HKKK TMP 38E050 © Markku Stenborg 2005 1 4. Mergers and Acquisitions Mergers are usually categorized by closeness of markets that firms operate in Horizontal

HKKK TMP 38E050

© Markku Stenborg 2005

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4. 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

– MC1 = AC1, there are no fixed costs

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4. 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 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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4. 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 – 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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4. 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 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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4. Mergers and AcquisitionsIncentives 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(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

• Firm i's Cournot-Nash equilibrium profit is

jijiiiiii qQcqqQqba ,))((

2

2

)1(

)(

nb

cacni

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4. Mergers and Acquisitions• 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

nb

ca

mnb

ca

m

22 )1)(1()1( mnmn

012 22 mnmnm

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4. Mergers and AcquisitionsCase 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

.12 2nnA

.14 2nnA

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4. Mergers and AcquisitionsCase 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

.1910 2nnA

nmnA 22/

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4. Mergers and Acquisitions• 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

mnmA 221/

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4. Mergers and Acquisitions• 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

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4. Mergers and Acquisitions• 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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4. Mergers and Acquisitions• 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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4. Mergers and Acquisitions• 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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4. Mergers and Acquisitions• 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

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4. Mergers and AcquisitionsMerger 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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4. Mergers and Acquisitions• 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, etcto produce pre-merger prices, quantities, and demand elasticities

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4. Mergers and Acquisitions• 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 [0, 1/e] so that eL [0, 1]– 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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4. Mergers and Acquisitions– 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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4. Mergers and Acquisitions• 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

Documents

HKKK TMP 38E050 © Markku Stenborg 2005 1 4. Mergers and Acquisitions Mergers are usually categorized by closeness of markets that firms operate in Horizontal