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HORIZONTAL MERGERSAdvanced Industrial Organization 1
THIBAUD VERGÉ
CREST-LEI
ENSAE 3A / Master APE (2009-2010)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 1 / 42
Introduction
Outline
1 Introduction
2 Cournot Mergers
3 Mergers with Differentiated Products
4 Some Practical Issues For Merger Analysis
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 2 / 42
Introduction Merger Control in the EU
Merger Control in the EU
Some Statistics (to end of November 2009)
4250 notified (i.e. proposed) mergers
Most cleared after phase I (preliminary investigation) with or withoutcommitments
191 phase II proceedings initiated (in depth investigation)
20 prohibition decisions (only 2 since January 2002, latest one in June 2007,proposed acquisition of Aer Lingus by Ryanair )
Remark: some of these prohibition decisions overturned in appeal
Most phase II mergers cleared with commitmentsStructural remedies (divestment of assets) as in Air France / KLM or Carrefour /Promodes
Behavioral remedies (as in Vivendi / Canal + / Seagram or recently in France inCanalSat / TPS)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 3 / 42
Introduction Merger Control in the EU
Merger Control: Procedure
Mergers (large enough and with European scope) have to benotified to the European CommissionThe DG Competition has one month to decide whether to clearthe merger (with or without commitment) or launch a phase IIinvestigationPhase II investigation lasts another four months
Merger AnalysisMarket definition (product and geographical markets)
Substantial Lessening of Competition TestSingle dominance (unilateral effects)Joint or collective dominance (risk of tacit collusion)
Evaluation of efficiency gains
Remedies (structural and / or behavioral)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 4 / 42
Introduction US Merger Control
US Merger Control and Use of HHI
Preliminary analysis of mergers should involve the following use of the HHI
Compute the pre-merger market shares (requires to properly define the relevantmarket)
Using these market shares, compute an estimated post-merger HHI (HHI’) andthe change in concentration (∆HHI)
Assumes that the market shares are not affected by the merger
Decision AlgorithmHHI′ < 1000 =⇒ Approve1000 ≤ HHI′ ≤ 1800 and
∆HHI ≤ 100 =⇒ Approve∆HHI > 100 =⇒ Investigate (significant competitive concerns)
HHI′ > 1800 and∆HHI ≤ 50 =⇒ Approve∆HHI > 50 =⇒ Investigate (significant competitive concerns)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 5 / 42
Introduction Preliminary theoretical remarks
Cournot Mergers are Rarely ProfitableSalant, Switzer and Reynolds (Quarterly Journal of Economics, 1983)
Reminder about Cournot Olipogolyn identical firms with marginal cost cLinear inverse demand function P(Q) = a− bQ
Individual profit writes as πC(n) = (a−c)2
b(n+1)2
Merger between m + 1 firms
∆πc = πc(n −m)− (m + 1)πc(n) =(a− c)2
b
(1
(n −m + 1)2 −m + 1
(n + 1)2
)
=(a− c)2
b(n −m + 1)2(n + 1)2
(n + 1)2 − (m + 1)(n −m + 1)2︸ ︷︷ ︸=−(n−m)2+m+1
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 6 / 42
Introduction Preliminary theoretical remarks
Cournot Mergers are Rarely ProfitableSalant, Switzer and Reynolds (Quarterly Journal of Economics, 1983)
2 4 6 8 10
2
4
6
8
10N
um
ber
of
mer
gin
g fi
rms
Initial number of firms
64
2
2 8 10
6
10
8
4
Profitable mergers
Unprofitable Mergers
Mergers to Monopoly
Mergers to Duopoly
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 7 / 42
Introduction Preliminary theoretical remarks
Bertrand Mergers are rarely profitable
Symmetric SituationsZero profit when firms are identical
Only a merger to monopoly can be profitable
Asymmetric situationsMergers which do not involve the most efficient firms are pointless
Only profitable mergers are mergers
To monopolyInvolving the two most efficient firms
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 8 / 42
Introduction Preliminary theoretical remarks
Solutions (i.e. more realistic frameworks)
Cournot MergersIncreasing marginal costs
Perry and Porter (American Economic Review, 1985)
McAfee and Williams (Journal of Industrial Economics, 1992)
Bertrand MergersDifferentiated products
Davidson and Deneckere (Rand Journal of Economics, 1985)
Logit demand model (widely used for econometric analysis)
Efficiency gains
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 9 / 42
Cournot Mergers
Outline
1 Introduction
2 Cournot Mergers
3 Mergers with Differentiated Products
4 Some Practical Issues For Merger Analysis
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 10 / 42
Cournot Mergers Oligopoly with Assets
Cournot Oligopoly with AssetsPerry and Porter (American Economic Review, 1985)
See also McAfee and Williams (Journal of Industrial Economics,1992)
A model of oligopoly with assets / capacitiesLinear Inverse demand function P(Q) = 1−Q
N firms each endowed with a quantity ki of assets
Common cost function C (q, k) = cq + γq2
2k + kF
To simplify assume no fixed costs (F = 0) and normalize c = 0
Quantity competition
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 11 / 42
Cournot Mergers Oligopoly with Assets
Cournot Model with Assets
Cournot Competition
Define β(k) = kγ+k and B(k) =
∑ni=1 β (ki)
Equilibrium price and quantities are given by:
P∗(k) =1
1 + B(k), Q∗(k) =
B(k)
1 + B(k)and q∗i (k) =
β (ki)
1 + B(k)
Individual equilibrium profit is:
π∗i (k) =β (ki) (1 + β (ki))
2(1 + B(k))
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 12 / 42
Cournot Mergers Oligopoly with Assets
Impact of mergers in this framework
Particular feature of this cost function
C(q, k ′ + k ′′
)= min
q′+q′′=q
(C(q′, k ′
)+ C
(q′′, k ′′
))= min
qi +qj =q, ki +kj =k′+k′′(C (qi , ki ) + C (qj , kj ))
No synergies (see Farrell and Shapiro (AER, 1990)) only efficient use of theassets
Well suited to analyze Cournot mergers and structural remedies
QuestionsWhen are mergers profitable for the merging firms?
When are mergers good for the consumers?
When are mergers welfare improving?
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 13 / 42
Cournot Mergers Oligopoly with Assets
Mergers without synergies always raise pricesFarrell and Shapiro (American Economic Review, 1990)
Impact on priceRemark that:
∆B = β(ki + kj
)−(β (ki) + β
(kj))
= −kikj
(ki + kj + 2γ
)(γ + ki + kj
)(γ + ki)
(γ + kj
) < 0
The merged entity reduces output after the mergerThe rivals increase output but not enough to compensate
Merger Control and Consumer SurplusIf consumer surplus is the welfare standard, mergers withoutsynergies should always be blocked
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 14 / 42
Cournot Mergers Oligopoly with Assets
Profitable Mergers
0 0.2 0.4 0.6 0.8 10
0.2
0.4
0.6
0.8
1
Firm 1’s share of the available assets
Fir
m 2
’s s
har
e of
th
e av
aila
ble
ass
ets
A merger between firms 2 and 3 is
profitable
Merger between firms 2 and 3
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 15 / 42
Cournot Mergers Oligopoly with Assets
Welfare Improving Mergers
0 0.2 0.4 0.6 0.8 10
0.2
0.4
0.6
0.8
1
Firm 1’s share of the available assets
Fir
m 2
’s s
har
e of
th
e av
aila
ble
ass
ets
A merger between firms 2 and 3 is
welfare improving
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 16 / 42
Cournot Mergers Oligopoly with Assets
Welfare Improving Mergers and HHIFrom McAfee and Williams (JIE, 1992)
Threshold for profitability
Threshold for welfare enhancement
Threshold for HHI rules
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 17 / 42
Cournot Mergers Efficiency Gains
Cournot Mergers with Efficiency Gains
Pre-merger FrameworkLinear inverse demand function P(q) = 1−Q
Pre-merger, n identical firms with constant marginal cost c
Equilibrium price and (individual profits) are therefore:
P∗ =1 + ncn + 1
= c +1− cn + 1
and π∗ =(1− c)2
(n + 1)2
Merger with Efficiency Gains2 of the n firms merge
Efficiency gains (for the insiders): cI = c − γ
Nothing changes for the outsiders: cO = c
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 18 / 42
Cournot Mergers Efficiency Gains
Merger with Efficiency Gains
Post-merger price and profitsEquilibrium quantities:
q∗∗I =1− c + (n − 1)γ
nand q∗∗O =
1− c − γn
Equilibrium price:
Q∗∗ =(n − 1)(1− c) + γ
n⇐⇒ P∗∗ = c +
1− c − γn
Equilibrium profits:
π∗∗I =(1− c − γ)(1− c + (n − 1)γ)
n2 and π∗∗O =(1− c − γ)2
n2
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 19 / 42
Cournot Mergers Efficiency Gains
Mergers with Efficiency Gains
Some RemarksA merger can be beneficial for consumers if the efficiency gainsare large enough
If a merger lowers (raises) the equilibrium price then it is bad(good) news for the outsiders
Mergers involving two firms only can be profitable
More generally small and large mergers can be profitable (butnot intermediate mergers))
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 20 / 42
Cournot Mergers Efficiency Gains
Profitable (small) Cournot Mergers
0.1 0.2 0.3 0.4 0.5
-0.01
0.01
0.02
0.03
Measure of Efficiency Gains
Profitable Mergers
All mergers are welfare improving
Price Lowering Mergers
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 21 / 42
Cournot Mergers Efficiency Gains
Mergers with Efficiency Gains
0.1 0.2 0.3 0.4 0.5
-0.03
-0.025
-0.02
-0.015
-0.01
-0.005
Initial number of firms varying from 3 to 7
Impact of the merger on insiders’ profits
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 22 / 42
Mergers with Differentiated Products
Outline
1 Introduction
2 Cournot Mergers
3 Mergers with Differentiated Products
4 Some Practical Issues For Merger Analysis
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 23 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Linear Demand with Differentiated Products
A Simple Version of “Brand Portfolio” ModelsThree variants of a given product
Pre-merger, three identical firms produce a variant each atconstant marginal cost c
Consumers have the following (gross) utility function:
U = y + a3∑
i=1
qi −3
2 (1 + β)
3∑i=1
q2i +
β
3
(3∑
i=1
qi
)2
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 24 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Linear Demand with Differentiated Product
Demand functionsDemand functions write as:
Di =13
a− (1 + β) pi +β
3
3∑j=1
pj
β is the parameter of substitutabilityβ = 0: products are independent (maximum differentiation)β →∞: products are (almost) perfect substitutes
Note that: p1 = p2 = p3 = p =⇒ q1 = q2 = q3 = 13 (a− p)
Fixed size of the market (does not depend on β or the number offirms)a is a market-size parameter
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 25 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Pre-merger outcome
Pre-merger: Three independent firmsEach firm (non-cooperatively sets its price pi so as to maximize itsprofit πi = (pi − c) Di
Prices, Quantities and Profits:
p∗i = c +3(a− c)
2(3 + β), q∗i =
(a− c)(3 + 2β)
6(3 + β)and π∗i =
(a− c)2(3 + 2β)
4(3 + β)2
Consumer Surplus and Total Welfare:
CS∗ =(a− c)2(3 + 2β)2
8(3 + β)2 and W ∗ =(a− c)2(27 + 24β + 4β2)
8(3 + β)2
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 26 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Post-Merger
Suppose that firms 1 and 2 merge
The new firm (I) now owns a portfolio of brands and maximizes its profitπI =
∑2i=1 (pi − c) Di
Impact of the merger on prices
p∗∗I = c +(a− c)(6 + 5β)
2 (6 + 6β + β2)> p∗∗O = c +
(a− c)(3 + 2β)
6β + β2 > p∗i
Merger ≈ Collusion between two firms =⇒ the insiders’ product are priced lessaggressively
Due to strategic complementarity, this lead to less aggressive behavior from theoutsider(s)
All prices thus go up
But the direct effect dominates, therefore the insiders’ prices increase more
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 27 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Impact on Price Absent Efficiency Gains
Outsider’s Price (pO)
Insi
der
s P
rice
(s)
(pI)
Insiders are less aggressive post
merger
Pre-Merger Equilibrium
Post-Merger Equilibrium
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 28 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Impact on Price With (Large Enough) Efficiency Gains
Outsider’s Price (pO)
Insi
der
s P
rice
(s)
(pI)
Merger makes the insiders less aggressive …
Pre-Merger Equilibrium
… but efficiency gains make them more aggressive
Post-Merger Equilibrium
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 29 / 42
Mergers with Differentiated Products Linear Demand with Differentiated Products
Impact on Profits and Total Welfare
Impact on ProfitsThe merger is profitable for the insiders
Rk: It is never profitable for the new entity to stop selling a product
The merger increases the outsider’s profit
However, the merger is more profitable for the outsider than for theinsiders
Impact on WelfareThe net effect of the merger on total welfare (unweighed sum ofconsumer surplus and profits) is negative
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 30 / 42
Mergers with Differentiated Products Logit Models
Logit Models
Discrete choice models of consumer behavior (McFadden,1978)
Widely by econometricians and in practice to evaluate mergers(with differentiated products)
Demand Modeln different products (mutually exclusive alternatives for theconsumers)
Consumer i derives utility Uij = αj − βpj + εij from consuminggood j , where:
αj : product-specific constant (characteristics)εij : random coefficient (i.e. unobservable subjective preferences ofconsumer i or unobservable product characteristics)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 31 / 42
Mergers with Differentiated Products Logit Models
Logit Demand Models
Logit DemandAssumption: The random coefficient are i.i.d. according to theextreme value distribution
We can then show that the demand for good j (i.e. the probabilitythat consumer i will buy good j) writes as:
πj =exp
(αj − βpj
)∑k∈J exp (αk − βpk )
Note that πj is also the market share of product of product jOnce the demand are computed, it is possible to solve for theNash-equilibrium of price competition game
Nested Multinomial Logit
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 32 / 42
Mergers with Differentiated Products Logit Models
How to use logit demand models for merger analysis?
Use the available data on prices and market shares to evaluatethe various coefficient of the model (i.e. αj and β)
Use the estimated demand model to solve for the post-mergerequilibrium
Evaluate consumer surplus (pre- and post-merger) and / or totalwelfare
Optimally we would like to estimate the supply side of the modelas well (i.e. cost functions) to take potential efficiency gains intoconsideration
Possibility to take relocation (change of product characteristic,product removal, . . . ) into account
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 33 / 42
Some Practical Issues For Merger Analysis
Outline
1 Introduction
2 Cournot Mergers
3 Mergers with Differentiated Products
4 Some Practical Issues For Merger Analysis
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 34 / 42
Some Practical Issues For Merger Analysis Unilateral Effects
Factors affecting market power
ConcentrationThe larger the number of independent firms operating after themerger, the less likely it is that the merger will be detrimental toconsumers
Rationale for the use of concentration indices (e.g. HHI)
Market Shares and CapacitiesThe lower the market shares of the merging firms, the lessdetrimental the effect on prices
Productive capacities (i.e. if rivals can increase production afterthe merger, it is likely that the price will raise)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 35 / 42
Some Practical Issues For Merger Analysis Unilateral Effects
Factors affecting market power
EntryThe firms’ ability to raise price is limited by the existence ofpotential entrantsNecessity to evaluate existing barriers to entry in the industry (i.e.sunk costs, . . . )Difficult assessment: need to evaluate if firms are likely to enterand when (uncertainty)
Other important factorsDemand variables (e.g. price elasticity)Buyer power (can go in both directions)Failing firm defence
What are the alternatives?
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 36 / 42
Some Practical Issues For Merger Analysis Coordinated Effects
Coordinated Effects
Risk of joint-dominanceSee chapter 11 (Collusion): what are the factors that makecollusive outcomes (i.e. tacit collusion) more likely to arise inequilibrium.
E.g. See Compte, Jenny and Rey (EER, 2002) and the Nestlé /Perrier merger.
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 37 / 42
Some Practical Issues For Merger Analysis Efficiency Gains
Nature and Assessment of Efficiency Gains
Theory: Variable or Fixed Costs?Variable cost savings are likely to have an impact on prices
However, output rationalization is not enough to lead to lowerprices post-merger (see oligopoly with assets)
I.e. real synergies (in the sense of Farrell and Shapiro) arerequired
Fixed cost savings (e.g. avoiding duplication of fixed costs) haveno impact on prices
Practice: Important to Identify the Nature of the Efficiency Gains
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 38 / 42
Some Practical Issues For Merger Analysis Efficiency Gains
Assessment of Efficiency Gains
Only efficiency gains that could not be achieved without themerger should be taken into account
Asymmetric information between firms and competitionauthorities
Firms have strong incentives to overstate efficiency claims
Genuine tendency to overstatement (merging parties are often toooptimistic, do not foresee difficulties to create synergies betweendifferent cultures, . . . )
Rival firms (outsiders) have a tendency to understate efficiencyclaims
Need for specialized independent auditors
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 39 / 42
Some Practical Issues For Merger Analysis Efficiency Gains
Efficiency Offence
If efficiency gains are too large, it is possible that the mergerwould force some outsiders to exit the market
This might then be detrimental for the consumers (higher prices)or even for total welfare
Note that if might be efficient to have fewer, bigger and moreefficient firms than more, smaller inefficient ones
However, we should then expect outsiders to react and merge in order tosurvive (see for instance Motta and Vasconcelos, IJIO, 2003)
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 40 / 42
Some Practical Issues For Merger Analysis Merger Remedies
Divestitures (i.e. Structural Remedies)
Types of DivestituresCapacities or Assets: Carrefour / Promodès, Total Fina /Elf, . . .
Brands: Unilever / Bestfoods, . . .
Problems with divestituresAsymmetric information
Possibility for the merging parties to divest unprofitable assets ordecrease the value of the divested assets
Identifying the right buyer
Risk of collusion (more symmetric situations, multi-market contact,. . . )
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 41 / 42
Some Practical Issues For Merger Analysis Merger Remedies
Behavioral Remedies
Types of RemediesLicensing agreements (Astra / Zeneca))
Non-discriminatory access to “essentiel facilities” (Vivendi /Canal+ / Seagram)Giving up important exclusivity agreements (Lufthansa / SAS)
Problems with behavioral remediesRequire ongoing regulation or constant monitoring
Easier to “evade” (asymmetric information between firms and theauthorities)
Might require a (transitory) period of collaboration between themerging parties and the entrant / licensee (risk of collusion,incentives not to collaborate effectively, . . . )
THIBAUD VERGÉ ( CREST-LEI ) Horizontal Mergers Advanced IO 1 42 / 42