Thursday, 14 April 2016

Are mergers going too far?

A few weeks ago the Economist ran a leading article, 'The problem with profits' (here's a link, but it may be paywalled). It argued that
The naughty secret of American firms is that life at home is much easier: their returns on equity are 40% higher in the United States than they are abroad. Aggregate domestic profits are at near-record levels relative to GDP
It also said that
incumbent firms are becoming more entrenched, not less...Our analysis of census data suggests that two-thirds of the economy’s 900-odd industries have become more concentrated since 1997. A tenth of the economy is at the mercy of a handful of firms—from dog food and batteries to airlines, telecoms and credit cards. A $10 trillion wave of mergers since 2008 has raised levels of concentration further
and argued for a policy response:
take aim at cosseted incumbents. Modernising the antitrust apparatus would help. Mergers that lead to high market share and too much pricing power still need to be policed
I ran the numbers myself on the level of US profits relative to US GDP, and here they are (using the excellent FRED database). Pre-tax profits (the red line) tend to be the headline number, but the better measure is after tax profits with statistical adjustments for stock valuation and depreciation (the green line).

On one measure, profits as a share of GDP had been in long-term decline from the early 1950s up to about 2002-03, on the other (better) measure profits had been steady over the same period, but they both agree that profits have indeed taken off since. The GFC made only a temporary dent, and the drop in recent quarters may be equally transient as it reflects the impact of plunging energy prices on the US energy sector (notably on the 'fracking' industry) and it too may well dissipate if oil prices continue to firm. Overall, yes, the profits share has risen to a historically high level.

The hypothesis that overlax, Type 2 error, policing of mergers - allowing ones through that have ended up substantially lessening competition - isn't proven. But the possibility that it might be, ought to give competition authorities serious pause for thought. It's possible that economic and judicial thinking on mergers has indeed swung too far in the pro-merger direction. 

At one point in the US it had been right down the other, Type 1 error end, disallowing mergers that were extremely unlikely to cause any competition issues: classic errors of that kind had included the Brown Shoe case in 1962 and the Von's Grocery case in 1966. In the grocery one, Von's and its intended merger party would have had 7.5% of the highly unconcentrated Los Angeles market between them. Since then, opinion has evolved, less weight is put on pure market share numbers, and more, rightly, on whether there will be still be effective constraints on the merged entity post-merger. Mergers reducing four market participants to three, or three to two, will still receive intense scrutiny, as they ought, but they can get the tick today in a way that would have been unthinkable fifty years ago. Even two to one may get approved in exceptional cases.

But it may be time for a rethink, especially because (as the saying goes) you generally can't unscramble the eggs if you've mistakenly let an anticompetitive merger go through. And the downside risks are probably a bit higher in New Zealand since a fair few of our markets are fairly concentrated already. As it happens, there's a particularly good example in the pipeline right now, with Z's proposed purchase of the Chevron petrol stations. It's a doozie, or, as the Commission put it in November, "The merger application is complex and involves a number of markets throughout the fuel supply chain. We have identified and notified Z Energy of several areas that we are continuing to investigate...Further work is also required to investigate the retail supply of petrol and diesel, as there are a number of retail sites where, if the merger proceeded, few options would remain for consumers". I wasn't in the least bit surprised that in December the Commission gave it itself another four months to mull it over (the indicative decision date is now April 29). It's a tough one.

If it's indeed the case that merger authorities risk erring down the Type 2 end - and we may be at particular risk because of the structure of our economy and its Z/Chevron decision points - then it gives added force to the arguments for evaluating merger decisions after the fact. There are some folk who say it can't be done, mainly because (they argue) you can't tell what the counterfactual would have been if the merger had not gone ahead. I'm not among their number, and neither, latterly, is the Commerce Commission, which, as I noted here, has creditably gone back and looked at how they've been turning out.

The more I think about it, though, the more I'm beginning to wonder whether an independent third party shouldn't do the job (or at least be co-opted into the Commission's evaluations). I've got a good deal of confidence in the Commission's people and processes, but even so it's generally not a good idea to make one of the players the referee. And if merger authorities everywhere have accidentally strayed into allowing too-big mergers, it probably needs someone outside the consensus groupthink to say so.


  1. Are incumbent firms really becoming more entrenched? Its worth keeping in mind this comment by Bourlee Lam at The Atlantic:

    [...] Richard Foster, a lecturer at the Yale School of Management, has found that the average lifespan of an S&P company dropped from 67 years in the 1920s to 15 years today. Foster also found that on average an S&P company is now being replaced every two weeks, and estimates that 75 percent of the S&P 500 firms will be replaced by new firms by 2027.

    Does this suggest incumbents are becoming more entrenched?

    Also how many merges are experiments? Firm A thinks it can make money by taking over firm B. So it runs the experiment by actually taking over B. After a while it discovers it wasn't such a great idea and so sell B or at least works out it only wants part of B and so sells the other parts of B off. At a point in time it may look like concentration has increased in the industry but a few years down the line it all looks different when the experiment has run it course and parts of B are sold. Stopping the merger would stop the experiment and stop what could turnout in the long-run to be a welfare enhancing move.

    1. Thanks Paul. On your 1st point re S&P churn indicating less entrenched rather than more, it's not sthg I know much about. The Econ made an argument for persistency:

      " A very profitable American firm has an 80% chance of being that way ten years later. In the 1990s the odds were only about 50%"

      and there's more in the Briefing they also wrote (interesting in itself) at

      On the experiment point, could be, but as a merger regulator I wouldn't want to allow anti-competitive mergers through, with the certainty of upfront and possibly substantial welfare costs, on the offchance that they might be welfare-enhancing experiments. Does not compute

    2. I take the point but you don't know the competitive effects until the experiment has run its course. The CC don't know that there are welfare costs ex ante. If they did know the outcome, firms wouldn't have to experiment in the first place.

    3. Yeah, but put yourself in the CC's shoes. The test it is obliged to use, is to be "satisfied that the acquisition will not have, or would not be likely to have, the effect of substantially lessening competition in a market", and it won't often get past the "satisfied" threshold if the calculus is, upfront allocative costs versus remote efficiencies of some kind.
      If the efficiencies are more immediately visible, by the way, and tell me if I'm teaching grandmothers, the CC can 'authorise' a merger on a net benefit test, which could cover some of the situations you mention. But v difficult otherwise to wave through sthg on "let's see what happens"

  2. Thanks Donal for a very provocative post. I have a request for clarification and a comment.

    Your main point seems to be that we should monitor the outcomes of past merger decisions, use that monitoring to draw inferences about NZ markets and feed all of that back into future merger decisions.

    As I read it, you are not suggesting we try to unscramble eggs that we later find shouldn't have been scrambled, but rather to learn from such errors and apply those insights when the next request for egg scrambling arrives. You are further suggesting that the ComCom shouldn't examine the ex-post effects of its own merger decisions: an independent third party should do it. Have I reflected your view correctly?

    I agree that ex-post merger reviews could be very useful and that a body independent of the Commerce Commission should do these reviews.

    If such a body were appointed its potential scope should not be limited to merger clearances: rejections also matter.

    These issues are of vital importance in NZ's small, open, developed economy.

  3. You have reflected my views bang on. I should probably have made the non-unscrambling point clearer. What's done is done. It's all about the approach to future decisions


Hi - sorry about the Captcha step for real people like yourself commenting, it's to baffle the bots