ge_honeywell

8/3/2019 GE_Honeywell.

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GE - Honeywell

Vertical Mergers, Bundling andProtectionism


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Introduction

On July 3, 2001, the European Commission blocked a $42 billionmerger between General Electric and Honeywell.

The reason for blocking this merger centered around the economic

theory of bundling.

On October 22, 2000, this merger was announced. The US Departmentof Justice gave it the green light. However, the European Commissionalso had to approve it because of the size of the two firms Euro sales.The EC denied the merger on July 3 of 2001.


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The Players

General Electric

One of the largest corporations in the world, grossing over $125 billionin 2001

Among many other interests, GE produces aircraft engines bothindependently and through a 50-50 joint venture called CFMI withSNECMA, a French company

GE competes with Pratt & Whitney and Rolls Royce as well as IAE, ajoint venture between the two

Honeywell

Produces a basket of aeronautical products including avionics, starter

motors, auxiliary power supplies, engine accessories, wheels, brakes,etc.

Does not produce engines, however

Achieved market prominence through a series of mergers andacquisitions

Over half of $23 billion 2001 revenue came from aerospace division


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The EC must prove that the merger would lead to market dominance:

A position of economic strength enjoyed by an undertaking which enables it toprevent effective competition being maintained on the relevant market by givingit the power to behave to an appreciable extent independently of its competitors,

customers, and ultimately of consumers.

Market dominance exists if a firm can price in an anticompetitive manner.

A strange case because firms were neither competitors, nor did theyhave a vertical relationship.

Instead the Commission focused on potential problems arising fromhorizontal integration

The Case Against


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The Commissions rejection hinged on their assertion that because GEand Honeywell were market leaders in their respective aeronauticalfields, the merger would allow them to bundle complementary productsat unbeatable prices

Thus, they could price other firms out of business and then assume a

monopoly status

The Commission denied a proposal that would lowercosts toconsumers?

Yes, because the cause would be pricing efficiencies rather thanproduction efficiencies, which it viewed as anticompetitive

Potential increases in consumer surplus were shunned for fear of thepossibility of anticompetitive behavior down the road

The Case Against (cont.)


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Bundling: The Economics

Three Types of Bundling

1. Pure Bundling: Two products are only sold together. They are unavailableseparately.

a. Shoes. You need both a left and a right shoe, but normally you cannot buythem individually.

2. Tying: One item is available by itself and also in a bundle with another item that isunavailable alone.

a. New car options. You can pay more for leather seats when you buy a car, butyou cant go to the dealership and get them a la carte

3. Mixed Bundling: Items are available separately but also as a bundle at a reducedprice.

a. Meals at restaurants. Your burger, fries, and Coke cost less together whenyou order them as a meal.


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Bundling: The Economics (cont.)

Cournot first considered the concept of bundling.

Two independent monopolists selling complementary goods could makemore money if they merged or coordinated and lowered their prices. Theprice drop of each good would stimulate sales of the other.

You buy more jet engines because they are cheaper, so now you havemore incentive (and money) to purchase the avionics with which to operatethem.

This is a Pareto improvement: everyone is better off. More consumersserved and more company revenues.

Cournots example is the horizontal version of double marginalization.Instead of each firm extracting welfare from the one below it, firms harmdemand for complementary goods through their own high prices.


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Problems with Cournots model

The firms are alone in the market. Their merger does not undercut someone

else.

Instead of simply selling more products, mergers can be used as a weaponagainst the competition when more than two firms populate the market.

Aircraft engines and avionics are only a small percentage of the cost of theairplane. It is unlikely that cost savings here would prompt manufacturers toconstruct very many more planes.

Firms in this market stand to gain from a merger primarily through conqueringrivals market share

Firms set the same price to all customers.

Bundling advantages vanish in the presence of price discrimination andnegotiation

Airplane manufacturers are few and valuable to vendors like GE and Honeywell,so they have considerable power to negotiate


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Bundling Theory

Note: The following information is useful to us as students, but as we will see it will not

be relevant to the case

Four firms in the market Two firms A1 and B1 sell different versions of good 1 Two firms A2 and B2 sell different versions of good 2

Like an airplane manufacturer who needs avionics and engines, consumers in themodel must purchase both goods

Thus, there are four choices (A1, A2), (B1, B2), (A1, B2), (B1, A2)

Consumers will choose the package that best suits their preferences.

There are three possible market structures: All goods sold separately A1 and A2 bundle versus B1 and B2 bundle A1 and A2 bundle versus B1 and B2 separate


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Bundling Theory (cont.)

Case 1: All Firms ActI

ndependently This is the baseline. Assume profit is 1.

Case 2: Bundle Versus Bundle Profits fall by 50% Intuition: Cutting price brings the same number of incremental customers

as when selling individually, so bundle price must equal independent pricein equilibrium

Case 3: Bundle Versus Components Bundling reduces profits slightly (~10%)

Though it gives the bundler an advantage in market share, it comes at theprice of lower profits and it will not do it

Mixed Bundling Again, bundling firm sacrifices profits (~3%) for market share


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Bundling Theory (cont.)

The European Commission reached the conclusion that economic incentiveswould lead the firm to engage in mixed bundling

It is a robust conclusion that a firm that bundles has an advantage over rivals

More tenuous a conclusion, however, is whether a multiproduct firm has aneconomic incentive to bundle

This would depend of the number of products in the bundle, elasticity of totalmarket demand, relative importance of the products to the consumer, and otherfactors.

To make robust conclusions about the market, our models must likewise be

robust.

In the end, the Commissions issue was not the impact of bundling on socialwelfare, but its effect on competition in the future

The Commission believed that this merger would lead to rivals exiting themarket and the merged firms exploiting their dominant position


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Market Dynamics

Can we assume that competitors will not respond in any way to bundling? This is unrealistic Competitors could coordinate and offer a bundle of their own This would reduce profits, but it would also level the playing field

Firms may fear that the original bundler will use its higher profits to invest in capital

or R&D that will give it advantages in a repeated game Customers may drive competition to offer a bundle even against its will Customers win in bundle-to-bundle competition

Remember, customers in this market are powerful and could easily pressurecompetitors into offering a bundle

Advantages to bundling disappear when competitors offer a bundle of their own

Thus, a bundling firm must expect the competition to follow suit


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Negotiating Bundles

Previous discussion assumes that market prices are uniform to consumers

In aerospace industry, this is not the case Customers have power to negotiate prices with vendors Vendors also spend resources to gain information on customers

They know about their customers previous purchases and what kind ofproducts they are likely to require

This gives them negotiating power, too When customer type is know and prices are negotiable, bundling cannotlead to higher profits

If customers want some products from both firms, they wont bundle

Imposing a bundle on consumers will force firms to pay for one goods lost

profits with the money they make on the other

Firms profit only to the extent that their products are differentiated, which givesthem power over the consumer

Bundling has little effect when firms have good information because it mitigates

their power over consumers


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Empirical Evidence Against GE Dominance and Bundling

Initially, the EC claimed GE's dominant position in aircraft engines meant the

company retained a commanding market share of 52.5%

Resale of parts drops market share to 41%, which still assumes CFMI iscompletely attributed to GE, though it is a joint venture with SNECMA.

If half of CFMI is attributed to GE, consideration drops market share to 28%

(excluding planes in production).

In reality, CFMI only existed at the time to produce engines for Boeing 737s, soGE's control of it had no effect on market power.

Even if CFMI control did contribute to market power, SNEMCA would have toagree to bundling, and they have no incentive to aid Honeywell.

Ultimately, engine sales are only 20% of total plane sales, which essentiallyeliminates the possibility of an engine firm being dominant.


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Impracticality of Bundling for GE

In the cases cited as relevant by the EC, the "bundling" discountswere small and probably a result of price negotiation.

In fact, the cases that did involve bundling found it uselessin signing purchasers.

The only way to "bundle" in GE's situation would be to offer futurediscounts on Honeywell parts, but there would be no incentive to doso once the engine is sold, especially because price negotiationwould take place anyway.

In addition to the fact that competitors could fight back by bundlingthemselves, planes stay in service for 25 years, so they could stayin business for quite a while.


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Making a DecisionA Check List of Weights and Balances

1. Incentive to Bundle?

2. What is the immediate gain to consumers from lower prices?

3. What will be the impact on competitors?

4. How long do we expect these lower prices to persist?

5. If the rivals exit, what is the expected harm?

Developed by Carl Shapiro and the US Department of Justice


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What the EC Considered

1. Incentive to Bundle?

a. Under what circumstance does the combined firm earn higher profits througha bundled pricing strategy?

b. Did either firm have an opportunity to bundle prior to the combination? If so,

is there evidence that bundling is a common practice in this industry?

i. If we see bundling, then what is the marginal impact of increasing thepotential scope of the bundle?

ii. If we do not see bundling, then how do the opportunities created by thiscombination create a different incentive to bundle?


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Recap: The Issue with the Merger

1. GE-Honeywell Will Engage in Bundling Activities

Bundling enables significant price advantages

Long-run lower prices will increase market dominance.

Increased market dominance will decrease competition

Decreased competition will result in increased long-term pricesand decreased long-term consumer welfare


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A Remedy: Block Bundling Behavior

Enforce a "no-bundle discount" strategy: Individual price levels must be no greater than the price of a

bundle of the same goods

To aid enforcement, each firm would supply

a price list of each good a price list of all bundles of goods

Any discord with the "no-bundle discount" rule would be a violation,

punishable by the EC

Rejected on EC philosophy against Behavioral Remedies


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Conclusion

GE-Honeywell Merger is Blocked

Block was based on concerns that bundling would flourish,causing competition to decline

Claims that bundling would occur were dismissed

Still the EC ruled that bundling was the primary reason tostop the merger

A shining example of international protectionism

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