International Think-Tank on Innovation and Competition
Should the EU Allow the Google-DoubleClick Merger?
January 28th, 2008
The merger between Google and DoubleClick, which is under the scrutiny of the EU in these days, will be a turning point in the fight to dominate the Internet. If approved, it’ll combine Google's dominance in pay-per-click Internet advertising with DoubleClick's dominance in ad serving services. Consumer groups and competitors have aggressively pushed regulators to reject the merger on the grounds that it would spawn a privacy nightmare, but it can be useful to examine the issue from a purely economic point of view.
When does a merger hurt consumers? A pre-condition for this is that the merger relaxes competition between two formerly independent firms and leads them to increase prices. Two further requirements are needed. First, the merger doesn’t create efficiency gains that may reduce unitary costs of production. Second, as emphasized by the theory of endogenous market structures (see for instance Welfare-Reducing Mergers in Differentiated Oligopolies with Free Entry by Nisvan Erkal and Daniel Piccinin or How Many Firms Should Be Leaders? Beneficial Concentration Revisited by Hiroaki Ino and Toshihiro Matsumura), it doesn’t attract the endogenously entry of new firms offering cheaper products. Of course, the extent to which a merger leads to increase the prices depends on multiple factors. First, high substitutability between the products of the merging firms brings higher incentives to increase post-merger prices (after all, firms producing unrelated goods would have no reasons to increase their prices). Second, when price-cost margins are high, it is more profitable to increase prices. Third, when the firms operate in a multi-sided market (as a software platform which charges both publishers and advertisers), a price change can optimize network effects between sides (increasing the value of the platform for both publishers and advertisers) leading to higher profitability.
What about the merger between Google and DoubleClick? Let us look for a horizontal overlapping between their markets. As well known, Google dominates the lucrative business of placing text ads next to search engine results: AdWords accounts for 70 % of search advertising revenue. DoubleClick leads a different business, that of placing banner ads on third-party publishers, accounting for more than 75 % of the reserved advertising channel, that is the valuable ad inventory that large web publishers directly negotiate with the advertisers. But this is not the end of the story, because most of the advertising space available on websites cannot be sold directly: therefore, most of it is typically sold through intermediaries that buy the so-called “remnant” ad inventory from web publishers and sell it to advertisers. In this huge “indirect” market our two companies have been strongly competing until today.
Google provides a vertically integrated intermediation platform between online publishers and advertisers: its AdSense reaches already more than 80 % of the revenue in the indirect channel with integrated ad networks. This platform targets advertising to the relevant websites (“contextual advertising”) and pays web publishers with a percentage of its revenues. Meanwhile, advertisers buy inventories from the platform through bids on the keywords that match the content of the webpages. In competition, DoubleClick offers an ad serving/management product, DART, for both publishers (DFP) and advertisers (DFA). The publisher tool, in particular, manages the inventory of a website, receives the ads from ad networks and delivers them in the relevant inventory (according to the behavioural history of internet users), usually for a small percentage of the price charged by the publishers on the advertisers. The market share of DFP is around 75 %. Now, since almost 60% of online advertising taking place through the indirect channel adopts integrated intermediation, Google controls about half of this global market and DoubleClick about a third of it. Together, they would control at least 80 % of the worldwide market for online advertising.
The two services offered by Google and DoubleClick are highly substitutable and, as a matter of fact, many web publishers use both for different inventories in the same website. Needless to say, for these publishers the two services are interchangeable: they can easily recode some space on the website served by one channel to be served by the other channel. Notice that switching to a different publisher tool involves high sunk costs in terms of investment in software, training of the staff, coding all of the publisher’s web pages, creating novel datasets, transferring ad campaigns to the system and more. These high switching costs, together with the difficulty for other companies to build alternative high quality intermediation services (even Yahoo! and Microsoft had a hard time), represent a substantial limit to endogenous entry of new firms in the short/medium run. Finally, notice that this merger could create efficiencies in the high fixed costs of production, but not in marginal costs for the simple reason that marginal costs in the software market are already close to zero. Consequently, any increase in mark-ups after the merger would be shifted on the prices.
The bottom line is simple. Before the merger, competitive forces kept prices under control: DoubleClick could not increase prices because many consumers would have quickly switched to AdSense, and vice versa. After the merger, these competitive constraints will disappear: Google will increase the price of DFP services, sure that most of the lost customers will switch to AdSense (other publisher tools would be penalized by the high switching costs). The profitability of the price increase would be enhanced further because of the high margins and of the network effects that Google could enjoy by increasing its market share (more publishers, more advertisers, more searches and so on). Moreover, Google could exploit the merger in its favour and against the competitors in other ways. For instance, DoubleClick uses a sophisticated algorithm to match ads to web pages, and reports information to advertisers: after the merger Google could bias the algorithm, favouring AdSense rather than other competitors. Finally, higher prices of DoubleClick may jeopardize competition and innovation of other firms competing with the Google’s integrated channel, and the dominance of Google after the merger would be strengthened once again. For these reasons the European Commission should be extremely careful in evaluating this merger, or in stating precise requirements for its approval. The dominance of Internet, the engine of the New Economy, is at stake.
