Transcript Slide 1

6 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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6 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
– MC1 = AC1, there are no fixed costs
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6 Mergers and Acquisitions
• Profit maximization under perfect competition forces firms to price
at marginal cost: pc = MC1
• Case 1: Merger to monopoly and costs stay at original level
– Profit maximization rule (MC = MR) implies output Qm1 and
price level pm1 so that deadweight loss DL1 takes place
– DL = (Qc- Qm1)(pm1- pc)/2
– This is strict decrease in welfare
• Also, merger means income transfer from consumers 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 an income redistribution
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6 Mergers and Acquisitions
• Case 2: Merger involves synergies
– Assume cost savings occur through decrease in marginal costs
– MC1 decreases to MC2
– Monopoly profit maximization implies price level pm2 which is
lower than that without cost savings pm1
– Deadweight loss occurs, but it is smaller than that without cost
savings
– DL = (Qc- Qm2)(pm2- pc)/2
– There arwe now cost savings due to the decrease in MC
• Amount is (pc-MC2)Qm2
– Efficiency is increased due to cost savings and decreased due
to market power - deadweight loss
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6 Mergers and Acquisitions
• 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’s point of view, we face a trade-off
– To determine whether a merger (or certain conduct ) is 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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6.1 Incentives to Merge
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(qi) = 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
 i  (a  b(qi  Qi ))qi  cqi ,
Qi   j i q j
• Firm i's Cournot-Nash equilibrium profit is
 icn
(a  c) 2

b(n  1) 2
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6.1 Incentives to Merge
• 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
1
( a  c) 2
1  m b(n  m  1) 2
( a  c) 2

b(n  1) 2
• that is, if
(n  1) 2
 (m  1)(n  m  1) 2
– Define LHS = A
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6.1 Incentives to Merge
Case 1: m=1
A  2n  1  n 2 .
• Notice that only if n=2, merger is profitable
• This means we have monopoly being created
• Hence, only if in duopoly both firms merge we have the merger
being in all firms' interest
Case 2: m=2
A  4n  1  n 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
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6.1 Incentives to Merge
Case 3: m=5
A  10n  19  n 2 .
• If n=6, merger is profitable: monopoly is 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
A / n  2m  2n
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
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6.1 Incentives to Merge
• Notice also that
A / m  1  2n  2m
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
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6.1 Incentives to Merge
• Decrease in output by one firm is 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
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6.1 Incentives to Merge
• Mergers not being profitable as 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 the Salant et al
Mergers in Bertrand Market
• Merger incentives under price competition?
• Prices are strategic complements
– Reaction functions are upward sloping
– Price increase by some firms is matched by price increase of
rival firms
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6.1 Incentives to Merge
• In Bertrand model firms engage in price competition with
differentiated products
• Price increase by merged company is matched by price increase of
rivals
– Reaction of outsiders reinforces initial price increase that
results from merger
– Merger of any size is beneficial for merging firms
• No business stealing effect
• This model predicts industries would usually evolve into monopoly!
• This, luckily, is not really what happens in the real world
– There seems to be forces which prevents monopolization
– These forces are not easily modelled and simple models do not
descibe real world phenomena in satisfying way
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6.1 Incentives to Merge
• Busines stealing effect is very much true in real world
– Often, firms benefiting most 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 buyer, seller and target
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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6.1 Incentives to Merge
• Kamien & Zang (QJE 1990): In capacity competition, does
monopolization 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
– Sellers want to ask more than buyers want to pay
• Monopoly profit is maximum buyer can pay
– In Cournot model, complete monopolization of an industry is
possible only if originally there were only a few firms in
industry
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6.2 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 due to consolidation are allowed
– Mergers without synergies increase price and hurt consumers
– Cost saving is assumed proportional to post-merger output
– Then deadweight loss is proportional to output reduction
– If cost saving outweigh the deadweight loss, net welfare effect
of merger is positive
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6.3 Merger Simulation
• Market definition is hard with differentiated goods and can be
misleading
– Market definition is {0,1} decision, good is either ”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
• Simulation allows to evaluate likelihood of synergies offsetting
price increases
• Simulation requires estimation of demands
– Own and cross-price elasticities or changes in residual demand
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6.3 Merger Simulation
• Merger simulation: the big picture
– Demand estimation
• Create demand models
• Get data and estimate demands
• Calibrate demand model to pre-merger prices, quantities,
and demand elasticities
– Set parameters so that it exactly predicts pre-merger
equilibrium
– Plugging pre-merger prices into model must yield premerger shares
• Predict post-merger marginal costs
– Try to evaluate synergies
– Use demand model & post-merger costs to compute postmerger prices
– Idea: if post-merger prices are well above pre-merger level,
transaction increases market power
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6.3 Merger Simulation
• Measuring market power is hard in practice
– Market power = L = (p-c)/p  [0, 1/e] so that eL  [0, 1]
– Quality of market power measure depends on accuracy of
estimates of marginal costs and demand elasticity
– 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 postmerger market power
• Limitation of simulation: price increase predictions are sensitive to
demand specification
– Functional form of demand determines magnitude of price
increases from merger
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6.3 Merger Simulation
• One should 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
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7 Predation
• Predation = firm drives rival out of market by making it incur
enough losses and then raises prises
– Why would prey exit?
– Why would prey stay out after price increased?
– Can predator really recoup losses suffered during price war?
Does predation make sense?
– If predation is possible and profitable, how can we separate
innocent aggressive competition from predation as restriction
on competition?
• Most cases apply so-called Areeda-Turner test:
P < LRMC, P < LRAVC, or P < LRATC + some other indications
 predation
– Costs are hard to define and measure
– Predation rare in case law. But is it really that rare?
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7 Predation
Financial market imperfections
• Old ”deep pocket” theory: richly endowed predator would charge
low prices to drive out poorly endowed rival
– Ignores possibility that profit-seeking investors would finance
prey
• Relation between prey and its investors
– Predator seeks to manipulate that relationship and drive prey
out of market or deter expansion into new markets
– Pedatory strategy viable because of capital market
imperfections
– Investors face agency or moral hazard problems
– Managers may take excessive risks, shield assets from
creditors, dilute outside equity, fail to exert sufficient effort, or
otherwise fail to protect investors’ interests
– Suppliers of capital can mitigate these agency problems by
extending financing in staged commitments, imposing threat
of termination in case of poor performance
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7 Predation
• Debt-holders can threaten to liquidate firm or deny new
credit
• VCs can refuse to extend additional financing when early
performance is poor
• Shareholders can decline to purchase additional equity if
expected returns are low due to disappointing initial
performance
– Predatory pricing in product markets becomes possible when
predator exploits termination threats to dry up financing of
rival firm
• Agency problems are particularly acute in financing of new
enterprises
– Uncertainty about cash flow in early stages
– Losses may be unavoidable start-up costs or due to agency
abuse
– Mitigate moral hazard by agreeing to extend financing only
when firms’ initial performance is adequate
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7 Predation
• Predator may slash price to drain prey of sufficient funds to meet
its loan commitments, forcing default
• Predator can lower prey’s earnings to impair prey’s debt capacity
by limiting collateral it can put up
• Lower earnings may cause lenders to wrongly believe that firms’
profits are likely to be lower or riskier in future and therefore to
stiffen their lending terms
• Contract that minimizes agency problems will maximize incentive
to prey
Reputation
• Predator lowers prices to mislead prey and potential entrants into
believing that market conditions are unfavorable
– Decision to enter or exit is based on evaluation of expected
future revenues and costs
– Most firms contemplating entry or exit do not have all
information to determine future revenues and costs
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7 Predation
– If incumbent firm is better informed than others about cost or
other market conditions, it may be able to influence the
expectations
– Incumbent firm can manipulate and distort market signals
about profitability, and influence the expectations through
pricing decisions or other actions
• Predator seeks to establish reputation as price cutter, based on
some perceived special advantage or characteristic
– Reputation effects may be present when predator sells in two
or more markets or in successive time periods within same
market
– One market or period serves as demonstration market with
predatory conduct, and the other market or time period
provides recoupment market, where predator reaps benefits
– Reputation-induced belief reduces future entrant’s expected
return and may deter entry
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7 Predation
Signaling
• Better informed predator reduces price to convince prey that
market conditions are unfavorable
– Aggregate demand is too low to justify presence of both firms
in market or expansion by prey
– Prey inferring weak demand from low price may be deterred
from expanding or induced to leave market
– Less plausible than previous predatory strategies
• Test market and signal jamming theories plausible
• Victim lacks knowledge and experience in market
• Introduce new product or brand to probe market response by
entering a limited “test market”
• Predator may attempt to frustrate this market test by either of two
predatory strategies
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7 Predation
• Test market predation
– Predator secretly cuts price to reduce entrant’s sales in test
market
– Induce entrant to believe that demand is low
– Entrant abandons entry or enters on smaller scale
• Signal jamming
– Predator openly cuts price to distort test market results
– Entrant can observe demand for its product only under
exceptional circumstance of an ongoing price war
– Market test is foiled, and entrant is unable to determine
whether market demand for its product is sufficient to support
entry
• Cost signaling
– Predator drastically reduces price to mislead prey to believe
that she has lower costs
– Predator trying to establish a reputation for low cost cuts price
below the short run profit-maximizing level
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7 Predation
– Observing predator’s low price, prey rationally believes there is
at least probability that predator has lower costs
– Lowers prey's expected return and causes prey to exit
– Limiting factor in applying cost signaling theory is possible
inconsistency between low price, predatory bluffing and
subsequent recoupment
– Attempt to raise price risks revealing signaling to prey and
other potential entrants, causing them to upgrade estimates of
market profitability
Policy
• Proof of scheme of predation only establishess that identified
strategy is plausible
• Need to show
– Below cost pricing: avoidable or incremental cost, not AVC
– Recoupment
– Business justification?
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7 Predation
• Financial market predation
– Prey depends on external financing
– Financing depends on its initial performance
– Predation reduces initial performance and threatens preys
financing and viability
– Predator can finance predation internally or has better access
to external finance as prey
• Reputation
– Multimarket predator faces localized competition
– Predator faces threat of sequential entry
– Reputation reinforces predatory strategy or increases
probalility of future price cuts
– Entrant observes previous exit or other adverse experiences
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7 Predation
• Test market predation
– Predator observes prey’s attempt to experiment on limited
basis
– Predator cuts price below following or anticipating entry
– Price cut prevents prey from learning true demand conditions
• Cost signaling
– Predator might have lower or reduced costs
– Predator reduces price
– Prey believes that predator has lower costs
– Possible cost reduction is sufficient to exit, deter entry or limit
expansion
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8 Merger Case
Airtours / First Choice merger
• Commisson case No IV/M.1524, available through course web site
www.cea.fi/joe.htm
• Airtours and First Choice supply leisure travel services (package
tours) in UK and Ireland
• Vertically integrated into upstream (airline operation) and
downstream (travel agency) businesses
• Relevant market: short-haul foreign package holidays in UK
– European beach, ski and city destinations
– Long-haul (Florida, Caribbean, Thailand etc) is not substitute
for short-haul
• Different aircaft
• Less rotation of aircraft -> higher crew and catering costs
• Operating cost per passenger/mile
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8 Merger Case
• Sufficient demand to fill large aircraft -> match fleet
composition closely to mix of passengers between larger
(long-haul) and smaller (short-haul)
• Different image for consumers
• Longer flight time and jet–lag can reduce ’usable’ holiday
time
• Short-haul holiday typically much cheaper than
comparable long-haul
• Market shares
– Airtours
19.4 %
– First C.
15.0 %
– NewCo
34.4 %
– Thomson
30.7 %
– Thomas Cook 20.4 %
– Cosmos
2.9 %
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8 Merger Case
• Surprise prohibition decision
– Three firm ”oligopoly” 85.5 % market share
– In past, much fluctuation in market shares, and exit and entry
– Package holidays differentiated, branded, consumer products
– UK MMC incuiry few years earlier concluded market was quite
competitive despite increased concentration
• Low barriers to entry
– Is collusion really sustainable?
• Court of First Instance overturned Commission’s decision because
of lack of evidence, treatment of facts
– CFI seemed to accept Commission’s general policy
Could commission be right?
• ”Oligopolists” are now vertical integrated, ”competitive fringe” not
– Competitive fringe less able to challenge oligopoly
– Raises entry costs as entrants need to enter all stages of
production and distribution
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8 Merger Case
• Two-stage competition: 1) reserve capacity 12-18 months in
advance, 2) price competition
– Firms have strong incentive to sell full capacity
– Steep discounts when departure dates are approaching
– Temptation to deviate from collusive price are strong, and
threat of punishment within selling period not credible
– Package holidays heterogenous good
– Less likely to reach collusive prices
• Commission: collusion on capacity rather than prices
– Firms choose low levels of capacity
– Deviation: set high level of capacity
– Punishment: choice of high levels of capacity for one or more
period
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8 Merger Case
– Unlikely in many sectors, capacity decisions constrain firms for
long periods
• Punishments costly and delayed
– In this industry, capacity decisions are reviewed periodically
• Semicollusion: collude on some variables, compete on
others
• Could lead to more intense competition than Cournot or
Bertrand behavior
– Firms might observe each others’ capacity decisions
– Collusion on capacities can be consistent with economics
– But is collusion likely?
• Demand is volatile:
– Hard to separate demand shock from deviation
– What demand are rivals’ predicting?
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8 Merger Case
• Even if ”oligopolists” collude, competition from outsiders
and entry to increase capacity
• Court: Commission was wrong
– Joint dominance:
• Market must be sufficiently transparent for members of
oligopoly to monitor each other
• Punishment mechanism that ensures ‘common policy’ is
sustainable as there is a need to counter the incentive to
cheat
• Reaction of competitors and customers does not
undermine benefits expected from ‘common policy’
– Commission must produce convincing evidence that all three
conditions would be met in particular case
– Firms have ‘right to adapt themselves intelligently to the
existing and anticipated conduct of their competitors’
• Commission had confused ‘acceptable’ oligopolistic
interaction with tacit coordination in the decision
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8 Merger Case
– No credible punishment mechanism
– Commission did not prove that market was sufficiently
transparent for oligopolists to monitor capacity when capacity
decisions were taken
– Analyses of demand growth and demand volatility were
fundamentally flawed
– Commission failed to give weight to responses of fringe
players and consumers to postulated reduction in output and
increase in prices
• My interpretation: Commission tried to increase scope of
dominance concept
– In US, merger might have been blocked
– With new EU rules and more careful analysis, merger might
have been blocked
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