Mergers

Types of Mergers
Horizontal: merger between two competitors.
Goods are substitutes.

Vertical: merger between two firms at different stages of the production process.
Goods are complements.

Conglomerate: no clear substitute or complementary relationship.

Why so many mergers?

Economies of scale: both in production and in things like R&D. Economies of scope: synergies between the two companies. Defensive mergers: to deal with contracting markets, excess capacity. Decrease competition: these are the mergers that antitrust is worried about.

How successful are mergers?

Studies of past merger waves have shown that two of every three merger deals have not worked. Why? Real world -- not economic theory.
Linking distribution systems is often difficult. Information systems often very difficult to mesh together. Clash of corporate cultures.

The Merger Paradox

Assume firms are merging to decrease competition (no cost advantages).
For horizontal mergers only 2 motives, economies of scale or decreasing competition.

Start with a basic Cournot model. If firms are symmetric, then profit of each firm is (a-c)2/b(n+1)2.

Merger Paradox cont

Start with n firms:
i = (a-c)2/b(n+1)2

Then m of the firms merge together to make (n - m +1) firms in the market. After merger, profits for each firm are:
i = (a-c)2/b(n-m+2)2

Less competition, but have profits for the combined firm increased or decreased?

Merger Paradox cont

Is (a-c)2/b(n-m+2)2 greater than or less than m*(a-c)2/b(n+1)2 ?
Get rid of the (a-c)2/b terms on both sides and rearrange to get this condition:

Only profitable for the combined firm if (n+1)2>m(n-m+2)2

Mergers cannot raise the profitability of the firms engaged in the merger even if 50% of the firms are involved in the merger.

Merger Paradox cont

According to this model, almost no mergers are profitable.
Those that are probably wouldn't make it past the antitrust authorities.

Intuition behind the model:

Free-rider effect -- decreasing the number of firms raises industry profit and per firm profit, but combined firms get relatively smaller share of the industry.

Merger Paradox cont

Why is this not the best model to look at?
Assumes firms are identical and that the merged firm has no advantages other than it is facing fewer competitors.

Merged Firm as a Stackelberg Leader

If the merged firm becomes a Stackelberg leader, it can improve its position. Assume 2 firms merge and act as a industry leader a la Stackelberg.
Leader gets (a-c)2/4b(n-1). Each follower gets (a-c)2/4b(n-1)2.

Compare this to premerger:

= 2 * (a-c)/b(n+1)2

Merged Firm as a Stackelberg Leader, cont

Always more profitable to merge if you can act as a Stackelberg leader.
Merger decreases profits of non-merging firms are long as there are four or more firms in the industry originally.

In this model, total output will increase.

So now we have a new paradox: Why would antitrust officials want to stop this type of merger?

Horizontal Mergers with Product Differentiation

Spatial model of product differentiation Possible benefits of merger.
Coordinate prices: price of one firm affects the demand for the other firm. Also can coordinate "location" (product design).

Start with a circle model this time, not a linear model.

Mergers with Product Differentiation, cont

Circle model similar to linear model, except there is no "end" problem.
Consumers evenly spaced around the circle. Each has a value of V and a cost of transport of t.

All firms have the same costs. F is fixed cost and c is constant marginal cost. Each firm sets price.

Mergers with Product Differentiation, cont

Consumers pay p + t(distance traveled) With symmetric firms, they locate 1/n away from each other, all set the same price. As long as V is sufficiently high, every consumer on the circle will buy. P* = t(length of circle)/n At this price, all consumers buy.

Mergers with Product Differentiation, cont

Merger has no effect if the two firms aren't neighbors.
Why? no competition between the firms that merge, so no way to decrease competition.

If neighboring firms merge, can lessen competition. Have "captive consumers" over which they have more market power and can increase profits by raising price.

Mergers with Product Differentiation, cont

Merger also benefits the other firms in the market -- allows them to raise price too. After the merger, combined firms may also change their product lines -- get closer to their neighbors. In this case, if there are efficiencies, they will be due to economies of scope.

Evaluating Mergers
None of the models presented assume any cost savings -- only reducing competition. We need a way to evaluate mergers that considers both the benefits of any cost savings as well as the affects of decreased competition.

1992 Merger Guidelines:

Define relevant product and geographic market. Measure concentration pre- & post- merger with HHI. If merger raises HHI by 100 points and post-merger HHI is > 1000, investigate further. Assess ease of entry into market. Assess likely competitive effects of merger. Assess any significant efficiencies that would result from the merger.