash flows", which emphasizes market share overproportlonatel *y.*

hypothesis of the Chicago School (efficiency causes concentration) than was originally thought:6

"The typical firm earning persistently high profits has a large market share in a differentiated product industry. If it is more efficient than its competitors, it is not because it produces the same product as they at lower costs, and sells it at lower prices. If anything, the price it charges probably exceeds that of its competitors for a *product that is perceived to be superior along one or more product characteristic dimensions .* ... The successful firm is more efficient than its competitors in using nonprice modes of competition."

Due to a high market share, the supplier can take advantage of his monopolistic discretion to charge higher prices; however, due to the lack of competitive pressure, it is not guaranteed that the effic:c~r.v gains will also be passed on to consumers. In this case, the hypothesis that an increase in the efficiency of a business due to cost reductions - be it actual or potential leads self-evidently to higher growth and greater welfare has not been established empirically. It has not been shown that a potential efficiency increase resulting from a merger would be synonymous with an increase in overall efficiency. 7Hence the role of market share not only serves as a basis for an efficiency explanation but also as a basis for a possible market power explanation. 8 As size of firm, level of market concentration, and explicit product differentiation are essentially all held constant, recent investigation has suggested that market share per se has to be considered a source of market power regardless of the level of concentration and that this kind of market power is distinct form the one usually associated with

6 Mueller, Dennis C., Profits in the Long Run, op. cit., 229, italics supplied; and cf. idem, United States' Antitrust: At the Crossroads, op. cit., 225, which emphasizes that "(f)irms with large market shares in differentiated product industries are more profitable presumably because they have higher quality products *or products which are perceived to be of higher quality* ... If one wants to describe the most profitable firm as being more efficient, they appear to be more efficient at differentiating their products through advertising or patentable product improvements.", italics supplied.

7 As a result, "Increased efficiency cannot necessarily be inferred from a presumed increase in profitability in the case of large firms. In such cases, profits may also be caused by market power. Such market power can in turn be regarded as almost a guarantee that the potential for efficiency and in particular innovation is not being exploited to the fullest and the the maximum welfare possible is not being achieved", Caspari, Manfred, Joint Ventures Under EEC Law and Policy, unpublished paper, presented at the Fordham Corporate Law Institute, **New** York, October 23, 1987, p. 8.

8 Cf., e.g., Pautler, A Review ... , supra, 611.

oligopolistic market structures. 9 The implications that can be drawn from these findings are that market share can be considered at least as important for the existence and exercise of market power as is the case with all the other elements of market structure and that Industries that may show competitive overall structure "may actually have a market power problem that is not apparent from overall industry performance". 10The results of these studies falsify the *Demsetz* hypothesis that profitability differences are an outflow of efficiency differentials, but do clearly Indicate that a unique kind of market power associated with market share is responsible for persistent above **average** profltability. 11

As has been empasized above, however, the monopoly problem or the problem of welfare losses due to monopoly and market power are assumed to play only a minor role in the U.S. 12

This seems to support the view that the supplier with a high market share Is profiting from lower costs as well as from higher prices; however, the customers do not gain necessarily from these increases in efficiency, and this contradicts the explicit goal of consumer welfare. 13 This makes It

9 This aspect of large market shares has strongly been emphasized particularly by Rhoades, Stephen A., Market Share as a Source of Market Power: Implications and Some Evidence, 37 JEB (1985), pp. 343-363, esp. 359; and Ibid., 347 and 350, which characterizes the underlying reasoning by asserting that there may be "product differentiation that Is unique to market leaders (in the buyer's perceptions) irrespective of specific product differentiation policies ... - giving market leaders an opportunity to sell their products at premium prices even if the quality of their products is identical to that of their competitors".

10 Rhoades, Market Share as a Source of Market Power ... , supra, 346.

11 Cf. again Rhoades, Market Share as a Source of Market Power ... , supra, 359 f., who concludes that "these findings, along with the work on strategic groups, raise the possibility that markets may generally be defined too broadly" and that "the antitrust authorities ... should devote **atten**tion to the market share of firms to be acquired, regardless of market concentration."

12 This view is based on the study of Harberger, Arnold C., Monopoly and Resource Allocation, 44 AER (1954), pp. 77-87. Losses of allocation would be more than compensated for by profits due to productive efficiency and, hence, would Increase 'consumer welfare'. This position has to be criticized since later studies have found higher welfare losses, as has been demonstrated supra; besides, the *Harberger* study on which the Chicago view is based has been criticized on many aspects, cf. Bobel, Wettbewerb und Industrlestruktur ... , op. cit., 179 ff. and 201 ff.

13 Cf. the legal wording of Art. 85 **para.** 3 Treaty of Rome where In the case of a rationalization cartel a fair share of the resulting benefits has to be passed on to consumers.

obvious that the efficiency differential explanation offered by *Demsetz* and others does not provide convincing evidence on "how one Is to distinguish those situations where scale economies only have efficiency effects, from those where the firms enjoying such economies realise entry into the Industry is difficult (for whatever reason) and thus set high prices". 14**A** major hint could be the extent to which market shares are necessary to exploit economies of scale. If it is assumed that beyond this point on a scale, additional efficiency gains, regardless of source, are non-existent or play a marginal role only, the corresponding market share could serve **as a** sort of borderline, indicating as it were the limits of a technical imperative. Beyond this point, undue market power could be assumed to **exist.**

The view that concentration is only caused by efficiency-differentials is consistent with the hypothesis that if the general conditions of production were characterized by economies of size and Increased Industry concentration with related efficiencies in an unlimited manner, welfare maximization resulting from the attainment of these economies, from the rate of technological progress, and from the availability of a superior management would require unlimited growth of slze. 15 A typical goal conflict as described above would arise since the attainment of all possible cost savings would result in a loss of effective competitive pressure within the particular market, which would otherwise tendentially hold down prices close to marginal costs. A trade-off between attainable efficiencies in the short-run and sufficient competitive pressure In the long-run would become necessary.18 In order to measure efficiency, an empirically observable relationship has to

be established between factors that determine the structure of an Industry

14 Cf. Clarke/Davies/Waterson, The Profitability-Concentration Relation: Market Power or Efficiency?, supra, 437; Herdzina, Klaus, Wettbewerbspolltlk, 2nd ed., Stuttgart 1987, p. 41. Fisher, Alan A., and Robert H. Lande, Efficiency Considerations in Merger Enforcement, 71 CLR (1983), pp. 1580- 1696, 1608: "After more than a decade of debate, neither side has proven its case, but the evidence tentatively suggests that both market-power and efficiency effects contribute to the overall relationship between concentration and profitability."

15 This postulate is the so-called traditional defense hypothesis and was first put forward by Schumpeter, Joseph H., Capitalism, Soclallsm and Democracy, New York 1942; and later by Galbraith, John K., American Capltallsm - The Concept of Countervailing Power, Boston 1952.

16 Cf. Groner, Helmut, Konzentration und Wettbewerbsordnung, 8 Jura (1986), pp. 520-527, 522; and Schmidt, Wettbewerbspolltik und Kartellrecht, op. cit., 84 ff. The adherents of the current tenet, perform this trade-off by means of the Williamson-model which we have treated supra.

and performance criteria such as profits, costs, or rate and extent of technological innovation. 17

# **2. The Range of Economies of Size as an Alternative Explana1Dry Approach**

Whether profitability can be viewed as an adequate indicator of the extent of productive efficiency is questionable, since the relative efficiency of a firm cannot only be evaluated merely on the basis of its profit rates. It is not only the latter which indicates whether the firm Is subject to sufficient competitive pressure, but also its relative success In the market, although, as we have emphasized, there are problems associated with this approach. 18 This market success may be evaluated on the basis of the so-called survivor test developed by *Stigler. 19*The standard of reference for the underlying cost situation Is the structure of an industry that for a longer period of time has not been subject to legal barriers to entry and, furthermore, has not changed its characteristics during that time period. 20 Thus, in determining the optimum firm size, the survivor technique proceeds to

"classify the firm in an industry by size, and calculate the share of industry output coming from each class over time. If the share of a given class falls, it is relatively inefficient, and in general Is more Inefficient the more rapidly the share falls",21

The other methods used are statistical cost analyses, engineering studies, and profitability studies. The question remains as to how valuable different

17 Cf. Bain, Industrial Organization, op. cit., 434 ff. Additional measures can only be determined vaguely, cf. ibid., 458 ff.

18 Cf. Bork, The Antitrust Paradox, op. cit., 104 f.

19 Originally the basis of the test was developed by John Stuart Mill, Principles of Political Economy, New York 1929, p. 134.

20 Cf. Demsetz, Harold, Economics as a Guide ... , supra, 375.; Scherer, Economies of Scale and Industrial Concentration, op. cit., 18; and for the deficiencies, Schmidt, Wettbewerbspolltik und Kartellrecht, op. cit., 91.

21 Stigler, The Organization of Industry, op. cit., 73; and for a critical assessment of the test, Bain, Joe S., Survival Ability as **a** Test of Efficiency, 59 AER (1969), pp. 99-104, and Shepherd, William G., What Does the Survivor Technique Show about Economies of Scale, 36 SEJ (1967), pp. 113-122. It has to be noted critically that the ability to survive not only depends on lntrafirm efficiencies, but also on other determinants, such as public policy intervention, economic influences due to foreign trade, economic boom or depression scenario, etc., Schmidt, Wettbewerbspolltl k und Kartell rec ht, op. cit., 91.

techniques are in the attempt to determine a minimum optimal scale22 and, furthermore, whether or not the choice of the measurement technique makes a difference in determining the extent of efficiencies that can be attained by rising industrial concentratlon.23

The most commonly used technique, and one that is considered at the same time to be the most appropriate one, is the engineering study, which tries to elaborate on the exact shape and properties of cost functions. This is done by the questioning of engineers specialized in the planning of new production facilities and currently or formerly employed by differently sized companies.24 If the use of statistical cost studies is commonly rejected25, the use of such engineering studies is also heavily disputed by some adherents of current theory: they have put forward a number of arguments against the applicability of such studies, the majority of which, however, can be rejected to a large extent. 211

Engineering studies are viewed as incomplete with regard to the full extent of efficiencies because "they can cover only technical processes, which leaves out ... product design; research; planning; administration; cost and

22 "Mlnlumum optimum scale is the smallest output per unit of time at which the plant or firm can realize the lowest-obtainable unit cost of production", Koch, Industrial Organization ... , op. cit., 127.

23 This also means efficiencies in addition to simple plant or firm economies. For detailed and critical surveys on the different measurement techniques, cf. McGee, Efficiency and Economies of Size, op. cit., 65-88; Monopolkommission, Hauptgutachten VI: Gesamtwirtschaftliche Chancen und Risi ken wachsender Unternehmensgrol3en, Baden-Baden 1986, paras. 600-604; Scherer, Industrial market structure ... , op. cit., 92-94; and Schmidt, Wettbewerbspolitlk und Kartellrecht, op. cit., 88-92.

24 "The persons or groups performing these functions accumulate much Information on alternative equipment and plant designs and the associated investment and operating costs", Scherer, Industrial market structure ... , op. cit., 94.

25 "Statistical cost studies utilize historical cost-output data to make inferences about economies of scale", Koch, Industrial Organization ... , op. cit., 128. The main problem of this technique seems to be the secrecy problem in data availability and the general Incomparability of interfirm cost data; it has to be rejected, therefore, cf. Monopolkommisslon, Hauptgutachten VI ... , op. cit., paras. 600 and 604; and Scherer, Industrial market structure ... , op. cit., 93. Profit studies are viewed as a complementary technique to engineering studies and/or survival tests.

26 Cf. most prominently, McGee, Efficiency and Economies of Size, op. cit., 68-80.

quality control; finance; marketing; and so on", 27These efficiencies should be considered as very insecure in nature, however. They vary considerably from case to case, they often resist proper measurement, where they do not, ambiguous results are often encountered. We are thus in an area of uncertainty. At the present, there is no evidence that the inclusion of further efficiencies enlarges the efficient size for the individual firm. 28

The alternative survivor test also shows weaknesses si gnlflcant enough to raise strong doubts about Its applicability:

239

27 McGee, Efficiency and Economies of Size, op. cit., 69; and Fisher/Lande, Efficiency Considerations in Merger Enforcement, supra, 1608: "In short, these studies inherently can focus only on part of what determines differential firm efficiency, and what the studies omit is frequently very important." For a general description of the insufficiencies and limitations of the scale economies analysis, cf. Gold, Bela, Changing Perspectives on Size, Scale, and Returns: An Interpretative Survey, 19 JEL (1981 ), pp. 5- 33.

perform an umbrella-pricing strategy on the grounds of mutual Interdependence within the nucleus, protecting those firms on the fringe of the oligopoly which are less efficient. 31

A sufficiently large number of competitors is necessary for an application of the technique. Small number studies (i.e., esp. oligopolies) result In confusing statements and often lead to the conclusion that quite different firm sizes are all seen to be optlmal. 32

Most of the empirical investigations that rely on the survivor technique reach conclusions almost identical with those of engineering estimates and cost studies. These results are that the minimum optimal size for firm or plant economies is usually a small fraction of total market demand, which seriously questions the role of economies in determining size and concentratlon.33

Contrary to the assertion of the efficiency-concentration adherents, the bulk of econometric studies of the post-war era34, which relate firm size to efficiency show that "scale economies were not so substantial that most indu-

32 Cf. Shepherd, What Does the Survivor Technique ... , supra.

31 "Conceivably, the competition referred to could involve the foreclosure of markets for outputs, monopolization of input markets, predatory pricing, and the like. Survival, then, might be an indicator of private efficiency but not of social efficiency", Koch, Industrial Organization ... , op. cit., 127, which is in accordance with our assumed cost-decreasing and priceraising effect of large market shares and the assertion that benefits not necessarily be passed on to consumers, due to barriers to entry and hence a lack of competitive pressure.

33 For a survey of the studies of *Bain, Haldi* and *Whitcomb, Pratten,* and *Scherer,* cf. McGee, Efficiency and Economies of Size, op. cit., 71-77. **Be**sides, this seems in accordance with the original tenet of the Chicago School, which holds that "full exploitation of available scale economies at both the plant and firm levels would ... result In small firms", Koch, Industrial Organization ... , op. cit., 123, citing Henry C. *Simons* and Frank H. *Knight.*

34 Although they assert that a high level of industry concentration is warranted by economies of large size, in many, if not most cases, it may not be possible to Identify or even quantify these economies. Therefore, adherents of current theory see It simply as a matter of **faith** that market structures that result from unrestrained competition are efficient market structures, cf. Singleton, Industrial Organization ... , op. cit., 44, citing *Demsetz.*

stries should be expected to be oligopolies" 35, regardless of what measurement technique was chosen in individual studies.

From a survey of the measurement of economies or dlseconomies of scale relying on engineering estimates, cost studies, and the survivor technique, and an inquiry into the main findings resulting from the studies it can be concluded that "(d)espite very different analytical approaches in the various studies, a general pattern seems to emerge from a very large number of studies; beyond a certain point, average costs do not vary substantially over wide ranges of plant sizes". 311 Moreover, the cost gradients which are responsible for the steepness of the individual cost curve, are generally low so that the cost disadvantage of firms that work at suboptimal plant levels are comparatively small and can easily be compensated or even more than compensated for by sufficient competitive pressure, disciplining costs, and the holding down of prices to marginal costs. Using a range from 4 to 14 percent for the alleged critical market share, after which no significant scale economies are likely to be attained, it is estimated that the true cost effect that results from a reduction of excess market share varies between 5 and 20 percent of additional monopoly profits achieved in the case of excess market share.37

35 Pautler, A Review ... , supra, 611; Shepherd, The Treatment of Market Power, op. cit., 119, who notes "that scale economies explain only a relatively small portion of the major dominant-firm positions". Cf. also Scherer, Industrial market structure •.. , op. cit., 94, who states that "with few exceptions, the minimum optimal plant scale revealed in studies of American manufacturing industries has been small relative to industry size." Idem, p. 95: "We conclude then that economies of scale at the plant level do not in the vast majority of instances necessitate high national concentration levels for U.S. manufacturing industries."

With regard to the underlying cost function, *Shepherd* reaches the conclusion, therefore that "(t)he typical 'industry' cost curve for the firm is dishshaped, with MES at 5 percent of the market or less. The constant-cost range may be wide, though presumably average cost rises eventually ... ". 311

Empirical evidence on this was strongly affirmed by some early Hearings of the U.S. Senate from 1964 to 1969 in which the economic and soclopolitical consequences of increased concentration in the economy were scrutinized. Essentially, these Hearings provided the following results:39

Probably the most recent study within the tradition of engineering studies which tries to elaborate on the interdependence of economies of scale and concentration Is the one performed by the German Monopolies Commission (MC) in Its Sixth Main Report. 41In its report the MC tested the significance of economies of scale in 18 branches of the German economy. The relation between the planned size of a plant and the average cost of production is

38 Shepherd, The Economics of Industrial Organization, op. cit., 206.

39 Cf. Economic Concentration: Hearings before the Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, United States Senate, Washington, D.C. 1964-1969, Parts 1-8a. An extensive evaluation of these Hearings may be found In Petry, Horst, Technischer Fortschritt, Integration, internationale Wettbewerbsfahlgkelt und Unternehmensgrof3e, 183 JNSt (1969), pp. 271-299.

40 This may be different In the case of relatively small national markets. However, economies of scale that bulk large relative to any national market, and would therefore lead inevitably to highly concentrated industries at the national level, may be smaller relative to the EEC market as a whole. Thus, the creation of the Common Market may serve as an antitrust policy, curbing what would otherwise be problematic levels of monopoly power In some national markets, cf. Krugman, Paul, whose study is part of the report "Efficiency, Stability and Equity: A Strategy for the Evolution of the Economic System of the European Community", Brussels, 1987.

41 Cf. Monopolkommission, Hauptgutachten VI ... , op. cit.

portrayed by what is called the 'long-range planning curve'. This planning curve comprises technical economies only and not pecuniary economies. 42 In all of the branches analyzed, the MC finds the minimum efficient size to become enlarged over time. Specialization as well as automatization advantages are the primary cause for this development, which seems to provide certain evidence for the size/concentration argument. However, industry concentration in a number of economic branches Is significantly higher than required by economies of scale. In the majority of the branches presented, industry concentration is lower than the full exploitation of technical economies would require them to be. 43

The importance of economies of scale may increase In the presence of a number of conditions which can be listed as follows: 44

In a number of economic branches the si gnlficance of economies of scale is diminished, however. Technical economies may lose some of their significance primarily due to a high proportion of transportation costs in relation to total costs, which do not allow significant economies to be realized. Other factors are fluctuating or stagnating market demand, making the exploitation

42 Cf. Monopolkommisslon, Hauptgutachten VI ... , op. cit., para. 593. The efficiency advantages are seen to be rooted in specialization advantages, physical laws (so-called 0.6 rule), economies of massed reserves, management capabilities and further residual efficiencies, cf. ibid., paras. 594- 599; and Shepherd, The Economics of Industrial Organization, op. cit., 170-172.

43 Cf. Monopolkommission, Hauptgutachten VI ... , op. cit., tabs. 40 and 41 at pp. 263 f.; and for a synopsis, Schmidt, Wettbewerbspolitik und Kartellrecht, op. cit., 90.

44 Cf. Monopolkommission, Hauptgutachten VI ... , op. cit., paras. 605-609.

of economies impossible, and changes In minimum efficient sizes as a result of frequent changes in make-or-buy decisions. 45

Summarizing these results, the proposition can be put forward that it is not advisable to yield all of the technical economies since the production flexibility which can be an Important management parameter is restricted In this case. Even in the cases In which larger minimum efficient sizes should be attained, this cannot solely be attributed to technical economies. It is additional research and development efficiencies as well as product differentiation advantages that underly present observable concentration tenden**cles.48**

The degree of efficiency gains from cost savings may be consistently overstated for two reasons: 47

If It is assumed - as is done by the current tenet - that meaningful barriers to potential competition do not exist, the latter argument seems crucial for critics of the Chicago School. As has been noted supra, economies of large scale production and product differentiation advantages of established over potential entrant firms have a dual character and can be regarded as efficiency advantages or (so-called) natural barriers to entry. According to *Bork* such natural barriers exist,

**45** Cf. Monopolkommission, Hauptgutachten VI ... , op. cit., paras. 750-755.

**46** Cf. Monopolkommission, Hauptgutachten VI ... , op. cit., para. 755. These economies are difficult to operationalize, however, and hence difficult to take Into consideration. Furthermore, it is unclear whether these additional efficiencies show up in general and are significant, cf. Schmidt, Wettbewerbspoliti k und Kartellrecht, op. cit., 104 f. It is furthermore open to question whether external growth via mergers is necessary to attain these efficiencies.

47 Cf. Shepherd, The Economics of Industrial Organization, op. cit., 195.

"(w)hen existing firms are efficient and possess valuable plants, equipment, knowledge, skill, and reputation. (Therefore,) potential entrants will find it correspondingly more difficult to enter the industry, since they must acquire those things".48

The ambiguous character of such barriers becomes obvious once again because they can be seen to impede sufficient competitive pressure, whereas they may present efficiencies at the same time.

Whereas the considerations above emphasized the extent of economies In a given state of technology, the additional question has to be raised as to what extent technological progress increases economies In research and development and hence makes corporate mergers and Internal growth in size unavoidable.49

Basically, economic and financial potentials of large sized companies enable them to respond to product differentiation strategies and competition for Innovations in a more appropriate way than rather small firms because of the amount of capital required. There is strong empirical evidence, however, that the ability to innovate is not necessarily associated with the willingness to innovate.so With regard to the basic Invention leading to the innovation, there is no empirical evidence whatsoever that the efficiency-causes-size or concentration hypothesis is deterministic In nature.51 The aforementioned U.S. Hearings came to the conclusion that the attainment of R&D efficiencies cannot necessarily be derived from mergers and internal growth. The reasoning that large sized companies are of extraordinary importance for the general rate of technological progress and economic development may be verified or falsified according to the individual Industry analyzed and this

48 Bork, The Antitrust Paradox, op. cit., 31 0 f. This explanation for the assertion that persistent competitive pressure might not become real competitive pressure is based on the fact that most of the newcomers are not able to survive after entry since they are less efficient than established firms. This has been established by simple observation of non-entry over a longer period of time, cf. Posner, The Chicago School of Antitrust Analysis, supra, 945.

49 This postulate is called the new defense hypothesis, cf. Schmidt, Wettbewerbspollti k und Kartellrecht, op. cit., 84.

50 Cf. Petry, Technlscher Fortschritt, ... , supra, 282 f.

51 For a variety of examples and additional empirical studies, cf. Schmidt, Wettbewerbspoliti k und Kartell rec ht, op. cit., 97-101.

evaluation may change over a period of time. Hence, economies of R&D cannot justify size and concentration in every single case. 52

Empirical evidence suggests that capacity expansions either by internal or by external corporate growth cannot be performed In an unlimited manner without changing the technical characteristics of the cost function, such as the cost gradient and the total level. Starting from a specified quantity of output, total average cost may increase, causing dlseconomies of scale. 53 Further complications with regard to the evaluation of the benefits and nontechnical efficiencies associated with economies from rising industry concentration arise from the fact that increased concentration is associated with a decrease In competitive pressure due to managerial slack, communication, and control problems, etc. 54Especially at high levels of concentration, the likelihood of higher costs increases because of the occurrence of such X-lnefficiencies that would outweigh economies of scale. Originally, It was argued in this context that the efficiency-losses due to monopolies were underestimated by traditional microeconomic methodology. It was *Leibenstein* who pointed out that a decline of competitive pressure means additional non-allocative efficiency-losses, which have their source in motivation problems and divergent goals among managers, owners, and employees of a firm. The assumption of average cost minimization as the firm's only goal is not tenable under these circumstances. 55*Leibenstein's* approach is crucially important for the assessment of productive efficiency, which is mainly determined by economies of scale and transaction-cost efficiencies. Whereas the current theoretical tenet holds that even at high levels of concentration decreasing costs are attainable by economies of scale or related efficiencies, the results of

52 Cf. Petry, Technischer Fortschritt, .•• , supra, 286.

53 Cf. Herdzina, Wettbewerbspolitl k, op. cit., 41.

54 Cf. our considerations on the WIiiiamson trade-off in this contribution. Cf. as well Lande, Robert H., Wealth Transfers as the Original and Primary Concern of Antitrust: The Efficiency Interpretation Challenged, 34 HastLJ (1982), pp. 67-151, 79: "(S)ome evidence suggests that the existence of monopolies might curtail overall research and Innovation or lead to other undesirable economic consequences."

55 Cf. Leibenstein, Harvey, Allocative Efficiency vs. "X-Efflclency", 35 AER 1966, pp. 392 - 407. Cf. as well *Shepherd* who states that "presumably average cost rises eventually because of (1) bureaucracy, from absolute size, and/or (2) x-inefficiency caused by the firm's market power. The constant costs may also mask a significant amount of pecuniary economies, the typical cost curve may slope upward instead of being flat", Shepherd, The Economics of Industrial Organization, op. cit., 206.

efficiency considerations may become quite different if *Leibenstein's* approach is taken Into account, since we have to consider a possible trade-off between a positive effect on economies of scale and a detrimental one on Xi nefficlencles. 59

These reflections have shown that size and (external) concentration as independent variables and efficiency as the dependent variable may increase in the same direction up to a certain level. From an overall economic point of view, however, X-inefficiencies and diseconomles of scale may contribute to a misallocation of economic resources after this level is surpassed. External concentration, therefore, Is not necessary to achieve efficiencies in every individual case. From an efficiency viewpoint the market solution may be superior in these cases.

Unless non-technical efficiencies - which will be treated infra - change these findings significantly, we are able to make the assertion that economies of scale may not be attained In an unlimited manner In the sense that these economies would require the firms to strive for large market shares. Although the points beyond which economies will not occur substantially (minimum efficient size) are a priori indeterminate for the general case, since they vary from industry to Industry, the aforementioned provides evidence that supracompetitive profitability beyond these thresholds is tendentially a result rather of market power than of efficiency. Increased likelihood of an occurrence of X-inefflciencies as concentration rises, tends to support this assertion, and hence tends to provide a theoretical basis for the rejection of the efficiency differential-hypothesis.

56 For an extensive survey on these counteracting effects, cf. Schmidt, Wettbewerbspolitik und Kartellrecht, op. cit., 92. With regard to the actual trade-off, *Scherer* comes to the conclusion that "(t)he evidence is fragmentary, but it is persuasive. 'X-inefflciency' exists, and it Is more apt to be reduced when competitive pressures are strong than when firms enjoy insulated market positions. What we do not know is how large are the differences systematically correlated with monopoly power. That X-lnefficiencies attributable to monopoly are at least as large as the welfare losses from resource misallocation seems eminently plausible. And they may well be considerably larger", Scherer, Industrial market structure ... , op. cit., 446.

# **3. The Evidence of Efficiency on the Basis of Merger Performance**

We have found no explicit definition of the efficiency criterion within the current theoretical approach, 57and even *Bork* had to concede58 that efficiency cannot be measured and that substitutes have to be used in order to evaluate whether increases in efficiency have occured. The question of how efficiency should actually be measured remains unanswered also because efficiencies are presumed to encompass much more than just technical economies. The assertion by advocates of the current tenet that efficiency can only be roughly estimated, leaves room for all kinds of subjective judgments.

The question remains, as to whether efficiencies beyond the technical ones can be measured at all. This makes necessary a method of determining these efficiencies. The most common attempt has been to cover additional efficiencies via an analysis of the effects of mergers. The results of these studies have been ambiguous and have shown that mergers do not always increase efficiency .59

Instead of efficiency, improved performance may represent redlstrl butlve gains without real efficiency advantages in terms of resource savings, resulting from factors such as from sources of tax avoidance, good bargaining due to imperfect or lopsided information, and market power gains. 110

With regard to studies based on accounting data, stock market data and changes in resulting market shares of the merging firms, the outcomes of the merger studies performed can be summarized as follows:81

57 Cf. Scherer, Separating Wheat from Chaff ... , supra, 995 f.

are;

This may finally lead us to the conclusion that aside from observed returns to stockholders of acquired firms there is no empirical evidence for the hypothesis that mergers generally improve the efficiency of the combined

64 Cf. e.g., Scherer, On the Current State ..• , op. cit.; recently also, Ravenscraft, David J., and Frederic **M.** Scherer, Mergers, Sell-Offs, and Economic Efficiency, Washington, D.C. 1987; and Green, Industrial Organization ... , supra, 496, who summarize the findings In the assertion that "if one examines the post-merger history of many merger partners, one often finds divestiture, sell-offs, abandonments and other signs of failure."

62 It Is considered a flaw In the assumptions about the effects of mergers that gains to stockholders are considered to be pure efficiency gains, as noted above.

63 Cf. e.g., Mueller, Dennis C., Mergers and Market Shares, 67 RES (1985), pp. 259-267, who reports a significant decline in the after merger combined shares for a sample of 210 acquisitions. From a logical point of **view** and following the reasoning of the current tenet, the combined share should have been Increased as a result of superior efficiency in comparison to competitors. This does not seem to be the case, however. Furthermore, "although firms with large market shares obtained primarily through internal growth tend to be more efficient than average, firms merging to achieve the same shares would not necessarily obtain comparable efficiencies", Fisher/Lande, Efficiency Considerations in Merger Enforcement, supra, 1609.

firms in terms of resources used.85 This may be so in individual cases, however.

# IV. **eoncludlng Remarks**

In **Part** 3 of the contribution we basically confirmed the validity of the traditional approach underlying public policy towards horizontal mergers (concentration-collusion doctrine), although a variety of refinements were found to be important. Strong evidence was found that performance criteria as used in the empirical studies on the concentration-collusion doctrine serve as indications of market power. However, some problems remained in attempting to measure market power by means of profitability. Most importantly, economic returns and other performance measures were found most likely to measure both efficiency and market power effects at the same time, the two sets of factors being hard to disentangle from each other properly.

By comparison, the alternative measurement technique provided by deadweight loss, which has already been presented, neglects power considerations to a large extent and is characterized by practical difficulties. The qualifications necessary to make use of the approach make the model lose its analytical clarity and applicability. Furthermore, the dead-weight loss is severely handicapped by the fact that It is static as a rule and strictly efficiency-oriented, whereas we prefer a multiple-goal approach. The measure is not able to offer a basis for generalization and it cannot serve as a broad-based concept for the purpose of empirical proof.

The traditional studies based on various performance criteria were found to have a variety of insufficiencies and shortcomings; these, however, do not call Into question empirical attempts to test different hypotheses. The findings on the robustness of such studies with regard to changes in the per-

65 The empirical "experience Is difficult to reconcile with the conjecture that mergers turned out on average to be profit-increasing and efficiency-enhancing", Ravenscraft, David J., and Frederic M. Scherer, The Profitability of Mergers, discussion paper, presented at the Third Meeting on Industrial Economics at the International Institute of Management, Ber Ii n 1986, p. 34. For a recent confirmation cf. idem, Life After Takeover, 36 JIE (1987), pp. 147-155, 155, who state again that "the hypothesis that tender offer takeovers are on average efficiency-increasing warrants much more skepticism than it has received thus far in the literatures of economics, corporate finance, and securities law".

formance measure provide evidence for the validity of the traditional studies. Data aggregation biases used to pose the most serious problems for these empirical studies. Due to Improved data bases, however, these difficulties have largely been circumvented.

The test of the rival hypotheses has shown that neither the concentrationcollusion doctrine nor the new learning hypothesis have made obvious to what extent horizontal industry concentration and the resulting economic performance are based on efficiency and to what extent they are due to market power. Also they have not shown whether industry concentration reflects market power consequences at the same time and hence serves as a basis for an extensive use of that power as a result.

(Relative) market share has been found to enable an Incumbent to increase efficiency but also to take advantage of monopolistic discretion by charging higher prices; however, due to a possible lack of competitive pressure, it Is not guaranteed that the efficiency gains will also be passed on to consumers. Hence the role of market shares not only serves as a basis for an efficiency explanation but also as a basis for a possible market power explanation. The efficiency-differential hypothesis is defective in that efficiency would imply higher profits, but higher profits do not necessarily imply efficiency.

Market share rather than concentration was found to be the crucial structural element. The supplier with a high market share may be profiting from lower costs as well as from higher prices; however, the customers do not necessarily gain from these increases in efficiency, a fact which contradicts the goal of consumer welfare that is explicitly appealed to by the adherents of current theory. With regard to technical economies, this makes it obvious that the efficiency differential explanation offered by the new learning hypothesis does not find convincing evidence on how one is to distinguish those situations where scale economies only have efficiency effects, from those where the firms enjoying such economies realize that entry into the industry is difficult and thus set high prices.

Furthermore, additional shortcomings invalidated the contents of the efficiency-causes-concentration explanation:

Technical economies as well as non-technical efficiencies were found to explain existing industry concentration only to a limited extent. This result can be considered a prima facie proof that beyond a relatively low threshold level undue market power may be assumed to emerge. At the same time,

firms with non-scale superiorities may increase their share of the market without external corporate growth. The attempt to grow primarily via external growth can also be seen to be in accordance with the assertion that efficiency is not the only motivation of corporate executives (e.g., empire building).

In the case of mergers, increased performance may represent redistributive gains without real efficiency advantages in terms of resource savings. Aside from observed returns to stockholders of acquired firms, there is no empirical evidence for the hypothesis that mergers generally improve the efficiency of the combined firms in terms of resources used.

## **fllC1..J; Vertical Mergers: Antlcanpetltlve Effects and the Attainment of Efficiencies**

Unlike In the case of policy concerning horizontal mergers, there is no consistent economic approach underlying policy on vertical mergers. For vertical Integration as such, no theoretical basis exists which Is comparable to the concentration collusion-doctrine In horizontal merger cases. 1 Thus far, antitrust policy has been concerned primarily with the tendency of vertical integration In general and vertical mergers In particular to generate anticompetitive effects by the "establishment of relationships between buyers and sellers which deprive their rivals of a fair opportunity to compete".2 Under the 1968 Merger Guidelines the U.S. Department of Justice challenged cases In which the upstream firm held 10% or more of its market and the downstream firm 6% or more and a foreclosure of roughly 10% of customers or sources of supply.3

Recent research has focused on comparisons of the costs arising from the use of different mechanisms for the mediation of economic activities and has emphasized possible economic advantages of contractual ties which lead to cost savings in comparison to other linkages.4 This has led to a strong notion among economists that vertical arrangements in general and vertical mergers in particular are efficiency-enhancing, carry little or no anticompe-

tltlve effects and, therefore, should not be considered (per se) illegal.5 The possible occurrence of both desirable efficiency effects as well as undesirable anticompetitive effects makes necessary an economic trade-off between these two effects.8

With regard to the evaluation of vertical mergers, three important Questions thus arise, which we will try to answer In the subsequent course of the inquiry. In this context, we have to determine

# I. **Yertlco! Integration and Efflclencv-Enhancement**

Under the conventional microeconomic assumption of zero costs of operating competitive markets, vertical integration, and hence the existence of Intracompany coordination of economic activities, poses an anomaly since there is no Incentive to Integrate under competitive conditlons.7 Cost savings due to technological linkage In the production process constituted the principal exception to this view. The underlying reasoning Is that '"successive processes which, naturally, follow Immediately In time and place dictate certain efficient manufacturing configurations; these, in turn, are believed to have common ownership lmpllcatlons'"9, and hence pose an incentive to Integrate.

5 Cf., e.g., Areeda, Phllllp, and Donald F. Turner, Antitrust Law: An Analysis of Antitrust Principles, vol. 3, Boston, Toronto 1978, § 726b; Posner, Richard A., The Chicago School of Antitrust Analysis, 127 UPLR (1979), pp. 925-952, 937 f.; WIiiiamson, Oliver E., Assessing Vertical Market Restrictions: Antitrust Ramifications of the Transaction Cost Approach, 127 UPLR (1979), pp. 953-993, 992 f., although not considered Chicagoan.

6 Cf., e.g., Areeda/Turner, Antitrust Law ... , vol. 4, op. cit., § 1000a. As has already been emphasized, this is a general problem in economics, cf. again Herdzina, Klaus, Wettbewerbspolltik, 2nd ed., Stuttgart 1987, pp. 35 ff.

7 Cf. Williamson, Oliver E., The Vertical Integration of Production: Market Failure Considerations, 61 AER (1971), pp. 112-123, 112.

8 Williamson, Oliver E., Markets and Hierarchies: Analysis and Antitrust Implications, **New** York 1975, p. 83; and cf. Bain, Joe S., Industrial Organization, 2nd ed., New York et al. 1968, p. 381; and Hovenkamp, Herbert, Economics and Federal Antitrust Law, St. Paul, Minn. 1985, p. 193.

Nevertheless, this approach was not seen to suffice in explaining why economic entitles would integrate some of the market activities. Disagreeing with the technological Interdependencies approach, *Coase* stated that it was due to "costs of using the price mechanism"9 that economic entities had an Incentive to Integrate some of the market activities to be carried out at lower costs by a joint organization.

### **1. Transaction costs and Different Mechanisms for the Organization of Economic Exchange**

# **a. Economic Exchange via Markets: costs of Using the Price Mechanism**

The vertical component of productive efficiency Is associated with the transaction-cost advantages that are generated from vertical Integration. The coordination of economic activities and the allocation of economic resources can be carried out by different mechanisms. According to the profit maximization principle advocated by adherents of the current tenet, the firm will choose the most **advantageous** mechanism. 10If the coordination is carried out by using the market mechanism, transaction-costs arise since the use of price **as an** Instrument of coordination Is assumed to entail costs. According to the original approach presented by *Coase,* transaction-costs consist of several components: 11

9 Coase, Ronald, The Nature of the Firm, 4 Economica (1937), pp. 386-405, 386. Cf. as well Robins, James A., Organizational Economics: Notes on the Use of Transaction-Cost Theory in the Study of Organizations, 32 ASQ (1987), pp. 68-86, 69: "In basic terms, transaction costs are those costs associated with an economic exchange that vary Independent of the competitive market price of the goods or services exchanged."

10 For a detailed survey on these different mechanisms of coordination cf. Ouchi, WIiiiam G., Markets, Bureaucracies, and Clans, 25 ASQ (1980), pp. 129-141; for the basic work on different mechanisms of economic coordination, cf. Coase, The Nature of the Firm, supra; and Ibid., 386: "The operation of a market costs something and by forming an organisation and allowing some authority ('an entrepreneur') to direct the resources certain marketing costs are saved."

11 Cf., e.g., Bossmann, Eva, Weshalb glbt es Unternehmungen?: Der Erklarungsansatz von Ronald H. Coase, 137 JITE (1981), pp. 667-673, 668 f.; Kaserman, Theories of Vertical Integration ••• , supra, 485; and Schmidt, Ingo, Wettbewerbspolltlk und Kartellrecht: Eine Elnf0hrung, 2nd ed., Stuttgart 1987, p. 94.

The original approach was extended mainly by Oliver E. *Williamson* who attempted to provide a coherent framework for inquiring into the determinants of vertical integration in different industries. 12 The reasoning underlying this approach Is that the achievement of transaction-cost advantages regarding the elimination of monopoly distortions, technical complementarlties, supply reliability, and economies in the acquisition of information are the essential reasons for vertical integration. ,a The causes of Inability of the market to perform its functions under certain circumstances, leading to the aforementioned outcomes, are presented by the so-called **organlzatlonal failures framework** provided by *Williamson.* Essentially, three conditions are responsible for incentives to integrate: 14

12 Cf. Williamson, Markets and Hierarchies ... , op. cit.; Idem, Transaction-Cost Economics: The Governance of Contractual Relations, 22 JLE (1979), pp. 233-261; and idem, The Vertical Integration of Production ... , supra.

13 Cf. Levy, David T., The Transaction Cost Approach to Vertical Integration: An Empirical Examination, 67 RES (1985), pp. 438-445, 438.

attractive in cases of **small-numbers bargaining** or in case of **uncertainty**  about the final results of the contract. 16

Conditions of **Information lmpactadness** which arise, "when true underlying circumstances relevant to the transaction, or related set of transactions, are known to one or more parties but cannot be costlessly discerned by or displayed for others".17

Since the operationalization and determination of costs arising from transactions seems an unsolvable problem, an attempt has been made to list transaction specific market characteristics as criteria for the determination of the extent of vertical integration. According to *Richardson,* the form of exchange depends on the transaction to be carried out. 18 If the economic activities to be performed are complementary and similar in their nature, a pooling of the activities into a corporation seems advisable.

Comparable but advanced criteria were set up by *Williamson* who extricated three different characteristics for the determination of integrative cases: 19

The pattern set according to the first two criteria can be summarized In the following synopsis:

16 Cf. Kaserman, Theories of Vertical Integration .•. , supra, 487; and as well Goffman, I., Strategic Interaction, Philadelphia 1969, p. 105.

17 WIiiiamson, Markets and Hierarchies ... , op. cit., 31.

18 Cf. Richardson, G.B., The Organisation of Industry, 82 EJ (1972), pp. 888 f.

19 Cf. Williamson, Oliver E., Economic Organisation: Firms, Markets and Polley Control, Brighton, Sussex 1986, pp. 105-118; and idem, On the Nature of the Firm: Some Recent Developments, 137 JITE (1981), pp. 675-680, 676.

*l.iL..1.;* Means of Governance **as a** Result of **Invest**•**ent** Characteristics and Transaction Frequency

*Source1* Williamson, Oliver E., Econo•ic Organisation: **Fir**•**s,** Markets and Policy Control, Brighton, Sussei 1986, p. 117.

## **b. Economic Exchange via Organizations: Costs of Using Internal Organization**

However, in contrast to the aforementioned costs of using the price mechanism In markets, there has to be some explanation as to explain why economic transactions are not performed by firm organizations altogether. Due to costs associated with the exercise of the internal entrepreneurial function, vertical Integration leads to costs resulting from the Internal organizing of economic transactlons:20

"Under certain conditions, markets are more efficient because they can mediate without paying the costs of managers, accountants, or personnel departments. Under other conditions, however, a market mechanism becomes so cumbersome that It Is less efficient than a bureaucracy."

These costs associated with the use of the Internal entrepreneurial function comprise primarily the following components:21

20 Ouchi, Markets, Bureaucracies, and Clans, supra, 129 et seq.

21 Cf. Coase, The Nature of the Firm, supra; Kaserman, Theories of Vertical Integration .•. , supra, 486; Schmidt, Wettbewerbspolitik und Kartellrecht, op. cit., 95; and WIiiiamson, Markets and Hierarchies ... , op. cit., 117-131.

Often the defects associated with market exchanges have to surmount a nontrivial threshold until internal organization offers clear cut efficiency advantages.22 It Is the primary task of antitrust theory to provide evidence on the level of that threshold in order to perform a possible efficiency trade-off.

#### **2. Efficiency-Enhancement as the Underlylng Reasoning for Vertlcal Integration**

According to current theory, vertical strategies in general and vertical mergers In particular, are advantageous for the economic agents performing the integration since the anticipated costs of organization are lower than the transaction-costs that arise through use of the price mechanism. It has been asserted that vertical market restrictions should be assumed to enhance efficiency per se. There Is virtually no "reason to assume that a vertical merger which lowers costs and prices, thus benefittlng consumers, is 'unfair' to rivals In any reasonable antitrust sense of that term". 23

According to the assertion that efficiency-enhancement Is the primary goal of competitors, the best strategy for the firm is to compare market transaction and internal organization costs and to merge vertically only to the extent that transaction-costs are equal to the costs of organizing. Each of the separate stages of the production and distribution process is autonomous, and In principle market contracts could be used to bring economic activity at successive stages into adjustment. The limits of vertical integration, however, are found In that the successive Interfaces are organized

22 Cf. Williamson, Markets and Hierarchies ... , op. cit., 130.

23 Areeda/Turner, Antitrust Law ••. , vol. 4, op. cit., § 1002. This has been emphasized strongly with regard to the Brown Shoe decision, cf. Bork, Robert H., and Ward S. Bowman, The Crisis in Antitrust, 65 CLR (1965), pp. 363-376, 372: "The Brown Shoe case employed the theory of exclusionary practices to outlaw vertical Integration that promised lower prices, ... , and the theory of 'social purpose' to justify the fact that the decision prevented the realization of efficiencies by a merger, which, realistically viewed, did not even remotely threaten competition."

In a way that economizes on transaction costs. 24Thus, the optimal degree of vertical Integration is discovered by an optimization calculus, based on the principles that

"a firm will tend to expand until the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising In another firm".25

The reasoning underlying the assertion of efficiency-enhancement as the sole purpose of business conduct Is identical to that underlying the **eva**luation of other vertical strategies, as is the case with tying arrangements.215

The crucial question that remains Is whether efficiency really represents the sole motivation for vertical integration or whether vertical integration is also performed because vertical mergers can be a source and carrier of market power.27 If this were the case, the aforementioned optimization calculus would lose its explanatory power with regard to the transaction mechanism chosen. Even if the costs of an economic transaction by the market were lower than the intra-corporate coordination costs for an economic transaction, there would remain a motivation to merge until the excess profits from a monopoly or limit price strategy equalled the total cost difference resulting from the two transaction mechanisms. 28 This in fact entails the

24 Cf. Williamson, Assessing Vertical Market Restrictions ... , supra, 958 f. Furthermore, there are limitations to an Internalization of economic transactions (e.g., organizational span of control) which are widely accepted, cf. Blair, Roger D., and David L. Kaserman, Law and Economics of Vertical Integration and Control, New York 1983, p. 25.

25 coase, The Nature of the Firm, supra, 396.

26 Cf. Posner, The Chicago School .•• , supra, 936. For a thorough and critical analysis of the current tenet, cf. Schmidt, Ingo, and Jan B. Rittaler, Die Chicago School of Antitrust Analysis: Wettbewerbstheoretische und -politische Analyse eines Credos, Baden-Baden 1986, pp. 84-86.

27 Cf. Bain, Industrial Organization, op. cit., 178 f., who denotes that mergers even happen in cases where cost savings are not attainable; and Kaysen, Carl, and Donald F. Turner, Antitrust Polley: An Economic and Legal Analysis, 3rd print., Cambridge 1971, p. 120. Furthermore, it is asserted that efficiency-enhancement used to be the primary intention of economic agents at the turn of the century when the exploitation of mass economies in production and distribution was started, cf. Chandler jr., Alfred D., The Visible Hand: The Managerial Revolution in American Business, 5th print., Cambridge, Mass. 1980, pp. 337-339.

28 Cf. Dirrhelmer, Manfred J., Karin Wagner and Thomas Hubner, Vertikale Integration In der Mlneralol- und chemischen Industrie, Meisenheim am Gian 1981, p. 14.

consideration of time-lags in market adjustment processes and a questioning of the presumption of a market mechanism which works frictionlessly.

## **3. Efficiency Gains vs. Anticompetitive Consequences: Necessity for a Trade-Off?**

Current theory presupposes on the one hand that efficiency-enhancement is the competitor's only goal and on the other that consumer welfare via an increase in business efficiency is the legislator's only intent. If both of the presumptions are called into question, it becomes obvious that a possible trade-off in terms of conflicting goals may involve a positive level (efficiency-enhancement vs. anticompetitive consequences) and a normative one (consumer welfare vs. other public goals), the treatment of which has to be carried out separately.

Regardless of the likelihood and force of anticompetitive consequences, not only the achievement of efficiencies has to be demonstrated but it has to be shown that competition is not significantly Impaired by vertical integration (e.g., ease of entry, low minimum efficient scale at the foreclosing level ). 29 The achievement of efficiencies has to be demonstrated because we may not presume a priori that efficiency-enhancement is the only objective of an economic agent, at least not in the sense of overall economic efficiency that translates on a one-to-one basis into consumer welfare. 30 Furthermore, consumer welfare in the definition of current theory does not equal economic welfare, as the term is used by independent scholars for the evaluation of vertical integration. Thus, we have to modify considerably the unrealistic qualifications of current theory, i.e. bear in mind that real world markets do not work in a frictionless way, barriers to competition exist and are often significant; and that a comparison of organization costs with transaction costs of the market Is often unfeasible.

Furthermore, Internal vertical growth is often considered superior in terms of efficiency achievement; this becomes even more important in the sense

29 Cf. Sullivan, Handbook of the Law of Antitrust, op. cit., 668.

30 At the same time, welfare effects of vertical integration are not determinable in an unambiguous manner. They have to be evaluated according to particular features of the actual market situation, cf. Blair/Kaserman, Law and Economics of Vertical Integration and Control, op. cit., 82; and Warren-Boulton, Frederick, Vertical Control of Markets: Business and Labor Practices, Cambridge, Mass. 1978, p. 109.

that internal growth is one principal way of expanding business action legally:31

"When a corporation chooses to grow by building it expects to face tests in the market for the product over the years required to establish and develop a new operation. It must fight its way in, that is, compete to succeed, and not buy its way In. I consider this a far better market test ... than the 'market test' involved in a merger for the market for firms is highly imperfect ... "

On a normative level, public goals other than just consumer welfare have to be taken into account. 32 This has to be considered a legitimate concern because the Incipiency doctrine still considered valid by the courts must be viewed as a result of the legislator's willingness to maintain unconcentrated structures and eventually sacrifice efficiencies in order to maintain competition. This was demonstrated supra and applies to vertical integration Just as well. Currently this is expressed by presumptive rules of illegality of vertical mergers. 33

A trade-off is certainly needed for the determination of the counteracting effects of vertical Integration or vertical mergers in particular. However, it has to be performed on a positive as well as on a normative level of analysis, including a critical appraisal of the shortcomings of current theory on a positive level and the intentions of legislation on the normative one.

31 Heflebower, Richard B., Comments on the F.T.C. Staff Document: Economic Report on Mergers and Vertical Integration in the Cement Industry, **Was**hington D.C. 1966, quoted from Mueller, Willard, Public Policy Toward Vertical Mergers, in: Weston, Fred, and Sam Peltzmann (eds.), Public Polley Toward Mergers, Pacific Palisades, Cal. 1969, pp. 150-166, 165 f.; cf. as well Areeda/Turner, Antitrust Law ... , vol. 3, op. cit., § 727d,e and idem, Antitrust Law ... , vol. 4, op. cit., § 1000c, who note that this may eventually lead to a resource waste.

32 This dictinction between a normative and a positive view is emphasized in that "(a)lternative views of the objectives of public policy **can have a**  considerable effect on the determination of general policy guidelines and on the degree of preference for an active interventionist policy approach. Differing conclusions can also result, however, from different assumptions or beliefs on questions of fact", cf. Warren-Boulton, Vertical Control of Markets ... , op. cit., 165.

33 Cf. Areeda/Turner, Antitrust Law •.• , vol. 4, op. cit., § 1011a; and Sullivan, Handbook of the Law of Antitrust, op. cit., 664, who mentions a market share of 15% and a market share foreclosed on either level of roughly 10-12%.

# II. **Emolclcol Evidence on the Extent** *at* **Yertlcol Integratfon and Asaoclated Efficiency Mvaotases**

# **1. The Measurement of the Extent of Vertical Integration**

In order to draw conclusions on the effects of vertical Integration, It is necessary to determine the extent of vertical integration along the different lines of production and distribution. 1Only if the degree of vertical integration, the essential independent variable, is precisely known, can we possibly determine and isolate particular consequences of an increase in the degree of vertical integration via econometric models. In this context, the degree of vertical integration is determined by the extent to which a particular firm substitutes intracorporate production and coordination for market transactions. 2

The pioneering work on the issue has been provided by *Adelman,* who proposed value added as a percentage of sales revenues, representing a sort of make-or-buy ratio, an Increase of which would indicate an increase in the degree of vertical integration et vice versa. 3 The crucial advantage of this Index is that neither the number of levels In the chain of production and distribution has to be calculated, nor their relative weight concerning the total number of the stages along the chain. However, the index has numerous dlsadvantages:4

For **a** detailed survey on the different approaches, cf. Fisher, Alan A., and Robert Sciacca, An Economic Analysis of Vertical Merger Enforcement Policy, in: Zerbe jr., Richard O. (ed.), Research In Law and Economics, vol. 6: Antitrust and Regulation, Greenwich, London 1984, pp. 1-133, 64-68.

2 Cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., **64.**

3 Cf. Adelman, Maurice A., Concept and Statistical Measurement of Vertical Integration, In: Stigler, George J. (ed.), Business Concentration and Price Policy, Princeton 1955, pp. 281-322.

**4** Cf. Dlrrheimer/Wagner/Hubner, Vertlkale Integration in der Mineralol- und chemlschen Industrie, op. cit., 28 f.

There have been attempts to modify the index, albeit without any great degree of success. 5 None of the subsequently developed indexes using relative employment, percentage of firms in an industry having two or more stages of production, vertical Herflndahl Index, or input-output studies **have**  overcome the main difficulties of empirical attempts to determine the degree of vertical Integration; they suffer from one or all of the following deficiencies: inconsistency with economic theory, a lack of operatlonallty, and limited usefulness with regard to economic and policy analysis.8 This has evidently handicapped studies using Indexes on the degree of vertical integration as an Independent variable In econometric models.7

#### **2. The Empirical Evidence on Efficiency-Enhancement**

Empirical studies attempting to find evidence of the validity of the transaction-cost approach and data on the extent of actual cost savings in the **case**  of Increased vertical integration may be placed in two categories:

5 Cf., e.g., Tucker, Irvin B., and Ronald P. Wilder, Trends in Vertical Integration In the U.S. Manufacturing Sector, 26 JIE (1977), pp. 81-94.

6 Cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Policy, op. cit., 68.

7 Currently, the census value added in relation to the sales of a firm Is used as the most appropriate Indicator of the extent of vertical integration, cf., e.g., Monopol kommlsslon, Hauptgutachten der Monopol kommlssion VI: Gesamtwlrtschaftliche Chancen und Rislken wachsender Unternehmensgrol3en, Baden-Baden 1986, tab. II.6, and paras. 233-235 for the qualifications necessary.

8 Transaction-specific market characteristics are supposed to serve as a proxy variable for anticipated cost savings that may not be operationalized quantitatively.

studies that attempt to quantify savings in transaction costs In the case of a change In the mechanism of economic coordination and which amounts to a change In the degree of vertical Integration.

Whereas the former category represents an Indirect attempt to determine the extent to which economic entitles economize on transaction costs, the latter represents a direct and quantifiable attempt to do this.

# **L**Studl• on TranSIIC'tlon-Speclflc **Market** Characteristics

A variety of empirical studies have tried to find support for the Implications of the transaction-cost approach by citing evidence that transaction-cost specific market characteristics pose an Incentive for vertical Integration:

9 Cf. Crandall, Robert, Vertical Integration and the Market for Repair Parts In the United States Automobile Industry, 26 JIE (1967/68), pp. 212-234; and Monteverde, Kirk, and David J. Teece, Supplier Switching Costs and **Vertical** Integration In the Automobile Industry, 13 BJE (1982), pp. 206- 213, esp. 206. This was confirmed for the relationship between research and development and vertical Integration, cf. Armour, Henry Ogden, and David J. Teece, Vertical Integration and Technological Innovation, 62 RES (1980), pp. 470-474.

firms" which "supports the implications of the transaction cost **ap**proach".1o

The results of the empirical studies are based on the premise that motivation for vertical Integration other than efficiency do not exist. Only to this respect did they confirm the Implications of the transaction-cost approach. However, there may be some other causal factors that are responsible for an incentive to integrate. Although efficiency increases through economizing on transaction costs may result from vertical integration, we are neither sure whether these gains are passed on to consumers as a result of sufficient competitive pressure, nor do these studies elaborate on possible anticompetitive effects as a result of increased vertical lntegration. 11 Furthermore, market power effects are largely neglected.

#### **b. Studies on Actual Cost Savings**

Empirical studies that attempt to measure the actual extent of cost savings from Increased vertical integration directly do not distinguish external vertical growth by mergers. Thus we have to accept a lack of knowledge regarding the comparison of cost savings associated with vertical mergers on the one hand and other forms of vertical Integration on the other.12

None of the empirical studies on costs savings from Increased vertical integration show quantitative results on marginal transaction-costs across different mechanisms of coordination through the various stages in the chain of production and distributlon. 13 This seems especially important with regard to the Isolation of motives underlying an increase in vertical Integration. In the case of a net increase in efficiency there would be an affirmation of the efficiency-enhancement hypothesis, although we cannot be sure whether this increase Is passed on to consumers as the current tenet contends. However, empirical findings showing a decrease in efficiency In the case of increased vertical integration would suggest a motivation other than efficiency-enhan-

10 Levy, The Transaction Cost Approach to Vertical Integration ... , supra, 443 f., and cf. Tucker/WIider, Trends In Vertical Integration ••• , supra.

11 This will be done infra in subsection III, after presentation of the deficiencies of the transaction cost approach concerning antitrust purposes.

12 Cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 68.

13 Cf. Bossmann, Weshalb glbt es Unternehmungen? ... , supra, 672.

cement. With regard to this respect, empirical studies are scarce and their results are ambiguous, to say the least. 14

The main obstacle to unambiguous conclusions Is the problem of distinguishing efficiency or cost saving effects from all other consequences, such as market power, price discrimination, evasion of regulation, and the llke. ,s In **a** study on the effects of vertical Integration on the basis of the Federal Trade Commission Line of Business data, which used an Index of vertical Integration based on Internal transfers as a percentage of the total of external sales and Internal transfers, *Ravenscraft* concludes that transaction cost **economies** exist. However, further studies are considered necessary In order to determine countervailing effects of monopoly power that **are neces**sary for a publlc pollcy trade-off. 19 The crucial deficiency seems to be that the results are compatible with an efficiency as well as with a market power explanation. This becomes obvious If one compares the two polar positions In this field. Whereas *Chandler* attempts to Interpret "the hlstorlcal process of American business as Including vertical Integration as a part of a long-run strategic process, contributing to the creation of ollgopollstlc structures and entry barrlers" 17, *WIiiiamson* reinterpreted the evidence as being consistent with the transaction cost approach, holding that the primary effect of the Increase in vertical Integration was lower costs. 11

14 Cf. Robins, Organizational Economics ••• , supra, 82; and for the studies, Demsetz, Harold, The Cost of Transacting, 82 QJE (1968), pp. 33-53; Dlrrhelmer, Manfred J., Vertical Integration: Transaction Cost Advantages versus Market Power Disadvantages, unpublished paper, International Institute of Management, Bertin 1984; Maddlgan, Ruth J., The Measurement of Vertical Integration, 63 RES (1981 ), pp. 328-336; and Ravenscraft, David J., Economics of Integration, unpublished paper, Federal Trade Commission, Washington, D.C. 1982. There are a number of further case studies presenting qualitative results, cf. Bossmann, Weshalb glbt es Unternehmungen? ..• , supra, 672.

15 Cf. Dlrrhelmer, Vertical Integration ••• , supra; Fisher/Sciacca, An Economic **Analysis** of Vertical Merger Enforcement Polley, op. cit., 72; and Maddlgan, The Measurement of Vertical Integration, supra.

16 Cf. Ravenscraft, Economics of Integration, supra; this Is affirmed by the studies of Dlrrhelmer, Vertical Integration •.• , supra; and Maddlgan, The Measurement of Vertical Integration, supra.

17 Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 69 f.; and for the original source, Chandler, The Visible Hand ... ,op.cit.

18 Cf. WIiiiamson, Assessing Vertical Market Restrictions ..• , supra, 968-974.

#### **3. A Critical Review of the Applicability of the Transaction-Cost Approach to an Efficiency Analysis of Vertical Integration**

The crucial issue is whether the analysis of transaction-cost advantages along various degrees of vertical integration and different transaction-cost specific market characteristics is operational and practical, and whether it is able to supply detailed prognoses on the efficiency consequences that will actually result from vertical mergers. 19

The use of marginal transaction-cost approach, which leads to the calculus on market transactions versus intra-organizational transactions, seems plausible at first sight. However, it remains without explanatory power and thus an empty box as long as it is not possible to determine exact cost levels and margins necessary to perform the trade-off. 20

Furthermore, the general applicability of the transaction-cost approach and similar approaches to a theory of institutional change has to be questioned fundamentally. It is held that the microeconomic concept of efficiency has to been seen as crucially important for the application of the transaction-cost approach and that the ability of the price system to alter the structure of systems of economic exchange in the direction of efficient economic arrangements depends on sufficient competitive pressure. If it is reallistically assumed, however, that economic equilibria are absent in most if not all of our markets, and, furthermore, that market imperfections and oligopolistic structures prevail, "e=nomic logic supports no causal inferences about the role of efficiency in determining social or organizational structure". 21Market imperfections make it much less likely that the most efficient competitors will survive in the end. Concerning the assumption of an essentially frictionless and perfectly competitive market, as assumed by the adherents of current theory, there is strong evidence that the imperfections actually found in reality may finally be responsible for the fact that "financial and market

19 Cf. Schmidt/Rittaler, Die Chicago School of Antitrust Analysis ... , op. cit., 50.

20 Cf. Bossmann, Weshalb gibt es Unternehmungen? ... , supra, 672.

21 Robins, Organizational Economics ... , supra, 71, and ibid., 74: "Transaction-cost analysis adopts a model that has clear meaning for organizations only in perfect markets and applies it to highly imperfect situations. The role played by efficiency is especially problematic in light of how little the neoclassical concept says about the behavior of individual organizations.

power, not economic efficiency, may determine the winners in the competitive race".22

As long as net efficiency gains are concluded from an increase in the degree of vertical Integration, motivations other than efficiency-enhancement are simply defined away for the purpose of analytical clarity and on the basis of **a** false assumption that economic agents only have consumer welfare on their minds. **We** have emphasized supra that efficiency does not represent the sole motivation for any kind of Internal and external corporate growth and this is also the case for vertical Integration. Vertical Integration In general and vertical mergers In particular can be a source and carrier of market power. 23 If this were be the case, the aforementioned optimization calculus would lose its explanatory power with regard to the transaction mechanism chosen. Even If **a** net efficiency loss In the short run resulted from the integration, there would remain a motivation to merge, until **excess**  profits from **a** monopoly or limit price strategy equalled the total cost difference resulting from **the two** transaction mechanisms. This would be so because of the belief that monopoly power which could be exploited In the time periods **after** the merger had occurred could be attained.24 Such a rationale is ruled out by the adherents of current theory, however, since persistent competitive pressure and frictionlessly working markets will not allow competitors to reap monopoly advantages, as a price raise attracts newcomers Immediately and the latter provide competition which erodes excess profits.

The assertion that meaningful barriers to competition do not exist, and hence that sufficient competitive pressure is believed to be persistent, regardless of the existing structural features of the markets Involved In vertical lntegratlon25, tends to define market power problems away and understates the likelihood of anticompetitive consequences. The absence of power

22 Mueller, Public Policy Toward Vertical Mergers, op. cit., 165; and again Robins, Organizational Economics ••. , supra, 79: "In the absence of perfect markets for all Inputs to production, the assumption that firms will be pushed In the direction of **a** common, transaction-cost minimizing organizational form Is unwarranted."

23 Cf. **Bain,** Industrial Organization, op. cit., 178 f.; and Kaysen/Turner, **An**titrust Polley ••• , op. cit., 120.

24 Cf. again Dlrrheimer/Wagner/HObner, Vertikale Integration in der Mlneralol- und chemischen Industrle, op. cit., 14.

25 Cf. Areeda/Turner, Antitrust Law ••• , vol. 3, op. cit., § 724a.

results In efficiency and efficiency Is synonymous with consumer welfare. However, an examination of actual or supposed Increases In business efficiency, whether they relate to allocative or productive efficiency, Is **a**  reflection of **a** comparative-static way of thinking. The aim of any realistic antitrust policy must be to secure the existence of sufficient competitive pressure to force firms to be dynamic, innovative and to adjust, as well as to compel them to actually pass on their internal welfare gains to the economy **as a** whole. Concerning the Brown Shoe case, for Instance, it Is correctly noted that

*"(t)he recognition that Integrated and chain operations may result In benefits to consumers in no way proves that* the Brown-Kinney merger actually resulted In such benefits; or that the merger route Is the only way to achieve such benefits; or, finally that even If such benefits, In fact, achieved by this merger, *they would have been passed on to consumers"* (citation omitted, Italics supplied).29

The terms 'transaction-costs' and 'organization costs' are difficult to handle, and In specific cases they can neither be determined In a precise manner empirically nor quantitatively measured. The terms are largely used In **a way**  that allows justification of certain phenomena ex post; this leads to the possibility that any development may be justified - but only ex post and crudely. **As a** result, the concept tends to become tautologous: a process that can be observed Is efficient because It developed the way It has!27

Only the restrictive premises of current theory are responsible for the mis-Interpretation of the transaction cost approach, and these are essentially provided by *Coase* and *Wi/111J111son.* On reallstlc premises and assumptions, the

26 Mueller, Public Policy Toward Vertical Mergers, op. cit., 162. The passing on of efficiency **gains** ls neglected on the basis of the assumptions dealt with supra. With regard to vertical integration, recent studies, however, **have** found **"evidence** that higher lntermarket contact between firms, combined with medium to high concentration levels, Increases the probability of collusion", Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 70. We will deal with anticompetitive consequences of vertical Integration Infra.

27 This seems to be analogous with the circular logic which we have criticized concerning the premises and assumptions of the current tenet supra. Cf. also, Bossmann, Weshalb glbt es Unternehmungen? ... , supra, 672 f.; Robins, Organizational Economics ••. , supra, 72, who state that *Wllti1J111son*  himself holds that the transaction cost approach Is virtually **able** to explain any economic change If It Is not operationalized further; cf. as **well,**  Schmldt/Rlttaler, Die Chicago School of Antitrust Analysis ... , op. cit., 50.

generality of the pro-efficiency argument is not tenable. As has been emphasized, the uncritical use of market models as well as the implicit analogy with neoclassical economics and perfect competition Is unwarranted. 211

# IIL **An Evaluation** *at* **P9M1h!a AotlmuPIUtlY• eonaaauancas Raaultloa frqn Ylrtlca! Intaaratlon**

#### **1. The Remaonlng Underlying Anticipated Antloompetltlve Conaequencas: Forecloaure of Actual and Potential Competitors**

The presumption of illegality of particular vertical mergers Is based on the notion of foreclosure of actual or potential competitors. In the Brown Shoe case the U.S. Supreme Court held that "(e)very extended vertical arrangement by Its very nature, for **at** least a time, denies to competitors of the supplier the opportunity to compete for part or all the trade of the customer party to the vertical arrangement" .1 Thus, foreclosure may be assumed If the integrated firms uses its vertically Integrated market position to deny comparably efficient non-Integrated competitors equal access to the markets for consumers and/ or suppliers. As a result, competitor firms that are not Integrated face a smaller output level or market share than would be the case If vertical Integration had not been performed.2 The extent of the market that Is removed from the competitors at the two successive **sta**ges of a particular vertical merger determines the degree of foreclosure:3

28 Cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 71; and Robins, Organizational Economics ... , supra, 70.

1 Brown Shoe v. U.S., 1962 CCH Trade Cases I 70,366, p. 76,492. Cf. as well Blalr/Kaserman, Law and Economics of Vertical Integration and Control, op. cit., 147-151; and Schmidt, Wettbewerbspolltlk und Kartellrecht, op. cit., 178.

2 Cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 38; and Hamilton, James L., and Soo Bock Lee, Vertical Merger, Market Foreclosure, and Economic Welfare, 53 SEJ (1986), pp. 948- 961, 949; and Schmidt, Ingo, us-amerlkanlsche und deutsche Wettbewerbspolltlk gegenuber Marktmacht, Berlin 1973, p. 142.

3 Comanor, William S., Vertical Mergers, Market Power, and the Antitrust Laws, 57 AER (1967), pp. 254-265, 256. For one of the early cases, cf. as well, U.S. v. E.I. du Pont de Nemours & Co., 1957 Trade Cases § 68,723.

"If .•. a firm with 50 percent of the market at an early stage acquires another who holds 10 percent market share at the only succeeding stage, then as a result of the merger, rivals of the latter firm are said to be foreclosed potentially from half of the market for needed supplies, while rivals of the former are foreclosed from about 10 percent of the market for their input. In this manner, moreover, the theory is symmetrical and is used to refer to either stage of production."

Regarding real cases of vertical integration, three typical forms of foreclosure may be dlscerned:4

Concerning cases in which market power Is absent in horizontal terms, there seems to be general agreement that vertical Integration Is not likely to have anticompetitive effects.5 However, the rather small market shares that **were**  used by courts to demonstrate that significant parts of the markets were foreclosed to rivals, have been challenged by scholarly commentary. In this context, the view is put forward that actual and potential competitors cannot possibly be foreclosed since vertical Integration as well as exclusionary practices are efficiency motivated, and frictionlessly working markets without barriers to entry would Immediately restore sufficient competitive pressure.11 Furthermore, the underlying reasoning of the foreclosure argument would be strongly In contrast to neoclassical price theory and the profit

5 Cf., **e.g.,** Areeda/Turner, Antitrust Law ... , vol. **4,** op. cit., § 1004c.

4 For a different classification cf. Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 38, who distinguish **between a**  case of 'self-dealing' and cases of 'discriminatory transfer pricing',

6 Cf. Bork, Vertical Integration and Competitive Processes, op. cit., 148.

maximizing principle that is **a** logical consequence of the homo oeconomicus presumption. Thus, It is concluded that the

"concern about possible market foreclosure Is misplaced. A manufacturer **may,** In certain circumstances, improve his market position by buying **retail** outlets and foreclosing them to his rivals. But, wherever he can do this, there are alternative ways of enhancing his market power which are distinctively superior to market foreclosure, which obtain all the advantages of foreclosure and avoid the costs specific to this practice. This being so, we should not expect foreclosure to be Important as a predatory tactlc". 7

Important antitrust cases have shown, however, that cases of foreclosure occur and that the actual share of the market that is foreclosured may be substantial.8

In the Volkswagen spare parts case, for Instance, the Volkswagen automobile company had Induced company affiliated repair shops to use original brand Volkswagen spare parts. These company affiliated repair shops accounted for 50 percent of the relevant market of spare parts compatible to Volkswagen automobiles. The German Federal Cartel Office held that all other producers of Volkswagen **spare parts as** well as spare part wholesalers would be unduely Impeded by being foreclosed from the 3.400 company affiliated repair shops representing 50 percent of the otherwise accessible relevant **market.•**

The particular anticompetitive effects became even more obvious In the Ford Motor Company case. 10 In this **case,** the U.S. Supreme Court held unlawful the acquisition of the Electric Autolite Company - one of the two unintegra-

7 Peltzmann, Sam, Issues In Vertical Integration Polley, In: Weston, Fred, and Sam Peltzmann (eds.), Public Polley Toward Mergers, Pacific Palisades, Cal. 1969, pp. 167-176, 168. Somewhat more moderate, cf. Bork, The Antitrust Paradox, op. cit., 238: "Whether or not one believes In the Law's foreclosure theory, *all so-called vertical merger cases should be handled through the application of horizontal merger standards"* (Italics in original).

8 Cf., e.g., Ford Motor Co. v. U.S., 1972 CCH Trade Cases, § 73,905; and VW-Identteile, WuW/E BGH, pp. 1829 ff.

9 Cf. VW-Identteile, WuW/E BKartA, pp. 1781 ff., however, this was not accepted by the German Federal Supreme Court on account of the argument that Volkswagen had a right to protect its quality standards by company affiliated repair shops. Foreclosure was accepted since It was not considered an undue Instrument *to* attain this objective, cf. again VW-Identtelle, WuW/E BGH, pp. 1829 ff.

10 For a discussion of the case, *cf.* Schmidt, US-amerikanlsche und deutsche Wettbewerbspolitlk ... , op. cit., 138 f.; and for the case, Ford Motor Co. v. U.S., op. cit.

ted spark plug manufacturers - by the Ford Motor Company that manufactures automobiles. Before the merger, Ford had purchased all of the spark plugs from Independent manufacturers. This accounted for roughly 1 o percent. The primary intent of the acquisition was to get a hold of a part of the profitable aftermarket for replacement of defective or worn out plugs. Concerning the Installation of original equipment, the market structure was characterized by a bilateral tight oligopoly. In the spark plug market Autolite held 15 percent of the market, General Motors, the largest U.S. automobile producer 30 percent, and Champion the other Independent manufacturer, 50 percent. General Motors, Ford, and Chrysler as the main purchasers of spark plugs accounted for 90 percent of the original equipment market.

The vertical merger was perceived to transmit the rigidity of the oligopolistic structure of the automobile Industry to the spark plug Industry and decreased the likelihood of competition between the former Independents, Autolite and Champlon.11

The essential anticompetitive consequences from the vertical merger were seen by the Court In the following factors:

Before elaborating on the possible anticompetitive effects more precisely, we wlll take a brief look at the effects of foreclosure on economic welfare. Whereas recent work In vertical integration has emphasized the effects of vertical Integration on resource allocation and economic welfare, the U.S. Supreme Court has not made any attempt to reveal the nature of the relationship between the degree of foreclosure and the extent of economic wel-

11 Cf. Bork, The Antitrust Paradox, op. cit., 235, and Ibid., 237: "The *Ford-Autolite* opinion falls to establish **a** valid theory of vertical foreclosure. It Is almost certainly merely another example of efficient Integration destroyed through reliance on an Incorrect economic theory" (Italics original).

fare. 12 No problem emerges If the degree of foreclosure Is negatively correlated with the extent of attainable economic welfare In the sense that If the share of the market foreclosed to actual and potential competitors Increases, then economic welfare decreases. This Is the essential reasoning behind the pejorative label attached to foreclosure. A trade-off becomes necessary, however, If "whatever bad effects of foreclosure exist are at least partially offset by the lower prices and higher output levels vertical Integration brlngs''. 13

Recent empirical work provides evidence for the necessity of a trade-off between the pure foreclosure effect and possible advantageous effects on economic welfare. Furthermore, empirical evidence suggests that "market foreclosure can be a poor Indicator of the economic welfare effect of vertical merger .•• (and) economic welfare is enhanced even though non-Integrated firms are 'foreclosed'". 14Thus, It seems necessary to postulate conditions under which reliable statements are possible about the net effects associated with such a trade-off, thereby facilitating a reasonable Judgment on vertical mergers In the light of possible counteracting effects. 15

Thus foreclosure may well be seen **as a** relevant criterion In the decision to give legal screening to vertical merger cases, It does not, however, seem to constitute an adequate criterion to condemn any vertical merger a priori. 18

# **2. Particular Anticompetitive Effects A880Clated with Foreclosure**

It is largely disputed to what extent vertical integration carries a potential for anticompetitive consequences. Whereas scholars that are associated with the traditional approach emphasize the anticompetitive potentlal of vertical mergers, Chicago scholars insist on an efficiency-enhancement potentlal of vertical arrangements. 17

## **L Price and output Consequences**

In classical monopoly theory, a decrease in output and an Increase In price are considered to be the consequences of a monopoly. Vertical integration that is characterized by a supplier/buyer relationship along distinct chains of production and distribution down to the consumer Is perceived not to alter market concentration, and hence not have direct price/quantity consequences. Thus, "(v)ertical Integration does not, of Itself, Increase the percentage of the market controlled by a fl rm". 18

This Is an acceptable standpoint, if one refers to the narrow concept of price and quantity, I.e. to market concentration in the sense of an Index of concentration not altered by an increase In vertical integratlon. 19However, if one takes into account possible leverage effects resulting from the fact that firms possess horizontal market power In their original market and un-

17 Cf. Scherer, Industrial market structure ... , op. cit., 303, who mentions that members of the Chicago School view vertical Integration as either socially desirable or Innocuous: "Vertical Integration Is perceived as enhancing efficiency by dissolving bilateral monopoly bargaining stalemates, eliminating double marginalization by vertical chain monopolies, and minimizing input substitution distortions."

18 Bork, Vertical Integration and Competitive Processes, op. cit., 142, and ibid., 143, furthermore holding that "a vertical acquisition can never create or increase a restriction of output. By cutting costs and creating efficiencies It can result In **an** Increase In output"; and cf. Areeda/Turner, Antitrust Law ... , vol. **4,** op. cit., § 1000a. For some basic discussion of the Issue, cf. Westfield, Fred **M.,** Vertical Integration: Does Product Price Rise or Fall?, 71 AER (1982), pp. 334-346.

19 Cf., e.g., Mueller, Public Polley Toward Vertical Mergers, op. cit., 151, who Is not a scholar of the current tenet: "Vertical integration, as such, does not confer market power on the Integrated firm. After all, few American enterprises are more vertically Integrated than the farmer selling his apples at a roadside stand. But he gains no market power merely because he controls all stages of production and distribution from the orchard to the ultlmate consumer."

der certain circumstances are able with a certain time-lag to transfer this market power via vertical merger to an originally competitive market, prices and quantity may change as a result of that leveraged market power. 20 This, in turn may make possible all the evils associated with discretionary behavior as a consequence of market power, such as price discrimination, supply squeeze, a raise of barriers to entry, and even the facllitatlon of collusive behavior on a second stage level. 21Instead of only considering a firm's market power as this is reflected by price/quantity conditions, it seems advisable to emphasize a firm's market position as defined by Its ability to "behave persistently in a manner different from the behavior that a competitive market would enforce on **a** firm facing otherwise similar cost and demand conditions".22 This market position is not necessarily identical with the market share the firm holds.

It Is commonly held that In the case of sufficient competition on both the markets Involved In a vertical merger the competitive consequences of a vertical merger are either neutral, because significant anticompetitive consequences cannot be determined, or pro-competitive because of the efficiency gains associated with the merger, the passing on of which is secured by sufficient competitive pressure,23

20 Cf. e.g., Kaserman, Theories of Vertical Integration ... , supra, 497, who asserts that "(t)here Is **a** possibility, ... , that such Integration may serve to solidify or expand the monopoly power that provided the original catalyst for vertical combination"; and Kaysen/Turner, Antitrust Policy ••• , op. cit., 121: "Firms possessing significant market power at one stage In a production chain, by Integrating backward or forward, spread that power to lower and higher stages."

21 Cf. Areeda/Turner, Antitrust Law •.• , vol. 4, op. cit., § 1007; and Kaserman, Theories of Vertical Integration ••• , supra, 497 note 38, who notes that it may well be difficult to trace the origin of such power ex post: "(I)f we view a vertically Integrated firm possessing monopoly power at successive stages of production, It may be very difficult to determine the direction of causation between the integrated structure and the monopoly power."

22 Kaysen/Turner, Antitrust Policy ... , op. cit., 75. The ability, then, to extend a market position from the original stage In the chain of production and distribution to another stage strongly relies on the horizontal market power the vertically Integrated firm possesses at the original stage, cf. Areeda/Turner, Antitrust Law ... , vol. **4,** op. cit., !I 1005; Comanor, Vertical Mergers, ... , supra, 255; and Dirrheimer/Wagner/HObner, Vertlkale Integration In der Mlneralol- und chemlschen Industrle, op. cit., 20 and 25.

23 Cf. Areeda/Turner, Antitrust Law ... , vol. 3, op. cit., § 724 and 724a.

Paradoxically, the case of a vertical merger of two monopolists is **associated**  with an increase in the final product's output and a decrease In the final product's price. It is assumed that prior to **a** vertical integration the output monopolist would have an incentive to buy less of the input and to substitute for other, less efficient, inputs to the greatest possible extent, whenever the input monopolist raised its price. This would increase the final product's price and decrease its output. This distortion in the allocation of resources is believed to be corrected in the case of a vertical merger because the combined monopolist cannot charge a monopoly price twice, and hence would charge an internal transfer price that would amount to his marginal costs for the input. Monopoly pricing is assumed to have been substituted for competitive prici ng. 24

At least two essential qualifications have to be made to this line of reasoning, however:

24 Cf. primarily Machlup, Fritz, and Martha Taber, Bilateral Monopoly, Successive Monopoly, and Vertical Integration, 27 Economica (1960), pp. 101- 119, esp. 102; and Fisher/Sciacca, An Economic Analysis of Vertical Merger Enforcement Polley, op. cit., 18. This is not accepted, however, by Blair/ Kaserman, Law and Economics of Vertical Control, op. cit., 31-36; and Warren-Boulton, Vertical Control of Markets ... , op. cit., 75 f.

25 Cf. Blair/Kaserman, Law and Economics of Vertical Control, op. cit., 82; and Warren-Boulton, Vertical Control of Markets ... , op. cit., ch. 4, particularly p. 92, who holds that In the case of variable proportions "vertical control results in higher prices for the consumers of the final product and reduced demand for nonmonopolized inputs."

26 Cf. Mallela, Parthasaradhi, and Babu Nahata, Theory of Vertical Control with Variable Proportions, 88 JPE (1980), pp. 1009-1025; and Vernon, John, and Daniel Graham, Profitability of Monopolization by Vertical Integration, 79 JPE (1971 ), pp. 924 f.

Recent empirical studies have tried to verify these Implications. They **have**  concluded that It seems Impossible to forecast which of the two effects at work will prevail. The potential for a net price raising effect Is greatest In cases of non-Integrated second stage buyers' Intermediate substitution posslbilltles.27

Summarizing, we are able to conclude that, In analogy to the horizontal case, vertical integration may be accompanied by efficiency-enhancing effects but also by detrimental price/quantity effects,31 These two effects are lnterwo-

27 Cf., e.g., Waterson, Michael, Vertical Integration, Variable Proportions and Ollgopoly, 92 EJ (1982), pp. 129-144. However, ambiguities are persistent since only a marginal change In the underlying conditions may end In contrary results, cf Fisher/Sciacca, An Economic Analysis of Vertical **Mer**ger Enforcement Polley, op. cit., 21.

ven In a complex interaction. We should thus be cautious In our judgments because efficiency effects may present themselves quickly but anticompetitive effects may occur with a certain tlme-lag.32

#### **b. Price and Supply Squeeze**

A further anticompetitive option exists for firms In a customer-competitor situation with market power at one stage. 33 This is the case if the integrated firm produces more than It uses for self-dealing at one stage In the chain of production and distribution and hence sells the excess supply to non-integrated competitors at the subsequent stage. Thus, the firm's customers become Its competltors.34 This Is the common basis for a distinct strategy of impairment of competitors that may be adopted by an Integrated firm in order to exert a squeeze on prices or supplies of non-Integrated competitors.35

Vertically Integrated producers are able to exert a price squeeze by decreasing the margin between the price for raw materials and the final product.311 Essentially, this may be done In three ways:37

raw materials constant and lowers the price for the flnal product;

**A** price squeeze is generally assumed to occur only under very rare conditions or to be altogether unllkely38• However, there **are a** number of case studies that show the empirical relevance of the problem.

For Instance, between 1955 and 1962 non-integrated competitors were exposed to a single as well as to a double price squeeze in the steel Industry In the United States. After 1955 price Increases for wire rods were much higher than those for drawn wire and wire fabrics. The double price squeeze started In 1959 when the prices for wire rods and drawn wire remained on **a**  high level, whereas the prices for wire fabrics such as welded wire, woven wire fences, nails, bale ties and barbed wire partly declined substantlally.39 These price squeezes were also employed by Integrated steel producers In the U.S. to discourage price cutting by less integrated wire product makers In the final product stage. In order to achieve this, integrated steel producers used a mixture of domestic and Imported lnputs:40

38 Cf., e.g., Areeda/Turner, Antitrust **Law** ... , vol. 3, op. cit., § 728c; and Peltzman, Issues In Vertical Integration Polley, op. cit., 171.

39 Cf. Adams, Vertical Power, Dual Distribution and the Squeeze ... , supra, 499. Cf. as well Comanor, Vertical Mergers, ... , supra, 255, and Scherer, Industrial market structure ... , op. cit., 304-306 for further examples. For the most important court cases cf. U.S. v. Aluminum Co. of America, 1964 Trade Cases § 71,243; and Kennecott Copper Corp. v. U.S., 1965 Trade Cases § 71,458.

40 Cf. Adams, Walter, and Joel Dirlam, Steel Imports and Vertical Oligopoly Power, 54 AER (1965), pp. 626-655.

*liL.1;* **Squeezing** 1n **the Steel** Industry

~ Adm, Walter, Vertical Power, Dual Distribution and the Squem. A Case Study in Steel, 9 AB (1964), pp, 493-508, 501.

Vertically integrated producers are often able to exert a supply squeeze upon non-integrated customers by denying supply to these customers In times of supply shortage. 41Integrated firms absorb an increased share of the input factors of the production process which leads to quantitative restrictions on input for non-integrated competitor or to the utilization of raw materials and factors of production that are of poor quality. This was the case, for instance, when major petroleum companies denied pipeline access and product supplies to non-Integrated refiners and marketers during the two periods of worldwide supply shortages of crude oil. 42

The occurrence of supply squeezes is rejected or deemed unlikely by scholars who are adherents of the current theoretical approach. 43 As the supply stage is assumed to be competitive, shortages can by nature only be temporary. Integrated firms may not alleviate supply shortage in such situations, unless they are willing to accept the loss in purchases of their non-integrated competitors in times after the shortage because "(a) free market knows no 'permanent shortage.' When demand exceeds supply, price will rise

41 Cf. Monopol kommission, Hauptgutachten der Monopol kommisslon I ••• , op. cit., para. 920; and Scherer, Industrial market structure ... , op. cit., 304.

42 Cf. Scherer, Industrial market structure ... , op. cit., 304, who holds that thesa tactics had only transitory success in keeping independent refiners and retailers in line. For the different forms of supply squeeze, cf. Areeda/Turner, Antitrust Law ... , vol. 3, op. cit., § 728b.

43 Cf. Areeda/Turner, Antitrust Law ... , vol. 4, op. cit., § 1003d; Bork, The Antitrust Paradox, op. cit., 243.

to the market clearing level. At that price there wlll be no 'shortage'."44 A permanent supply shortage may not be expected on markets without governmental or public price regulation, **because** price/quantity **are rede**fined at the clearing level, If this process Is Impeded by regulatory action, this Is not considered an antitrust problem but one of regulation. Even If the number of unlntegrated efficient rivals decreases **as a** result of a permanent supply shortage, the Integration of the other firms wlll not **lead** to **a**  doubting of monopoly profits because of the assumptions on price and output made supra. 45We have documented, however, that the assumptions as well as the conclusions are quite often not as unambiguous as asserted.

Regardless of the reasoning of current theory, there are a variety of reasons why price as well as supply squeezes may pose a serious problem to non-Integrated competitors of vertically Integrated firms:

44 Areeda/Turner, Antitrust Law •.. , vol. 4, op. cit., § 1003d.

45 Cf. Areeda/Turner, Antitrust Law ... , vol. 4, op. cit., § 1003.

46 Cf. Sullivan, Handbook of the Law of Antitrust, op. cit., 659.

47 Cf. Areeda/Turner, Antitrust Law ... , vol. 3, op. cit., § 728c1.

48 Cf. Comanor, Vertical Mergers, •.• , supra, 255.

tlon occurs, and even If It does occur, that It outweighs the effects of the supply squeeze.

# c. **Price Discrimination**

Price discrimination Is a pricing strategy by competitors which allows an economic agent to sell or purchase different units of an economic good or service "at price differentials not directly corresponding to differences In supply costs". 51In a perfectly competitive market price discrimination Is not a profitable strategy since price Is determined by the market forces and the economic agent as an element of atomistic Industry structure does not have discretionary power to change data. Commonly, three different conditions

49 Cf. Erstes Benzinprelsverfahren, in: Bundeskartellamt, Tiitlgkeitsberlcht 1967, BTDr. V/2841, p. 41; and Schmidt, Wettbewerbspolltik und Kartellrecht, op. cit., 140 f.