Determinants of firm and market structure Industrial Economics
Objectives • Bains 3 elements of market structure • What is the theory on economies of scale? • What is the theory on product differentiation? • What is the theory on absolute costs advantages? • Why do firms exist? • Transaction costs • opportunism • bounded rationality • asset specificity • assymetric information
Bain in 1956 identified 3 elements of market structure • Economies of scale • Product differentiation • Absolute cost advantages of existing firms
Previous advertising as an absolute cost advantage PMESnew ACnew ACest PMESest MES
Transaction Costs A spectrum of institutional costs including those of information, of negotiation, of drawing up and enforcing contracts, of delineating and policing property rights, of monitoring performance, and of changing institutional arrangements. In short, they comprise all those costs not directly incurred in the physical process of production. from The Palgrave Dictionary of Economics
Transaction Costs • Opportunism • Bounded Rationality • Asset-specificity • Asymmetric Information Hidden Information Hidden Actions • Team Production • Imperfect Commitment
Galbraith in ‘The New Industrial State’ • Managers place greater emphasis on increasing the size of the business rather than on its stock market value because: • Managerial salaries tend to be related to the size of the business • A growing business provides better career prospects • Growth is an objective most organisational elements can agree on
Mergers & Acquisitions • The merged firms may have increased market power which enables them to raise their prices. • The merged firms may be able to lower costs (or raise quality or get new products to the market faster). Economies of scale or scope. • Opportunism where either the stock market value reflects underachievement of existing management or stock markets are not perfectly efficient at valuing firms.
The Grossman-Hart Conundrum Assume that all shareholders have small shareholdings. Someone appears and makes a bid for your company which suggests it is not properly run. What is your optimal strategy? If it seems likely that they are right then it makes sense not to sell your shares but to hope that everyone else does so that you can free ride on the efforts of the raider and achieve the real value of your shares. But if everyone thinks like you no one will sell and so the takeover will fail. This of course means that inefficient managers could continue to be inefficient.
A summary of possible interactions of motives, firm efficiencies, and stock market efficiency.
Formal criterion for a value enhancing acquisition Before two separate firms, values V1 and V2. After a single firm, V(1+2) = [V1 + V2 + merger gains] - [V2 + merger premium] = V1 + gain - premium Therefore to add value to the acquirer, the discounted expected gains must exceed the merger premium paid for V1.
Porter 2 tests for whether or not acquisitions can create value.