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Horizontal Mergers

Horizontal Mergers. ECON 4100: Industrial Organization. Lecture 15. Introduction. Why do mergers occur? Example The Merger-paradox Merger and leadership: an example. Introduction. Merger mania is everywhere each week brings new announcements of mega-mergers AOL/Time-Warner

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Horizontal Mergers

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  1. Horizontal Mergers ECON 4100: Industrial Organization Lecture 15

  2. Introduction • Why do mergers occur? • Example • The Merger-paradox • Merger and leadership: an example

  3. Introduction • Merger mania is everywhere • each week brings new announcements of mega-mergers • AOL/Time-Warner • Compaq/Hewlett-Packard • Vodafone/Mannesman • Exxon/Mobil (biggest one in US ever?) • Is someone buying Disney now??? • each year seems to break the record of the year before

  4. Introduction • Why do mergers occur? • many reasons have been suggested relating to costs and market power (merger is the ultimate type of collusion!) But let us look first at the different types of mergers

  5. Questions • Horizontal merger (they make the same product, they join or one absorbs the other: a takeover ) • Complementary merger (different but related goods) • Vertical merger (companies at different stages of the production stream come together) backwards (buy the producer of your input) forwards (buy a seller of your output) • Diversification merger (conglomerates, completely unrelated products )

  6. Why do mergers occur? • Reasons for merger are many • need to become “global” • response to other mergers • search for synergies in operations (exploiting economies of scale and/or scope) to achieve cost savings (but remember that increased concentration can also lead to increased X-inefficiency) • To increase market dominance (so that they can charge a higher price)

  7. Why do mergers occur? • If mergers come in waves, mergers might be correlated. Some say that this is because companies, concerned about uncertainty, want to “defend” against it by using merger behavior, becoming bigger. This is tricky to prove as we cannot really measure uncertainty. But it would be another reason to explain mergers

  8. Why do mergers occur? • Friendly takeovers. Most often takeover bids are not fought off • Actually often the sold company wants to be taken over (the owner gets old etc.) • But also big companies ask to be bought. They fear that it will happen sooner or later, so they approach a company they would not mind being associated with. • Not all takeovers are aggressive (well, only in the movies )

  9. Why do mergers occur? • Now we see a financial motive… • If you buy a smaller “loser” firm (full of debts) you get it cheap and tax regulations make it a good idea, since you can deduct those liabilities you acquire against the tax bill for your successful current company • Basically the company is worth to you more than its book value, than the price you have to pay

  10. Why do mergers occur? • Sometimes mergers cannot be really explained because firms try to increase profits • These days there is often a separation between ownership and control (shareholders own the firm but professionals run it) • Profit might not be the driver for the managers (their income is more related to perhaps size)

  11. Why do mergers occur? • corporate growth enhances the social prominence, public prestige, and political power of senior executives. Rare is the CEO who wants to be remembered as presiding over an enterprise that makes fewer products in fewer plants in fewer countries than when he or she took office • even when such a course increases productivity and adds hundreds of millions of dollars of shareholder value. • The perquisites of the executive suite can be substantial, and they usually increase with company size • (Michael Jensen, Eclipse of the Public Corporation Harvard Business Review, Sept-Oct1989, pp. 61-74)

  12. Why do mergers occur? According to Robin Marris, managers are interested in both: • the Valuation ratio (the ratio of the value according to the public, the value of total shares, over the accounting value in the books of the companies’ assets) • the growth rate of the firm But shareholders want only the highest possible valuation ratio (remember that the idea of the expected future income from the firm is embedded in the price of the shares) Shareholders want the value of the shares to grow as much as possible relative to the book value of assets

  13. Why do mergers occur? According to Robin Marris, managers are interested in both: • the Valuation ratio Because high valuation ratios will protect your firm (and your job!) from takeover, but managers also want to have a high… • growth rate of the firm They are, to a certain extent willing to trade one for the other

  14. Why do mergers occur? Manager’s preferences (strictly convex and with a minimum V ratio, which shows where the firm is in real danger of takeover) V ratio V min Growth rate

  15. Is there a relationship between Valuation ratio and Growth rate? If we do not grow we are probably passing by good investment opportunities => we pass by opportunities to increase Valuation ratio If we grow, we exploit this investment opportunities, increasing Valuation ratio But the marginal profitability decreases as we grow and grow, right? Let us see

  16. Why do mergers occur? The growth rate that the shareholder wants V ratio The growth rate that the manager wants V min Growth rate

  17. Why do mergers occur? Managers want to grow faster than the shareholders want to grow Individual shareholders have less of a voice relative to the managers’ to get their way It is likely that companies tend to take over other firms at a higher rate than is optimal for the shareholders

  18. Why do mergers occur? Pure stock market myopia can help explain some mergers: If people think that the “whole is worth more than the sum of its parts”, when a conglomerate is buying other firms, the shareholders will feel better about that conglomerate and bid up the price of their stocks This increases the stock prices/earnings ratio for that conglomerate. If they now acquire an additional firm with a lower stock price/earnings ratio, by exchanging their own stock for the other firm’s stock… Everyone gains in the short run!  This is a pure financial motive, there are no real gains for anyone in the long run

  19. Why do mergers occur? Sometimes firms just want to get bigger for its own sake This might have been more applicable in the old days with firm owners feeling that they owned some sort of “empire” rather than a firm that was supposed to maximize profits

  20. Other questions • Are mergers beneficial or is there a need for regulation? • the US government is particularly concerned with these questions • anti-trust website • mergers might not be beneficial: they operate like legal cartels

  21. Horizontal mergers • Let us focus on mergers between firms that compete in the same product market… • We begin with a surprising result: the merger paradox • take the standard Cournot model • merger that is not merger to monopoly is unlikely to be profitable • unless “sufficiently many” of the firms merge • with linear demand and costs, at least 80% of the firms • but this type of merger is unlikely to be allowed

  22. An Example Assume 3 identical firms; market demand P = 140 - Q; each firm with marginal costs of $20. The firms act as Cournot competitors. Applying the Cournot equations we know that: each firm produces output q(3) = (140 - 20)/(3 + 1) = 30 units the product price is P(3) = 140 - 3x30 = $50 profit of each firm is p(3) = (50 - 20)x30 = $900 Now suppose that two of these firms merge then there are two independent firms so output of each changes to: q(2) = (140 - 20)/3 = 40 units; price is P(2) = 140 - 2x40 = $60 profit of each firm is p(2) = (60 - 20)x40 = $1,600 But prior to the merger the two firms had aggregate profit of $1,800 This merger is unprofitable and should not occur

  23. Example (cont.) Now suppose that all three firms merge. This creates a monopoly so that we have: output = (140 - 20)/2 = 60 units price = (140 - 60) = $80 profit = p(1) = (80 - 20)x60 = $3,600 Prior to this merger aggregate profit was 3x$900 = $2,700 Merger to monopoly is always profitable

  24. A Generalization  Take a Cournot market with N identical firms. Suppose that market demand is P = A - B.Q and that marginal costs of each firm are c. From standard Cournot analysis we know that the profit of each firm is: (A - c)2 The ordering of the firms does not matter pCi = B(N + 1)2 Now suppose that firms 1, 2,… M merge. This gives a market in which there are now N - M + 1 independent firms.

  25. Generalization (cont.) The newly merged firm chooses output qm to maximize profit, given by pm(qm, Q-m) = qm(A - B(qm + Q-m) - c) where Q-m = qm+1 + qm+2 + …. + qN is the aggregate output of the N - M firms that have not merged Each non-merged firm chooses output qi to maximize profit: pi(qi, Q-i) = qi(A - B(qi + Q-i) - c) where Q-i = is the aggregate output of the N - M firms excluding firm i plus the output of the merged firm qm Comparing the profit equations then tells us: the merged firm becomes just like any other firm in the market all of the N - M + 1 post-merger firms are identical and so must produce the same output and make the same profits

  26. Generalization (cont.) The profit of each of the merged and non-merged firms is then: Profit of each surviving firm increases with M (A - c)2 pCm = pCnm = B(N - M + 2)2 The aggregate profit of the merging firms pre-merger is: M.(A - c)2 M.pCi = B(N + 1)2 So for the merger to be profitable we need: (A - c)2 M.(A - c)2 > this simplifies to: B(N - M + 2)2 B(N + 1)2 (N + 1)2> M(N - M + 2)2 M > 0.8N for this inequality to be satisfied

  27. The Merger Paradox • The merged and non-merged firms, after the merger, get the same profit, sell the same output, at the same price. • The non-merged firms become better-off after the merger because now they earned market share (just by sitting back and relaxing!) As Stigler put it: merger should receive every form of encouragement from other firms, short of participation • The new merged firm rarely gets more profit after the merger than the sum of what the individual firms were getting before merging (plus they do face the costs of merging!) • It only happens when they merge towards something close to a monopoly, which will look suspicious to the regulator.

  28. The Merger Paradox • The new merged firm rarely gets more profit after the merger than the sum of what the individual firms were getting before merging (plus they do face the costs of merging!) • It only happens when they merge towards something close to a monopoly, which will look suspicious to the regulator • They just came up with one case in time for our class today: https://www.justice.gov/opa/pr/justice-department-challenges-attdirectv-s-acquisition-time-warner

  29. The Merger Paradox • Why is this happening? • the merged firm cannot commit to its potentially greater size • the merged firm is just like any other firm in the market • thus the merger causes the merged firm to lose market share • the merger effectively closes down part of the merged firm’s operations • this appears somewhat unreasonable

  30. The Merger Paradox • Can this be resolved? • need to alter the model somehow • product differentiation • Bertrand competition • give the merged firms some additional market power • perhaps they can exercise market leadership

  31. Horizontal Merger and Leadership • Suppose that when two firms merge they become Stackelberg leaders • how does this affect merger profitability? • what is the impact on consumers? Conclusions

  32. Merger and leadership: an example Suppose that there are N identical Cournot firms in the market Market demand is P = 140 - Q and marginal cost is $20 Prior to the merger the Cournot equilibrium has: output of each firm: 120/(N + 1); price: PC = (140 + 20N)/(N + 1) profit of each firm: pC = 14,400/(N + 1)2 Now suppose that 2 firms merge and become market leaders Since a merger is a legal cartel we can use the Selten analysis of the previous chapter to get the effect of this merger The merged firm will produce the Stackelberg output: QL = (140 - 20)/2 = 60 units

  33. The leadership example (cont.) There are N - 2 non-merged firms that act as followers. So they each produce output: 140 - 20 60 qF = = 2(N - 1) (N - 1) 60(N - 2) 60(2N - 3) Total output is: QT = 60 + = (N - 1) (N - 1) 40 + 20N Price is: PL = 140 - QT = (N - 1) 60 and the price-cost margin is PL - 20 = (N - 1)

  34. The leadership example (cont.) Profit of the merged (leader) firm is: pL = (PL - 20)QL = 3,600/(N - 1) Profit of each non-merged (follower) firm is: pF = (PL - 20)qF = 3,600/(N - 1)2 The merged firm is always more profitable than each non-merged firm Is the merger profitable for the merged firms? Profit pre-merger was: 2pC = 28,800/(N + 1)2 3,600 28,800 so pL> 2pC requires: > which requires: (N - 1) (N + 1)2 (N + 1)2> 8(N - 1) This is always true for N > 3

  35. The leadership example (cont.) What about the effect of the merger on the non-merged firms and on consumers? Profit pre-merger was: pC = 14,400/(N + 1)2 3,600 14,400 so pF>pC requires: > which requires: (N - 1)2 (N + 1)2 (N + 1)2> 4(N - 1)2 This is only true for N < 3 The pre-merger price-cost margin is: PC - 20 = 120/(N + 1) The post-merger price-cost margin is: PL - 20 = 60/(N - 1) 60 120 the merger reduces price if: < or 60N + 60 > 120N - 120 N - 1 N + 1 This is true if N > 3

  36. Mergers and Market Leadership • A two-firm merger that creates a market leader is profitable for the merged firms if there are three or more firms in the market • Moreover, such a merger • increases the market share of the merged firms • reduces profit and market share for each non-merged firm • benefits consumers by reducing price • So why worry about mergers? • What might the non-merged firms do? • Will they also seek merger partners? • If so, what then happens to price and consumer welfare?

  37. Mergers and leadership (cont.) • The “leadership” merger reduces profits of the non-merged firms • Won’t these firms also seek merger partners? • certainly consistent with casual evidence • So, consider more than one two-firm merger • creates a series of merged firms • and a series of non-merged firms • How does “leadership” work here? • (Daughety) merged firms compete against each other • but as a group act as leaders relative to the non-merged firms • another variant on the Cournot model CONCLUSIONS

  38. Mergers and leadership (cont.) • Need to distinguish output decisions of the group of leaders (L) and the group of followers (F) • stage game • stage 1: leaders each choose their output levels in competition with the other lead firms • stage 2: followers see output decisions of the lead firms, then choose their outputs with respect to residual demand in competition with other follower (non-merged) firms • Stick with the Cournot model we have used • market demand P = 140 - Q; marginal cost $20; N firms • the firms are in two groups • L leaders or merged firms • N - L followers or non-merged firms • solve this game “backwards”

  39. Mergers and leadership (cont.) Suppose that the aggregate output of the lead firms is QL Residual demand for the non-merged firms is then: P = 140 - QL - QF where Q = QL + QF and QF is output of the non-merged firms QF can be written qf + QF-f where QF-f denotes output of the non-merged firms other than firm f So the profit of non-merged firm f can be written: pf = (140 - QL - QF-f - qf - 20)qf = (120 - QL - QF-f - qf)qf Differentiate this with respect to qf to give the condition: pf/ qf = 120 - QL - QF-f - 2qf = 0 Solve this for qf

  40. An example of leadership (cont.) We have the best response functionfor firm f: qf = 60 - QL/2 - QF-f/2 as a response to both the output of the leaders andthe other followers But all the followers are identical so in equilibrium they produce the same outputs: so Q*F-f = (N - L - 1)q*f so q*f = 60 - QL/2 - (N - L - 1)q*f/2 so (N - L + 1)q*f/2 = 60 - QL/2 120 - QL q*f = N - L + 1 Aggregate output of the non-merged firms is then: (N - L)(120 - QL) Q*F = N - L + 1

  41. (N - L)(120 - QL) Q*F = N - L + 1 An example of leadership (cont.) What about a lead (merged) firm in stage 1? The same technique can be used. Residual demand for a lead firm is: P = 140 - QF - QL = 140 - QF - Q-l - ql where Q-l is output of all the lead firms other than firm l The difference between the merged firms and the non-merged firms is that each merged firm knows what QF is going to be. The typical lead firm correctly anticipates the actions of the non-merged firms and so can use this information Recall that and substitute this into the residual demand equation

  42. An example of leadership (cont.) This gives the residual demand equation For the moment we treat the merged firms as a group (N - L)(120 - QL) P = 140 - - QL N - L + 1 140 + 20(N - L) (N - L)QL = + - QL N - L + 1 N - L + 1 140 + 20(N - L) QL = - N - L + 1 N - L + 1 This can now be rewritten: 140 + 20(N - L) - Q-l ql P = - N - L + 1 N - L + 1

  43. An example of leadership (cont.) Profit of a typical merged firm is: pl = (P - 20)ql But we know what P is so we have 140 + 20(N - L) - Q-l ql P - 20 = - - 20 N - L + 1 N - L + 1 140 - 20 - Q-l ql = - N - L + 1 N - L + 1 So profit of a typical merged firm becomes: (120 - Q-l - ql) pl = ql (N - L + 1) Differentiate this with respect to ql to give the profit maximizing condition.

  44. (120 - Q-l - ql) pl = ql (N - L + 1) An example of leadership (cont.) We have: Differentiating gives the condition: 120 - Q-l - 2ql pl/ ql = = 0 N - L + 1 So we have the condition: Q*-l + 2q*l = 120 In solving this we can again use a symmetry argument: Since Q-l contains L - 1 firms in equilibrium all the lead firms will have the same output so Q*-l = (L - 1)q*l which gives: (L + 1)q*l = 120 so q*l = 120/(L + 1) Aggregate output of the merged firms is then: Q*L = 120L/(L + 1)

  45. (N - L)120 120 Q*F = q*F = (N - L + 1)(L + 1) (N - L + 1)(L + 1) (N - L)(120 - QL) Q*F = N - L + 1 An example of leadership (cont.) Recall that • Now substitute for Q*L = 120L/(L + 1). This gives: and • This has been a lot of work!!! But now we can see the effect of a group of mergers. • We can easily compare outputs of the different types of firms. The leader (merged) firms are larger than the follower (non-merged) firms: as we would expect

  46. An example of leadership (cont.) • What about profits? Is the profit of a leader firm more than twice that of the profit it would make as a follower? • To make this comparison we need the equilibrium price. • Aggregate output is: Q*F + Q*L (N - L)120 120L 120(N + NL - L2) so Q*T = + = (N - L + 1)(L + 1) (L + 1) (N - L + 1)(L + 1) • This looks nasty but check that it is greater than the Cournot output • Stackelberg leaders produce more than Cournot firms. This reduces output of the followers but not by an offsetting amount. • Followers are under pressure: lower output and lower prices. • Increases the likelihood that followers will merge.

  47. An example of leadership (cont.) • Check the profitability of an additional merger. To do so,we need profits of followers and leaders. • This requires that we calculate the price-cost margin. 120(N + NL - L2) Price is PL = 140 - Q*T = 140 - (N - L + 1)(L + 1) and the price-cost margin is PL - 20 which gives: 120 PL - 20 = (N - L + 1)(L + 1) • This then gives us the profit equations for each type of firm

  48. An example of leadership (cont.) • Profit of a typical follower is: 14,400 pf(N, L) = (N - L + 1)2(L + 1)2 • Profit of a typical leader is: 14,400 pl(N, L) = (N - L + 1)(L + 1)2 • Each leader is more profitable than each follower but this is not the appropriate comparison • If we were to compare profits of two followers before they merge with their profits after they merge…

  49. An example of leadership (cont.) • We would see that starting from any configuration of leaders and followers a further two firms will always wish to merge. (see simulation to check) • Is such a group of two-firm mergers desirable for consumers? • firms that join the leader group increase output • but there are fewer firms in the market • So will a further two-firm merger increase or decrease output? • for this to happen we must have L < N/3 - 1 For price to fall as a result of a merger the leader group should contain no more than one-third of the total number of firms in the market

  50. Cost synergies • Another solution for the paradox: cost synergies • Save fixed costs • Save variable costs

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