Horizontal Mergers Advanced Industrial Organization 1 · Perry and Porter (American Economic...

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


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)


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)


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)


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



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



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



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


Cournot Mergers

Outline

1 Introduction

2 Cournot Mergers




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



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))



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?



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



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



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



Welfare Improving Mergers and HHIFrom McAfee and Williams (JIE, 1992)

Threshold for profitability

Threshold for welfare enhancement

Threshold for HHI rules


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



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



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))



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



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


Mergers with Differentiated Products

Outline

1 Introduction

2 Cournot Mergers




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



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



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



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



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



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



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


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)



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



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


Some Practical Issues For Merger Analysis

Outline

1 Introduction

2 Cournot Mergers




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)


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?


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.


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



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



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)


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,. . . )


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, . . . )


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