Will the FTC Allow Microsoft to Buy Yahoo?

The big news this morning is that Microsoft has made a nearly $45 billion bid to buy Yahoo.

In general, regulators might frown on such a deal: after all, wasn’t Microsoft the behemoth that was going to take over the entire technology world in the late 1990s? And yet, as the Associated Press reports, most analysts believe that regulators in the U.S. and Europe are unlikely to stop the deal. Why?

In a word: Google.

What could Google possibly have to do with a proposed Microsoft–Yahoo merger? To answer this question, you need to stop and consider the current state of the Internet search-engine industry.

It’s difficult to use a single yardstick to measure how competitive an industry is. For much of the last century, regulators would use the four-firm concentration ratio, which measured the total market share of the top four firms in an industry. Unfortunately, that didn’t give a measure of the precise extent to which one of those firms might dominate the industry. For example, suppose that in two different industries, the top four firms each have a total of 80% of the market. However, in Industry A, each of the four firms has a 20% market share, while in Industry B, one firm has a market share of 50% and the others each have a 10% market share. The four-firm concentration ratio would treat these two industries equally.

Nowadays, the usual method used by the FTC is to examine the Herfindahl index, which is calculated as the sum of the squared market shares of each firm in an industry. By squaring the market shares, the HI rises when market power is concentrated in one or two companies. For example, in Industry A (described above), the HI would be equal to 20² + 20² + 20² + 20² = 1,600; but in Industry B, the HI would be equal to 50² + 10² + 10² + 10² = 2,800.

According to comScore, which tracks Internet usage patterns, there were approximately 9.6 billion “core” searches performed in 2007. Of those, Google accounted for about 58%, Yahoo for 23%, Microsoft for 10%, Time Warner for 5%, and Ask for 4%. This is clearly a very concentrated industry already; but since Google’s position is so dominant, it might actually help consumers if Google had a larger adversary within the industry.

Discussion Questions

1. Calculate the HI of the search industry before and after a potential merger between Microsoft and Yahoo. By how much does the HI of the industry increase?

2. Google and Yahoo get their search-based revenue from advertisers who place ads based on what people are searching for. However, using Google or Yahoo is free to Internet surfers. If you were a regulator, how would that fact impact your decision to support or oppose a merger between Microsoft and Yahoo?

3. Microsoft’s core business is selling operating system software. How might the acquisition of Yahoo affect that aspect of its business? Might regulators be concerned that having Yahoo become a part of Microsoft could increase Microsoft’s market share in its main market as well?

Should Resale Price Maintenance Be Legal?

If economists generally agree about anything, it is that competitively set prices maximize efficiency and welfare. On the other hand, another central tenet of economics is that efficiency may be achieved by allowing individuals and firms to enter into contracts with one another: for example, Ronald Coase famously showed that problems involving externalities could be solved if all affected parties could negotiate with one another.

However, not all contracts are legal. Most prominently, laws like the Sherman Antitrust Act place strict prohibitions on the kinds of contracts firms can write with one another. For example, airlines cannot agree with one another to keep prices high; that would be illegal collusion. Furthermore, manufacturers cannot require retailers to sell their products at a minimum price—a practice called "resale price maintenance."

The logic behind the banning of resale price maintenance is that the practice raises prices, and therefore decreases consumer welfare. This week, the ban came under attack as a leather-goods manufacturer argued before the Supreme Court that it should be allowed to dictate prices to retail outlets. Justice Antonin Scalia agreed, saying:

...the mere fact that [resale price maintenance] would increase prices doesn't prove anything. If in fact it's giving the consumer a choice of more service at a somewhat higher price, that would enhance consumer welfare, so long as there are competitive products at a lower price.

Recall that consumer surplus is defined by economists as the difference between what a consumer is willing to pay and the price they actually pay. One way of summarizing Justice Scalia's argument is that there are two variables in determining consumer surplus: the price, and the value of the service. If resale price maintenance encourages retail outlets to compete on service, the value to consumers may increase, and may increase more than the increase in price.

The key to this argument is the phrase "so long as there are competitive products at a lower price." In the case of the leather-goods market, it's true that there are lots of producers of leather goods. Therefore, high prices can only be sustained if there is an accompanying increase in quality of service.

Discussion Questions

1. Resale price maintenance agreements would seem to be good for retailers, as they allow them to sell at a price above marginal cost. Yet the plaintiff in this lawsuit was in fact the retailer, Kay's Kloset, who wanted to sell the leather goods made by Leegin Creative Leather Products at a discount. Who do you think benefits more from resale price maintenance agreements, manufacturers or retailers? Why?

2. On his blog, Greg Mankiw reprints the excellent summary from his textbook of the arguments for and against resale price maintenance. One argument for resale price maintenance is that it solves a free-rider problem that would otherwise prevent stores from offering good service:

[A manufacturer] may want its retailers to provide customers a pleasant showroom and a knowledgeable sales force. Yet, without resale price maintenance, some customers would take advantage of one store's service to learn about [a product's] features and then buy the item at a discount retailer that does not provide this service.

Do you think that resale price maintenance solves an important free-rider problem, as Mankiw suggests? Why or why not?

3. Resale price maintenance contracts are just one example of a kind of economic contract that is illegal. Philosophically, one might argue that it is illegal precisely because it limits the kind of contracts that one of the parties entering the contract can sign. For example, a resale price maintenance agreement that fixes the price of a leather jacket at $200 essentially stipulates that the retailer cannot enter into a contract with a buyer at which the jacket is sold for less than $200. Can you think of other contracts that people enter into that inhibit their ability to act freely in the future? Are they useful? Are they illegal? Should they be?

4. Some things are "per se" illegal under the Sherman Act, while for others, the "rule of reason" applies—that is, courts judge how anticompetitive they are on a case-by-case basis. If the leather-goods manufacturer is successful in this petition, resale price maintenance contracts would shift from the former category to the latter. Is that appropriate? How would you apply the "rule of reason" to a resale price maintenance case?

Defining Markets

One rarely has the opportunity to witness the formation of a monopoly, but that’s what will happen if satellite radio broadcasters XM and Sirius are allowed to complete their proposed merger. But is it really a monopoly? On the surface, this appears to be a classic example of “merger to monopoly.” XM and Sirius are the only two providers of subscription satellite radio services, so any merger should yield a single monopoly producer of that particular kind of service.

The central issue is the definition of the market. If the market is defined narrowly—satellite radio entertainment providers—then monopoly is exactly what will result. However, in a more broadly defined market, a combined XM–Sirius would not be a monopoly. For example, we could delineate the market to be all suppliers of audio content broadcast into cars (which would include the other radio providers now referred to as “terrestrial radio”), or even the market for all audio music, news, and entertainment sources (which would include Internet radio and downloads from websites like iTunes). In these broader markets, even a single "monopoly" satellite radio firm would face a great deal of competition.

The debate over this proposed merger will center around its impacts on competition and consumer welfare. If the market is narrowly defined, the traditional complaints regarding monopolies are legitimate: reduction in consumer choice, sub-optimal production of content, damping of innovative activities, and, of course, higher prices. However, the firms argue that consumers will benefit from efficiencies resulting from combined operations—their press release claims annual cost savings of up to $7 billion per year and outlines other expected synergies. Of course, it should be noted that both companies have been operating for over 5 years, but neither has generated a profit yet despite growing revenues and significant efforts to expand their subscriber bases.

There are several significant obstacles to the completion of this merger. In 2001, satellite television providers DirecTV and the Dish Network proposed a merger that was eventually blocked by antitrust authorities. Many observers see the XM–Sirius merger as the audio equivalent of the DirecTV–Dish Network deal. A further complication exists because when the two companies were originally licensed, the FCC explicitly forbade one company from owning both satellite broadcasters. The proposed merger will require FCC and Justice Department approval and will likely attract the attention of Congress, so the companies must be hoping that regulators will take a fresh look at the market and competition.

Discussion Questions

1. Can you think of other instances in which a firm dominates a narrowly defined market, but faces competitors from a more broadly defined market?

2. The most famous recent antitrust case was the Microsoft case. In that case, Microsoft argued that even though it dominated the market for computer operating systems, it was still vulnerable to competition from other forms of software. This is a similar argument to the one being made by XM and Sirius. Looking back on the last few years, how much merit did Microsoft's argument have? Does the rise of firms like Google and YouTube mean Microsoft's market power has eroded?

3. Sirius and XM argue that there are economies of scale that make the provider of satellite entertainment a natural monopoly, like the local power company. On the other hand, price wars between the two services may be just as much to blame for their failure to make money. If you were a regulator, what guidelines for pricing could you establish to allow the combined company to realize the economies of scale without gouging consumers on price?

Harold Elder is a professor of economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's master's and Ph.D. programs.