Industrial Economics:

Prices, market definition, and the effects of merger : Staples-Office Depot (1997) case

Fanny CANON Feruza CHAKKANOVA 2014-2015

Agenda

○ Introduction ○ Background ○ FTC’s case ○ The defendant’s arguments ○ Judge Hogan’s decision ○ Conclusion and aftermath ○ Questions

Introduction September, 1996: 2 largest office superstore chains in US Office Depot and Staples announced their agreement to merge Seven month later: the Federal Trade Commision voted 4 to 1 to oppose the merger on the grounds that it would harm competition and lead to higher prices The merging parties chose to contest the FTC’s actions in court June, 1997, after a 7 day trial Judge Hogan of the US District Court for the DC announced the final decision on the case

Background Staples first to pioneer the office superstore concept in 1986 and Staples started in 1987 Staples with 550 stores in 28 states (1997) Office Depot 500+ stores in 38 states (1997) The office superstore was to do for office supplies what the supermarket had done for home groceries

Typical superstore

Area: 23K-30K square feet Stocks: 5000-6000 items Location: urban business area

Market for OSS

23 competing OSS chains in the market 3 biggest OSS chains:

The success of OSS concept

Competitive rivalry between superstores benefited consumers ● OSS slashed down prices ● drowned down costs ● developed innovative approaches in o o o o marketing distribution store layout one-stop shopping

Merger agreement

● September 4, 1996 Staples and Office Depot announce agreement to merge ● Staples to acquire Office Depot 1.14 Staples share for each Office Depot share; $4 billion deal ● After 7-month investigation FTC decided to challenge the merger

The FTC’s case ○ Possible consequences of the merger: • decrease in competition • increase of prices Note: Comparison between the expected merger-related changes in prices and costs with the prices and costs that would have prevailed in the absence of merger.

Concentration and the competitive effects of a merger “Mergers or acquisitions should not be permitted to create, enhance, or facilitate the exercise of market power” ○ Two ways of gaining market power: - Explicit/ implicit coordination of actions - Unilateral conduct ○ Consequences: Transfer of wealth from buyer to seller - Misallocation of resources

Some evidences …

1. Defining the relevant market: “Consumable Office Supplies Sold Through Office Superstores”

Office superstores offer a distinct set of products and services Office Depot and Staples (OSS): Other vendors: ○ ○ Broad range of consumables Large amount of stock ○ ○ Limited assortment of consumables Small amount of stock => One-stop shopping opportunity

OSSs regard each other as their primary competitors ○ According to internal documents

Non-OSS retailers have little effect on OSSs’ price changes ○ Non-OSS retailers have little effect on Oss’s price changes ○ “A monopolist is distinguished not by the fact that it faces no competition, but by the fact that its closest competitors are too distant to prevent it from maintaining its price at a level significantly above cost”

Econometric evidence supported an OSS product market ○ Would a merger to monopoly among the OSS chains in a city allow the merged entity to raise the prices of consumable office supplies by 5% or more?

2. The merger’s Likely anticompetitive Consequences

Structural evidence: the change in concentration and market power

Year

1995 2000

Staples only Staples and Office Depot Staples and Offic eMax All three Total

17% 12% 29% 7% 37% 12% 17% 69% 100% 100%

Empirical evidences pointing to likely price increases ○ ○ ○ ○ ○ Prediction of Staples Management Direct comparisons of prices across local markets Estimates from econometric analysis Estimates from the prudential study Estimates from a stock-market event-probability study

Empirical evidences: Prediction of Staples Management:

Year

1995 2000

Staples only Staples and Office Depot Staples and Offic eMax All three Total

17% 12% 29% 7% 37% 12% 17% 69% 100% 100%

Empirical evidences: Direct comparisons of prices across local markets

Benchmark OSS Market Structure

Staples only Staples + OfficeMax

Comparison OSS Market Structure

Staples + Office Depot Staples + OfficeMax + Office Depot

Price Reduction

11.6% 4.9% Office Depot Only Office Depot + Staples Office Depot + Office Max Office Depot + Office Max + Staples 8.6% 2.5%

Empirical evidences: Estimates from econometric analysis o Overall price effects of the proposed merger: => Average of 7.3% Estimates from the prudential study o Prices are more competitive (+/- 5.8 percent lower) in a 3-player markets than in a 2-player markets.

Empirical evidences: Estimates from a stock-market event-probability study If the merger would raise prices If the merger would low prices ○ Both merging parties would benefit from it with higher share prices ○ The share values of the merging firms’ rivals would fall In this case : value of OfficeMax’s shares would raise by 12%.

3. Entry

Entry

o Potential entry of other OSS firms does not constrain the incumbents o Significant barriers to entry: Economies of scale in advertising Store level economies of scale Economies of multi store operations

4. Efficiencies were not sufficient to offset price increases

Efficiency claims made by the merger parties were exaggerated for several reasons: ○ ○ ○ The anticipated efficiency gains were the result of the merged firm’s increased scale Efficiencies analysis that was submitted to the FTC was different (showing higher efficiencies) from the one that was submitted to Staples’s board Only one seventh of the cost-saving would be passed through to consumers however, efficiency gains are relevant only if they result in lower prices to consumers

The defendant’s arguments

1.

The FTC’s product market definition was erroneous 2. Reasons the merger would not raise prices ● efficiencies from merger ● ease of entry into OSS retailing ● record of lowering prices after past acquisitions of other OSS firms

Efficiencies and Net Price Effect

OSS founded on the principle of providing low prices through large sales volume. ➔ The merger would lower the costs through increase in total volume of combined purchases from manufacturers ➔ Lower administrative, marketing, advertising, and distribution costs ➔ Cost reduction passes on to consumers, bringing down prices after the merger

Econometric study by Staples

● Office Depot had a small effect on Staples’ pricing ● Merger would increase prices for consumable goods by only 2.4% (compared with FTC’s estimate of 7.3%) ● Staples’ estimate of cost savings and efficiency gains lower the prices by 3% over all Staples’ products and stores ● The net effect of the merger would bring to average Staples customer 2.2% decrease in prices

No Barriers to Entry and Ease of expansion

● Stores can be constructed within months (e.g. Office Max) ● Low sunk costs ● No fashion trends in office supply products, so products do not decay ● Expand by increasing shelf space for office supply items not only by new store openings (e.g.Walmart)

Public and Private Equities

Blocking merger would impose losses on both consumers and shareholders ● Consumer benefits to be lost : ● efficiencies and lower prices ● faster combined company expansion create value for customers and for U.S. economy ● Shareholders benefits to be lost: ● extra profits due to cost savings In case of postmerger anticompetitive effect, the entity could split back into two separate companies

Judge Hogan’s Decision

The court granted preliminary injunction.

● Relevant product market defined as OSS submarket ● Staples and Office Depot would have dominant market share 45%-100% in many geographic markets after the merger ● FTC’s pricing evidence showed a reasonable likelihood of anticompetitive effect ● Neither public nor private equities claimed by defendants were enough to refute the anticompetitive effects

Court’s comments in response to defendant’s arguments

The product Market: submarket Likely effect on competition: dominant Entry: no OSS entry Efficiencies: unrealistic Estimates: unreliable

Conclusion and Aftermath

The FTC’s victory in Staples came as a surprise to many observers Staples and Office Depot together accounted for only a small percentage of the aggregate sales among many retailers of office supplies Studies by FTC showed Office superstores separate market, the key argument for anticompetitive effects

Conclusion and Aftermath

Most of efficiencies expected from merger were achieved without delay and not necessarily with price cuts Within 3 years Staples and Depot each achieved the size of 1000 stores - the size to be achieved as a single firm in case of merger

As of March, 2007

Staples

Expanded to

1522

office supply stores throughout U.S and Canada

Office Depot

Expanded to

1200

office supply stores throughout U.S and Canada

$16.1

billion sales

$15

billion sales

Question 1

Which of the following assumption was not used by the Federal Trade Commission to define the relevant market “office supplies sold through office superstores”?

a. Office superstores offer a distinct set of products and services b. Non-office superstore retailers have little effect on office superstores’ price changes c. Office superstores regard each other as their primary competitors

d. The type of customers targeted

Question 2

What is explicit/implicit coordination?

a. when firms agree to advertise a product together

b. when firms charge very similar prices for the same kind of products

c. when firms set a minimum price at which the product can be sold at d. when a supplier decides to only buy its raw material from one specific producer

Question 3

How does the value of the share evaluate when investors predict that a merger would raise prices?

a. the value goes down b. the value stay the same

c. the value goes up

d. it is impossible to say

Question 4

Which of the following can be the base for market definition?

a. Only the identity of the seller

b. The identity of the seller and the characteristics of the product or service supplied by the supplier

c. Size and format of the supplier d. Variety of goods sold by the supplier

Question 5

What was the determinant of the success of the OSS concept?

a. Ability to provide lower prices b. Innovative approaches in marketing and distribution c. Store layout and convenience of one stop shopping

d. All of the above