1.With reference to the Staple and Heinz-Beech Nut cases, discuss the central issues of the anticompetitive arguments. Carefully discuss the circumstances under which mergers may be undesirable and advantageous.

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Proposed Merger between Heinz and Beech-Nut Scrutinized1 OVERVIEW OF THE BABY FOOD MARKET Four million infants in the United States consume 80 million cases of jarred baby food annually, representing a domestic market of $865 million to $1 billion. The baby food market is dominated by three firms, Gerber Products Company (Gerber), Heinz and Beech-Nut. Gerber, the industry leader, enjoys a 65 percent market share while Heinz and Beech-Nut come in second and third, with a 17.4 percent and a 15.4 percent share respectively. Gerber enjoys unparalleled brand recognition with a brand loyalty greater than any other product sold in the United States. Gerber's products are found in over 90 percent of all American supermarkets. By contrast, Heinz is sold in approximately 40 percent of all supermarkets. Its sales are nationwide but concentrated in northern New England, the Southeast and Deep South and the Midwest. Despite its second-place domestic market share, Heinz is the largest producer of baby food in the world with $1 billion in sales worldwide. Its domestic baby food products with annual net sales of $103 million are manufactured at its Pittsburgh, Pennsylvania plant, which was updated in 1991 at a cost of $120 million. The plant operates at 40 percent of its production capacity and produces 12 million cases of baby food annually. Its baby food line includes about 130 SKUs (stock keeping units), that is, product varieties (e.g., strained carrots, apple sauce, etc.). Heinz lacks Gerber's brand recognition; it markets itself as a "value brand" with a shelf price several cents below Gerber's. Beech-Nut has a market share (15.4%) comparable to that of Heinz (17.4%), with $138.7 million in annual sales of baby food, of which 72 percent is jarred baby food. Its jarred baby food line consists of 128 SKUs. Beech-Nut manufactures all of its baby food in Canajoharie, New York at a manufacturing plant that was built in 1907 and began manufacturing baby food in 1931. Beech-Nut maintains price parity with Gerber, selling at about one penny less. It markets its product as a premium brand. Consumers generally view its product as comparable in quality to Gerber's. Beech-Nut is carried in approximately 45 percent of all grocery stores. Although its sales are nationwide, they are concentrated in New York, New Jersey, California and Florida. At the wholesale level, Heinz and Beech-Nut both make lump-sum payments called "fixed trade spending" (also known as "slotting fees" or "pay-to-stay" arrangements) to grocery stores to obtain shelf placement. Gerber, with its strong name recognition and brand loyalty, does not make such pay-to-stay payments. The other type of wholesale trade spending is "variable trade spending," which typically consists of manufacturers' discounts and allowances to supermarkets to create retail price differentials that entice the consumer to 1Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case is a condensed and slightly modified version of the public copy of the decision in FTC (Appellant) v. H.J. Heinz Co. and Milnot Holding Corporation that was argued on February 12, 2001 and decided April 27, 2001. No. 00-5362. It has been updated by Kyle Anderson, Michael Baye, and Jeffrey Prince. Managerial Economics and Business Strategy, 9e Page 1 purchase their product instead of a competitor's. On February 28, 2000 H.J. Heinz Company (Heinz) and Milnot Holding Corporation (Beech-Nut) entered into a merger agreement. Under the terms of their merger agreement, Heinz would acquire 100 percent of Beech-Nut's voting securities for $185 million. Arguments Supporting Anti-Competitiveness of Merger The relevant product market was defined as jarred baby food and the geographic market as the United States. Sufficiently large HHI figures indicate that a merger is anti-competitive. The pre-merger HHI score for the baby food industry is 4775 -- indicative of a highly concentrated industry. The merger of Heinz and Beech-Nut will increase the HHI by 510 points. This creates, by a wide margin, a presumption that the merger will lessen competition in the domestic jarred baby food market. It is probable that this merger will eliminate competition between the two merging parties at the wholesale level, where they are currently the only competitors for the second position on the supermarket shelves. Although Heinz and Beech-Nut claim that in areas that account for 80% of Beech-Nut sales, Heinz has a market share of about 2% and in areas that account for about 72% of Heinz sales, Beech-Nut's share is about 4%, there is evidence that Heinz and Beech-Nut are locked in an intense battle at the wholesale level to gain (and maintain) position as the second brand on retail shelves. Heinz's own documents recognize the wholesale competition and anticipate that the merger will end it. Indeed, those documents disclose that Heinz considered three options to end the vigorous wholesale competition with Beech-Nut: two involved innovative measures, while the third entailed the acquisition of Beech-Nut. Heinz chose the third and least pro-competitive of the options. Finally, the anticompetitive effect of the merger is further enhanced by high barriers to market entry. Barriers to entry are important in evaluating whether market concentration statistics accurately reflect the pre- and likely post- merger competitive picture. If entry barriers are low, the threat of outside entry can significantly alter the anticompetitive effects of the merger by deterring the remaining entities from colluding or exercising market power. Low barriers to entry enable a potential competitor to deter anticompetitive behavior by firms within the market simply by its ability to enter the market. Existing firms know that if they collude or exercise market power to charge supra-competitive prices, entry by firms currently not competing in the market becomes likely, thereby increasing the pressure on them to act competitively. In this case, there had been no significant entries in the baby food market in decades and new entry was "difficult and improbable." This finding seems to eliminate the possibility that the reduced competition caused by the merger will be ameliorated by new competition from outsiders. Arguments Supporting the Merger Extent of Pre-Merger Competition Heinz and Beech-Nut claim that they do not really compete against each other at the retail level. They also contend that consumers do not regard the products of the two companies as substitutes and generally only one of the two brands is available on any given store's shelves. Hence, there seems to be little competitive loss from the merger. This argument has a number of flaws. First, there is evidence that Heinz and Beech-Nut do in fact price against each other and that, where both are present in the same areas. There are at least ten metropolitan areas in which Heinz and Beech-Nut both have more than a 10 percent market share and their combined share exceeds 35 percent. They depress each other's prices as well as those of Gerber even though they are virtually never all found in the same store. By defining the relevant product market generically as jarred baby food, it was found that in areas where Heinz's and Beech-Nut's products are both sold, consumers will switch between them in response to a \"small but significant and non-transitory increase in price.\" Perhaps most important is the indisputable fact that the merger will eliminate competition at the wholesale level between the only two competitors for the "second shelf" position. Competition between Heinz and Beech-Nut to gain accounts at the wholesale level is fierce with each contest concluding in a winner-take-all result. Fixed trade spending, which consists of "slotting fees," "pay-to-stay" arrangements, new store allowances and other payments to retailers in exchange for shelf space and desired product display, does not affect consumer prices. It is impossible to conclude with any certainty that the consumer benefit from couponing initiatives would be lost in the merger. Post-Merger Efficiencies Heinz and Beech-Nut's second argument is their contention that the anticompetitive effects of the merger will be offset by efficiencies resulting from the union of the two companies, efficiencies which they assert will be used to compete more effectively against Gerber. It is true that a merger's primary benefit to the economy is its potential to generate efficiencies. As the Merger Guidelines now recognize, efficiencies "can enhance the merged firm's ability and incentive to compete, which may result in lower prices, improved quality, or new products." Nevertheless, the high market concentration levels present in this case require proof of extraordinary efficiencies. Moreover, given the high concentration levels, a rigorous analysis must be undertaken of the kinds of efficiencies being urged by the parties in order to ensure that those "efficiencies" represent more than mere speculation and promises about post-merger behavior. Assuming that post-merger efficiencies will outweigh the merger's anticompetitive effects, the consolidation of baby food production in Heinz's under-utilized Pittsburgh plant "will achieve substantial cost savings in salaries and operating costs." Heinz and Beech-Nut promise to improve product quality as a result of recipe consolidation. Heinz's distribution network is much more efficient than Beech-Nut's. Although Beech-Nut has an inefficient distribution system, it can make that system more efficient without merger. Heinz's own efficient distribution network illustrates that a firm the size of Beech-Nut does not need to merge in order to attain an efficient distribution system. The only cost reduction quantified as a percentage of pre-merger costs was the so called "variable conversion cost": the cost of processing the volume of baby food now processed by Beech-Nut. This cost would probably be reduced by 43% if the Beech-Nut production were shifted to Heinz's plant. The principal merger benefit asserted for Heinz is the acquisition of Beech-Nut's better recipes, which will allegedly make its product more attractive and permit expanded sales at prices lower than those charged by Beech-Nut, which produces at an inefficient plant. Heinz agreed that the taste of its products was not so bad that no amount of money could improve the brand's consumer appeal. That being the case, the question is how much Heinz would have to spend to make its product equivalent to the Beech-Nut product and hence whether Heinz could achieve the efficiencies of merger without eliminating Beech-Nut as a competitor. Innovation Heinz and Beech-Nut claim next that the merger is required to enable Heinz to innovate, and thus to improve its competitive position against Gerber. Heinz and Beech-Nut asserted that without the merger the two firms are unable to launch new products to compete with Gerber because they lack a sufficient shelf presence or All Commodity Volume (ACV). Product volume in retail stores throughout the country is measured by the product's ACV. Gerber's near 100 percent ACV is impressive because virtually all supermarkets stock at most two brands of baby food. In at least one area of the country as many as 80 percent of supermarket retailers stock only Gerber. In this case, given the old-economy nature of the industry as well as Heinz's position as the world's largest baby food manufacturer, it is a particularly difficult defense to prove. Heinz and Beech-Nut claim that new product launches are cost-effective only when a firm's ACV is 70% or greater (Heinz's is presently 40%; Beech-Nut's is 45%). This assertion was based on a graph that plotted revenue against ACV. The graph showed that only four out of 27 new products launched in 1995 had been successful--all for companies with an ACV of 70% or greater. The chart, however, does not establish this proposition, thus indicating that the merger is not necessary for innovation. All that the chart plotted was revenue against ACV and hence all it showed was the unsurprising fact that the greater a company's ACV, the greater the revenue it received. Because the graph did not plot the profitability (or any measure of "costeffectiveness"), there is no way to know whether a 70% ACV is required for a launch to be "successful" in an economic sense. Moreover, the number of data points on the chart was few; they were limited to launches in a single year; and they involved launches of all new grocery products rather than of baby food alone. Assessing such data's statistical significance in establishing the proposition at issue, i.e., the necessity of 70% ACV penetration, is thus highly speculative. Moreover, Heinz's insistence on a 70-plus ACV before it brings a new product to market may be largely to show promotional economies as a defense. Heinz argues that to profitably launch a new product, it must have nationwide market penetration to recoup the money spent on advertising and promotion. It wants to spread advertising costs out among as many product units as possible, thereby lowering the advertising cost per unit. It does not want to "waste" promotional expenditures in markets where its products are not on the shelf or where they are on only a few shelves. For example, in a metropolitan area in which Heinz has a 75 percent ACV, every dollar spent on advertising is two or three times more "effective" than in a market in which it has only a 25 percent ACV. As one authority notes, however, "[t]he case for recognizing a defense based on promotional economies is relatively weak." Structural Barriers to Collusion In order to coordinate successfully, firms must solve "cartel problems" such as reaching a consensus on price and market share and deterring each other from deviating from that consensus by either lowering price or increasing production. It seems that after the merger, the merged entity would want to expand its market share at Gerber's expense, thereby decreasing the likelihood of consensus on price and market share. The efficiencies that could possibly be created by the merger could give the merged firm the ability and incentive to take on Gerber in price and product improvements. The combination of a concentrated market and barriers to entry is a recipe for price coordination. With few rivals, firms may be able to coordinate their behavior, either by overt collusion or implicit understanding, in order to restrict output and achieve profits above competitive levels. The creation of a durable duopoly could afford both the opportunity and incentive for both firms to coordinate to increase prices. Tacit coordination is feared by antitrust policy even more than express collusion, for tacit coordination, even when observed, cannot easily be controlled directly by the antitrust laws. It is a central object of merger policy to obstruct the creation or reinforcement by merger of such oligopolistic market structures in which tacit coordination can occur. There seems to be no specific structural market barriers to collusion that are unique to the baby food industry, so the ordinary presumption of collusion in a merger to duopoly seems erroneous. Proposed Merger between Staples and Office Depot Leads to Concerns of Higher Prices1 In September, 1996, Staples agreed to acquire the assets of Office Depot. At the time, Staples, Office Depot, and Office Max were the three largest office supply retailers in the United States. Due to antitrust concerns, the Federal Trade Commission filed a complaint against the merger, citing the potential for significantly increased prices following the merger. The following is an outline of the complaint put forth by the FTC in 1997. OFFICE SUPPLY SUPERSTORE MARKET Staples and Office Depot pioneered the office superstore concept within months of each other in 1986. Over the next ten years, they and a number of other firms seized on the same strategy of providing a convenient, reliable and economical source of office supplies for small businesses and individuals with home offices. These firms competed aggressively, developing office superstores as a one-step destination, carrying a full line of consumable office supply items as well as assorted other products. Staples and Office Depot have been immensely successful: today, Staples has almost 500 stores and Office Depot has more than 500 stores nationwide; they compete head-to-head in 42 metropolitan areas across the country. On September 4, 1996, Staples and Office Depot entered into an agreement whereby Staples would acquire the stock and assets of Office Depot for $4 billion. The merged company would have combined annual sales that exceed $10 billion. Absent the merger, both companies planned to continue growing for the foreseeable future, and areas of head-to-head competition between the two firms would have increased significantly by the year 2000. Their success has redefined the retailing of office supplies in the United States, driving thousands of independent stationers out of business and eliminating by acquisition or bankruptcy some rivals who sought to compete in the office superstore market. In the process, they have created a unique competitive arena where these two and the only other surviving office superstore -- OfficeMax -- do battle. This intense competitive rivalry -particularly between Staples and Office Depot -- has redounded to the benefit of consumers. Each has slashed prices, driven costs down, developed innovative approaches to marketing, distribution and store layout, and expanded into new areas of the country, bringing increasing numbers of consumers the convenience of one-stop shopping at low prices. Office Depot has been the most aggressive and lowest-price competitor, in turn forcing Staples and OfficeMax to compete more aggressively. This merger would end this competitive battle and leave the merged firm free to raise prices significantly. 1 Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case is a condensed and modified version of the public copy of the FTC's motion for a temporary restraining order and preliminary injunction against the proposed merger between Staples and Office Depot dated April 10, 1997. No 1:97CV00701. It was updated by Kyle Anderson and Jeffrey Prince. In evaluating the legality of a merger, the antitrust laws essentially require a prediction as to whether the deal is likely to lead to less competition and, consequently, higher prices for consumers. Usually, that prediction is by necessity based on inferences derived from market concentration levels. Here, the court need not rely on market share based predictions alone. There is real world direct evidence -- based on the defendants' pricing behavior -- showing that this merger likely will lead to substantially higher prices for consumers. Staples and Office Depot today charge higher prices in those parts of the country where they do not compete against each other and lower prices where they are rivals. Staples' office supply prices are lowest in cities where all three of the national office superstores (Staples, Office Depot and OfficeMax) compete. Prices are higher in markets where the only other competitor is OfficeMax and higher in those areas of the country where Staples faces no other superstore rival. Similarly, Office Depot -- the low-price competitor -charges significantly higher prices where it faces little or no superstore competition. As shown in Figure 1, consumers in Orlando (where all three office superstores compete) pay $17.99 for a box of copy paper at Office Depot, while shoppers in nearby Leesburg, Florida (where Office Depot faces no competition) pay $24.99 for the same item. Figure 1: Comparison of Office Depot's Advertised Prices Cover Page of January 1997 Local Sunday Paper Supplement Orlando, FL Leesburg, FL (3 firms) (Depot only) Percent Difference Copy Paper $17.99 $24.99 39% Envelopes 2.79 4.79 72% Binders 1.72 2.99 74% File Folders 1.95 4.17 114% Uniball Pens 5.75 7.49 30% Of course, other retailers sell some office supplies, but none of them offers the one-stop shopping convenience of the office superstores. Most importantly, these retailers do not prevent superstores from charging anticompetitive prices. By contrast, superstores do. In city after city, the level of competition between superstores determines the prices consumers will pay for office supplies. Staples fully appreciates the significance of superstore competition. As all three superstore chains have expanded, Staples has found itself competing head-to-head in a growing number of markets and facing increasing pressure to cut prices. While neither of those past efforts was successful, it now proposes merging with Office Depot, the low-price leader. Staples has long recognized Office Depot as its chief competitive threat. Staples' prices and profit margins are lowest in markets where it competes with Office Depot. This merger thus threatens to injure both consumers who benefit from today's rivalry between Staples and Office Depot and those who otherwise would enjoy the future benefits of office superstore competition. The investment community too sees reduced competition as the inevitable result of this merger. One industry analyst stated that, by merging, "Staples and Office Depot have taken a major step towards avoiding the destructive price competition which would have accompanied approaching market saturation." Another was equally blunt: "The just announced merger of Staples and Office Depot permanently eliminates the lingering fear of intensified competition in three [superstore] markets." These real world facts paint a clear picture -- this merger will harm consumers. The Commission demonstrates here that the sale of office supplies (sometimes called "consumables") through office superstores offers consumers a unique combination of convenience, selection and price and therefore is the appropriate relevant product market; that the metropolitan areas that are likely to be affected by the proposed acquisition are relevant geographic markets; and that the proposed transaction would combine the only two competitors in many markets and would leave only one other superstore competitor in the others. Even in the absence of direct evidence, anticompetitive effects -- the power to raise prices to consumers -- are presumed where a merger gives a firm such a dominant market position. Staples Staples is the second-largest office superstore chain in the United States. Approximately 52% of Staples' revenues are derived from sales of office supplies; the balance is accounted for from the sale of computers, office furniture and other business related items. Office Depot Office Depot is the largest office superstore chain in the United States. According to Office Depot's 1995 Annual Report, "Office Depot continued to lead the office products industry, remaining first in total number of stores, first in average sales per store, first in average weekly store sales, first in total delivery sales, and most important to our shareholders, first in net earnings." Most importantly, Office Depot is the lowest price competitor among office superstore chains. Office Depot's retail operations mirror those of Staples: it sells a wide range of general office supplies, computers, office furniture and other business related items, and its primary customer base is small businesses and individuals with home offices. Like Staples, Office Depot has grown at a steady and increasing pace since its founding in 1986. Office Depot's total sales for 1996 were approximately $6.1 billion; 47% of which were accounted for by office supplies. ARGUMENTS AGAINST THE PROPOSED MERGER Evidence suggests that the effect of the proposed acquisition "may be substantially to lessen competition or to tend to create a monopoly" in the sale of office supplies sold through office superstores, in violation of Section 7 of the Clayton Act and Section 5 of the Federal Trade Commission Act. Serious and substantial questions about the legality of the proposed transaction suggest this merger should not be allowed to proceed. Section 7 of the Clayton Act prohibits any merger or acquisition "where in any line of commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition or to tend to create a monopoly." The focus of Section 7 is on arresting anticompetitive mergers "in their incipiency" and thus requires a prediction as to the merger's impact on future competition. In this case, the evidence provides a solid empirical foundation for assessing the likelihood of anticompetitive pricing: office superstores charge the highest prices for office supplies in those markets where they do not face competition from another office superstore, and they charge the lowest prices where they face the two other superstore competitors. The merger will turn the most competitive triopoly markets into duopolies, and will transform markets where only Staples and Office Depot compete into superstore monopolies. Defendants understand the anticompetitive potential of the proposed transaction. Indeed, eliminating competition is a primary motivation for the deal. To show the anticompetitive motive and the likely anticompetitive effects of a transaction requires the determination of (1) the product market in which to assess the transaction; (2) the geographic market in which to assess the transaction; and (3) the transaction's probable effect on competition in the product and geographic markets. In view of Staples' current pricing practices and its clear intent to diminish competition by acquiring its chief rival, it is not surprising that an analysis of the market's structure and characteristics confirms that Staples' acquisition of Office Depot will lead to less competition and higher prices. RELEVANT PRODUCT MARKETS: OFFICE SUPPLIES THROUGH OFFICE SUPERSTORES The lawfulness of an acquisition turns on the purchaser's "potential for creating, enhancing, or facilitating the exercise of market power -- the ability of one or more firms to raise prices above competitive levels for a significant period of time." The leading antitrust treatise states that "finding the relevant [product] market and its structure is not a goal in itself but a surrogate for market power." The tools for defining a product market "help evaluate the extent competition constrains market power and are, therefore, indirect measurements of a firm's market power." Product markets are defined by "the reasonable interchangeability of use or the cross elasticity of demand" between the product itself and possible substitutes for it. The relevant product market "must be drawn narrowly to exclude any other product to which, within reasonable variations in price, only a limited number of buyers will turn . . . ." In other words, if prices go up, will so many consumers switch to substitutes that the price increase becomes unprofitable? If not, those possible substitutes are properly excluded from the relevant market. A relevant product market is a market where "sellers, if unified by a hypothetical cartel or merger, could raise prices significantly above the competitive level." The 1992 Horizontal Merger Guidelines provide an analytical framework for finding the relevant product market by taking the smallest possible grouping of competing products or distributors, here office superstores, and asking whether a "hypothetical monopolist over that [product or] group of products would profitably impose at least a 'small but significant and non-transitory' [price] increase." United States Department of Justice and Federal Trade Commission, 1992 Horizontal Merger Guidelines, (hereinafter "Merger Guidelines") use five percent as the usual approximation of a "small but significant and non-transitory" price increase. 2 The term "profitably impose" simply asks whether, in the face of a price increase, enough customers will continue to buy from the monopolist to offset any sales lost to other sellers. So long as the additional profit from the price increase exceeds the profits lost from those consumers who turned to substitutes, the price increase would be profitable overall and the particular grouping of products is deemed to be a separate market for antitrust purposes. In this case, the exercise need not be hypothetical. The defendants' own current pricing practices show that an office superstore monopolist has the ability profitably to raise prices above competitive levels. When Staples, Office Depot and OfficeMax all compete in a city, prices are lowest. In two firm markets where Staples faces only its arch rival Office Depot, it charges slightly higher prices. But where Office Depot is not in the market and just Staples and OfficeMax are present, Staples raises its prices. Where Staples faces no office superstore competition, prices are higher than in three-firm markets. If Staples became a superstore monopolist, it would find it profitable to raise prices by much more than 5%.3 This real world application of the Merger Guidelines market definition test demonstrates that the demand cross elasticity between office superstores and other retail sources of office supplies is low: that is, that, even in the face of significantly higher prices, not enough customers consider these other sources to be adequate substitutes for office superstores to force prices down to the competitive levels found in geographic areas where all three superstore chains compete. This evidence that customers do not, and will not, switch in sufficient numbers to other sources of office supply products to defeat an anticompetitive price increase establishes that office superstores constitute a relevant product market. While other retailers also sell some office supplies, no other type of retail format offers the breadth of product line, inventory on hand, and convenience that office superstore customers require. Indeed, these retailers confirm the defendants' own assessment that superstores offer a unique combination of office products and services. 2Commentators have noted that, for retail markets characterized by high volume of sales but low profit margin per dollar of sales, a hypothetical price increase lower than 5% is appropriate. 3"There are no other office supply retailers that offer such a broad array of office supply merchandise at comparably low prices."); "... the only competitors to office superstores are the other office superstores"). Courts recognize that such a "cluster" of products and services may be a relevant product market, based on the benefit to consumers accruing from the convenience of purchasing complementary products from a single supplier. Supermarkets and commercial banking services (providing a combination of checking, savings and loan services) are but two examples. Staples and Office Depot have argued that a relevant market of office superstores fails to account for office supplies sold by these other retailers. This argument misses the point. The mere fact that two different classes of retail vendors both sell a particular type of merchandise does not mean that they are in the same product market. The proper focus in product market definition is not on whether other retailers have anything in common with office superstores, but whether a sufficient number of consumers would defect to these alternatives to make a small but significant price increase unprofitable. Here the real world evidence tells the story. Despite the fact that there are other retailers such as Wal-Mart, Target, Sam's Club, Kmart, Best Buy and Computer City in towns and cities such as Fredericksburg, VA, Lynchburg, VA, New Orleans, LA, Portland, ME, Buffalo, NY, Leesburg, FL, Reading, PA, and Jacksonville, FL, where there are no competing office superstores, the office superstore monopolist (be it Staples, Office Depot or OfficeMax) is still able to raise prices above levels in cities where there is superstore competition. Statistical analysis of these price differences by a leading economist confirms that the presence or absence of superstore competition -- not competition from other retailers -explains these price differences. Because office superstores offer a unique combination of price, convenience and product offerings, not enough customers switch to other retailers to defeat anticompetitive pricing. Documents from Staples and Office Depot provide powerful evidence in support of a separate product market. Both Staples and Office Depot reveal that significant price differences between geographic areas are based primarily on the level of office superstore competition. Although the companies will point to occasions where they changed price in response to someone else, other retailers do not pose a competitive constraint in any way comparable to office superstores. Even if the market were broadened to include other office supply retailers that exhibit some limited competitive interplay with superstores, the basic analysis would not change. The ultimate question is not the precise boundaries of the market, but whether the merger is likely to have an adverse impact on competition. If the market is defined broadly, the fact remains that the office superstores within that broad market interact principally with each other. It has been found that "submarkets" -- i.e., narrower relevant markets within broader markets, based on factors such as industry perception or the existence of different channels of distribution that demonstrate a special competitive interaction between some firms or product in the market. As shown above, industry perception, the pricing practices of office superstores, the significant differences between office superstores and other channels of distribution and the parties' own documents provide direct and substantial proof that, even within a broader market, office superstores constitute significant and unique competition for one another. RELEVANT GEOGRAPHIC MARKETS: METROPOLITAN AREAS WHERE STAPLES AND OFFICE DEPOT COMPETE In this case, the relevant markets include 42 metropolitan areas where both Staples and Office Depot operate office superstores and the numerous metropolitan areas throughout the country where -- but for this merger -- Staples and Office Depot had planned to be competitors in the near future. The focus in defining relevant geographic markets is to determine which areas of the country would be affected adversely by an acquisition. The relevant geographic market must "correspond with the commercial realities of the industry . . . ." Relevant geographic markets may be as large as the nation or the world, or as small as a metropolitan area or neighborhood. For all products and industries, the test for assessing the commercial realities is a practical one: can producers within certain geographic boundaries increase prices without triggering an outflow of customers to producers in other areas so as to make the price increase unprofitable overall? The fact that office superstores actually price higher in metropolitan areas where they face no office superstore competition demonstrates that they can charge supracompetitive prices without causing customers to travel elsewhere for office supplies. They advertise primarily on a local basis, and advertised prices vary dramatically from city to city. The business realities, therefore, demonstrate that metropolitan areas are relevant geographic markets for the purposes of assessing the merger's likely impact on competition. The geographic markets impacted by the proposed transaction include many of the most populous cities in the United States, across eighteen states and the District of Columbia. In 15 markets, the proposed merger will result in an office superstore monopoly. In another 27 metropolitan areas, the number of superstore competitors will be reduced from three to two. Finally, the merger eliminates future competition in many additional metropolitan areas, including four where Office Depot and Staples planned or had planned to compete with one another in the next few months. EVIDENCE ILLUSTRATING COMPETION THAT THE ACQUISITION MAY LESSEN After the relevant product and geographic markets are established, the next step of the inquiry under Section 7 is evaluating the impact of the acquisition on competition: that is, determining whether the proposed merger may hurt consumers by facilitating anticompetitive pricing in these markets. To aid in this predictive determination, courts look first at market concentration and the increase in market concentration created by the transaction, then examine such other factors as the nature of competition between the merging firms, other market participants, and barriers to entry. The task of predicting the competitive impact of the Staples/Office Depot merger is simplified in this case. Since prices are significantly lower where Office Depot and Staples compete, eliminating their head-to-head competition will free the parties to charge higher prices. Significantly Increased Concentration Mergers that significantly increase market concentration are presumptively unlawful because the fewer the competitors and the bigger the respective market shares, the greater the likelihood that a single firm, or a group of firms, could raise prices above competitive levels. Market concentration may be measured by determining the market shares of industry leaders or by calculating the Herfindahl-Hirshman Index ("HHI"). The combined shares of Staples and Office Depot in the office superstore market would be 100% in 15 metropolitan areas. In 27 other metropolitan areas, the post-merger market shares range from 45% to 94%, with HHIs ranging from 5,003 to 9,049. These percentages are far in excess of the levels raising a presumption of illegality. Even were a market defined to include the other retailers of office supplies who both Staples and Office Depot contend compete at least to some degree with office superstores, the combined market share of the defendants raises competitive concern. 4 Concentration is high and would increase significantly because of the merger. In the 42 geographic areas where Staples and Office Depot today compete, the post-merger HHI's average over 3,000, ranging from approximately 1,800 to over 5,000. Increases in HHI's are, on average, over 800 points; ranging from 162 to over 2,000. Merger will Lead to Higher Prices Market shares are not the only concern about the proposed merger. Other evidence shows that, by eliminating Staples' most significant, and in many markets, only rival, this merger will allow Staples to increase prices. Office Depot is and has been the industry maverick, leading prices and costs down (Depot acknowledges its maverick status). Over the years, Office Depot's innovative approaches to office supply retailing -- such as low-price guarantees and high-volume "mega stores". Staples fears Office Depot's innovated approach, and explain why Staples seeks to acquire Office Depot. It has been recognized that the elimination of a particularly aggressive competitor in a highly concentrated market increases the risk that prices will rise after the merger. Even were a market defined to include other retailers, superstores offer a distinct combination of convenience, product offering and price that differs significantly from other sellers of office supplies. This means that, for consumers, office superstores are particularly close substitutes for each other. The Merger Guidelines describe the potential anticompetitive effects of a merger of two rivals who are closer competitors than most others in the market: A merger between firms in a market for differentiated products [and services] may diminish competition by enabling the merged firm to profit by unilaterally raising the price of one or both products above the premerger level. Some of the sales loss due to the price rise merely will be diverted to . . . the merger partner and, depending on relative margins, capturing such sales loss through the merger may make the price increase 4The firms include: Wal_Mart, Kmart, Target, Sam's Club, BJ's Warehouse Clubs, Price/Costco, Best Buy, Computer City, and CompUSA. It also includes estimated sales of office supplies by independent stationers in each city. profitable even though it would not have been profitable premerger . . . The price rise will be greater the closer substitutes are the products of the merging firms, i.e., the more the buyers of one product consider the other product to be their next choice. The similarities between Staples and Office Depot and the intense nature of their rivalry are reflected in the pricing behavior of the two firms: Each prices low where the other is present and higher where they are not head-to-head competitors. Indeed, investment analysts view the elimination of close competition between Staples and Office Depot as a "benefit" to this merger. Wall Street recognizes that, if this deal is approved, Staples will do what it has done consistently in the past -- maximize prices wherever it faces reduced superstore competition. Without competition from Office Depot, Staples evidently concluded that neither OfficeMax nor any other retailer would force it to decrease prices. The elimination of this unique competitive relationship between Staples and Office Depot is what makes the merger so pernicious. If allowed, Staples will acquire significant additional power over price and consumers will be forced to pay millions of dollars in higher prices. In 15 cities Staples will have a post merger monopoly and be free to charge consumers the same high prices it charges today in markets where it faces no office superstore competition. This means prices will rise in those 15 cities alone. In the 27 markets where the merger reduces the superstore presence from 3 to 2, Staples' current pricing demonstrates that the reduction in competition will allow it to increase prices to consumers in those cities. 5 Using Staples' current pricing in one-, two- and three-firm markets as a guide, the merger exposes consumers to substantial annual price increases in cities where Staples and Office Depot compete. Elimination of Future Competition between Staples and Office Depot The merger of Staples and Office Depot also threatens to eliminate future competition in the many cities where the two firms had planned to open new stores. Before this merger, Staples and Office Depot were systematically expanding the competitive battlefield, moving into each other's markets, providing consumers with the benefits of heightened competition. Recent estimates prepared for Staples and Office Depot showed both companies opening several new stores by the year 2000. Without the merger, Office Depot had planned to become the third superstore chain in Bergen County, NJ; Fayetteville, NC; and Albany, Schenectady, Troy, NY and had planned to become the second superstore chain in Fredericksburg, VA. This merger thus eliminates planned additional competition that would have driven prices down in many more areas. 5For example, consumers in Columbus, OH (where Staples and OfficeMax compete) pay approximately higher prices for office supplies than in nearby Cincinnati (where Office Depot is present as well). Similarly, consumers in two-superstore Charlotte, NC pay higher prices for office supplies than consumers in nearby Greensboro, a three-superstore market. An outside analyst, Prudential Securities, found the same result on its own: it undertook a similar analysis in March, 1996 and found prices in Totowa, NJ, a three-player market, approximately 5% lower than prices in nearby Paramus, a two-player market. In all three instances, the one common characteristic of the markets with the higher prices -- Columbus, Charlotte, and Paramus -- is the absence of competition between Staples and Office Depot. Given that the superstore market is highly concentrated, the loss of this actual potential competition by the only chains uniquely situated to enter, and with actual plans to enter and provide effective competition, also violates Section 7. The elements of an actual potential competition case are met here. First the markets are highly concentrated. Second, independent entry will result in significant procompetitive effects. Third, Staples and Office Depot are two of only a few equally likely potential entrants. Fourth, Staples and Office Depot would have been likely entrants but for this merger. Finally, entry into these markets by either or both of these firms would occur in the near future. THE RELEVANT MARKET IS INSULATED FROM NEW ENTRY AND EXPANSION OR REPOSITIONING BY OTHER RETAILERS The analysis of the conditions of new entry into a relevant market is part of a determination of the likely anticompetitive effects of any acquisition, because if entry is unlikely, the merged entity can raise prices without attracting new competition. In assessing the conditions of entry, the ultimate issue is whether entry is so easy that it "would likely avert anticompetitive effects from [the] acquisition . . . ." The Merger Guidelines articulate the conditions under which entry would likely avert anticompetitive pricing. Entry is considered "easy" if it would be "timely, likely and sufficient in its magnitude, character and scope to deter or counteract the [anti]competitive effects" of a proposed transaction. Entry is timely if a new entrant would have a significant market impact within two years. Entry is likely if it would be profitable at premerger prices. Entry is sufficient if it would be on a large enough scale to counteract the anticompetitive effects of the transaction. Staples and Office Depot have argued that entry either by a new superstore chain or by repositioning of an existing retailer will be enough to avert anticompetitive effects from the acquisition. Current market realities indicate otherwise. Even with prices elevated in many markets across the country, entry is not occurring. On the contrary, firms have been exiting the market: over the past few years, the number of superstore chains has dropped. Office 1, for example, entered in 1991 and grew to thirty-five stores in eleven states by 1996. Office 1 is now in bankruptcy. Several other office superstores have exited the market altogether or have been acquired by one of the market incumbents. The failed entrants in this industry run the gamut of very large, well-known retail establishments from Kmart and Montgomery Ward to Ames and Zayres. The evidence that so many firms have exited and that no one is attempting to enter the market reflects the significant disadvantages facing a new challenger. De novo entry into the office superstore market is tantamount to starting a marathon when the other runners are in the last mile. There is too much ground to make up and no one with any sense is likely to try. A new entrant into the office superstore market must enter both at the local and national level to check anticompetitive pricing by market incumbents. Entry at the local level entails establishing a sufficiently large presence in each of the affected markets that the new entrant can achieve economies of distribution and advertising and can effectively constrain pricing by local market participants. But, in order to compete effectively in a given local market, a new firm has to establish the "critical mass" of stores necessary to achieve scale economies of advertising and distribution.6 In many markets, entry cannot occur at a sufficiently large scale to achieve the requisite critical mass because there is little, if any, room for new stores. Staples, Office Depot and OfficeMax have been expanding into new markets for over ten years, and are in the process of entering more every day. Staples and Office Depot are constantly evaluating the markets they currently participate in, as well as potential new markets. Similar results apply to the Washington, D.C. area where Staples and Office Depot operate 24 and 14 stores, respectively. In order to match the cost and distribution structures of the market incumbents, a new entrant would not only have to establish a presence in each of the local markets affected by the transaction, but would also have to enter on a nationwide scale. Staples, Office Depot and OfficeMax each have a nationwide network of approximately 500 or more stores. By operating at such a large scale, each of these firms is able to leverage their huge volumes into price concessions from their suppliers. They also are able to distribute most efficiently by setting up regional transshipping centers.7 In order to match the efficient cost structure of the current office superstore firms, a new entrant would have to open, on a national level, multiple stores in multiple geographic areas. Entry at the national level, of course, entails entry into scores of local markets. The hurdles that must be overcome to enter each of these markets are, therefore, exponentially greater if entry is attempted on a national level. Staples and Office Depot have argued in the alternative that the functional equivalent of entry would be repositioning by an existing retailer to attract office superstore customers. The likely "repositioners," they assert, are retailers such as Target, Wal-Mart, and Kmart, and computer superstores catering to small businesses, such as Best Buy. But it is instructive that these companies have not repositioned today in markets where Staples and Office Depot charge customers higher prices. It would require a dramatic change to the entire nature of their operations. And, it is unlikely that such changes would be undertaken. Staples' CEO does not consider Wal-Mart to be a competitive threat. Less than three weeks before the merger with Office Depot was announced, he flatly stated, "In our industry, WalMart has never been a factor." Other retailers and independents have also testified that they could not profitably reposition to attract office superstore business even if Staples increased prices anticompetitively. Best Buy actually attempted to reposition itself as an office supply retailer in 1994. Best Buy, an electronics retailer that carries a broad range of computers and business machines, sought to capture additional business by creating a separate office supply department. Two years later, they gave up. EFFICIENCIES MERGER 6As WILL NOT OFFSET ANTICOMPETITIVE EFFECTS OF one Staples official has stated, "it's really tough to steal the customers from a direct competitor when you don't have the economies of advertising leverage." This is particularly true in major markets, where the costs of advertising are extraordinarily expensive. 7A successful distribution network is key to offering consumers immediate access to a full stocking of a wide range of products -- a hallmark of a successful office superstore. Staples and Office Depot have asserted that the proposed acquisition would generate significant cost savings. They claim that if they are allowed to merge, they may well be able to reduce their costs by using the "best purchasing practices" of each company and by pressuring suppliers to give them bigger discounts. The evidence, however, will show that the claimed efficiencies are not likely to benefit consumers, are speculative, and can be achieved through means that do not have the dramatic anticompetitive effect of the merger. As a result, efficiencies are not a defense to the anticompetitive effects likely to result from this merger. The acid test of efficiencies is whether they benefit competition: A merger the effect of which may be to substantially lessen competition is not saved because, on some ultimate reckoning of social or economic debits and credits, it may be deemed beneficial. A value choice of such magnitude is beyond the ordinary limits of judicial competence, and in any event has been made for us already, by Congress. Alliant Techsystems, Inc., 808 F. Supp. At 23 (quoting Philadelphia Nat'l Bank, 374 U.S. at 371) Many courts, including this one, have interpreted the Supreme Court's admonitions as effectively precluding an efficiencies defense. Other courts have nevertheless held that, in appropriate circumstances, efficiencies generated by mergers can promote competition, just as the antitrust agencies consider appropriate efficiencies in evaluating a merger's likely competitive effect. Indeed, just this week the Commission and the Justice Department's Antitrust Division revised Section 4 of the Merger Guidelines to articulate how the agencies weigh efficiency claims in merger investigations. Even under the standard of University Health and the Section 4 of the Merger Guidelines, it is not enough for defendants to show cost savings resulting from the transaction. Defendants must show that competition will not be adversely affected by the merger: [A] defendant who seeks to overcome a presumption that a proposed acquisition would substantially lessen competition must demonstrate that the intended acquisition would result in significant economies and that these economies would benefit competition and, hence, consumers. University Health Inc., 983 F.2d at 1223; see Rockford Mem. Corp., 717 F. Supp. at 1289. Here the cost savings cannot be credited for three distinct reasons. First, they will not overcome the injury to competition resulting from this merger. Without the competitive rivalry provided by Office Depot, the force that has driven Staples to reduce costs and pass on these reduced costs in the form of lower prices will be lost. Once the competitive dynamic between Office Depot and Staples is removed, Staples will be free to increase its prices and retain any cost savings as additional profits. Indeed, if the past history of the two companies is any guide, cost savings tend to be passed on to consumers where there is superstore competition and retained as profit where there is not. A second limitation on efficiencies is that the claimed efficiencies may not be speculative. Because efficiencies are difficult to verify and quantify, the role that efficiencies play in merger analysis has been carefully circumscribed. Staples and Office Depot's efficiency claims are the essence of the speculative, self-serving assertions that the University Health court cautioned against. Since the proposed merger came under investigation, the Staples and Office Depot's claims of efficiencies have escalated beyond what the defendants estimated when their respective boards of directors approved the transaction last September. Such litigation driven efficiency estimates should be viewed with considerable suspicion. Third, defendants must also show that the efficiencies are specific to the merger. "[T]he Agency will consider only those efficiencies likely to be accomplished with the proposed merger and unlikely to be accomplished in the absence of either the proposed merger or another means having comparable anticompetitive effects." 8 Staples likely efficiency claims must fail because any cost savings they attribute to a merger with Office Depot can be, and most likely will be, achieved through other means that do not adversely affect competition. The major sources of defendants' claimed cost savings are possible cost reductions associated with volume purchasing and the utilization of best purchasing practices. Because both Staples and Office Depot are expanding rapidly, as is the office superstore market as a whole, the volume of products these companies purchase will increase with or without this merger. Each party to this merger had previously projected expanding within the next few years. Similarly, improved purchasing practices are achieved by the parties internally every day by searching for lower cost sources of supply. They are also available by hiring talented and proven purchasing representatives, and through the acquisition of other vendors of office supplies. The efficiencies claimed here are likely to accrue with or without the proposed transaction, since in a competitive environment both companies would seek out improved purchasing methods and would continue to increase the volume of products they purchase as they continue their inexorable expansion. Accordingly, defendants' cost savings are not merger specific, and therefore not cognizable under Section 7. NEED FOR INJUNCTIVE RELIEF Where, as here, the Commission has raised serious and substantial questions about the legality of a proposed transaction under Section 7, defendants face a difficult task of "justifying anything less than a full stop injunction." The strong presumption in favor of a preliminary injunction can be overcome only if: (1) significant equities compel that the transaction be permitted; (2) a less drastic remedy would preserve the Commission's ability to obtain eventual relief; and (3) a less drastic remedy would check interim competitive harm. The proposed acquisition will eliminate a price-cutting competitor and Staples' most fervent rival. Once Office Depot's separate identity is destroyed, it would be virtually impossible to restore competition in the marketplace by re-creating two independent companies after a full trial on the merits. Another compelling reason to halt illegal acquisitions before they occur is to prevent the interim harm to competition that would result even if a suitable divestiture remedy could be 8Merger Guidelines, 4.0; see University Health, 938 F.2d at 1222 n.30; United States v. Mercy Health Services, 902 F. Supp. 968, 987 (N.D. Iowa 1995); Rockford Mem. Hosp., 717 F. Supp. at 1289_91; Ivaco, 704 F. Supp. at 1425_26. devised. Given the risk of anticompetitive pricing that the merger raises, it is paramount that the benefits of competition not be dissipated during the pendency of an administrative proceeding in this case. The Commission has not only demonstrated the appropriate product and geographic markets, the unlikelihood of entry, the industry trend toward concentration, and the high posmerger market shares of the merged entity, but has provided evidence from the parties that if the acquisition is consummated prices will increase -- the ultimate issue in any horizontal merger case. The evidence amply demonstrates that the Commission has a substantial likelihood of prevailing in the administrative proceeding and that injunctive relief is necessary to preserve the benefits of free and open competition for the public. CONCLUSION For the reasons set forth above, the Court should grant the Commission's request for a preliminary injunction in order to maintain the status quo pending the outcome of the Commission's administrative proceeding. Staples and Office Depot Again Propose a Merger1 On February 4, 2015, Staples and Office Depot announced a definitive agreement between the two companies in which Staples would acquire all of the outstanding shares of Office Depot. Office Depot shareholders would receive cash and Staples stock in return for their shares of Office Depot stock. Based on the cash and stock offering, the deal values Office Depot $6.3 billion. This was the second proposed merger between the two companies. A 1996 proposed merger between the two companies was challenged by the Federal Trade Commission (FTC) on the grounds that it would create monopoly power in the office supply market. In July 1997, a judge issued an injunction against the merger, and the two companies withdrew their plans. However, much had changed in the retail landscape between 1997 and 2015. In December, 2015, the FTC filed an administrative complaint alleging that the merger violated antitrust law and would lead to significant harm to consumers. The following is an outline of the case argument presented by the FTC. NATURE OF THE CASE Staples and Office Depot areby a wide marginthe two largest vendors of consumable office supplies to large \"business-to-business\" (\"B-to-B\") customers (i.e., business customers buying for their own end-use) in the United States. Staples' and Office Depot's own documents state that they are the only participants in a \"two player\" national market. They are the best options for most large B-to-B customersand the only meaningful options for some large B-to-B customers particularly those with facilities in multiple regions of the country. And they are each other's closest competitors for such customers. As Staples explained at an internal Leadership Summit, \"There are only two real choices for customers,\" Staples and Office Depot. Office Depot similarly made clear to a customer that \"[o]n a national scale, Office Depot's competition is Staples.\" Direct head-to-head competition between Staples and Office Depot yields substantial benefits to large B-to-B customers in the form of lower prices and better service. If consummated, the merger of Staples and Office Depot (the \"Merger\") would eliminate that competition. Office Depot acknowledged this in April 2015two months after the Merger was announced encouraging a large B-to-B customer to accept its \"best and final\" offer promptly, stating, \"If and when [Staples'] purchase of Office Depot is approved, Staples will have no reason to make this offer.\" 1 Kyle Anderson, Michael Baye, and Jeffrey Prince prepared this case to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case was written based on the public documents involving the Federal Trade Commission vs Staples, Inc. and Office Depot, Inc. (December 2015). By eliminating direct competition between Staples and Office Depot, the Merger threatens significant harm to a wide range of large B-to-B customers. Office supplies vendors sell and distribute consumable office supplies (e.g., pens, staplers, notepads, folders, and copy paper) to all manner of businesses across the United States. Employees of these businesses use consumable office supplies in connection with their jobs. As a result, businesses depend on vendors to provide consistent and reliable delivery of consumable office supplies so that their employees have the products they need to work productively and on a cost-effective basis. Large B-to-B customers typically require an office supplies vendor with experience and a strong reputation for providing consumable office supplies to large B-to-B customers. These requirements are especially important for customers seeking delivery on a multiregional or national basis. Many large B-to-B customers require that their office supplies vendor provide a broad range of national-brand and private-label products, flexible and reliable delivery (including desktop delivery), high levels of customer service, customizable product catalogs, detailed utilization reporting, and sophisticated information technology (\"IT\") interfaces for procurement and billing. Moreover, large B-to-B customers require those features and services to be part of the transaction, along with consumable office supplies at competitive prices. Large businesses typically purchase consumable office supplies pursuant to contracts awarded through requests for proposal (\"RFPs\"), auctions, or bilateral negotiations. Staples and Office Depot generally compete head-to-head in such proceedings. They are often the two finalists in RFPs or other contests because they can obtain the lowest cost of goods from office supplies manufacturers and they possess similar networks of distribution centers, salesforces, and other services and features, such as strong reputations and experience, high levels of customer service, sophisticated IT, and product utilization monitoring and tracking. Large B-to-B customers often use those similar offerings to play one competitor off the other to obtain lower pricing, other financial incentives, better service, and improved contract terms. Indeed, Staples and Office Depot frequently lower prices, increase discounts, and offer other financial incentives to take business away from each other, and to avoid losing business to each other. Many large B-to-B customers contract with a single office supplies vendor for consumable office supplies. Doing so allows these customers to consolidate their purchases and leverage the bigger purchasing volume to negotiate lower prices and higher discounts, rebates, or other pricing concessions. In addition, contracting with a single office supplies vendor allows large businesses to track and monitor usage of office supplies through one vendor, rather than several different vendors, thereby lowering their costs and improving operational efficiency. Using a single office supplies vendor also provides large B-to-B cu