The Treatment of Efficiencies in Merger Review: An International Comparison

1 Statement of Purpose and Introduction

1.1 Purpose

This study has been prepared at the request of the Government of Canada in order to inform discussions related to the proper consideration of efficiencies in merger review in Canada. The immediate purpose of the report is to review and contrast the approaches taken by competition agencies and courts in a number of jurisdictions with respect to the principles and methods they apply in reviewing mergers that promise significant efficiencies at the same time as they threaten -- to at least some degree -- competition.

The study will focus on four jurisdictions: Australia, the European Union, the United Kingdom and the United States. These represent potentially important examples for Canada as they are all significant jurisdictions with modern economies (like Canada's) as well as sophisticated antitrust laws with skilled, professional enforcement agencies. The experience of these authorities will no doubt be relevant for the design of a Canadian approach.

1.2 Introduction

Mergers and acquisitions have become an important fact of the economic lives of modern market-based economies. Even if weaker growth has slowed the pace of M&A activity somewhat in the last few years, there is no denying that dynamic economies demand the kind of structural innovation often accomplished through the reallocation of assets and skilled workers in a merger. Under the right conditions, mergers can deliver a wide variety of benefits to customers, shareholders, employees and suppliers. These benefits include most obviously products produced at lower costs, products of higher quality and the creation of new products. Less obviously, mergers can contribute to stability of employment, to the retention and better application of scarce worker skills and to the better management of supply chains.

However, even as they promise benefits, mergers can pose certain risks for the aforementioned groups. Famously, many mergers have proven to be disasters for the firms involved. Indeed there is a growing empirical literature in economics showing that a significant fraction of mergers may not yield the benefits the merging firms expected.¹ While losses in these cases fall to those responsible for the transaction (and who stood to benefit if it was successful) other negative effects of mergers can fall on outsiders, principally customers and competitors. Mergers can contribute to the creation of market power, leading to higher prices for customers. Mergers can also help to build dominant firms, which may take advantage of their market strength to disadvantage smaller rivals through various means. They may, for example, choose to employ predatory techniques to eliminate small rivals, or they may insist that suppliers not sell to those rivals.

It is the concern with these external effects that has led many countries to enact merger review provisions as part of their antitrust arsenal. Indeed, merger review has become one of the three main elements of a modern competition law, together with rules on price-fixing and abuse of a dominant position. The challenge for public policy toward mergers is to craft a law, and design enforcement, that allows mergers that promise substantial social benefits to proceed while blocking (or restructuring) those that do more harm than good. Two difficult questions must be addressed: (i) which effects of mergers are to be viewed as good and which as bad; and (ii) what rules are to be used to evaluate a merger when there are both good and bad effects?

1.2.1 Motives for Mergers

The motives for mergers are many and varied, but most can be placed into one of two broad categories used by antitrust experts. First, mergers may be motivated by a desire to achieve certain efficiencies that will make the merged entity "better" than the original participants. It could be, for example, that the merger makes possible longer production runs, better use of scarce management skills or the sharing of important intellectual property. The result could be old products produced at lower cost or new and better products. Second, a merger may represent an attempt by the parties to reduce competitive pressure, creating market power and likely leading to higher prices. Of course, many mergers will be motivated by a desire to achieve both of these benefits for shareholders - lower costs and higher prices. While the lower costs can be viewed as society's gain (fewer resources used up) the higher prices hurt consumers. The various effects of such a merger can be illustrated with a diagram such as that in Figure 1.² In this diagram the line D represents the demand for some product by consumers. Initially - pre-merger - this product is produced and sold at price P1 which, thanks to vigorous competition by the two sellers, equaled the unit (or average) cost (AC1). The merger of the two firms produces market power, which is demonstrated by the fact that the price rises to P2, but at the same time it produces significant efficiencies that push the average costs down to the level AC2. The higher price leads consumers to buy fewer units - the number of units sold falls from Q1 to Q2. To analyze the impact of the merger on consumers and shareholders we need to measure how these price and quantity changes effect their welfare in this market. This we do using the economists' concepts of "consumers' surplus" and "producers' surplus".

Consumers' surplus refers to the difference between what consumers have to pay for a particular quantity of a good and the maximum they would have been willing to pay for that quantity. On a graph like that in Figure 1, this is illustrated by the area beneath the demand curve (which gives the value consumers place on each successive unit) and above the price they are paying. Before the merger, consumers were enjoying surplus equal to the combined areas A+B+C but due to the higher price post-merger, their surplus falls to that equal to area A. The firms' surplus can be represented here by their profits or the difference between the revenues they collect and the costs they pay. The profit per unit then will be the difference between the price and unit or average cost. Profits before the merger were zero as P1=AC1.³ After the merger, profits per unit rise to the difference between the new price (P2) and the new average cost (AC2). Total profits now are then illustrated by areas B+E.

Notice that area B, which was lost by consumers, is gained by the firms - that it, it represents a transfer of surplus from buyers to sellers. Area C is consumers' surplus lost by consumers and not transferred to firms - this is referred to as "deadweight loss" by economists and it represents surplus lost to society because the firms produce less output. The area E, on the other hand, represents new surplus created by the more efficient production of the merged firm.

We can therefore see that the merger has three main effects here: the restriction of output has created deadweight loss (area C); the higher price has transferred surplus from consumers to producers on the units still sold (area B); and the efficiencies have lowered the costs of producing this output (area E). There is a general consensus among antitrust scholars that the creation of deadweight loss is a bad thing for society and that efficiencies are a good thing. Views on the social impact of transfers are less homogeneous and this is reflected, in part, in the various approaches we study below.

1.2.2 Changing views of efficiencies

As this report is being written, many countries are struggling with the questions of, not only how to measure these effects, but also of how to weigh them. Tellingly, all the jurisdictions reviewed in this study are considering changes to their approach to evaluating efficiencies in merger cases, or have recently announced changes:

• In Australia, the 1999 Merger Guidelines described more completely how efficiencies will be considered in merger review and there are calls now for further revisions to the law to make it more sympathetic to efficiency claims.⁴
• In the European Union, pressure has been mounting for the Commission to consider efficiencies more positively after concerns arose in a number of cases that efficiencies were insufficiently appreciated. This concern rose again recently with the Commission's rejection of the GE-Honeywell merger. The Commission decided, in June 2000, to begin a major review of the Merger Regulation and in December 2001 a Green Paper outlining possible reforms was released. The Green Paper invited views as to how efficiencies could be incorporated without suggesting an approach itself. Commissioner Monti has said that he personally favours creating an efficiency defense.⁵
• In the United Kingdom, the government has produced a White Paper (2001) outlining possible changes in the competition law of the UK, in part to bring it closer to the model used for the EU. In anticipation of the forthcoming changes, there has recently been a marked reduction in the degree to which there is political involvement in antitrust decision-making.
• In the United States there continues to be an evolution in the way the enforcement agencies and courts treat efficiencies in mergers. In 1997 the joint FTC-DOJ Merger Guidelines were revised to provide a more detailed treatment of efficiencies and enforcement officials continue to speak publicly about how much respect efficiencies now receive in merger review.⁶

1.2.3 The Role of Efficiencies and the Goals of Antitrust

It would be fair to say that something of consensus has been developing as to some of the appropriate goals of competition policy. Typically now, competition policy is seen as a tool for protecting and enhancing the competitiveness of markets, not simply for the sake of competition, but because competition generates certain benefits that are valued.⁷ Most significantly perhaps, economists believe that competition contributes to an efficient allocation of resources, facilitating the creation of wealth and raising living standards. Competition can have other valued consequences, not necessarily unrelated to efficiency, such as providing low prices and broad product selection to consumers, protecting smaller businesses from abuses by larger firms and facilitating the economic integration of distinct geographic areas.

It is important to recognize that competition and efficiency are not one and the same thing, that mergers can have independent effects on both, and that these effects can be positive or negative in each case. Consider first the possible effects of mergers on competition. To begin we need some way to measure competition - i.e. what does it mean to have more competition or less? Competition could be measured by the number of competitors, or their size distribution or by some qualitative assessment of the vigorousness of their rivalry. However, the most common approach among economists is to assess the competitiveness of a market by how closely the market price approaches the competitive price - where the latter is taken to be the long run marginal cost of the good in question. This can be measured, for example, using the Lerner index -- the percentage deviation of price from marginal cost.⁸ Though competition is a process, it is measured here by its effect on price: mergers that reduce competition would reveal this through post-merger increases in the value of the Lerner Index.

Measured this way, mergers can increase or decrease competition in a market. If a merger combines two small firms, allowing them to realize significant efficiencies through economies of scale, it could well lead to lower prices (and a lower Lerner Index) by turning them into a much more powerful competitor for the established larger firms. On the other hand, if the merger reduces the number of vigorous competitors or eliminates a particularly effective competitor, it could certainly reduce the competitiveness of the market.

To stress an important point, mergers can generate efficiencies and affect competition. Their effects on competition can be direct, for example by reducing the number of vigorous competitors, or can work indirectly through efficiencies as when more efficient firms become stronger competitors. The result of this is that we should recognize that, with respect to efficiencies and competition, a merger will produce one of four outcomes:⁹

• there will be efficiency gains and an increase in competition;
• there will be efficiency losses and a reduction in competition;
• there will be efficiency gains but a reduction in competition; or
• there will be efficiency losses and an increase in competition.

If we anticipate category (i) there is little reason for antitrust intervention, and if a result like (iv) is anticipated, the merger will not be proposed by the parties. This leaves the antitrust authorities with cases (ii) and (iii). Case (ii) mergers will only come forward if the lessening of competition is sufficient to compensate the firm for the higher costs, but they would not fare well in the review process of any of the countries studied here.¹⁰ To approve such a merger requires that the authorities give greater weight to the interests of the merging parties than to those of consumers. Therefore, in these countries, the difficult cases are those in category (iii), those that lower costs but reduce competition.

1.2.4 Types of Efficiencies¹¹

With respect to efficiencies that represent real savings of resources, there are, broadly speaking four kinds of efficiencies that arise in the consideration of mergers; (i) productive efficiency; (ii) allocative efficiency; (iii) dynamic efficiency; and (iv) transactional efficiency.¹² What these various types of efficiencies have in common is that they allocate scarce resources to generate wealth. In addition, it is possible that the merger will generate pecuniary efficiencies - these are simply transfers from other agents in the economy rather than real resource savings. While these are less relevant in antitrust merger analysis, they may not be completely irrelevant and will be considered briefly in a later section below as well.

Productive efficiency refers to ability of firms to get the most output from the least input given the current technological constraints. Mergers can enhance productive efficiency in a number of ways. We give here three generic examples. First, the merged firm maybe benefit from economies of scale through longer production runs or the sharing of fixed assets. Second, the merging firms may have complementary specialties, the combination of which provide synergies allowing the new firm to produce higher quality and/or at a lower cost.¹³ Third, the merging firms may be complementary with respect to outputs in the sense that the merged firm will enjoy economies of scope, which arise when it is less costly to provide a set of products than to provide the products individually. Mergers that allow firms to offer more complete product lines and so to economize on marketing and distribution costs would create these kinds of benefits.

While much less talked about, it can also be the case that mergers actually harm productive efficiency. Most obviously this can arise if the merger never "works" in the sense that the two organizations are not successfully integrated, for example production and human resource problems are never sorted out.¹⁴ However, inefficiencies can also result from a merger that creates market power that shields the merged firm from the competitive pressure to keep costs down. We are referring here to what economists call "X-inefficiency" - roughly, the inefficiencies that arise when firms with market power get lazy with respect to cost control. Without being pushed by competition to keep them down, costs may creep up over time.¹⁵

Roughly speaking, allocative efficiency is achieved when firms produce any units for which consumers are willing to pay the marginal cost of production (i.e. firms produce the "optimal" quantity) and when whatever quantity is produced is allocated to the highest value buyers. Mergers can improve or impair the achievement of allocative efficiency. The greater concern is that they will damage allocative efficiency by creating market power, permitting firms to raise price by reducing the quantity produced below the optimal level. If the merger gives firms the ability to discriminate in price between different classes of buyer there can be the further problem that whatever quantity is produced is not allocated to the highest valued users.¹⁶

Some mergers may have more positive implications for allocative efficiency. We are thinking here specifically of vertical mergers (i.e. mergers of firms connected in the vertical distribution chain) and mergers of firms that produce complementary products. In the classic case of successive monopoly, a monopoly manufacturer sells its product to local monopoly retailers. If the manufacturer is to maximize its profits it will charge a price above its marginal cost, but profit-maximizing retailers will take this wholesale price and mark it up further. The resulting double mark-up will in many cases lead prices to be higher - and quantities lower - than if the manufacturer was to own the retailers and set their prices. Not only will retail prices be lower, but the total profits earned will generally be higher, so both consumers and producers win. The removal of the second mark-up through the merger will then improve allocative efficiency.

The achievement of dynamic efficiency requires that sufficient resources be devoted, and efficiently employed, to support innovation leading to lower costs and new/better products. With increased recognition of the importance of dynamic efficiencies merger analysis has become even more complicated, requiring us to predict a merger's impact not only on markets in the short term, but also well into the future.

As with the previous cases, mergers can improve or retard dynamic efficiencies. A merger of two firms with sub-efficient research and development groups might allow the R&D groups to benefit from economies of scale and become more successful. However, if mergers reduce the vigor with which firms undertake risky and costly research programs, the result could be less total research done and eventually a slower rate of technical progress in the market.

Finally, transactional efficiency recognizes that firms and consumers expend resources in an effort to define and protect property rights and that some forms of organization might mitigate the costs necessary to do this. For example, a firm with a promising new product may need additional services (e.g. marketing, distribution) to bring it to market successfully. It may seek these services from specialist "partners". However, in a world in which it is very difficult to protect and enforce intellectual property rights, the firm risks losing profits to former partners who may copy its ideas for themselves after they have been revealed in the course of the partnership. As a result, the innovating firm may undertake less innovative activity or it may spend inordinate sums protecting its secrets. Or it may not tell its partners all it should.¹⁷ A merger between the partners in this case, could create efficiencies by keeping all these services "in-house", reducing concerns about this kind of "opportunistic behaviour". As Coase (1937) recognized so many years ago, there is a cost for firms in using the market to obtain services and products they need, and there are also costs to firms associated with providing those for themselves. In general we would expect that a firm will expand into doing more and more for itself until the cost of organizing additional transactions within the firm are equal to the cost of using the market for the same transaction.

A transaction cost analysis can therefore help us understand why firms might choose not to rely exclusively on other firms through arms-length market-mediated exchange, but might instead prefer to protect themselves through more integrative arrangements such as strategic alliances or even mergers.

1.2.5 Incorporating Efficiencies Into Merger Analysis

Recognizing that efficiency effects can be associated with mergers then raises the important policy question of how efficiencies should be incorporated into the review of mergers by an antitrust agency. With respect to combining evidence of efficiencies with that of possibly increased market power, we suggest that there are at least six alternative approaches, each of which has been applied (to some extent) in one or more jurisdictions at some point in time. Roughly, they range from ignoring the efficiencies completely to giving them the same weight attached to every other effect of the merger. In the discussion that follows (apart from point 1) we will assume that the efficiencies have been properly measured and that the antitrust authority can be convinced of their magnitude.¹⁸

1. Ignore them: While accepting that most mergers are motivated by the desire to achieve certain efficiencies, it may still be that in some jurisdictions it is decided that the evaluation of efficiencies on a case by case basis is simply too difficult. It may then be determined that if a merger is expected to lessen competition it should be prohibited with no consideration of efficiencies. This per se approach to merger review is reminiscent of the per se rules for certain kinds of horizontal agreements found in, for example, the United States. It may be a bit extreme to suggest that this type of approach characterized the American model in the early years of the Cellar-Kefauver Act (1950), but it is true that American courts of that period were quite hostile to efficiency arguments.¹⁹
   
   
2. Efficiencies as motive: Antitrust regulators care about what the actual effects of a merger will be, but this they must try to predict with the imperfect information available to them. One important piece of information they would love to have is what the merging parties truly expected would be the effects of the merger. Of course, both sides recognize that merging firms hoping to create market power will not want to admit as much, so asking the firms directly is not very helpful. However, if the firms can persuasively demonstrate that real efficiencies will exist, this would constitute credible evidence that efficiency was the motive. Of course, this does not preclude market power effects as well, but it is progress. Perhaps the most telling case is when the merging firms cannot demonstrate that there will be efficiencies - this leaves market power as the leading alternative explanation.²⁰ Notice that under this approach the efficiencies are not applied as a defense or any counterweight to a lessening of competition - they are simply used as evidence that the merging firms did not expect there to be any such lessening. While we cannot say we know of any jurisdiction that uses this approach exclusively, we suspect the idea of using efficiencies when inferring motive is commonly applied.
   
   
3. Adjust the structural thresholds: A more sensible version of the first approach (ignore) was put forward by scholars associated with the Chicago school of antitrust.²¹ This approach agreed that efficiencies were an important consequence of most mergers but argued that they were very difficult to properly assess. The solution proposed was simply to set the structural thresholds higher before mergers were to be challenged but to otherwise not consider efficiencies on a case-by-case basis.
   
   
4. Efficiencies as part of the lessening of competition test: A third approach blends the consideration of efficiencies with that of the lessening of competition. If a country's law provides for action against mergers that lessen competition "substantially" (or some other such modifier) the door is opened to consider whether efficiencies render any particular lessening insubstantial.²² Thus, a merger that reduces competition but generates significant efficiencies might be saved under this approach by arguing that, thanks to the efficiencies, the lessening is not substantial. Pushing this still further, it has been suggested that we can even redefine the word "competition" to incorporate efficiencies without needed to use any modifier. While many economists (including the authors) associate "competition" with an absence of market power and therefore think about measuring it with something like a Lerner Index, other antitrust commentators have treated competition as more directly related to price levels. Under such a definition, a market is more competitive after a merger if price is lower, even if the merger has created a monopoly. It might be said that this is the path the United States has taken more recently, and it is approach that Röller et al (2000) have suggested might work (without changing the Merger Regulation) for the EU, if that Commission wanted to give efficiencies greater respect.
   
   
5. Efficiencies as part of a dominance test: When the concern of the agency is with the creation or extension of a dominant position, efficiencies for a merging and dominant firm, can be viewed as a bad thing. This was the case in some of the early U.S. cases (e.g. Procter & Gamble) and in numerous EU cases. Of course, as with lessening of competition tests as just described, efficiencies can be incorporated positively by blending their consideration into the evaluation of the merger's effect on dominance. For example, a merger creating a firm with a very large market share might be permitted, not because the firm will not have significant market power, but because it secured that position through the achievement of significant efficiencies. ²³
   
   
6. An efficiency defense: In this model, mergers that have been found to lessen competition can be defended by arguing that the efficiencies created outweigh (in some sense) the costs of the reduced competition. Canada's efficiency defense in section 96 of the Competition Act, certainly falls into this category. ²⁴

Comparing these six approaches, it is clear that the last is the one with the greatest scope for introducing efficiency arguments. However, the model as presented here does not tell us how we weigh anticompetitive effects against efficiencies. There are many possibilities here, and this is the topic to which we turn shortly.

First, however, we want to point out that there is another way in which efficiency considerations can be introduced into the review of mergers, and that is as an element to be considered as part of a Public Interest (or Public Benefits) Test. Under such as test, as applied in the U.K. and in Australia (for authorizations), various aspects of the public interest can be brought to bear on a decision regarding the social suitability of a merger. Public interest may be defined quite broadly, and has included such elements as employment effects and regional distributions of income.²⁵ When the public interest test is dominated by efficiency considerations, it can come to look rather like an efficiency defense (approach 6 above), but clearly this is not the only way it can work. In other cases efficiencies can be thrown into the "public interest soup" out of which decisions are served and it can be difficult to determine how important efficiencies actually are.

1.2.6 What Efficiencies Count?

Regardless of how they choose to use efficiencies (unless they choose to ignore them completely), enforcement agencies must decide what efficiencies will "count" as they evaluate the merger. In a system in which efficiencies are only relevant to the extent they contribute to the market power of a dominant firm, presumably any efficiency that contributes to the ability of the dominant firm to compete against its smaller rivals would be considered.

The situation is more complicated when efficiencies are seen as a positive factor to be considered against the possible anticompetitive effects of a merger. The agency may not want to give the merging firms credit for every dollar of cost reductions they achieve. And the agencies (and perhaps the courts) will have to decide what level of certainty is required before efficiency claims are accepted. To be specific, the agency must consider the following questions:²⁶

• To what extent should the efficiencies be merger specific - that is, must the parties demonstrate that the efficiencies will not be realized absent the merger?²⁷ In general antitrust agencies want to credit the merging parties with efficiencies that would not have been realized otherwise, but the degree of certainty they require about the counterfactual (what happens absent the merger) may vary. They may credit the merger with the efficiencies unless they are "very likely" to be achieved anyway, or they may apply a stricter test, for example, not accepting them if there is just "some chance" they would be achieved anyway.²⁸
• Should the parties be given credit for efficiencies that could be achieved through less anticompetitive means, such as through a joint venture, internal growth or alternative mergers that pose less competitive risks? Again, the question of certainty must be addressed - how likely must it be that the efficiencies can be achieved in some less anticompetitive way.²⁹ If the alternative is a different merger, for example, the agency must decide if the standard should be that the alternative merger "would likely" take place or simply that it could take place.
• Will cost reductions realized by the merging parties that represent transfers from other parties be considered?³⁰ There are, in general, two approaches here. If the efficiencies are being used to support an argument that the merged firm will be a better competitor to its rivals and so stimulate competition, then even efficiencies that represent transfers can be viewed as relevant. This possibility is provided for, for example, in the Australian Merger Guidelines (section 5.172). If, however, the efficiencies are being used to support a merger that will lessen competition, transfers are not relevant as they do not improve the allocation of resources.

As this discussion makes clear, the answers to these questions will -- to a considerable extent -- turn on the way efficiencies are to be incorporated into the review of the merger.

1.2.7 Trading off efficiency gains and competition losses

Whether we are weighing the value of the efficiency gains against the cost associated with the reduced competition explicitly as part of the evaluation of an efficiency defense claim or implicitly as part of the determination of a lessening of competition, we need a standard to tell us when the merger passes or fails. Referring back to Figure 1 where the effects of the merger are illustrated by areas B, C, and E, we can put this another way: what formula do we use to combine the information in B, C and E to create our decision about whether the merger will be approved or not? Almost certainly we will consider the lost value represented by area C to be bad and to lower the chances of approval, just as we consider the efficiencies in E to be good and likely to improve those chances. The views about the transfer B are less clear.

Broadly speaking it would appear that five different standards have emerged over time and we discuss each here briefly.

• Price standard
• Consumers' surplus standard
• Total surplus standard
• Hillsdown standard
• Weighted surplus standards

(i) Under a price standard, a merger is approved if the price will not increase as a result. In such an approach, efficiencies can be considered, but they will only save an anticompetitive merger (i.e. one that increases market power, perhaps as measured by the Lerner Index) if they are of such a magnitude that price actually falls (or does not rise) post merger. This approach is largely that of the U.S. authorities and it may be as far as their current law will let them take efficiencies. ³¹ Even to do this they need to combine the efficiency and lessening of competition effects of the merger into one - essentially redefining "competition" so as to refer to the price level. Under this test, the merger illustrated in Figure 1 would not be approved, regardless of the magnitude of the efficiencies area E.

(ii) The consumers' surplus standard is very similar to the price standard, but it allows for other (nonprice) changes brought about by the merger that impact upon the surplus derived by consumers. For example, suppose two new telephone networks proposed a merger and that prior to the merger their services were incompatible so that calls could not be made from one to another. With the merger, the compatibility difficulties would be sorted out and consumers would enjoy greatly expanded calling opportunities. In Figure 1 this would translate into a shifting outward of the demand curve. In a case such as this, it is possible for prices to rise somewhat while consumers remain better off because of the product improvements (e.g. larger network) made possible by the merger. If a merger raises (or at least does not lower) consumers' surplus, it would be approved under this standard.

Notice that differences between the consumers' surplus standard and the price standard can also arise due to a deterioration of the quality of the product post-merger. This could be due, for example, to a reduction in variety as firms trim the number of brands produced. In this case a merger might pass a price test (because prices do not rise) but fail a consumers' surplus test (because the reduced quality lowers total consumers' surplus). Importantly, it could be the very steps that create efficiencies (reducing staffing levels or numbers of brands) that lower consumers' surplus.

(iii) The total surplus standard is also very easy to describe. Under this test a merger is approved if the sum of consumers' plus producers' surplus (or profits) increases after the merger. In the case of Figure 1, this means that A+B+E (post merger surplus) must be greater than A+B+C (pre-merger surplus), or simply that E is larger than C. Notice that, in this approach, the transfer of surplus from consumers to producers represented by B is considered completely neutral - it is neither a good thing nor a bad thing.

The total surplus standard has broad (but not universal) support among economists who recognize that other standards will sometimes sacrifice social surplus.³² It is essentially the standard described by Williamson (1968) in his famous article. It has the advantage of relative simplicity - surpluses are simply added up with no special weighting attached to any particular groups. This means that we do not have to know anything about the consumers and producers except the effects on them of the merger - for example, we do not need to know if they are rich or poor buyers, or if the firms are large or small.

The total surplus standard appeared to be the standard guiding the Canadian Merger Enforcement Guidelines' interpretation of the efficiency defense in 1991, which continued to represent Competition Bureau policy until recently.

(iv) The Hillsdown standard derives from the obiter dictum in the (Canadian) Hillsdown decision in which Mme. Justice Reed suggested that she was far from certain that the total surplus standard was implied by the Canadian legislation.³³ As another possibility, she suggested that perhaps, under some conditions, the transfer of surplus from consumers to producers when prices increase post-merger should be viewed as a negative cost of the merger. Under the Hillsdown standard then, in our example in Figure 1, the benefits of the merger, as given by the efficiencies area E, would have to be larger than the loss in consumers' surplus, areas B+C. This standard is looser than the price standard - some mergers that raise price can still be approved if the efficiencies are great enough - but it is certainly tighter than the total surplus standard.

(v) Finally, under weighted surplus standards, the various effects of the merger are added together, as under the total surplus standard, but in this case each gets multiplied by some sort of "social weight" reflecting the importance attached to that group's welfare by the reviewing body. For example, it could be that the weighted surplus is determined by adding the losses suffered by consumers due to higher prices (a negative number) to the profit gains of the firms where these profit gains are first multiplied by some weighting factor such as 1/2 . Under such a formula, $10 million of lost consumer surplus would exactly balance $20 million of new firm profits.

While, in principle, such a weighting scheme allows for considerable flexibility in the administration of merger reviews, the challenge is in its implementation. The key question becomes one of determining what the appropriate weights are.³⁴ To our knowledge, no jurisdiction explicitly follows a weighted surplus approach, though all of the standards other than the total surplus standard imply weights that are greater for consumers than producers. In addition, given the inherent uncertainty of the review process, it may well be that weights are created indirectly when agencies are more careful about protecting, for example, the surplus of certain groups of consumers. And the public interest tests applied in some jurisdictions such as Australia and the U.K. can allow for consideration of distributional implications of mergers.

As described above, the public interest/benefits tests employed in some jurisdictions are fundamentally different from the tests just described in that they may consider effects of the merger beyond those on consumers and producers. For example, they may consider effects on workers or local economies. When this is the case, it is difficult to determine what weight efficiencies receive since there are potentially so many factors at work determining if the merger is in the public interest.³⁵

1.3 The Following Chapters

The chapters that follow describe the current policies related to the consideration of efficiencies in merger review in four jurisdictions: Australia, the European Union, the United Kingdom and the United States. To the extent possible we also provide some information about how these policies have evolved over the years, but it should be noted that apart from the United States, none of these jurisdictions have a very active history in this area. In the EU, for example, merger review has only existed (for all intents and purposes) since 1989. And while merger review has been a feature of competition policy in Australia and the United Kingdom for much longer, explicit discussions of the role of efficiencies have been few and relatively recent.

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¹See, for example, Mueller (1980) and the discussion in Röller et al (2000), pp. 36-42.

² This type of diagram was made famous by Oliver Williamson (1968) in his discussion of efficiencies in merger review. We use it here as an expositional device, not as a precise method for the evaluation of the effects of the merger. Williamson himself recognized the analysis can be complicated by such considerations as pre-existing market power and firms outside the merger who may or may not achieve any efficiencies.

³We are referring here to "economic profits" - an economists' term referring to profits over and above a normal rate of return (taking into account the level of risk ). Thus, a firm making zero economic profits is doing as well as we would expect a competitive firm to do and has no reason to exit the market - it is covering all its costs and making a normal rate of return on invested capital. Implicit here is the idea that "costs" as defined by economists include the full opportunity cost of all resources used in production - thus, the costs in the diagram above include an allowance for the normal return to invested capital.

⁴See, e.g. Williams and Woodbridge (forthcoming).

⁵ Monti (2002), p. 5.

⁶In his introduction to a special section of Antitrust devoted to a discussion of the 1997 revisions to the U.S. merger guidelines, Weiner (1997) says: "One trend in antitrust decisionmaking does seem clear: rigidity in the form of per se rules and market share presumptions is being abandoned in favor of a broader analysis and balancing of anticompetitive effects and procompetitive efficiencies."

⁷ There is not a consensus that this is the only goal of competition policy and we do not wish to suggest there is. There is disagreement about whether competition policy should be used, for example, to protect consumers from higher prices and to protect small business in its competition with big business.

⁸ To be precise, the Lerner index is given by L, where L = (price - marginal cost)/ price. In a perfectly competitive market L=0 since price will equal marginal cost. In a monopoly market it can be shown that L = 1/e where e is the market elasticity of demand.

⁹ Of course, there is also the possibility that there is no effect on efficiency and/or on competition.

¹⁰Such a case could arise if the only two firms in a market combined simply for market power reasons. The costs of effecting the merger and the possible X-inefficiencies that would arise post-merger could make the combined firm less efficient.

¹¹ There is a nice discussion of these types of efficiencies in Kolasky and Dick (2002).

¹² Transaction efficiency is not always listed as a distinct type of efficiency, however, following Kolasky and Dick (2002) we find it useful to give them their own category.

¹³ For example, one firm may have a very successful human resource management program and the other may be better at production.

¹⁴ Röller et al. (2001), chapter 4, have a very nice review of the empirical literature on the success of mergers.

¹⁵ The concept of X-inefficiency is due to Liebenstein (1966). See also the brief discussion and references cited in Church and Ware (2000, pp. 145-147). It is somewhat controversial with some economists arguing that all firms have trouble controlling costs and even firms with market power have an incentive to control them as best they can - they will have higher profits if they are successful.

¹⁶ In such a case, the firm will allocate output to the users that contribute the greatest additional revenue (i.e. marginal revenue) but these are not necessarily those who value it most highly (who are the ones willing to pay the highest price).

¹⁷ See, e.g., Williamson (1989).

¹⁸Most enforcement agencies (see the discussions in later chapters) will require that the efficiencies be supported by credible evidence that they represent real resource savings (and not just transfers from some agents to others), that they do not simply represent savings from reduced production, that they are very likely to be achieved and that they cannot (or would likely not) be achieved by less anticompetitive means. For the purposes of this discussion we assume these conditions have been met, or could be met.

¹⁹ See, e.g., Brown Shoe v. U.S., 370 U.S. 294 (1962); U.S. v. Philadelphia National Bank, 374 U.S. 321 (1963); and FTC v. Procter & Gamble Co., 386 U.S. 568 (1967).

²⁰Of course, there will be other possible explanations such as empire-building, so this is not necessarily the end of the investigation.

²¹ See, e.g. Posner (2001) and Bork (1978).

²²On the possible definitions of "competition" and how they relate to merger review in the U.S., see, e.g. Werden (1997).

²³ This discussion assumes that the dominance referred to represents a strong position by a single firm. It is interesting to consider, however, the implications were the antitrust authority and courts to consider "joint dominance" cases in which a group of firms together hold a dominant position. If the firms determined to be jointly dominant are not explicitly cooperating (or colluding) with each other, this approach could look very similar to the approach under which efficiencies are considered as part of a lessening of competition test.

²⁴As described briefly below, this may also, in effect, be what is happening in some jurisdictions (e.g. Australia) with public effects/benefits tests. Griffin and Sharp (1996) p. 657 express the view that U.S. cases have oscillated between considering efficiencies as part of an SLC test (category 4 above) and as a defense (category 6).

²⁵ These are examples from the U.K.. The reference to the Australian example here is to the conditions for securing an authorization for a merger - that is where the public benefits test applies. Outside of the authorization process, the model used for the consideration of efficiencies is more like the third approach described above - evidence of efficiencies can be used to argue that there will not be a substantial lessening of competition. There is not much guidance available as to what might constitute public benefits in Australia other than efficiencies.

²⁶ One question not listed here asks which party, the government or merging firms, has the responsibility of putting forward the efficiency arguments. This is not a very interesting question, however, because it is hard to imagine this burden not being put on the merging parties since they are the ones with the necessary data. They obviously also have an incentive to put them forward when efficiencies are treated positively by the agency and courts.

²⁷ For example, mergers can allow firms to take advantage of economies of scale, but if the market is growing the firms may also be able to achieve those economies through internal growth.

²⁸The 1997 U.S. Merger Guidelines, for example, indicates that the agencies will consider efficiencies that are "unlikely to be accomplished in the absence of either the proposed merger or another means having comparable anticompetitive effect".

²⁹This presents important challenges for the antitrust agency and courts because they will be forced to evaluate the efficiency of various alternatives without necessarily having access to the data they need. The 1997 U.S. Merger Guidelines indicate that, while the agencies while not consider efficiencies that could be achieved through some less restrictive means, they "will not insist upon a less restrictive alternative that is merely theoretical."

³⁰ These are sometimes referred to as pecuniary efficiencies. A merger than presents some tax-saving opportunities is the classic example. The tax savings are simply a transfer from the government tax authority (and ultimately other taxpayers) to the merging firms, and do not represent any real savings of resources. An ability of the larger (merged) firm to extract lower prices from suppliers can be similar - the savings are a transfer from those suppliers. However, if the lower prices from suppliers are due to certain efficiencies of dealing in larger orders, then the lower prices can represent real cost savings.

³¹ Some might suggest that this is a slightly extreme view of the American approach and point to the 1997 Guidelines' indication that efficiencies will be considered even if they are not immediately passed on to consumers. See, e.g. Kolasky and Dick (2002), p. 43.

³²Admittedly, total surplus as measured by economists is not necessarily the appropriate measure of social welfare we would like policy makers to use. Accordingly, we might be willing to sacrifice some surplus for other benefits - e.g. a preferred distribution of surplus.

³³ Canada (Director of Investigation and Research) v. Hillsdown Holdings (Canada) Ltd. (1992), 41 C.P.R. (3d) 289 (Comp. Trib.) . The characterization of this as the Hillsdown standard is due to McFetridge (1998).

³⁴ In an effort to try to operationalize the weighted surplus approach, Peter Townley suggested that the reviewing body (he was advising the Canadian Competition Bureau and addressing the Competition Tribunal) should first determine what relative weights for consumers and producers would make the net benefit or cost of the merger exactly zero. These weights are referred to as the "balancing weights". The reviewing authorities are then invited to compare the balancing weights to their perception of what would be a reasonable range for the true weights. In many cases it may be true that the balancing weights are far from what the reviewing authorities would apply. In such cases, the body may not need to settle on exactly what its precise weights are to determine if the merger should be allowed to proceed.

³⁵For example, if we observe a merger approved in which the efficiencies are slightly greater than the deadweight loss, it could be because the public interest test is really just a total surplus test, or it could be that there was some other consideration (e.g. protecting the jobs of workers at a financially-weak merger partner) that was the main reason for the approval.