Mergers Economic Issues Miguel A. Fonseca

readings Martin, S. Industrial Economics, ch. 10 Church & Ware, ch. 23 Motta (2000) – available online on the course website.

Recap Last week we started the class by looking at two extreme cases: Perfect competition: –“Atomistic”, price-taking firms, free entry and exit and perfect information. –Firms set P=MC Monopoly: –One firm, no entry, firm sets price to maximize profits (Q=(a-c)/2b)

Let’s meet in the middle: Cournot competition Neither perfect competition nor monopoly are realistic models of the world; it’s best to think of them as benchmarks. Most markets have a relatively small number of firms that compete for a share of the market. Unlike PC, it is reasonable to assume that what a firm does has an impact on what its rivals do.

Cournot Firms maximize their profits, given what their opponents do: If all firms make the same quantity decision simultaneously, we find that the equilibrium output is equal to:, where

Cournot (cont.) From the expression above, it is easy to see that if n=1, we have the monopoly output Also, as n -> infinity, the output produced by all the firms approaches the PC output (and price). Consequently, this means that as n rises, so does CS. Also, DWL goes down.

Mergers in a Cournot setting So, what happens if there is a merger in a Cournot market? The model basically says that if firm A buys firm B, it basically shuts that firm down and works as if it did not exist.

Mergers in a Cournot setting The merger has different impact on the different firms: –The merged firm reduces output; –The unmerged firms increase output. Essentially, in this framework, mergers merely result in reducing the number of competitors in the market. Is this realistic?

Differentiated products Firms often sell differentiated products. –E.g. 1: Sports cars (Ferrari, Porsche, Bentley…) –E.g. 2: Clothing (Prada, Gucci, Dior…) This means that some consumers may prefer a given product, even if it is more expensive. If two companies merge, they will have a larger portfolio of products with which to compete.

Limited capacity A firm may not be able to serve the entire market, even if it charges the lowest price. Let M be the total number of consumers and assume each consumer demands one unit of a homogenous good. Let K be the sum of individual firm capacities ki, where k 1 k i.

Limited capacity If M > K, competition is not effective and firms charge monopoly prices. If K -n > M, any (n-1) firms can cover the whole market, so we have pure Bertrand competition. If M > K -n, equilibrium takes the form of Edgeworth cycles.

Motivations for mergers Entry deterrence; –Increasing capacity; –Expanding product range; Gaining market power; Lowering costs through synergies; Larger firms will have easier access to capital; Speculative motives.

What are the effects of a merger? Unilateral effect –Lower number of firms leads to an increase in market power. –This will then lead to a rise in profits. Measures of market power and concentration: –The Herfindahl-Hirschman index: –m-firm concentration index:

What are the effects of a merger? Coordinated effect –Merger may facilitate collusion –Why? 1.With a smaller number of firms in the market, collusion is typically easier to sustain. Deviations from the agreements are easier to identify. 2.A merger may give rise to a more symmetric capacity/market share distribution. Collusion depends on the ability to discipline firms into sticking to the collusive outputs/prices; if one firm is too large, the other firms cannot punish it for breaking the agreement.

Merger policy Section 7 of the Clayton Act regulates merger policy in the US. It is loosely based on the degree of concentration in both pre- and post-merger markets. A merger will be challenged if: –Post-merger –Pre- and/or post-merger HHI ≥ Other important factors are: –Ease of entry; –Economies of scale; –Degree of foreign competition; –Profitability of pre-merged firms.

Merger Policy The Rome Treaty regulates merger policy in the European Union. EC Merger Regulation states: “A concentration which creates or strengthens a dominant position as a result of which effective competition would be significantly impeded in the Common Market (…) shall be declared incompatible with the Common Market” No objective criterion on which to analyse a merger, unlike the US.

Case study: Nestlé-Perrier merger In 1992, Nestlé, a player in the French bottled water sector (Vittel and Hepar) notified EC commission of the intention to purchase Perrier SA. In 1991 the bottled water market had an annual volume of 5.25 billion liters and 3 major firms: –Perrier: 35.9%; –BSN: 23% –Nestlé: 17.1% –A large number of very small local producers: 24%.

Nestlé-Perrier merger In order to avoid EU regulatory concerns, the two merging firms had agreed to sell Volvic (a major mineral source of Perrier) to BSN. They argued that the post-merger market would become a balanced duopoly: –(Nestlé + Perrier – Volvic)’s market share: 38% –(BSN + Volvic)’s market share: 38%

Nestlé-Perrier merger The EU Commission opposed the merger on various grounds: –Two main players would be of similar size and nature; –Cost structure is similar costs; –R&D’s role is minor; –Monitoring each others’ prices is easy; –Demand for water is relatively price inelastic; –High barriers to entry. In short, the potential for collusion is very high.

Nestlé-Perrier merger The Commission rejected the simple merger on the grounds of establishing a dominant firm with too much market power (Unilateral effect). It rejected the merger with the sell-off of Volvic for fears of establishing “oligopolistic” dominance (Coordinated effect).

Nestlé-Perrier merger Nestlé proposed to the Commission an alternative which involved: –Selling Volvic to BSN; –Selling off a variety of its brands (Vichy, Thonon, Pierval, St Yorre, etc), as well as 3 billion liters of water capacity to a third party. The Commission accepted this solution.

Nestlé-Perrier merger What would the outcome have been had the merger taken place in the US? Likely that they would have been rejected as well, since HHI> Market StructureHHI Original0.221 Merger0.334 Merger w/ Volvic transfer0.289 Accepted Merger proposal? (incomplete sales figures)