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Remarks to the Canadian Bar Association's Annual Fall Conference on Competition Law

André Downs, Ph.D.
Deputy Commissioner
Competition Policy Branch
Competition Bureau
Ottawa

September 20, 2001

Towards An Efficiency Standard For Reviewing Mergers

The tradeoff between efficiency and equity has always been an important consideration of economic policy. As a competition policy tool, an efficiency standard is essentially a balancing exercise between the anti-competitive consequences of a merger and the benefits associated with efficiency gains. The following describes how the Competition Bureau views the current enforcement status of the ‘efficiency defence.'

It has been almost a decade since Madame Justice Reed raised questions concerning how efficiencies are treated in the Competition Bureau's Merger Enforcement Guidelines. Her questions - and related ones - are only now being addressed in the context of the Superior Propane case¹. At issue is the appropriateness of a single-minded focus on efficiencies, while ignoring other impacts such as the transfer brought about by anti-competitive higher prices.

In its decision of April 4, 2001, the Federal Court of Appeal provided new rules and parameters in its interpretation of the efficiency defence. Specifically, it provides new information on the nature of the anti-competitive effects of a merger and also on how to balance these anti-competitive effects against real cost savings.

In considering the question, the Tribunal adopted the Total Surplus standard to assess mergers under s. 96 of the Competition Act. In its interpretation of the law under s. 96 effects, the Tribunal stated that s.1.1, the purpose clause, merely lists the benefits which flow from competition, and is not to be read into the individual sections of the substantive provisions of the Act. The efficiency defence in s. 96 was interpreted as a deliberate exception, which shows that efficiency is the paramount objective of merger policy, and which, in merger review, trumps other objectives of the Act.

In its majority decision, the Tribunal gave some reasons for adopting the Total Surplus standard. It claimed that distributional concerns do not fall within the merger provisions. Merger review requires a predictable test that finds favour among the legal, academic, economic and business communities. Not treating any transfer from consumers to firm-owners as a result of market power as neutral would write s. 96 out of the Act. If there are distributional concerns, there are better tools than competition law for addressing them.

The Tribunal wished to avoid making value judgements, but the Total Surplus standard entails -even if implicitly - a value judgement that, in some circumstances, may be unreasonable. Welfare economists recognize that the choice of any standard of merger review - the total Surplus Standard, the Price Standard et cetera - entails at least one value judgment. That is, efficiency and equity concerns cannot be separated if the analysis is to be economically meaningful.

In the Propane case, the Federal Court of Appeal stated that the Tribunal erred in law by utilizing the Total Surplus standard. It emphasized that this issue is a matter of law, not a matter of economic theory and that the enforcement policy of applying the total Surplus standard is inconsistent with the law. The Tribunal erred in law by concluding that the Total Surplus standard was the proper test to assess all the effects under section 96(1) because it does not take into account all of the effects of an anti-competitive merger, but only the negative effects on resource allocation measured by the deadweight loss.

The Federal Court of Appeal stated that s.1.1 is a purpose clause that must be respected on a case-by-case basis, and is not to be interpreted merely as a list of benefits which flow from enforcement of the Act in general. It was made clear that efficiency can no longer be pursued in the absence of distributional considerations because taking account of such considerations is a matter of law. Broader public interest objectives than efficiency are in the law and must be given proper weight in the enforcement of the merger provisions of the Act. A more judgmental assessment is required than what is called for by the largely quantitative calculation of the deadweight loss. The efficiency defence requires the assessment, inter alia, of the effects of anti-competitive higher prices, the impact on product choice, the impact on small and medium-sized firms, the consequences of creating monopoly, and the impact on participation of Canadian firms in international markets.

As Justice Evans has observed, economists can frame the relevant equity-efficiency tradeoffs in specific circumstances, but their resolution requires an appeal to broad public policy objectives and principles:

"(116) Conversely, it is in my view far from a fatal objection to the balancing weights approach that its proponent at the hearing before the Tribunal, Professor Townley, testified that, as an economist, he was unable to determine what were the effects of the merger of Superior and ICG and whether the efficiencies likely to be produced thereby were greater than, and offset, them. I take his point simply to have been that he was called as a witness expert in economics and that the balancing exercise called for by section 96 required broader public policy judgments that were outside his area of expertise, but were for the Tribunal to make as it thought would best advance the public interest within the parameters of the Act."

In other words, economists can frame the relevant equity-efficiency tradeoffs in specific circumstances, but their resolution requires an appeal to broad public policy objectives and principles and within the current Canadian competition policy context, such objectives and principles must come from the Competition Act.

Section 5 of the MEGs no longer applies

For the time being, Section 5 of the Merger Enforcement Guidelines (MEGs), no longer applies to the enforcement or the administration of the Canadian Competition Act. However, the Act itself continues to allow for an efficiency defence.

Criteria for an efficiency defence

The Federal Court of Appeal listed the criteria that a legal test for the efficiency defence must satisfy. The balancing weights method satisfies these criteria. The test should be flexible. The test should be flexible. It should not specify weights ex ante (before the fact) and the weights should not necessarily be applied uniformly across mergers. Discretion would be required in balancing the competing objectives identified in s.1.1. Weights would also be applied with discretion to evaluating the effects of income transfers. The test must advance the public interest within the parameters of the Act. It must be more consistent with the Act than the Total Surplus standard. The Federal Court of Appeal also made it clear that this would mean that there may not be a single standard that is "apposite" for all cases.

In summary, the balancing exercise dictated by the Federal Court of Appeal needs to go beyond the simple quantification exercise of the Total Surplus standard. It requires enough flexibility to assess all the anti-competitive effects of the merger and to ensure that appropriate quantitative and qualitative considerations are given to each of the objectives of the purpose clause. The balancing exercise also requires the discretion and the flexibility to incorporate the necessary qualitative considerations to the balancing of the effects of the merger in as much as they relate to the purpose clause.

There are some factors that the Bureau could consider when assessing the effects of a merger on these objectives. Regarding the effects of a merger on the efficiency and adaptability of the economy, the Bureau will generically consider the effects on the three broad types of efficiencies: allocative, technical and dynamic. While it may be difficult to quantify the effects of a merger on dynamic efficiencies , it can sometimes be determined on a qualitative basis that the effects of the merger will reduce the incentive of market participants to innovate and introduce new and better products, services and technologies.

In the global economy, the beneficial effects of competition can sometimes result in the substitution of domestically produced goods and services for imports. Also, increasing exports, even in perfectly competitive markets, generate benefits for Canadian producers without negatively impacting consumers. In addition, the benefits of competition can sometimes accrue from a better product offering by Canadian producers to world markets through product innovation and product repositioning.

The importance of barriers to entry is clearly recognized within the merger provisions of the Act and is an important factor determining the opportunities for small and medium-sized firms. Barriers to entry not only make a relevant market less contestable, but can also affect firms of different sizes differently. In particular, small and medium-sized firms can be more susceptible to predatory or exclusionary practices than large and well-financed firms. A new perspective gained from the Federal Court of Appeal decision is that, while the effects of barriers to entry on the ability of the merging firms to raise price are important, their impact on the opportunities for small and medium-sized firms to participate in the Canadian economy must also be taken into account in the efficiency defence.

A conflict between a more efficient economy and higher anti-competitive prices is clearly at the heart of any conflict arising in the context of the efficiency defence. The Federal Court of Appeal made it clear that the balancing of those effects simply could not be done within the framework provided by the Total Surplus standard. The importance of the effects of a merger on this objective should depend on the magnitude of the price increase and the characteristics of the market demand, as it represents a loss of consumer surplus resulting from higher ant-competitive prices. In some cases, the importance of this factor cannot be summarized quantitatively. A qualitative assessment of the effects of depriving consumers of competitive prices and product choices will often be required.

Assessing the anti-competitive effects of an efficiency-enhancing anti-competitive merger is only part of the analysis. One must also balance these effects against the efficiency gains and that balancing exercise must be consistent with the federal Court of Appeal decision, which requires no ex-ante determination of the importance of any one objective of the Act. Traditionally, economists have used several analytical tools to assess the net effects of an efficiency-enhancing anti-competitive merger. In his affidavit, Professor Townley has outlined the key assumptions underlying the Total Surplus, Consumer Surplus and Price standards and the inescapable equity-efficiency issues and measurement problems associated with the aggregation of different individual welfare measures within markets and across markets.

Professor Townley also introduced a method that, according to the Federal Court of Appeal, could be adapted to perform this balancing exercise, while recognizing that further elaboration and refinement is required depending on the particulars of a given case.

We find the approach to the assessment of the tradeoff between efficiency and the effects of anti-competitive higher prices that was proposed by the Federal Court of Appeal to be flexible and consistent with welfare economics. Implicit in the Total Surplus standard is an equal weighting of dollars accruing to consumers and firm owners. This means that the Total Surplus standard does not account for the transfer even if, in reality, this transfer may have adverse and severe effects. Hence, it does not take into account the specific circumstances of each case.

By contrast, implicit in the Price standard is that only dollars in the hands of consumers count; extra profits to the owners of the emerging firms do not enter in the calculus. Hence, the transfer is assumed to have adverse and severe effects even if it may be negligible relative to the efficiency gains. Again, this approach does not take into account the circumstances of a specific case.

The approach proposed by the Federal Court of appeal takes into account all quantitative and qualitative effects, including assessing the importance of the transfer as a direct consequence of depriving consumers of competitive prices, assessing the importance of how the merger may adversely affect the other objectives of the Act. Hence, these potentially adverse impacts are given weight in this analysis when they are important, and they are given little weight when they are not. Thus, unlike the Price and Total Surplus standards, in the Federal Court of Appeals approach the tradeoff is explicit and informed by the facts of the specific case at hand.

These considerations lead towards an integrated enforcement approach to the efficiencies defence. First, the familiar analytical tools traditionally used by competition authorities will continue to provide some guidance. Second, the principles put forward by the Federal Court of Appeal will dictate how the Bureau assesses the anti-competitive effects in the context of the efficiency defence and how the balancing exercise is conducted. Finally, we are looking forward to the redetermination of the Propane case by the Tribunal to provide additional clarity on how the Bureau should examine efficiency-enhancing anti-competitive mergers.