Do mergers result in a less dynamic economy?

David Havyatt

The Executive Summary of the Treasury Consultation Paper on Merger Reform states the central premise of the paper as:

In Australia, productivity growth has slowed over a long period, and most measures of dynamism have declined. A range of competition indicators – including industry concentration, incumbency, and firm mark ups – suggest a deterioration in competition in Australia since the early 2000s. This is consistent with trends in many other advanced economies.

The very imperfect theory of imperfect competition, specifically oligopolies, tells us that industry concentration and firm markups are closely related (in the Cournot model, industry markup is the concentration ratio measured by the Hirschman-Herfindahl Index divided by own price elasticity of demand). This increase in markup isn’t necessarily a bad thing.

To understand this point, we need to remember that the theory of competition is even more imperfect because our only theory is of “perfect” competition.

This competition model has so many buyers and sellers that no one buyer or seller can influence the market, each seller is producing a perfectly homogenous product, and the market is perfectly informed.

Only in this perfect but non-realisable model do prices equal costs, and no markup exists. Furthermore, the position at which prices equal costs is one of equilibrium (the very antithesis of dynamism).

FIRB rules
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Markets that actually exist don’t have these characteristics and aren’t in equilibrium. The latter point virtually guarantees that there is always an industry-wide net economic profit and, hence, markup.

The reasoning is simple. Each supplier has a slightly different cost structure, so the market clearing price is the cost of the most expensive producer. All the other producers set their price at the market clearing price and hence earn an economic profit.

A desire to increase economic profit drives innovation in incumbent businesses. As someone once put it to me, the objective of management isn’t to earn a return equal to the cost of capital; it is to exceed it.

A business can innovate in an existing market to reduce costs or make a product more attractive (to “gain market share”).

If we just focus on cost-reducing innovation, the business that reduces its costs has no incentive to pass all that cost reduction on to consumers. They may reduce prices slightly, but production capacity constrains their ability to grow their market share.

Similarly, the firm that innovates in products does so to command higher prices; a good example is the iPhone.

So innovation should result in increasing, not decreasing, markups. Of course, competing firms respond to the innovation by trying to match or surpass it. Eventually, some of the markup is “competed away.”

However, it is certainly true that markups will be higher at equilibrium with higher concentration. But it doesn’t follow that this is to the detriment of consumers.

As the Consultation Paper also notes, that isn’t the only issue. Businesses want to increase their market share to realise the benefits of scale and scope, such as having lower costs by making more of the same stuff or using resources to make other related stuff.

The position of consumers hinges on whether the net effect of the greater markup outweighs the benefit of lower costs to which the markup is applied. This is an empirical question that the Treasury’s markup estimations have not addressed.

Moving from whether mergers and greater concentration are inherently bad to specifics, the ACCC’s digital platform work heavily influences the Treasury paper.

Acquisitions such as Instagram by Facebook are viewed retrospectively with a longing for an imagined “what might have been”. Unfortunately, such retrospectives can’t adequately assess how well the acquired entity would have survived without the merger.

As noted previously on this website, the ability to sell an innovation to a larger industry player is one of the avenues for innovators to get a reward for their innovation.

As mentioned, the tiling technology developed by the Rasmussen brothers for Where 2 Technologies was fundamental to the construction of Google Maps. But so, too, was Keyhole’s spatial data visualisation tools.

Could a product with the capability of Google Maps have been developed without the acquisitions? If it could, would it have been able to be integrated with advertising and search successfully?

Even if we accept the premise that some merger activity has a deleterious effect on beneficial competition (meaning competition that doesn’t come at the expense of economies of scale and scope), it does not follow that revision to the ex ante clearance processes provides a clear pathway.

There are three primary reasons for this.

The first is that no matter how the law is changed, it still depends on the so-called “with and without tests.” This test requires the decision maker to be a fortune teller. Any economist who thinks they can forecast the market outcomes with and without a merger should get into stock picking.

The second is that every change of wording in legislation has no real meaning until a court gives it one. The disagreements between the ACCC and the Federal Court revolve around interpreting the existing provisions.

This game of legislation and interpretation interplay only introduces uncertainty. This may not amount “chilling investment” as frequently described by competition lawyers, but it certainly can’t be a positive for anything in the short term.

The third is that while the ACCC and others think they have a case that Type 1 errors are occurring in the current regime (mergers being allowed that are damaging competition), changes to strengthen the tests come with the risk of greater Type 2 errors (mergers stopped to the detriment of consumers by impeding innovation or by prohibiting the benefits of scale).

Most importantly, other changes to competition law can fix the Type 1 errors. The two most notable are the creation of divestiture orders and broadening the scope of access regimes.

The former is an old feature of US anti-trust law, most recently famous in the breakup of AT&T.

However, earlier divestitures include the voluntary (because they thought it would be ordered) of United Aircraft and Transport into Boeing, the aircraft maker, Pratt & Whitney, the engine maker, and United Airlines.

The divestiture power has been disfavoured in Australia, but one has been inserted into the Competition and Consumer Act as part of Malcolm Turnbull’s “big stick” legislation.

Access regimes provide the mechanism whereby scale can be maintained while also providing innovation in related markets.

Think about a new messaging platform and having mandated access to send and receive messages from the Messenger platform on Facebook.

It is a pity that the economists at Treasury and the ACCC can’t see the inconsistency between their market model based on perfect competition at static equilibrium and using it to describe levels of dynamism.

It is worse when the cure runs the risk of further damaging innovation by reducing innovators’ ability to get rewarded for their efforts.

David Havyatt is a former telco executive, former adviser to Federal Labor ministers and former advocate on behalf of energy consumers. He is a long term observer of Australian innovation policy.

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