Ecosystem theories of harm – a new risk or just a new word?

Economists Cecilia Nardini and Angelos Stenimachitis contributed to an article for Financier Worldwide, explaining what ecosystem theories of harm (TOHs) are, and exploring what the future might hold for their application in practice.

Introduction

‘Ecosystem’ theories of harm (TOHs) have been at the fore of recent, much-debated merger decisions by competition authorities. These decisions include the European Commission’s (EU’s) prohibition of Booking/eTraveli (2023) and conditional clearance (with remedies) of Microsoft/Activision (2023), which was in turn first blocked, and then allowed, under a different structure by the UK Competition and Markets Authority (CMA).

 For companies contemplating transactions in similar markets and for their advisers, these recent developments pose at least two important questions. First, what are ecosystem TOHs? And second, what might the future hold for their application in practice? This article considers each question in turn.

What are ecosystem TOHs?

The concept of ecosystem is loosely defined and flexibly used. It is predominantly used in digital markets to refer to multiproduct and multi-actor systems, where a constellation of products and services, often spanning multiple markets, are connected either through technical interoperability on the supply side or through demand-side complementarities. The economies of scale and scope and the network effects enabled by this combination drive the value of the ecosystem.

Ecosystems tend to form around a single core product or service that the other products or components are specifically (and often exclusively) designed to work with. The owner of that core product is typically the ecosystem ‘owner’ or ‘orchestrator’, and may fulfil a coordinating role between the different players in the system.

A basic example of an ecosystem that forms around a core product is the smartphone ecosystem (e.g., Apple iPhone). Here the operating system (iOS) is the core product, and the value of the iPhone is driven by the constellation of complementary services and components that interoperate with iOS, such as apps, the app store, accessories and any other interoperable device.

Ecosystems are typically regarded as beneficial for consumer welfare. They create value for users by integrating complementary functions in an optimised way and making innovation accessible.

However, in some instances ecosystems have been regarded as a vehicle for anti-competitive effects – particularly in mergers involving large companies that already derive a significant competitive advantage from the ecosystem they are part (or owner) of. In this context, concerns have been raised that the acquisition of a firm with complementary assets and the ensuing change in the buyer’s network of capabilities might increase the buyer’s competitive advantage (in markets where the buyer or the target might already be active, or even in new markets) to the detriment of competitors, and ultimately lead to consumer harm.

This concern underpins the ecosystem TOHs that emerged in some recent cases.

In merger review, the TOH sets out the manner in which, according to the competition authority, the merger might lead to a harmful outcome for consumers. Much as there is no one definition of what an ecosystem is, ecosystem TOHs have been articulated in different ways by competition authorities, with no single, cookie-cutter formulation.

Nonetheless, at their core, ecosystem TOHs borrow the key principles used in more traditional settings – primarily, standard foreclosure concerns in vertical or conglomerate mergers. These include concerns that a merger might increase a company’s ability and incentive to: (i) exclude competitors in other markets by owning an important input or functionality that others cannot replicate; (ii) leverage its market power to a related market through tying or bundling; and/or (iii) entrench an existing strong position in the primary market, through the acquisition of complementary products or potential competitors – especially competitors in adjacent markets or developing new markets.

What might the future hold for ecosystem TOHs?

Authorities’ thinking on ecosystem TOHs is evolving, which creates uncertainty around where and how they may apply them in future.

The first element of uncertainty is the specific framework that authorities use to assess ecosystem TOHs. The challenge for competition authorities, when a firm wants to acquire a new asset, is to capture the importance of the entire ecosystem of pre-existing assets and capabilities for post-merger competition.

The primary difference between vertical and conglomerate TOHs on one hand, and ecosystem TOHs on the other, is therefore the fact that the former focus on the relationship between the products or services of the merging parties, whereas the latter need to contend with the role of the entire network of products or services that revolve around those of the merging parties – most of which exist before the deal and are not directly affected by it.

On this basis, the notion has developed that the traditional merger review playbook needs to be expanded to account for the constellation of activities and assets in multiple markets across which firms concentrate and exert their dominance. The objective would be for competition authorities to have a framework to anticipate how the post-merger network of capabilities could be leveraged across different markets (including potentially some where the parties are not active pre-merger).

Specifying that framework adequately is challenging because ecosystems differ, as do the facts of each case and the specific interactions between the products, services and parties involved. There are also a wide range of conceptual issues that can potentially be captured with this concept. This difficulty can be seen in how ecosystem TOHs have been applied in recent cases, taking various forms.

For example, the CMA’s concern with the original structure of Microsoft/Activision (in which Microsoft proposed to acquire the entirety of Activision, one of the most popular and growing video game publishers in the world) was that the deal would reinforce Microsoft’s already strong position in cloud gaming – arising from its broader multi-product ecosystem – and give Microsoft the power to harm competing cloud gaming services by refusing to license Activision’s games. The EC expressed similar concerns, but approved the deal after Microsoft agreed to allow users on any cloud gaming platforms to stream its titles at no cost for 10 years. This was still not enough for the CMA, which only gave its approval when Microsoft proposed a fundamentally revised deal, that carved out Activision’s cloud streaming rights outside the EEA.

In Booking/eTraveli, which would have combined the leading hotel online travel agent (OTA) with one of the main providers of flight OTA services in Europe, the EC’s concern was that the deal would have allowed Booking to expand its travel services ecosystem, and use flights to further entrench its position in the market for online hotel bookings (as flights have a high chance to lead to the cross-selling of hotels). This strengthened ecosystem would, in turn, have reinforced the network effects Booking enjoys, increasing barriers to entry and expansion facing rival OTAs. Booking’s proposed remedy to show flight customers a choice screen with offers from competing hotel OTAs was deemed insufficient by the EC, and the deal was blocked.

In other cases – including Google/Fitbit (2020), approved with remedies by the EC, Meta/Giphy (2022), prohibited by the CMA, and Meta/Within (2023), approved after a failed attempt to block by the US Federal Trade Commission – authorities stopped short of explicitly articulating an ecosystem TOH, but the notion of ecosystem still featured in the debate.

The second element of uncertainty is whether – even if ecosystem TOHs were assessed on the basis of a common framework – different authorities would reach the same conclusion. This is obviously crucial for global deals that are reviewed in multiple jurisdictions, where remedies might be difficult to tailor by region or country. Microsoft/Activision in its original formulation (approved by the EC with remedies, and blocked by the CMA on the same facts) is a cautionary tale. Whether this is a testament to the confusion around the framework to use for ecosystem TOHs, or a different problem, it leaves firms and practitioners struggling to form an expectation on the outcome of a deal.

The third element of uncertainty is where ecosystem TOHs may be applied. Within the digital sphere, one might think that ecosystems primarily concern the usual (powerful) suspects (e.g., Google, Microsoft, Amazon, etc.), and conclude that most transactions outside this space are unlikely to meet resistance on the basis of ecosystem TOHs. However, Booking/eTraveli suggests that potentially any firm that own strong core products or services and wants to acquire complementary assets might be faced with Ecosystem TOHs. Still, authorities’ thinking and practices are developing, and there is considerable uncertainty on the how and where such ToHs might be employed and what the outcomes might be.

The impression is that, especially in mergers involving large firms seeking to expand their scope of activities, the use of ecosystem TOHs even in more ‘traditional’ markets is not precluded.

Conclusions

Ecosystems undoubtedly bring new elements and challenges to the economic analysis of mergers. At the same time, most of the classic merger review tools remain relevant and should arguably form the basis of competition authorities’ economic assessment.

Still, many questions surrounding ecosystem TOHs remain open, raising different elements of uncertainty for firms and practitioners. Whatever the answer to the question of what the appropriate conceptual framework is, and how ecosystem TOHs should be interpreted and applied to markets, a pressing priority for competition authorities and practitioners ought to be the delineation of clear limiting principles.

Without limiting principles, ecosystem TOHs risk leading back to structural presumptions, where competition authorities could find grounds to oppose potentially any attempts by firms in already strong positions in their native markets to expand through acquisitions.

Read the full article here

This article was originally published by Financier Worldwide here. The views expressed are those of the authors only and do not necessarily represent the views of Compass Lexecon, its management, its subsidiaries, its affiliates, its employees, or clients.