Vertical Mergers

6 Do vertical mergers facilitate upstream collusion?
Liberty Mncube, Lindiwe Khumalo and Mfundo Ngobese
The potential for vertical mergers to have anticompetitive effects depends on the
situation in individual markets, including the extent of market power at different
levels. In South Africa, high levels of concentration, coupled with extensive cross-
holdings by the major firms, give more cause for concern than in other jurisdictions
with larger and less concentrated markets.
This is reflected in the wariness with which South African competition authorities
have approached vertical mergers over the past decade. This approach has largely
been because of concerns that the mergers may lead to the foreclosure of the non-
integrated competitors and, to a lesser extent, that the vertical mergers may create an
environment that is more conducive to coordinated outcomes.
Vertical mergers involve the merger of firms that make products at different levels
in the manufacturing process of a final product (ABA Section of Antitrust Law
2008). The merging parties are therefore likely to have been in a customer–supplier
relationship pre-merger. The parties are not competitors in the same market. It is
well recognised in competition economics literature that vertical integration has the
potential to realise efficiencies. The Chicago School of the 1960s and 1970s pointed
out the weak microeconomic foundations of theories stating that a firm would
leverage its market power at one level to another level, explaining that, instead,
vertical mergers were more likely to be motivated by efficiencies (Riordan 2005).
The Chicago School, however, relies on assumptions of perfect information about
markets, efficient markets and economies of scale in an essentially static framework.
As pointed out in Riordan (2005), transaction-cost economics of the 1970s and
Free download from www.hsrcpress.ac.za
1980s staked a middle ground, identifying new efficiency rationales for vertical
integration, while cautioning that firms with market power may have strategic goals
that are poorly aligned with consumer welfare.1
In recent years, post–Chicago School theories have applied game-theoretic tools
to assess the scope for strategic behaviour in vertical mergers, together with the
effect of imperfect information on contracting. Under conditions of imperfect
information and strategic behaviour, there may be incentives for firms to engage in
anticompetitive behaviour whereby vertical integration alters industry conduct to the
detriment of competitors and consumers. Post–Chicago School economics identifies
a number of situations in which vertical foreclosure is a rational anticompetitive
strategy. Riordan (2005) in particular identifies three major theories that support
this: raising rivals’ cost, restoring monopoly power and ‘facilitating collusion’ (Hart
& Tirole 1990; Martin, Normann & Snyder 2001; Rey & Tirole 2003). This chapter
focuses on the facilitating collusion theory.
76
Competition law.indd 76 2012/11/06 3:13 PM

Generally, explicit and/or tacit collusion requires reaching an agreement, monitoring
compliance and punishing defections. Vertical integration might facilitate collusion
by aiding any of these activities. The facilitating collusion theory has deep roots in
competition policy, but has only recently had firm grounding in economic theory.2
The 1984 United States Non-Horizontal Merger Guidelines (United States Department
of Justice 1984)3 suggested two grounds for a ‘facilitating collusion’ theory of harm in
vertical mergers. First, a vertical merger may facilitate upstream collusion by making
it easier to monitor downstream prices (United States Department of Justice 1984,
section 4.221).4 Second, vertical integration may facilitate collusion through the
acquisition of a ‘disruptive buyer’. The guidelines state that a disruptive buyer must
be one that is substantially different from the others, the idea being that price cutting
to this buyer is particularly attractive, so that the removal of this buyer from the
downstream market may significantly reduce incentives to deviate from a collusive
agreement (United States Department of Justice 1984, section 4.222). This theory has
shifted focus to another theory that states that vertical mergers may result in total
foreclosure of non-integrated rivals either upstream or downstream, by absorbing
capacity from the market to use internally. In addition, a vertical merger may also
affect the stability of explicit collusion.
South African experience shows that a number of collusion cases have involved
intermediate goods, with a significant portion of these cases involving industries
where one or more firms are vertically integrated. Furthermore, several of these
cases have involved firms that have been prohibited from integrating vertically.
This chapter illustrates the value of an economic approach in the analysis of vertical
mergers.
First, the chapter outlines the approach of the South African Competition
Commission. After a brief overview of the proportion of vertical mergers in relation
to all mergers, it describes the theoretical framework that can be used in analysing
the effects of vertical mergers on collusion. Then it looks at international case law
for examples in which an economic approach underpinned the assessment of vertical
mergers. It then illustrates the relevance of the theory of ‘facilitating upstream

collusion’ in the context of recent South African cases.
The approach of the South African Competition Commission

In South Africa the proportion of mergers identified as purely vertical in nature
has fluctuated, with the average at 8 per cent of all mergers between 2000/01 and
2008/09 (see Table 6.1). However, mergers with a mix of horizontal and vertical
characteristics have increased, which means that the proportion of mergers with a
vertical dimension was at 22 per cent of all mergers in 2008/09.
There are no specific provisions in the Competition Act (1998) pertaining to vertical
merger analysis. The tendency has rather been for the competition authorities to
follow international practice, such as that reflected in the International Competition
77

t h e d e v e lopm e nt of comp e tition law and e conomics in sout h africa
Table 6.1 Percentage of mergers filed by type (year ending March)

2000/ 2001/ 2002/ 2003/ 2004/ 2005/ 2006/ 2007/ 2008/
Merger type/year 01 02 03 04 05 06 07 08 09
Horizontal 62 66 65 51 56 54 49 57 48
Vertical 9 10 6 8 9 11 8 6 9
Horizontal and vertical 5 1 4 7 8 17 13
Conglomerate 22 13 17 26 24 26 26 37 30
Management buyout 2 10 8 8 3 9
Total 100 100 100 100 100 100 100 100 100
Source: Competition Commission’s annual reports
Network and Organization for Economic Cooperation and Development (OECD)

documents, as a guide, in conjunction with the application of the substantial-
lessening-of-competition test in terms of section 12A(1) of the Competition Act.
The Act sets out factors that the competition authorities must take into account
in determining the effect on competition, which have implications for all types of
mergers, including horizontal, conglomerate and vertical. These factors include the
probability that firms will behave competitively or cooperatively after the merger,
ease of entry, levels and trends of concentration, and any history of collusion, degree
of countervailing power, dynamic characteristics (such as innovation and product
differentiation), and the nature and extent of vertical integration.
The factors set out in the Competition Act are in line with those identified by the
OECD (OECD Directorate for Financial and Enterprise Affairs 2007), which cover:
• the levels of concentration in the upstream and/or downstream market;
• the ability of the merging firms to behave anticompetitively;
• any incentives for the merging firms to behave anticompetitively; and

• the actual effect/s on competition, and who will be affected by the behaviour.
If the largest firm’s market share is high and there are high levels of concentration in
the upstream and downstream markets, adverse competitive effects are more likely.
Although the analysis of vertical mergers involves an assessment of the ability and
incentive to foreclose, this chapter focuses on the possible coordinated effects that
may arise.
Theoretical background
A vertical merger facilitates collusion if it enables firms, either upstream or
downstream, to more effectively coordinate, either because a vertical merger makes
reaching a tacit agreement on the coordinated outcome easier and/or it makes the
monitoring and enforcement of an agreement more effective. The literature on
78

do v e rtical m e rg e rs facilitat e upstr e am collusion ?
the impact of vertical mergers on upstream collusion is both recent and limited. It
consists of the contributions by Riordan and Salop (1995), Nocke and White (2005,
2007), and Normann (2009).5 For a discussion of this literature, see Riordan (2005).
In this chapter, the authors adopt the Nocke and White model to illustrate how a
firm could use a vertical merger to facilitate upstream collusion. According to Nocke
and White (2007), a vertical merger between an upstream and a downstream firm
has two opposing effects on the incentives for upstream firms to collude. On the one
hand, upstream firms that are not party to the merger will typically not be able to sell
to the integrated downstream buyer when they choose to deviate from any collusive
agreement. Any deviation would alert the integrated firm to the deviation.
Put differently, the optimal way for an upstream firm to deviate is to undercut the
fixed fees and wholesale prices of its rivals only marginally. This allows the deviant
firm to steal all of its rivals’ business while downstream output remains close to
monopoly levels; hence the deviant firm’s profits are close to monopoly profit. Such
a strategy is no longer feasible when one or more downstream firms are integrated.
Integrated downstream firms will always prefer to buy from their upstream affiliate
at marginal cost than to buy from a deviant firm at any price that gives the latter
positive profits (essentially, they would rather these profits went to their upstream
affiliate than to another firm). Integrated downstream firms can be relied on to reject
any offer that would be profitable for a deviating upstream firm, which can help to
enforce the collusive agreement. A deviating upstream firm cannot hope to attain the
full monopoly profit from deviating if one or more downstream firms are integrated
with its rivals. Vertical integration by an upstream firm reduces the number of
outlets through which its rivals can sell when deviating, generally reducing their
profit from cheating, and thus facilitating collusion.
On the other hand, there is a counteracting punishment effect, which makes collusion
difficult. This counteracting effect reduces the severity of the punishment that can
be levelled at the merging firms if they cheat on the agreement. In other words,
downstream firms may earn rents in the non-cooperative equilibrium of the model.
If an upstream firm integrates with a downstream firm, these rents now become
part of the profit of the merged entity. Therefore, the merged entity can expect to
make more profits in the non-cooperative punishment phase than the upstream
firm could make alone. Conversely, assuming there are no changes in market share,
the merged entity will make the same profit as would the upstream firm alone when
monopoly profits are sustained. So, for a given collusive market share, the merged
entity suffers relatively less from a switch from collusive to punishment phases, and
is correspondingly more tempted to cheat on any collusive agreement.
An important result of the Nocke and White model is that the outlet effect of
a single vertical integration outweighs the punishment effect for an upstream
industry producing homogeneous goods.6 Furthermore, as the size of the integrated
downstream unit increases, the size of the outlet effect increases faster than the size
79

of the punishment effect (Nocke & White 2010). Therefore, integrating with a larger
downstream unit facilitates collusion the most.
In some circumstances, it may be that downstream firms set their strategic variable
after they know what input costs they will face. This means that downstream prices
(or quantities) can potentially react to upstream deviations within the same period
that they are made. The reaction effect means that during the deviation period, a
vertically integrated firm is better able to punish deviations of upstream competitors
by quickly increasing competition in the downstream market. The reaction effect
further facilitates collusion. The lack-of-commitment effect means that a vertically
integrated firm finds a departure from upstream collusion less profitable because of
rivalry in the downstream market. Independent downstream firms are less willing
to deal with a vertically integrated firm because of a rational expectation that the
vertically integrated firm will expand in the downstream market if the collusion
breaks down. The lack-of-commitment effect therefore makes upstream collusion
easier to sustain.
International case law

The model discussed in the preceding section is noteworthy because it loosely relates
the reaction effect to the US Justice Department’s non-horizontal merger guidelines’
theory that vertical integration facilitates collusion by making it easier to monitor
downstream prices, and the outlet effect to the US guidelines’ disruptive-buyer
theory.
As cartels are inherently unstable, the challenge to sustain a cartel lies in finding ways
to ensure adherence to a collusive agreement by devising punishment mechanisms
that will make deviation from a collusive outcome unattractive. This challenge
is also referred to as the cartel problem. The cartel problem is compounded in
markets where there is tacit collusion, as there is no communication between market
participants. It should be noted that merger review seeks to avoid the creation of
conditions where consciously explicit collusion, tacit collusion or even parallel

behaviour is likely to occur.
While tacitly and explicitly collusive conduct may be enjoined in terms of relevant
antitrust enforcement provisions, conscious parallelism may not be so enjoined.
Accordingly, the authors use the terms ‘coordinated conduct’ or ‘coordination’ to
refer to all of these instances. Both international and South African case law shows
that in certain circumstances, vertical mergers can facilitate coordination both
upstream and downstream.
It is essential to note as a preliminary point that the three effects outlined by
Nocke and White that tend to facilitate collusion (i.e. outlet, reaction and lack-
of-commitment effects) should be placed within the context of the three elements
that were outlined in the European Court of First Instance’s Airtours v Commission
decision relating to a determination of whether market conditions are such that
80

there is likely to be coordination. First, market participants must possess an ability

to coordinate, meaning that market participants must be able to reach terms of
coordination. Second, once the terms of coordination are accepted, coordination
must be sustainable. Coordination will not be sustainable if deviations cannot be
deterred. Finally, coordination must be feasible. It is not feasible to coordinate in a
market characterised by low entry barriers and buyers with countervailing power.
The European Commission recently reviewed the proposed mergers of TomTom/
Tele Atlas and Nokia/Navteq. Tele Atlas and Navteq are the only two suppliers of
navigable digital map databases with European Economic Area coverage. Essentially,
the market for the supply of navigable digital map databases in this area is a duopoly.
A digital map database is described as
a compilation of digital data which typically includes (i) geographic
information which contains the position and shape of each feature on
a map (such as roads, railways, rivers and indications of land use), (ii)
attributes which contain additional information associated with features
on the map (such as street names, addresses, driving directions, turn
restrictions and speed limits) and (iii) display information. (Nokia/Navteq:
para. 19)
Navigable digital map databases are ultimately used as input in the production of
navigation devices such as portable navigation devices, personal digital assistants,
global positioning system (GPS)-enabled mobile telephones and ‘in-dash’ navigation
devices.7 There are firms that develop and supply navigation software to navigation
device manufacturers. However, some navigation device producers, such as TomTom,
have in-house software development capabilities. There are therefore three levels to
the supply chain: the upstream production of navigable digital map databases; the
intermediate development of navigation software; and the downstream production
of navigation devices. TomTom is a downstream producer of navigation devices
(more specifically, portable navigation devices) and is an intermediate developer and
supplier of navigation software to third parties. Nokia, on the other hand, produces
and supplies GPS-enabled mobile phones and has an in-house navigation software
development capability used solely for internal purposes.
In both the Tele Atlas and Nokia cases, the European Commission found that each
of these vertical mergers was unlikely to facilitate coordination in the upstream
market for navigable digital map databases. In the commission’s view, there was no
indication that Tele Atlas and Navteq coordinated with each other in the upstream.
Investigations showed that they competed on price and non-price aspects, and that
innovation was an important feature of this market.
In addition, the commission found that the characteristics of the market were such
that coordination was unlikely to take place. In particular, coordination on prices
was found to be unlikely, as database prices are not transparent and there was no
evidence of a geographic split between Tele Atlas and Navteq. The other factor that
81

the commission considered in the Tele Atlas case, which was decided before the
Navteq case, was that the vertical integration of the proposed merger between Tele
Atlas and TomTom decreased market symmetry, whereas Navteq was not integrated
with Nokia. These market characteristics related to the ability to coordinate.
In relation to sustainability, the European Commission noted that the database
market is characterised by large and infrequent contracts, which increased incentives
to deviate from a collusive agreement. The commission also found that high fixed
costs and low marginal costs in the database industry make deviation attractive.
One of the important assumptions in the basic model of Nocke and White is the
stability in the number and relative sizes of downstream firms. In order for the outlet
effect to provide a strong incentive for coordination in the upstream market, the
downstream arm of the integrated firm must have one of a fixed number of outlets
of fixed relative sizes – otherwise sales that will be achieved by an undercutting non-
integrated firm will not be constrained by the fact that it cannot offer its products
through the downstream arm of an integrated rival. The commission noted certain
aspects of both the portable navigation devices market in the Tele Atlas case and the
GPS-enabled mobile telephones in the Navteq case, which indicate that in both these
markets the number and/or size of market players is far from being stable. In the Tele
Atlas case, the commission found that in 2004, TomTom, Garmin, Navman and six
other firms entered the market. It noted further, however, that despite this relatively
large number of entrants in the portable navigation devices market, these have failed
to capture more than marginal market shares and remain minor players. This factor
will seem to favour the existence of an outlet effect, particularly if the merger is
taking place with an incumbent firm enjoying the advantages of first mover.
Nonetheless, the commission did not attach much significance to the first-mover
advantages in the Tele Atlas case, as it eventually held that there had been numerous
entrants in the four years before the merger and that the relative sizes of the
portable navigation devices, manufacturers had not been stable. In the Navteq case,
the commission’s view was that the market for mobile telephones with navigation
features was nascent, with a high growth potential. The commission noted: ‘Finally,
an allocation of customers would also be difficult, as in the portable navigation
devices market, and in the downstream mobile markets, the size of the firms is far
from stable and numerous new companies regularly enter one or other of those
markets’ (Nokia/Navteq: para. 403).
In the Tele Atlas case, the commission made it clear that some aspects of a vertical
merger may possibly increase the scope for coordination. In a summation of the
outlet and punishment effects, the commission noted:
For instance, the fact that one downstream customer is now integrated
with an upstream company could reduce the possibility for the non-
integrated company to deviate from a collusive agreement. However,
a vertical merger also has effects that may decrease the scope for
82

coordination. For instance, the fact that one downstream customer is now
integrated diminishes the possibility to punish the integrated company if
it were to deviate. (TomTom/Tele Atlas: footnote 195)
It should be noted that the incentive to coordinate upstream can also be related to
whether or not there is an incentive to foreclose rivals in the downstream market.
This is because the downstream arm of a vertically integrated firm will benefit
from increased profits as higher input prices will be faced by its downstream rivals,
while it may continue to purchase its inputs at cost from its upstream division.
Thus the integrated firm’s downstream arm will be more competitive than its
rivals. In the Tele Atlas case, the commission found that databases account for less
than 10 per cent of the portable navigation devices’ wholesale price. In addition,
the extent of the retail price increase will depend on the pass-on rate of TomTom’s
competitors. Accordingly, the commission found that a 10 per cent price increase
will only lead to a 0.5 per cent wholesale price increase. If the portable navigation
devices’ manufacturers pass on 50 per cent of the price increase, under any
reasonable elasticity and diversion ratio, such a price increase would lead to very
few additional sales for the merged firm.
The European Commission found that the revenues that will be lost in the upstream
market as a result of a partial foreclosure strategy designed to increase rivals’ costs
will exceed gains from increased sales of portable navigation devices that will be
captured by the merged entity downstream. In the Navteq case, the commission’s
econometric analysis also indicated that the merged entity would only capture a
relatively limited amount of sales downstream by increasing map database pricing
to Nokia’s competitors. It can therefore be argued that the incentive to coordinate
pricing upstream is lessened by the fact that the amount of sales that will be captured
downstream by the integrated firm is non-existent, or insignificant, due to limited
retail price increases by rivals.
In most vertical mergers where facilitation of coordination was a concern, the issues
traversed relate to the merger’s likelihood to increase the scope for coordination as
a result of the merger making it easier to reach terms of coordination, by making
monitoring easy due to increasing the levels of market transparency in the market,
or by creating a conduit for information exchange.
In the Accor/Hilton/Six Continents/JV merger, the European Commission had to
assess the formation of a joint venture between Accor, Hilton, Six Continents and
WorldRes (to be referred to as WorldRes Europe Ltd [WRE]). Accor, Hilton and
Six Continents operated in the upstream hotel accommodation market while WRE
was to function as a computerised reservation system, or global distribution system,
downstream of its parents’ activities. WRE was to provide travel agencies with
information and enable them to make hotel reservations. The market investigation
focused on increased flow of information between the parents (the hotels), providing
them with the incentive and ability to coordinate. In addition, the information that
would have been available through WRE was not such that it would have allowed the
83

hotel parents to deduce patterns of offer and demand: the information was found to
be already available on reservation websites.
In the Shell/DEA and BP/E.ON (Veba) mergers, the European Commission looked at
various characteristics of the ethylene market and adopted simultaneous decisions.
These mergers had both vertical and horizontal elements. The commission
concluded that the two proposed transactions would result in the creation of a
collective dominant position of the two new entities Shell/DEA and BP/E.ON in the
upstream market for the supply of ethylene on the ARG pipeline network (ARG+).
The commission found that the market had the necessary characteristics relating
to ability, sustainability and feasibility of coordination. From a vertical perspective,
the commission noted that as the only non-vertically integrated suppliers, DEA and
Veba are the main price setters in the ethylene market. The removal of these non-
integrated upstream suppliers was found to be likely to alter the ability to coordinate
and for incentives to exist, as the proposed merger would establish downstream links
that enhance the chances for coordination.
The European Commission found that as all ethylene suppliers would be vertically
integrated, they would have similar incentives regarding companies that compete
with their downstream divisions in the market for ethylene derivatives. An incentive
to make downstream non-vertically integrated rivals less competitive would exist for
all ethylene suppliers on the ARG+ network post-merger.
In the US, the Department of Justice challenged the proposed acquisition of
Masonite (United States v Premdor Inc.), one of the two major producers of ‘interior
moulded doorskins’ (doorskins), by Premdor Inc., one of the two major producers
of ‘interior moulded doors’ (doors) and a minor producer of doorskins, in 2001.
The Department of Justice alleged that doorskins and doors were separate markets,
and in each market Premdor’s and Masonite’s only major competitor was vertically
integrated into both doorskins and doors. Premdor had a 40 per cent market share
of the moulded-door market. Its major competitor was In Door. There was also a
competitive fringe consisting of nine firms, none of which had a market share greater
than 5 per cent. Masonite and In Door produced the vast majority of doorskins.
Masonite was the larger of the two firms, with over 50 per cent of the market, and
Premdor was its major customer. The third largest doorskin manufacturer, with less
than 10 per cent of the market, was a joint venture that included Premdor. All of the
joint venture’s output was sold to Premdor. Both In Door and Masonite sold to the
unintegrated downstream door manufacturers.
The Department of Justice alleged that the market was susceptible to coordination:
it was concentrated and the product was homogeneous. There was a history of
collusion in the downstream market. The Department of Justice alleged that the
proposed vertical integration would facilitate price coordination with the existing
vertically integrated firm at both levels of the supply chain, by eliminating factors
that had hitherto impeded coordination. First, before the merger, any joint attempt
by Masonite and its competitor to raise the price of doorskins ran the risk of spurring
84

Premdor to expand its production of doorskins both for its own use and for the use
of other door manufacturers.
Second, absent the merger, the Department of Justice alleged that expansion by
Premdor upstream in the doorskin market constrained the ability of Masonite and In
Door to coordinate in the upstream market. Post-merger, Premdor would have less
incentive to expand its output upstream, as it benefits from higher upstream prices,
as an integrated supplier, in the downstream market.
Third, In Door would constrain coordination because its lower cost structure
created incentives for it to lower prices to obtain greater market share. The ability
to coordinate would be enhanced because the merger would create cost parity.
Masonite/Premdor would have similar costs post-merger due to the elimination
of double marginalisation. Fourth, pre-merger asymmetries of information
impeded coordination. Those asymmetries would be eliminated by the merger. The
Department of Justice’s concerns were resolved through a package of divestitures
designed to establish another competitor in the doorskin market.
Evidence from selected cases in South Africa

As noted above, an incentive to coordinate upstream can also be related to whether
or not there is an incentive to foreclose rivals in the downstream markets. When it
upheld the decision of the Competition Tribunal in Mondi/Kohler Core and Tubes
(KC&T), the Competition Appeal Court clearly recognised the interdependence
between input foreclosure and upstream coordination. First, the court found that
Mondi was likely to prioritise the needs of KC&T’s downstream core- and tube-
manufacturing business over those of its competitors. In the court’s view, the
existence of an acknowledged capacity constraint faced by Mondi in the upstream
production of core boards used in the downstream production of core and tubes
constituted sufficient justification for a restriction of supply. This strategy was found
to be in all likelihood beneficial to Mondi, as Sappi, the only other supplier of core
boards, would be left with an effective near monopoly over third-party sales. Due to
the lack of other viable alternative suppliers, Sappi would have been in a position to
raise prices of its core boards to rival core and tube manufacturers.
It should be noted that, in turn, Mondi and Sappi were also major customers of core
and tubes. The Competition Appeal Court found that core and tubes constituted
a small proportion of the price of composite products sold by Sappi and Mondi.
Accordingly, it was found that Mondi and Sappi would not have faced much
resistance from their customers as a result of limited price increases of composite
materials. Therefore, although there may have been substantial price increases in the
manufacture of core and tubes, this would not translate to a significant price increase
of composite products. Sappi and Mondi were therefore likely to gain more from
coordinating over higher prices in the supply of core boards than they would lose as
a result of such cost increases in the downstream market, as these would not have
85

been substantial and could have been passed on with limited effects on sales. In fact,
if KC&T had continued to obtain its core boards from Mondi at cost, it would have
been more competitive than its rivals, an additional gain for Mondi.
When looking at the facts of the KC&T case, it seems that the decision of the
Competition Tribunal, and confirmed by the Competition Appeal Court, can only
be strengthened further by the basic model of Nocke and White. The Competition
Appeal Court noted that KC&T was dominant in the market for the supply of core
and tubes. The market appeared to be stable with limited entry. KC&T therefore
constituted an important customer for core boards. Therefore, if Sappi cheated on a
collusive outcome by undercutting, it may not have been able to increase its sales, as in
order to do so, its offer would need to have been accepted by KC&T (outlet effect). The
punishment effect is unlikely to be significant, because by cheating on the collusive
outcome, Mondi would be likely to lose more profits than it would have gained: the
price of core boards is a small proportion of the ultimate price of composite products.
Changes brought about by vertical integration do not provide a basis for concern
unless the conditions for coordinated effects, as set out in the Airtours case, are met
and changes brought about by the merger strengthen or increase the likelihood of
coordination. The Competition Appeal Court effectively found that the merging
parties had the ability to collude and that collusion would be both feasible and
sustainable. The merging parties themselves acknowledged that the structure of the
market was susceptible to collusion even before the merger.
In January 2008, the Competition Commission prohibited a vertical merger between
DPI Plastics (Pty) Ltd and Incledon Cape (Pty) Ltd. DPI Plastics is involved in the
manufacturing and distribution of plastic pipes and fittings for various applications,
including civil building, construction, plumbing, industry, mining and irrigation.
Incledon Cape operates as a wholesaler and supplier of a wide range of products,
including pipes, fittings, valves, flanges, threading machines, water meters, plumbing
and related products used in the engineering, agriculture, plumbing and municipal
industries.
At the time of the transaction, there was a horizontal overlap in the activities of the
merging firms in the market for the wholesale distribution of pipeline solutions.
Pipeline solutions involve a basket of products required to transfer water, including
pipes, fittings, water meters, valves, pumps and other related piping products to suit
customer needs. The proposed transaction also resulted in vertical integration, in
that DPI Plastics is a manufacturer of plastic pipes and fittings, while Incledon Cape
is a distributor of these products. There were nine firms in the upstream market,
three of which were already vertically integrated into the downstream market,
including DPI Plastics.
During the course of the merger investigation, the commission uncovered information
that suggested that there was collusion in the markets for the manufacture of pipeline
solutions in the Western Cape. The investigation revealed the existence of a cartel,
86

which was mainly engaged in collusive tendering with various manufacturers and
merchants in the region, and included the merging parties as members. On the basis
of the existence of collusion (and on other grounds), the commission prohibited
the merger. Subsequent to the prohibition of the merger, DPI Plastics applied for
immunity from prosecution in terms of the commission’s corporate leniency policy.
The matter has since been referred to the Competition Tribunal for adjudication.
Although the commission found it sufficient to prohibit the merger on the basis that
there was an existing cartel, elements of the Nocke and White model can be drawn
on to illustrate how the vertical merger could have facilitated upstream collusion.
In order to show that vertical mergers facilitate upstream collusion, Nocke and
White (2007) make what at first appears to be a rather strong assumption. They
assume that the discount factor is low enough to make it necessary for colluding and
that upstream firms set market shares in such a way as to minimise the collective
incentive to deviate. In other words, firms need to agree on a market-share split as
a necessary condition for tacitly coordinating their prices. It turns out that in the
plastic pipes cartel such an agreement existed. For instance, in the Eastern Cape,
the manufacturers of PVC and high-density polyethylene pipes in the region held
several meetings wherein it was agreed, inter alia, that contracts would be allocated
to the individual manufacturers to reflect their pre-existing market shares.
As we have already established, there is an outlet effect associated with each vertical
integration, and this reduces the incentives for non-integrated upstream firms to
cheat. Countering the adverse effects of vertical integration is a punishment effect
of vertical integration. The punishment effect refers to the fact that the acquisition
of a downstream firm might increase the integrated firm’s incentive to defect from
upstream collusion by securing profits in the downstream market should the
collusion collapse. Nocke and White (2007) acknowledge that the interplay between
the outlet effects and the punishment effect may be more complicated with each
vertical merger, in the case of multiple integration.
When considering the number of vertical integrations that one would expect to see
in an industry, Nocke and White (2007) point out that there is, in addition to the
collusive motive, a market-share motive for vertical mergers. (One might expect to
see more mergers, as firms may have an incentive to vertically integrate to obtain a
larger share of the collusive pie, even when the vertical merger increases the critical
discount factor.) The merging parties’ post-merger market share for the distribution
of pipeline solutions in the Western Cape was approximately 45 per cent, with a
market-share accretion of 20 per cent. Since a verticaly integrated firm may have
an incentive to cheat, other firms may be willing to concede this increase in market
share for collusion not to break down. In this chapter we argue that there was both
a collusive and a market-share motive for the vertical merger between DPI Plastics
and Incledon Cape. A vertical merger may appear to increase market share, but that
does not imply that all firms in the industry should integrate, as this could upset the
equilibrium for collusion.
87

The commission blocked a few transactions in the reinforcing- and fencing-steel

industry in 2008. Some of these transactions would have resulted in vertical
integration, and the commission was concerned that they could have facilitated
coordination both upstream and downstream. In September 2008, the commission
prohibited a merger wherein Cape Gate sought to acquire Cape Africa, Transvaal
Gate and Fence & Tube (Cape Gate/Cape Africa, Transvaal Gate and Fence and
Tube).8 During its investigation, the commission found that the market for wire and
wire products was cartelised. The transaction resulted in the vertical integration
of various activities. First, Cape Gate manufactures a range of steel, wire and wire
products, some of which are supplied to Cape Africa (a joint venture between Cape
Gate and Transvaal Gate), sold in the province of Limpopo. Second, Cape Gate
produces galvanised wire, which is used downstream by Transvaal Gate and by Cape
Gate itself to make fencing products, like commercial chain-link fencing. Finally,
Fence & Tube distributes its products through Cape Africa in Limpopo.
It should be noted that Cape Gate and Cape Africa were already vertically integrated
and that a significant effect was brought about by the acquisition of Transvaal Gate.
The commission noted that the upstream market for the production of galvanised
wire was highly concentrated, with sales of the two players accounting for a
significant proportion of the market. Both the upstream and downstream markets
were cartelised, with market players integrated both up- and downstream.
The commission was therefore of the view that not only was Transvaal Gate an
effective competitor that was about to be removed from the market, but Transvaal
Gate would effectively have been part of an existing cartel post-merger. It can
therefore be argued that Transvaal Gate was, pre-merger, an avenue that existed
for upstream manufacturers of galvanised wire to expand their sales if they were to
cheat on the coordinated outcome. Post-merger, this avenue would not have been
available, and, as such, this would have strengthened the already existing outlet
effect. The importance of Transvaal Gate in the downstream market, however, was
not fully explored.
Various players in the market for the supply of reinforcing steel are vertically
integrated. Integration occurs from wire and rod manufacture down to bar
yards, which cut, bend and supply reinforcing steel to construction projects. In
September 2008, the commission blocked a merger wherein Aveng sought to
acquire Silverton Reinforcing, Koedoespoort Reinforcing, Witbank Reinforcing
and Nelspruit Reinforcing bar yards. This transaction had both a horizontal and a
vertical dimension. Aveng operated major bar yards in the country under the name
Steeledale, hence the horizontal overlap with target firms. In addition, Aveng is
involved in the upstream market for the production of mesh and wire. The target
firms are downstream suppliers of mesh and wire in construction projects. During
the merger investigation, Aveng applied for corporate leniency in respect of the
upstream market for the production and supply of mesh.
88

In this transaction the commission did not find that vertical integration would be
likely to facilitate coordination. This was linked to the commission’s finding that
the proportion of mesh sourced by the target firms was very small, and therefore
that the transaction was unlikely to result in customer foreclosure. Accordingly,
the target firms were not sufficiently important outlets, and foreclosure of access to
them was likely to make deviation by upstream rivals from the coordinated outcome
unattractive.
Clearly, vertical mergers in collusive markets are likely to attract attention from
competition authorities and a finding of likelihood of foreclosure could intensify
coordinated-effect concerns.
Lessons and conclusions

Collusion enables firms to restrict competition and raise prices by exerting market
power they would not otherwise have. Fighting collusion is a major area of activity for
any competition authority and this is likely to continue. Through the merger review
regime, competition authorities can prevent the emergence of industry structures that
are prone to collusion by taking this into account when evaluating proposed mergers
ex ante. They can also prohibit vertical mergers that facilitate collusion.
What is apparent from most of the South African cases discussed in this chapter is
that the basis for prohibitions had little to do with changes that would be brought
about by the merger, but appeared to have much to do with the involvement of either
or both of the merging firms in a cartel. There was thus little economic analysis in
evaluating the merger on the effect of the merger on existing collusion.
The authors’ view is that the commission’s analysis could have been strengthened
by an economic analysis of the likely effects of the mergers on collusive activity. As
noted above, vertical integration by an upstream firm reduces the number of outlets
through which its rivals can sell when deviating, generally reducing their profit from
cheating and thus facilitating collusion. However, if an increasing number of firms

integrate downstream, other countervailing effects may begin to outweigh the outlet
effect. In an extreme case, when all firms are vertically integrated it should be noted
that competition at one level of the market is eliminated and therefore the outlet
effect no longer holds.
Transactions that result in vertical integration of firms that operate in vertically
integrated markets may not bring about an anticompetitive outcome from foreclosure
of an outlet to upstream firms that choose to deviate from collusion. If the end product
is sufficiently homogeneous, the vertically integrated deviating upstream firm can
capture market share from its competitors through its own vertical chain. Therefore,
the punishment effect is likely to outweigh the outlet effect. Nevertheless, a merger
increasing the number of vertically integrated firms may still reduce asymmetry
between market players so as to make collusion easy to achieve and sustain.
89

Notes
1 See also Williamson (1975).
2 Nocke and White (2007) analyse collusion among upstream firms that use two-part tariffs
in a dynamic model. They compare the minimum discount factor required for collusion
to be a sub game-perfect Nash equilibrium with integration to the standard case of vertical
separation. They show that vertical integration unambiguously facilitates collusion.
3 These guidelines have been superseded by the 1992 Horizontal Merger Guidelines
(with 8 April 1997 revisions to section 4 on efficiencies).
4 See also Nocke and White (2003) and Riordan (2005).
5 Normann (2009) analyses the impact vertical integration has on upstream firms’ ability to
collude when downstream firms pay a linear price for the input. As the downstream unit of
the integrated firms is delivered internally at marginal cost, it benefits from a raising-rivals’-
cost effect when the input market is collusive. The main result is that vertical integration
facilitates upstream collusion. Riordan and Salop (1995) sketch an informal theory of how
information exchange through a vertically integrated firm facilitates upstream collusion.
6 However, the assumption that the discount factor is low enough to enable collusion and that
upstream firms set market shares in such a way as to minimise the collective incentive to
deviate is quite restrictive.
7 Navigable devices use navigation software that combines geographic positioning from a GPS
receiver, data contained in the navigable digital database and other information in order to
provide navigation functionality.
8 This document is confidential, but a non-confidential version can be made available on
request to the Competition Commission.
References
ABA Section of Antitrust Law (2008) Mergers and acquisitions: Understanding the antitrust issues,
3rd ed. Chicago: American Bar Association
Aveng (Africa) Ltd / Wire Products (Pty) Ltd and others CC Case no. 2008Apr3697
Aveng (Africa) Ltd / Koedoespoort Reinforcing Steel (Pty) Ltd CC Case no. 2008Jun3785
Aveng (Africa) Ltd / Witbank Reinforcing and Wire Products (Pty) Ltd CC Case no. 2008Jun3786
Aveng (Africa) Ltd / Nelspruit Reinforcing Supplies (Pty) Ltd CC Case no. 2008Jun3787
Cape Gate / Cape Africa, Transvaal Gate and Fence and Tube CC Case no. 2008Jun3788
Case COMP/M.3101, Accor / Hilton / Six Continents / JV
Case COMP/M.2533 BP/E.ON
Case COMP/M.4942, Nokia/Navteq
Case COMP/M.2389, Shell/DEA
Case COMP/M.4854, TomTom/Tele Atlas
CFI judgment of 06.06.2002 on case T-342/99, Airtours v Commission of the European
Communities
DPI Plastics (Pty) Ltd / Incledon Cape (Pty) Ltd CC Case no. 2007Oct3263
Hart O & Tirole J (1990) Vertical integration and market foreclosure. Brookings Papers on
Economic Activity. Microeconomics Vol. 1990: 205–276
90

Martin S, Normann HT & Snyder CM (2001) Vertical foreclosure in experimental markets.

RAND Journal of Economics 32: 466–496
Mondi / Kohler Core and Tubes Case no. 20/CAC/Jun02
Nocke, V & White, L (2003) Do Vertical Mergers Facilitate Upstream Collusion? PIER Working
Paper 03-033, University of Pennsylvania
Nocke V & White L (2007) Do vertical mergers facilitate upstream collusion? American Economic
Review 97(4)
Nocke V & White L (2010) Vertical merger, collusion, and disruptive buyers. International
Journal of Industrial Organisation 28: 350–354
Normann HT (2009) Vertical integration, raising rivals’ costs and upstream collusion. European
Economic Review 53(4): 461–480
OECD Directorate for Financial and Enterprise Affairs (2007) Vertical mergers, Policy
Roundtables DAF/COMP/(2007)21
Rey P & Tirole J (2003): A primer on foreclosure, Mimeo, University of Toulouse. Also published as
Rey P & Tirole J (2005) Handbook of industrial organization, vol. III A primer on foreclosure,
North Holland
Riordan M (2005) Competitive effects of vertical integration. In P Buccirossi (Ed.) Handbook of
antitrust economics. Cambridge, MA: MIT Press
Riordan M & Salop G (1995) Evaluating vertical mergers – a post–Chicago approach. Antitrust
Law Journal 63: 513–568
United States Department of Justice (1984) Merger guidelines. Non-horizontal merger guidelines,
14 June
United States v Premdor Inc., No. 1:01CV01696 (D.D.C. 2001)
Williamson OE (1975) Markets and hierarchies: Analysis and antitrust implications. New York:
Free Press
91

Vertical Mergers

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Vertical Mergers

Uploaded by

Copyright:

Available Formats

6 Do vertical mergers facilitate upstream collusion?

Liberty Mncube, Lindiwe Khumalo and Mfundo Ngobese

Competition law.indd 76 2012/11/06 3:13 PM

mergers. It then illustrates the relevance of the theory of ‘facilitating upstream

The approach of the South African Competition Commission

Competition law.indd 77 2012/11/06 3:13 PM

Table 6.1 Percentage of mergers filed by type (year ending March)

Horizontal and vertical 5 1 4 7 8 17 13

Management buyout 2 10 8 8 3 9

Source: Competition Commission’s annual reports

Network and Organization for Economic Cooperation and Development (OECD)

• any incentives for the merging firms to behave anticompetitively; and

Competition law.indd 78 2012/11/06 3:13 PM

Competition law.indd 79 2012/11/06 3:13 PM

International case law

conditions where consciously explicit collusion, tacit collusion or even parallel

Competition law.indd 80 2012/11/06 3:13 PM

there is likely to be coordination. First, market participants must possess an ability

Competition law.indd 81 2012/11/06 3:13 PM

Competition law.indd 82 2012/11/06 3:13 PM

Competition law.indd 83 2012/11/06 3:13 PM

Competition law.indd 84 2012/11/06 3:13 PM

Evidence from selected cases in South Africa

Competition law.indd 85 2012/11/06 3:13 PM

Competition law.indd 86 2012/11/06 3:13 PM

Competition law.indd 87 2012/11/06 3:13 PM

The commission blocked a few transactions in the reinforcing- and fencing-steel

Competition law.indd 88 2012/11/06 3:13 PM

Lessons and conclusions

cheating and thus facilitating collusion. However, if an increasing number of firms

Competition law.indd 89 2012/11/06 3:13 PM

Competition law.indd 90 2012/11/06 3:13 PM

Martin S, Normann HT & Snyder CM (2001) Vertical foreclosure in experimental markets.

Competition law.indd 91 2012/11/06 3:13 PM

You might also like