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An Incentive Contract as Merger Conduct Remedy

25 Pages Posted: 30 Dec 2015  

J.P. Sevilla

Independent

Date Written: December 29, 2015

Abstract

The policy goal of merger remedies is to facilitate mergers’ potential contribution to dynamic and productive efficiencies while preserving pre-merger consumer surplus. But recent empirical scholarship shows that most remedies fail to achieve this goal. I propose an incentive contract, inspired by the theory of incentive-based regulation in general and price-cap regulation in particular, that can serve as a conduct remedy and that has strong theoretical and practical advantages relative to standard divestiture and conduct remedies.

The remedy requires the merged firm to contract with a private third party to whom it makes cash payments whenever it raises price or lowers quantity or quality relative to pre-merger levels, where the payments are at least as large as the revenue gain from such actions. To cope with adverse demand shocks, the contract lets the firm sell a lower than pre-merger quantity so long as price is no higher and quality no lower than pre-merger. To cope with adverse supply shocks, the pre-merger price threshold that the contract does not allow the firm’s post-merger price to exceed can be adjusted by an index of input cost inflation. To cope with variations in product quality, the contract lets the firm vary quality so long as the post-merger product is weakly revealed-preferred by its customers to the pre-merger product. The payout structure effectively imposes a contractual obligation on the firm to preserve pre-merger consumer surplus, while giving the firm a residual claim on all merger-induced cost savings thereby eliminating moral hazard.

The firm’s payouts to its contractual counterparty are contingent on the same three variables — price, quantity, and quality — that are the central terms in the firm’s own sales contracts with its customers. The same market forces, contract laws, and external auditing mechanisms that ensure adequate observability of these variables to the firm’s customers therefore ensure their observability to the counterparty. The contract does not require information on economic costs or the demand curve. In contrast to divestitures, my remedy does not require the merging firm to shed parts potentially critical to its efficiency.

Standard conduct remedies suffer from risks of asymmetric information, incomplete specification, countervailing incentives, irrelevance in face of market dynamics, and agency inappropriateness for regulatory roles. In contrast, my contract conditions on variables less vulnerable to problems of asymmetric information and incomplete specification. It shapes incentives only to the minimal extent necessary to preserve consumer surplus, only as much as any other contract does, and in a way that induces the firm to find the least cost way of preserving consumer surplus. It addresses market dynamics arising from adverse demand and supply shocks and product innovation. It absolves the agencies of the fraught responsibilities of predicting merger effects and post-merger regulation. It relies on contract- and market-based mechanisms for securing the policy goals of the merger regime. It is more sensitive, specific, and implementable than standard remedies. It is potentially the most light-handed of remedies since a merged firm committed to fulfilling its part of the policy bargain will find none of its constraints binding.

Suggested Citation

Sevilla, J.P., An Incentive Contract as Merger Conduct Remedy (December 29, 2015). Available at SSRN: https://ssrn.com/abstract=2709084 or http://dx.doi.org/10.2139/ssrn.2709084

J.P. Sevilla (Contact Author)

Independent ( email )

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