The Economics of e-Commerce and the Internet
Edward J. Deak, Ph.D.
Ch. 8 – Answers for Discussion and Review Questions
1. Identify and distinguish between the three general types of mergers. How do
vertical mergers alter the nature of the decision-making process?
The three types of general mergers include first, horizontal mergers that involve a
union between two firms that sell the same product in the same geographic
market. Prior to the merger, these firms were competitors. The second type is a
vertical merger between two firms that stand in a buyer supplier relationship as
part of the supply chain. The final merger type is that of a conglomerate merger
between two firms that either produce unrelated products or produce the same
product but sell it in different geographic markets. A vertical merger changes the
decision-making process from one that is focused on the contracts and market
negotiated exchange of products and services to a system of production based
upon hierarchical command and control. Decisions are made by managers of the
vertically integrated firm and not in response to arms length competition based
upon price.
2. Identify and discuss the economic efficiencies that can result for mergers. Are
these expected efficiencies always realized, and how might they enhance
competitiveness if they do appear?
Typically mergers create efficiencies based upon economies of scale and other
forms of cost reductions such as the elimination of duplicate effort. These
efficiencies lead to the level of combined output being produced at a lower unit
cost. This is another of those “it depends” answers. Sometimes these efficiencies
appear because the architects of the merger did a good job of planning the merger,
anticipating the results and working to blend the two previously independent
corporate cultures. Conversely, mergers fail if they are poorly planned, poorly
executed or create frictions among the previously competitive but now united
employee units. Merged firms are larger, more efficient competitors that can
serve a larger geographic market with a wider range of products and services. As
such, they can be ferociously competitive.
3. Identify and discuss the sources of market power enhancement that can result
from various types of mergers. How does the AOL-TW merger demonstrate the
potential for power enhancement?
A horizontal merger eliminates an existing competitor. Depending upon the size
of the firms involved, it raises the level of market concentration, and increases the
potential for coordinated behavior among the remaining firms in the industry. A
Deak e-Commerce Answers Ch.8, Page 1
vertical merger between a formerly independent buyer and seller creates the
potential for market foreclosure, limiting the access of other independent buyers
or sellers to the now integrated units of the merged firm. Foreclosure can limit
the sales and market shares of the remaining independent firms forcing them to
look for merger partners or even to exit the market. Conglomerate mergers can
eliminate a potential entrant whose presence and threat of entry limited the pricing
or other competitive behavior of firms already in the industry. They can also lead
to cross-subsidization where a richer parent in one industry financially supports
the continued existence and competitive initiatives of a smaller, newly acquired
subsidiary.
Potentially the union of AOL and Time-Warner had elements of a both a vertical
and conglomerate merger. Technical economies of scope were expected to lower
the production costs for the merged firm, while synergies in the sale of advertising
products would enhance the attractiveness of AOL-TW as a place for other firms
to direct their marketing dollars. Lastly, AOL’s Internet presence was thought to
provide a potential vertical outlet for the entertainment and information content of
TW. The relationship was expected to reinforce AOL’s dominance in the ISP
market.
4. Does the Yankee-Nets union appear to be a merger driven by efficiency or the
desire to enhance profits through the exercise of post-merger market power?
Why?
The Yankee-Net union is driven more by the potential exercise of market power
than efficiency enhancement. The merger has led to little new efficiency through
combined operations, and has primarily served as a vehicle for marketing the
televised games of each team over the new YES Network. Rather than selling the
cable rights to an existing sports channel, the YES Network markets the games
directly to the local cable operators. The per viewer monthly charges for the
network are steep and leverage the strong local viewing power of the Yankess,
who play at most a seven month schedule, into a twelve month, higher profit, 24/7
subscription package.
5. What factors led to the softening of regulatory attitudes toward allowing mergers
of all types during the 1990’s? Why weren’t the regulators worried about merger
based increases in market power?
Four reasons contributed to the more relaxed regulatory attitude towards mergers
in the 1990’s. First, was the trend towards the globalization of markets. This
required mega-sized firms with the ability to operate efficiently anywhere in the
world. The second reason was the rapid pace of technological change. Rapid
technological change undermines existing market power by creating new
opportunities for rival products and processes. Third was the movement towards
deregulation that made markets more competitive. Greater competition could
work to offset the power created by larger firms. Lastly, the regulators grew more
Deak e-Commerce Answers Ch.8, Page 2
willing to accept the efficiency argument as a justification of allowing mergers to
go forward. Greater efficiency would lower costs and make the remaining firms
more price competitive.
6. Have the economic and financial consequences of Internet and other mergers
typically lived up to the pre-merger expectations? Why?
In general, the efficiency and financial consequences of mergers have usually
fallen far short of the pre-merger expectations. While some mergers, such as the
union of Exxon and Mobil in the oil industry, have done very well in reducing
costs the majority of mergers are badly conceived, poorly planned, and/or poorly
executed. This has often led to a later and expensive spin-off of part or all of the
merged properties. For example AT&T spent billions of dollars to acquire a
number of cable TV franchises serving a substantial portion of the market.
However, the inability of AT&T to execute its business plan to combine the
delivery of cable and telephone signals in one line, led to the eventual sale of the
cable unit to Comcast a rival cable supplier.
7. Identify the key merger-controlling provisions in Section 7 of the Clayton Act.
How do these provisions work to block anticompetitive mergers in their
incipiency?
Section 7 applies to any merger in any product market in any section of the
county where the affect may be to lessen competition or tend to create a
monopoly. It blocks the growth of market power in its incipiency, or at an early
stage, because market power does not have to be achieved before the Act can be
invoked. Also, the merger doesn’t have to conclusively led to market power, it
only needs to show a tendency towards that end. Lastly, the wording of the act
gives considerable latitude to the Court in defining both the geographic market
and the relevant product market.
8. How does the merger of AOL and Time Warner work to create a link between
media content and distribution? In what ways does this union pose a threat to
other media content or distribution firms?
Time Warner is one of the largest media content producers in the U.S. with
interests in film, music, television, cable systems and cable networks, magazines,
book publishing and other areas. AOL is the dominant ISP providing links to the
Internet and serving as a portal for an entertainment hungry, youthful audience.
One of the objectives of the merger was to allow TW content to be shown and
marketed on the AOL site. Other independent content and distribution firms
might have reason to fear the AOL-TW merger if it limited the ability of a
distributor such as a cable system from securing equal access to a cable network
owned by AOL-TW. Conversely, a content provider might be placed at a
competitive disadvantage if it was unable to secure distribution on an equal basis
with a rival AOL-TW property. If this union proved to be efficient and profitable,
Deak e-Commerce Answers Ch.8, Page 3
then it might precipitate other mergers between content producers and
distributors.
9. What types of competitive concerns attracted FCC and FTC attention when they
approved the AOL Time Warner merger? How did the two regulatory agencies
address these concerns? What kinds of competitive concerns did the two
regulatory bodies choose to ignore?
The focus of the FTC’s concern was directed towards competitive affects upon
the delivery of Internet service. The FTC addressed this concern by stipulating a
number of rules that the combined firm must follow to enhance the level of
competitive ISP service being carried over the firm’s cable system. The FCC
directed its regulatory attention to the interoperability of AOL’s instant messaging
system. They attached a number of conditions to the approval of the merger that
would require a broader and more rapid integration of AOL’s IM system into a
more universal standard that would allow easy access from one system to another.
Both regulatory agencies ignored the problems resulting from the integration of
an entertainment content provider with a content distributor and they did nothing
to address the numerous clashes between independent providers of content and
content distributors as well as with the combined AOL-TW.
10. Why are media and cable companies “bulking up”? How are they accomplishing
this goal? Is it an economic efficiency or a market power strategy? Why?
Bulking up refers to the various players acquiring more assets to use as both a
sword and shield against other media titans. These assets are generally being
accumulated through mergers or acquisitions, with some firms selling off assets
for a variety of reasons while others acquire them to further enhance their size and
competitive strength. For the most part, this is a market power strategy given that
the vertical integration of content and distribution has not yet proven to be an
efficiency enhancing strategy.
11. What was the nature of the conflict between Time Warner and Disney/ABC? How
did the Cable Act of 1992 contribute to this conflict?
The Cable Act of 1992 required cable operators to either carry local signals at
their request but without compensating the local stations, or to obtain
retransmission consent from the local station in exchange for some form of
negotiated compensation. Disney, who owns ABC, wanted the compensation to
involve dropping the Disney Channel from a premium pay to an extended basic
status, and to add two minor Disney channels to the system in exchange for
carrying the local signal for the ABC owned station. Time Warner Cable refused
the deal. They pulled the local ABC owned stations off the air in their delivery
area during the spring 2000 “sweeps week” audience measurement period. The
dispute was quickly settled by a private, negotiated settlement.
Deak e-Commerce Answers Ch.8, Page 4
12. What was the nature of the conflict between AOL and Microsoft? Why did the
two firms at first cooperate and then later find themselves in a goal conflict?
At first the firms agreed to a mutually beneficial arrangement. In 1996, Microsoft
agreed to host the AOL icon on its opening screen to promote the growth of AOL
over rival ISPs. In turn AOL agreed to use the Microsoft Explorer browser to
help promote the growth of Explorer in its struggle with Netscape Navigator. As
time passed the two firms became more rivalrous as Microsoft chose to be a
bigger player in the Internet and their spheres of influence began to overlap.
Microsoft began its own ISP, MSN, which became a rival for AOL. The two
firms backed rival Internet music player systems. In 1999, AOL created a rival
instant messaging system. Lastly, AOL began to pay computer makers for the
placement of its icon on the opening desktop, thereby avoiding the need to
cooperate with Microsoft.
13. Describe the various parts of the conflict between the cable system operators
and the cable content producers. How does the economic concept of
countervailing power help to frame an understanding of this conflict?
On the one hand, cable operators and content producers have a symbiotic, or
mutually beneficial relationship, in that the profits of one depend upon the quality
of the service provided by the other. Conversely, as independent entities, they are
often in an economic conflict over the price to be paid for the content and the
conditions under which the cable operator will carry that content. Countervailing
power involves one side acquiring economic clout in order to gain bargaining
equality or perhaps even leverage over an opponent. To achieve this power some
cable operators have acquired content producers while some content producers
have acquired cable outlets.
14. How have recent judicial decisions affected both the cable ownership and
programming rights, as well as local broadcast TV ownership rules? What might
be the consequences for cable and broadcast efficiency and power resulting from
these decisions?
FCC rules had limited horizontal cable coverage and vertical cable content. The
goals of these rules were to limit the growth of cable market power and to
preserve diversity in local cable programming. In 2001, a Federal Court vacated
these rules and remanded them back to the FCC for modification and/or
justification. The FCC also had local TV ownership and dual TV-Cable
ownership rules that limited the potential growth of media market power in a
single geographic market. These too were overturned by a Federal Court
decision. To the extent that these rules are relaxed or eliminated by the FCC, it
will allow the further integration of media content and distribution along with
greater potential control over local markets by a single cable and/or TV firm.
Deak e-Commerce Answers Ch.8, Page 5