Ifo Viewpoint No. 36: E.ON, Ruhrgas and Consumer Protection

Hans-Werner Sinn
Munich 17 July 2002

After long deliberations, the German Ministry of Economics has made its decision: E.ON may acquire the majority interest in Bergemann AG and with it control over Ruhrgas. Ruhrgas is the major gas importer in central Europe, and the E.ON group with its many public utilities and local gas distributors is an important supplier for the end users in Germany. A new global player in the power industry has been created, comprising vertically integrated services from gas imports down to the ultimate consumer.

This will create more security in the European gas supply in light of the foreseeable crises and distribution conflicts that will unfold in the coming decades over shrinking supply and will retain profits in Europe that would have flowed elsewhere. The long-term, major investments with pay-off periods of more than fifty years, which are normal in the gas business, will become more controllable with vertical integration because they free customers and vendors of gas at the wholesale level from the danger of holding each other up after having invested in irreversible structures. The gigantic reserves of E.ON can be invested for the benefit of consumers in new gas pipelines, storage and other gas infrastructure projects.

Consumer protection organisations see this differently and have threatened to bring action against the decision. But they do not really know what they are doing, since they assume that the merger will lead to higher prices to the detriment of the consumer. The consumer protection advocates overlook not only that the merger will lead to more investment in the gas supply, higher amounts of gas sold and lower prices, but they also ignore the fundamental difference between vertical and horizontal enterprise mergers. Whereas horizontal mergers in fact tend to produce oligopolistic price increases at the consumer’s expense, vertical mergers tend to have precisely the opposite result.

Nothing is worse for the consumer than vertical margin competition among enterprises in a vertical supply chain that set their prices independently of each other. Vertical margin competition leads to a final price that is higher than the one leading to the common profit maximum of the enterprises involved. The reduction of this vertical competition through mergers leads to lower prices.

The reason for this is unfortunately hidden from many true and putative competition specialists but is easy to understand. If an enterprise in the supply chain increases its prices, it does not take into consideration that the resultant sales reduction has a negative external effect on the other enterprises in the supply chain that must also accept lower sales or must reduce their own margins. A high-price policy that overshoots the joint profit maximum is therefore the result of vertical competition. This is the exact opposite of horizontal competition in which not a price increase but a price decrease of one enterprise has a negative external effect on another enterprise. In the horizontal context, a low-price policy that goes below the joint profit maximum is the result of competition.

If enterprises merge, competition is reduced and the external effects are internalised. The enterprises show consideration for each other in their pricing policies. In this respect there is no difference between horizontal and vertical competition. If horizontal competition is diminished, however, consideration of the others means higher prices, and, if vertical competition is diminished, it means lower prices. The lower prices expand the common sales of all enterprises in the supply chain and lead both to an expansion of profits and to an increase of benefits for the consumer.

The merger of E.ON and Ruhrgas is a clear case of vertical integration. In this merger there is a harmony of interest between the consumers and the enterprises involved, because both groups want lower prices and higher sales volumes. Only the other enterprises, which are competitors of Ruhrgas and E.ON at the various supply stages, face disadvantages because the new merger confronts them as a more aggressive rival. But this is always the case if the market is stimulated and achieves better results for the consumers. The political and legal protests of competitors are mostly irrelevant from the point of view of economic welfare. They are indeed a clear sign that policy-makers have decided in favour of the consumers.

Even if the Ministry of Economics has not used this argument, it is a positive sign that it overcame the narrow legal position of the cartel office and the monopoly commission and made a decision that will benefit consumers. For such a decision, based on the economic advantages of the fusion, the Ministry virtually had no choice according to Sec. 42 of the Law against Restraints of Competition (GWB).

Even in cases where competition is reduced, the economic advantages can predominate, and this is generally the case when a reduction of vertical competition is involved. Vertically integrated enterprise groups, that also still compete with each other on a horizontal level, are normal and desirable organisational forms in a market economy. Whoever rejects these mergers using competition arguments that stem from the discussion of horizontal enterprise mergers, commits a serious error of thinking. The consumer associations should take careful stock of what they are doing. Big business is not always a disadvantage for consumers.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

German original published as "Vertikaler Vorteil" in Financial Times Deutschland (9 July 2002, p. 26).