Merger

HKKK TMP 38E050
Markku Stenborg 2005

1
Mergers and Acquisitions
Mergers are usually categorized by closeness of markets that
firms operate in
Horizontal merger
Merging firms operate in same relevant market, firms are
directly competing
Market shares in relevant markets change as result of
merger
Vertical merger
Merging firms operate at different stages of a production
or distribution chain
Firms products belong to same relevant market do not
compete horizontally
At least one firm can potentially be using the other firms'
products as inputs in its production
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4. Mergers and Acquisitions
Conglomerate merger
Mergers not belonging to those above
Product extension
Products of the firms not competing but firms use
close marketing channels or production processes
Market extension
Products are competing but relevant geographic
markets are separate
Pure conglomerate mergers (none of those mentioned)
Effects of Merger
Suppose duopoly which behaves competitively
Assume firms have identical cost functions and constant
returns to scale prevail
MC
1
= AC
1
, there are no fixed costs
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Profit maximization under perfect competition forces firms to
price at marginal cost: p
c
= MC
1
Case 1: Merger to monopoly and costs stay at original level
Profit maximization rule (MC = MR) implies output Q
m1

and price level p
m1
so that deadweight loss DL
1
takes
place
DL = (Q
c
- Q
m1
)(p
m1
- p
c
)/2
This is strict decrease welfare
Also, merger means an income transfer from customers
to owners of newco.
In this case, there would be reasons to block merger
Merger needs to be blocked for its deadweight loss
creating effect, not because it means income
redistribution
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Case 2: Merger involves synergies
Assume cost savings occur through decrease in marginal
costs
MC
1
decreases to MC
2
Monopoly profit maximization implies price level p
m2

which is lower than that without cost savings p
m1
Deadweight loss occurs, but it is smaller than that
without cost savings
DL = (Q
c
- Q
m2
)(p
m2
- p
c
)/2
Cost savings due to the decrease in MC
Amount is (p
c
-MC
2
)Q
m2
Efficiency is increased due to cost savings and decreased
due to market power - deadweight loss
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Case 2 illustrates typical situation in antitrust
Many types of decisions and conduct by firms may be
harmful for welfare while increasing it in other ways
From antitrust authority point of view, we face a trade-
off
To determine whether certain conduct or decisions to
merge are harmful on welfare, the authority should
compare gains and losses to welfare
In US, this seems to be the case, efficiency defence
In EU, efficiency gains are more of reason to block
merger, efficiency offense
Difference partly due to legislation?
Market dominance in EU
Significant lessening of competition in US
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Incentives for horizontal mergers
Salant, Switzer & Reynolds (QJE, 1982)
Merger in Cournot market
Assume an industry structure characterized by:
n identical firms (cost functions are identical)
Cournot or capacity competition
Constant returns to scale: C(q
i
) = C(q) = cq, c > 0
Linear demand is assumed linear: p(Q) = a - bQ, a,b > 0
No possibilities for entry
Profit function of any firm is then

Firm i's Cournot-Nash equilibrium profit is

j i j i i i i i i
q Q cq q Q q b a
=
E = + = , )) ( ( t
2
2
) 1 (
) (
+
=
n b
c a
cn
i
t
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Merger between any two firms: there is one firm less in the
industry than before
n firm industry changes into n-1 firm industry
Suppose m of n firms decide to merge (1 < m < n)
m firms have incentive to merge if being part of merged
entity gives more profit than staying unmerged, that is, if

that is if

Define LHS = A
2
2
2
2
) 1 (
) (
) 1 (
) (
1
1
+
>
+
+ n b
c a
m n b
c a
m
2 2
) 1 )( 1 ( ) 1 ( + + > + m n m n
0 1 2
2 2
> + + m n m nm
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Case 1: m=1

Notice that only if n=2, merger is profitable
Monopoly created
Hence, only if in duopoly both firms merge we have the
merger being in all firms' interest

Case 2: m=2

Notice that only if n=3, merger is profitable
This again means we have a monopoly being created
Only if in triopoly all firms merge, merger is in all firms'
interest
. 1 2
2
n n A + =
. 1 4
2
n n A =
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Case 3: m=5

If n=6, merger is profitable: monopoly created
But now even with n=7 merging is profitable
Creation of a duopoly through merger is profitable
With n=8, merger is again unprofitable

More generally
Notice that

which is < 0
Thus, A is decreasing in n, number of firms in industry
More there are firms before merger, other things equal, more
difficult it is for merger to be profitable for merging firms
. 19 10
2
n n A =
n m n A 2 2 / = c c
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Notice also that

which is > 0
Thus, A is increasing in m, number of firms that decide to
merge
More there are firms that take part in merger, other
things equal, easier it is for merger to be profitable for
merging firms
Irrespective of value of m or n, only if 80 % of firms in
industry takes part in merger, merger is profitable
Merger to monopoly is always in firms' interest
Typical Cournot model where nothing but number of firms
changes price level increases after merger
This follows from quantity competition since quantities are
strategic substitutes
m n m A 2 2 1 / + = c c
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Decrease in output by one firm is (partly) matched by an
increase in output by rival firm
In Cournot model, once some firms merge, they decrease
their total output, as they act as single firm
Firms not party to merger increase their output
Under many parameter values, firms which mostly benefit
from merger are non-merging firms
Business stealing effect
Model says that mergers are not usually profitable
Then we should not usually observe mergers, assuming that
firms are rationally behaving agents!
Not a good description of the real world where mergers are
taking place in increasing numbers
Model misses some essential aspects of the phenomenon
Mergers occur endogenously, not exogenously
Cost savings needs be incorporated

HKKK TMP 38E050
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In Salant et al. one reason for mergers being unprofitable
due to strategic substitutes
Decrease in production of some firms is matched by an
increase in production by the competitors
One way to overcome this effect is to assume U-shaped
costs (strictly convex costs)
Rivals have less incentive for expansion of production as
costs are increased
Mergers are more probable than in Salant et al
Mergers in Bertrand Market
In models above firms' strategies were quantities
Deneckere & Davidson (RJE 1985) merger incentives under
price competition
Prices are strategic complements
Price increase by some firms is matched by price increase
of rival firms
Reaction functions are upward sloping
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In differentiated products Bertrand model firms engage in
price competition
Price increase followed by merger is matched by price
increase of rivals
Reaction of outsiders reinforces initial price increase that
results from merger
Then merger of any size is beneficial for merging firms
No business stealing effect
Notice that this model predicts industries would usually
evolve into monopoly!
This, luckily, is not really what happens in real world
There seems to be forces which prevent monopolization
These forces are not easily modelled and simple models
do not descibe real world phenomena in satisfying way
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Notice that busines stealing effect is very much true in real
world
Often, firms benefiting from mergers are non-merging
firms
Thus, usually Cournot competition best describes real
world phenomena, this holds with merger theory as well
In preceding models acquiring and target firms were not
differentiated
Firms were black boxes, mere MC-functions
Only effect is reduction in number of (symmetric) firms
In real world acquisitions, there usually is buying and selling
side in transaction
Transaction creates a larger entity
Seller sets price based on many factors
Asset value of the firm
Expected evolution of industry (expected profits)
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Kamien & Zang (QJE 1990): In quantity competition, does
monopolization of industries take place when acquisition
process is endogenous?
In quantity game, total industry profit increases with a
decreasing number of firms
Any firm increases its profit as number of firms in industry
diminishes
This follows from the nature of Cournot competition
Seller knows that it would gain in profits if it would sell later
rather than sooner
As a consequence of this, sellers want to ask more than
buyers want to pay
Monopoly profit is maximum buyer can pay
In Cournot model following can be showed: complete
monopolization of an industry is possible only if originally
there were only a few firms in industry
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Welfare effects of mergers
Merger without cost savings reduces welfare; if merger
involves cost savings, we have trade-off
Farrell & Shapiro (AER 1990) is most thorough model on
welfare implications of horizontal mergers
Quantity competition and general demand structures
Cost-savings are allowed
Mergers without synergies increase price and hurt
consumers
Cost saving is proportional to post-merger output
Deadweight loss is proportional to output reduction
If cost saving outweigh the deadweight loss, net welfare
effect of merger is positive

HKKK TMP 38E050
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Merger simulation
Market definition is hard with differentiated goods and can
be misleading
Market definition is {0,1} decision, good is in or out
In reality goods belong to [0,1], they pose varying
degree of competitive pressure to each other
Increase in market power is interesting, not market
definition
Pure structural analysis of competitive effects can be
misleading
Simulation uses economic models grounded in theory to
predict effect of mergers on prices in relevant markets
Simulation allows direct measuring of changes in market
power
Easier than measuring of market power
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Simulation allows to evaluate likelihood of synergies
offsetting price increases
Simulation requires estimation of demands
Minimum: own and cross-price elasticities
Merger simulation: the big picture
Demand estimation
Create demand models
Get data and estimate demands
Calibrate demand model(s)
constant elasticity
linear
logit
AIDS, etc
to produce pre-merger prices, quantities, and demand
elasticities
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Calibrate model: set parameters so that it exactly
predicts pre-merger equilibrium
Plugging pre-merger prices into model must yield
pre-merger shares
Predict post-merger marginal costs
Try to evaluate synergies
Use demand model & post-merger costs to compute
post-merger prices
Idea: if post-merger prices are well above pre-merger
level, transaction increases market power
Measuring market power is hard
Market power = L
L = (p-c)/p e [0, 1/e] so that eL e [0, 1]
u has basically same info content as L
Quality of market power measure depends on accuracy of
estimates of marginal costs and demand elasticity
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Data and estimation problems lead to biased measure of
market power
Why would measuring changes in market power be easier?
Estimated price change reacts less to estimated MC or
demand, as we use same instrument to measure pre
and post-merger market power
Limitation of simulation: price increase predictions are
sensitive to functional form used for demand
Functional form of demand determines magnitude of
price increases from merger
Linear and logit demand yield smallest price increases
Constant elasticity and AIDS demand typically yield price
increases that are at least several times larger than those
with linear or logit demand
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Use calibrated models in manner that makes them
insensitive to functional form of demand
Compute compensating marginal cost reductions (CMCR)
that exactly offsets price-increasing effects
CMCRs do not depend on functional form of demand as
pre and post merger equilibrium prices and quantities are
precisely same
If merger synergies appear likely to reduce merging
firms cost as much as CMCRs, merger is unlikely to harm
consumers
If merger synergies clearly fall well short, significant
price increases are likely
Visit http://antitrust.org/simulation.html
Fool around with Linear Bertrand Merger
If you have access to Mathematica, take a look at
SimMerger to get feeling of what simulation is about

Merger

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Merger

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HKKK TMP 38E050

Markku Stenborg 2005

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