Mergers

M vs A

• An acquisition happens when one company buys another.

• A merger occurs when companies become a single new company. A

merger occurs when two companies agree to combine and form a new,
single company.
Top deals of 2023 and 2024
Horizontal Mergers

• The immediate and most dramatic way for a company to expand its size and
influence market structure is to purchase another company.
• Historical examples
• late 1800s, Standard Oil Company gained a 90% share of the petroleum
market by purchasing more than 120 competitors.
• 1960s, ITT (International Telephone and Telegraph) became a diversified
corporation by acquiring 52 domestic and 55 foreign companies, including
such well-known businesses as Avis Rent-a-Car, Continental Baking (Wonder
Bread), Hartford Insurance, and Sheraton Hotels.
• 2008, with Bank of America purchasing Merrill Lynch, a provider of insurance
and financial services, for $50 billion
• Wells Fargo Bank purchasing Wachovia Bank for $15.1 billion
Main Motives for Merger

1. Market Power

• If a merger enables the combined firm to raise prices, ceteris paribus, it will raise
the profit and market value of the firm.

• Most natural for horizontal mergers, because they reduce the number of
competitors.

• If firms compete in a Cournot-type game, for example, average firm profit

increases with a decrease in the number of competitors.

• Such mergers are socially undesirable because they increase allocative inefficiency
Main Motives for Merger

2. Efficiency
• Merger can raise productivity, depending on the type of merger.
• One example is an industry that has substantial economies of scale,
where a horizontal merger between two firms leads to lower unit
costs.
Market for corporate control hypothesis.
• Ownership shares of public corporations are traded on the stock market.
• Firms with ineffective managers will experience declining profits, which
will cause an observable decline in the market (stock) value of the firm.
• At some point, the firm will go bankrupt and exit the market.
• Before this happens, however, a firm with a successful management team
may purchase the failing firm and replace its inefficient managers with
more efficient ones.
THE HYUNDAI-KIA MERGER
• Korean automobile industry was not immune to the 1997 Asian crisis: except for
Hyundai, every automaker — Kia, Daewoo, Sangyong, Samsung
fell into serious financial distress.
• Kia declared bankruptcy in 1997 and was acquired by Hyundai (beating
Samsung and Ford at the auction block).
• Hyundai-Kia (HK) merger promised a series of cost efficiencies
• Number of R&D centers was reduced from eight to two: (the Namyang R&D
Center for passenger car models, and the Junju R&D Center for commercial
vehicles).
• A new business unit, Hyundai Mobis, was created in 2000 for the purpose of
standardizing parts and modules across Hyundai and Kia plants.
• HK was able to consolidate production and take better advantage of scale
economies
THE HYUNDAI-KIA MERGER
THE HYUNDAI-KIA MERGER
 THE HYUNDAI-KIA MERGER
• Korean Fair Trade Commission acknowledged the trade-off between the merger’s
negative effect (greater market power in the domestic market) and positive effect
(greater cost efficiencies and competitiveness in export markets).

• Impact on welfare suggest that the price and cost effects approximately
compensated for each other, so that total welfare remained relatively unchanged.

• However, the impact was not uniform: consumers were harmed by the merger,
whereas the automakers’ shareholders benefited.
Other Motives for Merger

• First, firms may pursue a merger to reduce risk (i.e., the variance in profits).
Applicable to conglomerate mergers, because a conglomerate merger increases
the extent to which a firm is diversified into different markets.

• Second, government policy can influence merger activity. Eg. Deregulation.

• Third: non-profit maximizing behavior

• some managers are overly optimistic or excessively driven to build corporate
empires, which can also lead to excessive merger activity
Horizontal mergers
Early mergers
• 1892 merger between Thomson-Houston and Edison General Electric
to form the General Electric Company
• US Steel Corporation became a dominant firm by merging 785 plants
in 1901.
• This gave the company control of about 65% of the steel capacity in the USA.
• Benefited US Steel by reducing price competition.
• Before the merger, the combined value of the individual companies was
approximately $700 million, and after the merger US Steel was worth
approximately $1.4 billion.
Horizontal mergers

• Firms in the same industry may merge to increase market power.

• Horizontal mergers can reduce both competition and production costs.

• Less competition is socially undesirable and lower costs are socially

desirable, the welfare effect of horizontal merger depends on the
relative importance of these two effects.
An Example

 Assume 3 identical firms; market demand P = 150 - Q; each firm with marginal costs of $30. The
firms act as Cournot competitors.
 Applying the Cournot equations we know that:
• each firm produces output q(3) = (150 - 30)/(3 + 1) = 30 units
• the product price is P(3) = 150 - 3x30 = $60
• profit of each firm is p(3) = (60 - 30)x30 = $900

 Now suppose that two of these firms merge, then there are two independent firms so output of
each changes to:
q(2) = (150 - 30)/3 = 40 units; price is P(2) = 150 - 2x40 = $70
profit of each firm is p(2) = (70 - 30)x40 = $1,600
 But prior to the merger the two firms had total profit of $1,800

This merger is unprofitable and should not occur

Mergers between several firms (Pepall et al. 15.1)
• Consider a Cournot model with n firms

• Cournot equilibrium prices and profits increase as the number of

competitors decreases.

• Horizontal merger will increase the profits of the average firm.

• Salant et al. (1983) showed that firms participating in the merger do

not necessarily earn greater profit (the merger paradox).
Mergers between several firms
• Cournot model with n original firms that produce homogeneous goods.

• Inverse demand is p = a – bQ,

• where p is price, Q is industry output

• Firm i’s total cost is

where is firm i’s output, b > 0, and a > c > 0.

• Cournot equilibrium profit ( ) is

=
Mergers between several firms
• If m firms engage in a horizontal merger where 2 m n, this leaves n – m + 1 firms
in the industry.

• For example, if 3 firms merge in a market that originally has 6 firms, four firms
remain (6 – 3 + 1 = 4).

• if m firms merge, firm i’s profits become

=
Mergers between several firms
• Merger reduces the number of firms, firm i’s profits increase as a result of the
merger.
• This is because overall industry output falls with fewer firms in the Cournot
model.
• For a merger of m firms to be profitable for the combined firm, its post-merger
profits must be greater than its premerger profits of all m firms
• For firms involved in the merger, post-merger profits are and premerger profits are
m times .
• Merger to be profitable:
>
Mergers between several firms
• This condition is met when > m, For this condition to hold, m must be greater than
80% of n.
• More precisely, the following condition must hold for a merger to be profitable,
m > (2n + 3 - )
This condition does not depend on demand or cost parameters
Result
Mergers between multiple firms are profitable for Cournot competitors only if
a highly concentrated market results
Horizontal merger & market power
• The profitability of the merger depends on two opposite forces:
(i) by internalizing previous rivalry, the merged entity reduces its quantity and,
increases its profit.

(ii) the outside firms react by increasing their quantity (as quantities are strategic
substitutes in a Cournot industry), which reduces the profitability of the merger.

• For the first effect to dominate, the number of outside firms must be small enough
• Horizontal merger generally benefits outside firms more than the merged firm.

• The Salant et al. (1983) model suggests that firms are unlikely to pursue
horizontal mergers for market power reasons because today’s antitrust
enforcement would forbid a merger that involved more than 80% of the firms in
an industry
Efficiency Motive for Horizontal Mergers
• Firms may also engage in a horizontal merger if it lowers costs.

• There are two principal ways that this can happen:

(1) the market for corporate control applies when an efficiently run
firm buys a poorly managed one.
• As inefficient managers are replaced by a more efficient management team,
this can reduce overhead (fixed) costs.
• It can also cause inputs to be used more efficiently, thus, lowering variable
costs.
Efficiency Motive for Horizontal Mergers
(2) firms may merge in order to increase their size and take advantage of
economies of scale.

There are two types of scale economies:

• Technical economies: larger firm can use fewer inputs to produce a
unit of output. This produces genuine cost savings to society.

• Pecuniary economies: larger firm’s ability to bargain for lower input

prices, associated with quantity discounts for raw materials or lower
interest rates for financial capital
Efficiency Motive for Horizontal Mergers
• The main contribution of Williamson’s (1968) work is the so called Williamson
trade-off: in evaluating the effect of a horizontal merger on economic efficiency,
one must compare the loss due to a reduction in competition with the gain due to
lower costs.

• If a merger results in a sufficient reduction in costs relative to the increase in

market power, then consumers as well as society can be better off.

• Society is worse off, however, if horizontal mergers increase market power and
have little or no effect on costs.
The Empirical Evidence
• If markets are efficient, one can use stock market data to test the hypothesis that
an event like a horizontal merger is motivated by market power or efficiency.
• Mergers that increase market power will produce higher prices, ceteris paribus,
which benefits all firms in the industry.
• This will cause the stock values of all firms to rise, both merging and rival firms
alike.
• Mergers motivated by efficiency alone, however, will make the merging firm a
tougher competitor and harm rivals. Thus, the stock value of rival firms will fall.
• The event study approach implies the following test: a horizontal merger that
increases the market value of rival firms implies that the market power effect is
dominant; and a horizontal merger that lowers the value of rival firms implies that
the efficiency effect is dominant.
• To use the test, all one needs to do is analyze stock-price reactions of rival firms to
a horizontal merger announcement.
The Empirical Evidence
• Kim and Singal (1993) examined 14 airline mergers that affected 11,629 routes.
They found that horizontal mergers were motivated by both market power and
efficiency.
• Merging firms raised fares an average of 9.4% relative to comparable routes.
• In mergers involving airlines that use the same airport hub, however, fares
declined.
• This suggests that such mergers were motivated by efficiency considerations
(e.g., the merger led to reduced overhead of maintaining the hub).

E. Han Kim, Vijay Singal (1993) Mergers and Market Power: Evidence from the
Airline Industry, American Economic Review, Vol. 83, No. 3, pp. 549-569.
Merger with synergies (Pepall et al 15.2)
• If a merger creates sufficiently large cost savings it should be profitable
• 3 Cournot firms.
• Consumer demand is given by p=150 – Q, where Q is aggregate output, which
pre-merger is q1 + q2 + q3.
• Two of these firms are low-cost firms with a marginal cost of 30, so that total
costs at each are given by
q1) = f + 30 q1 ; q2) = f + 30 q2
• The third firm is potentially high-cost, q3) = f + b30q3 where b ≥ 1 is a measure of
the cost disadvantage for firm 3
• f represents fixed costs associated with overhead expenses (marketing or for
maintaining corporate headquarters).
• What is the effect of a merger of firms 2 and 3?
Case A: Merger Reduces Fixed Costs

• Suppose that b = 1
• all firms have the same marginal costs of 30Merger is likely to be profitable
• but the merged firms has fixed costs af withwhen
1 <fixed 2 are “high” and
a <costs
the merger gives “significant”
• We know from the previous example that: savings in fixed costs
• pre-merger profit of each firm are 900 – f
• post-merger
• the non-merged firm has profit 1,600 - f
• the merged firm has profit 1,600 – af
• The merger is profitable for the merged firm if:
• 1,600 – af > 1,800 – 2f
• which requires that a < 2 – 200/f
Case A: 2

• Also, the non-merged firm always gains

• and gains more than the merged firms
• So the merger paradox remains in one form
• why merge?
• why not wait for other firms to merge?
Case B: Merger Reduces Variable Costs

• Suppose that merger reduces variable costs

• assume that b > 1 and that f = 0
• firms 2 and 3 merge
• so production is rationalized by shutting down high-cost operations
• pre-merger:
90  3b C 210  90b
– outputs are: q1C q2C  ; q3 
4 2 4
– profits are: C C
  
90  3b 
; C 
210  90b 2

1 2 3
16 16
– post-merger profits are $1,600 for both the merged and non-merged
firms
Case B: 2

• Is this a profitable merger?

• For the merged firm’s profit to increase requires:
 90  3b 2 210  90b 2  Merger of a high-cost and low-
1,600     0
 cost firm is profitable if cost
 16 16  disadvantage of the high-cost
• This simplifies to: (7 – 3b)(15b – 9)> 0 firm is “great enough”

• first term must be positive for firm 3 to have non-negative output

pre-merger
• so the merger is profitable if the second term is positive
• which requires b > 19/15
Summary

• Mergers can be profitable if cost savings are great enough

• but there is no guarantee that consumers gain
• in both our examples consumers lose from the merger
• Farrell and Shapiro (1990)
• cost savings necessary to benefit consumers are much greater than cost
savings that make a merger profitable
• so should be skeptical of “cost savings” justifications of mergers
• and the paradox remains
• non-merged firms benefit more from merger than merged firms
Vertical Relations
• We normally think of firms as selling products and services to consumers
• Most firms sell to other firms, not to final consumers.

• Cement producers sell cement to concrete producers, who then sell concrete to
construction firms;
• TV set manufacturers sell TV sets to retailers, who then sell them to
consumers
Vertical Relations
• Why the relation between a manufacturer and a retailer is substantially different
from the direct relation between a firm and the final consumer?

1. the firm that sells directly to the consumer normally controls most of the
variables : price, quality, advertising, sales service, and so on.
• For manufacturer who sells through a retailer: there are many determinants of
final demand which fall beyond the manufacturer’s control.
• For example, the level of sales service and local advertising is normally
controlled by the retailer.
• Retail price, an essential determinant of final demand, is set by the retailer, not
the manufacturer.
Vertical Relations
2.
• Retailers compete with each other (whereas consumers do not).

• Retailer cares about the wholesale price it has to pay the manufacturer
as well as the wholesale price paid by other retailers.

• Wholesale price determines marginal cost (the retailer’s marginal

cost), and each firm’s equilibrium profit is a function of all firms
marginal cost.
Vertical Relations

3. Number of intermediate firms is small, whereas the number of final

consumers is large; a firm that sells to the final consumer has more
market power than a firm that sells to other firms.

Most of the market power is on the buyer’s side: large supermarket

chains, for example, have a great degree of market power with respect
to suppliers.
Vertical Relations
• ‘Vertical relations” relations between two firms in sequence along the value chain

• Case of a manufacturer selling to one or several retailers.

• An upstream firm (e.g., cement producer, flour producer) sells to a

downstream firm (e.g., concrete producer, bakery).
Double marginalization

• Upstream: Monopolist
• Constant marginal cost c, no fixed cost
• Sell to the downstream firm at a wholesale price w

• Downstream (retailer): Monopolist

• Buy goods for wholesale price w
• No further cost
• Sell to the final customer at a retail price p

• Demand for final customers: q(p) = a - p

Double marginalization

• First, determine quantity of downstream monopolist for a given w:

(q,w) = (a – q - w)q

This gives inverse demand for upstream monopolist: w(q) = a – 2q

Double marginalization

Equilibrium
(q) = (- c)q
• Such that (, , =

• Pre-merger: double marginalization

• Monopolist overcharges on every levels of value chain
• Retail prices inefficiently high (from social and firm perspective)
Double marginalization

• Merger between upstream and downstream monopolist

• Joint profit:
(q) = +
• Maximize joint profit
(q) = (a – c – q)q
• Equilibrium prices fall to and joint profit increases to
• Merger eliminates double marginalization, which increases profits &
consumer surplus.
Vertical mergers
Vertical Restrictions to Reduce Double Markups

• The problem with the successive monopolies is that the retailer has an
incentive to restrict output and raise price.

• The manufacturer does not want its retailer to restrict output —or,
equivalently, to increase its price , above the wholesale price , —
because profits from the distributor’s markup go to the distributor, not
the manufacturer.

• The manufacturer wants as efficient a distribution system as possible

(that is, with the smallest distributor’s markup).
Vertical Restraints
• The manufacturer wants to induce competition at the retailer level
• Three vertical restrictions that manufacturers can use to induce a monopoly
distributor to behave more competitively
(i) impose contractually a maximum retail price , that the distributor can charge.
• manufacturer prevents a retailer from raising its price much above the
wholesale price .
• the retailer distributor sells more units.
• If is set equal to the distributor behaves like a competitive firm, sells units,
and the outcome is the same as with an integrated firm.
• If the distributor does not accept this restriction, and is set between and
Vertical Restraints
(ii) Quantity forcing
• Imposes a sales quota on a distributor; i.e., the distributor must sell a
minimum number of units.
• Manufacturer does not have to restrict a distributor’s price.
• Sales quotas induce distributors to expand their output by lowering their
prices.
• Automobile dealerships and computer retailers have sales quotas.
Vertical Restraints
(iii) Franchise
• Charging a retailer per unit of output.
• Two-part pricing scheme.
• It charges the retailer one price for the product and a second price for the right
to sell the product.
• For example, the manufacturer sells the franchise rights, or rights to sell the
product (often together with a brand name) to the retailer, for a franchise fee.
Summary

• If there is only one distributor, the problem of double monopoly markups may
occur.

• If vertical integration is not feasible, vertical restraints such as maximum retail

prices, quotas, or franchise fees may reduce or eliminate the problem.
Free Riding Among Distributors

• Several independent firms distribute one manufacturer’s product.

• Each distributor benefits from the promotional activities of other

distributors without having to pay for them.

• Some vertical restraints that may minimize free riding

Free Riding Among Distributors

• Where distributors must make substantial expenditures (for advertising,

showrooms, training a sales staff, training purchasing agents, maintaining quality)
to sell a product, free riding is likely, because some of that sales effort helps other
distributors.

• A distributor that cannot reap the full benefits of its sales efforts has an incentive
to reduce those efforts and thereby sell less of the manufacturer’s product.

• Free riding, arises since distributors are not compensated separately for sales
efforts; they are compensated for sales efforts on behalf of a particular product
only when they sell that product.
Free Riding Among Distributors

• Suppose that one distributor heavily advertises a manufacturer’s product that is

also carried by another distributor.

• The first distributor creates a demand for the product, which benefits both
distributors, but the second distributor incurs no cost at all.

• First distributor may have little incentive to advertise, because it does not capture
the full benefits of its advertising.
Free Riding Among Distributors

Berkeley campus of the University of California. A discounter opened a store next

door to a retailer that sold stereo equipment in a fancy, well-stocked showroom with
carpets and attractive lighting. The discounter piled its merchandise in its original
boxes on a linoleum floor under minimal lighting. The store had a crude,
handwritten sign in the window that said, “Go next door, see which equipment you
want, then come here for a lower price.”
Exclusive territory

• Single distributor may sell a product within a region:

• The distributor obtains monopoly rights to customers who buy within
its territory.
• Exclusive territories usually involve a promise by the manufacturer
that other distributors will not be allowed to locate within a certain
distance of the existing distributor
How to avoid free riding

(ii) limit the number of distributors

(iii) resale price maintenance agreement where a manufacturer sets a minimum

price that retailers may charge.
• For example, if the wholesale price the distributor pays is $10, and the
minimum resale price is $20, each dealer has an incentive to spend up to $10
to attract customers.
• Thus, up to $10 per unit is invested in advertising, training sales staff, or fancy
showrooms.
• Minimum price restrictions channel competition among distributors toward
sales effort and away from price cutting. They lead to more sales effort than
occurs without them.
(iv) advertise on behalf of its distributors
Hyundai and Resale Price Maintenance in India
• Case filed against Hyundai by its authorised dealers,
Enterprise Solutions and St Anthony’s Cars.
• Hyundai’s dealership agreement:
• Seek consent prior to taking up dealerships with a competing brand, and to
procure spare parts either directly from Hyundai or through its pre-approved
vendors.
• Discount control mechanism that required that its dealers not discount
the cars they sold at a rate higher than that mentioned in the policy.
• Hyundai was said to have closely monitored and
punished any retailers that violated this policy by
imposing high penalties or even refusing to supply cars
to them.
Hyundai and Resale Price Maintenance in India
• Hyundai enforced this policy by setting up mystery
shopping agencies to conduct unannounced visits to the
dealers’ showrooms and collect penalty amounts for
violations of the policy, which would then be distributed
amongst all non-violating dealers in equal proportion or
utilised to pay for the dealers’ share of advertisement
expenditure.