CROSS-BORDER MERGERS

AS INSTRUMENTS OF

COMPARATIVE ADVANTAGE

J. Peter Neary

University College Dublin and CEPR

www.ucd.ie/~economic/staff/pneary/neary.htm

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5. Cross-Border Mergers and Acquisitions

So far: Greenfield FDI only

BUT: Cross-border M&As are quantitatively much more important

Now: Oligopoly model essential (almost) • No: Barba Navaretti/Venables (2003), Nocke/Yeaple (2004), Head/Ries (2005)

• Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc.

• Here: Neary (2004)

Model of 2-country integrated market:• Cournot oligopoly

• Home: n firms with cost c; Foreign: n* with cost c*

• Absent mergers: “Cone of diversification” in {c, c*} space

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Cross-border mergers:• M&A’s a huge % of all FDI: more than greenfield FDI

• A high % of mergers are cross-border

• Cross-border merger waves linked to market integration[EU Single Market; Mercosur]

How to explain them?• I.O.:

• Strategic and efficiency motives

• All partial equilibrium

• Macro: Major innovationsJovanovic/Rousseau (2003)

• International Trade Theory: • Dominant paradigms: Competition (perfect/monopolistic)

• Needed: Oligopoly in GE

4

Plan

1. Specialisation Patterns in the Absence of Mergers

2. Myopic Mergers

3. Forward-Looking Mergers

4. General Oligopolistic Equilibrium:• Factor and Goods Markets: Ricardo + Cournot

• Demand: Continuum-Quadratic Preferences

5. Mergers in General Equilibrium

6. Mergers and Welfare

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1. Specialisation Patterns Without Mergers

• Consider a typical sector, in partial equilibrium• Homogeneous-good Cournot competition• 2 countries, integrated world market• Perceived linear demands: p = a - b x• Given numbers of firms at home & abroad: n, n*• Firms in each country have identical costs: c, c*• Equilibrium home sales:

n c a* ' 0 10

• Also holds with no foreign firms:

ya n c n c

b n n

' ( )

' ( )

* * *

*

1

1

c a c 0 01' ( ) *ca n c

n

' * *

* 1

• So: y>0

6

c

c*

a '

H firms unprofitable when n*=0

a '

7

c

c*

H firms unprofitablewhen n*>0

a '

a '

0 1a

a

n'

'*

c a c 0 01' ( ) *

8

c

c*

H firms profitable

a '

a '

a

n

'* 1

9

Symmetrically:c

c*

F firms profitable

a '

a '

a

n

'

1

a

n

'* 1

10

Equilibrium Production Patternsfor Arbitrary Home and Foreign Costs

c

c*

HF: Homeand foreignproduction

O: No home orforeign production

F: Foreign production only

H: Homeproduction only

a '

a '

a

n

'

1

a

n

'* 1

11

Fig. 4: Equilibrium Production Patternsin Free Trade without FDI

c O: No home orforeign production

~c

F: Foreign production only

H: Homeproduction only

c*

HF: Homeand foreignproduction

~*c

(c,c*;n,n*)=0

*(c,c*;n,n*)=0

12

c

c*

O: No home orforeign production

F: Foreign production only

H: Homeproduction only

Compare with perfect competition:

a '

a '

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2. Myopic Mergers

Assumption 1: Only bilateral mergers can occur.

Immediate gain from a merger:

Assumption 2: A merger will not take place if GFH is zero or negative.

Assumption 3: A merger will take place if GFH is strictly positive.

G n n n n n n n nFH ( , ) ( , ) ( , ) ( , )* * * * * * 1

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What are the incentives to merge?• No incentive if all firms are identical (and n+n*>2)

[Salant, Switzer, Reynolds (QJE 1983): “Cournot merger paradox”]

• Nor if the 2 merging firms are identical (and n+n*>2)[Proposition 1]

• Intuition:

• i.e., the profits of the acquiring firm would have to double for such a merger to be profitable

• Same for all firms like the acquiring firm

Myopic Mergers (cont.)

G n n n n n nHH ( , ) ( , ) ( , )* * * 1 2

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• BUT: Outputs are strategic substitutes

Myopic Mergers (cont.)

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• BUT: Outputs are strategic substitutes

Myopic Mergers (cont.)

• Removing a rival shifts down the reaction functions of all others

• Movement along own reac. func.

• So: Outputs and operating profits rise for all surviving firms (including the acquiring firm)

• Hence: If firms differ in cost, a low-cost/high-cost takeover may be profitable

yF

y F

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Proposition 2: If c>c*, a takeover by a foreign firm is profitable if the home firm has sufficiently high costs:

GFH>0 IFF:

Proof:

c a c 1 1 1 01 0' ( ) *

G y y yFH ( ) ( )* *1

20

202

( )( )* * * *y y y y y1 0 1 0 02

Lemma y y yn: * *1 0

10

10 1 0 0n y y y ny( )* *

c a c 1 11' ( ) *

1

2

2

2 1 2 1

2 1

( ) /

( ) ( )

( )

*n n n n n

n n 0

18

OFc

c*

HF

H

Incentives for foreign firms totake over home

1 a'

0a'

19

a–c

Fig. 5: The Components of Gainfrom a Cross-Border Acquisition by a Foreign Firm

*

Q R a–c*

GFH < 0

GFH > 0

20

OFc

c*

HF

H

Incentives for foreign firms totake over home

Incentives for home firms to

take over foreign

Similarly, GHF >0 IFF: c a c* * *' ( ) 1 11

1* 'a

Fig. 2: Takeover Incentives

1 a'

0a'

21

Fig. 6: Cross-Border Merger Incentives

Incentives for home firms to

take over foreign

c

c*

H

OF

HF

Incentives for foreign firms totake over home

=0

GFH=0

GHF=0

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Effects of one takeover on incentives for more?• All surviving firms have higher output and profits:

y y* > 0• Low-cost firms have higher output to begin with• So, their profits rise by more: GFH is decreasing in n

[Proposition 3]

• i.e., “Merger Waves” / “Domino Mergers”: =>• No high-cost firms survive• Mergers may not take place if n is large, even though

further mergers would be profitable• Encouraging “national champions” by promoting

domestic mergers in high-cost sectors makes foreign takeovers more likely (in the absence of cost synergies)

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5. Cross-Border Mergers and Acquisitions (cont.)

Merger gains:• For an acquisition of a home by a foreign firm:

GFH(c, c*; n, n*) = *(.) (.)

• Always negative between identical firmsSalant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox”

• Positive for a sufficiently large cost advantage

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5. Cross-Border Mergers and Acquisitions (cont.)

So: Autarky to free trade encourages cross-border M&As

Further results:

• GFH decreasing in n: Merger waves

• GFH decreasing in t (definitely for high t)So partial trade liberalisation encourages cross-border M&As

Empirical evidence: • Brakman/Garretsen/van Marrewijk (2005): Evidence in

favour of comparative advantage and merger waves

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a–c

Fig. 5a: Merger Waves:Effects of a Fall in n

*

Q R a–c*

R'

26

• Continuum of sectors, indexed z [0,1]• Ricardian cost structure:

c(z) = wz),

c*(z) = w*z)• Assume home more efficient in low-z sectors• 2 threshold sectors

[Perfect competition: c(z)=c*(z) is the threshold for specialisation]

4. General Oligopolistic Equilibrium

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Fig. 1: Equilibrium Production Patternsfor a Given Cost Distribution

c

c*

Foreign production only

Home and foreign

production

Homeproduction only

O

c*(0)

z z~

z 0

z 1

z z~*

c*(1)

c(0)

c(1)

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Demand

“Continuum-quadratic” preferences:

Max U x z ax z bx z dz[{ ( )}] [ ( ) ( ) ] 12

2

0

1

subject to: ( ) ( )p z x z dz I0

1

p z a bx za bIp

p

( ) [ ( )],12

• Objective demand functions: depend on income and all prices

• Summing over 2 countries => Linear subjective demand funcs:

p z a b x z a a a b b( ) ' ' ( ), ' ( ) / , ' / ,* *

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GOLE: The Full Model

Three nominal variables: w, w*,• Absolute values are indeterminate• Convenient normalisation: W=w, W*=w*

Full employment:

y z W W z(~, , ) , ~* 0 1

y z W W z* * * *(~ , , ) , ~ 0 0

Threshold sectors:

L L W W z ( , , ~)*

L L W W z* * * *( , , ~ )

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Assume symmetric countries:• n=n*, L=L*, etc. => W=W*Wage adjustment:• Expanding and contracting firms in both• BUT: High-cost firms contract by more• So: Demand for labour falls• Wages fall, dampening merger incentives

Threshold sectors:

5. Mergers in General Equilibrium

G W z W z a W z( ,~; ) (~) ( ) (~)*

1 0

Labour-market equilibrium:L L W z

( , ~ )

( )

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Fig. 3a: Simultaneous Determination of Wages and Threshold Sectors: The No-Mergers Equilibrium

W

L=L(.)

G(.; )0 0

~z 1½

G W z( ,~; )

0

L L W z

( , ~ )( )

~z0

W0

32

G W z( , ~; )

0

L L W z

( , ~ )( )

Fig. 3: Simultaneous Determination of Wages and Threshold Sectors

W

~z 1½

G(.; )0 0

G(.; )1 0G(.; )2 0

L=L(.)

~z0

W0

~z1~z2

W1

W2

33

F

Fig. 4: Wage Adjustments Dampen Cross-Border Merger Waves

c

c*

HF

O

H

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Partial-equilibrium intuition: W = CS + [Only changes in sectors where mergers occur matter]

1. Less competition Some prices CS 2. High-cost firms are eliminated

2. Dominates [Lahiri-Ono EJ 1988]

GE: Consumers are also profit recipients[Welfare is just the consumer’s (indirect) utility function]

1a. At given wages, only effect 1. matters U 2a. W all prices U

So: Full effect ambiguous in GE, but for different reasons from partial equilibrium

6. Mergers and Welfare

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~( )U a p 2 2

12

2 2 21

12

0 p

z

zp W z n n dz p W z n dz ( , ; , ) ( , ; , )*

~*

~

p W z n na nW z n W z

n nand p W z n

a n W z

n( , ; , )

( ) ( )( , ; , )

( )** *

**

* *

*

1

01

12

2

2 20d

dzp W z n n p W z n

p~ ( , ; , ) ( , ; , )* *

p W z n n p W z n( , ; , ) ( , ; , )* *0

b n

ny W z n n IFF y

'( , ; , ) (.)*

*

10 0

So: ~ ~( , ~ )

( )U U W z

At given wages, mergers (z~ ) raise prices in all sectors:

Mergers and Welfare (cont.)

Indirect utility:

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G W z( , ~; )

0

L L W z

( , ~ )( )

Fig. 5a: Mergers Increase Welfare

W

~z 1½

G(.; )0 0G(.; )1 0

G(.; )2 0

~( , ~ )

( )U U W z

E0

E2

E1

~(.)U U

L=L(.)

37

G W z( , ~; )

0

L L W z

( , ~ )( )

Fig. 5b: Mergers Reduce Welfare

W

~z 1½

G(.; )0 0G(.; )1 0

G(.; )2 0

~( , ~ )

( )U U W z

E0

E2

E1

~(.)U U

L=L(.)

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Conclusion

Cross-border mergers are “instruments of comparative advantage”:

• More specialisation• Welfare may rise

Despite:• Reduced competition in many sectors• Redistribution from wages to profits

Empirical predictions: • Trade liberalisation increases FDI• Absent cost synergies, low-cost firms acquire high-

cost foreign rivals• FDI & trade are complements

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Conclusion

• Cross-border M&As encouraged by trade liberalisation

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