chapter 11: horizontal mergers1 mergers. chapter 11: horizontal mergers2 introduction merger mania...

Chapter 11: Horizontal Mergers 1

Mergers


Introduction

• Merger mania of 1990s disappeared after 9/11/2001

• But now appears to be returning– Oracle/PeopleSoft

– AT&T/Cingular

– Bank of America/Fleet

• Reasons for merger– cost savings

– search for synergies in operations

– more efficient pricing and/or improved service to customers


Questions• Are mergers beneficial or is there a need for regulation?

– cost reduction is potentially beneficial– but mergers can “look like” legal cartels

• and so may be detrimental• US government is particularly concerned with these

questions– Antitrust Division Merger Guidelines

• seek to balance harm to competition with avoiding unnecessary interference

• Explore these issues in next two chapters– distinguish mergers that are

• horizontal: Bank of America/Fleet• vertical: Disney/ABC• conglomerate: Gillette/Duracell; Quaker Oats/Snapple


Horizontal mergers• Merger between firms that compete in the same product

market– some bank mergers– hospitals– oil companies

• 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


An Example Assume 3 identical firms; market demand P = 150 - Q; each firm with marginal costs of $30. The firms act as Cournot competitors. Applying the Cournot equations we know that:

each firm produces output q(3) = (150 - 30)/(3 + 1) = 30 unitsthe product price is P(3) = 150 - 3x30 = $60profit of each firm is (3) = (60 - 30)x30 = $900

Now suppose that two of these firms merge, thenthere are two independent firms so output of each changes to:

q(2) = (150 - 30)/3 = 40 units; price is P(2) = 150 - 2x40 = $70

profit of each firm is (2) = (70 - 30)x40 = $1,600

But prior to the merger the two firms had total profit of $1,800

This merger is unprofitable and should not occur


A Generalization Take a Cournot market with N identical firms.

Suppose that market demand is P = A - B.Q and that marginal costs of each firm are c.

From standard Cournot analysis we know the profit of each firm is:

Ci =

(A - c)2

B(N + 1)2

Now suppose that firms 1, 2,… M merge. This gives a market in which there are now N - M + 1 independent firms.

The ordering of the firmsdoes not matter


Generalization 2

Each non-merged firm chooses output qi to maximize profit:

i(qi, Q-i) = qi(A - B(qi + Q-i) - c)

where Q-i = is the aggregate output of the N - M firms excluding firm i plus the output of the merged firm qm

The newly merged firm chooses output qm to maximize profit:

m(qm, Q-m) = qm(A - B(qm + Q-m) - c)

where Q-m = qm+1 + qm+2 + …. + qN is the aggregate output of the N - M firms that have not merged

Comparing the profit equations then tells us:

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


Generalization 3 The profit of each of the merged and non-merged firms is then:

Cm = C

nm =(A - c)2

B(N - M + 2)2

The aggregate profit of the merging firms pre-merger is:

Profit of each surviving firmincreases with M

Ci =

M(A - c)2

B(N + 1)2

So for the merger to be profitable we need:

(A - c)2

B(N - M + 2)2>

M(A - c)2

B(N + 1)2this simplifies to:

(N + 1)2 > M(N - M + 2)2


The Merger Paradox Substitute M = aN to give the equation

(N + 1)2 > aN(N – aN + 2)2

Solving this for a > a(N) tells us that a merger is profitable for the merged firms if and only if:

a > a(N) = N

NN

2

4523

Typical examples of a(N) are:

N 5 10 15 20 25a(N) 80% 81.5% 83.1% 84.5% 85.5%

M 4 9 13 17 22


The Merger Paradox 2• Why is this happening?

– 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 firm’s

operations– this appears somewhat unreasonable

• Can this be resolved?– need to alter the model somehow

• asymmetric costs• timing: perhaps the merged firms act like market leaders• product differentiation

Chapter 12: Vertical and Conglomerate Mergers

11

Introduction• General Electric and Honeywell proposed to merge in

2000– GE supplies jet engines for commercial aircraft– Honeywell produced various electrical and other control systems

for jet aircraft• Deal was approved in the US• But was blocked by the EU Competition Directorate

– this was a merger of complementary firms– it is “like” a vertical merger– so can potentially remove inefficiencies in pricing

• benefiting the merged firms and consumers– so why block the merger?


12

Introduction 2

• Vertical mergers can be detrimental– if they facilitate market foreclosure by the merged firms

• refuse to supply non-merged rivals

• But they can also be beneficial– if they remove market inefficiencies

• Regulators need to look for the balance these two forces in considering any proposed merger


13

Complementary Mergers• Consider first a merger between firms that supply

complementary products• A simple example:

– final production requires two inputs in fixed proportions– one unit of each input is needed to make one unit of output– input producers are monopolists– final product producer is a monopolist– demand for the final product is P = 140 - Q– marginal costs of upstream producers and final producer (other

than for the two inputs) normalized to zero.• What is the effect of merger between the two upstream

producers?


14

Complementary mergers 2

Supplier 1 Supplier 2

price v1price v2

price P

Final Producer

Consumers


15

Complementary producers Consider the profit of the final producer: this is

f = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q

Maximize this with respect to Q

f/Q = 140 - (v1 + v2) - 2Q = 0

Solve this for Q

Q = 70 - (v1 + v2)/2 This gives us the demand for each input

Q1 = Q2 = 70 - (v1 + v2)/2 So the profit of supplier 1 is then:

1 = v1Q1 = v1(70 - v1/2 - v2/2) Maximize this with respect to v1


16

Complementary producers 2

Maximize this with respect to v1

1 = v1Q1 = v1(70 - v1/2 - v2/2)

1/v1 = 70 - v1 - v2/2 = 0

Solve this for v1

v1 = 70 - v2/2 We can do exactly the same for v2

v2 = 70 - v1/2

The price charged byeach supplier is a

function of the othersupplier’s price

We need to solvethese two pricing

equations

v2

v1

140

70

R1

70

140

R2

v1 = 70 - (70 - v1/2)/2 = 35 + v1/4so 3v1/4 = 35, i.e., v1 = $46.67

46.67

and v2 = $46.6746.67


17

Complementary products 3 Recall that Q = Q1 = Q2 = 70 - (v1 + v2)/2

so Q = Q1 = Q2 = 23.33 units

The final product price is P = 140 - Q = $116.67

Profits of the three firms are then:

supplier 1 and supplier 2: 1 = 2 = 46.67 x 23.33 = $1,088.81

final producer: f = (116.67 - 46.67 - 46.67) x 23.33 = $544.29


18

Complementary products 4


23.33 units @ $46.67 each

23.33 units @ $116.67 each

Final Producer

Consumers

23.33 units @ $46.67 each

Now suppose that thetwo suppliers merge


19

Complementary mergers 5


price v

price P

Final Producer

Consumers

The merger allows thetwo firms to coordinate

their prices


20

Complementary mergers 6 Consider the profit of the final producer: this is

f = (P - v)Q = (140 - v - Q)Q

Maximize this with respect to Q

f/Q = 140- v - 2Q = 0

Solve this for Q

Q = 70 - v/2 This gives us the demand for each input

Q1 = Q2 = Qm = 70 - v/2 So the profit of the merged supplier is:

m = vQm = v(70 - v/2)

Maximize this with respect to v


21

Complementary mergers 7m = vQm = v(70 - v/2)

Differentiate with respect to v

m/v = 70 - v = 0so v = $70

This is the cost of the combinedinput: the merger has reduced

costs to the final producer

Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units

This gives the final product price P = 140 - Q = $105

The merger has reducedthe final product price:

consumers gain

What about profits? For the merged upstream firm:m = vQm = 70 x 35 = $2,480

This is greater than thecombined pre-merger

profit For the final producer:

f = (105 - 70) x 35 = $1,225 This is greater than the

pre-merger profit


22

Complementary mergers 8• A merger of complementary producers has

– increased profits of the merged firms– increased profit of the final producer– reduced the price charged to consumers

Everybody gains from this merger: a Pareto improvement! Why?

• This merger corrects a market failure– prior to the merger the upstream suppliers do not take full

account of their interdependence– cut in price by one of them reduces downstream costs, increases

downstream output and benefits the other upstream firm– but this is an externality and so is ignored

• Merger internalizes the externality


23

Vertical Mergers• The same result arises when we consider vertical mergers:

mergers of upstream and downstream firms• If the merging firms have market power

– lack of co-ordination in their independent decisions– double marginalization– merger can lead to a general improvement

• Illustrate with a simple model– one upstream and one downstream monopolist

• manufacturer and retailer– upstream firm has marginal costs c– sells product to the retailer at price r per unit– no other retail costs: one unit of input gives one unit of output– retail demand is P = A – BQ


24

Vertical merger 2

ManufacturerMarginal costs c

wholesale price r

Price P

Consumer Demand: P = A - BQ


25

Vertical merger 3

• Consider the retailer’s decision– identify profit-maximizing output

– set the profit maximizing pricePrice

Quantity

DemandA

A/B

marginal revenue downstream is MR = A – 2BQ

MRA/2B

retail marginal cost is r

MCr

equate MC = MR to give the quantity Q = (A - r)/2B

A - r2B

identify the price from the demand curve: P = A - BQ = (A + r)/2

(A+r)/2 profit to the retailer is (P - r)Q which is D = (A - r)2/4B

profit to the manufacturer is (r-c)Q which is M = (r - c)(A - r)/2B

Retail

Profit

c

Man. Profit


26

Vertical merger 4

Price

Quantity

DemandA

A/B

MR

A/2B

MCr

suppose the manufacturer sets a different price r1

r1

A - r2B

then the downstream firm’s output choice changes to the output Q1 = (A - r1)/2B

A - r1

2B

and so on for other input prices

demand for the manufacturer’s output is just the downstream marginal revenue curve

Upstream demand


27

Vertical merger 5

Price

Quantity

Demand

A

A/B

MR

A/2B

the manufacturer’s marginal cost is c

Upstream demand

c MC

upstream demand is Q = (A - r)/2B which is r = A – 2BQupstream marginal revenue is, therefore, MRu = A – 4BQ

A/4B

equate MRu = MC: A – 4BQ = c

so Q*=(A-c)/4B

(A-c)/4B

the input price is (A+c)/2 (A+c)/2

while the consumer price is (3A+c)/4

(3A+c)/4

the manufacturer’s profit is (A-c)2/8B

the retailer’s profit is (A-c)2/16BMRu

Manufacturer Profit

Retail Profit


28

Vertical merger 6• 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 transferprice nets out of theprofit calculations

• Back to the example


29

Vertical merger 7

Price

Quantity

Demand

A

A/B

MR

the integrated demand is P(Q) = A - BQ

c MC

marginal revenue is MR = A – 2BQ

marginal cost is cso the profit-maximizing output requires that A – 2BQ = cso Q* = (A – c)/2B

(A-c)/2B

so the retail price is P = (A + c)/2(A+c)/2

This merger has benefited consumers

aggregate profit of the integrated firm is (A – c)2/4B

This merger has benefited the two

firms

Aggregate Profit


30

Vertical merger 8• 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 plays off manufacturers against each other– so obtains input at marginal cost– gets the integrated profit without integration

• Why worry about vertical integration?– two possible reasons

• price discrimination• vertical foreclosure

chapter 11: horizontal mergers1 mergers. chapter 11: horizontal mergers2 introduction merger mania...

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