6 Mergers and Acquisitions

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6 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

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6 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

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6 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 in welfare
• Also, merger means income transfer from consumers
  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 an
  income redistribution

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6 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
• There arwe now 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

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6 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 authoritys point of view, we face
  a trade-off
• To determine whether a merger (or certain conduct
  ) is 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

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6.1 Incentives to Merge

• 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

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6.1 Incentives to Merge

• 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

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6.1 Incentives to Merge

• Case 1 m1
• Notice that only if n2, merger is profitable
• This means we have monopoly being 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

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6.1 Incentives to Merge

• Case 3 m5
• If n6, merger is profitable monopoly is 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

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6.1 Incentives to Merge

• 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

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6.1 Incentives to Merge

• Decrease in output by one firm is 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

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6.1 Incentives to Merge

• Mergers not being profitable as 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 the Salant et
  al
• Mergers in Bertrand Market
• Merger incentives under price competition?
• Prices are strategic complements
• Reaction functions are upward sloping
• Price increase by some firms is matched by price
  increase of rival firms

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6.1 Incentives to Merge

• In Bertrand model firms engage in price
  competition with differentiated products
• Price increase by merged company is matched by
  price increase of rivals
• Reaction of outsiders reinforces initial price
  increase that results from merger
• Merger of any size is beneficial for merging
  firms
• No business stealing effect
• This model predicts industries would usually
  evolve into monopoly!
• This, luckily, is not really what happens in the
  real world
• There seems to be forces which prevents
  monopolization
• These forces are not easily modelled and simple
  models do not descibe real world phenomena in
  satisfying way

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6.1 Incentives to Merge

• Busines stealing effect is very much true in real
  world
• Often, firms benefiting most 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
  buyer, seller and target 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)

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6.1 Incentives to Merge

• Kamien Zang (QJE 1990) In capacity
  competition, does monopolization 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
• Sellers want to ask more than buyers want to pay
• Monopoly profit is maximum buyer can pay
• In Cournot model, complete monopolization of an
  industry is possible only if originally there
  were only a few firms in industry

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6.2 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 due to consolidation are allowed
• Mergers without synergies increase price and hurt
  consumers
• Cost saving is assumed proportional to
  post-merger output
• Then deadweight loss is proportional to output
  reduction
• If cost saving outweigh the deadweight loss, net
  welfare effect of merger is positive

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6.3 Merger Simulation

• Market definition is hard with differentiated
  goods and can be misleading
• Market definition is 0,1 decision, good is
  either 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
• Simulation allows to evaluate likelihood of
  synergies offsetting price increases
• Simulation requires estimation of demands
• Own and cross-price elasticities or changes in
  residual demand

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6.3 Merger Simulation

• Merger simulation the big picture
• Demand estimation
• Create demand models
• Get data and estimate demands
• Calibrate demand model to pre-merger prices,
  quantities, and demand elasticities
• 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

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6.3 Merger Simulation

• Measuring market power is hard in practice
• Market power L (p-c)/p ? 0, 1/e so that eL
  ? 0, 1
• Quality of market power measure depends on
  accuracy of estimates of marginal costs and
  demand elasticity
• 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 demand specification
• Functional form of demand determines magnitude of
  price increases from merger

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6.3 Merger Simulation

• One should 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

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7 Predation

• Predation firm drives rival out of market by
  making it incur enough losses and then raises
  prises
• Why would prey exit?
• Why would prey stay out after price increased?
• Can predator really recoup losses suffered during
  price war? Does predation make sense?
• If predation is possible and profitable, how can
  we separate innocent aggressive competition from
  predation as restriction on competition?
• Most cases apply so-called Areeda-Turner testP
  lt LRMC, P lt LRAVC, or P lt LRATC some other
  indications? predation
• Costs are hard to define and measure
• Predation rare in case law. But is it really that
  rare?

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7 Predation

• Financial market imperfections
• Old deep pocket theory richly endowed predator
  would charge low prices to drive out poorly
  endowed rival
• Ignores possibility that profit-seeking investors
  would finance prey
• Relation between prey and its investors
• Predator seeks to manipulate that relationship
  and drive prey out of market or deter expansion
  into new markets
• Pedatory strategy viable because of capital
  market imperfections
• Investors face agency or moral hazard problems
• Managers may take excessive risks, shield assets
  from creditors, dilute outside equity, fail to
  exert sufficient effort, or otherwise fail to
  protect investors interests
• Suppliers of capital can mitigate these agency
  problems by extending financing in staged
  commitments, imposing threat of termination in
  case of poor performance

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7 Predation

• Debt-holders can threaten to liquidate firm or
  deny new credit
• VCs can refuse to extend additional financing
  when early performance is poor
• Shareholders can decline to purchase additional
  equity if expected returns are low due to
  disappointing initial performance
• Predatory pricing in product markets becomes
  possible when predator exploits termination
  threats to dry up financing of rival firm
• Agency problems are particularly acute in
  financing of new enterprises
• Uncertainty about cash flow in early stages
• Losses may be unavoidable start-up costs or due
  to agency abuse
• Mitigate moral hazard by agreeing to extend
  financing only when firms initial performance is
  adequate

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7 Predation

• Predator may slash price to drain prey of
  sufficient funds to meet its loan commitments,
  forcing default
• Predator can lower preys earnings to impair
  preys debt capacity by limiting collateral it
  can put up
• Lower earnings may cause lenders to wrongly
  believe that firms profits are likely to be
  lower or riskier in future and therefore to
  stiffen their lending terms
• Contract that minimizes agency problems will
  maximize incentive to prey
• Reputation
• Predator lowers prices to mislead prey and
  potential entrants into believing that market
  conditions are unfavorable
• Decision to enter or exit is based on evaluation
  of expected future revenues and costs
• Most firms contemplating entry or exit do not
  have all information to determine future revenues
  and costs

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7 Predation

• If incumbent firm is better informed than others
  about cost or other market conditions, it may be
  able to influence the expectations
• Incumbent firm can manipulate and distort market
  signals about profitability, and influence the
  expectations through pricing decisions or other
  actions
• Predator seeks to establish reputation as price
  cutter, based on some perceived special advantage
  or characteristic
• Reputation effects may be present when predator
  sells in two or more markets or in successive
  time periods within same market
• One market or period serves as demonstration
  market with predatory conduct, and the other
  market or time period provides recoupment market,
  where predator reaps benefits
• Reputation-induced belief reduces future
  entrants expected return and may deter entry

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7 Predation

• Signaling
• Better informed predator reduces price to
  convince prey that market conditions are
  unfavorable
• Aggregate demand is too low to justify presence
  of both firms in market or expansion by prey
• Prey inferring weak demand from low price may be
  deterred from expanding or induced to leave
  market
• Less plausible than previous predatory strategies
• Test market and signal jamming theories plausible
• Victim lacks knowledge and experience in market
• Introduce new product or brand to probe market
  response by entering a limited test market
• Predator may attempt to frustrate this market
  test by either of two predatory strategies

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7 Predation

• Test market predation
• Predator secretly cuts price to reduce entrants
  sales in test market
• Induce entrant to believe that demand is low
• Entrant abandons entry or enters on smaller scale
• Signal jamming
• Predator openly cuts price to distort test market
  results
• Entrant can observe demand for its product only
  under exceptional circumstance of an ongoing
  price war
• Market test is foiled, and entrant is unable to
  determine whether market demand for its product
  is sufficient to support entry
• Cost signaling
• Predator drastically reduces price to mislead
  prey to believe that she has lower costs
• Predator trying to establish a reputation for low
  cost cuts price below the short run
  profit-maximizing level

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7 Predation

• Observing predators low price, prey rationally
  believes there is at least probability that
  predator has lower costs
• Lowers prey's expected return and causes prey to
  exit
• Limiting factor in applying cost signaling theory
  is possible inconsistency between low price,
  predatory bluffing and subsequent recoupment
• Attempt to raise price risks revealing signaling
  to prey and other potential entrants, causing
  them to upgrade estimates of market profitability
• Policy
• Proof of scheme of predation only establishess
  that identified strategy is plausible
• Need to show
• Below cost pricing avoidable or incremental
  cost, not AVC
• Recoupment
• Business justification?

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7 Predation

• Financial market predation
• Prey depends on external financing
• Financing depends on its initial performance
• Predation reduces initial performance and
  threatens preys financing and viability
• Predator can finance predation internally or has
  better access to external finance as prey
• Reputation
• Multimarket predator faces localized competition
• Predator faces threat of sequential entry
• Reputation reinforces predatory strategy or
  increases probalility of future price cuts
• Entrant observes previous exit or other adverse
  experiences

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7 Predation

• Test market predation
• Predator observes preys attempt to experiment on
  limited basis
• Predator cuts price below following or
  anticipating entry
• Price cut prevents prey from learning true demand
  conditions
• Cost signaling
• Predator might have lower or reduced costs
• Predator reduces price
• Prey believes that predator has lower costs
• Possible cost reduction is sufficient to exit,
  deter entry or limit expansion

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8 Merger Case

• Airtours / First Choice merger
• Commisson case No IV/M.1524, available through
  course web site www.cea.fi/joe.htm
• Airtours and First Choice supply leisure travel
  services (package tours) in UK and Ireland
• Vertically integrated into upstream (airline
  operation) and downstream (travel agency)
  businesses
• Relevant market short-haul foreign package
  holidays in UK
• European beach, ski and city destinations
• Long-haul (Florida, Caribbean, Thailand etc) is
  not substitute for short-haul
• Different aircaft
• Less rotation of aircraft -gt higher crew and
  catering costs
• Operating cost per passenger/mile

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8 Merger Case

• Sufficient demand to fill large aircraft -gt match
  fleet composition closely to mix of passengers
  between larger (long-haul) and smaller
  (short-haul)
• Different image for consumers
• Longer flight time and jetlag can reduce
  usable holiday time
• Short-haul holiday typically much cheaper than
  comparable long-haul
• Market shares
• Airtours 19.4
• First C. 15.0
• NewCo 34.4
• Thomson 30.7
• Thomas Cook 20.4
• Cosmos 2.9

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8 Merger Case

• Surprise prohibition decision
• Three firm oligopoly 85.5 market share
• In past, much fluctuation in market shares, and
  exit and entry
• Package holidays differentiated, branded,
  consumer products
• UK MMC incuiry few years earlier concluded market
  was quite competitive despite increased
  concentration
• Low barriers to entry
• Is collusion really sustainable?
• Court of First Instance overturned Commissions
  decision because of lack of evidence, treatment
  of facts
• CFI seemed to accept Commissions general policy
• Could commission be right?
• Oligopolists are now vertical integrated,
  competitive fringe not
• Competitive fringe less able to challenge
  oligopoly
• Raises entry costs as entrants need to enter all
  stages of production and distribution

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8 Merger Case

• Two-stage competition 1) reserve capacity 12-18
  months in advance, 2) price competition
• Firms have strong incentive to sell full capacity
• Steep discounts when departure dates are
  approaching
• Temptation to deviate from collusive price are
  strong, and threat of punishment within selling
  period not credible
• Package holidays heterogenous good
• Less likely to reach collusive prices
• Commission collusion on capacity rather than
  prices
• Firms choose low levels of capacity
• Deviation set high level of capacity
• Punishment choice of high levels of capacity for
  one or more period

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8 Merger Case

• Unlikely in many sectors, capacity decisions
  constrain firms for long periods
• Punishments costly and delayed
• In this industry, capacity decisions are reviewed
  periodically
• Semicollusion collude on some variables, compete
  on others
• Could lead to more intense competition than
  Cournot or Bertrand behavior
• Firms might observe each others capacity
  decisions
• Collusion on capacities can be consistent with
  economics
• But is collusion likely?
• Demand is volatile
• Hard to separate demand shock from deviation
• What demand are rivals predicting?

36
8 Merger Case

• Even if oligopolists collude, competition from
  outsiders and entry to increase capacity
• Court Commission was wrong
• Joint dominance
• Market must be sufficiently transparent for
  members of oligopoly to monitor each other
• Punishment mechanism that ensures common policy
  is sustainable as there is a need to counter the
  incentive to cheat
• Reaction of competitors and customers does not
  undermine benefits expected from common policy
• Commission must produce convincing evidence that
  all three conditions would be met in particular
  case
• Firms have right to adapt themselves
  intelligently to the existing and anticipated
  conduct of their competitors
• Commission had confused acceptable
  oligopolistic interaction with tacit coordination
  in the decision

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8 Merger Case

• No credible punishment mechanism
• Commission did not prove that market was
  sufficiently transparent for oligopolists to
  monitor capacity when capacity decisions were
  taken
• Analyses of demand growth and demand volatility
  were fundamentally flawed
• Commission failed to give weight to responses of
  fringe players and consumers to postulated
  reduction in output and increase in prices
• My interpretation Commission tried to increase
  scope of dominance concept
• In US, merger might have been blocked
• With new EU rules and more careful analysis,
  merger might have been blocked