CROSS-BORDER MERGERS AS INSTRUMENTS OF COMPARATIVE ADVANTAGE

1. CROSS-BORDER MERGERSAS INSTRUMENTS OFCOMPARATIVE ADVANTAGE J. Peter Neary University College Dublin and CEPR www.ucd.ie/~economic/staff/pneary/neary.htm

2. 5. Cross-Border Mergers and Acquisitions • So far: Greenfield FDI only • BUT: Cross-border M&As are quantitatively much more important • Now: Oligopoly model essential (almost) • No: Barba Navaretti/Venables (2003), Nocke/Yeaple (2004), Head/Ries (2005) • Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc. • Here: Neary (2004) • Model of 2-country integrated market: • Cournot oligopoly • Home: n firms with cost c; Foreign: n* with cost c* • Absent mergers: “Cone of diversification” in {c, c*} space

3. Cross-border mergers: • M&A’s a huge % of all FDI: more than greenfield FDI • A high % of mergers are cross-border • Cross-border merger waves linked to market integration [EU Single Market; Mercosur] • How to explain them? • I.O.: • Strategic and efficiency motives • All partial equilibrium • Macro: Major innovations • Jovanovic/Rousseau (2003) • International Trade Theory: • Dominant paradigms: Competition (perfect/monopolistic) • Needed: Oligopoly in GE

4. Plan • Specialisation Patterns in the Absence of Mergers • Myopic Mergers • Forward-Looking Mergers • General Oligopolistic Equilibrium: • Factor and Goods Markets: Ricardo + Cournot • Demand: Continuum-Quadratic Preferences • Mergers in General Equilibrium • Mergers and Welfare

5. 1. Specialisation Patterns Without Mergers • Consider a typical sector, in partial equilibrium • Homogeneous-good Cournot competition • 2 countries, integrated world market • Perceived linear demands: p = a¢ - b ¢x • Given numbers of firms at home & abroad: n, n* • Firms in each country have identical costs: c, c* • Equilibrium home sales: • So: y>0  • Also holds with no foreign firms:

6. c H firms unprofitable when n*=0 a ' c* a '

7. c H firms unprofitable when n*>0 a ' c* a '

8. c a ' H firms profitable c* a '

9. c • Symmetrically: a ' F firms profitable c* a '

10. c F: Foreign production only O: No home or foreign production • Equilibrium Production Patterns • for Arbitrary Home and Foreign Costs a ' H: Home production only HF: Home and foreign production c* a '

11. p(c,c*;n,n*)=0 p*(c,c*;n,n*)=0 c F: Foreign production only O: No home or foreign production • Fig.4: Equilibrium Production Patterns • in Free Trade without FDI H: Home production only HF: Home and foreign production c*

12. Compare with perfect competition: c O: No home or foreign production F: Foreign production only a ' H: Home production only c* a '

13. 2. Myopic Mergers • Assumption 1: Only bilateral mergers can occur. • Immediate gain from a merger: Assumption 2: A merger will not take place if GFH is zero or negative. Assumption 3: A merger will take place if GFH is strictly positive.

14. Myopic Mergers (cont.) • What are the incentives to merge? • No incentive if all firms are identical (and n+n*>2) • [Salant, Switzer, Reynolds (QJE 1983): “Cournot merger paradox”] • Nor if the 2 merging firms are identical (and n+n*>2) • [Proposition 1] • Intuition: • i.e., the profits of the acquiring firm would have to double for such a merger to be profitable • Same for all firms like the acquiring firm

15. Myopic Mergers (cont.) • BUT: Outputs are strategic substitutes

16. Myopic Mergers (cont.) • BUT: Outputs are strategic substitutes • Removing a rival shifts down the reaction functions of all others • Movement along own reac. func. • So: Outputs and operating profits rise for all surviving firms (including the acquiring firm) • Hence: If firms differ in cost, a low-cost/high-cost takeover may be profitable yF

17. Proposition 2: If c>c*, a takeover by a foreign firm is profitable if the home firm has sufficiently high costs: • GFH>0 IFF: Proof:

18. c O F Incentives for foreign firms to take over home H HF c*

19. p Dp* GFH <0 GFH >0 a–c Q R a–c* Fig. 5: The Components of Gain from a Cross-Border Acquisition by a Foreign Firm

20. Similarly, GHF>0 IFF: c O F • Fig. 2: Takeover Incentives Incentives for foreign firms to take over home H Incentives for home firms to take over foreign HF c*

21. Incentives for foreign firms to take over home p=0 GFH=0 Incentives for home firms to take over foreign GHF=0 c F O • Fig. 6: Cross-Border Merger Incentives H HF c*

22. Effects of one takeover on incentives for more? • All surviving firms have higher output and profits: • Dy=Dy* > 0 • Low-cost firms have higher output to begin with • So, their profits rise by more: GFH is decreasing in n • [Proposition 3] • i.e., “Merger Waves” / “Domino Mergers”: • => • No high-cost firms survive • Mergers may not take place if n is large, even though further mergers would be profitable • Encouraging “national champions” by promoting domestic mergers in high-cost sectors makes foreign takeovers more likely (in the absence of cost synergies)

23. 5. Cross-Border Mergers and Acquisitions (cont.) • Merger gains: • For an acquisition of a home by a foreign firm: • GFH(c, c*; n, n*) = D*(.)  (.) • Always negative between identical firms • Salant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox” • Positive for a sufficiently large cost advantage

24. 5. Cross-Border Mergers and Acquisitions (cont.) • So: Autarky to free trade encourages cross-border M&As • Further results: • GFHdecreasing in n:Merger waves • GFHdecreasing in t (definitely for high t) • So partial trade liberalisation encourages cross-border M&As • Empirical evidence: • Brakman/Garretsen/van Marrewijk (2005): Evidence in favour of comparative advantage and merger waves

25. R' p Dp* a–c Q R a–c* Fig. 5a: Merger Waves: Effects of a Fall in n

26. 4. General Oligopolistic Equilibrium • Continuum of sectors, indexed z  [0,1] • Ricardian cost structure: • c(z) = wa(z), • c*(z) = w*a*(z) • Assume home more efficient in low-z sectors • 2 threshold sectors • [Perfect competition: c(z)=c*(z)is the threshold for specialisation]

27. c Foreign production only O • Fig. 1: Equilibrium Production Patterns • for a Given Cost Distribution c(1) Home production only Home and foreign production c(0) c* c*(1) c*(0)

28. Demand • “Continuum-quadratic” preferences: • Objective demand functions: depend on income and all prices • Summing over 2 countries => Linear subjective demand funcs:

29. GOLE: The Full Model • Three nominal variables: w, w*,l • Absolute values are indeterminate • Convenient normalisation: W=lw, W*=lw* • Full employment: Threshold sectors:

30. 5. Mergers in General Equilibrium • Assume symmetric countries: • n=n*, L=L*, etc. => W=W* • Wage adjustment: • Expanding and contracting firms in both • BUT: High-cost firms contract by more • So: Demand for labour falls • Wages fall, dampening merger incentives • Threshold sectors: Labour-market equilibrium:

31. W L=L(.) ½ 1 Fig. 3a: Simultaneous Determination of Wages and Threshold Sectors: The No-Mergers Equilibrium

32. W L=L(.) ½ 1 Fig. 3: Simultaneous Determination of Wages and Threshold Sectors

33. c F O • Fig. 4: Wage Adjustments Dampen • Cross-Border Merger Waves H HF c*

34. 6. Mergers and Welfare • Partial-equilibrium intuition: W = CS + Sp • [Only changes in sectors where mergers occur matter] • 1. Less competition Some prices ­ CS¯ • 2. High-cost firms are eliminated Sp­ • 2. Dominates [Lahiri-Ono EJ 1988] • GE: Consumers are also profit recipients • [Welfare is just the consumer’s (indirect) utility function] • 1a. At given wages, only effect 1. matters  U ¯ • 2a. W¯ all prices ¯U ­ • So: Full effect ambiguous in GE, but for different reasons from partial equilibrium

35. Mergers and Welfare (cont.) Indirect utility: • So: At given wages, mergers (z~ ¯) raise prices in all sectors:

36. W E0 E1 L=L(.) E2 ½ 1 Fig. 5a: Mergers Increase Welfare

37. W E0 E1 L=L(.) E2 ½ 1 Fig. 5b: Mergers Reduce Welfare

38. Conclusion • Cross-border mergers are “instruments of comparative advantage”: • More specialisation • Welfare may rise • Despite: • Reduced competition in many sectors • Redistribution from wages to profits • Empirical predictions: • Trade liberalisation increases FDI • Absent cost synergies, low-cost firms acquire high-cost foreign rivals • FDI & trade are complements

39. Conclusion • Cross-border M&As encouraged by trade liberalisation