the analytics of constrained optimal decisions microeco nomics spring 2016 dynamic pricing (II) ………….1industry consolidation (ad companies) ………….8 industry consolidation (newspapers) session nine

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |1 industry consolidation Consolidation: Omnicom and Publicis AD COMPANIES ► Omnicom Group Inc. and Publicis Groupe SA said Sunday, July 28 th, 2013, they will merge to create a $35.1 billion advertising giant, overtaking current market leader WPP PLC in the industry's biggest deal ever. U.S.-based Omnicom and France's Publicis, the second and third biggest ad companies respectively by revenue, said they will create a new entity called the Publicis Omnicom Group in a merger of equals. Revenue for 2012 (billions) Western Europe North America Rest of World Total Market Share WPP PLC$5.80$5.65$4.97$ % Omnicom Group$3.59$7.30$3.32$ % Publicis Groupe$2.38$4.12$1.89$ % Interpublic Group$1.44$3.78$1.78$ % Proforma Dentsu & Aegis$0.96$0.77$4.68$ % Havas$1.12$0.73$0.41$ % ► We will use this case as a motivation for an analysis of consolidation in an industry in which firms compete in capacities. To keep the setup as simple as possible let’s assume: ● there are three identical firms that compete in the market, index them as i = 1,2,3 ● quantity for firm i is therefore q i, i = 1,2,3 ● marginal cost (in cents) for each firm is MC = 200 ● market demand is P = 800 – Q, where Q is the total quantity supplied by the firm active in the market ► Step 1: we derive the market equilibrium with three firms as described above ► Step 2: we assume firm 2 and firm 3 merge and compute the equilibrium with the resulting two firms in the market ► Step 3: under what conditions is the merged firm better off compared to the un-consolidated situation?

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |2 industry consolidation MERGER ANALYSIS ► Step 1 : Market outcome with three firms, pre-consolidation ● From the perspective of firm 1 : - the residual demand is P = (800 – q 2 – q 3 ) – q 1 with marginal revenue MR 1 = (800 – q 2 – q 3 ) – 2 q 1 - profit maximization for residual demand requires MR 1 = MC thus (800 – q 2 – q 3 ) – 2 q 1 = the solution is immediate as q 1 = 300 – 0.5( q 2 + q 3 ) [equation 1] ● From the perspective of firm 2 : - the residual demand is P = (800 – q 1 – q 3 ) – q 2 with marginal revenue MR 2 = (800 – q 1 – q 3 ) – 2 q 2 - profit maximization for residual demand requires MR 2 = MC thus (800 – q 1 – q 3 ) – 2 q 2 = the solution is immediate as q 2 = 300 – 0.5( q 1 + q 3 ) [equation 2] ● From the perspective of firm 3 : - the residual demand is P = (800 – q 1 – q 2 ) – q 3 with marginal revenue MR 3 = (800 – q 1 – q 2 ) – 2 q 3 - profit maximization for residual demand requires MR 2 = MC thus (800 – q 1 – q 2 ) – 2 q 3 = the solution is immediate as q 3 = 300 – 0.5( q 1 + q 2 ) [equation 3] We have to solve this system of three equations with three unknowns ( q 1, q 2 and q 3 ). In this particular case, when the firms are perfectly identical we get a symmetric system which implies that q 1 = q 2 = q 3. Say q * is this common value, then q * = 300 – 0.5( q * + q *) with solution q * = 150, i.e. q 1 = q 2 = q 3 = 150

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |3 industry consolidation MERGER ANALYSIS ► Step 1 : Market outcome with three firms, pre-consolidation ● From the perspective of firm 1 the best response (reaction function) is given by q 1 = 300 – 0.5( q 2 + q 3 ) ● The solution is q 1 = 150 and q 2 = q 3 = 150, this is point (O) in the diagram ● Price in the market is given by P * = 800 – ( q 1 + q 2 + q 1 ) = 350 ● Profit for each firm is the same and equal to Π * = ( P * – MC ) q * = (350 – 200)·150 = 22,500 The pre-merger cumulative profit for firm 2 and firm 3 is thus Π 2+3 * = 45,000 q 1 = 300 – 0.5( q 2 + q 3 ) q1q1 q2 + q3q2 + q3 firm 1’s best response to firm 2 and firm 3 actions pre-merger (O)

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |4 industry consolidation MERGER ANALYSIS ► Step 2 : Market outcome with two firms, post-consolidation Here we assume that firm 2 and firm 3 merge into firm (2,3) with a resulting marginal cost of MC 2,3 = 200. There are two firms in the market now. Let q 1 the quantity produced by firm1 and q 2,3 the quantity produced by the consolidated firm (2,3). ● From the perspective of firm 1 : - the residual demand is P = (800 – q 2,3 ) – q 1 with marginal revenue MR 1 = (800 – q 2,3 ) – 2 q 1 - profit maximization for residual demand requires MR 1 = MC 1 thus (800 – q 2,3 ) – 2 q 1 = the solution is immediate as q 1 = 300 – 0.5 q 2,3 [equation 1] ● From the perspective of firm (2,3) : - the residual demand is P = (800 – q 1 ) – q 2,3 with marginal revenue MR 2,3 = (800 – q 1 ) – 2 q 2,3 - profit maximization for residual demand requires MR 2,3 = MC 2,3 thus (800 – q 1 ) – 2 q 2,3 = the solution is immediate as q 2,3 = 300 – 0.5 q 1 [equation 2] We have to solve this system of two equations with two unknowns ( q 1 and q 2,3 ). Again the firms are perfectly identical thus we get a symmetric system, which implies that q 1 = q 2,3. Say q ** is this common value, then q ** = 300 – 0.5 q ** with solution q ** = 200, i.e. q 1 = q 2,3 = 200

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |5 industry consolidation MERGER ANALYSIS ► Step 2 : Market outcome with two firms, post-consolidation ● From the perspective of firm 1 the best response (reaction function) is given by q 1 = 300 – 0.5 q 2,3 while, from the perspective of firm (2,3), the best response (reaction function) is given by q 2,3 = 300 – 0.5 q 1 q 1 = 300 – 0.5 q 2,3 q1q1 q 2,3 firm 1’s best response to firm (2,3)’s actions ● The solution is q 1 = 200 and q 2,3 = 200, this is point (M) in the diagram ● Price in the market is given by P ** = 800 – ( q 1 + q 2,3 ) = 400 ● Profit for each firm is the same and equal to Π ** = ( P ** – MC ) q ** = (400 – 200)·200 = 40,000 The post-merger cumulative profit for firm 2 and firm 3 is thus Π 2,3 ** = 40, q 2,3 = 300 – 0.5 q 1 firm (2,3)’s best response to firm 1’s actions 200 post-merger pre-merger 600 (O) (M)

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |6 industry consolidation MERGER ANALYSIS ► Step 2 : Market outcome with two firms, post-consolidation ● Looks like the merger does not create a higher profit for the combined firms, i.e. the merger cannot make both the shareholders of firm 2 and firm 3 better off… Π 2,3 ** = 40,000 < Π 2+3 * = 45,000 ● On the other hand firm 1 is far better off… Π 1 ** = 40,000 > Π 1 * = 22,500 ● Pre-merger firm 2 and firm 3 together supply a total of 300 units while post merger the supply of the consolidated firm is 200… ● Price increases but not by enough to make for the reduction in supply, and the reason that price does not increase is that much is that firm 1 increases its own supply (from 150 to 200) as an optimal respond to the reduced supply from the new consolidated firm ● The consolidation would increase the profit (for firm 2 and firm 3) if firms have a limited capacity, i.e. cannot increase its supply say above 150.

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |7 industry consolidation MERGER ANALYSIS ► Step 3 : Limited capacity, post-consolidation ● Let’s assume for the moment that all three firms have limited capacity of 150. Then the pre-merger market outcome is unchanged. But the reaction function for firm 1 is now slightly changed as shown in the diagram. Since it cannot offer anything above 150 the reaction function is “cut” at 150. q 1 = min{150, 300 – 0.5 q 2,3 } q1q1 q 2,3 firm 1’s best response to firm (2,3)’s actions q 2,3 = 300 – 0.5 q 1 firm (2,3)’s best response to firm 1’s actions 200 post-merger 600 (M) pre-merger (O) (L) post-merger 225 ● The solution is q 1 = 150 and q 2,3 = 225, this is point (L) in the diagram ● Price in the market is given by P *** = 800 – ( q 1 + q 2,3 ) = 425 ● Profit for firm 1 is Π 1 *** = ( P *** – MC 1 ) q 1 *** = = (425 – 200)·150 = 33,500 ● The post-merger profit for firm (2,3) is Π 2,3 *** = ( P *** – MC 2,3 ) q 2,3 *** = = (425 – 200)·225 = 50,625 ► When a competitor has a limited capacity the market outcome is altered towards an increase in profit post-merger.

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |8 industry consolidation Newsprint Industry Consolidation INDUSTRY ANALYSIS ► Industry facts : ► Consolidation: ● The economies-of-scale case: Consolidations helps capture economies of scale …..by reducing overhead per ton, better use of resources This eventually translate into lower prices to customers ● The market power case: Greater power over buyers, thus higher prices Better management of capacity Price signaling and collusion

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |9 industry consolidation INDUSTRY ANALYSIS ► Capacity management ► The graph is suggestive of deliberate reduction in capacity, resulting in increasing or at least stemming the decline in prices ► But this leaves the following puzzle: Why would a merged firm shut down plants that they were profitable to operate pre-merger? Newsprint Industry Consolidation

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |10 industry consolidation CAPACITY ANALYSIS ► Capacity management: You have three identical manufacturing units, each producing q. Current price is p 0 and you contemplate closing down one unit thus reducing your own supply to 2 q. Assume all others are always producing at maximum capacity. p Q demand p0p0 3q p Q demand p0p0 2q Q0Q0 Q0Q0 qq Q1Q1 p1p1 close this unit profit loss profit extra profit gain ● loss of profit on closed unit at old price ● gain of profit on open units at new price ► Case I: Tight Market

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |11 industry consolidation CAPACITY ANALYSIS ► Capacity management: in comparing the gain with loss from shutting-down capacity there are two factors to consider: p Q “steep” demand p0p0 2q Q0Q0 q Q1Q1 p1p1 profit extra profit gain p Q “flat” demand p0p0 2q Q0Q0 q Q1Q1 p1p1 profit extra profit gain gain on opened units at new price ● Position and shape of demand curve ● Competitors’ cost profiles ► Case I: Tight Market

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |12 industry consolidation CAPACITY ANALYSIS ► Capacity management: You have three identical manufacturing units, each producing q. Current price is p 0 and you contemplate closing down one unit thus reducing your own supply to 2 q. Assume all others are always producing at maximum capacity. p Q demand p0p0 3q p Q 2q Q0Q0 qq Q1=Q0Q1=Q0 close this unit profit loss profit extra profit ● loss of profit on closed unit at old price ● no gain of profit on open units at new price p1=p0p1=p0 demand ► Case II: Over Capacity

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |13 industry consolidation CAPACITY ANALYSIS p Q 2q q Q1=Q0Q1=Q0 profit extra profit p1=p0p1=p0 “steep” demand ► Capacity management: in comparing the gain with loss from shutting-down capacity there are two factors to consider: ● Position and shape of demand curve ● Competitors’ cost profiles ► Case II: Over Capacity p Q 2q q Q1=Q0Q1=Q0 profit extra profit p1=p0p1=p0 “flat” demand no gain on opened units at new price

microeconomic s the analytics of constrained optimal decisions lecture 9 dynamic pricing (II)  2016 Kellogg School of Management lecture 9 page |14 industry consolidation CAPACITY ANALYSIS ► Capacity management: ● orange company has capacity q ● purple company has capacity q L at low cost and q H at high cost p Q demand p0p0 q p1p1 close this unit profit orange ► If the purple firm would close the high-cost facility it would gain P ► If the orange firm acquires purple firm and would close the high-cost facility it would gain O + P qLqL qHqH profit purple qHqH p Q demand p0p0 qqLqL qHqH qHqH O P loss gain