Responding to Developments in Economics and the Courts:

Entry in the Merger Guidelines

Jonathan B. Baker†*

The 1982 Merger Guidelines,1 the anniversary of which we are celebrating today, were preceded by Merger Guidelines issued in 1968 by Assistant Attorney General Donald Turner.2 My late father-in-law, Robert A. Hammond, who worked on the 1968 Guidelines at the Antitrust Division,3 once told me that the Justice Department drafting team thought about every major relevant Supreme Court antitrust decision and made sure that they could point to a sentence that encapsulated its holding. My immediate reaction, only partly facetious, was that if we were doing anything similar in drafting the 1992 Merger Guidelines,4 which I worked on while at the Antitrust Division, it was instead to encapsulate every major article on industrial organization economics published in the American Economic Review.

To be sure, times had changed over the intervening quarter century. The 1968 Merger Guidelines were issued on the heels of a wave of important Supreme Court merger decisions, including Philadelphia National Bank,5 Alcoa (Rome Cable),6 Continental Can,7 Consolidated Foods,8 Von's Grocery,9 Pabst,10 and Procter & Gamble.11 By 1992, in contrast, the Supreme Court had been silent on merger enforcement for nearly two decades,12 while economists had been developing new ideas related to merger analysis generally, and the analysis of entry in particular. The game theory revolution in microeconomics was well underway, and economists had begun to look at entry deterrence in strategic terms, rather than in terms of barriers with height that could be assessed in the abstract. One important challenge facing the drafters revising the entry section in 1992 was thus to reconsider the old debate between "Bainian" and "Stiglerian" barriers to entry through the lens of these then-recent developments in economics.

Although the drafters of the 1992 Merger Guidelines were not closely parsing Supreme Court opinions, they were also well aware of developments in the case law in the lower courts. Nowhere in that drafting project were the problems of steering between the demands of precedent and economic logic more difficult than in writing the section on entry. The Justice Department had just been on the losing side of two appellate decisions refusing to enjoin mergers on grounds of ease of entry, Baker Hughes13 and Syufy.14 Both appellate courts had sharply criticized the Justice Department's entry arguments and the Department's seeming lack of fidelity to the 1984 Merger Guidelines,15 which were then in force. The drafters of the 1992 Merger Guidelines understood the need to respond to these decisions by setting forth a method of analysis that would harmonize the Division's internal analytic approach to entry with the judiciary's concerns.

Sections A and B of this essay examine in turn the economic and legal challenges involving entry that government enforcers confronted during the early 1990s. Section C describes how the framework for entry analysis of the 1992 Merger Guidelines sought to deal with those challenges. 16 Section D evaluates how well that framework has succeeded after a decade of experience. A brief concluding section sketches two unresolved issues that may become more salient.

A.	The Economic Debate about Conditions of Entry

1.	Bain vs. Stigler

The antitrust analysis of new competition before the game theory era was dominated by the contrasting views of two pioneering industrial organization economists, Joe S. Bain and George Stigler , on defining "barriers to entry."17 In brief overview, Bain was interested in the effect of market structure on firm conduct and industry performance. He emphasized the way a range of structural factors created entry barriers, preventing new competition even when incumbents' prices exceeded competitive levels (so might be expected to attract entry). Bain 's list of important entry barriers included absolute cost advantages of incumbents, product differentiation, and economies of scale (lower costs that arise when output and sales increase).18

Stigler , too, was interested in the determinants of market concentration. But his approach to the question could be read as resisting the interventionist implications of Bain 's analysis of entry barriers. Some of Stigler's fire was directed at the claim that high capital requirements could prevent new competition when incumbents were exercising market power.19 He questioned the once common appeal to "imperfections-in-the-capital-market" by asking whether even large capital requirements would stand in the way of a firm seeking to finance a reasonable entry plan, given the wide range of well-funded participants in financial and credit markets.20

In analyzing entry, as elsewhere in Chicago school critiques of structural era antitrust,21 Stigler suggested that many practices previously thought harmful to competition in fact reflected healthy competition. He defined entry barriers as the additional long-run costs that must be incurred by an entrant relative to the long-run costs faced by incumbent firms.22 This definition might include the possibility, of great concern to Chicago school antitrust commentators, that entry would be prevented by regulation, patents, tariffs or other government action. But if incumbents obtained an advantage over entrants by being first to make expenditures that entrants would need to replicate in order to compete, or if the market could not support multiple firms at the scale needed to achieve low costs, those advantages should merely be seen as an appropriate reward that competition provides to the incumbent, who had the foresight or luck to enter first.

Stigler's definition of entry barriers thus excluded multiple factors that Bain had suggested might inhibit new competition when incumbent firms were charging prices above the competitive level. Scale economies would not count when entrants could, in principle, achieve comparably low costs through internal growth. Product differentiation also would not count, unless the costs of advertising, product design or other means of achieving differentiation were higher for a new firm than for an incumbent firm. Accordingly, Stigler's perspective on entry barriers suggested a more permissive merger policy than did Bain's.

The debate between Bainian and Stilgerian perspectives on entry barriers provided a critical backdrop to the F.T.C.'s Echlin decision in 1985. The Commission majority noted that Stigler's definition of entry barriers was "widely accepted in the legal and economic communities."23 After all, the FTC majority explained, "low-cost incumbent firms can keep prices above the competitive level as long as those prices remain below the level that would provide an incentive to higher-cost potential entrants ... [erecting] a permanent barrier to new entry that would allow the maintenance of supracompetitive profits for an indefinite period of time."24

But if Stigler won the definitional battle in Echlin, Bain won the war.25 The Commission majority did insist that absent a Stiglerian barrier, new firms would enter and drive prices down to competitive levels eventually. But they qualified severely the implication of that observation for merger policy. "From the standpoint of the public, however, it makes a great deal of difference whether this occurs sooner or later."26 Accordingly, the FTC majority also recognized, as a second type of entry difficulty, an "impediment to entry."27 An impediment was defined in Bainian terms, as "any condition that necessarily delays entry into a market for a significant period of time, and thus allows market power to be exercised in the interim."28

2.	Strategic Entry Deterrence

During the decade before the FTC decided Echlin, economists had begun to look at entry deterrence in strategic terms.29 This work focused on the significance of "sunk" costs, that is expenditures by entrants that could not be recouped in the event the firm were later to exit. If the fixed costs of entry are not sunk, and entrants have variable costs comparable to those of incumbents, the market is "contestable" and performs competitively regardless of market concentration among incumbent sellers.30 But if entry requires sunk expenditures (irreversible investments), and incumbents would be expected to react quickly to cut price in response to entry, entry may be deterred even if the pre-entry price exceeds competitive levels. This may occur because the prospective entrant, recognizing the prospect of post-entry competition, will not expect to earn a contribution margin (revenues less variable costs) adequate to cover its own sunk costs.31

The strategic approach to understanding entry conditions offered industrial organization economists a way to transcend the old debate between Bain and Stigler. It explained that high fixed expenditures by entrants could, under some circumstances, deter entry, even if the expenditures merely mimicked costs previously borne by incumbents. That might occur if fixed expenditures would also be sunk. The categories of fixed expenditures highlighted by Bain — including the product design and advertising expenditures that often underlie product differentiation, and the up- front costs of developing a large production facility — often are irreversible to a significant extent. That is, much of the brand reputation and product development costs may not be transferrable to another product were the first product not to succeed, and the plant and equipment used to produce a new product may have no other use, so would merely be sold as scrap in the event of exit. If so, the presence of these fixed (and sunk) expenditures may deter entry, as Bain supposed. But if the same fixed expenditures would not be sunk, entry would not be deterred, as those following Stigler suggested.

The drafting of the 1992 Merger Guidelines provided an opportunity to incorporate this new economic learning about entry. The economic logic of strategic entry deterrence lies behind the Guidelines analysis of the "likelihood" of entry.32 The entry likelihood section explains that a new competitor with an entry plan requiring significant sunk expenditures — a "committed" entrant33 — would not find entry profitable if its output would be too large for the market to absorb without depressing prices further, considering the scale at which entry would take place and the likely sales opportunities available to the new competitor.34 Moreover, those sales opportunities would be less if the incumbent firms had made prior sunk investments in excess production capacity, and in consequence would be expected to respond to new competition by expanding their own output, driving down the market price.35

B.	The Challenge Posed by the Courts

The 1992 Merger Guidelines were drafted in the immediate wake of two 1990 appeals court decisions, in Baker Hughes and Syufy, that together appeared to pose a fundamental challenge to the government's approach to entry analysis. I have told this story in detail elsewhere,36 and so will merely sketch it here.

To understand the government's litigation problem, it is useful to begin with the 1982 Merger Guidelines. Those Guidelines recognized that easy entry trumps high concentration – that is, that a merger is unlikely to harm competition if entry is sufficiently easy, regardless of market concentration.37 During the mid-1980s, the courts agreed, most importantly in the Second Circuit's 1984 decision in Waste Management.38 These cases dealt with what the 1992 Guidelines term "uncommitted" entry, though the distinction between committed and uncommitted entry, while suggested by the economic literature on strategic entry deterrence, was as yet unknown to the courts.39

Strategic considerations are not important when entry is uncommitted. Uncommitted entry is "hit and run:" any uncommitted entrant seeing a short term opportunity to profit by diverting output into a market would be expected to do so, even if that profit opportunity were likely to disappear shortly after entry. In consequence, the distinction between whether a firm could enter and whether it would enter is not important in analyzing uncommitted entry. But the economic literature on strategic entry deterrence makes entry likelihood (profitability) a central question with respect to committed entry: when entry requires significant sunk expenditures, a firm that could enter may find it unprofitable to do so for fear that post-entry competition would depress the price it would receive, leaving it unable to recover its sunk investments. The distinction between uncommitted and committed entry is important in understanding the problem created for the government's merger enforcement program by the Justice Department's litigation losses in Baker Hughes and Syufy.40

Baker Hughes and Syufy both involved unsuccessful Justice Department challenges to mergers, where both the district court and the appellate court found for the merging firms on grounds of ease of entry. Both decisions were highly critical of government antitrust enforcers. The D.C. Circuit decision, Baker Hughes, "reads like an exasperated effort to rein in a runaway agency thought to have willfully ignored the teaching of Waste Management."41 The court rejected the government's contention that entry must be "quick and effective" to count, on the ground that this requirement overlooks the way potential competition never resulting in actual entry can nevertheless exert competitive pressure on a market.42 The Ninth Circuit, in Syufy, also employed strong rhetoric. The court suggested that it should have been obvious that entry was easy in the industry in which the merger occurred, and concluded that the government's position on entry was based on "a shopworn argument we had thought long abandoned: that efficient, aggressive competition is itself a structural barrier to entry."43

Both courts appear to have misunderstood what the government argued. In each case, the government made an entry likelihood argument rooted in the economic literature on strategic entry deterrence. In arguing for an injunction against the merger reviewed in Baker Hughes, the government highlighted facts suggesting that entry would require significant sunk investments to create a reputation for product quality and reliable future service, which could not be undertaken quickly or profitably.44 In Syufy, the Justice Department contended that entry at a scale large enough to achieve low costs would turn out to be unprofitable because entry at that scale would depress market prices.45 While the government was making arguments about committed entry, however, that point was not understood by the courts. In both cases, the appeals court viewed the trial record as establishing that entry should be viewed as uncommitted (not involving significant time or sunk expenditures)46 and easy. In each, in short, the court's exasperation with the government grew out of a misunderstanding: the court believed, incorrectly, that the Justice Department was ignoring Waste Management and its own Merger Guidelines47 in refusing to accept that easy entry precluded the possibility of competitive harm from merger.48

The resulting challenge for the drafters of the 1992 Merger Guidelines was to explain clearly the significance of the distinction between committed and uncommitted entry. If courts could not be convinced to make that distinction, they would not undertake to analyze the profitability of entry, and would instead wrongly limit their analysis to whether entry could occur. The Antitrust Division front office had worked out a new articulation in late 1989, 49 even before Baker Hughes and Syufy were decided. They discarded the "quick and effective" terminology rejected in Baker Hughes for the "timeliness, likelihood, and sufficiency" concepts that later appeared in the 1992 Merger Guidelines to test whether committed entry would counteract or deter a competitive problem.50 But it was left to the Guidelines to spell out specifically how these concepts, particularly entry likelihood, would be assessed in practice. 51

C.	Drafting the Entry Section

The demands on the drafters of the entry section of the 1992 Merger Guidelines went beyond the need to resolve these economic and legal debates. One reason the 1982 Merger Guidelines had been so successful is that they were "fully specified."52 However difficult the Guidelines might be to apply in practice, they avoided conceptual ambiguities to the extent possible and they sought to maintain logical consistency.53

With respect to uncommitted entry, the approach of the 1992 Merger Guidelines was similar to that taken in 1982 and reaffirmed in its essentials in 1984. All three sets of Guidelines include in the market firms that do not participate at current prices, but that could do so quickly and cheaply in the event prices were to rise slightly, and assign those firms a market share based upon the production capacity they would profitably divert into the market under such circumstances.54 But it was more difficult to meet the goal of fully specifying the guidelines, and in particular, to solve the problem of ensuring logical consistency, when it came to setting forth an approach for assessing the likelihood of committed entry.55

In addressing the likelihood of committed entry, the drafters of the 1992 Merger Guidelines identified a logical consistency problem with the approach taken in 1982 and 1984. In economic theory, logical consistency is achieved by ensuring that a description of market outcomes is an equilibrium model. But the older approach could not be an equilibrium.56 The earlier Guidelines had evaluated the profitability of entry assuming that the merger led to a small increase in price lasting for a substantial period of time.57 Yet an entrant who makes significant irreversible investments, and thus plans to remain in the relevant market, does not evaluate the profitability of entry at an elevated price that might occur through the short-term exercise of market power before entry competes away that power. Rather, the committed entrant evaluates the profitability of entry at the long-run post-entry price, which is the price it expects to receive. It will thus consider the extent to which its entry, the concomitant addition to industry output, and the likely reaction of incumbents, will reduce the long-run post-entry price below a pre-entry price reflective of incumbent seller market power.

At what price should the profitability of committed entry be tested in merger analysis? The 1992 Merger Guidelines provided a then-novel and logically consistent answer. Committed entry is in for the long haul. If the committed entry solves the competitive problem, the post-merger price will quickly return to a level no higher than the pre-merger price. Thus, the prospective committed entrant must determine whether its entry plan would be profitable assuming it would receive no more than the pre-merger price, not an elevated price reflective of short-run market power.

But if entry at pre-merger prices would be profitable after the transaction, why would it not have been profitable before, leading the new firm to have entered already? The 1992 Merger Guidelines also answer this question.58 The market after the merger is not the same as the market before: if the merger generates market power, price is higher and output lower than it was pre- merger, thus creating additional sales opportunities for an entrant beyond what had been available prior to the merger, and creating the possibility that entry may be profitable after the merger even if it had not been profitable before.

Will the additional sales opportunity resulting from a potentially anticompetitive merger be sufficient to make entry profitable? That depends on the extent to which the entry itself will depress price, by increasing market output directly and by inducing pricing and output responses from incumbent sellers. The 1992 Merger Guidelines provide a fully-specified method of assessing the profitability of entry under such circumstances. They compare an entrant's "minimum viable scale"59 – its break-even annual sales at pre-merger prices,60 often expressed as a fraction of industry annual sales – with an estimate of the sales opportunities facing the entrant after the merger. As a rule of thumb, the Guidelines suggest that an entry plan may not be plausible if the minimum viable scale exceeds 5 percent of total market sales. 61

D.	Evaluating the Guidelines' Entry Framework

How has the framework for entry analysis set forth in the 1992 Merger Guidelines fared over the following decade? Its greatest success has probably been in clarifying the relevant issues conceptually. The distinction between committed and uncommitted entry is a basic implication of the modern (strategic) microeconomic analysis of entry conditions. So, too, are the key economic ideas embedded in entry likelihood analysis: that new competition can be deterred by the prospect that price will fall with entry, and that incumbents can engineer such a situation by making commitments to post-entry competition.

The enforcement agencies no longer habitually lose merger challenges on grounds of ease of entry,62 and this change of fortune may to some extent be attributed to the Guidelines' success in articulating the distinction between committed and uncommitted entry and explaining why the difference matters. Thus, the district court in Cardinal Health directly followed the 1992 Merger Guidelines by evaluating separately whether (committed) entry would be timely, likely, and sufficient to solve the competitive problem, concluding that it would not mainly on the ground of insufficiency.63 Similarly, in Staples the district court found a way to harmonize the entry analysis of Baker Hughes, which formally controls in the D.C. Circuit, with the standards of the 1992 Merger Guidelines by asking as the primary test whether new competition "would avert the merger's anticompetitive effects."64 The use of "would" in preference to "could" in this articulation can be read as calling for a profitability analysis, as suggested by the Guidelines' entry likelihood test.

Another indicator of the success of the entry framework established in 1992 is its spread to doctrinal areas beyond mergers.65 The enforcement agencies have themselves adapted entry standards from the Merger Guidelines to the context of analyzing agreements among rivals.66 Some courts have done likewise, including the Ninth Circuit in Rebel Oil,67 a monopolization case. That court recognized that entry, though easy for some firms, may be insufficient to solve a competitive problem "if the market is unable to correct itself despite the entry of small rivals" and cited the Merger Guidelines "timely, likely, and sufficient" language as persuasive authority for undertaking that analysis.68

But the Guidelines' entry section has been criticized. F.T.C. Commissioner Thomas Leary recently raised two concerns that may be shared by others: that the agencies never find uncommitted entry, and that the methodology for evaluating committed entry is impractical given the limits of reasonably available information.69 The first of these criticisms may actually reflect the Merger Guidelines' success in educating enforcement agency staff and outside counsel about the distinction between committed and uncommitted entry. When a merger takes place in a market in which entry requires little in the way of sunk investments or time, and the number of prospective entrants are not limited, the agency likely recognizes the situation right away and allows the merger to proceed without the need for an extensive investigation. It is unlikely, for example, that a merger among firms packaging into kits replacement parts used to tune-up automobile carburetors, the business at issue in Echlin, would draw a second request today.70 Under such circumstances, it is unlikely that a current F.T.C. Commissioner would be asked to review personally an uncommitted entry case.

The second criticism, that the Guidelines's approach is impractical, appears aimed mainly at the Merger Guidelines' methodology for assessing entry likelihood. This criticism raises a fair issue, but it is important to put it into perspective. When the agencies conclude that committed entry would not solve the competitive problem from merger, they usually do so on grounds of untimeliness or insufficiency.71 Investigations that turn on entry likelihood are not common, and litigation over entry likelihood is rarer still.

Moreover, the Guidelines drafters were aware that mathematical precision in the application of concepts like "minimum viable scale" and "sales opportunities" would often prove elusive, notwithstanding the underlying conceptual rigor. That does not render the concepts useless. They still can focus the inquiry on the relevant factors that determine whether committed entry would be profitable in the post-merger market environment, and frame the qualitative testimony of those with actual entry experience in the industry.72 Indeed, in my experience, this is how the entry likelihood approach has been employed in those few investigations in which the profitability of committed entry is central, regardless of whether quantitative evidence is available.73

In any case, there may be no good alternative to the entry likelihood methodology of the 1992 Merger Guidelines. Commissioner Leary suggests that the agencies apply a test based on the history of entry and whether special circumstances affect the predictive value of that history.74 But evidence that entry has occurred in the past may be double-edged, consistent with either low entry barriers in the past (which permitted it) or the past exercise of market power (which induced it).75 Similarly, the absence of past entry could be consistent either with a competitive market or entry barriers.76

Accordingly, if the implications of past entry history are assessed responsibly, doing so will almost necessarily lead to the analytic approach of the 1992 Merger Guidelines. The Guidelines explain that recent examples of entry, whether successful or unsuccessful, may provide a useful starting point for identifying the necessary actions, time requirements, and characteristics of possible entry alternatives.77 But past entry evidence must be analyzed with care to ensure that it is probative.78 Can entrants today employ the same approaches as had been successful in the past? Can they do so as cheaply as did the entrants? Would entrants today reasonably expect to receive as high a price as did their predecessors, who may have entered when there was less post-entry competition or the market was larger? As these questions suggest, careful analysis of the probative value of past examples of committed entry will quickly turn into an entry likelihood analysis, along Merger Guidelines lines.

E.	Two Unresolved Issues

The 1992 Merger Guidelines framework for entry analysis continues to embody the best current economic thinking. Still, two unresolved issues in its application may increase in salience. The first is an economic question not fully addressed in 1992. If entry is deterred by the prospect of post-entry competition, it is important to understand how aggressively market participants would compete in the event a new firm were to enter. The 1992 Merger Guidelines recognize this point, treating the issue as a reason that the "sales opportunities" facing the entrant may be larger or smaller than 5 percent of total market sales, the benchmark against which an estimate of minimum viable scale is tested in entry likelihood analysis.79 But the Guidelines offer no guide for thinking about how to adjust sales opportunities for the likely output response of incumbents in reaction to merger and entry, perhaps of necessity because the issue is closely related to the analysis of the likely competitive effects of the transaction.80

The second unresolved issue is a legal question involving burdens of proof. The Merger Guidelines disclaim allocation of burdens; they describe an analytic framework adopted by the enforcement agencies, not a legal framework that should be employed by a court.81 But the Guidelines have informed the case law, even in non-merger litigation.82 Courts applying the Philadelphia National Bank83 presumption of anticompetitive effect from market concentration generally address entry as a rebuttal factor, designed to respond to the government's showing of concentration.84 This approach clearly places a burden of production on defendant, but it may or may not place on defendant the burden of persuasion to prove that entry would solve a competitive problem arising from an acquisition.85 This issue awaits clarification in further litigation.