Lecture Notes 12: Mergers
Economists talk about three kinds of mergers.
โข Horizontal integration refers to integration of multiple producers of the same product. A
horizontal merger occurs when multiple producers at the same stage of production join together. American Airlines buying US Airways is an example of a horizontal merger.
โข Vertical integration occurs when a firm integrates various stages in the production of a single product. A vertical merger occurs when two firms merge that produce components for a single product. If Toyota buys the manufacturer of glass used to produce windshields, this is a vertical merger.
โข A conglomerate merger involves integration of different, unrelated product lines. An example is Walt Disneyโs purchase of ABC.
We will treat horizontal and conglomerate mergers first and then finish with vertical integration, which raises the most interesting issues.
Horizontal Mergers
Interestingly, in a Cournot model with many identical firms, a merger of two firms is not profitable.1 Unless the merger creates a monopoly, the merged firm actually earns less profit than
the two firms earned on their own. Even if multiple firms merge, it can be shown that more than 80% of the firms would have to merge in order to create any increase in profit. Weโll have to look somewhere else for a reason to merge.
โข If firms have different costs, then a merger may be profitable because it reduce costs by allowing the merged firm to use the lower-cost technology.
A couple of interesting things about this result. First, the increased concentration raises prices and the net result is bad for consumers, even after accounting for the ability of firms to use the lower-cost technology. Second, the non-merged firms actually benefit more than the merged firm benefits from the merger. Thus, in this model itโs actually better to wait around for other firms to merge.
โข If the merged firm can become a Stackelberg leader, then the merger is profitable.
A merged firm might become large enough to establish itself as the industry leader. In this case, the merger increases total profits for the merged firms. Another interesting result about this model is that there is an incentive after this point for follower firms to merge, which can explain the domino effect often observed with industry mergers. These mergers can end up increasing or reducing price, so they could be good or bad for consumers.
โข If products are differentiated, mergers can reduce competitive pressures and will generally lead to an increase in profit for both the merged firm and for nonmerged firms.
โข In a spatial model, a merger between two adjacent firms increases profits by allowing the firms to raise prices for โcaptiveโ customers located in the middle. (It is important that the firms coordinate their pricing). This spills over to other firms, and nonmerged firms also enjoy increases in their profits.
โข If an industry features strong economies of scale, there could be cost reductions from mergers. For example, a merged firm might require only one headquarters and require fewer managers. If these cost savings are significant, consumers might actually end up with lower prices.
Of all our situations in which firms elect to engage in mergers, only the last one really has the potential to create benefits for consumers. Mergers that are initiated to gain from economies of scale tend to be good for society. Mergers that are initiated to increase market power may be profitable for firms (then again, they may not), but these are generally bad for society.
Conglomerate Mergers
A conglomerate merger offers no possibility for efficiency gains based on specialization or economies of scale. Thus, how can we explain why a conglomerate merger would make sense? There are a few explanations
1. Even if there are no economies of scale, there may be economies of scope, which means that a firm reduces its average costs by producing a larger variety of products. As an example, there may be a machine that can be used to produce both Product A and Product B, so a merger can allow the merged firm to exploit common inputs and make better use of their capital (e.g. avoiding idle machines for the production of either product).2
2. If there is a shortage of managerial talent, a conglomerate merger could let a talented manager spread her skills to different products more effectively.
2 Then again, canโt the firms just lease use of their machines to each other and accomplish the same objective without
3. If products face variable demand, a conglomerate merger could present a risk-reducing arrangement by letting the firm hedge its bets across different products. It could also use its revenues from one product to finance capital infusions into the other.
4. Managers may want to initiate conglomerate mergers to grow their companies, which often increases their own income given the way that managerial compensation is designed. Thus, some economists have suggested that managers might push even conglomerate mergers that are not profitable for the corporation because they grow the company and grow the managersโ pay.
Vertical Integration
Vertical integration occurs when a firm participates in more than one stage of production or distribution of its product. An oft-cited example is Perdue, which owns chickens, produces chicken feed and does all its own meat packaging. Forward integration occurs when a firm buys another firm at a later production stage. Think about GM buying a car dealership. Backward integration
occurs when a firm buys another firm at an earlier production stage. Think about GM buying the glass company that produces its windshields. Basically, the essence of vertical integration is that a firm produces services it needs for production and/or distribution rather than relying on buying these services from another firm.
In addition to treating vertical mergers, we will also address the closely related issue of vertical restrictions, whereby firms do not integrate but there are contractual terms that restrict the activity of nonintegrated firms. For example, car manufacturers often impose rules on dealerships that distribute their cars.
Vertical integration forces a company to do multiple things and seemingly reduces the gains from specialization. Why should GM be an expert in manufacturing glass? Nevertheless, there are a number of potential gains from vertical integration. Here are the most important ones.
1. Lower transactions costs โ The process of doing business with someone itself creates a cost. For example, GM has to hire lawyers to negotiate and write contracts with glass suppliers. Vertical integration eliminates these transactions costs.
economics as a holdup. The manufacturer can eliminate the potential for a holdup by producing its own computer chips.
Note that (1) and (2) are more of a problem for specialized inputs that are specific to the firm purchasing them. If there is a competitive market for the input, contracting is easier and holdups are more difficult because there is competition and a clear market price.
3. Eliminate incentive problems โ A supply firm might not have a strong incentive to produce high-quality inputs, because it is not responsible for the final product sold to consumers. An integrated firm has an incentive to ensure quality of each component from start to finish.
4. Eliminate uncertainty โ Related to the previous point, a manufacturer might have a difficult time monitoring the quality of inputs it buys from a supplier. Producing the inputs itself makes it easier for the firm to monitor quality.
5. Make coordination easier โ Itโs cheaper for steel mills to produce their own iron because they can run the iron directly into the steel furnace when they melt it. If the steel mill purchased the iron, it would have to be cooled down by the iron supplier and then heated and melted all over again by the steel mill. Theoretically, the steel mill and the iron supplier could be located next to each other, but itโs easier to coordinate the production and reduces transactions costs if the firms are integrated.
6. Assure supply โ If there is frequently a shortage of the input in question, a firm might find it preferable to produce the input itself instead of relying on the market and running the risk of not being able to deliver to customers. Again, this is less of a problem if there is a well-established competitive market for the input.
7. Eliminate externalities โ Honda dealerships everywhere benefit when West Chesterโs Honda dealership provides good service. Good service at one location builds the brand quality and benefits all other locations as well. Thus, the West Chester Honda dealership might not have strong enough incentives to provide good service because many of those benefits are externalized to other branches. Integration would solve this problem.
8. Avoid taxes and regulation โ An integrated firm can avoid sales taxes on the purchase of its inputs. Integration also presents opportunities for firms to shift profits from high-tax jurisdictions to low-tax jurisdictions.3
3 For example, suppose that windshield glass is made in California (high-tax) but cars are assembled in Alabama
9. Forward integration to monopolize downstream firms โ A supplier of an input might purchase all of the โdownstreamโ manufacturers in order to monopolize production. This is especially true if the manufacturers have some flexibility in their production process and can use more of the input from the purchasing firm.
10. Prevent arbitrage / allow price discrimination โ Suppose a supplier sells wire to Firm A and Firm B, but wants to charge a higher price to Firm A. The problem is that Firm B could buy wire and resell it to firm A. If the supplier buys Firm B, it would certainly solve that problem.
11. Eliminate double marginalization โ The double marginalization problem is the subject of the next section.
Double Marginalization
Letโs illustrate the double marginalization problem by means of an example. Crystal Springs is the only supplier of a special kind of mineral water to Aquaclara. In turn, Aquaclara has a monopoly in distributing water to consumers. Market demand for the water is ๐๐ = 1000 โ ๐๐. Crystal Springs has no costs associated with extracting the water. After Crystal Springs extracts the water, it sells the water to Aquaclara at cost ๐๐ per gallon. Aquaclara has no costs other than the supply cost of the water from Crystal Springs. Aquaclara sets a price ๐๐ at which it sells water to consumers.
Firms are not integrated
In order to figure out the optimal prices, we have to use backwards induction. Whatever cost ๐๐ is set by Crystal Springs, Aquaclara will set its output to maximize its profit.
ฮ ๐ด๐ด = ๐๐๐๐ โ ๐๐๐๐
= (1000 โ ๐๐) โ ๐๐ โ ๐๐๐๐ = 1000๐๐ โ ๐๐2โ ๐๐๐๐
In order to maximize profit, Aquaclara chooses:
๐๐ฮ ๐ด๐ด
๐๐๐๐ = 1000 โ 2๐๐ โ ๐๐ = 0 โ ๐๐ = 500 โ12 ๐๐
This is essentially a reaction function. Crystal Springs knows that, for whatever price ๐๐ it sets to sell to Aquaclara, the expression above gives the amount of water that Aquaclara will purchase from them.
In turn, Crystal Springs will set ๐๐ to maximize its own profit.
ฮ ๐ถ๐ถ = ๐๐๐๐ โ 0
= ๐๐ โ ๏ฟฝ500 โ12 ๐๐๏ฟฝ
= 500๐๐ โ12 ๐๐2
Choosing ๐๐ to maximize profit:
๐๐ฮ ๐ถ๐ถ
๐๐๐๐ = 500 โ ๐๐ = 0 โ ๐๐ = 500
Thus, Crystal Springs will set a price ๐๐ = 500 for selling water to Aquaclara. In turn, Aquaclara
will purchase ๐๐ = 500 โ1
2๐๐ = 250 gallons of water and will set price ๐๐ = 1000 โ ๐๐ = 750 for
its customers.
Letโs calculate the profits of the two firms.
ฮ ๐ด๐ด = $500 โ 250 = $125,000
ฮ ๐ถ๐ถ = $750 โ 250 โ $500 โ 250 = $62,500
Firms are vertically integrated
Now letโs see what happens if Aquaclara and Crystal Springs merge into a single firm that sells water directly to customers. The vertically integrated firm will maximize profit.
ฮ ๐๐ = ๐๐๐๐ โ 0
= (1000 โ ๐๐) โ ๐๐ = 1000๐๐ โ ๐๐2
To maximize profit for the merged firm:
๐๐ฮ ๐๐
The market price is ๐๐ = 1000 โ ๐๐ = 500, and the profits of the integrated firm are:
ฮ ๐๐ = $500 โ 500 = $250,000
In this example, we can see a clear motive for vertical integration. When the firms were nonintegrated, Crystal Springs and Aquaclara together earned a total profit of $187,500. But the vertically integrated firm earns a profit of $250,000. A clear incentive to merge.
In fact, the merger makes the consumers better off too. Theyโre paying $500 for the water instead of paying $750. This particular merger is good for the firms and for consumers.
Whatโs going on here? Itโs some basic economics at work. The nonintegrated firms each charge their own monopoly markup, leading to two deadweight losses imposed on society. This is known as the double marginalization problem. By contrast, the integrated firm imposes only one markup. By reducing deadweight loss the merger enhances efficiency, benefitting both consumers and firms.
The lesson is that vertical mergers to eliminate double markups are good for society. However, even if a merger is not possible, a supplier might impose restrictions on downstream firms in order to reduce the double marginalization problem. We turn to these vertical restrictions in the next section.
Vertical Restrictions
Vertical restrictions are restrictions imposed by manufacturers on distributors.
The basic issue is a simple incentive problem. The goal of the distributors is to maximize their own profit, which as we saw in the previous section can come at the expense of the manufacturerโs profit. By contrast, the manufacturer wants the distributor to act in a way that will bring maximum profits to the manufacturer.
The most basic issue to resolve is the elimination of double markups.
1. Manufacturer imposes a maximum selling price on distributors โ This is the cleanest solution, obviously, but itโs illegal in the US. Manufacturers are not allowed to control the retail prices of independent distributors.
3. Manufacturer uses a two-part tariff โ The manufacturer can sell to the distributor at marginal cost, so that the distributor faces the same costs as the manufacturer and will set the level of output that the manufacturer would have set. This might seem like a bad deal for the manufacturer initially, but he can use a two-part tariff to seize the distributorโs surplus from being able to purchase from the manufacturer at marginal cost. What do you think franchise fees are for?
In addition to eliminating double marginalization, another important motivation for vertical restrictions is to reduce free-riding among distributors.
As discussed earlier, all Honda dealers can potentially benefit from good service provided by one dealership. Ads that West Chesterโs Honda dealership runs can generate Honda sales for other dealerships. A dealer with a large showroom and well-trained staff might well be providing information to customers who buy a Honda elsewhere. And maintaining a good reputation is good for the brand overall. Individual dealers might prefer to shirk on these activities and free-ride on other dealers and the reputation that they build.
What are some solutions?
1. Exclusive territory โ Give distributors an exclusive territory, which provides more of an incentive for distributors to provide good service for their own customers and reduces opportunities for free-riding.
2. Control advertising at the corporate level โ There might be too much incentive for free-riding when individual distributors pay for their own ads; each distributor might prefer to save on ads and free-ride from other distributors that aggressively advertise the product. The manufacturer can solve this problem by taking money from distributors and running the advertising campaign itself.
3. Monitor distributors and set up rewards for those that do well.
4. Resale price maintenance โ A manufacturer can set a minimum price for distributors in order to force them to improve service quality and compete on aspects other than price. This is known as resale price maintenance and is illegal in the US.
How do these vertical restrictions impact consumers? Itโs a mixed bag.
On the positive side, vertical restrictions that eliminate double marginalization reduce price and enhance efficiency in the market. And distributors facing monitoring and rules from manufacturers to prevent free-riding have more of an incentive to stimulate sales effort and provide better service to customers.
On the negative side, vertical restrictions can be used for anticompetitive purposes. For example, vertical restrictions can effectively monopolize the sale of some key input and increase rivalsโ costs. Territorial allocation can facilitate the formation of monopolies and cartels. And control over distributors makes collusion among manufacturers easier because distributorsโ prices can be easily controlled.
As a final note, regulations against vertical restrictions make little sense if mergers are easy and manufacturers can simply vertically integrate instead โ which does the same thing.
Franchising
Franchising is an arrangement whereby the franchisor sells a brand name and a method of doing business to a franchisee, but with significant vertical restrictions. Typically, the franchisee pays a fixed fee and a royalty on sales to the franchisor. This arrangement is common in gas stations (85% of locations), fast-food restaurants (79% of locations) and car dealerships (basically universal).
At first, it seems like the franchisor corporation should just own the locations itself in order to avoid double marginalization problems. The big problem is an incentive problem. A manager of a corporate-owned store (where the profits go to the corporation) has less incentive to invest high effort than the owner of a franchise (who keeps the profits).
Corporate ownership can work well when it is easy to monitor managers for high effort โ for example, if the store is close to corporate headquarters. But franchising is more common when it is difficult for the corporation to continuously supervise the location. A franchisee owner, because he keeps the firmโs profits, is more invested and is in a better position to monitor the location and ensure high quality.
Concluding Remarks
to leave the firms nonintegrated to benefit from specialization. Indeed, while there is a 92% chance that a complex and specialized input will be produced internally, there is only a 2% chance that a nonspecialized input will be. For example, auto manufacturers produces the machines they need to manufacture cars, because these are specialized and have no use on the open market. Market power does not appear to have any substantial impact on whether firms will vertically integrate.
Exercises
Problem 1
A franchisee faces a demand curve given by ๐๐ = 100 โ ๐๐ and incurs a cost of $40 for each unit of output that it sells.
a. Suppose that the franchisor charges a royalty of ๐ก๐ก for each unit of output sold by the franchisee, so that the franchiseeโs total costs are 40๐๐ + ๐ก๐ก๐๐. How many units of output will the franchisee sell to maximize profit?
b. Suppose instead that the franchisor takes a proportion ๐๐ of the franchiseeโs profits, so that the franchisee keeps only a proportion 1 โ ๐๐ of the profits. How many units of output will the franchisee sell to maximize profit?
c. Which system creates a larger distortion in the franchiseeโs behavior? Which system do you think the franchisor should prefer?
d. In light of your answer in (c), why would a franchisor ever use a royalty instead of taking a fraction of the profits?
Problem 2
Consider a market where the demand curve is ๐๐ = 1200 โ ๐๐ and with no production costs.
a. If there are ๐๐ firms in operation, find the Cournot equilibrium output of each firm. Your answer will depend on ๐๐.
b. Suppose that there are initially three firms. Two of the firms are considering whether to merge. Is there any incentive for the merger?
c. Suppose instead that there are initially only two firms. They are considering whether to merge. Is there any incentive for this merger?
d. What is the important difference between (b) and (c)?
e. Suppose now that there are initially 11 firms and that 3 of the firms are considering whether to merge into a single firm. Is there any incentive for this merger?
f. Suppose instead that there are initially 11 firms and that 10 of the firms are considering whether to merge into a single firm. Is there any incentive for this merger?
g. What do your answers to (e) and (f) show?
h. In (f), who benefits more from the merger โ the merging firms or the non-merged firm?
Problem 3
Problem 4
A monopolistic producer uses an exclusive dealer network to distribute its product. However, some exporters buy the product in another country and then resell it in the United States (these are called grey market sales). Interestingly, producers often make no efforts to stop these grey market sales, even those that compete with their own distributors. Can you explain why?
Problem 5
