Excerpt
A dissertation submitted in
partial fulfilment of the
requirements for the degree
of Bachelor of Law Honours
at the University of
Strathclyde, Glasgow. © April
2002.
M E R G E R P O L I C Y
I N T H E E - C O N O M Y
Andreas Seip
MERGER POLICY IN THE E-CONOMY 1 May 2002
2
Contents
Chapter One: Introduction...4
Chapter Two: The E-conomy...7
x Section 2.1.: The Peculiarity of the E-conomy...12
x Section 2.1.1.: Investment and Increasing Returns...12
x Section 2.1.2.: Network Effects...14
x Section 2.1.3.: Output Properties...19
x Section 2.1.4.: Pioneering Effects and Instant Scalability...23
x Section 2.1.5.: The WinnerTakesMost Effects...27
x Section 2.2.: The E-conomy's Essence in Antitrust...27
x Section 2.3.: Dynamic v. Perfect Competition...29
Chapter Three: Implications for Competition Policy...35
x Section 3.1.: The Commission's Relevant Market
Definition...35
x Section 3.1.1.: The Substitutability Test...37
x Section 3.1.2.: Entry Analysis...42
x Section 3.1.3.: Market Integration...47
x Section 3.1.4.: Market Shares...49
x Section 3.2.: Treatment of Dominance...55
MERGER POLICY IN THE E-CONOMY 1 May 2002
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x Section 3.3.: Accounting for the Risks...65
Chapter Four: A Regulatory Outlook...71
x Section 4.1.: Pragmatic Analysis...72
x Section 4.1.1.: The SSNIP A Performance Interface...75
x Section 4.1.2.: Barriers to Entry and Subtle Incentives...77
x Section 4.1.3.: Market Power The Volatile Incidence...78
Chapter Five: A Dynamic Intermarket Conception...83
Bibliography...87
MERGER POLICY IN THE E-CONOMY 1 May 2002
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C h a p t e r O n e
I n t r o d u c t i o n
This paper addresses the economic policy context surrounding the
European merger regulation in high-tech industries. The rapidity of
technological change raises questions as to the operation of the
dynamic parameters underlying high-tech industries. While the
identification of those parameters appears to be straightforward, the
interpretation of the effects posed by the dynamics is rather
controversial.
On the one hand, it is argued that the very dynamics of high-tech
industries create or strengthen dominant companies whereby
consumers run the risk of adopting inefficient technologies.
However, the present paper is to contest this reasoning since
performance competition and the resultant Schumpeterian process of
disequlibria makes a so-called lock-in unlikely.
MERGER POLICY IN THE E-CONOMY 1 May 2002
5
The second chapter is to identify the distinctive parameters of high-
tech industries, whereby a contrasting analysis between the two
dimensions of economic performance, establishes dynamic
competition as best utilised to serve the furtherance of consumer
welfare. The third chapter is to consider the implications of dynamic
competition for current relevant market definition by discussing the
deficiencies of current practice. Recent competitive developments
appear to confirm a broad, intermarket and technologies-based
competition among firms. The fourth chapter, therefore, seeks to
propose analytical tools that are capable of evaluating the state of
competition more accurately. To that end, the cornerstones of
relevant market definition are redefined by including a performance
based test, an enquiry into capability explanations and the setting of
time frames to assess entry competition.
The final chapter is to conclude that although Schumpeterian
dynamic competition deals with the expectation of innovation, the
proposed analysis is the more accurate approach to intermarket
competition. The goal of this paper is to provide a pragmatic
framework that assists merger analysis in evaluating the ongoing
MERGER POLICY IN THE E-CONOMY 1 May 2002
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transformation of industrial organisation in the high-tech
environment.
MERGER POLICY IN THE E-CONOMY 1 May 2002
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C h a p t e r T w o
T h e E - c o n o m y
`New economy', `innovation economy', `knowledge economy' and
`network economy' are all terms which broadly seek to describe the
ongoing transformation of industrial organisation and business
strategies, but which are at best vague in scope.
1
While `new
economy' bears a broad meaning by referring to virtually all sectors
in the economy where information is the basic feature, which
functions as output and input good,
2
the `network economy' may be
very narrow in its scope.
3
The present paper's preference lies with
the term `e-conomy' termed by Cohen, Bradford DeLong and
1
Cohen, S., Bradford DeLong, J., Zysman, J. `Tools for Thought: What Is New and
Important About the E-conomy' BRIE Working Paper No. 138, 27 Feb. 2000, at pp.
3 et seq. available at: http://www.j-bradford-delong.net./OpEd/
virtual/technet/Tools_for_Thought.doc. See also Minda, G. `Antitrust regulability
and the new digital economy: A proposal for integrating "hard" and "soft"
regulation'
2001 Antitrust Bulletin Vol. 46(3), 439.
2
Klodt, H. `The Essence of the New Economy' Kiel Discussion Paper 375, Kiel
Institute of World Economics, Kiel 2001. Also available at http://www.uni-
kiel.de:8080/IfW/pub/pub.htm.
3
Network economy may cause confusion by referring only to physical networks
such as telephone networks, airline networks etc. which are also described as `real'
networks as opposed to `virtual' networks. See further Shapiro, C. and Varian, H.
Information Rules: A Strategic Guide to the Network Economy (Boston: Harvard
Business School Press, 1999), at p. 174.
MERGER POLICY IN THE E-CONOMY 1 May 2002
8
Zysman
4
since it accurately reflects the economy and policy context
that is sought to be addressed in the present paper.
The term `e-conomy' describes the economic transformation, which is
triggered by the development and dissemination of information
technology based products and services comprising computer chips,
broadband internet, wireless communication and software.
5
While
the origins of e-conomy firms can be traced, the competitive reality is
about firms seeking to acquire each other's strengths with a variety
of business integrated. Consequently, AOL Time Warner could be
defined as a media conglomerate with a focus on online services and
media content, but it also has a significant stake in cable and
telecoms networks
6
as well as technology with its acquisition of
Netscape in 1999.
7
The rationale for the e-conomy coverage lies in the importance of
these sectors, in that they have been undergoing rapid change and
4
Cohen, S. et al. (2000), at p. 3.
5
Ibid.
6
This is, however, limited to AOL Time Warner's operations in the USA.
7
Hoover's Company Profile Database - American Public Companies 2002, Load-
Date: 4 Feb. 2002.
MERGER POLICY IN THE E-CONOMY 1 May 2002
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growth in the past decade.
8
In particular, computer and internet
technology have revolutionised business practices and industry
organisation across the globe by increasing efficiency through
decentralising, outsourcing, downsizing, knowledge management and
strategic alliances.
9
The new technologies have thus enabled firms to
avoid intermediaries, establish just-in-time production and diversify
marketing efforts.
10
In a nutshell, a new reality emerged with more
entrepreneurial business that is capable of innovating and
commercialising more rapidly.
11
However, the growth of the e-conomy is also extended to the
demand-side environment and non-business consumers. In
particular, the internet penetration is continuing to grow in Europe.
The graph below illustrates current estimated European internet
8
Given the increasing importance as a major force behind economic growth,
heightened antitrust scrutiny is believed to be mandatory according to the view of
Balto, D., Pitofsky, R. `Antitrust and high-tech industries: The new challenge' 1998
Antitrust Bulletin 43(3/4), 583, at p. 584. See further section on the risks.
9
Cohen, S. et al. (2000), at pp. 3 ff.
10
Cusumano, M.A., Yoffie, D.B. Competing on Internet Time (New York:
Touchstone, 2000) at p. 6. For example, Dell utilised the internet to realise just-
in-time production for PCs, see also MSNBC.com `The `New Economy' re-examined:
It boomed, it burst and its technological innovations changed the way Americans
thought about business ... maybe' of 17 Mar. 2002. An example of diversifying
marketing operations would be the vertical integration exhibited by the AOL Time
Warner structure which raised fears as to anticompetitive effects. See further
AOL/Time Warner (COMP/M. 1845) [2000] OJ C130/8, at p. 14, paragraph 53. The
issue is further explored in the context of network effects.
11
Cohen, S. et al. (2000), at p. 21.
MERGER POLICY IN THE E-CONOMY 1 May 2002
10
coverage in the selected countries against the respective country's
population as of January 2002.
12
0
10
20
30
40
50
60
70
80
90
Figure 1: EUROPEAN ONLINE POPULATION
POPULATION
8,2
10,3
10,2
5,4
5,2
60
83
10,6
10,1
4
57,7
4,5
16
10,1
40
8,9
7,3
59,6
INTERNET USER
2,7
2,7
2,2
1,6
2,15
11
26
1,3
0,73
1
11
2,2
6,8
2
7
4,5
3,4
33
A
B
CZ
DK
FIN
F
D
GR
H
IRE
I NOR NL
P
E
SWE CH
GB
Source: Cyberatlas, January 2002.
European internet penetration is estimated to have increased from 18
per cent in March 2000 to 36 per cent in June 2001
13
and is expected
to reach 255 million users by 2004.
14
However, the upward tendency
is endangered by the slowdown of internet penetration in Europe
12
NETstatistica European Internet Economy 2002. Available at http://www.
netstatistica.com/pdfs/netstatistica_europe_022002.pdf.
13
See further FT.com, `Brussels warns of plateau in EU internet take-up', of 12
Feb. 2002.
14
eMarketer study available at http://www.netstatistica.com/index.cfm?gn =6&id=
cg_ eu.
MERGER POLICY IN THE E-CONOMY 1 May 2002
11
during the second half of 2001 due to a perceived lack of introducing
fast broadband connections throughout Europe.
15
Dynamic competition
16
has a delicate influence on the complex ex
ante merger analysis carried out by the Competition Commission's
Merger Task Force (MTF).
17
The Schumpeterian conception of
dynamic competition appears to correspond to the rapid growth that
is enjoyed by the e-conomy. In following Schumpeter, competition is
for the market replacing thereby the traditional emphasis on price
competition. This is referred to as disequilibria achieved through
innovation in terms of new products and technology.
18
15
This tendency seems to be confirmed by national statistics. See further FT.com,
`Brussels warns of plateau in EU internet take-up' of 12 Feb. 2002 and `Oftel
reports slowing growth in internet traffic' of 15 Feb. 2002. The broadband rollout
in Europe is viewed as being crucial not only for the take-off of the content e-
conomy, but also as a continuation of the liberalisation process. See FT.com,
`Broadband's failure to connect Europeans' of 2 Dec. 2001.
16
For the purposes of the present paper the more descriptive terms dynamic and
static competition are utilised instead of the synonyms technical progress and
economic efficiency respectively to be found in economic literature.
17
The relevant legislation is the European Community Merger Regulation (ECMR),
Council Regulation 4064/89 on the control of concentrations between undertakings,
[1989] OJ L395/1, as amended by Council Regulation 1310/97, [1997] OJ L180/1.
18
Compare Schumpeter, J.A. `The Process of Creative Destruction' in Capitalism,
Socialism and Democracy (London: George Allen & Unwin Ltd., 5
th
edn., 1976) at
p. 84. Schumpeter disputes the textbook economic theory's modus operandi of
competition along price because it collapses if quality competition and sales efforts
are admitted. Instead he refers to capitalist reality which dictates competition on
the basis of a new commodity, new technology etc. which strikes at the very
existence of the firms' lives as opposed to their profit margins.
MERGER POLICY IN THE E-CONOMY 1 May 2002
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2.1.
The Peculiarity of the E-conomy
The e-conomy's essence is the creation of intellectual property and
the initiation or adaptation to technological change.
19
A central
feature is that undertakings compete fiercely for emerging markets,
because this will ultimately determine their future lead in market
share. It is, therefore, necessary to explore as to how this is
achieved in the e-conomy comprising the parameters of investment
and increasing returns, network effects, output properties, pioneering
effects and instant scalability, and `winner-takes-most' effects.
2.1.1.
Investment and Increasing Returns
Essential to gaining a competitive edge in the e-conomy is
investment. The fixed sunk costs
20
tend to be particularly high in the
e-conomy, if investments have to be made into research and
development (R&D) of software and/or hardware, or the setting up of
delivery channels through physical networks, which cannot be fully
19
Compare Ahlborn, C. `Competition Law in the New Economy: Is European
Competition Law up to the Challenge?' 2001 ECLR 156.
20
Sunk costs are all costs associated with entry. Zero sunk costs refers to a
situation in which a firm is enabled a costless exit because of the costs being fully
recoverable. See also Viscusi, W.K., Vernon, J.M., Harrington, J.E., Jr. Economics
of Regulation and Antitrust (Cambridge, Massachusetts: MIT Press, 3
rd
Edition,
2000) at pp. 160 161.
MERGER POLICY IN THE E-CONOMY 1 May 2002
13
recovered because of a concentrated market.
21
Apart from
maintenance and marketing costs, it is important to note that the
subsequent production or service provision costs are low.
22
This cost
relationship is also referred to as the e-conomy exhibiting increasing
returns. Particularly, software qualifies as exhibiting increasing
returns, since an unusually high percentage of its cots are absorbed
by initial fixed costs but subsequent modification costs are minimal.
23
While this refers to increasing returns on the supply side potentially
leading to a natural monopoly,
24
there is also a demand side form of
increasing returns in the e-conomy, which results in a more
21
See also Ahlborn, C. (2001), at p. 159. In proceeding on the assumption that a
market is concentrated and an exiting firm has to sell its assets at a scrap price,
because of a lacking market for the assets. See further Viscusi, W.K. et al. (2000)
at pp. 160 161.
22
See Klodt, H. (2001) referring to the creation of substantial firm economies as a
result of low marginal costs of information goods. See also Minda, G. (2001) at p.
439.
23
Margolis, S.E., Liebowitz, S.J. Winners, Losers, & Microsoft: Competition and
Antitrust in High Technology (Oakland: Oakland Independent Institute, 1999) at p.
82. However, as the authors emphasise, it is important to note that one has to
study increasing returns in the individual case since other high-tech sectors, such
as chip makers may not experience the same increasing returns as software, since
the initial costs in developing a chip may be significantly less than the subsequent
fixed costs of fabrication plants. See also McKenzie, R.B., Dwight, R.L. `How digital
economics revises antitrust thinking' 2001 Antitrust Bulletin 46(2), 253.
24
Further examples would include Value Added Networks (VANs) like Reuters FX
and Email systems, which are characterized by large fixed costs and low variable
costs. Heal, G. `Price and Market Share Dynamics in Network Industries', in Heal,
G. (ed.) The Economics of Increasing Returns (Cheltenham: The International
Library of Critical Writings in Economics, An Elgar Reference Collection, 1999).
Industries displaying scale economies tend to be more concentrated than others
see Viscusi, W.K. et al. (2000) at p. 150.
MERGER POLICY IN THE E-CONOMY 1 May 2002
14
concentrated market.
25
This phenomenon of demand-side increasing
returns is also known as network effects.
26
2.1.2.
Network Effects
Network effects describe the phenomenon whereby the value of a
good to a consumer is dependent not only on the characteristics of
the product, but also on how many other users have adopted the
same product.
27
The success of a network product will occur if it
attracts a `critical mass'
28
of users, thus providing strong incentives
to other potential users to join.
29
An example of network effects
would be applications such as AOL Instant Messenger or ICQ. The
more people that use the same instant chat application (particularly if
they know each other), the more sense it makes for the user to have
that type of instant messenger.
30
25
See `Foreword' at p. x by Hirshleifer, J. in Margolis, S.E., Liebowitz, S.J. (1999).
26
Synonymously, demand-side increasing returns are referred to as demand-side
scale economies see Veljanovski, C. `E.C. Antitrust in the New European Economy:
Is the European Commission's View of the Network Economy Right?' 2001 ECLR
115; McKenzie, R.B. and Dwight, R.L. (2001) at pp. 253 298.
27
See Hirshleifer, J., op. cit. See also Heal, G. (1999) at p. 192.
28
Critical mass is not further defined, since the exact number of users required will
depend on product or service specific factors.
29
Heal, G. (1999) at p. 192.
30
Compare Ahlborn, C. (2001) at p. 159. The principle of network's value increase
to each user with network growth is referred to as Metcalfe's law. See also Cohen,
S. (2000) as well as Shapiro, C. and Varian, H. (1999) at pp. 173 225 arguing
that the positive feedback effects can equally result in a rapid growth decline.
MERGER POLICY IN THE E-CONOMY 1 May 2002
15
It appears that the Commission's view is that omnipresent network
effects tend to be inherent in the e-conomy and specifically the
communications sector.
31
Dominance is then created by the positive
feedback effects, because the more users that join the network, the
greater are the risks of them becoming locked into the technology.
Consequently, the whole e-conomy may adopt inefficient standards,
because of the early entry of service providers gaining dominance by
confining innovation to them. This could even entail that other
service providers offering better quality and/or quantity would not be
able to displace the dominance of the pioneering service provider.
32
However, one should be very cautious in defining the circumstances
in which such a lock-in may occur, if at all, since empirical studies
dispute very persuasively the existence of such a process.
33
31
Ungerer, H. `Access Issues under EU Regulation and Anti-trust Law - The Case of
Telecommunications and Internet Markets', address to Panel on Substantive
Comparative Antitrust Issues in Japan, the U.S. and the European Union, 23 24
Jun. 2000, Washington D.C., at p. 4.
32
Monti, M. `Defining the boundaries competition policy in high tech sectors' UBS
Warburg Conference Europe 20/20, Barcelona, 11 Sep. 2001, DN: SPEECH/01/375.
See also id. `Competition in the New Economy' 10th International Conference on
Competition, Bundeskartellamt, Berlin, 21 May 2001, DN: SPEECH/01/232.
33
The issue is further addressed in section 2.1.4.
MERGER POLICY IN THE E-CONOMY 1 May 2002
16
The nature of network effects coupled with the critical mass effect
34
can lead to a natural monopoly which may be further strengthened in
concentration through supply-side increasing returns discussed in the
previous section. It is important, however, that network effects per
se do not raise any competition concerns. The Commission is mainly
concerned with so called bottleneck markets, whereby access to
necessary infrastructure is restricted or foreclosed;
35
the availability
of good quality content is monopolised;
36
or increasing convergence
between related technologies is shifting the balance towards already
dominant players.
37
AOL Time Warner pioneered vertical integration in the e-conomy by
combining digital distribution technology of an Internet Service
34
See further Heal, G. (1999). A firm is dependent on it reaching a certain scale
as well as concurring with overall industry growth, because otherwise a capturing
of the rise is unlikely.
35
The MCI WorldCom/Sprint (Comm/M.1741), [2000] OJ C143/4 transaction would
have resulted in such a dominant force so as to enable the undertaking to prevent
competitors and customers from having universal access to the internet. See also
Langer, J. `The MCI Worldcom Sprint merger decision reviewed' 2001 EU Focus
88/89, 2 5.
36
The Time Warner EMI merger was finally abandoned by the parties, since the
Commission had concerns in respect of the created dominance in desirable music
copyrights and the potential for leveraging this strength into the digital delivery of
music.
37
See Abbamonte, G.B., Rabassa, V. `Foreclosure and Vertical Mergers The
Commission's Review of Vertical Effects in the Last Wave of Media and Internet
Mergers: AOL/Time Warner, Vivendi/Seagram, MCI WorldCom/Sprint' 2001 ECLR
214.
MERGER POLICY IN THE E-CONOMY 1 May 2002
17
Provider (ISP) with a range of media content of a traditional
publishing business.
38
The link up illustrates the Commission's
concern as to a bottleneck market in which the network operator
internalises the network benefits by effectively "owning" the
consumer.
39
This would be achieved, if AOL were to develop a
proprietary format for the digital distribution of music combined with
its significant music library.
40
38
See Abbamonte, G.B., Rabassa, V. (2001) at pp. 222 ff. See also FT.com, `AOL
set to pay $6.75bn for Bertelsmann stake' of 4 Jan. 2002. Examples of follow-up
developments would include the merger between Vivendi/Canal+/Seagram
(COMP/M.2050), [2000] OJ C311/3 leading to a pooling of Universal's music arm
with Vivendi's multi-access portal Vizzazi, or the joint venture between T-Online,
Germany's leading ISP, with publisher Axel Springer's marketing arm to create
Interactive Media, see FT.com, `T-Online takes Springer online stake' of 17 Oct.
2001.
39
See Veljanovski, C. (2001) at p. 116. See also Balto, D., Pitofsky, R. (1998) at
pp. 593. The authors' view in the latter article seems to correspond with the
Commission's concern in that older dominant networks are competing through
cheaper or better services, if they are faced with competition, but these are only
the short term benefits of network externalities, which would not outweigh the
longer term benefits of cheaper or newer technologies.
40
See AOL/Time Warner Decision in particular pp. 8 9 at paragraph 29 and p. 14
at paragraphs 53 55. See also Rubinfeld, D.L. `Antitrust enforcement in dynamic
network industries' 1998 Antitrust Bulletin 43(3/4), at pp. 859 882 emphasizes
the difficulties to entry which may arise through the conditioning by a proprietary
format. For economically beneficial effects of vertical integration see Mueller, T.,
von der Groeben, E. `EU Merger Clearance in the New Economy' 2001 GCR 27 29,
at p. 29. The interaction with intellectual property issues makes this area
particularly complex. For a discussion see FT.com, `Cyberspace copyright
protection reinforced' of 5 Mar. 2002 for new Wipo international treaty; the Notes
`Exploitative Publishers, Untrustworthy Systems, and the Dream of a Digital
Revolution for Artists' 2001 HLR, 114(8), 2348; Sheremata, W.A. `New issues in
competition policy raised by information technology industries' 1998 Antitrust
Bulletin, 43(3/4) at pp. 568 573.
MERGER POLICY IN THE E-CONOMY 1 May 2002
18
In defence of network effects as phenomena of creating potentially
natural monopolies, it can be argued that compatibility with many
networks competing seems to be central to international connectivity
in particular in the mobile phone industry. Network growth is thus
perceived to increase consumer benefits and ultimately profits.
41
An
artificial creation of a fragmented service or product provision in an
industry would effectively reduce consumer welfare.
In addition, the Commission's claims derived from tipping the
market, such as new subscriber growth will be captured by larger
networks, is criticised on the basis that in the mobile phone industry
later entrants have gained significant market share across Europe.
42
Similarly, the ISP environment is subject to change, whereby
newcomers have been able to build a significant stake in the
market.
43
This is because network effects operate symmetrically, so
that excessive price increases or failure to correspond to consumer
demand potentially causes the network in a downward spiral
41
See Veljanovski, C. (2001) at p. 116.
42
Id. `Mobiles, Mergers and Network Effects', Case Associates, 2001 available at
http://www.casecon.com.
43
See further the discussion in section 3.1.4.
MERGER POLICY IN THE E-CONOMY 1 May 2002
19
particularly in internet and mobile phone markets where demand
substitution is easily realised by low switching costs.
44
2.1.3.
Output Properties
However, the extent and magnitude of substitution is also dependent
on the attributes of the product or service in question, which in turn
should help to define market power. The diversity of products and
services in the e-conomy parallels that of the old economy. A new
layer of developing and/or delivering mechanisms is added in the e-
conomy, which could be viewed as distinct. It has been argued that
those products in the e-conomy, such as games are durable goods
and are offered at competitive prices, since the goods can be used
and reused almost without limit.
45
Consequently, companies in the
e-conomy are always competing against their own benchmark of
previous sales, which keep prices for new products low to create an
incentive to substitution.
46
44
At least in these markets the network externalities as expressed in Balto, D.,
Pitofsky, R. (1998) at pp. 593 594 are irrelevant, because of the negligible
switching costs involved.
45
Ahlborn, C. (2001) at p. 159.
46
Klodt, H. (2001) suggests that in countering potential market failure
undertakings would have to bundle and version products, attract free riders, and
establish reputation as the most important business strategies for the new
economy.
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