Post-Merger Incentives in Retail-To-Wholesale Mergers

Post-merger incentives in retail-to-wholesale mergers

Jon Adlard, David Foster April 2018

Abstract The recent mergers of Tesco / Booker and Co-op / Nisa in the UK are vertical transactions combining a grocery retailer and a grocery wholesaler. In both cases, the grocery wholesaler supplies but does not own downstream grocery retailers. Transactions such as this raise two main questions for a competition authority. First, would the merged entity have the ability and incentive to deteriorate its retail proposition, in the hope that its wholesale business benets via end-consumers switching to retailers supplied by its wholesale arm? Second, would the merged entity have the ability and incentive to deteriorate its wholesale proposition, in the hope that end-consumers switch from retailers it supplies to its own retail operation? This paper derives a modied version of the standard horizontal GUPPI framework that can be used to assess post-merger incentives in mergers involving a wholesaler and retailer. We show that it is equivalent to the vGUPPI approach set out in Salop and Moresi (2012), albeit that our vGUPPI expressions are a function of retail-to-retail diversion ratios (which can be estimated through empirical methods, e.g. customer surveys). Finally, we comment on how this framework was adopted by the Competition and Markets Authority in Tesco / Booker, focusing on the practicalities of estimating the various inputs required to assess a large number of local areas where Tesco and Booker-supplied retail stores were present.

1 1 Introduction

[To follow]

2 Model and derivation of vGUPPIs 2.1 Market structure We assume a model of dierentiated Betrand competition, with the following structure and notation:

• A vertically integrated grocery retailer purchases its supplies directly from suppliers at pricecr and charges a price of pr in the downstream grocery retail market.

• A non-vertically integrated grocery retailer purchases a proportion of its total supplies (denotedγw) from a wholesaler at a pricew and charges a price of pd in the downstream grocery retail market.

• The wholesaler purchases from suppliers at a price of pw and charges a price of w to the downstream retailer (i.e. the same price at which the retailer purchases from the wholesaler). In addition, this wholesaler supplies other retailers in the downstream grocery market at a pricew. This is summarised in [ ] below. Figure [ ]

As set out in [ ] below, we consider two potential mergers involving the wholesaler:

2 • A merger of a vertically integrated retailer with the wholesaler. • A merger of a non-vertically integrated retailer with the wholesaler.

Figure [ ]

For both of the above scenarios, we derive the vertical GUPPI (as per Salop and Moresi (2012)) for:

• The retailer: which measures the incentive that the merged entity has to deteriorate its retail proposition post-merger. Such an incentive may exist if end-consumers would switch to rival retailers supplied by the merged entity's wholesale arm, and these retailers would in turn increase their wholesale purchases with the merged entity.

• The wholesaler: which measures the incentive that the merged entity has to deteriorate its wholesale proposition post-merger. This incentive may exist if such a deterioration would lead to end-consumers diverting from retail stores supplied by the merged entity's wholesale arm to the merged entity's retail arm

2.2 Vertical GUPPI for a vertically integrated retailer acquiring a wholesaler 2.2.1 Pre-merger

Pre-merger, the prot maximisation problem of the retailer r can be written as:

0 0 0 max π = (p − cr)q 0 r r r pr The rst-order condition results in:

0 1 0 pr = cr − 0 qr ∂qr 0 ∂pr

3 2.2.2 Post-merger When a retailer acquires a wholesaler, this means taking account of the impact of retail pricing decisions on the prots of the acquired wholesaler. For example, if a retail price increase causes customers to divert to retail competitors also supplied by the wholesaler, this might increase their wholesale purchases at the merged entity, thereby increasing the overall prots of the merged entity. Post-merger, the prot maximisation problem of the retailer (assuming that the retailer faces the same level of marginal costs pre- and post-merger, i.e. 0 1 ), taking into account that it now owns a wholesaler (whose prots cr = cr = cr are partially dependent on the retailer's price) is:

1 1 1 max π = (p − cr)q + (w − cw)qw 1 r r r pr

1 ∂qr Re-arranging the rst-order condition and divding through by 1 results in: ∂pr

∂qw 1 1 1 1 ∂pr pr = cr − 1 qr − 1 (w − cw) ∂qr ∂qr 1 1 ∂pr ∂pr

∂qw 1 ∂pr The term− 1 in the above is the diversion ration from the wholesaler to the ∂qr ∂p1 retailer - thatr is, of the total volumes lost by the retailer in response to a price 1 ∂qr ∂qw increase ( 1 ), the proportion that is re-captured by its wholesale entity ( 1 ). ∂pr ∂pr ∂qw 1 If we write that ∂pr then the above expression becomes: − 1 = DRr→w ∂qr 1 ∂pr

1 1 1 pr = cr − 1 qr + DRr→w(w − cw) ∂qr 1 ∂pr

2.2.3 Implied post-merger increase Using the above, the implied post-merger price increase of the retailer (in abso- lute terms, and based on the rst-order eect only), can be written as:     1 0 1 1 1 0 pr − pr = cr − 1 qr + DRr→w(w − cw) − cr − 0 qr  ∂qr ∂qr 1 0 ∂pr ∂pr Which as an implied percentage post-merger price increase is:   1 0 1 0 pr − pr 1 qr qr w 1 0 = − 0  1 − 0  + DRr→w(w − cw) 0 p p ∂qr ∂qr w p r r 1 0 r ∂pr ∂pr

4   1 0 1 0 pr − pr 1 qr qr w 0 = − 0  1 − 0  + DRr→wmw 0 p p ∂qr ∂qr p r r ∂p1 ∂p0 r r r | {z } vGUP P Ir→w

As noted above DRr→w is the diversion ratio from the retailer to a wholesaler in response to a price increase. Up to this point, the analysis is the same as for any horizontal merger. However, in a case where the other merging party is a wholesaler, one can further decompose the diversion ratio DRr→w. This is because end-consumers in the downstream retail groceries sector shopping at the vertically integrated retailer do not directly switch to shopping with the wholesaler (as the wholesaler is present at another level of the supply chain). Rather, end-consumers may switch from the retailer to a competing non-vertically integrated retailer (denoted with subscript d), who, in response to an increase in their retail sales, purchases some proportion of their wholesale requirements from the wholesaler in question (denoted γw, as per [ ] above). It is therefore this indirect eect that has the potential to result in higher sales for the wholesaler, and this eect will be larger or smaller depending on the size of γw. Given this, we can write that:

∂qw ∂qd 1 1 ∂pr ∂pr ∂qw DRr→w = − 1 = − 1 = DRr→dγw ∂qr ∂qr ∂q 1 1 d ∂pr ∂pr The expression for rst-order eect of the merger on the retailer's post-merger price then becomes:   1 0 1 0 pr − pr 1 qr qr w 0 = − 0  1 − 0  + DRr→dγwmw 0 p p ∂qr ∂qr p r r ∂p1 ∂p0 r r r | {z } vGUP P Ir→w The second term represents the vertical GUPPI for a vertically integrated retailer acquiring a wholesaler (that supplies some of the vertically integrated retailer's rivals). This expression represents the margin earned expressed in wholesale terms on sales diverting from the retailer to competing rivals that are supplied by the wholesaler. The rst term in above expression captures the adjustment that needs to be made to the vertical GUPPI in order to reect the fact that the upward pricing pressure (approximated using vGUP P Ir→w) may not be passed-through to prices fully, and the proportion of the vertical GUPPI passed-through to prices will depend upon the shape of the demand curve. For example, it can be shown that under linear demand the above expression becomes:   p1 − p0 1  w  r r = DR γ m  0  r→d w w 0  pr 2  pr  | {z } vGUP P Ir→w

5 Where 1 is the level of cost pass-through under linear demand. 2

We note that it also possible to writevGUP P Ir→w as a function of the standard horizontal GUPPI between r and d:

pd GUP P Ir→d = DRr→dmd 0 pr

pd mw w vGUP P Ir→w = DRr→dmd 0 γw pr md pd

mw w vGUP P Ir→w = GUP P Ir→d γw md pd This is informative insofar as it shows that the retailer's incentive to deteriorate its proposition post-merger when acquiring a wholesaler will always be lower than if it were to acquire its downstream retail rival (at the same level of the supply chain), given that:

• A downstream retailer cannot source more than 100% of its purchases from a whoelsaler, meaning that 0 ≤ γw ≤ 1. • In order for a downstream retailer to realise a prot on their wholesale purchases, it must be the case that wholesale prices are less than retail prices, i.e. w ≤ 1. pd • Broady speaking, wholeslae margins may be expected to be less than retailer margins, i.e. mw < 1.1 md By way of example, if we assume that the ratio of wholesale to retail margins is 50%, the ratio of wholesale prices to retail prices is 80% and a retailer purchases 50% of their wholesale purchases from the wholesaler, then the incentive for the retailer to deteriorate its proposition post-merger is one fth of the incentive were it to be merging with the downstream retailer (rather than the wholesaler from which it purchases its supplies):

vGUP P Ir→w mw w = γw = 20% GUP P Ir→d md pd 2.3 Vertical GUPPI for a non-vertically integrated retailer acquiring a wholesaler Using the same approach as above, but with the dierence that: (i) pre-merger the downstream retailer d purchases its inputs at price w from the wholsaler; and (ii) post-merger the downstream retailer purchases its inputs atcwrather than w (as it has access to the wholesaler's purchasing price cw), the above becomes the following.

1For example, see paragraph 38(c) of the CMA's Final Report in Tesco / Booker.

6 2.3.1 Pre-merger

max π0 = (p0 − w)q0 0 d d d pd Which results in the following rst-order condition:

0 1 0 pd = w − 0 qd ∂qd 0 ∂pd

2.3.2 Post-merger

1 1 1 max π = (p − cw)q + (w − cw)qw 1 d d d pd Which results in the following rst-order condition:

1 1 1 pd = cw − 1 qd + DRd→w(w − cw) ∂qd 1 ∂pd

2.3.3 Implied post-merger increase Using the above two expressions, the implied percentage post-merger price increase (based on the rst-order eect of the merger on prices is):   p1 − p0 1 q1 q0 w (w − c ) d d = − d − d + DR m − w 0 0  ∂q1 ∂q0  d→w w 0 0 pd pd d d pd pd ∂p1 ∂p0 d d | {z } vGUP P Id→w The dierence between this expression and the vGUPPI in the case of the vertically integrated retailer is that there is a now an osetting eect created by the elimination of double marginalisation. This arises because downstream retailer is now able to source products directly from the supplier at a lower price than pre-merger, rather than having to purchase via the wholesaler (who itself earns a margin). The above expression for vGUP P Id→r is equivalent to equations (A13) and (A14) in Salop and Moresi (2012). Finally, for completeness we note that the above can also be written in terms of the retail-to-retail diversion ratio from the downstream retailer to a competing downstream retailer who purchases a proportion of their purchases γwfrom the merged entity's wholesale arm:

w (w − cw) vGUP P Id→w = DRd→d0 γwmw 0 − 0 pd pd

Where DRd→d0 is the diversion ratio between the downstream retailer now owned by the merged entity and a rival downstream retailer supplied by the merged entity's wholesale arm.

7 2.4 Vertical GUPPI for a wholesaler acquiring a retailer In this case we adopt the same approach as the case of the retailer acquiring a wholeslaer, albeit with the dierence that the focus is on the pre- and post- merger rst-order conditions of the wholesaler (rather than the retailer).

2.4.1 Pre-merger Pre-merger, the prot maximisation problem of the wholesaler is:

0 0 0 max πw = (w − cw)qw w0 Which produces the rst-order condition:

0 1 0 w = cw − 0 qw ∂qw ∂w0

∂q0 An important component in this expression is w , which is the sales lost at the ∂w0 wholesale level in response to a wholesale deterioration (i.e. an increase in w). These lost sales can be decomposed into two elements:

• Lost sales that are the result of downstream retailers switching their wholesale purchases to other wholesale suppliers.

• Lost sales that are the result of downstream retailers passing on the deterioration to their customers (and losing retail sales as a result).

In the case of the retail-to-wholesale vGUP P Ir→w, we noted that the change in a wholesaler's sales in response to a change in the level of sales of a downstream retailer is given as ∂qw . It therefore follows that . This is ∂q = γw qw = γwqd intuitive: the quantityd sold to a downstream retailer by a wholesaler is the product of how much that retailer sells in the downstream market and the proportion of that retailer' purchases from the wholesaler. In addition:

• The quantity that the retailer sells in the downstream market is dependnt on its price pd which is in turn dependent on the price charged by the wholesaler w, i.e. qd = f(pd(w)). • The proportion of a retailer's purchases from a wholesaler will be dependent on the wholesale price i.e. γw = f(w) This means that: ∂q ∂ ∂ w = (γ q ) = (γ (w)q (p (w))) ∂w ∂w w d ∂w w d d Which, using the chain rule, can be wrirten as:

8 ∂qw ∂qd ∂pd ∂γw = γw + qd ∂w ∂pd ∂w ∂w

The term ∂pd in the above is the proportion of any wholesale deterioration that ∂w is passed-through by the end-retailer in the form of a worsened retail proposition. If we assume that any wholesale deterioration is smoothed equally across all products sold by the retailer, and use the term α to denote the proportion of a given deterioration that is passed-through by the retailer, then we can write that ∂pd . If this is substituted into the expression for ∂qw then we obtain: ∂w = αγw ∂w

∂qw 2 ∂qd ∂γw = αγw + qd ∂w ∂pd ∂w

qw Substituing that qd = and re-arranging: γw

∂γw 1 ∂qw 2 ∂qd 1 = γw − γw α ∂w qw ∂w ∂pd qd

Inserting w into the rst term and pd into the second term of the above and w pd re-arranging produces an expression for ∂γw w : ∂w γw

∂γw w w = εw − γwα εd ∂w γw pd The expression above gives the wholesale price elasticity of the proportion of goods sourced from the merging party wholesaler (that is, in response to a marginal increase in the wholesale price of goods, what impact does this have on the proportion of goods that a retailer sources from the wholesaler). In this expression, the elasticites of demand for the upstream wholesaler and the downstream retailer can be inferred from their margins using the pre-merger 1 rst order (Lerner) condition (i.e. mi = − ) for the retailer and wholesaler. If mi there is only one downstream retailer d, then the following condition will hold:

∂γw w 1 w 1 = − + γwα ∂w γw mw pd md In the more general case there could be several downstream retailers who all source a proportion of their purchases from the merging party wholesaler. A wholesale deterioration aects all of these downstream customers in aggregate, and εd in the expression above represents the aggregate elasticity of demand for those downstream customers as a group. If one makes the further assumption that the downstream customers of the wholesaler are symmetric (in particular in the sense that they each source the same proportion (γw) of their purchases from the wholesaler) then it follows that their pricing reaction to a wholesale price increase would be symmetric.

9 This assumption means that we can think about the downstream customers of the merging party wholesaler in aggregate as a single entity (since their pricing reactions to wholesale price increases will be uniform). It also means that we can infer their aggregate elasticity from their pre-merger margins. In particular, with symmetry between downstream retail customers of the merging party wholesaler, the aggregate elasticity will satisfy the following condition:

1 md(1 − DRd→D) = − εD Where:

• εD is the aggregate elasticity of all the downstream customers of the merging party wholesaler.

• md is the percentage margin of an individual downstream retailer, who sources some of its wholesale purchases from the merging party wholsaler.

• DRd→Dis the diversion ratio from the individual downstream customer of the merging party wholesaler to all other downstream customers of the merging party wholesaler.

This means that under the scenario where the merging party wholesaler has several (symmetric) downstream customers, the wholesale sourcing elasticity becomes:

∂γw w 1 w 1 = − + γwα (1) ∂w γw mw pd md(1 − DRd→D)

2.4.2 Post-merger Following a merger, the rst order condition for the wholesaler will also take into account the impact of wholesale pricing on the prots of the merged entity's retail arm. This means that the rst order condition becomes:2

1 1 1 max πw = (w − cw)qw + (pr − cr)qr w1

∂qr 1 1 1 ∂q1 w = cw − 1 qw − 1 (pr − cr) ∂qw ∂qw ∂w1 ∂w1

∂qr ∂q1 In this case, the expression − 1 is the diversion ratio from the wholesaler to ∂qw 1 the retailer - i.e. of the total volumes∂w that the wholeslaer loses following a price

2For simplicity, we assume that pre- and post-merger marginal costs of the wholesaler are the same, and the retailer and the wholesaler continue have marginal costs of cr and cwrespectively (although both of these could easily be relaxed in order to take account of post-merger eciencies).

10 increase, what proportion is re-captured by the merged entity's retail operation. This means that we can write:

1 1 1 w = cw − 1 qw + DRw→r(pr − cr) ∂qw ∂w1

2.4.3 Implied post-merger price increase

The expression for the implied percentage price increase (w1−w0) is similar to w0 that derived for the retailer taking into account its pricing decisions on the wholesaler's prots, but with the positions of the retailer and wholesaler re- versed: ! (w1 − w0) 1 q1 q0 p = − w − w + DR m r 0 0 ∂q1 ∂q0 w→r r w w w w w0 ∂w1 ∂w0 | {z } vGUP P Iw→r

The expression vGUP P Iw→r reects the potential incentive to deteriorate the wholesaler's proposition. This may occur if downstream retailers served by the wholesaler pass on any wholesale deterioration (in the form of a worsened retail proposition), and this leads to retail sales switching the merged entity's retail arm.

As in the case of DRr→w, the diversion ratio DRw→r is not something which can be directly measured in the standard way, because it reects the indirect relationship between changes to the wholesale oering of the merging party wholesaler and the behaviour of end consumers at the downstream retail level. So the next step is to decompose this diversion ratio so that it can be expressed in terms of more measurable components. In particular, we want to rewrite the wholesaler-to-retailer diversion in terms of the retailer-to-retailer diversion ratio

(i.e. DRd→r) at the downstream level (since this retail-level diversion ratio is something that can be obtained empirically from surveys or other evidence of customer behaviour in the retail market).

We start by noting that DRw→r can be wrtten as the product of two terms:

∂qr ∂qd ∂qr ∂qd ∂w ∂w ∂w ∂w DRw→r = − = − = − DRd→r ∂qw ∂qw ∂qd ∂qw ∂w ∂w ∂w ∂w |{z} DRd→r This is equivalent to saying that the proportion of sales the diverts from the wholesaler to the merged entity's retail arm is the product of:

• The proportion of the wholesaler's overall volume loss following a price increase that occurs due to a reduction in the sales of the retailer in the downstream retail market (due to the retailer passing-on some or all of ∂qd the increase in wholesale price increase), i.e. ∂w . ∂qw ∂w

11 • The proportion of the downstream retailers total volume loss that diverts to the retail arm of the merged entity (vis-à-vis other retailer competitors). This is equivalent to the diversion ratio from the downstream retailer ∂qr served by the wholesaler and the merged entity's wholesale arm, i.e. ∂w ∂qw = ∂w DRd→r Given the above, we can write:

∂qd ∂w pr vGUP P Iw→r = DRd→r mr ∂qw w ∂w 0

∂qw ∂qd ∂pd ∂γw ∂qw ∂qd ∂γw Recalling that = γw + qd or = γw + qd, and that ∂w ∂pd ∂w ∂w ∂w ∂wd ∂w qw qd = , it is possible to write that: γw 1 ∂qw − qw ∂γw γw ∂w γw ∂w 1 1 ∂γw ∂w DRw→r = DRd→r = DRd→r 1 − qw ∂qw γ γ ∂w ∂q ∂w w w w If we insert w into the nal expression, and recalling the Lerner condition, then w we can write that: 1 w ∂γw 1 1 ∂γw w DRw→r = DRd→r 1 − = DRd→r 1 + mw γw γw ∂w εw γw ∂w γw This expanded expression for the key diversion ratio in the wholesale-to-retail vGUPPI is now a function of the downstream diversion ratio DRd→r and the wholesale sourcing elasticity, ∂γw w . Using the expression for this wholesale ∂w γw sourcing elasticity derived above (equation (1)) means that we can write the diversion ratio DRw→r as follows: 1 w 1 1 DRw→r = DRd→r 1 + γwα − mw γw pd md(1 − DRd→D) mw

w mw DRd→r DRw→r = α pd md (1 − DRd→D)

The term DRd→r represents the net diversion ratio to the retail arm of the (1−DRd→D ) merging Party (from the retailer served by the merged entity's wholesale arm) once diversion to other downstream retailers served by the merged entity's wholesale arm is excluded. In practice there would be no diversion between downstream customers, as each of those downstream customers would increase their retail prices following a wholesale price increase (assuming they behave in the same way). If we write this diversion as:

DRd→r DRD→r = 1 − DRd→D

12 Then the expression for vGUP P Iw→r becomes: pr w mw pr vGUP P Iw→r = mrDRw→r 0 = DRD→rα mr 0 w pd md w

pr Noting that DRD→rmr is the standard horizontal GUPPI for a retailer ac- pD quiring a competing retailer, we can write vGUP P Iw→r as an adjusted form of the retail-to-retail GUPPI as if the merger were happening between the downstream retailer D and the merging party retailer r:

mw vGUP P Iw→r = α GUP P ID→r md

The adjustment factor mw reects the fact that the wholesaler does not own or α m control the pricing of the downstreamd retailers, and must instead raise wholesale prices and rely on the downstream retailers both:

• Not switching supplies to third party wholesalers. This is represented by the ratio of the wholesaler margin to the downstream retailer margin mw m , which is equivalent to the ratio of the two rm's elasticities. d

• Passing-through any wholesale deterioration (represented by the term α).

ExpressingvGUP P Iw→ras a function of the standard horizontal GUPPI demon- strates that as with vGUP P Ir→w that the post-merger incentive in a wholesale-to-retail merger is lower than a retail-to-retail merger between the retailer served by the wholesaler and the merging party retailer. This is because mw is in the event that cost pass-through is less than full, and wholesale α m < 1 marginsd are less than retail margins. By way of example, if cost pass-through is 50% and the ratio of wholesale to retail margins is assumed to be 50%, then vGUP P Iw→r is one quarter of the size of GUP P ID→r. It is also possible to show that the above is eqivalent to that of Salop and Moresi (2012) for the case of an upstream entity merging with a downstream rm, by noting that: p vGUP P I = m r DR w→r r w0 w→r

∂qr ! pr ∂w vGUP P Iw→r = mr − w0 ∂qw ∂w

∂qw ∂qd ∂γw As qr (pd(w)) and = γw + qd then: ∂w ∂wd ∂w

∂qr ∂pd ! ∂qr ∂pd ! pr ∂pd ∂w pr ∂pd ∂w vGUP P Iw→r = mr = mr 0 ∂qd ∂γw 0 ∂qd ∂pd ∂γw w −γw − qd w −γw − qd ∂wd ∂w ∂pd ∂w ∂w

∂qr ∂pd (pr − cr) ∂pd ∂w (2) vGUP P Iw→r = ∂qd ∂pd ∂γw 0 −γw − qd w ∂pd ∂w ∂w

13 Where - if one changes the notation - then the above expression is equivalent to equation (A7) in Salop and Moresi (2012), from which (A8) is then derived:3

∂D1 ∂P2 (P1 − C1) 1 ∂P2 ∂W2 vGUP P I = 1 1 ∂D2 ∂P2 ∂S2 1 −S2 1 − 1 D2 A2W2 ∂P2 ∂W2 ∂W2

Indeed, if one divided the numerator and denominator of expresion (2) by− ∂qd ∂pd and ∂pd ∂w insert the rst-order condition of the downstram retailer ∂qd qd = − ∂p (pd − cd) then the following is obtained: d

pr DRd→r vGUP P Iw→r = mr 0 ∂γw w w ∂w γw 1 + md ∂pd w γw ∂w pd Which, using equivalent notation to Salop and Moresi (2012), is the same as their equation (A8).

DR M P vGUP P I = 21 1 1 E 1 1 (1 + M2 SR/EP ) S2 A2W2 3 Application: Tesco / Booker (Competition and Markets Authority, 2017)

In 2017 the UK Competition and Markets Authority (CMA) investigated the anticipated merger of Tesco PLC (Tesco), the UK's largest grocery retailer, and Booker Group Plc (Booker), the UK's largest grocery wholesaler. Tesco owns approximately 3,500 supermarkets and convenience stores, while Booker provides wholesale grocery services to a large number of independent retailers. Booker also owns four symbol group brands Londis, Budgens, Premier and Family Shopper which are collections of independent retail stores aliated with Booker and operating under a common brand. As noted by the CMA, an independent retailer aliated to a symbol group is independent from the wholesaler, but generally commits to minimum purchase requirements (and other conditions which vary by wholesaler and symbol group brand), in return for use of the symbol brand and other benets such as improved promotions. As of 2017, Booker had approximately 5,500 retailers aliated to one of its four symbol group brands. The Tesco / Booker merger is broadly equivalent to the case involving a merger of a non-vertically integrated retailer and a wholesaler discussed in Section [ ], as illustrated in Figure [ ] below.

Figure [ ]

3 The term A2 is redundant in our case.

14 Consistent with the standard framework for assessing competitive eects in vertical mergers, the CMA assessed whether the merged Tesco / Booker entity would have the ability and incentive to implement a vertical theory of harm, and if so, whether the eect of any such strategy would be of a large enough magnitude to result in a substantial lessening of competition.

• As regards to the merged entity's ability to implement a vertical theory of harm, the CMA focused primarily on whether it would be possible for Tesco and/or Booker to target a post-merger deterioration on those specic local areas where such a strategy may be most successful.

• Given the large number of local areas where Tesco and Booker-supplied stores are present, the CMA required a systematic approach for evaluating the extent to which the merged entity may have the incentive to deteriorate the proposition of Tesco and/or Booker post-merger. The approach that the CMA adopted was the vertical GUPPI framework set out in Section [ ] above, proposed by the merging Parties as part of the CMA process. This was used by the CMA to assess whether the merged entity would have the incentive to deteriorate:

Tesco's retail proposition in order to benet Booker's wholesale businesses, by re-capturing sales indirectly through Booker-supplied retailers increasing their purchases from Booker; and o Booker's wholesale proposition in order to benet Tesco's retail businesses, by re- capturing sales indirectly through sales diverting Booker-supplied retailers to Tesco's retail stores.

15 Booker's wholesale proposition in order to benet Tesco's retail businesses, by re-capturing sales indirectly through sales diverting Booker- supplied retailers to Tesco's retail stores. We discuss below how the CMA implemented the vGUPPI framework in the context of a retail-wholesale merger, and the practical challenges that it faced in doing so.

3.1 Merged entity's incentive to deteriorate Tesco's retail proposition in order to benet Booker's wholesale business To assess whether Tesco would have the incentive to deteriorate its retail proposition in order to indirectly re-capture sales at Booker's wholesale business, the CMA estimated a retail-to-wholesale vertical GUPPI for more than 2,300 Tesco stores that were in close proximity to an independent retailer supplied by Booker (both those aliated to one of Booker's symbol group brands and those operating as fully independent retailers). For each Tesco store the CMA sought to estimate the following equation, analogous to that set out in [ ] above for the more general case:

J X pBWj vGUP P I = DR m γ Ti→BS Ti→BSj BWj p BWj j=1 Ti Where: is a measure of the incentive that the merged entity would • vGUP P ITi→BS have to deteriorate Tesco's retail proposition post-merger at store i ∈ I (in the hope of indirectly capturing wholesale sales through customers switching Tesco stores to Booker-supplied retail stores). is an estimate of the diversion ratio from Tesco store to • DRTi→BSj i Booker-supplied retail store j, where j ∈ J denotes that Tesco may benet from diversion to multiple Booker-supplied retail stores in a given local area. is the variable (wholesale) prot margin that Booker earns on any • mBWj aditional wholesale purchases made by retailer j. p • BWj is the ratio of Booker's wholesale prices to retailer j and the retail pTi price level of Tesco store i. is the proportion of any additional wholesale purchases made by • γBWj Booker-supplied retailer j from Booker (rather than third party wholesalers).

16 Given the sheer number of Tesco and Booker-supplied retail stores, combined with data limitations in terms of what was feasible in the time available, the CMA sought to parameterise the above inputs using a combination of highly localised data (where available) and more broad brush assumptions that it gleaned from other empirical exercises.

: in previous cases the CMA has used the results of consumer • DRTi→BSj surveys to estimate diversion ratios between merging parties at the same level of the supply chain. However, given the large number of overlaps between Tesco and Booker-supplied retail stores such an approach was not feasible, and the CMA therefore sought to proxy for diversion ratios using a weighted share of shops (WSS) approach. This approach estti- mates diversion ratios by allocating all competing rms within the relevant catchment area a certain weight, depending on: (i) their distance from

Ti (with closer rms being given a higher weight than those more distant); and (ii) the fascia of the rm, to reect that certain retailers may exert

a greater competitive constraint on Ti than other rms (e.g. due to the stocking of tobacco or not). The weight of BSj is then divided by the sum of all retailer weights in the catchment area to estimate a diversion ratio. This approach is discussed in more detail in Annex [ ]. : in some instances, Booker was able to provide wholesale gross • mBWj margin information at the customer level, which the CMA then translated into a customer-specic variable margin by deducting the national dierence between Booker's gross and variable margins . Where customer level wholesale margins were not available, the CMA applied an estimate of the national variable margin for each local store.

p • BWj : evidence on the relative prices of Booker wholesale and Tesco retail pT wasi obtained from information held by the Parties that they collect when tracking competitor prices. While in theory this ratio could vary according to each Tesco i and Booker-supplied retail store j, the high prevalence of national pricing operated by both Parties means that any such variation is likely to be minimal. In addition, and as noted by the CMA, small variation in this parameter is unlikely to cause material changes to the estimate of . vGUP P ITi→BSj : as Booker has no insight into how much its retail customers source • γBWj from third party suppliers, this parameter was more challenging for the CMA to estimate. The CMA's approach was two-fold to deriving an estimate of Booker's share of retailer wallet:

First, it adopted a default assumption that Booker's share of wallet for Booker symbol group retailers and independent retailers (where served by Booker) were 78% and 60% respectively, based on the results of a survey of independent retailers that the CMA commissioned for the purposes of the merger inquiry.

17 Second, where retailers spent very little with Booker , the CMA estimated Booker's share of wallet at the retailer level, by dividing their actual purchases with Booker in the last year by the CMA's estimate of their total wallet (i.e. total wholesale purchases across all suppliers). Using the inputs described above, and estimating the term for vGUP P ITi→BSj more than 2,300 Tesco stores overlapping with one or more Booker-supplied retail stores within a mile, the CMA found that a vGUPPI of 5% or more was produced in only 11 areas. Moreover, in each of these 11 areas, the vGUPPI was less than 10% - the threshold that the Parties considered to be appropriate for identifying the level at which Tesco would have the incentive to deteriorate its proposition post-merger. The CMA also took comfort from the fact its input assumptions were likely to be conservative, and that Tesco implementing such a strategy would likely to be:

• Costly, insofar as it would involve Tesco having to implement a targeted local strategy.

• Risky, given that such a theory of harm relies on indirect re-capture at Booker wholesale via a retailer which the merged entity does not own nor operate, and which could therefore choose to move volumes away from the merged entity's wholesale arm and towards other wholesalers. Based on the above, the CMA was condent that the merged entity would not have the incentive to deteriorate its retail proposition in any local area.

3.2 Merged entity's incentive to deteriorate Booker's wholesale proposition in order to benet Tesco's retail business The starting point for the CMA's assessment of the merged entity's incentive to deteriorate Booker's wholesale proposition was the wholesale-to-retail vGUPPI expression set out in [ ] above:

J X pBW mBW pTj vGUP P I = DR α i i m BSi→Tj BSi→Tj BSi p m Tj p j=1 BSi BSi BWi This expression estimates the merged entity's incentive to deteriorate Booker's wholesale proposition on the portfolio of products that they currently purchase from Booker. However, if Booker supplies only a small proportion of the wholesale requirements of a given retailer, then any upward pricing pressure at the wholesale level would be small when expressed in terms of the overall retail proposition of the retailer in question (and vice versa). expressed in terms of the overall retail proposition of the retailer in question (and vice versa). By way of example, under linear demand a of 10% would suggest vGUP P IBSi→Tj a post-merger price increase by Booker of 5% to retailer i. But, if this retailer

18 purchases only 25% of its total wholesale requirements from Booker, then this price increase when translated into a retail price increase at retailer i's store is only 1.25% (i.e. signicantly smaller). This dilution between wholesale and retail occurs because Booker does not supply all of the retailer's wholesale requirements (and therefore any post-merger upward pricing pressure applies to allow a proportion of a retailer's overall proposition), and was acknowledged by the CMA. To account for this additional dilution eect, the CMA multiplied the term by retailer 's vGUP P IBSi→Tj i share of purchases with Booker (i.e ): γBWi

J X pBW mBW pTj vGUPˆ P I = γ DR α i i m BSi→Tj BWi BSi→Tj BSi p m Tj p j=1 BSi BSi BWi Where:

ˆ is a measure of the incentive that the merged entity has • vGUP P IBSi→Tj to deteriorate Booker's wholesale proposition to retailer i, expressed in terms of retailer i's overall retail proposition. is the proportion of any wholesale deterioration that Booker- • DRBSi→TJ supplied retailer i would pass-through to their retail oer. is the proportion of any wholesale deterioration that Booker-supplied • αBSi retailer i would pass-through to their retail oer. p • BWi is the ratio of Booker's wholesale prices to retailer i and that retailer's pBS downstreami retail prices.

m • BWi is the ratio of Booker's wholesale variable margin on its sales to mBSi retailer i and that retailer's downstream variable margin. is the variable margin earned by Tesco at store . • mTj j p • Tj is the ratio of Tesco's prices at store j and Booker's wholesale prices pBWi to retailer i. is Booker's share of wallet of retailer i's total wholesale purchases. • γBWi As in the case of the Tesco-to-Booker vGUPPI, precisely estimating all of the above parameters at the local level was a challenging exercise. Two particular diculties in the context of Booker-to-Tesco vGUPPIs included:

was unknown to Booker, given that all of its retailers are independent • mBSi operators over which Booker has no control. As such, this parameter could not be estimated at the individual retailer level, and the CMA used a single retail variable margin estimate for each of the main symbol groups operated by Booker (based on evidence submitted by the Parties).

19 The level of retailer cost pass-through is a key input to the Booker-to- • αBSi Tesco vGUPPI, and can have a signicant impact on the results: moving from full cost pass-through (i.e. 100%) to 50% is equivalent to halv- ing Booker's incentive to deteriorate its proposition post-merger (all else equal). Again, as Booker does not own or operate its retailers' stores, it has no visibility into how they may react to a change in Booker's wholesale proposition. An added complication is that the term relates αBSi to the level of cost pass-through following a unilateral wholesale cost increase (i.e. one faced by retailer i but not by other retailers), of which in practice there are likely to be very few (as most wholesale price changes will be market-wide). Estimating this parameter for each retailer i was therefore not feasible, and the CMA used a single estimate of αBS based on evidence gathered from the Parties and its own analysis. In this re- spect, the CMA's survey of independent retailers suggested that the rate of cost pass-through following a hypothetical wholesale price increase of 5% was around 75%. The Parties considered that this was likely to be an overstatement, as it did not reect the fact that Booker's ability to inuence retail prices is likely to be constrained by several factors. This included, for example, the fact that a large proportion of Booker's sales to retailers comprise price-marked-packs, where the price is set by the manufacturer, and therefore a wholesale price increase by Booker is unlikely to lead to a retail price increase by the retailer. Considering all of the evidence, the CMA assumed a central estimate

for αBS of 75%, but acknowledged this may lead to Booker's incentive to deteriorate its proposition to be overstated. It therefore

undertook an additional analysis with αBS = 0.5. The remaining input parameters for ˆ were estimated using the vGUP P IBSi→Tj same approach as used by the CMA for ˆ , i.e. store-specic mar- vGUP P IBSi→Tj gin information for Tesco, wholesale margin information at the individual retailer level where available, average price ratios based on price-checking under- taken by the Parties and the WSS approach for an estimate of ˆ vGUP P IBSi→Tj (albeit with certain changes to the fascia weightings to reect that the strength exerted by certain competitors on a Booker-supplied retail store may dier to the strength exerted by equivalent competitors on a Tesco). Based on the above, the CMA estimated ˆ for more than 12,000 vGUP P IBSi→Tj areas in which a Booker-supplied retail store overlapped with one or more Tesco stores within one mile. It found that in only ten areas was this term above 5%, and in no areas was it above 10%. Even these ndings were likely to have been an overstatement of Booker's incentive to deteriorate its proposition post-merger, given that: • As noted in Section [ ], if Booker's level of cost pass-through (not to be confused with the retailer's level of cost pass-through αBS) is less than full, then this means that Booker's implied rst-order price increase will be less than that estimated by ˆ . vGUP P IBSi→Tj

20 • Analogous to the case of Tesco-to-Booker, implementing a highly targeted wholesale deterioration at specic retail customers would be costly (in order to identify the relevant retailers and tailor Booker's wholesale proposition accordingly) this means that the overall protability of a Booker deterioration is likely to be less than that implied by considering the incentive indicated by ˆ . vGUP P IBSi→Tj • To the extent that the merger gives rise to any marginal cost reductions at Booker, this would serve to create downward pressure of Booker's wholesale prices post-merger (as noted in Section [ ] above). Based on the above, and also a review of wholesale competition in the local areas where ˆ was above 10%, the CMA concluded that the level vGUP P IBSi→Tj of competition in wholesaling and retailing services was signicant enough to mean that the merged entity would not have any material incentive to worsen wholesale price or service at a local level. As a potential extension to the CMA's approach for measuring the merged entity's incentive to deteriorate its wholesale proposition, we note that if it were possible to derive estimates for: (i) Booker's level of cost pass-through (which we denote αBW ) and; (ii) the extent of any merger-specic marginal cost reductions (denoted ( 1 0 ), then it would be possible to directly incorporate two cBW − cBW of the three qualitative factors outlined in [ ] above into the upward pricing pressure framework. In particular, one could write that:   p1 − p0 J p c1 − c0 BSi BSi X pBWi mBWi Tj BWi BWi 0 = αBW  DRBSi→Tj αBSi mTj +  p pBS mBS pBW p 0 BSi j=1 i i i BWi

Where c1 − c0 < 0 (as post-merger marginal costs are lower than pre- BWi BWi merger) and - under most forms of demand curve (e.g. linear) -αBW ≤ 1, such that these two eects serve to lower Booker's incentive to deteriorate its proposition post-merger. This expression could be further adjusted such that the implied rst order price increase is expressed in terms of the overall retail proposition of Booker-supplied retailer i, by multiplying it by the proportion of the retailer's overall wholesale purchases that it sources from Booker:    p1 −˜ p0 J p c1 − c0 BSi BSi X pBWi mBWi Tj BWi BWi 0 = γBWi αBW  DRBSi→Tj αBSi mTj +  p pBS mBS pBW p 0 BSi j=1 i i i BWi 4 Concluding remarks

[To follow]