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EC930 Theory ofIndustrial Organisation

2013-14, spring term

Mergers and Merger Control

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Outline:

Readings: Lecture notes 9 Optional: Cabral – chs 9, 15

Market Power Gains of (Horizontal) Merger

Merger Paradox

Merger Efficiencies

Pass Through Market Power and Efficiencies in an Equilibrium Context

Merger Approval Measuring the Effect of Merger Market Definition

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q2

q1

Contract curve

R1

R2

q2M

q1M

The contract curve traces out the tangencies of theisoprofit contours. As profits increase according toa negative relation between q1 and q2, the tangencycannot occur at a point of negative slope of theisoprofit contour. A point of zero or infinite slopecannot be a point of tangency, as it is never the casethat both isoprofits have zero or both have infiniteslope. It is possible, however, for both to have positiveslope and be tangent. All such points lie to the left of the reaction functions.

Furthermore, the total output must sum to QM, where the merged firm is indifferent about which “unit” produces the output if both “units” have the same marginal cost.

Effects of Merger:Output Reduction

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Merger Paradox

Example: P = 1-Q; c = 0; N identical Cournot competitors .

Let two firms merge in each configuration (to create N-1 identical Cournot firms):

N pre-merger

Firm i profitper firm pre-merger

Pre-merger total profit

Post-merger total profit per firm

Post-merger profit per merged firm

1 1/4 1/4 1/4 ¼

2 1/9 2/9 1/4 1/8

3 1/16 3/16 1/9 1/18

4 1/25 4/25 1/16 1/32

5 1/36 5/36 1/25 1/50

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Intuition: When firms merge in a Cournot industry, they tend to cut output (aswe saw above)

But this induces the rival(s) to increase output since the reaction functions slope down.

This means that the merged entity creates a positive externality on rivals bydecreasing output and so raising market price –

but they “take advantage of this”, creating a negative externality on the merged entitywhen they increase output and so lower price.

Clearly, this reasoning doesn’t hold in the case when no rivals remain after merger.

Merger Paradox -- Intuition

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Resolving the Merger Paradox

But firms do merge…so how can we resolve this paradox?

Price competition with product differentiation: Reaction functions slope upwards,so any merger must be profitable, even without efficiencies, as the reaction of rivalstends to raise price even further.

Capacity constraints can limit rivals’ reactions. If no increase in rival output underCournot, then merger must be profitable.

But unconstrained Cournot still seems like a reasonable model…so what is wrong?

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One solution is cost efficiencies…

While it is clear that this can create an incentive to merge for the firms, does it alsocreate a benefit for consumers?

If total output falls along this contract curve compared to the non-merger output,then consumer surplus will tend to fall.

However; clearly, if one “unit” faces lower marginal cost, allocating all production to that unit is the Pareto efficient allocation between the two firms, assuming that profitscan be transferred easily across units. Output may rise in this case, so consumersurplus may also rise.

This is an example of merger-specific efficiencies that can offset the market powereffect of a merger.

Efficiency Vs. Market Power in Merger

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Competition authorities value such efficiencies and may clear a merger if they exist.

This assumes efficiencies apply to marginal cost. If fixed costs are saved, then theprice effect of the merger is less clear and so approval is less clear as well.

Further, it assumes that some of the cost saving is “passed through” to consumers vialower prices. This depends on the elasticity of the residual demand of the firm:

Recall from lecture 2: first order condition of firm i in a Cournot setting is:

Where .

Hence, the larger is the elasticity of residual demand, the larger the effect of a (marginal) cost reduction on price.

This, in turn depends on overall demand elasticity and number of competitors.

Pass Through and Merger Efficiency Gains

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Balancing Market Power and Efficiencies (Farrell and Shapiro, AER, 1990)

HHI/CR based rules (lecture 2):

1. Market Shares may be wrong

Suppose we use change in HHI or CRi as basis for rejecting merger. But these assumethat post-merger shares are just sum of pre-merger shares.

Eg. In ten firm industry with equal market shares CR3 = 30% pre-merger of any pair of firms and CR = 40% post-merger.

But if market shares equalise, post-merger then CR3 should only be 34%...

Hence, we need to conduct equilibrium analysis to know what true market shares will be.

2. Rise in HHI/CR may not decrease welfare under asymmetries

While HHI rules justified by Cournot behaviour when identical firms, if some havelower cost, then transfer of output towards more efficient producers may raise consumersurplus.

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Suppose, then, that two firms merge that have different costs. They can reallocateproduction after merger across the “units” but obtain no other cost benefits (“rationalisation” of production); then:

the merger will cause price to rise when it allows rationalisation of production.

In other words, the effect of decreasing market competition always dominates theeffect of rationalising production. This is bad for consumers.

Example: Two Cournot competitors merge to monopoly. c1 < c2.

The merged firm will allocate all production to unit with lower cost.

Pre-merger: Ppre = (1+c1+c2)/3 Post-merger: Ppost = (1+c1)/2

If 1-2c2 +c1 > 0 then post merger price is higher. But (1- 2c2+c1)/3 is pre-mergeroutput of firm 2, so if firm 2 was producing pre-merger, as we have assumed, pricemust rise.

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If we allow for synergies beyond rationalisation (so that costs fall in the post-mergerfirm beyond what the constituent parts could obtain pre-merger) then

the larger the market shares of the merging firms, or the smaller the industryprice elasticity of demand, the greater must be the synergies in order for price to fallpost-merger.

Specifically: ) where cM is merged cost, i firms merge and the sum of market sharesis taken over these i firms; ε is price elasticity of demand, and p is pre-merger price.All variables are measured pre-merger.

Recall that the usual first order condition in the Cournot equilibrium sets:

ci = p(1-si/ε).

Farrell and Shapiro’s condition observes that pre-merger price must be “too high” if the outputs that generate it (and the consequent market shares) don’t generate equality for the merged entity. The merged entity will have an incentive to increaseoutput so price must fall (compared to pre-merger levels) – in equilibrium.

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Generally, cost savings must be substantial for cost effects to dominateprice effects (so that consumers are helped by the merger). This is confirmed inlinear examples, for instance.

Furthermore, from the F&S condition:

If elasticity is small then price effects of changing output are likelyto be large – so cost savings must rise.

If market shares are large, then the effect on output when they merge isalso is large, so the price effect is large -- and cost savings must rise.

Elasticities will depend on the number of firms in the industry, so indirectlywe still have some reason to look at concentration and market shares.

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Finally, a (Cournot) merger will tend to (1) decrease merged firm total output compared to individual outputs pre-merger, (2) increase non-merged firm total output, (3) raiseprice.

If we take the perspective of total welfare of all firms and consumers, does thenegative effect on consumers dominate the positive effect on non-merged firms?

No. The reason is that the increase in non-merged firm output raises both consumerwelfare and non-merged firm welfare share.

Indeed, Farrell and Shapiro find that:

If m of the N firms in a Cournot market merge, then as long as their initial joint market share is not too large, any profitable merger that raises price also raises total welfare.

Indeed, if the external market share is large, then the output effect on outsiders islarge compared to the output reduction effect of insiders, triggering welfare gains.

(Notice that if we just merged firms with no cost saving, the merger would not be“profitable”, so we should not see any gains. This condition requires some kind of improvement in cost.)

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Methods for deciding whether a merger will create harm:

1. Merger simulation (see Salmon/Deodorant cases, reviewed earlier): calculate equilibrium pre- and post-merger and compare welfare (examples in notes).

These are time-consuming and must necessarily rely on a lot of assumptions. Robustness checks increase time involved. Mergers often require some speed to maintain potential profitability/interest. This method is the best justified by theory, however.

2. Consultation exercises with industry/consumer/buyer groups

These are interested parties, so teasing out unbiased information is hard and final consumers tend to be poorly informed about merger effects.

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3. HHI/CR

We have just seen this is not equilibrium analysis, and so is theoretically flawed; on the other hand, concentration and market shares can give a hint of effect of merger. (Note F&S final condition!) This could be a useful first step.

Rule of thumb that has been used:

US: HHI < 1000 no need for further investigation 1000 < HHI < 1800 maximum “safe” change in HHI due to merger = 100 HHI > 1800 maximum “safe” change in HHI due to merger = 50

EC: HHI < 1000 no need for further investigation 1000 < HHI < 2000 maximum “safe” change in HHI due to merger = 250 2000 < HHI maximum “safe” change in HHI due to merger = 150

ie: 10 equally sized firms or more no problem 5 equally sized firms or fewer very tough view

8 firm industry where two firms merge safe (HHI inc. about 200) in EC only 6 firm industry where two firms merge not safe anywhere.

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4. Diversion Ratios

Suppose the price of product i rises (all others held constant). Define: The diversion ratio of product i to product j:

The proportion of this product’s loss in sales that moves to substitute product j is dij = (sales of i moving to j)/(total loss in sales to i).

when firms producing i and j merge, the merged entity internalises the diversion effect of a change in price – so it is more willing to raise price.

Hence, if the diversion ratio is large, the effect of the merger on price should also be large.

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The larger the profit margin on product j, the larger the effect on the price of i when the firms merge since by raising the price of i, the merged firm can divert sales to the higher margin product.

If the two products have the same marginal cost, this effect can be captured by adjusting the diversion ratio by the price ratio:

GUPPIij = dij(pj/pi)

If costs differ, an alternative measure uses the gross margin (this will be derived in a few pages):

GUPPIij = dij(mj)pj/pi

In practice GUPPI > 10% investigate further GUPPI < 5% don’t investigate further

Note that (1) GUPPI > 10% means something different when underlyingdemand shape is different (2) measured diversion ratios due to historic price changesmay result from changes in preferences or other factors.

On the other hand, they are quick and require little data and easy to apply for differentiated products.

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While the number of bidders is clearly relevant in auction markets, the equivalentof diversion ratios – the ranking of bids -- can be more informative since, by identifying the “runner up” in each auction, we can get an idea of the effect of a particular merger on the transaction price paid.

eg. In a second bid auction, the second “highest” bid is the transaction price, so a merger between the top two firms could affect transaction price whereas a merger involving a much less competitive firm might affect price little.

Market shares can potentially be used as a similar proxy over time, since theygive us an idea of which firm(s) have been successful in the past and so the firmsthat are most active in affecting market price.

Taking these together, we could for example investigate:

Pi = a + bNi + cAi + dBi + gAiBi

Where i is the auction market, N is the number of firms participating, A and B aredummy variables set to 1 if firm A or B participates in the bidding. g and b measurethe effect that A’s and B’s bidding have on each other and the effect of changing thenumber of bidders per se.

Diversion Ratios and GUPPI’S: An Application to Wembley/O2 Merger

We discussed “GUPPI” measures the price effect (ie consumer harm) of a merger. We used the Wembley, O2 merger as an example, so the subscripts will be W for Wembley and O for O2.

We define (one version of) the GUPPI as follows:

GUPPIw,o = dw,omo[po/pw] = Value of W’s lost sales recovered by O2 divided by revenues lost by W when raise price.

What does this try to measure? The upward pressure on prices due to the merger.

Why should prices tend to rise with the merger? When any firm raises price, it loses somesales from the market entirely and loses some sales to competitors.

eg. When VW raises price, it creates some people who use bicycles or motorbikes instead and also creates some people who buy a Peugeot instead.

If Peugeot and VW were to merge, however, then some of the diverted sales would remain“within the company” and so the company is “less hurt” by the same price rise than pre-merger. Hence, there is an upward pressure on price caused by the merger.

Derivation of GUPPI

Let Qw (Po,Pw) = demand function of Wembley (pre-merger) Qo (Po,Pw) = demand function of O2 (pre-merger)

A Wembley price increase raises O2’s pre-merger sales, and the firm gets a profit marginon each of these sales. Hence, the “benefit” to the O2 of Wembley’s lost sales is:

)( oow

o cPP

Q

Where the marginal cost of O2 is co.

And the revenues lost by Wembley when it raises its price are:

In other words, the revenue effect on Wembley is the product of the lost sales and the priceon each of these sales.

The ratio of these two quantities is the GUPPI:

)( oow

o cPP

Q

𝜕𝑄𝑤

𝜕𝑃𝑤

𝑃𝑤

= } {} =

= diversion ratio (of total sales decrease of Wembley that are recovered by new partner)x (margin on sales) x (price ratio).

This is what we defined the GUPPI as at the beginning of the presentation…

P*w P**w

π

Price

Pre-merger optimum Post-merger optimum

The GUPPI essentially measures the slope of the profit function at the pre-merger point. The larger is the slope, the farther to the right the post-merger price will lie.

The problem is that the GUPPI doesn’t tell us exactly how far to the right the new pricewill lie. This is because the shape of the profit function matters…and the GUPPI onlyreflects the local shape. The merger may create a large change, though.

In practice, linear demands often are used. In this case a 5-10% GUPPI will be enoughto generate sufficient price rises that merger will be viewed as problematic (causinga 5% or greater rise in price.)

A full-fledged merger simulation (as we discussed earlier in term with fish and shampoo)would give an idea of the precise shape of the profit function…but is costly.

Hence, GUPPIs are used to get a first look at whether a full simulation model would beworth the cost. If the GUPPI is too high (5% or more) then probably not…

Wembley specifics

Ancillary Income: If O2 has ancillary activities (like restaurants and parking) then the profitmargins at the O2 may be, effectively, higher than otherwise would be. This tends to raisethe mo term in our expression for the GUPPI. If this term rises, then we should expect thepost-merger price rises at Wembley to be *larger* than the basic GUPPI predicts.

We could formalise this idea as follows:

Pre-merger, Wembley maximises (WRT Pw) :

Post-merger, Wembley maximises (WRT both P) : +

Where Δμo = ancillary sales from services at the venue.

We can manipulate the first order condition with respect to Pw to get the modifiedGUPPI that is appropriate to this case.

The modified GUPPI behaves quite differently:

To get the 5% “modified” GUPPI that is the “trigger” for a negative evaluation by competition authorities, and for an ancillary profit measure of £10k per event,for example, to get a 5% upward price pressure, we would need a “basic” GUPPIOf 11%.

And for an ancillary profit of £40k per event, we would need a “basic” GUPPI of 39%to get a 5% upward price pressure.

The intuition is that the ancillary revenues create an incentive for the firms to pricethe event low in order to pull customers in and then profit from the ancillary services.

Hence, the change in business model projected for Wembley to ancillary service revenue from solely event revenue will tend to create a downward pressure on eventprices. Factoring this into the upward price calculation makes a big difference to howmuch we predict the O2-Wembley merger will affect ticket prices for customers.

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5. Statistical Methods

Check past relation between price and concentration using panel data:

Pit = ai + bHHIit + cXit + errorit … run for large number of markets, I, (countries/states) and time periods, t. and variables usually measured in logs and X is set of controls (eg country size)

From this, we can infer the price effect of a proposed merger once we know HHIand change in HHI due to the merger. As this is based on historical data, specific information for this merger, such asentry or cost savings will not be taken into account.

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Market Definition

HHI/CR requires some definition of the market – other methods (diversion ratios) don’t.SNIP test usually determines this. Say Coke wants to merge with Innocent Smoothies:

Start with narrowest market (Coca Cola). Would it be profitable for Coke to raiseits price 5% for a sustained period – if it were the only competitor in the relevantmarket? If so, then stop. Coke’s merger probably won’t affect price (since Coke is a market on its own).

If not, increase definition (Any cola) because the price rise clearly would divert a lotof sales to “substitute” products. Would it be profitable for these firms, acting asa monopolist, to raise price 5% for a sustained period? If so, then stop. Coke’s merger won’t affect price since colas form a separate market.

If not, increase definition (all sodas)…

(all beverages)…

Then compute market shares for appropriate definition. V. big markets smallmerger effects; V. small markets small merger effects.

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Cointegration of prices often used to indicate similar markets (salmon case)

Cross price elasticity or diversion ratios also used.

Consumer surveys used.

Or…diversion ratio can be used in order to avoid having to define a market in a first step. The diversion ratio allows diversion to be measured and taken asan indication of market definition.

Since market definition is divisive, it can be better to skirt around this issue.

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Summary

Mergers can confer an externality on non-merging firms

This externality can reduce the benefits of merger, despite market power gains overall for the market.

Efficiencies can counteract the market power effect

The extent to which efficiencies are passed through to consumers affects this gain and depends on the elasticity of (residual) demand which, in turn, depends on concentration.

Concentration ratios by themselves are not well theoretically justified.

Neither is HHI, as we need to compare equilibrium shares and prices rather than use pre-merger shares. This is harder and takes more time, so non-equilibrium analysis often done first to narrow down the number of merger cases viewed as “problematic”

When we do this, the link between HHI and price/welfare is less clear as merger can allow for rationalisation of product even if it doesn’t create synergies.

Synergies make the argument for HHI even weaker. Indeed, if not too many firms merge, any profitable merger may raise (total) welfare!

Market Definition a first step to any HHI/CR analysis, although diversion ratios can “short circuit” this step.

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References

Farrell, J, and C. Shapiro (1990) “Horizontal Mergers: An Equilibrium Analysis”, American Economic Review 80(1), 107-126.