CROSS-BORDER MERGERS AS INSTRUMENTS OF COMPARATIVE ADVANTAGE J. Peter Neary University College Dublin and CEPR

2 5. Cross-Border Mergers and Acquisitions So far: Greenfield FDI only BUT: Cross-border M&As are quantitatively much more important Now: Oligopoly model essential (almost) No: Barba Navaretti/Venables (2003), Nocke/Yeaple (2004), Head/Ries (2005) Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc. Here: Neary (2004) Model of 2-country integrated market: Cournot oligopoly Home: n firms with cost c; Foreign: n* with cost c* Absent mergers: “Cone of diversification” in {c, c*} space

3 Cross-border mergers: M&A’s a huge % of all FDI: more than greenfield FDI A high % of mergers are cross-border Cross-border merger waves linked to market integration [EU Single Market; Mercosur] How to explain them? I.O.: Strategic and efficiency motives All partial equilibrium Macro: Major innovations Jovanovic/Rousseau (2003) International Trade Theory: Dominant paradigms: Competition (perfect/monopolistic) Needed: Oligopoly in GE

4 Plan 1.Specialisation Patterns in the Absence of Mergers 2.Myopic Mergers 3.Forward-Looking Mergers 4.General Oligopolistic Equilibrium: Factor and Goods Markets: Ricardo + Cournot Demand: Continuum-Quadratic Preferences 5.Mergers in General Equilibrium 6.Mergers and Welfare

5 1. Specialisation Patterns Without Mergers Consider a typical sector, in partial equilibrium Homogeneous-good Cournot competition 2 countries, integrated world market Perceived linear demands: p = a - b x Given numbers of firms at home & abroad: n, n* Firms in each country have identical costs: c, c* Equilibrium home sales: Also holds with no foreign firms: So: y>0 

6 c c* a ' H firms unprofitable when n*=0 a '

7 c c* H firms unprofitable when n*>0 a '

8 c c* H firms profitable a '

9 Symmetrically: c c* F firms profitable a '

10 Equilibrium Production Patterns for Arbitrary Home and Foreign Costs c c* HF: Home and foreign production O: No home or foreign production F: Foreign production only H: Home production only a '

11 Fig. 4: Equilibrium Production Patterns in Free Trade without FDI c O: No home or foreign production F: Foreign production only H: Home production only c* HF: Home and foreign production  (c,c*;n,n*)=0  *(c,c*;n,n*)=0

12 c c* O: No home or foreign production F: Foreign production only H: Home production only Compare with perfect competition: a '

13 2. Myopic Mergers Assumption 1: Only bilateral mergers can occur. Immediate gain from a merger: Assumption 2: A merger will not take place if G FH is zero or negative. Assumption 3: A merger will take place if G FH is strictly positive.

14 What are the incentives to merge? No incentive if all firms are identical (and n+n*>2) [Salant, Switzer, Reynolds (QJE 1983): “Cournot merger paradox” ] Nor if the 2 merging firms are identical (and n+n*>2) [Proposition 1] Intuition: i.e., the profits of the acquiring firm would have to double for such a merger to be profitable Same for all firms like the acquiring firm Myopic Mergers (cont.)

15 BUT: Outputs are strategic substitutes Myopic Mergers (cont.)

16 BUT: Outputs are strategic substitutes Myopic Mergers (cont.) Removing a rival shifts down the reaction functions of all others Movement along own reac. func. So: Outputs and operating profits rise for all surviving firms (including the acquiring firm) Hence: If firms differ in cost, a low- cost/high-cost takeover may be profitable yFyF

17 Proposition 2: If c>c*, a takeover by a foreign firm is profitable if the home firm has sufficiently high costs: G FH >0 IFF : Proof:

18 O F c c* HF H Incentives for foreign firms to take over home

19 a–ca–c Fig. 5: The Components of Gain from a Cross-Border Acquisition by a Foreign Firm  * QRa–c*a–c*  G FH < 0 G FH > 0

20 O F c c* HF H Incentives for foreign firms to take over home Incentives for home firms to take over foreign Similarly, G HF >0 IFF: Fig. 2: Takeover Incentives

21 Fig. 6: Cross-Border Merger Incentives Incentives for home firms to take over foreign c c* H O F HF Incentives for foreign firms to take over home  =0 G FH =0 G HF =0

22 Effects of one takeover on incentives for more? All surviving firms have higher output and profits:  y   y* > 0 Low-cost firms have higher output to begin with So, their profits rise by more: G FH is decreasing in n [Proposition 3] i.e., “Merger Waves” / “Domino Mergers”: => No high-cost firms survive Mergers may not take place if n is large, even though further mergers would be profitable Encouraging “national champions” by promoting domestic mergers in high-cost sectors makes foreign takeovers more likely (in the absence of cost synergies)

23 5. Cross-Border Mergers and Acquisitions (cont.) Merger gains: For an acquisition of a home by a foreign firm: G FH (c, c*; n, n*) =  *(.)   (.) Always negative between identical firms Salant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox” Positive for a sufficiently large cost advantage

24 5. Cross-Border Mergers and Acquisitions (cont.) So: Autarky to free trade encourages cross-border M&As Further results: G FH decreasing in n: Merger waves G FH decreasing in t (definitely for high t) So partial trade liberalisation encourages cross-border M&As Empirical evidence: Brakman/Garretsen/van Marrewijk (2005): Evidence in favour of comparative advantage and merger waves

25 a–ca–c Fig. 5a: Merger Waves: Effects of a Fall in n  * QR a–c*a–c*  R'R'

26 Continuum of sectors, indexed z  [0,1] Ricardian cost structure: c(z) = w  z), c*(z) = w*  z) Assume home more efficient in low-z sectors 2 threshold sectors [Perfect competition: c(z)=c*(z) is the threshold for specialisation] 4. General Oligopolistic Equilibrium

27 Fig. 1: Equilibrium Production Patterns for a Given Cost Distribution c c* Foreign production only Home and foreign production Home production only O c*(0)c*(1) c(0)c(0) c(1)c(1)

28 Demand “Continuum-quadratic” preferences: Objective demand functions: depend on income and all prices Summing over 2 countries => Linear subjective demand funcs:

29 GOLE: The Full Model Three nominal variables: w, w*,  Absolute values are indeterminate Convenient normalisation: W= w, W*= w* Full employment: Threshold sectors:

30 Assume symmetric countries: n=n*, L=L*, etc. => W=W* Wage adjustment: Expanding and contracting firms in both BUT: High-cost firms contract by more So: Demand for labour falls Wages fall, dampening merger incentives Threshold sectors: 5. Mergers in General Equilibrium Labour-market equilibrium:

31 Fig. 3a: Simultaneous Determination of Wages and Threshold Sectors: The No-Mergers Equilibrium W L=L(.) 1 ½

32 Fig. 3: Simultaneous Determination of Wages and Threshold Sectors W 1 ½ L=L(.)

33 F Fig. 4: Wage Adjustments Dampen Cross-Border Merger Waves c c* HF O H

34 Partial-equilibrium intuition: W = CS +  [Only changes in sectors where mergers occur matter] 1. Less competition  Some prices   CS  2. High-cost firms are eliminated     2. Dominates [Lahiri-Ono EJ 1988] GE: Consumers are also profit recipients [Welfare is just the consumer’s (indirect) utility function] 1a. At given wages, only effect 1. matters  U  2a. W  all prices   U  So: Full effect ambiguous in GE, but for different reasons from partial equilibrium 6. Mergers and Welfare

35 So: At given wages, mergers (z~  ) raise prices in all sectors: Mergers and Welfare (cont.) Indirect utility:

36 Fig. 5a: Mergers Increase Welfare W 1 ½ E0E0 E2E2 E1E1 L=L(.)

37 Fig. 5b: Mergers Reduce Welfare W 1 ½ E0E0 E2E2 E1E1 L=L(.)

38 Conclusion Cross-border mergers are “instruments of comparative advantage”: More specialisation Welfare may rise Despite: Reduced competition in many sectors Redistribution from wages to profits Empirical predictions: Trade liberalisation increases FDI Absent cost synergies, low-cost firms acquire high- cost foreign rivals FDI & trade are complements

39 Conclusion Cross-border M&As encouraged by trade liberalisation

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