ECON3: AQA June 2011: Question 6:

As always with exam questions, the key is to understand exactly what the question is asking. In this case it is relatively straight forward, we need to be able to explain what benefits there are for the firms and the consumers if two firms merge (note that the question specifically says “such as the one proposed between British Airways and Iberia Airlines”. This means, whilst the case study is about this proposed merger, you can talk about others and you will be well credited for them. Once again showing that having good examples to use in exams will be well rewarded.) as well as explaining what disadvantages there might be for both and then evaluate this.

In very basic terms, what are the potential advantages and disadvantages of mergers.

Clearly this question is about mergers, so I would start by explaining exactly what this means:

Phil Hensman @PhilsEconomics

A merger occurs when two separate companies come under the control of one board of directors. There are a number of examples, the most common of which include horizontal integration, where firms at the same stage of production come together and vertical integration where firms from different stages of production come together.

It is very important that we don’t lose sight of the question and start spouting irrelevant theory, so:

Clearly in the case of BA and Iberia, these companies provide the same service to customers, so this would be an example of a horizontal merger.

Examiners, when they are marking, are looking for candidates to hit certain levels, up to a maximum of Level 5. This is the criteria for Level 3:

To some extent this can be achieved by including a relevant diagram and linking it back to the question. Therefore it is really important to get an explained diagram into your answer as quickly as possible. Once you have done this, the examiner is

looking for examples of Level 4 work:

And then comes Level 5:

Phil Hensman @PhilsEconomics

So, back to the question, at this point, I would put in a relevant diagram with a good explanation of why it is relevant to the question.

Currently BA has 44% of landing slots at Heathrow Airport, the largest and busiest airport in the UK (evidence of wider knowledge of this industry), in legal terms, this is already considered to be a

legal monopoly, so, merging with Iberia, and therefore increasing this share, the monopoly power that it could exercise would be further enhanced.

When a firm dominates a market, such as when it has monopoly power, it allows them to set an output level where it can maximise profit. It would choose to produce at an output level where marginal cost is equal to marginal revenue (PMO), and, as shown in the diagram by the shaded area, would have the ability to make supernormal profit (the profit above that which is expected by the entrepreneur for organising the factors of production and taking risks.) Clearly this is very good for the companies involved in the merger. (Here I’m letting the examiner know that I am keeping

Phil Hensman @PhilsEconomics

the question in mind and that everything I am writing is relevant to the question. If I find I have written a paragraph that I can’t link back to the question, it’s a wasted paragraph.)However, the extent to which this is beneficial to the consumer is questionable. When a company has a monopoly, it is likely to face a relatively inelastic demand curve, as consumers have little alternative, so are likely to take have to take the high prices offered by the monopoly. If this market were more contestable, (which clearly it isn’t as BA own many of the landing slots at Heathrow, meaning other firms face large barriers to entry) then the price is more likely to be determined closer to where demand is equal to average cost, much lower than R1, the price set by a monopoly facing a relatively uncontestable market. This means that consumers are facing much higher prices, and as such this situation can not claim to be ‘good for consumers’ (Hello Mr Examiner, I’m still sticking to answering the question and putting in lots of relevant economics…).

However, whilst in the short term (I’m evaluating now, as I’m not assuming there is a constant answer, I’m considering different scenarios, which could lead to different outcomes) the consumers face higher prices, there is the possibility that in the long term these supernormal profits could be reinvested by the company into either new, improved services, such as new aircraft, offering faster, more comfortable, more fuel efficient flights, and these cost savings could be passed onto the consumer in the form of lower prices, if the firm wishes to be dynamically efficient. Alternatively, it is possible that this profit is used to give out larger dividends to shareholders, in which case the benefits to the consumer are not evident. (My use of language is key here to receiving marks for evaluation. For more information on this, read the following: The Hat Of Generalisation ) The likelihood of the firm wishing to be dynamically efficient would probably depend (a great word for showing evaluation, last year I had a student who would always write this in capital letters to let the examiner know that he was evaluating… He got an A. #justsayin) upon the level of competition that they face on each route, the more competition they face, the less likely they are to be complacent about how they treat their customers. Therefore, we can determine that it is possible that mergers could be beneficial to consumers. (Yes Mr Examiner, I’m still here, doing what I do best…. Answering the question)

Along with this, by growing in size there is a possibility that the newly created firm could benefit from Economies of Scale, through their increased output. These could include purchasing economies of scale, through bulk buy discounts, which could be further enhanced by the fact that the new firm may also now have more monopsony power when it comes to buying their factors of production and therefore could lead to lower average costs; or it could come in the form of managerial economies of scale, however this could come at some cost. It is likely that if the firms do merge that there would be a number of duplicate roles which managers fulfil for both companies, which could mean some redundancies. Whilst these cost reductions would clearly be beneficial to the producer (still on track in terms of answering the question) the extent to which consumers would find this beneficial would depend upon if these cost savings are passed onto the consumer in the form of price cuts, or if the firm would just keep more profit.

Of course, it is also possible that once merged, the firm could have become large enough to suffer from diseconomies of scale, where this may see the average costs of the firm grow. This could be down to the firm having a lot of employees and communication becoming increasingly difficult or staff becoming disillusioned or demotivated by having new bosses who do not necessarily understand the culture operating in the previous firm. This is quite likely to happen in this particular case, as the two companies are from different countries, with different languages, which clearly are likely to enhance these difficulties, which are likely to have negative implications for the consumer as well as the producer, as higher costs are likely to mean higher prices.

It is also evident that the firms would attempt to make cost savings by some European routes being ‘rationalised’. Again, if these cost savings are passed onto consumers in the form of reduced prices, clearly there are benefits, but this would also see less planes flying routes within Europe, less competition and less choice for the consumer, which could result in higher prices and therefore is probably not going to be of benefit to the consumer as much as the producer.

Phil Hensman @PhilsEconomics

(Time for me to conclude my findings, and the key thing to do here is to go back to the question and answer it.)Whilst it is clear that there are many possible advantages and disadvantages to both the consumers and the companies involved, on balance (showing that I’m weighing up the arguments) it is fairly clear that the vast majority of the benefits fall to the producers, and even if the merger goes wrong, any problems will see the consumer and the producer suffer, whereas any benefits will be for the producer, which may be passed onto the consumer, but there are no guarantees of this. The extent to which the benefits fall to the consumer will be largely determined by the regulators, and, as the European Union’s Competition Commissioner stopped a merger between BA, Iberia and AA in 2009, as they felt it would raise prices and reduce consumer choice, it is highly likely they would reach the same conclusion again. Therefore it can be concluded that, whilst there is a possibility that this merger could result in benefits to consumers, it is far more likely that the producers will benefit.

Here is the whole essay without the annotations:

A merger occurs when two separate companies come under the control of one board of directors. There are a number of examples, the most common of which include horizontal integration, where firms at the same stage of production come together and vertical integration where firms from different stages of production come together.

Clearly in the case of BA and Iberia, these companies provide the same service to customers, so this would be an example of a horizontal merger.

Currently BA has 44% of landing slots at Heathrow Airport, the largest and busiest airport in the UK, in legal terms, this is already considered to be a legal monopoly, so, merging with Iberia, and therefore increasing this share, the monopoly power that it could exercise would be further enhanced.

Phil Hensman @PhilsEconomics

When a firm dominates a market, such as when it has monopoly power, it allows them to set an output level where it can maximise profit. It would choose to produce at an output level where marginal cost is equal to marginal revenue (PMO), and, as shown in the diagram by the shaded area, would have the ability to make supernormal profit (the profit above that which is expected by the entrepreneur for organising the factors of production and taking risks.) Clearly this is very good for the companies involved in the merger.

However, the extent to which this is beneficial to the consumer is questionable. When a company has a monopoly, it is likely to face a relatively inelastic demand curve, as consumers have little alternative, so are likely to take have to take the high prices offered by the monopoly. If this market were more contestable, (which clearly it isn’t as BA own many of the landing slots at Heathrow, meaning other firms face large barriers to entry) then the price is more likely to be determined closer to where demand is equal to average cost, much lower than R1, the price set by a monopoly facing a relatively uncontestable market. This means that consumers are facing much higher prices, and as such this situation can not claim to be ‘good for consumers’.

However, whilst in the short term the consumers face higher prices, there is the possibility that in the long term these supernormal profits could be reinvested by the company into either new, improved services, such as new aircraft, offering faster, more comfortable, more fuel efficient flights, and these cost savings could be passed onto the consumer in the form of lower prices, if the firm wishes to be dynamically efficient. Alternatively, it is possible that this profit is used to give out larger dividends to shareholders, in which case the benefits to the consumer are not evident.

The likelihood of the firm wishing to be dynamically efficient would probably depend upon the level of competition that they face on each route, the more competition they face, the less likely they are to be complacent about how they treat their customers. Therefore, we can determine that it is possible that mergers could be beneficial to consumers.

Phil Hensman @PhilsEconomics

Along with this, by growing in size there is a possibility that the newly created firm could benefit from Economies of Scale, through their increased output. These could include purchasing economies of scale, through bulk buy discounts, which could be further enhanced by the fact that the new firm may also now have more monopsony power when it comes to buying their factors of production and therefore could lead to lower average costs; or it could come in the form of managerial economies of scale, however this could come at some cost. It is likely that if the firms do merge that there would be a number of duplicate roles which managers fulfil for both companies, which could mean some redundancies. Whilst these cost reductions would clearly be beneficial to the producer the extent to which consumers would find this beneficial would depend upon if these cost savings are passed onto the consumer in the form of price cuts, or if the firm would just keep more profit.

Of course, it is also possible that once merged, the firm could have become large enough to suffer from diseconomies of scale, where this may see the average costs of the firm grow. This could be down to the firm having a lot of employees and communication becoming increasingly difficult or staff becoming disillusioned or demotivated by having new bosses who do not necessarily understand the culture operating in the previous firm. This is quite likely to happen in this particular case, as the two companies are from different countries, with different languages, which clearly are likely to enhance these difficulties, which are likely to have negative implications for the consumer as well as the producer, as higher costs are likely to mean higher prices.

It is also evident that the firms would attempt to make cost savings by some European routes being ‘rationalised’. Again, if these cost savings are passed onto consumers in the form of reduced prices, clearly there are benefits, but this would also see less planes flying routes within Europe, less competition and less choice for the consumer, which could result in higher prices and therefore is probably not going to be of benefit to the consumer as much as the producer.

Whilst it is clear that there are many possible advantages and disadvantages to both the consumers and the companies involved, on balance it is fairly clear that the vast majority of the benefits fall to the producers, and even if the merger goes wrong, any problems will see the consumer and the producer suffer, whereas any benefits will be for the producer, which may be passed onto the consumer, but there are no guarantees of this. The extent to which the benefits fall to the consumer will be largely determined by the regulators, and, as the European Union’s Competition Commissioner stopped a merger between BA, Iberia and AA in 2009, as they felt it would raise prices and reduce consumer choice, it is highly likely they would reach the same conclusion again. Therefore it can be concluded that, whilst there is a possibility that this merger could result in benefits to consumers, it is far more likely that the producers will benefit.

Phil Hensman @PhilsEconomics