Mergers and Acquisitions: Primer on Economic Considerations in the FTC and DOJ Horizontal Merger Approval Process

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The Federal Trade Commission (FTC) and Department of Justice (DOJ) jointly enforce antitrust
laws that cover mergers and acquisitions of large companies. Initially, firms seeking a merger
notify the agencies of their intent and provide information on their products and industries.
Consumers, competitors, and other interested parties may also notify the enforcement agencies of
their concerns. If the enforcement agencies determine a full review is warranted, they acquire
more detailed information from the merging firms.
Regulatory agencies focus on several economic criteria to evaluate a proposed merger. First, they
define the market according to likely substitution patterns by consumers and calculate the
industry concentration. A merger is less likely to be approved if it would result in significant and
non-transitory price changes (i.e. market power). Even if the merger would result in market
power, the merger may be approved if the market is contestable, that is, if new firms could and
likely would enter and compete. Cognizable efficiency, meaning an efficiency that is neither
vague nor speculative, is another factor that could allow firms to merge even if market power
results. If a firm or division would likely fail anyway, the agencies may permit the merger. In
summation, the antitrust enforcement agencies balance likely anticompetitive costs of the
proposed merger against likely efficiency gains.
This report will be updated as conditions warrant.

Backgr ound ............................................................................................................................... 1
Horizontal Merger Approval Process........................................................................................1
Regulatory Agency Economic Analysis....................................................................................2
Market Definition................................................................................................................2
Competitive Effects............................................................................................................3
Barriers to Entry..................................................................................................................3
Cognizable Efficiencies......................................................................................................4
Failing Firms or Divisions..................................................................................................4
Table 1. FTC Horizontal Merger Investigations 1996-2003............................................................5
Author Contact Information............................................................................................................5

The number and value of mergers in some industries have reached historically high levels. For
example, Businessweek reports that “merger mania” is sweeping through the pharmaceutical ¹
industry. More than 1,000 biotech, medical device, and pharmaceutical companies worth $136
billion were acquired in 2006. The economic effects of mergers and the role that federal agencies
play in approving mergers have frequently been the subject of congressional oversight. This
report examines the economic factors that are applied in the approval process for horizontal
mergers.
The term horizontal refers to firms at the same point in the production process. For example, parts
of goods are often produced separately and then brought to another firm for assembly. If two
firms that purchased parts and then assembled vacuum cleaners wished to merge, they would be
considered horizontal firms in the vacuum assembly industry. Extending this example, a vertical
merger refers to the merger of a vacuum cleaner assembly firm and a firm that manufactures
some of the parts for vacuum cleaners. Approval of proposed horizontal mergers focuses on five
economic criteria: (1) market definition, (2) competitive effects, (3) barriers to entry by new ²
firms, (4) cognizable efficiencies, and (5) failing firms or divisions.
The Federal Trade Commission (FTC) and the Department of Justice (DOJ) jointly enforce the
antitrust laws. The Clayton Act prohibits mergers that may substantially lessen competition or ³
create a monopoly. Section 7a of the Clayton Act, often called the Hart-Scott-Rodino (HSR) Act, ⁴
requires prior notification of large mergers to both the FTC and DOJ. The regulatory agencies
have joint authority over all subject areas but generally divide cases between them according
relative expertise in similar cases.
In general, the approval process starts with firms providing the two regulatory agencies pre-
merger notification and relevant information. The agencies examine the information and if they
have concerns issue a second information request. This so-called “second sweep” often requires
detailed up-to-date data. Because second sweeps can impose significant costs in both time and
money, the regulatory agencies encourage parties to discuss potential issues with agency
personnel during the pre-approval process so that second sweeps can be narrowly tailored to the ⁵
most relevant information.
“Hot documents” are another important element in triggering second sweeps. Hot documents
refer to instances in which third parties provide documents that predict merger-related ⁶
anticompetitive effects. Hot documents often claim that the merger will result in higher prices.

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However, the regulatory agencies will also consider a document hot if it reasonably claims other
anticompetitive effects such as a likelihood that the merger could delay adding new productive
capacity or reduce innovation.
The standards used by the FTC and DOJ to evaluate the economic effects of mergers can be
found in “Horizontal Merger Guidelines” issued jointly April 2, 1992. The guidelines state, “the
unifying theme of the [horizontal merger] Guidelines is that mergers should not be permitted to ⁷
create or enhance market power or to facilitate its exercise.” Market power is defined as the
ability of firms to raise prices above the competitive level for a significant time (or lower prices if
the merging firms are buyers rather than sellers). Analysis of market power focuses on market
definition, competitive effects, entry barriers, cognizable efficiencies, and failing firms.
Defining the relevant market and determining concentration requires an analysis of the products
of the merging parties. Although use of general market definitions and concentration levels such
as the classifications used by the Bureau of Economic Analysis (BEA) may be acceptable for the
initial pre-merger notification, a second sweep often involves more detailed information on the
firms’ specific products and potential substitutes. Economists in the regulatory agencies use the
information to estimate the likelihood and ability of consumers to respond to small increases in
the price of the firms’ products. The market includes available substitutes even if they are not in
the same BEA classification. For example, the substitutes for short distance air-shuttle service
may include a bus line rather than a national airline.
The antitrust regulatory agencies consider several factors when calculating market concentration ⁸
ratios and examining consumer reactions to price changes:
• evidence that buyers have shifted purchases in response to price/quality in the
past;
• evidence that sellers conduct their business assuming consumers are flexible;
• evidence of competition in related sectors and industries; and
• evidence of substantial costs to switching products.

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Market definition and competition analysis often result in narrower definitions than observers ⁹
would expect. To determine the scope of the relevant market, analysts use the term SSNIP, small
but significant and non-transitory increases in price. SSNIP refers to the smallest grouping of
products for which a hypothetical monopolist could raise price 5%. In the case of ice cream, the
SSNIP differentiated super premium ice cream from standard ice cream. Even though there are
many regional ice cream brands, the FTC ordered divestiture between Dreyers and Nestle because
it determined that the market for “super premium ice cream” was concentrated.
In addition to market definition and concentration, the regulatory agencies also consider potential
competitive effects of mergers, which can be counter-intuitive. For example, there is some ¹⁰
evidence that non-merging firms in an industry may gain more than merging firms do. If market
data is available, agency analysts may estimate the own-price elasticity and the cross-price
elasticity of demand. Own-price elasticity refers to the percentage change in quantity demanded
for a percentage change in the same product’s price. Cross-price elasticity refers to the percentage
change in quantity demanded for one product for a percentage change in the price of another
product. The merger approval process includes consideration of competitive effects in the
industry as a whole, not just the two merging firms.
The ability to raise prices is a common focus of evaluating anticompetitive effects. For example,
a wave of mergers in the petroleum industry in the late 1990s raised concerns about competition
in that industry. When Exxon Corporation and Mobil Oil proposed a merger in 1999, the FTC
evaluated the firms in each product market that they competed. William Baer, director of the
FTC’s Bureau of Competition at the time, testified to the House Commerce Committee
Subcommittee on Energy and Power that the commission examined the effects of every oil and ¹¹
gas merger for 20 years. The analysis ultimately resulted in permitting Exxon and Mobil to
merge.
If a merger is expected to affect market power, then the regulatory agencies determine whether
the market is contestable. A contestable market is one without substantial barriers to entry. If the
market is contestable, the agencies will consider how likely it is that new suppliers could compete
with the merging firms if they tried to exercise market power. If it is unlikely that the merging
firms could sustain price increases, then the regulatory agencies may approve the merger even if ¹²
it temporarily concentrates the industry.
Lack of barriers to entry played an important part in deciding an after-market care automotive
merger. In July 1985, the FTC permitted Echlin Inc. to acquire Borg-Warner Corp. because the

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Commission found that “there are no barriers to entry into the market for the assembly and sale of ¹³
carburetor kits.” The Commission pointed out that two new firms had entered the business in
recent years and that one person had started in the business with a $500 at-home assembly kit.
The regulatory agencies may approve mergers expected to increase market power if the merger
would increase economic efficiency. Firms often attempt to improve efficiency by rearranging
their internal procedures. However, the regulatory agencies recognize that a merger may
encourage efficiency by allowing firms to look externally for ways to better allocate their
productive resources. To facilitate merger approval, any resulting efficiencies must be merger-¹⁴
specific and cognizable. By cognizable the regulatory agencies mean that efficiency claims can
not rely on vague or speculative assertions.
Cognizable efficiencies formed the basis for approval of the Genzyme-Novazyme merger.¹⁵ These
firms were the only companies trying to develop treatment for a rare disease, Pompe. The merger
resulted in the formation of a monopoly. The FTC approved the merger because it was convinced
knowledge-sharing between the two scientific research labs provided a better chance of
developing a cure for the disease. The Commission weighed the costs of reduced competition
against the benefits of shared knowledge.
The regulatory agencies may approve a merger that might otherwise be prevented if one of the
firms is failing, or a division of a firm is failing. One argument for allowing this failing-firm
defense is that even if the merger is prevented, the market would still become more concentrated
if no other firm acquires the firm or division. In asserting the failing-firm defense, parties try to
demonstrate that the failing firm (1) would not meet its financial obligations in the near future, (2)
is not a viable Chapter 11 candidate, (3) made a good faith effort to secure reasonable offers from
other sources, and (4) or division’s assets would exit the market if the merger is prevented.
The failing firm defense has critics. On January 24, 2007, Congress heard testimony on the failing
firm defense in the context of airline mergers. Consumer advocates argued that the failing firm
defense should be limited to an industry “that is otherwise competitive and exhibits a healthy ¹⁶
competitive structure.” The FTC held hearings on competition policy during the Clinton
Administration. An antitrust mergers practitioner argued that merger policy should distinguish
between acquisitions intending to infuse capital to compete vigorously in the industry and ¹⁷
acquisitions designed to passively maintain a revenue stream.

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Table 1 presents data on FTC horizontal merger investigations during 1996-2003. Enforcement
action generally declines as the number of significant competitors increases. During the period,
the FTC had 573 formal merger investigations (second sweeps). Of those, 441 resulted in
enforcement actions and 132 were closed without action.
Table 1. FTC Horizontal Merger Investigations 1996-2003
^Outcome^{Change in the}
^{Number of}^Enfo^rcement^{Closed with No}^Total
^Competitors^Action^Action
^{2 to 1}¹²⁸⁵¹³³
^{3 to 2}¹⁵⁶²⁸¹⁸⁴
^{4 to 3}¹⁰²³²¹³⁴
^{5 to 4}³²²⁰⁵²
^{6 to 5}¹³¹⁹³²
^{7 to 6}²⁸¹⁰
^{8 to 7}⁶⁶¹²
^{9 to 8}⁰⁴⁴
^{10 to 9}²¹³
^{10+ 0}⁹⁹
^Source:^{Federal Trade Commission}
In conclusion, the process of approving corporate mergers has two stages. In the initial stage,
merging parties notify the FTC and DOJ of their intentions and attempt to provide enough market
information to avoid the costs of a second sweep. If the agencies decide to investigate further,
then detailed market information is used to determine likely increases in sustainable market
power, if any. In examining sustainable market power, the regulatory agencies focus on market
definition, competitive effects, market contestability, cognizable efficiencies, and failing firms.
For an example of the merger application process in the utility industry, see CRS Report
RL32133, Federal Merger Review Authorities and Electric Utility Restructuring, by Aaron M.
Flynn, Janice E. Rubin, and Michael V. Seitzinger.
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