Transcript EC 170: Industrial Organization

Vertical and Conglomerate
Mergers
Chapter 17: Vertical and
Conglomerate Mergers
1
Introduction
• General Electric and Honeywell proposed to merge in
2000
– GE supplies jet engines for commercial aircraft
– Honeywell produced various electrical and other control systems
for jet aircraft
• Deal was approved in the US
• But was blocked by the EU Competition Directorate
– this was a merger of complementary firms
– it is “like” a vertical merger
– so can potentially remove inefficiencies in pricing
• benefiting the merged firms and consumers
– so why block the merger?
Chapter 17: Vertical and
Conglomerate Mergers
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Introduction 2
• Vertical mergers can be detrimental
– if they facilitate market foreclosure by the merged firms
• refuse to supply non-merged rivals
• But they can also be beneficial
– if they remove market inefficiencies
• Regulators need to look for the balance these two forces in
considering any proposed merger
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary Mergers
• Consider first a merger between firms that supply
complementary products
• A simple example:
–
–
–
–
–
–
final production requires two inputs in fixed proportions
one unit of each input is needed to make one unit of output
input producers are monopolists
final product producer is a monopolist
demand for the final product is P = 140 - Q
marginal costs of upstream producers and final producer (other
than for the two inputs) normalized to zero.
• What is the effect of merger between the two upstream
producers?
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary mergers 2
Supplier 1
Supplier 2
price v2
price v1
Final Producer
price P
Consumers
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary producers
 Consider the profit of the final producer: this is
pf = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q
 Maximize this with respect to Q
Solve this for Q
pf/Q = 140 - (v1 + v2) - 2Q = 0
 Q = 70 - (v1 + v2)/2
 This gives us the demand for each input
Q1 = Q2 = 70 - (v1 + v2)/2
 So the profit of supplier 1 is then:
p1 = v1Q1 = v1(70 - v1/2 - v2/2)
 Maximize this with respect to v1
Chapter 17: Vertical and
Conglomerate Mergers
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The price charged by
We need to solve
each supplier is a
function of theComplementary
other
producers these
2 two pricing
equations
supplier’s
price
1
Solve this for v
p = v1Q1 = v1(70 - v1/2 - v2/2)
1
 Maximize this with respect to v1
p1/v1 = 70 - v1 - v2/2 = 0
v1 = 70 - v2/2
 We can do exactly the same for v2 v2
140
v2 = 70 - v1/2
R1
v1 = 70 - (70 - v1/2)/2 = 35 + v1/4
so 3v1/4 = 35, i.e., v1 = $46.67
and v2 = $46.67
70
46.67
R2
46.67 70
Chapter 17: Vertical and
Conglomerate Mergers
140
v1
7
Complementary products 3
 Recall that Q = Q1 = Q2 = 70 - (v1 + v2)/2
so Q = Q1 = Q2 = 23.33 units
 The final product price is P = 140 - Q = $116.67
 Profits of the three firms are then:
supplier 1 and supplier 2: p1 = p2 = 46.67 x 23.33 = $1,088.81
final producer: pf = (116.67 - 46.67 - 46.67) x 23.33 = $544.29
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary products 4
Supplier 1
Now suppose that the
two suppliers merge Supplier 2
23.33 units @
$46.67 each
23.33 units @
$46.67 each
Final Producer
23.33 units @ $116.67 each
Consumers
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary mergers 5
Supplier 1
Supplier 2
price v
The merger allows the
two firms to coordinate
their prices
Final Producer
price P
Consumers
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary mergers 6
 Consider the profit of the final producer: this is
pf = (P - v)Q = (140 - v - Q)Q
 Maximize this with respect to Q
pf/Q = 140 - v - 2Q = 0
 Q = 70 - v/2
 This gives us the demand for each input
Q1 = Q2 = Qm = 70 - v/2
 So the profit of the merged supplier is:
pm = vQm = v(70 - v/2)
Solve this for
Q
 Maximize this with respect to v
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary
mergers 7
This is the cost of the combined
pm = vQm = v(70 - v/2)
The has
merger
has reduced
input: the merger
reduced
the final
product price:
costs to the final
producer
 Differentiate with respect to v
consumers gain
pm/v = 70 - v = 0
so v = $70
 Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units
 This gives the final product price P = 140 - Q = $105
This is greater
 What about profits? For the merged upstream
firm: than the
combined pre-merger
profit
pm = vQm = 70 x 35 = $2,480
 For the final producer:
pf = (105 - 70) x 35 = $1,225
This is greater than the
pre-merger profit
Chapter 17: Vertical and
Conglomerate Mergers
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Complementary mergers 8
• A merger of complementary producers has
– increased profits of the merged firms
– increased profit of the final producer
– reduced the price charged to consumers
Everybody gains from this merger: a Pareto improvement! Why?
• This merger corrects a market failure
– prior to the merger the upstream suppliers do not take full
account of their interdependence
– cut in price by one of them reduces downstream costs, increases
downstream output and benefits the other upstream firm
– but this is an externality and so is ignored
• Merger internalizes the externality
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical Mergers
• The same result arises when we consider vertical mergers:
mergers of upstream and downstream firms
• If the merging firms have market power
– lack of co-ordination in their independent decisions
– double marginalization
– merger can lead to a general improvement
• Illustrate with a simple model
– one upstream and one downstream monopolist
–
–
–
–
• manufacturer and retailer
upstream firm has marginal costs c
sells product to the retailer at price r per unit
no other retail costs: one unit of input gives one unit of output
retail demand is P = A – BQ
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 2
Marginal
costs c
Manufacturer
wholesale price r
Price P
Consumer Demand: P = A - BQ
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 3
• Consider the retailer’s decision
– identify profit-maximizing output
– set the profit maximizing price
Price
A
Demand

marginal revenue downstream is
MR = A – 2BQ
 retail marginal cost is r

equate MC = MR to give the
quantity Q = (A - r)/2B

identify the price from the demand
curve: P = A - BQ = (A + r)/2

profit to the retailer is (P - r)Q
which is pD = (A - r)2/4B
(A+r)/2
Retail
Profit
r
Man.
c Profit
A-r
2B
MC
MR
A/2B

profit to the manufacturer is (r-c)Q
which is pM = (r - c)(A - r)/2B
A/B Quantity
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 4

suppose the manufacturer sets a
different price r1
 then the downstream firm’s
output choice changes to the output
Q1 = (A - r1)/2B
Price
A
Demand

r1
r
A - r1
2B
and so on for other input prices
demand for the manufacturer’s
output is just the downstream
marginal revenue curve

MC
Upstream demand
MR
Quantity
A - r A/2B
A/B
2B
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 5
Price
A
Manufacturer Profit
(3A+c)/4
Demand
(A+c)/2
Upstream demand
c
(A-c)/4B
MRu
MR
A/4B A/2B
the manufacturer’s marginal cost is c
 upstream demand is Q = (A - r)/2B which
is r = A – 2BQ
 upstream marginal revenue is, therefore,
MRu = A – 4BQ
 equate MRu = MC: A – 4BQ = c

Retail Profit
MC
A/B

so Q*=(A-c)/4B the input price is (A+c)/2

while the consumer price is (3A+c)/4

the manufacturer’s profit is (A-c)2/8B

the retailer’s profit is (A-c)2/16B
Quantity
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 6
• Now suppose that the retailer and manufacturer merge
–
–
–
–
manufacturer takes over the retail outlet
retailer is now a downstream division of an integrated firm
the integrated firm aims to maximize total profit
Suppose the upstream division sets an internal (transfer)
price of r for its product
– Suppose that consumer demand is P = P(Q) The internal transfer
price nets out of the
– Total profit is:
• upstream division: (r - c)Q
• downstream division: (P(Q) - r)Q
• aggregate profit: (P(Q) - c)Q
profit calculations
• Back to the example
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 7
This merger has
 the integrated demand is P(Q) = A - BQ
benefited the two
This merger has
 marginal revenue is MR = A – 2BQ
Price firms benefited consumers

A
Demand
(A+c)/2
Aggregate
Profit
c
MR
(A-c)/2B
marginal cost is c
 so the profit-maximizing output requires
that A – 2BQ = c
 so Q* = (A – c)/2B
 so the retail price is P = (A + c)/2

aggregate profit of the integrated firm is
(A – c)2/4B
MC
A/B
Quantity
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger 8
• Integration increases profits and consumer surplus
• Why?
– the firms have some degree of market power
– so they price above marginal cost
– so integration corrects a market failure: double marginalization
• What if manufacture were competitive?
– retailer plays off manufacturers against each other
– so obtains input at marginal cost
– gets the integrated profit without integration
• Why worry about vertical integration?
– two possible reasons
• price discrimination
• vertical foreclosure
Chapter 17: Vertical and
Conglomerate Mergers
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Price discrimination
• Upstream firm selling to two downstream markets
– different demands in the two markets

v1
the seller wants to price
discriminate between these
markets
 set v1 < v2
v2

va
Market 1
P
Market 2
P
D1
Q
D2
Q
Chapter 17: Vertical and
Conglomerate Mergers
but suppose that buyers
can arbitrage
 then buyer 2 offers to buy
from buyer 1 at a price va
such that v1 < va < v2
 arbitrage prevents price
discrimination
 if the seller integrates
into market 1 arbitrage is
prevented
22
Vertical foreclosure
• Vertically integrated firm refuses to supply other firms
– so integration can eliminate competitors

suppose that the seller is supplying
three firms with an essential input

the seller integrates with one buyer

if the seller refuses to supply the other
buyers they are driven out of business

is this a sensible thing to do?
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 2
• Vertical foreclosure may reduce competition
– offsets benefits of removing double marginalization
• But for this to work
– foreclosure has to be a credible strategy for the merged firms
– foreclosure must be subgame perfect
• Consider two models of foreclosure
– Salinger (1988) with Cournot competition
– Ordover, Saloner and Salop (1990) with price competition
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 3
integrated
will
 Suppose that there are some integratedThe
firms
and somefirm
independent
upstream and downstream producersnot source on the independent
market
 Profit of an integrated firm is:
The integrated firm will
pI = (PD - cU - cD)qDi
not sell on the independent
market
 Profit of an independent upstream firm is:
pU = (PU - cU)qUn
 Profit of an independent downstream firm is:
pD = (PD - PU - cD)qDn
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 4
 For the independent upstream firms to survive requires PU - cU > 0
 The downstream unit of an integrated firm obtains input at cost cU
 Buying from an independent firm costs PU > cU
so the downstream divisions will not source externally
 Now suppose
that an upstream division of an integrated firm is
Profit from
this unit
is true:
selling to independent
downstream firms it earns PU - cU But
on each
soldso
selling
diverting output from
Profit from
 Divert internally
one unit to its downstream
division: this leaves the downstream
the external market
price unchanged: it earns PD -selling
cU - cD on this unit diverted
increases profits
externally
PD - PU - cD > 0 for independent downstream firms to survive
PD - cU - cD > PU - cU requires: PD - PU - cD > 0
so the upstream divisions will not sell externally
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 5
• Foreclosure happens
– but is not necessarily harmful to consumers
• reduces number of buyers in the upstream market
• increases prices charged by independent sellers to nonintegrated downstream firms
• but integrated downstream divisions obtain inputs at cost
• puts pressure on non-integrated downstream firms
– provided there are “enough” independent upstream
firms the anti-competitive effects of foreclosure will be
offset by the cost advantages of vertical integration
• There are also strategic effects that might prevent
foreclosure
– to discourage non-integrated firms from integrating
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 6
• The strategic aspects are considered in Ordover, Saloner
and Salop (OSS)
– suppose there are two downstream and two upstream firms
• downstream firms make differentiated products
• upstream firms make homogeneous products
– both sets of firms compete in prices
– suppose that U1 merges with D1
•
•
•
•
suppose also that they credibly refuse to supply D2
then U2 is a monopoly supplier to D2
U2 and D2 set prices reflecting double marginalization
so they may well choose to merge also
– but U1 and D1 can foresee this and may choose not to merge
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical foreclosure 7
• The OSS analysis thus far requires that there is no other
source of the input supply
– if there is such a source this will constrain U2’s price
• may make merger of U2 and D2 less likely
• Also, U1D1 may try to undermine the merger another way
– offer to supply D2 undercutting U2
– find a price such that U2 and D2 have no incentive to merge
– so complete foreclosure is avoided
• Note that there is a timing problem with this analysis
– U1 and D1 decide whether or not to merge
• if they do not the market continues as is
• if they do, they seek to undermine a merger of U2 and D2
– but if U1/D1 don’t merge U2/D2 have a strong incentive to merge
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical Merger and Oligopoly
• Implication: we need to consider a simultaneous model
– fear of vertical merger by one pair of firms might induce
vertical merger by other firms
– this might lead to a prisoners’ dilemma game
• vertical merger harms firms
• benefits consumers
• and is a Nash equilibrium for the merging firms
• Consider a (reasonably) simple model
– two upstream and two downstream Cournot firms
– downstream demand is P = A – BQ
– upstream firms’ marginal costs are cU and downstream firms’
marginal costs (excluding the upstream input) are cD
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 2
• Competition in three stages
– stage 1:
• upstream and downstream firms choose simultaneously
whether or not to merge
– U1 merges with D1 and/or U2 with D2
– stage 2:
• non-merged upstream firms compete in quantities
• merged upstream firms supply their downstream
divisions at marginal cost cU
– stage 3:
• downstream firms compete in quantities
• Three cases:
– no vertical merger; one vertical merger; two vertical
mergers
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 3
• Case 1: no vertical merger
– competition in the upstream market generates an
intermediate product price PU
– so downstream marginal cost is PU + cD
– Cournot equilibrium output of each downstream firm is
• q1D = q2D = (A – PU – cD)/3B
– Cournot equilibrium profit of each downstream firm is
• p 1D = p2D = (A – PU – cD)2/9B
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 4
• Aggregate output in the downstream market is derived
demand in the upstream market: QD = QU
– aggregate output is QD = QU = 2(A – PU – cD)/3B
– in inverse form PU = (A – cD) – 3BQU/2
– this is a standard linear demand p = a – bQ with a = (A – cD)
and b = 3B/2
– So Cournot equilibrium output of each upstream firm is
• q1U = q2U = [(A – cD) – cU]/(9B/2) = 2(A – cU – cD)/9B
– The equilibrium upstream input price is
• PU = (A – cD + 2cU)/3
– Profit of each upstream supplier is
• p1U = p2U = 2(A – cU – cD)2/27B
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 5
• Substitute for PU into the downstream equilibrium
– equilibrium downstream output is q1D = q2D = 2(A – cU –
cD)/9B
– equilibrium profit is p1D = p2D = 4(A – cU – cD)2/81B
• As expected, output of each upstream firm equals output of
each downstream firm
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 6
• Case 2: two vertical mergers
–
–
–
–
–
–
this is the simplest case
each downstream division has marginal cost cU + cD
and market demand is P = A – BQ
so Cournot equilibrium output downstream is
q1D = q2D = (A – cU – cD)/3B
and Cournot equilibrium profit of each downstream firm
(and so of each integrated firm) is
– p1D = p2D = (A – cU – cD)2/9B
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 7
• Case 3: One vertical merger
– suppose that U1 and D1 merge
– from the Salinger analysis the merged firm
• will not supply the non-merged downstream firm
• will not buy from the non-merged upstream firm
– suppose that U2 sets price PU for its intermediate product
• downstream firm 2 has marginal cost PU + cD
• downstream firm 1 has marginal cost cU + cD
• downstream demand is P = A – BQ
• so equilibrium Cournot outputs are
• q1D = (A – 2cU – cD + PU)/3B
• q2D = (A – 2PU – cD + cU)/3B
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 8
• Equilibrium downstream profits are
• p1D = (A – 2cU – cD + PU)2/9B
• p2D = (A – 2PU – cD + cU)2/9B
– We know PU > cU so the integrated downstream division has
greater output and profit than the non-integrated firm
– Output of the downstream non-merged firm is demand for
the upstream non-merged firm’s output: q2D = q2U
– so derived demand for the non-merged upstream firm is
• PU = (A – cD + cU)/2 – 3Bq2U/2
• this is linear of the form P = a – bq
• and upstream firm 2 is a monopoly supplier with marginal
cost cU
• so sets output (a – cU)/2b and price (a + cU)/2
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 9
– this gives the equilibrium upstream non-merged output:
• q2U = (A – cU – cD)/6B
– and price
• PU = (A + 3cU – cD)/4
– profit of the non-merged upstream firm is
• p2D = (A – cU – cD)2/24B
– using the equilibrium non-merged input price PU then gives
• q1D = 5(A – cU – cD)/12B
• q2D = (A – cU – cD)/6B
– equilibrium downstream profits are
• p1D = 25(A – cU – cD )2/144B
• p2D = (A – cU – cD )2/36B
– The merged division is larger and more profitable than the nonmerged firm
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 10
• We can now solve the first stage game
– calculate aggregate profits of an upstream and downstream
firm or an integrated firm
• merger will be suggested if it increases aggregate profit
–
–
–
–
note that all profits have the term (A – cU – cD)/B in common
so we can give this term any value
so assume that A = 100, B = 1 and cU = cD = 23
this gives the pay-off matrix:
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger and oligopoly 11

the perfect equilibrium is (Merger, Merger)
 this is a prisoners’ dilemma game
 Merger is dominant for both so timing is not important
Firms 2
No Merger
Firms 1
No Merger
Merger
Merger
$360, $360
$202.50, $506.25
$506.25, $202.50
$324, $324
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger - reappraisal
• Vertical merger has three effects in this model
– removes double marginalization
– reduces cost for a downstream integrated firm and makes
downstream market more competitive
– reduces competitive pressures in the upstream market
• In the model the first two effects dominate
– so consumers benefit from lower prices even with only one vertical
merger
– but in equilibrium the firms lose from vertical merger
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical merger – reappraisal 2
• Recall the proposed GE-Honeywell merger
– if this is the only merger then the merged firm gains and the
non-merged firms lose
• appears to be this that guided the EU Competition Directorate
• but consumers benefit even in this scenario
• and rivals have a clear strategic response: merge
– so the EU must have believed that merger by rivals was not
possible
• Or would be strategically prevented by GE-Honeywell
– and that if the integrated GE-Honeywell gains a monopoly
position price will rise
• Many believe that this was unlikely
• So the decision remains questionable
Chapter 17: Vertical and
Conglomerate Mergers
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Conglomerate Mergers
• Bring under common control firms whose products are
neither substitutes nor complements
– results in a diversified firm
– period from 1960s to early 1980s is when many were forms
• Is there a convincing rationale for this type of merger?
– if not then probably an accident of history
– gradually corrected by downsizing and focus on “core
competence”
• Possible rationales:
Chapter 17: Vertical and
Conglomerate Mergers
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Conglomerate mergers 2
• Economies of scope
– but these generally derive from use of common inputs
– so merged firms should be related in some respect
• similar markets
• similar technologies
– data do not support this hypothesis
Chapter 17: Vertical and
Conglomerate Mergers
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Conglomerate mergers 3
• Economize on transactions costs
– take a specialized machine can produce two goods A and B
• markets for A and B are concentrated
• if machine is used to produce only A there is spare capacity
– then owner may wish also to produce B – conglomeration
– the owner could also lease use of the machine to a
specialized B producer to avoid conglomeration
• but this has problems
– negotiating and bargaining over the lease
• conglomeration avoids these problems
– particularly important when the asset is knowledge intensive
– so this motive is reasonable
• but the assets are common to all the conglomerates products
• not supported by the data
Chapter 17: Vertical and
Conglomerate Mergers
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Conglomerate mergers 4
• Managerial motives
– conglomeration suits interests of management but not
shareholder
• division of ownership and control of large public corporations
• monitoring of management is far from perfect
• so management can pursue its own agenda to some extent
– suppose management compensation based on firm growth
• easier to grow by acquisition than internally
• horizontal merger may be blocked by regulators
• so grow by conglomeration
– conglomeration to reduce management risk
• diversified firm has diversified risk
• this diversifies the risk that management faces
• Seems to be supported by the evidence
Chapter 17: Vertical and
Conglomerate Mergers
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Empirical Application: Vertical Integration in
the Ready-Mixed Concrete Industry
• Ready-mixed concrete made by combining cement in
almost fixed proportion with sand, gravel and water.
• Also, because of high transport costs, concrete markets
tend to be very local
• So, this industry is a good place to test for the effects of
vertical integration because the standard modeling
assumptions are met and there are a lot of observations
• Hortaçsu and Syverson (2006) identify 348 local markets
for ready-mixed concrete over the years 1963 to 1997 and
use these to investigate the effects of vertical integration
Chapter 17: Vertical and
Conglomerate Mergers
47
Vertical Integration in the Ready-Mixed
Concrete Industry 2
Three Estimates of the Effect of Vertical Integration on Concrete Prices
Independent Variable
Effect on Weighted Average Market Price (log)
Market Share
of Vertically
Integrated Firms
-0.090*
(0.041)
-0.086*
(0.041)
-0.043
(0.039)
Market Share of
Multiple Plant Firms
____
0.015
(0.022)
0.001
(0.024)
Weighted Average
Total Factor Productivity _ _ _ _
R2
0.433
____
-0.293*
(0.054)
0.434
0.573
* Significant at five percent level.
Chapter 17: Vertical and
Conglomerate Mergers
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Vertical Integration in the Ready-Mixed
Concrete Industry 2
• Implications of Hortaçsu and Syverson (2006) results
– Vertical Integration appears to lower final prices by
anywhere from 4.3% to nearly 9%
– The effect appears to be due largely to higher productivity in
vertically integrated firms
– But has little to do with the operation of multiplant firms
• Basic Result: In Ready-Mixed Concrete, Vertical
Integration has been good for consumers and firms,
alike
Chapter 17: Vertical and
Conglomerate Mergers
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