Chapter 8 Mergers

1
Chapter 8 Mergers
2
Introduction

• Merger mania is everywhere
• each week brings new announcements of
  mega-mergers
• Cingular/ATT Wireless
• Air France/KLM
• Why do mergers occur?
• need to become global
• response to other mergers
• search for synergies in operations
• increase in market power

3
Questions

• Are mergers beneficial or is there a need for
  regulation?
• the governments are particularly concerned with
  market power of the merged firms and potential
  cost advantages
• mergers might not be beneficial for society they
  operate like legal cartels

• Are all mergers the same or are there different
  types?

• horizontal

• vertical

• conglomerate

4
Horizontal mergers

• Merger between firms that compete in the same
  product market
• mobile operators
• airlines
• Begin with a surprising result the merger
  paradox
• take the standard Cournot model
• merger that is not merger to monopoly is unlikely
  to be profitable
• unless sufficiently many of the firms merge
• with linear demand and costs, at least 80 of the
  firms
• but this type of merger is unlikely to be allowed

5
An Example
? Assume 3 identical firms market demand P 140
- Q each firm with marginal costs of 20. The
firms act as Cournot competitors.
? Applying the Cournot equations we know that
each firm produces output q(3) (140 - 20)/(3
1) 30 units
the product price is P(3) 140 - 3x30 50
profit of each firm is p(3) (50 - 20)x30 900
? Now suppose that two of these firms merge
then there are two independent firms so output of
each changes to
q(2) (140 - 20)/3 40 units
price is P(2) 140 - 2x40 60
profit of each firm is p(2) (60 - 20)x40
1,600
? But prior to the merger the two firms had
aggregate profit of 1,800
This merger is unprofitable and should not occur
6
Example (cont.)
? Now suppose that all three firms merge.
? This creates a monopoly so that we have
output (140 - 20)/2 60 units
price (140 - 60) 80
profit p(1) (80 - 20)x60 3,600
? Prior to this merger aggregate profit was
3x900 2,700
Merger to monopoly is always profitable
7
A Generalization
N firms in the industry, of which M merge
A merger is only profitable if it includes a
large proportion of firms active in the industry.
If PA-BQ and MC c, then the merger is
profitable if at least 80 of the firms merge.
The merged firm becomes just like any other firm
in the market
All of the N - M 1 post-merger firms are
identical and so must produce the same output and
make the same profits
8
The Merger Paradox
Two effects
higher industry profits
- fewer firms
- the merged firms produce a lower proportion of
output than before
they get a lower proportion of industry profits
9
The Merger Paradox

• Why is this happening?
• the merged firm cannot commit to its potentially
  greater size
• the merged firm is just like any other firm in
  the market
• thus the merger causes the merged firm to lose
  market share
• the merger effectively closes down part of the
  merged firms operations
• this appears somewhat unreasonable
• Can this be resolved?
• give the merged firms some additional market
  power
• perhaps they can exercise market leadership
• need to alter the model somehow
• product differentiation
• Bertrand competition

10
Horizontal Merger and Leadership

• Suppose that when two firms merge they become
  Stackelberg leaders
• how does this affect merger profitability?
• what is the impact on consumers?

11
Merger and leadership an example
? Suppose that there are N identical Cournot
firms in the market
? Market demand is P 140 - Q and marginal cost
is 20
? Prior to the merger the Cournot equilibrium has
output of each firm 120/(N 1)
price PC (140 20N)/(N 1)
profit of each firm pC 14,400/(N 1)2
? Now suppose that 2 firms merge and become
market leaders
? The merged firm will produce the Stackelberg
output
QL (140 - 20)/2 60 units
12
The leadership example (cont.)
? There are N - 2 non-merged firms that act as
followers. The residual demand after
subtracting the leaders output is
P 140 QL QF 80 - QF
80 - 20
60
qF

So each follower produces
(N - 1)
N 21
? Total output is
60(N - 2)
60(2N - 3)
QT
60

(N - 1)
(N - 1)
40 20N
? Price is PL 140 - QT
(N - 1)
60
Price-cost margin is PL - 20
(N - 1)
13
The leadership example (cont.)
? Profit of the merged (lead) firm is
pL (PL - 20)QL
3,600/(N - 1)
? Profit of each non-merged (follower) firm is
pF (PL - 20)qF
3,600/(N - 1)2
The merged firm is always more profitable than
each non-merged firm
? Is the merger profitable for the merged firms?
Profit pre-merger was
2pC 28,800/(N 1)2
3,600
28,800
so pL gt 2pC requires
gt
which requires
(N - 1)
(N 1)2
(N 1)2 gt 8(N - 1)
This is always true for N gt 3
14
The leadership example (cont.)
? What about the effect of the merger on the
non-merged firms and on consumers?
? Profit pre-merger was
pC 14,400/(N 1)2
3,600
14,400
so pF gt pC requires
gt
which requires
(N - 1)2
(N 1)2
(N 1)2 gt 4(N - 1)2
This is only true for N lt 3
? The pre-merger price-cost margin is PC - 20
120/(N 1)
? The post-merger price-cost margin is PL - 20
60/(N - 1)
60
120
the merger reduces price if
lt
or 60N 60 lt 120N - 120
N - 1
N 1
This is true if N? 3
15
Mergers and Market Leadership

• A two-firm merger that creates a market leader is
  profitable for the merged firms if there are
  three or more firms in the market
• Moreover, such a merger
• increases the market share of the merged firms
• reduces profit and market share for each
  non-merged firm
• benefits consumers by reducing price
• So why worry about mergers?
• What might the non-merged firms do?
• Will they also seek merger partners?
• If so, what then happens to price and consumer
  welfare?

16
Mergers and leadership (cont.)

• So, consider more than one two-firm merger
• creates a series of merged firms
• and a series of non-merged firms
• How does leadership work here?
• merged firms compete against each other
• but as a group act as leaders relative to the
  non-merged firms

17
Mergers and leadership (cont.)

• Need to distinguish output decisions of the group
  of leaders (L) and the group of followers (F)
• stage game
• stage 1 each leader chooses its output level in
  competition with the other lead firms
• stage 2 followers see output decisions of the
  lead firms then choose their outputs with respect
  to residual demand in competition with other
  follower (non-merged) firms

18
An example of leadership (cont.)

• Starting from any configuration of leaders and
  followers a further two firms will always wish to
  merge.
• Is such a group of two-firm mergers desirable for
  consumers?
• firms that join the leader group increase output
• but there are fewer firms in the market
• So will a further two-firm merger increase or
  decrease output?
• output increases if there are not too many
  mergers
• if the demand is P 140 Q and MC 20, not
  more than 1/3 of firms in the industry should
  merge

19
Product differentiation

• Suppose firms are offering different varieties of
  a product
• the analogy is that these products have different
  locations
• then merger between some of these firms avoids
  some of the problems of the merger paradox
• dont have to close down particular locations
• but can coordinate prices and, perhaps, locations
• Many mergers like this
• join product lines that compete but do not
  perfectly overlap

20
The Spatial Model

• The model is as follows
• a market called Main Circle of length L
• consumers uniformly distributed over this market
• supplied by firms located along the street
• the firms are competitors, fixed costs F, zero
  marginal cost
• each consumer buys exactly one unit of the good
  provided that its full price is less than V
• consumers incur transport costs of t per unit
  distance in travelling to a firm
• a consumer buys from the firm offering the lowest
  full price
• What prices will the firms charge?
• To see what is happening consider two
  representative firms

21
The spatial model illustrated
Assume that firm 1 sets price p1 and firm
2 sets price p2
What if firm 1 raises its price?
Price
Price
p1
p2
p1
xm
xm
Firm 1
Firm 2
All consumers to the left of xm buy from firm 1
xm moves to the left some consumers switch to
firm 2
And all consumers to the right buy from firm 2
22
The Spatial Model

• Suppose that there are five firms evenly
  distributed

1
? these firms will split the market
r12
r51
? we can then calculate the Nash equilibrium
prices each firm will charge
2
5
? each firm will charge a price of p tL/5
r45
r23
? profit of each firm is then tL2/25 - F
4
3
r34
23
Merger of Differentiated Products
A merger of firms 2 and 4 does nothing
? now consider a merger between some of these
firms
A merger of firms 2 and 3 does something
Price
? a merger of non-neighboring firms has no effect
? but a merger of neighboring firms changes the
equilibrium
1
2
3
4
5
r51
r12
r23
r34
r45
r51
Main Circle (flattened)
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Merger of Differentiated Products
? merger of 2 and 3 induces them to raise their
prices
Price
? so the other firms also increase their prices
? the merged firms lose some market share
? what happens to profits?
1
2
3
4
5
r51
r12
r23
r34
r45
r51
Main Circle (flattened)
25
Spatial Merger (cont.)

• This merger is profitable for the merged firms
• And it is not the best that they can do
• change the locations of the merged firms
• expect them to move outwards, retaining captive
  consumers
• perhaps change the number of firms or products
  on offer
• expect some increase in variety
• But consumers lose out from this type of merger
• all prices have increased
• For consumers to derive any benefits either
• increased product variety so that consumers are
  closer
• there are cost synergies not available to the
  non-merged firms
• e.g. if there are economies of scope
• Profitability comes from credible commitment

26
Vertical Mergers

• Now consider very different types of mergers
• between firms at different stages in the
  production chain
• upstream firms produce inputs
• downstream firms produce the final good
• also applies to suppliers of complementary
  products
• These mergers turn out, in general, to be
  beneficial for everyone.

27
Vertical Mergers

• If the merging firms have market power
• lack of co-ordination in their independent
  decisions
• double marginalization
• merger can lead to a general improvement
• same principle as with producers of complementary
  goods (lecture 3)
• Illustrate with a simple model
• one upstream and one downstream monopolist
• manufacturer and retailer
• upstream firm has marginal costs 20
• sells product to the retailer at price r per unit
• retailer has no other costs one unit of input
  gives one unit of output
• retail demand is P 140 - Q

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Vertical merger (cont.)
Manufacturer
Marginal costs 20
wholesale price r
Price P
Consumer Demand P 140 - Q
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Vertical merger (cont.)

• Consider the retailers decision
• identify profit-maximizing output
• set the profit maximizing price

? marginal revenue downstream is MR 140 - 2Q
? marginal cost is r
Price
? equate MC MR to give the quantity Q (140 -
r)/2
140
Demand
? identify the price from the demand curve P
140 - Q (140 r)/2
(140r)/2
? profit to the retailer is (P - r)Q which is pD
(140 - r)2/4
? profit to the manufacturer is (r-c)Q which is
pM (r - c)(140 - r)/2
MCd
r
MCu
c
MR
Quantity
140
70
30
Vertical merger (cont.)
? suppose the manufacturer sets a different price
r1
Price
? then the downstream firms output choice
changes to the output Q1 (140 - r1)/2
140
Demand
? and so on for other input prices
r1
MCd1

• demand for the manufacturers output is just the
  downstream marginal revenue curve
• Qu (140 r)/2

MCd
r
Upstream demand
MR
Quantity
140
70
31
Vertical merger (cont.)
? the manufacturers marginal cost is 20
? upstream demand is Q (140 - r)/2 which is r
140 - 2Q
Price
? upstream marginal revenue is, therefore, MRu
140 - 4Q
140
? equate MRu MCu 140 - 4Q 20
110
Demand
and the input price is 80
? so Q 30
80
MCd
? while the consumer price is 110
Upstream demand
? the manufacturers profit is 1800
20
? the retailers profit is 900
MCu
MRu
MR
Quantity
140
70
35
30
32
Vertical merger (cont.)

• Now suppose that the retailer and manufacturer
  merge
• manufacturer takes over the retail outlet
• retailer is now a downstream division of an
  integrated firm
• the integrated firm aims to maximize total profit
• Suppose the upstream division sets an internal
  (transfer) price of r for its product
• Suppose that consumer demand is P P(Q)
• Total profit is
• upstream division (r - c)Q
• downstream division (P(Q) - r)Q
• aggregate profit (P(Q) - c)Q

The internal transfer price nets out of the
profits calculations

• Back to the example

33
Vertical merger (cont.)
This merger has benefited consumers
This merger has benefited the two firms
? the integrated demand is P(Q) 140 - Q
? marginal revenue is MR 140 - 2Q
Price
? marginal cost is 20
140
? so the profit-maximizing output requires that
140 - 2Q 20
? so Q 60
Demand
? so the retail price is P 80
80
? aggregate profit of the integrated firm is (80
- 20)x60 3,600
20
MC
MR
Quantity
140
70
60
34
Vertical merger (cont.)

• Integration increases profits and consumer
  surplus
• Why?
• the firms have some degree of market power
• so they price above marginal cost
• so integration corrects a market failure double
  marginalization
• What if manufacture were competitive?
• retailer obtains input at marginal cost
• gets the integrated profit without integration
• Why worry about vertical integration?
• two possible reasons
• price discrimination
• vertical foreclosure

35
Vertical foreclosure

• Vertically integrated firm refuses to supply
  other firms
• so integration can eliminate competitors

? suppose that the seller is supplying three
firms with an essential input
? the seller integrates with one buyer
? if the seller refuses to supply the other
buyers they are driven out of business
? is this a sensible thing to do?
36
Vertical foreclosure
The integrated firm will not source on the
independent market
? Suppose that there are some integrated firms
and some independent upstream and downstream
producers
The integrated firm will not sell on the
independent market
? Profit of an integrated firm is
pI (PD - cU - cD)qDi
? Profit of an independent upstream firm is
pU (PU - cU)qUn
? Profit of an independent downstream firm is
pD (PD - PU - cD)qDn
37
Vertical foreclosure
? The downstream unit of an integrated firm
obtains input at cost cU
? For the independent upstream firms to survive
requires PU - cU gt 0
? Buying from an independent firm costs PU gt cU
so the downstream divisions will not source
externally
? Now suppose that an upstream division of an
integrated firm is selling to independent
downstream firms
it earns PU - cU on each unit sold
PD - PU - cD gt 0 for independent downstream
firms to survive.
Thus, PU lt PD cD and so the integrated firm
earns less than PD - cD - cU
? Divert one unit to its downstream division
it earns PD - cU - cD on this unit diverted
so the upstream divisions will not sell externally
38
Vertical foreclosure (cont.)

• Foreclosure happens
• but is not necessarily harmful to consumers
• reduces number of firms in the downstream market
• but integrated downstream divisions obtain inputs
  at cost
• puts pressure on non-integrated downstream firms
• provided there are enough independent upstream
  firms (who can still provide inputs to
  independent downstream firms) the
  anti-competitive effects of foreclosure will be
  offset by the cost advantages of vertical
  integration
• There are also strategic effects that might
  prevent foreclosure
• to avoid non-integrated firms from integrating