The Role of Undertakings in Regulatory Decision-

Making*

by

Teresa Fels, Joshua S. Gans and Stephen P. King**

University of Melbourne

First Draft: 29th July, 1998

This Version: 20th November, 1998

The Australian Competition and Consumer Commission

(ACCC) has powers under the Trade Practices Act to accept
undertakings from industry participants interested in taking actions,
such as mergers, that may potentially be anti-competitive. This paper
conducts an economic analysis of the role of such undertakings.
Focussing on the special case of horizontal mergers, we demonstrate
how undertakings can provide an imperfectly informed regulator
with a credible signal of the positive social benefits of a proposed
merger. In particular, if the merged parties undertake not to reduce
their output following the merger, then it can be demonstrated that a
merger will only be proposed if results in net social benefits. There are
practical issues involved in implementing a behavioural undertaking
such as a minimum quantity commitment. However, we argue that
these are no less difficult than other regulatory activities currently
pursued by the ACCC. Journal of Economic Literature Classification
Numbers: L41, L50

Keywords. undertaking, competition policy, mergers, signalling.

*
We thank Ian Harper, Donald Robertson and Philip Williams for helpful discussions. Of course,
responsibility for all views expressed lies with the authors.
**
Department of Economics, Department of Economics and Melbourne Business School, respectively.
All correspondence to Joshua Gans, Melbourne Business School, 200 Leicester Street, Carlton,
Victoria 3053; E-mail: J.Gans@mbs.unimelb.edu.au. The latest version of this paper is available at
http://www.mbs.unimelb.edu.au/home/jgans.
 2

I. Introduction

The problem of asymmetric information is at the heart of regulatory

economics. A regulator, when attempting to make socially desirable
decisions, must rely on information provided by regulated parties. Those
parties often have an incentive to distort the information they provide to
protect their private interests, and the regulator must take account of the
distortion when attempting to use this information. In general, it becomes
impossible for the regulator to formulate a first best solution.1
The ability of regulators to elicit and use accurate information may be
constrained or expanded by legislation. In 1993, the Australian Competition
and Consumer Commission (ACCC) was given additional powers that allow
it to accept enforceable undertakings when firm behaviour might lead to
violations of the Trade Practices Act (1974); hereafter TPA. For example,
suppose two firms wish to merge but are concerned that this merger will be
deemed illegal under the TPA as it may substantially lessen competition. The
firms might offer enforceable undertakings as part of an informal clearance or
authorisation of the merger. The undertakings might ensure that the merger
does not substantially lessen competition or that, even if competition is
affected, there are sufficient offsetting public benefits. By offering enforceable
undertakings, firms can address ACCC concerns. This provides the firms with
regulatory certainty and can allow mergers to go ahead when, otherwise, they
would have been opposed by the ACCC.
To date, the ACCC has shown a strong preference for structural rather
than behavioural undertakings. Structural undertakings are once off actions
that alter entry conditions or either vertical or horizontal relationships in an
industry. Most notably, structural undertakings involve a relevant firm
selling some critical assets to either a current competitor or a potential new
entrant, even though the selling firm may not find the sale profit maximising.
 3

In contrast, a behavioural undertaking involves a commitment by a relevant

firm to act in a particular way in the future, even though such an action may
not be consistent with profit maximisation. Behavioural undertakings require
some on-going price monitoring or other form of regulation. The on-going
nature of behavioural undertakings has concerned the ACCC.
We argue that behavioural undertakings might provide benefits that
more than outweigh the on-going monitoring costs. Behavioural undertakings
can help regulators make better decisions, leading to improved efficiency and
social welfare. This is because firms can use behavioural undertakings to
credibly signal that the public benefit of their proposed arrangement outweighs
any anti-competitive detriment, in terms of dead-weight losses that might be
realised.
Below, we illustrate our argument focussing on a merger between two
firms in the same industry. Such a merger may lead to a substantial reduction
in competition, in which case it would contravene section 50 of the TPA. The
ACCC may authorise the merger if there are public benefits that outweigh
these anticompetitive effects. For example, the merger may result in synergies
between the operations of the two firms, leading to cost savings and more
efficient production. If these savings are large enough to offset the (potential)
dead weight loss from diminished competition, then the merger will raise
social welfare.2 The regulator, however, faces a dilemma. How does it know
that cost reductions will be sufficiently large to lead to a positive social
outcome? Relying on the information of industry participants is at best
imperfect, and at worst potentially misleading. Consultants’ reports
commissioned by the merging firms that show large cost reductions are, by
themselves, unlikely to be useful. Given a lack of credible information, a

1
There is a large economics literature that considers this general problem and potential solutions.
Baron (1989) and Laffont and Tirole (1992) provide useful survey of this literature.
2
The ACCC may consider cost savings as a ‘public benefit’. However, it has stated that if cost savings
are retained by the relevant firms and not passed on to consumers then they are likely to be given less
importance in evaluating the net public benefit or detriment from a merger, compared with the same
situation where the cost savings are passed on to consumers. See the ACCC’s merger guidelines
(Australian Competition and Consumer Commission, 1996), paragraphs 6.43 and 6.44. In the parlance
 4

cautious regulator may be to refuse to authorise many mergers that might

otherwise result in social benefits.
Undertakings can help resolve the information asymmetry between the
firms and the regulator. An appropriate undertaking can act like a guarantee
that information is accurate. Again, if we consider a potential merger, if the
regulator is concerned that the merger will lead to a reduction in quantity
(increase in price), an undertaking by the merged firm not to reduce its
output post-merger performs a signalling role. If the merger is expected to
lead to such large cost savings that the merged firms would raise (aggregate)
output, leading to lower industry prices, then the guarantee not to lower post-
merger output will not bind. The merger is clearly socially desirable and the
firms are happy to offer the quantity guarantee. If cost savings are smaller,
but the merger is socially efficient then, as we show below, the merged firms
would still prefer to offer a quantity based undertaking rather than forgo the
merger. In fact, only in those situations where the merger leads to a reduction
in social welfare will the parties to the merger prefer not to offer a quantity
guarantee. Given that a private merger goes ahead, despite the output
guarantee, is a signal that the merger is socially efficient.
The intuition underlying our analysis is quite simple. If parties wish to
engage in an activity that potentially violates the TPA, but, in the opinion of
the relevant parties themselves, will lead to an increase in social welfare, then
it is often possible for the parties to present an undertaking that guarantees
that social welfare will not fall. If two firms are seeking a vertical merger and
there is a fear of foreclosure, then this may be assuaged by an undertaking
guaranteeing third party access at the same terms and conditions as are
currently available. If a firm wishes to charge prices that may be claimed to be
predatory by competitors, then the firm can offset this by committing not to
raise prices for at least a period of time sufficiently long to offset any
predatory concerns. Firms can offer these undertakings because, if an activity

of economics, this means that a merger is more likely to be authorised if it not only raises social
welfare but also ensures that some of the welfare gain is passed on to consumers.
 5

raises social welfare, then the firms can afford to either share some of these
gains while still raising profits, or at least commit not to undertake any
secondary actions (such as lowering output post-merger) that may harm
consumers. A gain in social welfare creates a potential benefit to both the
relevant firms and consumers, and a behavioural undertaking can signal
these mutual benefits to the regulator.
We illustrate our argument in detail below, focussing on the case of a
horizontal merger. We begin by outlining the legal process of authorisations
and undertakings and reporting on some examples of how these have been
applied to date. We note that the ACCC has accepted many undertakings
with respect to mergers but that the vast majority of these have been
structural rather than behavioural in nature. Section III then constructs the
problem facing the regulator in merger analysis. In section IV, we
demonstrate how a quantity undertaking can provide a perfect signal about
the social efficiency of a merger. Indeed, we demonstrate there that such a
signal might also lead to socially beneficial mergers taking place that might
otherwise have been privately unprofitable. Section V discusses the practical
problems involved with behavioural undertakings that may concern the
ACCC. We argue that these concerns are misplaced given that half of the TPA
and role of the ACCC is about on-going regulation. A final section concludes.

II. The Current Legal Status of Undertakings

Before examining the economic role of undertakings, it is useful to

discuss briefly their current legal status and their relationship to merger laws.
Section 50 of the TPA prohibits mergers or acquisitions that have the effect or
likely effect of substantially lessening competition in a substantial market,
unless authorised by the ACCC under section 88 of the Act. Prior to 1993, the
then Trade Practices Commission often faced an all or nothing choice when
examining mergers under section 50 – the Commission either opposed the
merger or it did not. Any conditions that it wished to impose on the merger
 6

through a deed of settlement were difficult to enforce. To enforce an

agreement, the Commission would have been required to take action in a
Supreme Court, a process subject to lengthy delays.
Alternatively, mergers could be dealt with under the more flexible
authorisation process. This has always allowed for authorisations to be
granted subject to conditions being imposed by the ACCC.3 If the conditions
were not met, the authorisation lapsed and the ACCC could seek divestiture
of the merger under section 81 of the Act for up to three years after the
merger had taken place. At first glance, it may appear that conditions
provided the ACCC with a powerful regulatory tool. In practice, however,
conditions were often problematic. The sanction of divestiture was not often
credible because of the practical difficulties in separating an integrated entity.
In fact, the divestiture sanction has never been sought by the ACCC or by any
private party pursuant to a lapsed authorisation and there remains some
doubt that it would be granted by a Court.
Partly in response to these problems, section 87B was enacted in 1993.
Section 87B provides for the ACCC to accept legally enforceable undertakings
in relation to mergers dealt with under either a section 50 analysis or under
the authorisation process.4
Section 87B undertakings have various legal features. First, the
relevant party must offer written undertakings. They cannot be imposed by
the ACCC. However, the ACCC has the power to reject undertakings and is
in a strong bargaining position when negotiating undertakings because it may
otherwise oppose a merger. Secondly, undertakings are not reviewable on
their merits by a Court. However, when undertakings are offered under an
authorisation process it now appears that, if the decision is appealed, the

3
Mergers examined under section 50 will contravene the TPA if they have the (likely) effect of
substantially lessening competition in a substantial market. However, mergers dealt with under the
authorisation process will be allowed notwithstanding an anticompetitive effect so long as it can be
shown that the merger will produce a net public benefit. The main benefits likely to be given weight
by the ACCC are cost efficiencies and factors leading to an increase in international competitiveness.
Therefore, the types of undertakings parties will make under each process are quite different.
4
Section 87B undertakings can also be accepted by the ACCC in the exercise of all its powers (except
Part X) of the TPA.
 7

Australian Competition Tribunal can accept or reject undertakings. It is not

yet clear whether the Tribunal can vary undertakings. Thirdly, undertakings
can be varied or subsequently withdrawn by mutual agreement between the
ACCC and the relevant parties.
Although undertakings are legally enforceable, to date, the ACCC has
preferred parties to fix any concerns it has about a merger before the mergers
takes place. When accepting undertakings, the ACCC has shown a strong
preference for structural rather than behavioural undertakings. The ACCC
has stated that it is unlikely to accept price, output, quality and service
guarantees on their own. This reflects a traditional antitrust view. In its
merger guidelines the ACCC has stated that behavioural undertakings are
“extremely difficult to make certain and workable in detail, … require
continuing monitoring, and where breaches are detected they are often
dependent on enforcement after the event.” 5
The ACCC’s guidelines also state that behavioural undertakings are
not favoured because they are inflexible to market changes such as
contractions in demand. The ACCC also questions the optimal duration of
behavioural undertakings.6
The most common type of structural undertaking accepted by the
ACCC when considering a merger involves the divestiture of assets.
Divestiture undertakings usually have the effect of averting a substantial
lessening of competition. For example in the Sigma-QDL merger (two
wholesale distributors of pharmaceutical products), examined under section
50, the ACCC concluded that the merger was only likely to substantially
lessen competition in one state market. Sigma agreed to sell off the Victorian

5
See Australian Competition and Consumer Commission (1996) paragraph 7.11. Clearly behavioural
undertakings raise regulatory issues despite being offered by the relevant firm(s). Prior to the ACCC
making a decision about a merger, firms will often be relatively willing to offer undertakings.
However, once the ACCC has decided not to oppose a merger and the merger has been implemented,
firms’ incentives to implement the undertakings are sharply reduced and a significant degree of
monitoring by the ACCC is often required. However, the same problems also arise to some degree with
structural undertakings. For example, if the undertaking involves asset sales, it may be difficult for the
ACCC to guarantee that the assets actually sold are the same as specified in the undertaking. Further,
the sale will usually only occur if the firm receives a reasonable price. But this may be a source of
dispute.
 8

assets it would acquire after the merger, thereby avoiding the anti-
competitive effects of the merger.
The Ampol-Caltex merger also involved a structural undertaking. The
ACCC concluded that the proposed merger would breach section 50 by
reducing the number of oil companied from five to four. The parties offered
undertakings that had the effect inter alia of facilitating import competition
that would not otherwise have occurred. In this instance the undertaking to
increase import competition was regarded as balancing the reduced
competition in the domestic market.
Despite the strong statements in the merger guidelines, the ACCC will
accept behavioural undertakings so long as they are coupled with structural
undertakings. In the Caltex-Ampol merger ,the parties agreed not to deal
exclusively, thereby relieving concerns about the vertical aspects of the
merger. The parties also guaranteed supply of petrol at a competitive price
during a transition phase. Similarly in the Westpac-Bank of Melbourne
merger the parties agreed to provide access to third parties of its ATMs at
agreed upon access prices.
Behavioural undertakings have also been used in authorisations to
ensure that there are sufficient public benefits from a merger. In the Davids-
Composite Buyers case, the ACCC accepted undertakings regarding the terms
and conditions between Davids and retail consumers. Presumably, this
undertaking was accepted to guarantee that private benefits, in the form of
cost savings to Davids, were (at least in part) passed on to retail consumers.
These undertakings were later withdrawn and the Tribunal authorised the
merger without such undertakings.
While the ACCC largely dismisses behavioural undertakings as
unworkable, they do not consider the potential benefits that might flow from
behavioural undertakings. As we demonstrate, these benefits might be
substantial.

6
See Australian Competition and Consumer Commission (1996) paragraph 7.10.
 9

III. The Regulator’s Problem in Merger Analysis

Horizontal mergers are a concern for regulators because, all other

things being equal, they are likely to be anti-competitive. That is, they result
in price increases, output reductions and, consequently, a deadweight loss of
social surplus. But if mergers alter the cost structure of the industry, they may
raise social welfare. Demsetz (1974) argued that mergers might lead to
industry-wide production rationalisation. While the merger might reduce
industry output, it also may result in that output being produced with a lower
average cost. Indeed, it is even possible that a merger between duopolists
might be welfare improving.7
Williamson (1968) noted that a merger might reduce production costs
through synergies (lower marginal costs) or the elimination of duplicated
investments (lower fixed costs) for the merged firms. Again this can mean
that a merger raises social welfare despite increasing market power. 8
In theory, if a regulator had sufficient information, it could examine the
costs and benefits of a merger and evaluate the net effect of the merger on
social welfare. Farrell and Shapiro (1990) model this evaluation for a
homogenous good Cournot oligopoly. Their argument has been graphically
summarised by Ziss (1998) and we utilise his framework here.
Suppose that two firms in an industry are considering merging. Their
initial marginal costs identical and equal to c.9 If the firms merge, the merged
firm’s marginal cost is reduced below c by ∆ > 0. The pre-merger industry
price and output are Q0 and P0 respectively. After the merger these will
change to Q1 and P1. If the cost reduction, ∆, is large enough, it could be the

7
Suppose that market (inverse) demand is given by P = 10 – (q1 + q2). Firm 1 has a (constant)
marginal cost of 0 while 2’s is c. The firms initially compete as Cournot duopolists. If c > 25/11and
merger rationalises production to 1’s assets, then a merger raises the sum of consumer and producer
surplus. This is because the merger reduces average industry costs be a sufficient amount to overcome
deadweight losses associated with the merged firm’s market power. Such efficiency improvements
from the removal of smaller firms can also occur in contestable markets (see Gans and Quiggin, 1997).
8
While Demsetz (1974) notes that a merger may remove an inefficient competitor, Williamson (1968)
notes that a merger can create a new more efficient firm.
9
The assumption of constant marginal costs is made without loss in generality. All the arguments
below extend to the case of increasing (or indeed, decreasing) marginal costs, although this would
complicate the graphical analysis.
 10

case that P1 < P0 so that the merger is pro-competitive rather than anti-
competitive.
Alternatively, it could be the case that P1 > P0. Social welfare will fall
due to the reduction in industry sales after the merger. But this will be at least
partially offset by gains in producer surplus due to more efficient production.
Determining the net effect of the merger on social welfare requires explicit
analysis, as depicted in Figure 1. Suppose that the merged firms reduce their
combined output from q0 to q1. The area E represents the increment to profits
from the cost reductions achieved by the merging firms while B – D is the net
increment in the merged firm’s profits from a greater ability to exercise
market power. However, the merged firms lose A to other firms who expand
production in response to the rise in industry price.10 Those firms also gain F
as a result of the price rise. The total change in industry producer surplus as a
result of the merger is B + E – D + F.11 The merger will be privately profitable
for the relevant firms if B + E – A – D is positive. B + C + F represents the loss
in consumer surplus as a result of the merger. Therefore, the merger will be
socially beneficial if B + E – D + F exceeds B + C + F, or E > C + D.
Given the potential for cost reductions, the regulator faces a difficult
problem when evaluating a merger. A particular merger proposal may be
predominantly motivated by a reduction in competition (B – D – A) or by cost

10
Our conclusions in this paper about the desirability of minimum quantity undertakings rest on three
relatively weak assumptions about firm interaction. First, we assume that if there is an increase (no
change) in the total output of one subset of firms then the best response by all other firms leads to an
increase (no change) in total industry output ceteris paribus. In other words, if a subset of firms raises
their output, other firms may lower output but not to such a degree that total industry output falls. This
is a standard assumption and is satisfied, for example, by a standard Cournot model. Also, if there is no
change in the output of a subset of firms then, in the absence of any other change, total industry output
is unchanged. This means that simply the act of merger with no change in the output of the merged
firms cannot change the behaviour of other firms in the industry. This will normally be satisfied so long
as firms make independent strategic decisions.
Secondly, we assume that there is a unique well-defined equilibrium in the industry both pre-
merger and post-merger. This assumption is for convenience as it enables us to ignore issues of
multiple equilibria.
Thirdly, we assume that if a subset of firms face an increase in production costs then its
equilibrium output cannot increase ceteris paribus. This rules out the intuitively implausible case
where a merger raises the merged firms’ costs, the merged firms increase output, industry output rises
and consumer prices fall, but social welfare falls because of the rise in the merged firms’ costs.
The diagrammatic analysis presented in this paper is based on a standard Cournot model but
this is purely for exposition.
11
A is simply a transfer among firms and does not affect industry producer surplus.
 11

reductions for the firms (E). However, evidence on cost reductions comes
from the merging firms themselves. If those firms know that a regulator is
more likely to authorise a merger if there is favourable evidence on cost
reductions then the firms are likely to present such evidence. Unfortunately,
this information may be distorted and unreliable. While the merging firms
know the true underlying motivation for the merger and the expected extent
of any cost reductions that are likely to be achieved, there is an asymmetry of
information between the regulator and firms. The regulator may try and
reduce this asymmetry by conducting further investigations but it will
inevitably need to rely on information provided by parties who have a vested
interest in the merger. It will be difficult for the regulator to verify
information provided to it. After all, the regulator is not trying to determine
cost reductions that have already been achieved but rather the merging firms’
beliefs about potential savings and the true reason behind the merger. So the
regulator must look upon the information provided by parties with a sceptical
eye and potentially might refuse some mergers that would be socially
beneficial.12
The regulator may try and gather other information about the
proposed merger that is less open to distortion and manipulation. Swan
(1995) argues that competitors’ responses to the merger provide relevant
information to regulators.
As a matter of logic, rivals should unambiguously support mergers which are
anti-competitive but will do their best to prevent mergers which promote
synergies and cost reductions. To the extent that the merger has elements of
both anti-competitive effects and synergistic cost reductions, the net balance
between these two offsetting effects should determine the attitude of rivals
towards the merger. Rivals are likely to have a better idea than any group
outside the industry, no matter how knowledgeable, as to whether a
proposed merger is on balance pro- or anti-competitive in its effect. The more
that synergistic cost reductions outweigh anti-competitive effects, the more
likely rivals are to oppose the merger. (Swan, 1995, pp.88-89; the italics in
original)

In the context of our discussion, Swan’s argument concerns the value of F +

A, the change in profits realised by the merging firms’competitors. F + A will

12
See Milgrom and Roberts (1986) for a discussion of the optimality of such scepticism.
 12

be less than 0, and competitors will be harmed by the merger, only if P0 > P1.
In this case, the merger is pro-competitive. Swan argues that if competitors
object to a merger, they are signalling to a regulator that F + A < 0 and, as a
result, the regulator should infer that such a merger is socially beneficial and
allow it go ahead. On the other hand, if rivals do not oppose a merger, this
indicates that F + A ≥ 0 and the case for the merger depends on the magnitude
of cost reductions.
Swan’s argument appears to give the regulator a means of evaluating a
merger without determining the extent of cost reductions. However, it has
two serious limitations. First, if competitors’ reactions did provide a perfect
signal of F + A, then this tells the regulator about the potential for the merger
to result in lower prices. But social welfare may improve even if P0 < P1. The
information reduces the regulator’s information problem but does not solve it.
More importantly, the “reactions” of rivals may be manipulated, so that any
systematic attempt by the regulator to use this information would undermine
its value. To see this, imagine that a regulator adopts a rule that if rivals object
it approves the merger. Then rivals will have an incentive to act strategically
in their response to a merger proposal. If it really is the case that F + A ≤ 0,
they should keep silent or perhaps publicly support the merger. On the other
hand, if it is the case that F + A > 0, they should publicly decry the merger. It
cannot be an equilibrium for the information provided by rivals’ objections
(or otherwise) to be useful to regulators.
Farrell and Shapiro (1990) suggest an alternative approach to help
alleviate the regulator’s problem.13 The fact that a merger is proposed at all
indicates that it is privately profitable so that B + E > A + D. A merger is
socially desirable if and only if E > C + D. Hence, if A > B + C, it must be the
case that any privately profitable merger is socially desirable as well.14 In
effect, the Farrell and Shapiro test evaluates the net benefits to agents other
than the merging firms. These are the other firms in the industry (who get F +

13
Similar, more specific analyses are provided by Levin (1990) and McAfee and Williams (1992).
 13

A) and consumers who lose (F + B + C). This external effect is positive if A > B
+ C.
The Farrell and Shapiro test reduces the regulator’s reliance on
information supplied by the merging firms because the components A, B and
C do not directly depend on the degree of cost savings. A relates to the
aggressiveness of competing firms’ responses to output reductions. B
depends on the market share of the merging firms. C relates to the elasticity of
market demand. Farrell and Shapiro (1990) provide some simple tests that are
based only on pre-merger market shares and demand elasticity that indicate
when a privately profitable merger will be socially profitable. These tests,
however, suffer from several difficulties. First, they require specific
knowledge of market and technological conditions. Second, they are only
sufficient conditions. Hence, some socially profitable mergers may not pass
the tests. Finally, the tests rely on private profitability. Regulatory rules based
on them do not ensure that every socially profitable merger takes place.15
The Farrell and Shapiro approach offers a way for regulators to trade-
off the anti-competitive and cost reducing effects of a merger. But it is far
from perfect. As we will discuss in the next section, effective undertakings
may help regulators to evaluate mergers without having to obtain detailed
knowledge of the industry structure and of the magnitude of potential cost
reductions.

IV. Undertakings as Signals

How can a behavioural undertaking improve regulatory decision-

making on mergers? Suppose a merger is both privately profitable and
socially desirable, but in the absence of an undertaking, the merger will both
violate section 50 of the TPA and fail to be authorised by the ACCC. Then the
firms that wish to merge have an incentive to assuage the regulator’s concerns

14
A merger is privately profitable if E – D > A – B and socially beneficial if E – D > C. The private
condition is more stringent than the social condition if A – B > C.
 14

by presenting a behavioural undertaking. The behavioural undertaking must

credibly signal the regulator that the merger will raise social welfare and, to
the degree that the regulator weights consumer surplus more highly than
firm profits, must signal that consumers will not lose from the merger.
Assume that the regulator can observe the pre-merger output of the
firms, q0. Recall that a reduction in social welfare can only occur if Q1 < Q0. As
outside firms’ costs do not change following the merger, their market share
will be unchanged if q1 = q0, and will tend to fall if q1 > q0. This means that so
long as q1 ≥ q0, Q1 must be at least equal to Q0. Hence, if the merger proposal
involves an undertaking that q1 ≥ q0, social welfare cannot fall as a result of
the merger.
If an undertaking is made to at least maintain pre-merger total output,
how does this change the relevant firms’ incentives to merge? If ∆ is
sufficiently large, the merged firm’s equilibrium output will rise as a result of
the merger. In this case, the undertaking will not bind and the private
profitability of the merger will be unchanged.
On the other hand, if ∆ is small, so that in the post-merger equilibrium
the quantity undertaking binds the merged firms, the private incentive to
merger changes from B + E – A – D to E + G + H. But this new private gain is
precisely the social benefit from any cost reduction, given the pre-merger
oligopolistic behaviour. While consumer surplus is unchanged, the merged
firm receives higher profits from the cost reduction. The undertaking that
guarantees that post-merger output will not fall below pre-merger output
precisely aligns the private and social incentives for a merger.
Finally, what if ∆ is zero or negative. In this case, the merger was only
proposed to raise profits and was socially undesirable. The minimum
quantity undertaking prevents the merged firms from seizing any increased

15
Ziss (1998) also demonstrates that when output decisions are delegated within a corporation, the
tests are limited in their applicability.
 15

industry profits so firms that seek to merge when there are no cost savings
would not be willing to make such an undertaking.16
In brief, a minimum quantity undertaking is a credible signal that the
merger involves expected cost savings and guarantees that those cost savings
will not be more than offset by a fall in consumer surplus due to diminished
post-merger competition.
There are several things to emphasise about the minimum quantity
undertaking. First, the regulator does not need to know anything about the
industry, the magnitude of ∆, or the level of concentration in the industry. All
it needs to know is q0. While determining q0 may be difficult in practice it will
often present the regulator with significantly less difficulty than determining
likely cost savings or potential competitive reactions.
Secondly, it is well known that socially beneficial mergers may not be
privately profitable in a Cournot oligopoly (Salant, Switzer and Reynolds,
1983). This is because the merged firm loses A to other firms in the industry. If
A is large, it is possible that a socially beneficial merger is not privately
profitable.17 However, with the undertaking, the merged firm does not lose A
as a result of the merger. The minimum quantity undertaking aligns private
and social incentives and encourages mergers that are socially desirable but,
in the absence of a minimum quantity undertaking, would not have been
privately profitable. This is possible because the undertaking changes the
post-merger equilibrium in the industry. It can help the merged firms
maintain higher output when this is in both their own and society’s interest
but, in the absence of the undertaking, would not be credible.
Finally, note that the undertaking actually improves the efficiency of
the merger. Without an undertaking, the regulator could approve a merger if

16
Formally, to see that these conclusions follow from our three assumptions on firm behaviour
presented in footnote 12, the second assumption means that we can avoid multiple equilibria. If ∆ < 0,
then the quantity undertaking must bind by the third assumption, so the merged firms will make a loss.
The merger is socially and privately unprofitable. If ∆ ≥ 0 and the quantity undertaking does not bind,
then industry output must rise by the first assumption so the merger is socially profitable if it is
privately profitable. If the quantity undertaking binds, then by the first assumption, industry output will
be unchanged and the merger is socially desirable if it is privately profitable.
17
Note that the social benefits from a merger are greater than the private benefits if A – B > C.
 16

it believed E > C + D. However, with the undertaking, there is no loss in

consumer surplus from the merger but any cost reductions are still achieved
(and, in fact, spread over a larger quantity). The undertakings procedure,
besides improving decision-making, also raises socially efficiency.
In principle, a maximum price undertaking can achieve the same result
as a minimum quantity undertaking. This is obvious from Figure 1. If the
merged firm gave an undertaking not to price above P0 then it could only
achieve this in equilibrium by selling at least q0 units. A price undertaking,
however, seems an indirect way to guarantee that a merger does not have
anticompetitive effects. The anticompetitive potential of a merger arises
because the merged firms might have an incentive to restrict quantity to raise
the market price. It is the quantity restriction that is the original cause of the
anticompetitive effect and it seems reasonable to target an undertaking at the
quantity restriction rather than the price that flows from the quantity
restriction.18 Further, unlike the situation when regulating a monopoly, the
merged firm will generally not be the sole producer in the market after the
merger. The merged firm cannot, by itself control the industry price. Rather
the equilibrium price will reflect the strategic decisions of all firms. A price
undertaking by the merged firm may alter the strategic interactions in the
industry in an undesirable way.19

V. Designing a Minimum Quantity Undertaking.

An undertaking by the parties to a merger that they will retain their

output after the merger to at least the pre-merger level(s) theoretically

18
To see why quantity rather than price undertakings directly address the competitive concerns,
consider the following simple example. Suppose a merged firm made a price undertaking then sold on
its operations to create another company. The ‘shell’ of the merged companies can trivially satisfy the
price restriction and simultaneously sell nothing. The new company would be free of the price
restriction and can set its production to maximise profit. This could not occur under a minimum
quantity restriction as the ‘shell’ would still have to meet the outcome target or face a penalty.
19
For example, the industry may move to a new equilibrium where the merged firm reduces production
but other firms raise production so that industry output and price remain unchanged. This outcome
satisfies the price undertaking but, to the degree that the merged firm has lower production costs, this
outcome represents a less efficient mix of production than under a quantity undertaking.
 17

performs a perfect signalling role. There are, however, a number of practical

issues that need to be considered.

Measuring the initial quantity

In order to accept a quantity undertaking, the regulator must have a

good idea of the output levels of the relevant firms before the merger. The
regulator may have difficulty determining these levels, particularly if the
firms produce a variety of products with different specifications and qualities
that appeal to different groups of customers. However, the regulator does not
have to determine these quantities for themselves. Rather, the parties seeking
the merger must convince the regulator that the quantity undertaking is
sufficiently stringent to prevent the merger from being anticompetitive. While
the regulator will need to rely on information supplied by the merging firms
and these firms have an incentive to distort and manipulate this information,
the relevant data is historic and to a large degree can be confirmed by market
inquiries. This stands in sharp contrast to claims of future cost savings that
may be uncertain and highly speculative.
It could also be argued that firms would have an incentive to reduce
aggregate output before seeking a merger in order to reduce the effect of a
quantity undertaking. If the firms can agree to lower q0 prior to the merger
then they can legitimately claim that they will sustain q0 after the merger
while still having an anticompetitive effect. This problem, however, is easily
overstated. First, it is clearly illegal for firms to collude in this way before a
merger. The firms, if detected, could be prosecuted under section 45 of the
TPA. The penalties for anticompetitive collusion are severe. Secondly, if a
firm acted unilaterally to restrict its quantity in order to prepare itself for a
possible future merger, it would suffer a loss of profits. The firm would be
trading off its short-term profits for the potential of gaining more effective
market power after a possible future merger. To sustain this action for any
significant period of time, the firm would have to be relatively certain of a
successful merger in the near future. It seems unlikely that such unilateral
 18

action would be profitable except in the relatively short term. To the degree
that the regulator can judge an appropriate quantity undertaking on the basis
of outputs over a number of years, it is unlikely that unilateral preparation for
merger would represent a major problem.
When using historic data to judge an appropriate quantity
undertaking, the regulator will need to allow for a variety of factors that may
alter output over time. These same issues arise when placing the quantity
undertaking in a dynamic context, and are discussed below.

The nature of a quantity undertaking

In many ways, the practical issues surrounding a minimum quantity

undertaking are the same as apply to monopoly price caps. A price cap (or
CPI-X regulation) is a rule that limits the changes in output prices allowed to
a monopoly. The rule is adjusted for general increases in input prices, as well
as industry specific factors. If one particular input is crucially important then
the monopoly may be allowed to immediately pass price changes in that
input through to customers. The price cap rule can allow for changes in
demand and product mix by applying to a bundle of outputs.
A similar approach can be used to implement a minimum quantity
undertaking. The undertaking can be adjusted for cyclical changes in
economy-wide demand by using a GNP measure or an alternative index.
Specific factors that are crucial to demand in the relevant market, such as
world oil prices for car demand, can also be built into the minimum output
rule. Supply-side factors, such as changes in critical input prices, can also be
considered.
The minimum quantity undertaking may be based on a well-defined
bundle of outputs. These can be designed to allow the firm flexibility to adjust
the output mix in the face of changes in product-specific costs or demands.
 19

There has been significant work on price cap regulation that provides the
basis for analysing appropriate quantity undertakings.20
In some ways, a quantity undertaking has significant advantages over
traditional price cap regulation. First, under price cap regulation an outside
authority often imposes the rule on the firm. In contrast, under a quantity
undertaking the firms that are seeking the merger and who gain the benefits
from the merger also design the quantity rule. They must then convince the
regulator that the rule is appropriate. This has a number of benefits. Unlike a
standard regulated firm that has interests directly opposed to the regulator,
the interests of the merging firms and the regulator are partially aligned. To
the degree that the merger is efficient, both sides gain from the merger going
ahead. In fact, as noted above, an effective minimum quantity undertaking
can improve the profitability of a merger so both the merging firms and the
regulator may gain from the undertaking process. Secondly, the merging
firms can make subjective judgements about the degree of adjustment to build
into the undertaking. The firms are in the best position to evaluate future risks
from a quantity undertaking. If they adjust for future changes in the
undertaking rule, they must convince the regulator that the rule is
appropriate. The firms can trade off the market risk with the regulatory risk.
Finally, unlike price cap regulation, a quantity undertaking will usually have
a fixed and finite life. The quantity undertaking is designed to prevent
anticompetitive abuse of market power by merged firms in the short to
medium term. A minimum quantity undertaking is not meant to be a long
term solution to potential market power. Rather, it is a regulatory tool that
can be used in the medium term to prevent potential abuse of market power.
In the longer term, competition could usually be expected to mute or
eliminate anticompetitive market power.

20
For example, Armstrong, Cowan and Vickers (1994) presents a useful overview of price caps
including regulatory experience in the UK.
 20

Penalties and enforcement

A quantity undertaking would include penalties for any breach. It is

clearly not credible for these penalties to involve the reversal of the merger.
However, they could involve a severe monetary penalty for the merged firm.
The ability to enforce the undertaking will depend on the clarity of the
quantity constraint. If the quantity constraint is poorly specified and is based
on an index of output that is easily manipulated by the merged firm then it
will clearly be ineffective. But experience with price caps and other regulatory
tools can be brought to bear to design clear, well functioning quantity
undertakings. Further, before the merger actually takes place, both the firms
seeking the merger and the regulator have an incentive to find a mutually
satisfactory quantity undertaking.

Anticompetitive spillovers from an undertaking

Could a quantity undertaking be used in a socially undesirable way?

There may be concerns that a quantity undertaking could be used to limit
future entry into the industry. Future potential entrants know that they will
face an aggressive competitor, in the sense that the merged firm will be forced
to maintain output even after successful new entry. This, in turn, may make
entry less profitable and less likely to succeed.
This problem may be faced directly through the quantity undertaking.
If there is new entry in the industry, and this leads to a substantial change in
the output of other firms, then the regulator may retain the discretion to lower
or remove the quantity undertaking on the merged firms. Such a revision
makes perfect sense. After all, the reason for the undertaking was that the
merger was likely to substantially lessen competition. If new entry occurs and
this raises competition then the anticompetitive effects of the merger are
reduced. If the new entrant is well funded and likely to be a long term
success, then the regulator can reduce the quantity undertaking to
accommodate this new entry or even remove the undertaking completely.
 21

Secondly, while an undertaking may make entry more risky in the

short term, it need not have this effect in the longer term. A quantity
undertaking generally will have a finite life. A potential new entrant can plan
for the end of the undertaking adjusting its entry strategy to coincide with
this time.
Alternatively, it is theoretically possible for quantity undertakings to
encourage inefficient mergers for strategic reasons. Two firms might find it
mutually profitable to be able to commit to raise output. By merging and
providing a quantity undertaking that exceeds the sum of their pre-merger
quantities, the firms can commit to act aggressively. Even if the merger offers
no cost efficiencies and is costly, such a credible commitment, enforced by the
ACCC, may be strategically valuable.
Clearly, it is not desirable to encourage inefficient mergers. But it
seems unlikely and unnecessary for the firms to merge to offer such a
commitment. There is nothing stopping firms from forming a joint venture
where they agree to maintain a high level of total output. So long as such an
agreement was not ‘predatory’it would not violate the TPA. In other words,
the firms could write a standard enforceable contract to raise output and do
not need the assistance of the ACCC.

VI. Behavioural Undertakings and the ACCC

The ACCC’s unwillingness to accept behavioural undertakings is

understandable. From a traditional antitrust perspective, competition laws
establish rules against socially undesirable behaviour by firms. But beyond
these laws, the authorities do not interfere in the day-to-day activities of the
market place. Behavioural undertakings, by contrast, require on-going
supervision and monitoring. In this sense, they are closer to tools of
regulation rather than antitrust.
This simple division between antitrust laws and regulation is clearly
outdated in Australia. The ACCC is not simply a body that enforces a set of
 22

market rules. Unlike the U.S. Department of Justice, the ACCC has a variety
of roles that involve on-going regulation.
The ACCC was formed on November 6, 1995 when the Trade Practices
Commission and the Prices Surveillance Authorities merged. Under the Prices
Surveillance Act 1983, the Commission has a mandate to monitor specified
prices, to vet proposed price rises for certain firms and to investigate pricing
practices when requested by the federal treasurer.
The ACCC arbitrates and determines access terms and conditions
under Part IIIA of the TPA. Further, the ACCC regulates prices for
aeronautical charges at privatised airports and for a variety of
telecommunications services. The ACCC also has a role in monitoring service
quality, for example, when regulating airports. Put simply, the ACCC has
significant experience with the type of on-going monitoring that would be
needed for a successful behavioural undertaking.
As noted above, the willingness of the ACCC to accept structural
rather than behavioural undertakings may reflect a simplistic belief about the
ease of enforcement of the former relative to the latter. Structural
undertakings may be difficult to formulate. The ACCC will often require
more information when judging a structural undertaking compared with, say,
a quantity undertaking. For example, if the merging firms undertake to divest
certain assets, then the ACCC must know if these assets will be sufficient to
allow either improved competition by current competitors or for new firms to
enter. It will often be difficult for the ACCC to judge the appropriateness of
the relevant assets. Structural undertakings also have rather uncertain
consequences. While some assets may be sold under an undertaking, this is
not the same thing as ensuring that potential competitors buy these assets and
then successfully enter the relevant industry.
In contrast, behavioural undertakings, such as the quantity
undertaking discussed above, may be relatively easy. While the actual
quantity rule may be complex, there is significant experience in formulating
similar rules. More importantly, behavioural undertakings can be specific to
 23

the underlying competitive problem. The problem with a merger is that the
merged firms might lower total output to use their increased market power.
A behavioural undertaking based on quantity directly addresses this issue,
unlike a structural undertaking. Further, subject to issues of enforcement, the
quantity undertaking discussed above acted as a perfect mechanism to
separate socially desirable and undesirable mergers. In contrast, an
undertaking to, say, sell certain assets, may prevent socially desirable mergers
if such a sale raises the merged firm’s costs of operation. Conversely, it may
allow undesirable mergers to continue. The asset sale may remove some of
the merged firm’s ability to exploit market power but still leave it with the
ability to raise prices and limit output after the merger.

VII. Conclusion

The ability of the ACCC to accept undertakings under section 87B of

the TPA, has the potential to improve merger analysis. As shown above, a
simple quantity undertaking made by the merging firms provides a strong
signal that the merger is, on the whole, beneficial to society. Further, the
undertaking can change the distribution of the gains from a merger, making
sure that consumers do not face higher prices and may even raise the merger
benefits.
To date, however, the ACCC has shown a reluctance to accept this type
of behavioural undertaking. In part, this reflects fallacious reasoning. It is far
from clear that behavioural undertakings are particularly difficult to
formulate or enforce, as the ACCC has claimed, particularly when compared
with structural undertakings that the ACCC has been willing to accept. In
fact, there are strong arguments that the ACCC, with its extensive regulatory
experience, is uniquely placed to enforce behavioural undertakings. In many
ways these undertakings are easier to design and implement because, at least
at the initial stage of the undertaking, both the firms seeking a cost-reducing
merger and the ACCC have similar objectives.
 24

The reluctance on the part of the ACCC to accept behavioural

undertakings means that much of the potential benefit of undertakings may
be lost. The simple model presented above shows that a quantity
undertaking, when perfectly enforceable, is a perfect signal about the social
desirability of a merger. Given our (relatively weak) assumptions about
competition, firms will only be willing to offer such an undertaking if the
merger leads to net cost savings in the absence of any increase in market
power. In contrast, if the main force driving the merger is the anticompetitive
intention to use market power to restrict output after the merger, then the
relevant firms will not be willing to offer a quantity undertaking.
Clearly behavioural undertakings, such as a quantity guarantee, are
not perfectly enforceable. But given the potential benefits that they offer, and
the ACCC’s significant practical experience with other regulatory schemes, it
is undesirable to dismiss behavioural undertakings as unworkable.
 25

Figure 1

P1
P0 F B C

A D

c
H E G
c-∆

q1 P(Q)

q0

Q1 Q0 Q
 26

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