4' Mergers and Acquisitions

1
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

2
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

3
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

4
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

5
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

6
4. Mergers and Acquisitions

• Incentives 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 gt
  0
• Linear demand is assumed linear p(Q) a - bQ,
  a,b gt 0
• No possibilities for entry
• Profit function of any firm is then
• Firm i's Cournot-Nash equilibrium profit is

7
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 lt m lt 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

8
4. Mergers and Acquisitions

• Case 1 m1
• Notice that only if n2, merger is profitable
• Monopoly created
• Hence, only if in duopoly both firms merge we
  have the merger being in all firms' interest
• Case 2 m2
• Notice that only if n3, 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

9
4. Mergers and Acquisitions

• Case 3 m5
• If n6, merger is profitable monopoly created
• But now even with n7 merging is profitable
• Creation of a duopoly through merger is
  profitable
• With n8, merger is again unprofitable
• More generally
• Notice that
• which is lt 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

10
4. Mergers and Acquisitions

• Notice also that
• which is gt 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

11
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

12
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

13
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

14
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)

15
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

16

• 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

17
4. Mergers and Acquisitions

• Merger 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

18
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, etc
• to produce pre-merger prices, quantities, and
  demand elasticities

19
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

20
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

21
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