1. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede0 Joensuu 2004 6 Mergers and Acquisitions Mergers are usually categorized by closeness of markets that firms operate in Horizontal merger –Merging firms operate in same relevant market, firms are directly competing –Market shares in relevant markets change as result of merger Vertical merger –Merging firms operate at different stages of a production or distribution chain –Firms products belong to same relevant market do not compete horizontally –At least one firm can potentially be using the other firms' products as inputs in its production

2. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede1 Joensuu 2004 6 Mergers and Acquisitions Conglomerate merger –Mergers not belonging to those above –Product extension Products of the firms not competing but firms use close marketing channels or production processes –Market extension Products are competing but relevant geographic markets are separate –Pure conglomerate mergers (none of those mentioned) Effects of Merger Suppose duopoly which behaves competitively Assume firms have identical cost functions and constant returns to scale prevail –MC 1 = AC 1, there are no fixed costs

3. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede2 Joensuu 2004 6 Mergers and Acquisitions Profit maximization under perfect competition forces firms to price at marginal cost: p c = MC 1 Case 1: Merger to monopoly and costs stay at original level –Profit maximization rule (MC = MR) implies output Q m1 and price level p m1 so that deadweight loss DL 1 takes place –DL = (Q c - Q m1 )(p m1 - p c )/2 –This is strict decrease in welfare Also, merger means income transfer from consumers to owners of Newco –In this case, there would be reasons to block merger –Merger needs to be blocked for its deadweight loss creating effect, not because it means an income redistribution

4. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede3 Joensuu 2004 6 Mergers and Acquisitions Case 2: Merger involves synergies –Assume cost savings occur through decrease in marginal costs –MC 1 decreases to MC 2 –Monopoly profit maximization implies price level p m2 which is lower than that without cost savings p m1 –Deadweight loss occurs, but it is smaller than that without cost savings –DL = (Q c - Q m2 )(p m2 - p c )/2 –There arwe now cost savings due to the decrease in MC Amount is (p c -MC 2 )Q m2 –Efficiency is increased due to cost savings and decreased due to market power - deadweight loss

5. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede4 Joensuu 2004 6 Mergers and Acquisitions Case 2 illustrates typical situation in antitrust –Many types of decisions and conduct by firms may be harmful for welfare while increasing it in other ways –From antitrust authority’s point of view, we face a trade-off –To determine whether a merger (or certain conduct ) is harmful on welfare, the authority should compare gains and losses to welfare In US, this seems to be the case, efficiency defence In EU, efficiency gains are more of reason to block merger, efficiency offense Difference partly due to legislation? –Market dominance in EU –Significant lessening of competition in US

6. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede5 Joensuu 2004 6.1 Incentives to Merge Merger in Cournot market Assume an industry structure characterized by: –n identical firms (cost functions are identical) –Cournot or capacity competition –Constant returns to scale: C(q i ) = C(q) = cq, c > 0 –Linear demand is assumed linear: p(Q) = a - bQ, a,b > 0 –No possibilities for entry Profit function of any firm is then Firm i's Cournot-Nash equilibrium profit is

7. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede6 Joensuu 2004 6.1 Incentives to Merge Merger between any two firms: there is one firm less in the industry than before –n firm industry changes into n-1 firm industry Suppose m of n firms decide to merge (1 < m < n) m firms have incentive to merge if being part of merged entity gives more profit than staying unmerged, that is, if that is, if –Define LHS = A

8. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede7 Joensuu 2004 6.1 Incentives to Merge Case 1: m=1 Notice that only if n=2, merger is profitable This means we have monopoly being created Hence, only if in duopoly both firms merge we have the merger being in all firms' interest Case 2: m=2 Notice that only if n=3, merger is profitable –This again means we have a monopoly being created –Only if in triopoly all firms merge, merger is in all firms' interest

9. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede8 Joensuu 2004 6.1 Incentives to Merge Case 3: m=5 If n=6, merger is profitable: monopoly is created But now even with n=7 merging is profitable –Creation of a duopoly through merger is profitable With n=8, merger is again unprofitable More generally Notice that which is < 0 Thus, A is decreasing in n, number of firms in industry More there are firms before merger, other things equal, more difficult it is for merger to be profitable for merging firms

10. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede9 Joensuu 2004 6.1 Incentives to Merge Notice also that which is > 0 Thus, A is increasing in m, number of firms that decide to merge –More there are firms that take part in merger, other things equal, easier it is for merger to be profitable for merging firms Irrespective of value of m or n, only if 80 % of firms in industry takes part in merger, merger is profitable –Merger to monopoly is always in firms' interest Typical Cournot model where nothing but number of firms changes  price level increases after merger –This follows from quantity competition since quantities are strategic substitutes

11. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede10 Joensuu 2004 6.1 Incentives to Merge Decrease in output by one firm is matched by an increase in output by rival firm In Cournot model, once some firms merge, they decrease their total output, as they act as single firm Firms not party to merger increase their output Under many parameter values, firms which mostly benefit from merger are non-merging firms –Business stealing effect Model says that mergers are not usually profitable –Then we should not usually observe mergers, assuming that firms are rationally behaving agents! –Not a good description of the real world where mergers are taking place in increasing numbers Model misses some essential aspects of the phenomenon –Mergers occur endogenously, not exogenously –Cost savings needs be incorporated

12. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede11 Joensuu 2004 6.1 Incentives to Merge Mergers not being profitable as due to strategic substitutes –Decrease in production of some firms is matched by an increase in production by the competitors One way to overcome this effect is to assume U-shaped costs (strictly convex costs) –Rivals have less incentive for expansion of production as costs are increased –Mergers are more probable than in the Salant et al Mergers in Bertrand Market Merger incentives under price competition? Prices are strategic complements –Reaction functions are upward sloping –Price increase by some firms is matched by price increase of rival firms

13. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede12 Joensuu 2004 6.1 Incentives to Merge In Bertrand model firms engage in price competition with differentiated products Price increase by merged company is matched by price increase of rivals –Reaction of outsiders reinforces initial price increase that results from merger –Merger of any size is beneficial for merging firms No business stealing effect This model predicts industries would usually evolve into monopoly! This, luckily, is not really what happens in the real world –There seems to be forces which prevents monopolization –These forces are not easily modelled and simple models do not descibe real world phenomena in satisfying way

14. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede13 Joensuu 2004 6.1 Incentives to Merge Busines stealing effect is very much true in real world –Often, firms benefiting most from mergers are non-merging firms –Thus, usually Cournot competition best describes real world phenomena, this holds with merger theory as well In preceding models acquiring and target firms were not differentiated –Firms were ”black boxes”, mere MC-functions –Only effect is reduction in number of (symmetric) firms In real world acquisitions, there usually is buyer, seller and target in transaction –Transaction creates a larger entity –Seller sets price based on many factors Asset value of the firm Expected evolution of industry (expected profits)

15. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede14 Joensuu 2004 6.1 Incentives to Merge Kamien & Zang (QJE 1990): In capacity competition, does monopolization take place when acquisition process is endogenous? –In quantity game, total industry profit increases with a decreasing number of firms –Any firm increases its profit as number of firms in industry diminishes This follows from the nature of Cournot competition –Seller knows that it would gain in profits if it would sell later rather than sooner –Sellers want to ask more than buyers want to pay Monopoly profit is maximum buyer can pay –In Cournot model, complete monopolization of an industry is possible only if originally there were only a few firms in industry

16. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede15 Joensuu 2004 6.2 Welfare Effects of Mergers Merger without cost savings reduces welfare; if merger involves cost savings, we have trade-off Farrell & Shapiro (AER 1990) is most thorough model on welfare implications of horizontal mergers –Quantity competition and general demand structures –Cost-savings due to consolidation are allowed –Mergers without synergies increase price and hurt consumers –Cost saving is assumed proportional to post-merger output –Then deadweight loss is proportional to output reduction –If cost saving outweigh the deadweight loss, net welfare effect of merger is positive

17. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede16 Joensuu 2004 6.3 Merger Simulation Market definition is hard with differentiated goods and can be misleading –Market definition is {0,1} decision, good is either ”in” or ”out” –In reality goods belong to [0,1], they pose varying degree of competitive pressure to each other Increase in market power is interesting, not market definition Pure structural analysis of competitive effects can be misleading Simulation uses economic models grounded in theory to predict effect of mergers on prices in relevant markets Simulation allows direct measuring of changes in market power –Easier than measuring of market power Simulation allows to evaluate likelihood of synergies offsetting price increases Simulation requires estimation of demands –Own and cross-price elasticities or changes in residual demand

18. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede17 Joensuu 2004 6.3 Merger Simulation Merger simulation: the big picture –Demand estimation Create demand models Get data and estimate demands Calibrate demand model to pre-merger prices, quantities, and demand elasticities –Set parameters so that it exactly predicts pre-merger equilibrium –Plugging pre-merger prices into model must yield pre- merger shares Predict post-merger marginal costs –Try to evaluate synergies –Use demand model & post-merger costs to compute post- merger prices –Idea: if post-merger prices are well above pre-merger level, transaction increases market power

19. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede18 Joensuu 2004 6.3 Merger Simulation Measuring market power is hard in practice –Market power = L = (p-c)/p  [0, 1/e] so that eL  [0, 1] –Quality of market power measure depends on accuracy of estimates of marginal costs and demand elasticity –Data and estimation problems lead to biased measure of market power Why would measuring changes in market power be easier? –Estimated price change reacts less to estimated MC or demand, as we use same instrument to measure pre and post- merger market power Limitation of simulation: price increase predictions are sensitive to demand specification –Functional form of demand determines magnitude of price increases from merger

20. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede19 Joensuu 2004 6.3 Merger Simulation One should use calibrated models in manner that makes them insensitive to functional form of demand –Compute compensating marginal cost reductions (CMCR) that exactly offsets price-increasing effects –CMCRs do not depend on functional form of demand as pre and post merger equilibrium prices and quantities are precisely same –If merger synergies appear likely to reduce merging firms’ cost as much as CMCRs, merger is unlikely to harm consumers –If merger synergies clearly fall well short, significant price increases are likely Visit http://antitrust.org/simulation.html –Fool around with Linear Bertrand Merger –If you have access to Mathematica, take a look at SimMerger to get feeling of what simulation is about

21. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede20 Joensuu 2004 7 Predation Predation = firm drives rival out of market by making it incur enough losses and then raises prises –Why would prey exit? –Why would prey stay out after price increased? –Can predator really recoup losses suffered during price war? Does predation make sense? –If predation is possible and profitable, how can we separate innocent aggressive competition from predation as restriction on competition? Most cases apply so-called Areeda-Turner test: P < LRMC, P < LRAVC, or P < LRATC + some other indications  predation –Costs are hard to define and measure –Predation rare in case law. But is it really that rare?

22. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede21 Joensuu 2004 7 Predation Financial market imperfections Old ”deep pocket” theory: richly endowed predator would charge low prices to drive out poorly endowed rival –Ignores possibility that profit-seeking investors would finance prey Relation between prey and its investors –Predator seeks to manipulate that relationship and drive prey out of market or deter expansion into new markets –Pedatory strategy viable because of capital market imperfections –Investors face agency or moral hazard problems –Managers may take excessive risks, shield assets from creditors, dilute outside equity, fail to exert sufficient effort, or otherwise fail to protect investors’ interests –Suppliers of capital can mitigate these agency problems by extending financing in staged commitments, imposing threat of termination in case of poor performance

23. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede22 Joensuu 2004 7 Predation Debt-holders can threaten to liquidate firm or deny new credit VCs can refuse to extend additional financing when early performance is poor Shareholders can decline to purchase additional equity if expected returns are low due to disappointing initial performance –Predatory pricing in product markets becomes possible when predator exploits termination threats to dry up financing of rival firm Agency problems are particularly acute in financing of new enterprises –Uncertainty about cash flow in early stages –Losses may be unavoidable start-up costs or due to agency abuse –Mitigate moral hazard by agreeing to extend financing only when firms’ initial performance is adequate

24. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede23 Joensuu 2004 7 Predation Predator may slash price to drain prey of sufficient funds to meet its loan commitments, forcing default Predator can lower prey’s earnings to impair prey’s debt capacity by limiting collateral it can put up Lower earnings may cause lenders to wrongly believe that firms’ profits are likely to be lower or riskier in future and therefore to stiffen their lending terms Contract that minimizes agency problems will maximize incentive to prey Reputation Predator lowers prices to mislead prey and potential entrants into believing that market conditions are unfavorable –Decision to enter or exit is based on evaluation of expected future revenues and costs –Most firms contemplating entry or exit do not have all information to determine future revenues and costs

25. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede24 Joensuu 2004 7 Predation –If incumbent firm is better informed than others about cost or other market conditions, it may be able to influence the expectations –Incumbent firm can manipulate and distort market signals about profitability, and influence the expectations through pricing decisions or other actions Predator seeks to establish reputation as price cutter, based on some perceived special advantage or characteristic –Reputation effects may be present when predator sells in two or more markets or in successive time periods within same market –One market or period serves as demonstration market with predatory conduct, and the other market or time period provides recoupment market, where predator reaps benefits –Reputation-induced belief reduces future entrant’s expected return and may deter entry

26. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede25 Joensuu 2004 7 Predation Signaling Better informed predator reduces price to convince prey that market conditions are unfavorable –Aggregate demand is too low to justify presence of both firms in market or expansion by prey –Prey inferring weak demand from low price may be deterred from expanding or induced to leave market –Less plausible than previous predatory strategies Test market and signal jamming theories plausible Victim lacks knowledge and experience in market Introduce new product or brand to probe market response by entering a limited “test market” Predator may attempt to frustrate this market test by either of two predatory strategies

27. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede26 Joensuu 2004 7 Predation Test market predation –Predator secretly cuts price to reduce entrant’s sales in test market –Induce entrant to believe that demand is low –Entrant abandons entry or enters on smaller scale Signal jamming –Predator openly cuts price to distort test market results –Entrant can observe demand for its product only under exceptional circumstance of an ongoing price war –Market test is foiled, and entrant is unable to determine whether market demand for its product is sufficient to support entry Cost signaling –Predator drastically reduces price to mislead prey to believe that she has lower costs –Predator trying to establish a reputation for low cost cuts price below the short run profit-maximizing level

28. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede27 Joensuu 2004 7 Predation –Observing predator’s low price, prey rationally believes there is at least probability that predator has lower costs –Lowers prey's expected return and causes prey to exit –Limiting factor in applying cost signaling theory is possible inconsistency between low price, predatory bluffing and subsequent recoupment –Attempt to raise price risks revealing signaling to prey and other potential entrants, causing them to upgrade estimates of market profitability Policy Proof of scheme of predation only establishess that identified strategy is plausible Need to show –Below cost pricing: avoidable or incremental cost, not AVC –Recoupment –Business justification?

29. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede28 Joensuu 2004 7 Predation Financial market predation –Prey depends on external financing –Financing depends on its initial performance –Predation reduces initial performance and threatens preys financing and viability –Predator can finance predation internally or has better access to external finance as prey Reputation –Multimarket predator faces localized competition –Predator faces threat of sequential entry –Reputation reinforces predatory strategy or increases probalility of future price cuts –Entrant observes previous exit or other adverse experiences

30. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede29 Joensuu 2004 7 Predation Test market predation –Predator observes prey’s attempt to experiment on limited basis –Predator cuts price below following or anticipating entry –Price cut prevents prey from learning true demand conditions Cost signaling –Predator might have lower or reduced costs –Predator reduces price –Prey believes that predator has lower costs –Possible cost reduction is sufficient to exit, deter entry or limit expansion

31. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede30 Joensuu 2004 8 Merger Case Airtours / First Choice merger Commisson case No IV/M.1524, available through course web site www.cea.fi/joe.htm Airtours and First Choice supply leisure travel services (package tours) in UK and Ireland Vertically integrated into upstream (airline operation) and downstream (travel agency) businesses Relevant market: short-haul foreign package holidays in UK –European beach, ski and city destinations –Long-haul (Florida, Caribbean, Thailand etc) is not substitute for short-haul Different aircaft Less rotation of aircraft -> higher crew and catering costs Operating cost per passenger/mile

32. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede31 Joensuu 2004 8 Merger Case Sufficient demand to fill large aircraft -> match fleet composition closely to mix of passengers between larger (long-haul) and smaller (short-haul) Different image for consumers Longer flight time and jet–lag can reduce ’usable’ holiday time Short-haul holiday typically much cheaper than comparable long-haul Market shares –Airtours19.4 % –First C.15.0 % –NewCo34.4 % –Thomson30.7 % –Thomas Cook20.4 % –Cosmos2.9 %

33. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede32 Joensuu 2004 8 Merger Case Surprise prohibition decision –Three firm ”oligopoly” 85.5 % market share –In past, much fluctuation in market shares, and exit and entry –Package holidays differentiated, branded, consumer products –UK MMC incuiry few years earlier concluded market was quite competitive despite increased concentration Low barriers to entry –Is collusion really sustainable? Court of First Instance overturned Commission’s decision because of lack of evidence, treatment of facts –CFI seemed to accept Commission’s general policy Could commission be right? ”Oligopolists” are now vertical integrated, ”competitive fringe” not –Competitive fringe less able to challenge oligopoly –Raises entry costs as entrants need to enter all stages of production and distribution

34. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede33 Joensuu 2004 8 Merger Case Two-stage competition: 1) reserve capacity 12-18 months in advance, 2) price competition –Firms have strong incentive to sell full capacity –Steep discounts when departure dates are approaching –Temptation to deviate from collusive price are strong, and threat of punishment within selling period not credible –Package holidays heterogenous good –Less likely to reach collusive prices Commission: collusion on capacity rather than prices –Firms choose low levels of capacity –Deviation: set high level of capacity –Punishment: choice of high levels of capacity for one or more period

35. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede34 Joensuu 2004 8 Merger Case –Unlikely in many sectors, capacity decisions constrain firms for long periods Punishments costly and delayed –In this industry, capacity decisions are reviewed periodically Semicollusion: collude on some variables, compete on others Could lead to more intense competition than Cournot or Bertrand behavior –Firms might observe each others’ capacity decisions –Collusion on capacities can be consistent with economics –But is collusion likely? Demand is volatile: –Hard to separate demand shock from deviation –What demand are rivals’ predicting?

36. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede35 Joensuu 2004 8 Merger Case Even if ”oligopolists” collude, competition from outsiders and entry to increase capacity Court: Commission was wrong –Joint dominance: Market must be sufficiently transparent for members of oligopoly to monitor each other Punishment mechanism that ensures ‘common policy’ is sustainable as there is a need to counter the incentive to cheat Reaction of competitors and customers does not undermine benefits expected from ‘common policy’ –Commission must produce convincing evidence that all three conditions would be met in particular case –Firms have ‘right to adapt themselves intelligently to the existing and anticipated conduct of their competitors’ Commission had confused ‘acceptable’ oligopolistic interaction with tacit coordination in the decision

37. Markku Stenborg: Kilpailu- ja yhtiöoikeuden taloustiede36 Joensuu 2004 8 Merger Case –No credible punishment mechanism –Commission did not prove that market was sufficiently transparent for oligopolists to monitor capacity when capacity decisions were taken –Analyses of demand growth and demand volatility were fundamentally flawed –Commission failed to give weight to responses of fringe players and consumers to postulated reduction in output and increase in prices My interpretation: Commission tried to increase scope of dominance concept –In US, merger might have been blocked –With new EU rules and more careful analysis, merger might have been blocked