The comment by Gregory J. Werden (1991) on our paper, ‘Horizontal mergers: an equilibrium analysis (Farrell and Shapiro, 1990a) is largely based on a misunderstanding. We first address some general issues that he raises and then turn to the technical point that occupies most of his comment.

Policy and externalities

Werden writes that we ‘make the largely unqualified suggestion that current enforcement policy be replaced with an analysis based on the external effects of mergers’ (p. 368–9). We are not sure what he means by ‘largely unqualified’, but we do indeed believe, on general grounds, that an externality-based policy, if feasible, would be desirable.

The very basis of a market economy is to restrict government intervention to the minimum necessary. While economists differ considerably in what they believe to be necessary intervention, almost all would agree that externalities should constitute the main basis for intervention other than income-distribution concerns. Moreover, antitrust (including merger) policy that is not based on the analysis of externalities may prevent efficiency gains that may often outweigh the anticompetitive inefficiencies prevented by the antitrust policy (see Oliver Williamson, 1968). In our view, a serious obstacle facing current merger policy is that the regulators must try to evaluate, from the outside, the likely internal efficiencies resulting from a proposed merger.