ECN 3103 Industrial Organisation 7. Mergers and Acquisitions Mr. Sydney Armstrong Lecturer 1 The University of Guyana Semester 1, 2015

Introduction Global merger activities since 1980: - big companies involved: Time Warner/America Online US$130 billion, Exxon/Mobil Oil US$77 billion, BP/Amoco US$56 billion

- types of mergers: horizontal mergers (goods are substitutes) vertical mergers (goods are complements) conglomerate mergers (no clear relationship) - reasons for mergers and acquisitions market power, economies of scale (production and/or R&D), economies of scope (synergies), market access (input, output and retail channel), finance + taxes, defensive mergers to deal with contracting markets

CASE: DaimlerChrysler merger $3 billion savings coming from advanced technologies (eliminate overlapping research into fuel cells), finance (reduce back office costs, tax planning), purchasing (consolidate parts and equipment buying), joint production (Daimlers sport utility in plant where Chrysler produces Jeeps and minivans), new products (cooperation on future products such as minivans), new markets (cooperation in emerging markets Latin America and Asia) - studies of past merger waves have shown that two out of three merger deals have not worked - linking distribution systems is often difficult - information systems often very difficult to mesh together - clash of corporate cultures

Mergers and Competition Policy - firms are required to notify their merger intention to competition authorities in all concerned markets merger regulation guidelines to assess competitive impact of proposed merger - we analyse welfare effects of horizontal mergers and identify main circumstances under which such mergers should or should not be allowed - we discuss challenges of merger analysis in practice, e.g. market definition

Our Plan 1 Horizontal Mergers 1. 1 Simple Price Model 1 Our Plan 1 Horizontal Mergers 1.1 Simple Price Model 1.2 Mergers in Cournot Model 2 Merger Analysis in Practice

Horizontal Mergers 1.1 Mergers and Price Competition - horizontal mergers have clear potential for anticompetitive effects as number of competitors is reduced by one - the potential increase in market power has to be weighed against any socially beneficial cost savings simple model (Williamson, 1986): market for homogenous good, two firms in price competition - merger-to-monopoly reduces production cost from AC0 = MC0 = c0 to AC1 = MC1 = c1 < c0 - merger allows to implement monopoly allocation (no new entry) - the net effect of the merger on social welfare depends on amount of cost savings and demand elasticity

Graph: Social cost and benefit of merger-to-monopoly - merger allows to produce post-merger quantity at lower cost (social benefit) - merger leads to deadweight loss as consumer who bought pre-merger are priced out of the market (social cost)

Graph: Social cost and benefit of merger from three to two - again: merger allows to produce post-merger quantity at lower cost (social benefit) - merger leads to deadweight loss and loss of profit on marginal consumers (social cost)

Mergers in Cournot Model - consider standard Cournot model (firms compete in quantities) - n ≥2 firms in the industry with marginal cost c and fixed cost F - a maximum of two firms can merge at a time - merger can imply fixed cost saving for merging entity - if any two firms merge the merged entity can reduce its fixed cost from 2F to (2 - α )F where 0 ≤ α ≤ 2 - synergy parameter represents: α= 0: no synergy α = 1: avoids duplication of fixed cost α > 1: strong synergies α = 2: maximum synergies

Some results on merger incentives in the Cournot model Result 1: A merger is more profitable, the higher the efficiency gains. Result 2: For a given cost savings level, a merger may be profitable if the number of firms in the industry is either very small or very large. - with few firms: merger to increase market power, with many firms: merger to reduce cost Result 3: Without efficiency gains (α = 0) only “merger-to- monopoly“ profitable. - “Merger Paradox": relatively little incentives to merge in Cournot model with symmetric firms - market power increase from merger not very strong - in general: the less competitive industry, the less incentives to merge

Result 4: Non-merging firms may benefit more from a merger than merging rms. - here: they have twice as much gross profits as merging parties but don’t have fixed cost savings - merged entity reduces quantity in market to increase price - optimal response for non-merged firm is to increase their quantity - merger may even trigger new entry - however, with marginal cost savings from merger, or other strategic benefits, non-merging firms may be put at competitive disadvantage - indeed in many cases: non-merging firms may strongly support or oppose a proposed merger

- two different reactions to merger announcements: In August 1998, BP said it would buy Amoco Co. in the largest industrial merger ever The announcement pushed up stock prices of most major oil companies. Mobil went up 10 percent in the following two days. As a response to the announcement of the merger between British Airways and American Airlines, Virgin Atlantic - a smaller competitor in the London-US routes painted its aircrafts with the message “BA/AA no way". - next we compare the private incentives to merge with social efficiency of mergers