GE - Honeywell Vertical Mergers, Bundling and Protectionism

Introduction On July 3, 2001, the European Commission blocked a $42 billion merger between General Electric and Honeywell. The reason for blocking this merger centered around the economic theory of bundling. On October 22, 2000, this merger was announced. The US Department of Justice gave it the green light. However, the European Commission also had to approve it because of the size of the two firms’ Euro sales. The EC denied the merger on July 3 of 2001.

The Players General Electric One of the largest corporations in the world, grossing over $125 billion in 2001 Among many other interests, GE produces aircraft engines both independently and through a joint venture called CFMI with SNECMA, a French company GE competes with Pratt & Whitney and Rolls Royce as well as IAE, a joint venture between the two Honeywell Produces a basket of aeronautical products including avionics, starter motors, auxiliary power supplies, engine accessories, wheels, brakes, etc. Does not produce engines, however Achieved market prominence through a series of mergers and acquisitions Over half of $23 billion 2001 revenue came from aerospace division

The EC must prove that the merger would lead to market dominance: A position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by giving it the power to behave to an appreciable extent independently of its competitors, customers, and ultimately of consumers. Market dominance exists if a firm can price in an anticompetitive manner. A strange case because firms were neither competitors, nor did they have a vertical relationship. Instead the Commission focused on potential problems arising from horizontal integration The Case Against

The Commission’s rejection hinged on their assertion that because GE and Honeywell were market leaders in their respective aeronautical fields, the merger would allow them to bundle complementary products at unbeatable prices Thus, they could price other firms out of business and then assume a monopoly status The Commission denied a proposal that would lower costs to consumers? Yes, because the cause would be pricing efficiencies rather than production efficiencies, which it viewed as anticompetitive Potential increases in consumer surplus were shunned for fear of the possibility of anticompetitive behavior down the road The Case Against (cont.)

Bundling: The Economics Three Types of Bundling 1.Pure Bundling: Two products are only sold together. They are unavailable separately. a.Shoes. You need both a left and a right shoe, but normally you cannot buy them individually. 2.Tying: One item is available by itself and also in a bundle with another item that is unavailable alone. a.New car options. You can pay more for leather seats when you buy a car, but you can’t go to the dealership and get them a la carte 3.Mixed Bundling: Items are available separately but also as a bundle at a reduced price. a.‘Meals’ at restaurants. Your burger, fries, and Coke cost less together when you order them as a meal.

Bundling: The Economics (cont.) Cournot first considered the concept of bundling. Two independent monopolists selling complementary goods could make more money if they merged or coordinated and lowered their prices. The price drop of each good would stimulate sales of the other. You buy more jet engines because they are cheaper, so now you have more incentive (and money) to purchase the avionics with which to operate them. This is a Pareto improvement: everyone is better off. More consumers served and more company revenues. Cournot’s example is the horizontal version of double marginalization. Instead of each firm extracting welfare from the one below it, firms harm demand for complementary goods through their own high prices.

Problems with Cournot’s model The firms are alone in the market. Their merger does not undercut someone else. Instead of simply selling more products, mergers can be used as a weapon against the competition when more than two firms populate the market. Aircraft engines and avionics are only a small percentage of the cost of the airplane. It is unlikely that cost savings here would prompt manufacturers to construct very many more planes. Firms in this market stand to gain from a merger primarily through conquering rivals’ market share Firms set the same price to all customers. Bundling advantages vanish in the presence of price discrimination and negotiation Airplane manufacturers are few and valuable to vendors like GE and Honeywell, so they have considerable power to negotiate

Bundling Theory Note: The following information is useful to us as students, but as we will see it will not be relevant to the case Four firms in the market −Two firms A1 and B1 sell different versions of good 1 −Two firms A2 and B2 sell different versions of good 2 Like an airplane manufacturer who needs avionics and engines, consumers in the model must purchase both goods Thus, there are four choices −(A1, A2), (B1, B2), (A1, B2), (B1, A2) Consumers will choose the package that best suits their preferences. There are three possible market structures: −All goods sold separately −A1 and A2 bundle versus B1 and B2 bundle −A1 and A2 bundle versus B1 and B2 separate

Bundling Theory (cont.) Case 1: All Firms Act Independently This is the baseline. Assume profit is 1. Case 2: Bundle Versus Bundle Profits fall by 50% Intuition: Cutting price brings the same number of incremental customers as when selling individually, so bundle price must equal independent price in equilibrium Case 3: Bundle Versus Components Bundling reduces profits slightly (~10%) Though it gives the bundler an advantage in market share, it comes at the price of lower profits and it will not do it Mixed Bundling Again, bundling firm sacrifices profits (~3%) for market share

Bundling Theory (cont.) The European Commission reached the conclusion that economic incentives would lead the firm to engage in mixed bundling It is a robust conclusion that a firm that bundles has an advantage over rivals More tenuous a conclusion, however, is whether a multiproduct firm has an economic incentive to bundle This would depend of the number of products in the bundle, elasticity of total market demand, relative importance of the products to the consumer, and other factors. To make robust conclusions about the market, our models must likewise be robust. In the end, the Commission’s issue was not the impact of bundling on social welfare, but its effect on competition in the future The Commission believed that this merger would lead to rivals exiting the market and the merged firms exploiting their dominant position

Market Dynamics Can we assume that competitors will not respond in any way to bundling? −This is unrealistic −Competitors could coordinate and offer a bundle of their own −This would reduce profits, but it would also level the playing field Firms may fear that the original bundler will use its higher profits to invest in capital or R&D that will give it advantages in a repeated game −Customers may drive competition to offer a bundle even against its will −Customers win in bundle-to-bundle competition Remember, customers in this market are powerful and could easily pressure competitors into offering a bundle Advantages to bundling disappear when competitors offer a bundle of their own −Thus, a bundling firm must expect the competition to follow suit

Negotiating Bundles Previous discussion assumes that market prices are uniform to consumers −In aerospace industry, this is not the case −Customers have power to negotiate prices with vendors −Vendors also spend resources to gain information on customers They know about their customers’ previous purchases and what kind of products they are likely to require −This gives them negotiating power, too −When customer type is know and prices are negotiable, bundling cannot lead to higher profits If customers want some products from both firms, they won’t bundle Imposing a bundle on consumers will force firms to pay for one good’s lost profits with the money they make on the other Firms profit only to the extent that their products are differentiated, which gives them power over the consumer Bundling has little effect when firms have good information because it mitigates their power over consumers

Empirical Evidence Against GE Dominance and Bundling Initially, the EC claimed GE's dominant position in aircraft engines meant the company retained a commanding market share of 52.5% Resale of parts drops market share to 41%, which still assumes CFMI is completely attributed to GE, though it is a joint venture with SNECMA. If half of CFMI is attributed to GE, consideration drops market share to 28% (excluding planes in production). In reality, CFMI only existed at the time to produce engines for Boeing 737s, so GE's control of it had no effect on market power. Even if CFMI control did contribute to market power, SNEMCA would have to agree to bundling, and they have no incentive to aid Honeywell. Ultimately, engine sales are only 20% of total plane sales, which essentially eliminates the possibility of an engine firm being dominant.

Impracticality of Bundling for GE In the cases cited as relevant by the EC, the "bundling" discounts were small and probably a result of price negotiation. In fact, the cases that did involve bundling found it useless in signing purchasers. The only way to "bundle" in GE's situation would be to offer future discounts on Honeywell parts, but there would be no incentive to do so once the engine is sold, especially because price negotiation would take place anyway. In addition to the fact that competitors could fight back by bundling themselves, planes stay in service for 25 years, so they could stay in business for quite a while.

Making a Decision A Check List of Weights and Balances 1.Incentive to Bundle? 2.What is the immediate gain to consumers from lower prices? 3.What will be the impact on competitors? 4.How long do we expect these lower prices to persist? 5.If the rivals exit, what is the expected harm? Developed by Carl Shapiro and the US Department of Justice

What the EC Considered 1. Incentive to Bundle? a.Under what circumstance does the combined firm earn higher profits through a bundled pricing strategy? b.Did either firm have an opportunity to bundle prior to the combination? If so, is there evidence that bundling is a common practice in this industry? i.If we see bundling, then what is the marginal impact of increasing the potential scope of the bundle? ii.If we do not see bundling, then how do the opportunities created by this combination create a different incentive to bundle?

Recap: The Issue with the Merger 1.GE-Honeywell Will Engage in Bundling Activities Bundling enables significant price advantages Long-run lower prices will increase market dominance. Increased market dominance will decrease competition Decreased competition will result in increased long-term prices and decreased long-term consumer welfare

A Remedy: Block Bundling Behavior Enforce a "no-bundle discount" strategy: Individual price levels must be no greater than the price of a bundle of the same goods To aid enforcement, each firm would supply a price list of each good a price list of all bundles of goods Any discord with the "no-bundle discount" rule would be a violation, punishable by the EC Rejected on EC philosophy against Behavioral Remedies

Conclusion GE-Honeywell Merger is Blocked Block was based on concerns that bundling would flourish, causing competition to decline Claims that bundling would occur were dismissed Still the EC ruled that bundling was the primary reason to stop the merger A shining example of international protectionism