Industrial Organization Lecture 5 Concentration, Mergers...

Binglin Gong Fudan University

Industrial Organization

Lecture 5

Concentration, Mergers,

and Entry Barriers

Questions to Answer

1. Why do firms in some industries make pure profits?

2. When oligopolies make pure profits, how come entry

of new firms does not always occur, thereby eliminating

all pure profits?

3. What can explain mergers among firms in a given

industry?

Questions to Answer (Cont.)

4. What is and what should be the regulators' attitudes

towards concentrated industries? More precisely,

(a) Should the regulator limit and control mergers

among firms in the same industry?

(b) Even if mergers do not occur, should the regulator

attempt to control the degree of concentration in

industries?

Outline of This Lecture

• Discusses and defines methods for measuring

the degree of concentration in an industry.

• Analyzes merger activities among firms and

how those activities affect the industry's level

of concentration.

• Explain why entry does not always occur

despite the fact that existing firms in the

industry make strictly positive profits—entry

barriers & entry deterrence.

Concentration Measures

• The most concentrated industry has a monopoly

market structure.

• When the number of firms is greater than one, there

are two factors that influence concentration:

(a) the number of firms in the industry, and

(b) the distribution of output among the firms in the

industry.

• Thus, a measure of concentration should be sensitive

to both the distribution of the industry's output across

firms as well as the number of firms in the industry.


• When the market is splitted more evenly among more

firms, the concentration level is lower.

• Assume there are N firms in an industry.

Use i as the index for firms, i=1,…, N.

qi is the output of firm i.

Q is the total output in this industry.

• Firm’s percentage share in industry’s output =

Si=100(qi/Q)


• We can rank them from high to low. S(i) is the ith

highest share.

• Two measures of concentration

– Four firm concentration ratio

– The Herfindahl-Hirshman index

Example

• The Herfindahl-Hirshman index contains more

information and is more accurate. It is more

frequently used.

Mergers

• The terms mergers, takeovers, acquisitions, and

integration describe a situation where independently

owned firms join under the same ownership.

• We will use the term merger to refer to any type of

joining ownership and disregard the question of

whether the merger is initiated by both firms, or

whether one firm was taken over by another. Instead,

we investigate the gains and incentives to merge and

the consequences of mergers for the subsequent

performance and productivity of the firms involved,

for consumers' welfare, and for social welfare.

Types of Mergers

• Horizontal: merger between two competitors:

Goods are substitutes.

• Vertical: merger between a firm producing an

intermediate good (or a factor of production)

and a firm producing the final good that uses

this intermediate good.

• Conglomerate: merger between firms

producing less related products.

Conglomerate Merger

• Product extension: The acquiring and acquired

firms are functionally related in production or

distribution.

• Market extension: The firms produce the same

products but sell them in different geographic

markets.

• Other conglomerate: The firms are essentially

unrelated in the products they produce and

distribute.

Merger Waves

Period Name Facet [31]

1893–1904 First Wave Horizontal mergers

1919–1929 Second Wave Vertical mergers

1955–1970 Third Wave Diversified conglomerate

mergers

1974–1989 Fourth Wave

Co-generic mergers;

Hostile takeovers;

Corporate Raiding

1993–2000 Fifth Wave Cross-border mergers,

mega-mergers

2003–2008 Sixth Wave

Globalisation,

Shareholder Activism,

Private Equity, LBO

2014- Seventh Wave

https://en.wikipedia.org/wiki/Mergers_and_acquisitions#cite_note-31

Mergers in The Real World

Google

• Acquisitions: Motorola Mobility, Waze, Deja

News (Google Groups), Dodgeball (Google

Latitude), JotSpot (Google Sites),

GrandCentral (Google Voice), Next New

Networks (YouTube Next Lab and Audience

Development Group).

• Spinnoffs: Frommers, SketchUp, Google

Radio Automation.

Why So Many Mergers in The Real

World? Possible Answers:

• Economies of scale: both in production and in

things like R&D.

• Economies of scope: synergies between the

two companies. Defensive mergers: to deal

with contracting markets, excess capacity.

• Decrease competition: these are the mergers

that antitrust is worried about.

How Successful Are Mergers?

• Studies of past merger waves have shown that two of

every three merger deals have not worked.

• Why?

• Real world problems like.

1. Linking distribution systems is often difficult.

2. Information systems often very difficult to mesh

together.

3. Clash of corporate cultures.

The “Merger Paradox”

Horizontal Merger of

Heterogeneous Firms

Proposition 8.1

• Under a Cournot market structure, a merger

among firms leading to an increase in

concentration does not necessarily imply an

overall welfare reduction.

• The intuition behind Proposition 8.1 is that

when firms have different production costs,

there exists a tradeoff between production

efficiency and the degree of monopolization.

Merged Firm as A Stackelberg

Leader

Merged Firm as A Stackelberg

Leader • Always more profitable to merge if you can act

as a Stackelberg leader.

• Merger decreases profits of non-merging firms

are long as there are four or more firms in the

industry originally.

• In this model, total output will increase.

• So now we have a new paradox: Why would

antitrust officials want to stop this type of

merger?

Horizontal Mergers with Product

Differentiation • Spatial model of product differentiation

• Possible benefits of merger：

Coordinate prices: price of one firm affects the

demand for the other firm.

• Also can coordinate "location" (product

design).

• Start with a circle model this time, not a linear

model.


Differentiation • Circle model similar to linear model, except there is no "end“

problem.

• Consumers evenly spaced around the circle.

• Each has a value of s and a cost of transport of t.

• All firms have the same costs. F is fixed cost and c is constant

marginal cost.

• Each firm sets price.

• Consumers pay p + t(distance traveled)

• With symmetric firms, they locate 1/n away from each other,

all set the same price.

• As long as s is sufficiently high, every consumer on the circle

will buy.


Differentiation • P* = t(length of circle)/n

• At this price, all consumers buy.

• Merger has no effect if the two firms aren't neighbors.

• Why? no competition between the firms that merge,

so no way to decrease competition.

• If neighboring firms merge, can lessen competition.

Have "captive consumers" over which they have

more market power and can increase profits by

raising price.


Differentiation • Merger also benefits the other firms in the market –

allows them to raise price too.

• After the merger, combined firms may also change

their product lines -- get closer to their neighbors.

• In this case, if there are efficiencies, they will be due

to economies of scope.

Evaluating Mergers

• None of the models presented assume any cost

savings – only reducing competition.

• We need a way to evaluate mergers that

considers both the benefits of any cost savings

as well as the affects of decreased competition.

1992 Merger Guidelines

• Define relevant product and geographic market.

• Measure concentration pre- & post- merger with HHI.

If merger raises HHI by 100 points and post-merger

HHI is > 1000, investigate further.

• Assess ease of entry into market.

• Assess likely competitive effects of merger.

• Assess any significant efficiencies that would result

from the merger.

Vertical Merger

• A vertical merger is defined as a merger

between a supplier (producer) of an

intermediate good and a producer of a final

good who uses this intermediate good as a

factor of production. The common terminology

used to describe these firms is to call the

intermediate-good suppliers as upstream firms,

and the final-good producers as downstream

firms.

Vertical Merger

Proposition 8.2

• A merger between an upstream and a downstream

firm increases the output level of the merged firm and

reduces the output level of the downstream firm that

does not merge.

• Proposition 8.2 is rather intuitive. The downstream

firm that does not merge faces an increase in its input

cost resulting from having to buy its input from a

single monopoly firm B. Hence, the increase in firm

2's production cost and the reduction in firm 1's

production cost would increase the output of firm 1

and reduce the output of firm 2.

Proposition 8.3

1. The combined profit of the merging upstream and

downstream firms increase after they merge.

2. A merger between the upstream and the downstream

firms will not foreclose the market of the disjoint

downstream firm but will only reduce its profit.

• It is often argued that vertical mergers lead to a

foreclosure of the disjoint downstream firms (firm B

or firm 1 or both go out of business). This cannot

happen in the present model since the upstream firm

B will reduce the input price to prevent firm 2 from

leaving the market (firm B sells only to firm 2 after

the merger).

Horizontal Merger among Firms

Producing Complementary Products

Proposition 8.4

Entry Barriers

• Why do we frequently observe that firms do

not enter an industry despite the fact that the

existing firms in the industry make above

normal profits?

• Barriers to entry are considered an important

structural characteristic of an industry.

Entry Barriers

• Absolute cost advantages of incumbent firms

• Economies of scale

• Product-differentiation advantages of incumbent firms, such as

reputation and goodwill.

• Politicians and all levels of governments may explicitly or

implicitly support the existing firms (and the existing firms

may in return support and contribute to the campaigns of

politicians).

• Learning experience possessed by the existing firms

• Consumers' loyalty to brands already consumed

• Availability of financing (banks are less eager to lend to new

investors)

Sunk Costs Generate Entry Barriers

• Sunk costs: costs that cannot be reversed or for which

the investment associated with paying them cannot be

converted to other causes, or resold in order to

recapture part of the investment cost.

• Examples: legal fees and taxes that an entering firm

must bear prior to the actual entry, market surveys

(almost always mandated by the investors),

advertising costs, and expenditures on

nontransportable, nonconvertible plant and

equipment, such as the site preparation work for any

plant.

Sunk Costs Generate Entry Barriers

• In a market for a homogeneous product, the existence

of even small sunk costs can serve as an entry barrier

so that entry will not occur even if the incumbent

continues to make a monopoly profit.

Proposition 8.5

• For any level of sunk entry cost satisfying

, , there exists a unique subgame perfect

equilibrium where firm A is a monopoly earning

a and firm B stays out.

• That is, in a SPE, the entrant foresees that after entry

occurs (the second stage of the game), the incumbent

will switch from being a monopoly to being in an

aggressive price competition and leading the

marginal-cost pricing. Hence, in the first stage the

potential entrant will choose not to enter since staying

out yields zero profit.

• Proposition 8.5 is rather disturbing because it means

that entry will never occur as long as there are some

(even infinitesimal) sunk costs associated with entry.

However, Proposition 8.5 applies only to

homogeneous products. In fact, under these

circumstances, it is likely that the entrant will engage

itself in further investments (higher sunk costs) in

order to develop a differentiated brand, in which case

price competition need not yield zero or negative

profits.

• However, Proposition 8.5 makes a point by stating

that even small sunk cost can create all the conditions

for entry barriers. In fact, the incumbent does not

need to do anything to deter this entry and simply

continues producing the monopoly output level.

• Proposition 8.5 highlights the role ex-post

competition plays in creating entry barriers. What

generates the entry barriers even for negligible sunk

cost is the intensity of the postentry price

competition.

If A Firm Could Receive An Amount

of Ø>0 upon Exit

Proposition 8.6

• There exists a unique subgame perfect equilibrium for

the game described in Figure 8.3, where firm B enters

and firm A (incumbent) exits the industry.

• Proposition 8.6 states that the market for this product

will remain dominated by a monopoly market

structure despite the fact that entry (and exit) occur.

One monopoly replaces another monopoly. Hence,

from the consumers' point of view, this particular

market will be regarded as one that has substantial

entry barriers.

Entry Deterrence

• We assume that initially there is one firm, called the

incumbent or the established firm, that is a monopoly

in a certain market.

• In the second stage, we assume that another firm,

called the potential entrant is entering the market if

entry results in above normal profit.

Entry Deterrence

• Blockaded entry: The incumbent is not threatened by

entry; no firm would find it profitable to enter, even if

the incumbent produces the monopoly output level.

• Deterred entry: The incumbent modifies its behavior

(say, by lowering price or expanding capacity) in

order to deter entry; if prices are lowered, then we say

that the incumbent exercises limit pricing.

• Accommodated entry: Entry occurs, and the

incumbent firm modifies its action to take into

account of entry that occurs.

Entry Deterrence

Potential

Rival

Incumbent

Incumbent

3000

Rival 0

8-52

Incumbent

1100

Rival 900

Incumbent

600

Rival -200

Equilibrium

Are Threats Effective?

• For the potential entrant, the optimal strategy is to

enter. If the competitor enters the market, warfare

strategy payoff is lower than accommodation

strategy payoff for the incumbent.

• But this outcome is not desired by the incumbent.

So in order to deter entry, the incumbent can carry

out the threat of warfare.

• Questions: Can such a threat deter entry? Why?

How to understand the rationality of competitors?

8-53

Commitments

• Commitment——An action taken by a

player which make its threat to become

credible.

• An example: IBM declared a very low price

after three years when it brought its new PC

into the market.

• Questions: What’s the effect of IBM’s

action? Why was this action feasible？ 8-54

Credibility of Commitment

• How can the incumbent’s threat become

credible in the game of entry deterrence?

• One commitment is to install a additional

production capacity, which is excrescent

when the potential entrant enter the market

and is a strong weapon to lower the price

when entry happens 8-55

Payoffs after an 800 Investment

Potential

Rival

Incumbent

Incumbent

2200

Rival 0

8-56

Incumbent

300

Rival 900

Incumbent

600

Rival -200

Equilibrium

Some Specific Strategies

• “Promising the lowest price” strategy

• “We promise that the prices of what we sell are

the lowest in the city. If customers who bought

the goods in our shop can find lower price for

the same goods during one month, in addition to

repaying the margin, we will further compensate

10% of the sum. ”

• Questions: What’s the effect of the strategy? If

you are the boss of another shop, how can you

make the price? 8-57

Merger vs. Predation

• Sometimes merger can be more profitable than

predation, sometimes not.

• However, – merger may not be allowed by the authorities

• monopoly power – what if there are additional potential entrants?

• may enter purely in the hope of being bought out

• Main point remains: threat of predation has to be

credible if it is to work

Industrial Organization Lecture 5 Concentration, Mergers...

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