Merger Enforcement in Dynamic and Innovative Markets

By Pedro Gonzaga, OECD Competition Division, Directorate for Financial and Enterprise Affairs. The topic will be discussed at a panel during the 2020 OECD Competition Open Day.*

Modern competition dynamics are challenging the work of competition authorities all around the world. Merger enforcement, in particular, increasingly requires case handlers to predict the effects of complex mergers in dynamic markets where unprecedented levels of innovation lead to constant change. If the review of mergers in traditional industries was already a daunting task, the growing number of merger cases in rapidly evolving industries, such as high technology, consumer services and online retail, is now putting enforcers to the test.

When facing the challenges of reviewing mergers in dynamic markets, existing literature does not always provide useful answers to enforcers. It often focuses on the relationship between market concentration and innovation, giving few insights on how to differentiate pro-competitive mergers from anti-competitive mergers. Some literature puts forward practical proposals for adapting merger enforcement but many of these proposals are contentious and have not been widely adopted. The proposals to define “innovation markets” are a case in point.

In light of the importance of preserving accurate and predictable merger enforcement when innovation is at stake, this post looks at two questions. Should authorities expand the timeframe of merger review with a view to capturing longer-term effects on investment and innovation? Can simple practical options to adapt merger enforcement in the context of dynamic markets be identified without having to significantly depart from the use of traditional merger enforcement tools?

What should be the timeframe of merger review in dynamic markets?

Horizontal mergers generally have ambiguous effects on consumers, regardless of the timeframe of analysis. On the one hand, a horizontal merger eliminates a direct or potential competitor, reducing the level of competition within the market. On the other hand, a merger can create efficiency gains that often benefit consumers. This trade-off implies that a horizontal merger can have either a positive or a negative impact on consumers in the short term, by affecting prices and quality, as well as in the long term, by affecting investment, innovation, and hence future prices and offerings.

Traditional merger enforcement focuses on short-term price effects, which might be good predictors of the overall long-term effects of mergers in markets that are static by nature (i.e. markets that change little over time). Take the example of industries for the extraction of natural resources or the production of homogenous raw materials, such as cement. In these industries, where entry rates are small and disruptive innovation is rare, a merger has often a similar impact in the short-term and long-term, because the market tends to evolve slowly over time.

In contrast, in markets that have a more dynamic nature, the short-term effects of a merger can differ more substantially from the long-term effects. For instance, in a market where new technologies require risky investments that generate substantial innovation spillovers, a merger may temporarily harm consumers with higher prices, but also lead to greater investment and innovation that will eventually bring great consumer gains. Alternatively, in a market where intellectual property rights are strong and firms compete fiercely on innovation dimensions, a merger may not cause any immediate harm, but still reduce long-term innovation.

Since short-term effects are not always good predictors of long-term effects in dynamic markets, a short sighted merger enforcement can result in enforcement errors. In other words, by looking only at immediate price effects, authorities risk in some occasions blocking a merger that would increase innovation efforts (over enforcement) or clearing a merger that will dampen competition on innovation dimensions (under enforcement). Given the central importance of innovation for economic growth, it is likely that enforcement errors in dynamic markets are particularly costly for consumers.

It seems therefore desirable that, whenever innovation is at stake, competition authorities assess the effects of mergers over a sufficiently long timeframe. It is of course hard to establish with precision what the optimal timeframe of analysis should be, because attempting to look very far into the future might also lead to enforcement errors and increase enforcement unpredictability.

How can authorities adapt merger enforcement in the context of dynamic markets?

Even if extending the timeframe of merger review is in some cases desirable, it is not always clear how authorities can assess the long-term effects of mergers in practice. The OECD held a roundtable on merger control in dynamic markets in 2019 where competition authorities from all over the world presented complex merger cases from their jurisdictions and discussed practical solutions to adapt the different stages of the review process. An OECD background note described some of the available options which can be summarised as follows:

1. Identifying substitute pipeline products and innovation capabilities.

Substitution analysis is at the core of merger enforcement, allowing authorities to assess whether the merging firms are close competitors and to identify the main competitive constraints. Normally authorities assess the substitutability of overlapping products and geographical areas where both firms currently compete, but some authorities have also started considering possible future overlaps, by looking at pipeline products and projects to enter new geographical regions. To extend the analysis further into the future, authorities can also assess whether the merging firms own overlapping innovation capabilities, such as substitutable intellectual property rights, laboratories, skilled workers, technologies or rare natural resources, whose concentration in a limited number of firms may compromise competition in the long term.

2. Assessing the evolution of market shares over time

Competition authorities have increasingly recognised that a simple analysis of market share and concentration data within merger control has important limitations, especially in dynamic industries. A market can be concentrated but still contestable, as long as there are enough potential and indirect competitors exerting competitive pressure. In this sense, the assessment of how market shares evolve over time may portray a more accurate picture of the competitive landscape. In particular, a merger is less likely to harm consumers when market shares are unstable and not strongly correlated with past market shares, suggesting a certain level of dynamic competition.

3. Measuring barriers to entry and exit

Mergers can only harm consumers beyond the very short term if there are substantial entry and exit barriers that enable firms to sustain market power. For that reason, it is important to evaluate whether entrants have to bear costs that incumbents do not have to incur (entry barriers), as well as to bear substantial sunk costs (exit barriers). As these costs are often hard to measure, competition authorities can also use indirect evidence to assess barriers to entry and exit. The probably most reliable indirect indicator of low barriers is evidence of repeated past entry and exit.

4. Considering dynamic efficiency claims

The burden of proving that a merger creates efficiency gains lies on the merging parties, and authorities very rarely accept such claims. Nevertheless, there are good reasons to consider efficiency claims in dynamic markets, as the economic literature suggests that in some occasions an increase in market concentration can foster innovation and investment. Apart from potentially generating economies of scale in R&D activity, a merger may help the merging firms appropriating innovation spillovers or even reward an entrepreneur with a successful exit strategy, in both cases promoting innovation. Naturally, it is important to verify that such efficiency effects are merger specific and passed through to consumers.

5. Designing flexible remedies

One of the challenges of merger enforcement is to come up with adequate remedies when it is largely uncertain how the market will look in the future. A possible way to deal with uncertainty is to design flexible remedies that adapt to changes in market circumstances. In the case of behavioural remedies, authorities may introduce review clauses that allow the remedy to be altered or even eliminated once it becomes unnecessary. With respect to structural remedies, which are often irreversible by nature, authorities may consider divestiture measures that are conditional on the observation of future events (e.g. lack of new entry within an established timeframe), especially when there is not enough information to predict how the market will evolve at the time of the decision.

Despite new challenges, traditional merger tools appear sufficient

Despite the overall challenges of assessing mergers in highly dynamic markets, authorities can implement simple practical measures to make merger enforcement more effective in preserving long-term competition and promoting innovation in these markets, without necessarily departing from traditional merger tools. Indeed, so far the general analytical framework of merger enforcement appears to be sufficient to address competitive challenges in dynamic markets, even if the application of those tools may have to be adapted to a new market reality.