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Antitrust in 60 Seconds: Vertical vs. Horizontal Mergers

· November 19, 2018

The 60-Second Read:

A commonly used identifier for a merger is “vertical or “horizontal.” A horizontal merger is one between firms on the same level of a supply chain, or horizontal to each other, that could compete with each other. For example, a wholesaler buys products from manufacturers and then sells them to retailers. If a wholesaler acquired another wholesaler it would be a horizontal merger because they are on the same level of the supply chain.

A vertical merger is one in which a company on one level of a supply chain buys a company on another. Using the same example, if a wholesaler acquires a retailer or a manufacturer then that would be a vertical merger. Key to this concept is that these companies are related in some way that does not involve substantial direct competition. Vertical relationships may not always be as clear as in the classic supply chain model that describes industry as a chain from raw materials to the end consumer. Because of this, the term vertical merger is sometimes a catch all term used to cover mergers that aren’t clearly between direct competitors.

The type of merger is important for antitrust analysis. The risk is often clear in horizontal mergers while vertical mergers are far more difficult to analyze because the companies do not directly compete. Analysis is centered around theories of how the merger could impact their horizontal competition. For example, if a wholesaler acquires the only manufacturer of an important product then other wholesalers would suffer. However, studies have shown that vertical mergers are largely procompetitive. This research has been persuasive in courts and challenges of vertical mergers are generally more difficult than horizontal merger challenges.

Supply Chain Management 101

To best understand the horizontal/vertical divide, it is useful to step back and look at the business school thinking of supply chains. The classic model envisions a chain of goods that starts with raw materials and terminates with a sale of a product to the end consumer. This chain will often involve many companies. For example, to make a computer you first need mining companies to harvest the metals and silicon, you need chip manufacturers to make the processors and memory, you need a computer manufacturer to put the parts together and load an operating system, and you need a retailer to sell the computer to the customer. Each of these steps are vertical steps along the supply chain, and competing companies within each step are horizontal to each other.

Management may decide that integration is useful for achieving a company goal. The type of integration matters, as each type can be used to solve specific problems. It is important to note that integration does not necessarily need to be done through an acquisition or merger. There are types of contractual relationships that heavily integrate companies without combining them. The classic example is a franchisor-franchisee relationship. Many local fast food restaurants are owned by a franchisee who is in a contractual relationship with McDonald’s or Burger King to exclusively sell their food under a common set of rules that dictate things like branding or quality standards. In most states it is also prohibited for car manufacturers to sell directly to consumers, so car dealerships are usually independently owned and operated through a contractual relationship with the auto manufacturer.

Horizontal integration solves a narrow set of problems for companies. This type of integration can provide economies of scale, which are benefits like reducing per unit costs due to running a bigger operation. They can also provide economies of scope, which are benefits in being able to provide a better variety of a product. Horizontal integration can also help companies enter into new geographic markets or to serve a new class of customers (for example, expanding into business-to-business).

Vertical integration solves a different and much broader set of problems. This integration can lower costs and increase the stability of supply of an important input. Products and services can improve integration, and talent from the different workforces can share ideas and more closely collaborate. Collaboration can lead to the development of new products and innovation. A merger of companies with different structures can share their strengths and cover each other’s weaknesses. (Some of these benefits are detailed in a prior DisCo post on the acquisition of startups). Finally, vertical integration can eliminate double marginalization, which is a harmful situation that occurs when multiple companies in a supply chain have market power. In this situation, each company prices too high. Combining these companies actually lowers prices because it reduces the number of times along a supply chain that a company tries to price above market.

There is also a third category of acquisitions called a conglomerate acquisition. This is an acquisition of a company that is completely unrelated. This type of acquisition will not be covered in this post for two reasons: 1) there are very little, if any, competition concerns in a conglomerate acquisition; and 2) businesses have become interrelated enough that enforcers are hesitant to call an acquisition a conglomerate acquisition and will instead typically analyze it as a vertical acquisition.

How Enforcers View Mergers

While certain contracts between companies can violate antitrust laws, enforcers are most interested in full mergers between two different companies because mergers have the greatest impact on competition. The most important question to an enforcer is whether the merger is procompetitive, competition neutral, or anticompetitive. If the merger benefits competition or has no effect on competition, then enforcers do not have any role to play. However, if the merger is anticompetitive, then enforcers typically ask whether this is a merger that has some benefits that could be preserved through a remedy that completely fixes the anticompetitive aspects of the deal. If not, enforcers usually conclude that the merger should be blocked in its entirety.

The type of merger affects how enforcers investigate and develop potential theories of harm to competition. Horizontal mergers eliminate a current or potential competitor and therefore are the most suspect. Vertical mergers are more complicated for enforcers. They are largely beneficial but can provide a company with new strategies to harm their competitors. For this reason, analysis of vertical mergers is often highly fact specific. Enforcers need to look at how the merger might change the company’s incentive and ability to engage in strategies that harm competitors. Enforcers are also concerned that a vertical merger could be used to create barriers to entry if new competitors have to enter the market at both levels simultaneously, called two-stage entry.

Enforcers must also look at whether any benefits the merging parties claim are merger specific, or whether they could be achieved without a merger. These claimed benefits face different challenges based on the type of merger. In horizontal mergers, enforcers will typically look at whether the benefits of scale could be duplicated with new capital investment. Could the company simply invest in expanding into a new market, improving their facilities to reduce costs, or spending more on marketing and customer relations? In vertical mergers, enforcers will typically look at whether the benefits could be achieved through a carefully constructed contract between the two companies rather than a full merger.

Legal Application

While the empirical work on vertical mergers is somewhat nascent, a 2005 review of vertical merger and restraints studies by James Cooper and Luke Froeb only identified one example where vertical integration harmed consumers. These empirics have had sway in the courts, and judges tend to view vertical integration favorably.

The last vertical merger Supreme Court case was the 1972 decision in Ford Motor Co. v. United States. However, enforcers and judges in lower courts generally look to two later vertical conduct cases for guidance in policing vertical mergers. The first case is the 1977 GTE Sylvania decision. The case involved franchise contracts with strict limits on where stores were allowed to sell Sylvania’s TVs. Although franchisees were not given exclusive territories, the objective of Sylvania was to optimally manage how many competing stores were in a given area, to encourage retailers to be more aggressive and competent in selling Sylvania’s products. The Supreme Court listed the potential procompetitive benefits of restricting competition among retailers selling the same brand to increase competition between different brands. In doing so, the Supreme Court eased the standard by which this conduct is judged, allowing the opportunity for courts to examine evidence of these benefits.

In the 2007 Leegin Creative Leather Products v. PSKS, Inc. case, the Supreme Court once again revisited vertical restrictions in the form of resale price maintenance. In its decision, the Supreme Court reversed a prior decision in order to ease the standard by which resale price maintenance is judged and allow courts to examine evidence of benefits of such conduct. These benefits can be illustrated with a modern example: take a VR company that has trouble convincing customers to buy into this new technology. The VR company discovers that consumers that are provided a VR experience usually want to buy their system, so they give brick-and-mortar retailers incentives to set up costly VR spaces. However, customers who wish to buy VR systems find it cheaper to buy online and the brick-and-mortar stores lose the money they invest. These stores refuse to keep providing VR spaces. The VR company might wish to impose price restraints on online retailers to prevent this from happening. These are the type of benefits that the Leegin court considered when deciding that resale price maintenance should not be per se illegal.

These two Supreme Court cases reversed much older precedent that strictly judged vertical conduct, and highlighted the potential procompetitive benefits of such conduct. This sent a message to enforcers and lower courts, who began to view vertical conduct — including mergers — to be generally procompetitive unless the facts suggest differently. This change in enforcement has given the perception that enforcement in vertical mergers is difficult. This is a topic that is debated vigorously among antitrust scholars, with some suggesting that vertical merger enforcement should be increased and others cautioning against overly aggressive vertical enforcement.

Two recent cases show that it is not easy to make blanket statements about vertical merger enforcement. In the proposed Comcast/Time Warner Cable merger, enforcers were having difficulty putting together a horizontal case because cable markets tend to be divided with only one option per area and the companies only competed with each other directly in a few areas. Even if enforcers could prove harm in these areas was significant, it would only require a small divestiture and the merger would probably be allowed to go through. However, the merger did have significant vertical concerns. The merged company would be able to exert much more control over content, and its expanded control of nationwide broadband internet service opened up new strategies to harm streaming rivals. Reports suggest that the FCC and DoJ were getting ready to challenge the deal on these theories, and the proposed merger collapsed.

Compare this with the completed merger between AT&T and Time Warner that is still being litigated. This was a vertical merger of content and distribution. The government put on a case that the merger would give AT&T the incentive and ability to use Time Warner’s content to harm rivals and impede the growth of online video distributors. However, Judge Leon rejected these arguments in a strongly worded 172-page opinion. The case is currently on appeal, however there are signs that the DoJ might have been right. Since the merger, AT&T has raised prices and allowed HBO to go dark on its rival Dish during a pricing dispute.

Competition

Some, if not all of society’s most useful innovations are the byproduct of competition. In fact, although it may sound counterintuitive, innovation often flourishes when an incumbent is threatened by a new entrant because the threat of losing users to the competition drives product improvement. The Internet and the products and companies it has enabled are no exception; companies need to constantly stay on their toes, as the next startup is ready to knock them down with a better product.