The Department of Justice (DOJ) last November shocked many observers in the telecommunications and entertainment industries by suing to stop the $108 billion acquisition of Time Warner Inc. by AT&T. The last time the DOJ went to court to attempt to block a “vertical” merger (when a company merges with one of the companies that buys its product) was 1977. The departure from precedent did not stop there: in 2011, the DOJ approved a very similar merger between NBC Universal (NBCU) and Comcast, albeit it with several conditions attached. The DOJ’s apparent shift in course allowed the media to hone in on a potentially tantalizing theory: that President Trump, who vocally criticizes CNN, a channel owned by Time Warner subsidiary Turner Broadcasting, unduly influenced the DOJ to block the merger. Such meddling would be a serious abuse of presidential power.
This article does not speculate on the president’s role in blocking the merger, but instead looks at the economics of the transaction. The DOJ complaint claims that the merger of AT&T and Time Warner “would result in fewer innovative offerings and higher bills for American families.” Whether one agrees or not, there are real economic issues behind the claim, issues the DOJ itself identified as concerns in its 2011 consent decree allowing the NBCU/Comcast merger to go through with conditions. However, if there is one entity this article can definitively criticize, it is the DOJ itself. In both cases, it has relied on economic logic that can be called into question and mathematical models that were intended to formalize broad concepts in an academic setting, not predict the future with enough precision to provide grounds to approve or block multibillion-dollar mergers.
The Trouble With Vertical Mergers
Antitrust laws often concern horizontal mergers, where the companies’ products directly compete. If the two largest breakfast-cereal companies merged, the new entity would command a larger share of the market, and might be able to raise prices to consumers. Vertical mergers, on the other hand, are when a company merges with one of the companies that buys its output. As the figure below shows, the contested merger between AT&T and Time Warner is vertical in nature. Time Warner and its subsidiaries produce television shows and manage TV channels, while AT&T, primarily through its subsidiary DirecTV, distributes channels to customers via satellite TV.
Regulators’ primary concern in vertical mergers is so-called vertical foreclosure, when the “upstream” part of the newly merged firm behaves in a competitively harmful way toward its “downstream” competitors. The DOJ sums up this theory with respect to the current case as follows:
As AT&T has expressly recognized, however, distributors that control popular programming “have the incentive and ability to use (and indeed have used whenever and wherever they can) that control as a weapon to hinder competition.” Specifically, as DirecTV has explained, such vertically integrated programmers “can much more credibly threaten to withhold programming from rival [distributors]” and can “use such threats to demand higher prices and more favorable terms.” Accordingly, were this merger allowed to proceed, the newly combined firm likely would — just as AT&T/DirecTV has already predicted — use its control of Time Warner’s popular programming as a weapon to harm competition. AT&T/DirecTV would hinder its rivals by forcing them to pay hundreds of millions of dollars more per year for Time Warner’s networks, and it would use its increased power to slow the industry’s transition to new and exciting video distribution models that provide greater choice for consumers.
Under the DOJ’s theory, if a rival cable or satellite TV provider such as Charter or Dish Network did not agree to a higher price for Time Warner’s programming, the newly merged entity would be in a better position than Time Warner because some of the other firm’s customers would switch to AT&T’s DirecTV to avoid losing these channels. The complaint also identifies internet-based on-demand video (such as Netflix) and streaming video (such as Sling) as growing competition to traditional cable and satellite TV providers, and suggests that a merged AT&T/Time Warner would have greater incentive or ability to stifle the growth of such competition.
In a brief document released soon after the DOJ complaint, AT&T cited the departure of the DOJ’s decision from precedent, noting that it approves the vast majority of vertical mergers between large corporations, including the 2011 NBCU/Comcast merger.
Apples, Oranges, and Peacocks
In January 2011, the DOJ and Federal Communications Commission (FCC) collaborated to approve the NBCU/Comcast merger subject to a long list of conditions. In arriving at those conditions, both agencies cited concerns very similar to those spelled out in the newer DOJ complaint above. The DOJ and FCC approved the merger subject to conditions including the new entity licensing its content to online competitors, agreeing to arbitration in the event of pricing disputes, relinquishing management rights in the jointly owned Hulu service, and following the set of rules known at the time as net neutrality. Some of the conditions have sunset provisions that remove them beginning later this year.
While lawyers and expert witnesses in the AT&T/Time Warner matter will no doubt quibble about any differences between it and the conditionally approved NBCU/Comcast merger, a look at the market shares of the companies in play shows in broad terms just how much the two mergers have in common. The charts below show market shares for TV channels and pay-TV distributors, respectively. Between HBO and Turner Broadcasting, Time Warner controls channels accounting for 16.3 percent of viewers in 2016, while NBC Universal controls channels accounting for a strikingly similar 16.4 percent. AT&T controls 26 percent of the distribution market (between DirecTV, which accounts for about 21 percent, and AT&T U-Verse, which makes up the remainder), while Comcast has a 23 percent share.
Though something of a bipartisan consensus on antitrust policy has emerged in the last generation, one would generally expect Departments of Justice under Republican presidents to be more permissive toward mergers than Democratic ones. The fact that a Republican DOJ is suing to block a merger that so closely resembles a deal conditionally accepted by a Democratic DOJ seven years ago is indeed surprising. One potential reason for the difference may be the approach of current antitrust chief Makan Delrahim, who has criticized the complex webs of conditions the DOJ has put on vertical mergers such as NBCU/Comcast. Delrahim prefers so-called structural rather than conditional remedies — simpler conditions, such as divesting business units, that do not require the government to keep intervening over time. It has been reported that the DOJ asked AT&T and Time Warner to sell either Turner Broadcasting or DirecTV, though for the purposes of this analysis, that would have been equivalent to blocking the merger.
The Very Model of a Modern Major Merger
The DOJ has used the same basic economics in both mergers to justify a lengthy set of conditions for NBCU/Comcast and outright reject AT&T/Time Warner. That economic logic is dubious, and the documents in both cases suggest a heavy reliance on questionable estimates generated by theoretical economic models that are problematic in reaching such decisions.
As set forth in the complaint against AT&T and Time Warner:
If, in negotiations, Time Warner seeks too high a price for the Turner TV networks, the video distributor across the table may walk away. Without a deal, Time Warner loses monthly payments from the video distributor and advertising revenue — and gains nothing in return. This merger, if allowed, would change that. After the merger, if the merged company raised prices of the Turner networks to the video distributor and no deal were reached, resulting in a blackout of such networks, the merged company would still lose monthly payments and advertising revenue from the video distributor with whom it could not reach a deal, but, importantly, it would now get an offsetting benefit. Because the video distributor walking away from a deal with the merged company would lose access to Turner’s popular programming, some of the video distributor’s valuable customers would be dissatisfied and switch to a competing video distributor. Some of those departing customers would sign up with AT&T/DirecTV, bringing with them significant new profits for the merged company. This improvement in Time Warner’s best alternative to a deal resulting from the proposed merger — and therefore in its negotiating leverage — would give the merged firm the ability to credibly demand higher prices than it otherwise would.
To truly understand the degree to which the merged entity would be in a better bargaining position, it is necessary to know the revenue they would lose from rejected deals with other distributors, the number of new customers DirecTV would get if one or more systems did not offer HBO and Turner networks, and the increased price in the bargaining process that the merged entity would receive with such added leverage. It is only possible to estimate with any accuracy the first of these quantities.
The table below shows 2016 revenue for the Turner, HBO, and Warner divisions from subscription and content, available in the company’s annual report. By assuming these divisions charge equal prices to all distributors, we can remove DirecTV’s share of the market, and adjust reported global revenue to revenue from the United States, to estimate that the merged entity would lose over $10 billion in revenue from other distributors in a scenario where DirecTV had exclusive rights to the content in question (i.e., full vertical foreclosure). While it is not possible to know how many new customers DirecTV would get in this scenario, it would be unlikely to recoup these losses, which equal half of the company’s current U.S. revenue of about $20 billion. Furthermore, the profit margin on DirecTV customers is likely to be lower than that on licensing content, since the former involves capital equipment, installation, and customer service while the latter only entails making content available that has already been produced.
If the merged entity is better off charging distributors the price Time Warner charges today than giving DirecTV exclusive access, how much has the company’s bargaining position really improved? While we intend this as a rhetorical question, the FCC’s documents in the NBCU/Comcast matter show that some economists are more than happy to attempt to answer that question. The process relied upon by the FCC involves assuming that the increased price NBC can charge distributors is governed by a “Nash bargaining model.” This model in turn requires as inputs estimates of the bargaining skill of each party, how many subscribers a distributor would lose without the networks in question, how many of those subscribers would switch to Comcast, and Comcast’s profit per subscriber. Each of those inputs in turn requires heroic assumptions and another layer of mathematical models.
If the AT&T/Time Warner case goes to court as currently planned, here’s what will happen: the DOJ will trot out a series of models and calculations similar to those cited by the FCC in the NBCU/Comcast matter, to attempt to prove that Time Warner would raise its prices to AT&T’s rivals should the merger take place, and that those price increases would be passed along to consumers. AT&T will then put forward an expert witness, likely a prominent academic economist backed by an economic consulting firm and well compensated for their time and reputation, who will call into question each and every one of the assumptions and inputs used by the DOJ. AT&T’s expert will argue that under the correct assumptions, one can see that prices would increase very little, if at all. Both sides will cite academic literature, and employ hundreds of man-hours of data analysis. And both sides will succeed in proving that the other side is wrong. That’s because Nash bargaining models and econometric estimates of switching rates from cable companies were designed to help economists think about overall phenomena, not provide precise estimates of outcomes from one specific merger.
Regarding the blanket application of models to all economic questions, Rollo Handy and AIER founder E.C. Harwood wrote that “some of the displays of technical proficiency may be impressive, especially to those less skilled in mathematics, but there is little evidence that useful scientific inquiry has been advanced thereby, and there is much evidence that such elaborate theorizing lends a false appearance of authenticity to assertions that by no means are scientifically warranted.” The FCC and DOJ’s decisions depend on the idea that the merged firm can raise prices for content to its rivals. The several layers of simplifying assumptions necessary to estimate the magnitude of such increases render any resulting estimates of price increases virtually meaningless. One could just as easily write down a game-theoretic model where the bargaining position of the combined entity does not improve at all since the status quo prices are better than the alternative outcome.
A Dose of Humility
When relationships between variables cannot be directly observed, economists too often rely on simplified models and untested assumptions to “do their best” to provide an answer. But a more modest and less arbitrary antitrust policy might start with regulators being clear about what they do and do not know. We do not know how many customers would switch from a major cable operator to another provider after the loss of a popular set of channels, because it has never happened. The model required to estimate this rate, which feeds into an attempt to predict the outcome of a human bargaining process, should not serve as the basis for allowing or blocking mergers with billions of dollars at stake. Whether or not the president had a hand in the DOJ’s recent decision, our approach to antitrust policy needs a closer look.