AT&T-Time Warner and New Thinking on Vertical Mergers

The Issue:

Barely a month since U.S. District Court Judge Richard Leon ruled against the efforts of the Justice Department (DOJ) to block AT&T’s acquisition of Time Warner, DOJ filed to appeal his decision. The fate of the appeal is uncertain and AT&T completed its acquisition of Time Warner within days of the original ruling. But the appeal signals that the issues the case has raised will continue to be debated for some time to come. The antitrust efforts on this merger are particularly consequential because they represent the first time in decades in which the Department of Justice attempted to block a vertical merger. The move reflects new thinking on the competitive impacts of vertical mergers, which is especially relevant in the new digital age and with the rise of targeted advertising based on “big data.”

The antitrust efforts represent the first time in decades in which the Department of Justice has attempted to block a vertical merger.

The Facts:

• The link between AT&T and Time-Warner is a vertical one combining firms at different levels of the production and distribution chain. Antitrust merger cases usually focus on horizontal mergers where two (or more) firms that directly compete with each other with products that are very similar combine into one company. In opposing horizontal mergers, regulators typically argue that the combined firm would reduce competition for that particular product, resulting in higher prices and diminished options for consumers. In the case of the AT&T-Time-Warner merger however, the companies offer very different products and services. Time-Warner owns and produces video content including CNN, HBO, DC Comics, and Warner Bros. Studios (and film library). However, it does not sell this content directly to consumers but, instead, sells to cable and satellite TV operators of which AT&T is the largest through its ownership of DirecTV.
• Early in the history of antitrust, vertical combinations were viewed as potentially anticompetitive as horizontal ones. An early case was United States v. Terminal Railroad Association (1912). Here, fourteen of the 24 railroad lines that then converged in St. Louis formed an association that bought the only station with a railroad bridge over the Mississippi River. The association then denied use of that station to all non-association members, putting those railroads at a major competitive disadvantage. The case made it to the Supreme Court, which agreed that the combination of railroads buying the one St. Louis terminal violated antitrust laws. (However, instead of dissolving the association, the Court set up rules that the association had to admit other railroad as members or at least allow them access the station on an equal basis.) Years later, in Brown Shoe Co. v. United States (1962), the DOJ successfully blocked a merger between Brown, a leading shoe manufacturer, and Kinney, the country’s largest family shoe retailer. The Justice Department argued — and the Supreme Court ultimately agreed — that a combined Brown-Kinney company would be able to block other shoe manufacturers from selling downstream through Kinney’s stores thus depriving these rivals of an important access point to final consumers.
• Official concern over vertical mergers has waned over the past several decades and prosecution of such mergers has been virtually non-existent. This reflects the rise of a consensus associated with the Chicago School and articulated powerfully by Robert Bork in The Antitrust Paradox, his influential 1978 book. Bork’s argument was three-fold. First, he invoked what’s known as “the single monopoly profit” argument that meant that even if a vertical merger resulted in the exclusion of some firms from part of the market, it only changed the distribution of profit among firms, not the total profit overall. In this view, the original St. Louis station and bridge already had a monopoly and was (or could have been) earning the monopoly maximum profit. The railroad association just changed who got that profit — not the profit and price mark-up itself. Second, Bork argued that a vertical merger that restricted market interactions with rival firms at different levels of the production or distribution chain made little economic sense. Such action, he argued, basically required the firm to forego revenue (and profit) it could earn by instead selling services to upstream or downstream rivals. According to this argument, the retail division of the merged firm (Kinney) had every reason to carry and sell shoes produced by shoe manufacturers other than Brown because it would make a profit from doing so. Finally, Bork noted that vertical integration often led to cost-saving efficiencies that would actually lead to lower prices. As independent companies, Brown would markup the prices for its shoes to Kinney just as it did with other retailers. This raises Kinney’s costs and lowers its profit. Merging put Brown and Kinney on the same team — with the incentive to keep costs down in order to compete as efficiently as possible in the downstream retail market.
• It’s hard to overstate the impact that Bork and the Chicago School analysis had on antitrust policy and enforcement. From the late 1970’s on, neither the Department of Justice nor the Federal Trade Commission challenged a purely vertical merger in court until the AT&T-Time-Warner case. Private litigation has been almost as limited and rarely successful. The arguments of Bork and the Chicago School became dominant in the courts. Indeed, there emerged a de facto presumption that vertical mergers were not only not harmful but, in fact, generally positive for consumers as well as for the merging firms.
• However, economic analysis has moved on and there are good reasons to recognize that vertical mergers can pose anticompetitive threats. The rise of game theory and a deeper analysis of imperfectly competitive markets combined with the experience of real-world business people to foster the development of a more modern post-Chicago view. To begin with, the post-Chicago approach has made it clear that, except under very special circumstances, the “single profit” argument does not hold. What is at stake is not so much whether the vertical merger raises the current profit. Instead, but just as importantly, what is important to consider is that the merger protects that profit from the discipline of potential competition. Take a simple case of a monopoly manufacturer selling to a monopoly retailer. In this bilateral relation, both firms have a lot of power and negotiations over the wholesale price can be contentious. In each market, there is room to enter. The monopoly manufacturer would love to have some options regarding who sells its product. The monopoly dealer would equally like to have alternative suppliers. Indeed, the manufacturer may decide to set up its own downstream retail firm. Likewise, the monopoly retailer may decide to enter the upstream market with its own manufacturing company. Any of the above entry scenarios would introduce some competition into the markets and likely generate lower consumer prices. But none may happen if the two current monopoly firms merge. Obviously, neither of the two original firms will have a reason to enter the other’s market once they’ve merged. And a new independent retailer or independent manufacturer may be deterred from entering by a merged manufacturing-and-retailing giant.
• Similarly, restricting access to rival firms at different levels of the production or distribution chain may make economic sense overall. Consider for instance two manufacturers and two retailers — all four operating as independent firms. Suppose now that one of the manufacturers merges with one of the retailers. Does this merged firm have an incentive to stop selling its manufacturing output to the one independent retailer left that competes with the acquired retailer? Quite possibly, yes. By preventing manufacturing sales to the independent retailer, the merged firm effectively gives the other manufacturer a monopoly vis-à-vis that independent retail firm. This will likely lead to higher input prices for the independent retailer that, in turn, force it to charge higher retail prices downstream and thus allowing the merged retailer to raise its prices as well.
• To be sure, there are potential efficiency gains from a vertical merger. Some of these may reflect the elimination of the “double mark-up” noted above. Other efficiencies may come from better coordination. For example, a railroad that runs a line to a large coal mine could, for a substantial capital cost, invest in cars and rails tailored to carry that grade of coal most efficiently. Yet the railroad may not make the investment because, once made, the railroad’s bargaining position vis-à-vis the coal mine will be very weak. It cannot easily use that capital elsewhere and the coal-mining firm knows that. Once the two firms merge however, they become one firm that only cares about the total profit — not how it is divided between two companies. By aligning their interests, the merged companies are more likely to invest in ways that result in more efficient production.
• The arguments for and against the AT&T-Time Warner case provide a real world testing ground for the arguments expressed by Bork and the Chicago school and the new post-Chicago approach. For example, DOJ argued that the merged firm would raise the cost of licensing for series such as Game of Thrones (or cease to offer it altogether) to competitor cable companies. This would be a way to get more subscribers to DirecTV and increase its subscription price. AT&T argued, on the other hand, that the merger would benefit consumers due to the efficiencies it would bring. Some of these claimed efficiencies were based on ending a double markup. AT&T would now get the Time-Warner content at cost and it could pass on the savings to its DirecTV subscribers.
• The increasing value of consumer information is particularly relevant for vertical mergers. AT&T claimed that the merger would lead to hundreds of millions in increased annual advertising revenue that could subsidize the cost of providing content to viewers. In particular, AT&T argued that Time-Warner needed AT&T’s extensive digital network and related consumer data to provide more targeted advertising. The rise of video streaming across a variety of platforms has led to a major fall in the demand for traditional TV advertising. Advertisers greatly value the ability to identify precisely a viewer’s characteristics or the digital profile that these new media platforms offer but that traditional TV cannot. AT&T hopes to marry its digital consumer tracking and delivery capabilities with Time-Warner’s rich content to be at the front of where media markets are headed. The DOJ countered that AT&T could prevent or deter the emergence of new smaller media platforms such as Playstation Vue and Dish Sling, whose success will also likely depend upon targeted advertising revenue. This is because AT&T could deny these firms access to content especially if they coordinated their efforts with Comcast/NBC, the other large integrated media company. (Comcast has already merged with NBCUniversal.)