econ 4631- lecture 2 - university of washingtonevidence suggests that consumers demand a quite large...

Econ 4631- Lecture 2

Pat BajariUniversity of Minnesota

January 2009

Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 1 / 29

First readings

1 Chapter 2 of C&P2 Borenstein, Airline Mergers


Outline

1 The Neoclassical Model in 5 minutes2 Ownership and Control3 Separation of management and control4 Mergers


The Firm and Costs

The neoclassical model of the �rm has the following components:

1 Technology: A �rm transforms capital and labor into output2 Behavioral assumption: The �rm maximizes pro�ts3 Price taking assumption: output prices and input prices are exogenousto the �rm


The Firm and Costs

Let q denote the quantity produced, l labor and k capital

Let q = f (k, l) denote the production function

In the neoclassical model, a �rm de�ned by its production function

Let p be the price of q, w the wage rate and r the rental rate ofcapital


The Firm and Costs

Pro�ts are de�ned by:

pf (k, l)� wl � rk

First order conditions:

p∂f (k, l)

∂l= w

p∂f (k, l)

∂k= r

Marginal revenue product equals input price


The Firm and Costs

It is a short distance from this calculus to e¢ ciency.

First welfare theorem: Market allocations are e¢ cient, e.g. theinvisible hand works.

Second welfare theorem: Any e¢ cient allocation can be achieved bylump sum taxes/transfers.


Ownership and Control

The above model abstracts from many, many important andinteresting details about �rms

A �rst abstraction is that the person who owns the �rm is not usuallythe person operating the �rm

There are three basic forms of ownership in the U.S.

- sole proprietorships (single owner)

- partnerships (multiple owners)

- corporations



Corporations are most important in terms of aggregate activity

They account for 87 percent of business sales

Propriotorships tends to be small.

The �xed costs of incorporating are non-trivial

If propriotorships are successful, they may eventually incorporate

Partnerships are less common. However, they are the norm in someindustries, e.g. law �rms.



Why are coporations so dominant:

1 Limited liability- stock holders are not liable for debt with personalassets

2 Financing- the ability to issue shares is a source of cash

Start ups- business model is entry into a high risk/high return industry

Employees �nance the �rm in part by giving their labor at adiscounted rate

The employees receive stock, or options for stock, as part of theircompensation



3. Diversi�cation

Stock allows ownership to be split up into many small pieces

Shareholders can own stock in many companies

Don�t have all of your eggs in one basket

A presumption of modern economics and �nance is that people arerisk averse.

E.g. 500K with certainty is prefereable to $1 million with .5 probabiliyand zero with .5 probability.

Evidence suggests that consumers demand a quite large premium forassuming risk


Debt Holders Versus Stock Holders

Debt holders and Equity holders typically have di¤erent incentives

Example- Table 2 of the text

Debt holders prefer safer projects since they get less of the upside

Debt holders may restrict the actions of the equity holders- bondconvenants

Also, debt holders are the residual claimants to the �rm�s assets

Because of incentive problems, some e¢ cient deals may not get�nanced

Formally modeling these trade o¤s is the province of corporate �nance


Debt Holders Versus Stock Holders

A nice example of this is the run on money market funds inSeptember of 2008

Amount in money market funds fell from $3.535 trillion on September9, 2008

Fell to $3.288 trillion ten days later

Money markets involve short term borrowing including commercialpaper (short terms obligations by corporations) and short livedmortgage backed and asset backed securities


Debt Holders Versus Equity Holders

During this time, large �nancial institutions borrowed heavily usingmoney markets

The non-regulated part (e.g. Wall Street) was leveraged at rates of33 or 50 to 1

Leverage can allow for spectacular rates of return.

Suppose borrow from money market holders, pay them 4 or 4.5percent

You take the cash from money market holders and use it for trading



Suppose you can earn 8 percent rate of return in trading or otherinvestments

After you get done trading, you have 3.5-4 percent on your leveragedfunds

This is 3.5 percent on 50 times your underlying assets

This is a spectacular rate of return



However, the problem is that the persons running the �rm may betempted to take excessive risk

The borrower, because they have limited liability, cannot lose money

Basic �nance suggests high risk and high return are related

This is like playing heads I (the borrower) win, tails you (the lender)lose

Remark: These risks are all compounded when there is the perceptionthat banks can be bailed out.

Then the incentives of the bondholders to monitor the equity holdersare diminished.


Ownership Versus Control

There are similar problems between the owners of a �rm and thepeople who operate a �rm

In corporations, managers are often compensated by options

That is, for a �xed price, they will be able to purchase stocks at afuture date

On the one hand, stock options, make the manager care about the�rms pro�ts

However, the owners of the �rm only get dividends or the ordinaryrate of return on the stock

Managers get the rate of return on the options

The manager may prefer riskier investments, driving a wedge betweenthe incentives of owners and managers


Mergers

One important way that corporations grow and evolve is throughmergers

In 2007, $4.5 trillion dollars of announced mergers worldwide


Mergers

Why do mergers occur?

1 Di¤erences in e¢ ciency.

Cross �rm di¤erences in productivity explain 30-50 percent of outputin some data sets

2. Complimentarities

Related lines of business and coordination of e¤ortsDelta/NWA non-overlaping markets and complimentary �eets

3. Market power

Merging reduces competition and hence increases prices

4. Managerial incentives

Park (2008), Poorly run big �rms buy poorly run small �rmsHeads I win, tails you lose


Mergers

Empirically, mergers on average are a good deal for the acquiredcompany, a bad deal for the purchaser

Shareholders of acquired �rm get 16-25 percent premium

Acquiring �rm -3 percent premium in 80�s and 90�s (why did they doit??)

Overall shareholder value goes up 2 to 7.5 perent

Mergers are also pro-cyclical with stock prices (why buy when theprice is high???)


Event Studies

One way to assess if a merger enhances e¢ ciency is an event study

At time merger is announced, look at share price of competitors

If merger will weaken competition, share prices of competitors shouldgo up

If merger increases competition, share prices of competitors goes down


Case Study- Borenstein

Question: Did airline mergers in mid-1980�s result in increased ticketprices?

Two mergers- Northwest/Republic and TWA/Ozark

At MSP airport, NW and RC, accounted for 42 and 37 percent of theemplanements

High degree of overlap on routes �ow

In many cases, the only potential competitors on particular routes

TWA carried 57 percent of the tra¢ c from STL and OZ carried 25percent



Table 1 looks at price changes from 1985-1987

Holding distance �xed, what is the price of the route compared to thenational average

Compared to national average- this controls for nation wide trends

Use distance since this re�ects fuel costs- important operating expense



Bornstein weights prices by the number of passenger miles �own

The idea is that not all prices are equal

For example, Minneapolis to Chicago is more important thanMinneapolis to Salt Lake City

First period is probably before or during merger negotiations

Second period, agreement reached but before mergers

Third period, a yaer after the mergers took place



Minneapolis and St. Louis goes from one of the cheaper hubs to oneof the more expensive

11.4 percent change in Minneapolis and 8.6 percent change in St.Louis

Preliminary evidence that the mergers raised prices compared to anational benchmark



Table 2-Breaks it down by intensity of competition

Markets in which there is less competition has a greater price e¤ect

This was also present in market where NWA/RC did not competehead to head

Borenstein suggests potential competition is important as well asactual competition

Much of the price changes occured from 85 to 86- before the actualmerger

These results are typically "statistically sign�cant"

Results that are signi�cant at the 1 or 5 percent level are used asstandard that you can reject the hypothesis that the e¤ect was zero



Table 3- Gain in share from non-hub city

Consider the MSP to Chicago route

Fliers from Chicago are less locked into NWA

If NWA gains more in share from Chicago originations than MSPoriginations, this is consistent with it becoming more attractive

This was true for both mergers



Borenstein argues that airlines competed on load factors

Fewer passengers on the plane when competition was higher

Proxy for service quality

For both TWA and NWA, load factors went up and capacity wentdown on routes that previously had merger partner

Suggests that service quality went down while prices went up


econ 4631- lecture 2 - university of washingtonevidence suggests that consumers demand a quite large...

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