Section 2: Mergers

EC 171: Topics in Industrial Organization

Section 2: Mergers


Introduction• Merger mania is everywhere

– each week brings new announcements of mega-mergers• AOL/Time-Warner

• Pfizer/Warner-Lambert

• Vodafone/Mannesman

– each year seems to break the record of the year before

• Reasons for merger are many– need to become “global”

– response to other mergers

– search for synergies in operations

– to achieve significant cost savings


Questions• Why do mergers occur?

– many reasons have been suggested relating to costs and market power

• Are mergers beneficial or is there a need for regulation?– the US government is particularly concerned with these questions

– anti-trust website

– mergers might not be beneficial: they operate like legal cartels

• Are all mergers the same or are there different types?– distinguish mergers that are

• horizontal

• complementary

• vertical

http://www.usdoj.gov/atr/index.html

http://www.usdoj.gov/atr/index.html


Horizontal mergers• Merger between firms that compete in the same product

market– some bank mergers

– hospitals

– oil companies

• Begin with a surprising result: the merger paradox– take the standard Cournot model

– merger that is not merger to monopoly is unlikely to be profitable• unless “sufficiently many” of the firms merge

• with linear demand and costs, at least 80% of the firms

• but this type of merger is unlikely to be allowed


An Example Assume 3 identical firms; market demand P = 140 - Q; each firm with marginal costs of $20. The firms act as Cournot competitors.

Applying the Cournot equations we know that:

each firm produces output q(3) = (140 - 20)/(3 + 1) = 30 units

the product price is P(3) = 140 - 3x30 = $50

profit of each firm is (3) = (50 - 20)x30 = $900

Now suppose that two of these firms merge

then there are two independent firms so output of each changes to:

q(2) = (140 - 20)/3 = 40 units; price is P(2) = 140 - 2x40 = $60

profit of each firm is (2) = (60 - 20)x40 = $1,600

But prior to the merger the two firms had aggregate profit of $1,800

This merger is unprofitable and should not occur


Example (cont.) Now suppose that all three firms merge.

This creates a monopoly so that we have:

output = (140 - 20)/2 = 60 units

price = (140 - 60) = $80

profit = (1) = (80 - 20)x60 = $3,600

Prior to this merger aggregate profit was 3x$900 = $2,700

Merger to monopoly is always profitable


A Generalization Take a Cournot market with N identical firms.

Suppose that market demand is P = A - B.Q and that marginal costs of each firm are c.

From standard Cournot analysis we know that the profit of each firm is:

Ci =

(A - c)2

B(N + 1)2

Now suppose that firms 1, 2,… M merge. This gives a market in which there are now N - M + 1 independent firms.

The ordering of the firmsdoes not matter

The ordering of the firmsdoes not matter


Generalization (cont.)

Each non-merged firm chooses output qi to maximize profit:

i(qi, Q-i) = qi(A - B(qi + Q-i) - c)

where Q-i = is the aggregate output of the N - M firms excluding firm i plus the output of the merged firm qm

The newly merged firm chooses output qm to maximize profit, given by

m(qm, Q-m) = qm(A - B(qm + Q-m) - c)

where Q-m = qm+1 + qm+2 + …. + qN is the aggregate output of the N - M firms that have not merged

Comparing the profit equations then tells us:

the merged firm becomes just like any other firm in the market

all of the N - M + 1 post-merger firms are identical and so must produce the same output and make the same profits


Generalization (cont.) The profit of each of the merged and non-merged firms is then:

Cm = C

nm =(A - c)2

B(N - M + 2)2

The aggregate profit of the merging firms pre-merger is:

Profit of each surviving firmincreases with M

Profit of each surviving firmincreases with M

Ci =

M.(A - c)2

B(N + 1)2

So for the merger to be profitable we need:

(A - c)2

B(N - M + 2)2>

M.(A - c)2

B(N + 1)2this simplifies to:

(N + 1)2 > M(N - M + 2)2

M > 0.8N for this inequality to be satisfied


The Merger Paradox• Why is this happening?

– the merged firm cannot commit to its potentially greater size

– the merged firm is just like any other firm in the market

– thus the merger causes the merged firm to lose market share

– the merger effectively closes down part of the merged firm’s operations

• this appears somewhat unreasonable

• Can this be resolved?– need to alter the model somehow

• product differentiation

• Bertrand competition

– give the merged firms some additional market power• perhaps they can exercise market leadership


Horizontal Merger and Leadership• Suppose that when two firms merge they become

Stackelberg leaders– how does this affect merger profitability?

– what is the impact on consumers?


Merger and leadership: an example Suppose that there are N identical Cournot firms in the market

Market demand is P = 140 - Q and marginal cost is $20

Now suppose that 2 firms merge and become market leaders

Since a merger is a legal cartel we can use the Selten analysis of the previous chapter to get the effect of this merger

The merged firm will produce the Stackelberg output:

Prior to the merger the Cournot equilibrium has:

output of each firm: 120/(N + 1); price: PC = (140 + 20N)/(N + 1)

profit of each firm: C = 14,400/(N + 1)2

QL = (140 - 20)/2 = 60 units


The leadership example (cont.) There are N - 2 non-merged firms that act as followers. So they each produce output:

qF =140 - 20

2(N - 1)=

Total output is: QT =

60

(N - 1)

60 +60(N - 2)

(N - 1)=

60(2N - 3)

(N - 1)

Price is: PL = 140 - QT =40 + 20N

(N - 1)

and the price-cost margin is PL - 20 =60

(N - 1)


The leadership example (cont.)

Profit of the merged (lead) firm is:

L = (PL - 20)QL = 3,600/(N - 1)

Profit of each non-merged (follower) firm is:

F = (PL - 20)qF = 3,600/(N - 1)2

The merged firm is always more profitable than each non-merged firm

Is the merger profitable for the merged firms?

Profit pre-merger was: 2C = 28,800/(N + 1)2

so L > 2C requires:3,600

(N - 1)>

28,800

(N + 1)2which requires:

(N + 1)2 > 8(N - 1) This is always true for N > 3


The leadership example (cont.) What about the effect of the merger on the non-merged firms and on consumers?

Profit pre-merger was: C = 14,400/(N + 1)2

so F > C requires:3,600

(N - 1)2>

14,400

(N + 1)2which requires:

(N + 1)2 > 4(N - 1)2 This is only true for N < 3

The pre-merger price-cost margin is: PC - 20 = 120/(N + 1)

The post-merger price-cost margin is: PL - 20 = 60/(N - 1)

the merger reduces price if:60

N - 1<

120

N + 1or 60N + 60 > 120N - 120

This is true if N > 3


Mergers and Market Leadership• A two-firm merger that creates a market leader is

profitable for the merged firms if there are three or more firms in the market

• Moreover, such a merger– increases the market share of the merged firms

– reduces profit and market share for each non-merged firm

– benefits consumers by reducing price

• So why worry about mergers?

• What might the non-merged firms do?

• Will they also seek merger partners?

• If so, what then happens to price and consumer welfare?


Mergers and leadership (cont.)• The “leadership” merger reduces profits of the non-merged

firms

• Won’t these firms also seek merger partners?– certainly consistent with casual evidence

• So, consider more than one two-firm merger– creates a series of merged firms

– and a series of non-merged firms

• How does “leadership” work here?– (Daughety) merged firms compete against each other

– but as a group act as leaders relative to the non-merged firms

– another variant on the Cournot model


Mergers and leadership (cont.)• Need to distinguish output decisions of the group of

leaders (L) and the group of followers (F)– stage game

• stage 1: leaders each choose their output levels in competition with the other lead firms

• stage 2: followers see output decisions of the lead firms then choose their outputs with respect to residual demand in competition with other follower (non-merged) firms

• Stick with the Cournot model we have used– market demand P = 140 - Q; marginal cost $20; N firms

– the firms are in two groups• L leaders or merged firms

• N - L followers or non-merged firms

– solve this game “backwards”


Mergers and leadership (cont.) Suppose that the aggregate output of the lead firms is QL

Residual demand for the non-merged firms is then:

P = 140 - QL - QF

QF can be written qf + QF-f

where QF-f denotes output of the non-merged firms other than firm f

where Q = QL + QF and QF is output of the non-merged firms

So the profit of non-merged firm f can be written:

f = (140 - QL - QF-f - qf - 20)qf = (120 - QL - QF-f - qf)qf

Differentiate this with respect to qf to give the condition:

f/ qf = 120 - QL - QF-f - 2qf = 0Solve this for qf

Solve this for qf


An example of leadership (cont.) We have the best response function for firm f:

qf = 60 - QL/2 - QF-f/2

as a response to both the output of the leaders and the other followers

But all the followers are identical

so in equilibrium they produce the same outputs:

so Q*F-f = (N - L - 1)q*f

so q*f = 60 - QL/2 - (N - L - 1)q*f/2 so (N - L + 1)q*f/2 = 60 - QL/2

q*f =120 - QL

N - L + 1

Aggregate output of the non-merged firms is then:

Q*F =(N - L)(120 - QL)

N - L + 1


An example of leadership (cont.) What about a lead (merged) firm in stage 1?

The same technique can be used. Residual demand for a lead firm is:

P = 140 - QF - QL = 140 - QF - Q-l - ql

where Q-l is output of all the lead firms other than firm l

The difference between the merged firms and the non-merged firms is that each merged firm knows what QF is going to be.

The typical lead firm correctly anticipates the actions of the non-merged firms and so can use this information

Recall that Q*F =(N - L)(120 - QL)

N - L + 1

and substitute this into the residual demand equation


An example of leadership (cont.) This gives the residual demand equation

P = 140 -(N - L)(120 - QL)

N - L + 1- QL

For the moment wetreat the merged firms

as a group

For the moment wetreat the merged firms

as a group

=140 + 20(N - L)

N - L + 1+

(N - L)QL

N - L + 1- QL

=140 + 20(N - L)

N - L + 1-

QL

N - L + 1

This can now be rewritten:

P =140 + 20(N - L) - Q-l

N - L + 1-

ql

N - L + 1


An example of leadership (cont.) Profit of a typical merged firm is: l = (P - 20)ql

140 + 20(N - L) - Q-l

N - L + 1-

ql

N - L + 1

But we know what P is so we have

P - 20 = - 20

=140 - 20 - Q-l

N - L + 1-

ql

N - L + 1

So profit of a typical merged firm becomes:

l =(120 - Q-l - ql)

(N - L + 1)ql

Differentiate this with respect to ql to give the profit maximizing condition.


An example of leadership (cont.)

l =(120 - Q-l - ql)

(N - L + 1)ql We have:

Differentiating gives the condition:

l/ ql =120 - Q-l - 2ql

N - L + 1= 0

So we have the condition: Q*-l + 2q*l = 120

In solving this we can again use a symmetry argument:

in equilibrium all the lead firms will have the same output

so Q*-l = (L - 1)q*l

Since Q-l containsL - 1 firms

Since Q-l containsL - 1 firms

which gives: (L + 1)q*l = 120 so q*l = 120/(L + 1)

Aggregate output of the merged firms is then: Q*L = 120L/(L + 1)


Recall that Q*F =(N - L)(120 - QL)

N - L + 1


Now substitute for Q*L = 120L/(L + 1). This gives:

Q*F =(N - L)120

(N - L + 1)(L + 1)q*F =

120

(N - L + 1)(L + 1)and

This has been a lot of work!!! But now we can see the effect of a group of mergers.

We can easily compare outputs of the different types of firms.

The leader (merged) firms are larger than the follower (non-merged) firms: as we would expect



To make this comparison we need the equilibrium price.

Aggregate output is: Q*F + Q*L

so Q*T =(N - L)120

(N - L + 1)(L + 1)+

120L

(L + 1)=

120(N + NL - L2)

(N - L + 1)(L + 1)

This looks nasty but check that it is greater than the Cournot output

What about profits? Is the profit of a leader firm more than twice that of the profit it would make as a follower?

Stackelberg leaders produce more than Cournot firms. This reduces output of the followers but not by an offsetting amount.

Followers are under pressure: lower output and lower prices.

Increases the likelihood that followers will merge.


An example of leadership (cont.) Check the profitability of an additional merger. To do so,we need profits of followers and leaders.

This requires that we calculate the price-cost margin.

Price is PL = 140 - Q*T =120(N + NL - L2)

(N - L + 1)(L + 1)140 -

and the price-cost margin is PL - 20 which gives:

PL - 20 =120

(N - L + 1)(L + 1)

This then gives us the profit equations for each type of firm


An example of leadership (cont.) Profit of a typical follower is:

f(N, L) =14,400

(N - L + 1)2(L + 1)2

Profit of a typical leader is:

l(N, L) =14,400

(N - L + 1)(L + 1)2

Each leader is more profitable than each follower but this is not the appropriate comparison Compare profits of two followers before they merge with their profits after they merge.


An example of leadership (cont.)• Starting from any configuration of leaders and followers a

further two firms will always wish to merge.

• Is such a group of two-firm mergers desirable for consumers?– firms that join the leader group increase output

– but there are fewer firms in the market

• So will a further two-firm merger increase or decrease output?– for this to happen we must have L < N/3 - 1

For price to fall as a result of a merger the leader group should contain no more than one-third of the total number of

firms in the market


Product Differentiation and Merger• The discussion so far has assumed that products are

identical

• It can be extended to differentiated products:– suppose demand is of the form:

– q1 = A - Bp1 + C(p2 + p3 +…+ pn)

– and similarly for the other products

• Now a merger allows coordination of the outputs of the different products

• but the merger does not lead to one of the products being eliminated


An Example of Product Differentiation

QC = 63.42 - 3.98PC + 2.25PP

QP = 49.52 - 5.48PP + 1.40PC

MCC = $4.96

MCP = $3.96

This example can be generalized to more than two products


Product differentiation• Take a different approach

– spatial model of product differentiation

• The idea is simple– suppose firms are offering different varieties of a product

– the analogy is that these products have different “locations”

– then merger between some of these firms avoids some of the problems of the merger paradox

• don’t have to close down particular locations

• but can coordinate prices and, perhaps, locations

• Many mergers “look like” this– join product lines that compete but do not perfectly overlap


The Spatial Model• The model is as follows

– a market called Main Circle of length L

– consumers uniformly distributed over this market

– supplied by firms located along the street

– the firms are competitors: fixed costs F, zero marginal cost

– each consumer buys exactly one unit of the good provided that its full price is less than V

– consumers incur transport costs of t per unit distance in travelling to a firm

– a consumer buys from the firm offering the lowest full price

• What prices will the firms charge?

• To see what is happening consider two representative firms


The spatial model illustrated

Firm 1 Firm 2

Assume that firm 1 setsprice p1 and firm 2 sets

price p2

Price Price

p1

p2

xm

All consumers to theleft of xm buy from

firm 1And all consumers

to the right buy fromfirm 2

What if firm 1 raisesits price?

p’1

x’m

xm moves to theleft: some consumers

switch to firm 2


The Spatial Model• Suppose that there are five firms evenly distributed

1

2

34

5

these firms will split the market

r12

r23

r34

r45

r51

we can then calculate the Nash equilibrium prices each firm will charge

each firm will charge a price of p* = tL/5 profit of each firm is then tL2/25 - F


Merger of Differentiated Products

1 2 3 4 5

Price

Main Circle (flattened)

r51 r12 r23 r34 r45 r51

now consider a merger between some of these firms

a merger of non-neighboring firms has no effect

A merger of firms2 and 4 does

nothing

but a merger of neighboring firms changes the equilibrium

A merger of firms2 and 3 doessomething


Merger of Differentiated Products

1 2 3 4 5

Price

Main Circle (flattened)

r51 r12 r23 r34 r45 r51

merger of 2 and 3 induces them to raise their prices

so the other firms also increase their prices

the merged firms lose some market share what happens to profits?


Spatial Merger (cont.)

The impact of the merger on prices and profits is as follows

Pre-Merger Post-Merger

Price Profit Price Profit

1

2

3

4

5

tL/5 tL2/25

tL/5 tL2/25

tL/5 tL2/25

tL/5 tL2/25

tL/5 tL2/25

1

2

3

4

5

14tL/60 49tL2/900

19tL/60 361tL2/7200

19tL/60 361tL2/7200

14tL/60 49tL2/900

13tL/60 169tL2/3600


Spatial Merger (cont.)• This merger is profitable for the merged firms

• And it is not the best that they can do– change the locations of the merged firms

• expect them to move “outwards”, retaining captive consumers

– perhaps change the number of firms: or products on offer• expect some increase in variety

• But consumers lose out from this type of merger– all prices have increased

• For consumers to derive any benefits either– increased product variety so that consumers are “closer”

– there are cost synergies not available to the non-merged firms• e.g. if there are economies of scope

• Profitability comes from credible commitment


Price Discrimination What happens if the firms can price discriminate?

This leads to a dramatic change in the price equilibrium

t t

i i+1

take two neighboring firms

s

consider a consumer located at s

Pricep1

i

suppose firm i sets price p1i

i+1 can undercut with price p1i+1

p1i+1

i can undercut with price p2i

p2i

and so oni wins this competition by “just” undercutting i+1’s cost of supplying s

p*i(s)

the same thing happens at every consumer locationequilibrium prices are illustrated by the bold linesFirm i supplies

these consumers

Firm i suppliesthese consumers

and firm i+1these consumers

and firm i+1these consumers


Merger with price discrimination Start with a no-merger equilibrium

1 2 3 4

Price equilibriumpre-merger is given

by the bold lines

Profit for each firmis given by theshaded areas

This is much betterfor consumers than no price discrimination


Merger with price discrimination Now suppose that firms 2 and 3 merge

1 2 3 4

They no longer compete in prices so the price equilibrium changes Prices to the captiveconsumers between

2 and 3 increase

Prices to the captiveconsumers between

2 and 3 increaseProfits to themerged firms

increase

Profits to themerged firms

increase

This is beneficial for the merged firms but harms

consumers


Vertical Mergers• Now consider very different types of mergers

– between firms at different stages in the production chain

– also applies to suppliers of complementary products

• These mergers turn out, in general, to be beneficial for everyone.


Complementary Mergers• Take a simple example:

– final production requires two inputs in fixed proportions

– one unit of each input is needed to make one unit of output

– input producers are monopolists

– final product producer is a monopolist

– demand for the final product is P = 140 - Q

– marginal costs of upstream producers and final producer (other than for the two inputs) normalized to zero.

• What is the effect of merger between the two upstream producers?


Complementary mergers (cont.)

Supplier 1 Supplier 2

price v1price v2

price P

Final Producer

Consumers


Complementary producers Consider the profit of the final producer: this is

f = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q

Maximize this with respect to Q

f/Q = 140 - (v1 + v2) - 2Q = 0

Solve this for QSolve this for Q

Q = 70 - (v1 + v2)/2

This gives us the demand for each input

Q1 = Q2 = 70 - (v1 + v2)/2

So the profit of supplier 1 is then: 1 = v1Q1 = v1(70 - v1/2 - v2/2)

Maximize this with respect to v1


Complementary producers (cont.)

Maximize this with respect to v1

1 = v1Q1 = v1(70 - v1/2 - v2/2)

1/v1 =

70 - v1 - v2/2 = 0

Solve this for v1Solve this for v1

v1 = 70 - v2/2

We can do exactly the same for v2

v2 = 70 - v1/2

The price charged byeach supplier is a

function of the othersupplier’s price

We need to solvethese two pricing

equations

v2

v1

140

70

R1

70

140

R2

v1 = 70 - (70 - v1/2)/2 = 35 + v1/4

so 3v1/4 = 35 so v1 = $46.67

46.67

and v2 = $46.6746.67


Complementary products (cont.) Recall that Q = Q1 = Q2 = 70 - (v1 + v2)/2

so Q = Q1 = Q2 = 23.33 units

The final product price is P = 140 - Q = $116.67

Profits of the three firms are then:

supplier 1 and supplier 2: 1 = 2 = 46.67 x 23.33 = $1,088.81

final producer: f = (116.67 - 46.67 - 46.67) x 23.33 = $544.29


Complementary products (cont)


23.33 units @ $46.67 each

23.33 units @ $116.67 each

Final Producer

Consumers

23.33 units @ $46.67 each

Now suppose that thetwo suppliers merge


Complementary mergers (cont.)


price v

price P

Final Producer

Consumers

The merger allows thetwo firms to coordinate

their prices


Complementary merger (cont.) Consider the profit of the final producer: this is

f = (P - v)Q = (140 - v - Q)Q

Maximize this with respect to Q

f/Q = 140 - v - 2Q = 0

Solve this for QSolve this for Q

Q = 70 - v/2

This gives us the demand for each input

Q1 = Q2 = Qm = 70 - v/2

So the profit of the merged supplier is: m = vQm = v(70 - v/2)

Maximize this with respect to v


Complementary merger (cont.)

m = vQm = v(70 - v/2)

Differentiate with respect to v

m/v = 70 - v = 0 so v = $70

This is the cost of the combinedinput so the merger has reduced

costs to the final producer

This is the cost of the combinedinput so the merger has reduced

costs to the final producer

Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units

This gives the final product price P = 140 - Q = $105

The merger has reducedthe final product price:

consumers gain

The merger has reducedthe final product price:

consumers gain

What about profits? For the merged upstream firm:

m = vQm = 70 x 35 = $2,480

This is greater than thecombined pre-merger

profit

This is greater than thecombined pre-merger

profit

For the final producer:

f = (105 - 70) x 35 = $1,225

This is greater than thepre-merger profit

This is greater than thepre-merger profit


Complementary mergers (cont.)• A merger of complementary producers has

– increased profits of the merged firms

– increased profit of the final producer

– reduced the price charged to consumers

Everybody gains from this merger: a Pareto improvement! Why?

• This merger corrects a market failure– prior to the merger the upstream suppliers do not take full account of

their interdependence– reduction in price by one of them reduces downstream costs,

increases downstream output and benefits the other upstream firm– but this is an externality and so is ignored

• Merger internalizes the externality


Vertical Mergers• The same kinds of result arise when we consider vertical

mergers: mergers of upstream and downstream firms

• If the merging firms have market power– lack of co-ordination in their independent decisions

– double marginalization

– merger can lead to a general improvement

• Illustrate with a simple model– one upstream and one downstream monopolist

• manufacturer and retailer

– upstream firm has marginal costs $20

– sells product to the retailer at price r per unit

– retailer has no other costs: one unit of input gives one unit of output

– retail demand is P = 140 - Q


Vertical merger (cont.)

ManufacturerMarginal costs $20

wholesale price r

Price P

Consumer Demand: P = 140 - Q


Vertical merger (cont.)• Consider the retailer’s decision

– identify profit-maximizing output

– set the profit maximizing pricePrice

Quantity

Demand140

140

marginal revenue downstream is MR = 140 - 2Q

MR

70

marginal cost is r

MCr

equate MC = MR to give the quantity Q = (140 - r)/2

140 - r

2

identify the price from the demand curve: P = 140 - Q = (140 + r)/2

(140+r)/2 profit to the retailer is (P - r)Q which is D = (140 - r)2/4

profit to the manufacturer is (r-c)Q which is M = (r - c)(140 - r)/2



Price

Quantity

Demand140

140

MR

70

MCr

suppose the manufacturer sets a different price r1

r1

140 - r

2

then the downstream firm’s output choice changes to the output Q1 = (140 - r1)/2

140 - r1

2

and so on for other input prices

demand for the manufacturer’s output is just the downstream marginal revenue curve

Upstream demand



Price

Quantity

Demand

140

140

MR

70

the manufacturer’s marginal cost is $20

Upstream demand

20 MC

upstream demand is Q = (140 - r)/2 which is r = 140 - 2Qupstream marginal revenue is, therefore, MRu = 140 - 4Q

35

equate MRu = MC: 140 - 4Q = 20

so Q* = 30

30

and the input price is $80 80

while the consumer price is $110

110

the manufacturer’s profit is $1800

the retailer’s profit is $900MRu


Vertical merger (cont.)• Now suppose that the retailer and manufacturer merge

– manufacturer takes over the retail outlet

– retailer is now a downstream division of an integrated firm

– the integrated firm aims to maximize total profit

– Suppose the upstream division sets an internal (transfer) price of r for its product

– Suppose that consumer demand is P = P(Q)

– Total profit is:• upstream division: (r - c)Q

• downstream division: (P(Q) - r)Q

• aggregate profit: (P(Q) - c)Q

The internal transferprice nets out of theprofit calculations

The internal transferprice nets out of theprofit calculations

• Back to the example



Price

Quantity

Demand

140

140

MR

70

the integrated demand is P(Q) = 140 - Q

20 MC

marginal revenue is MR = 140 - 2Q

marginal cost is $20so the profit-maximizing output requires that 140 - 2Q = 20so Q* = 60

60

so the retail price is P = $8080

This merger has benefited consumers

aggregate profit of the integrated firm is (80 - 20)x60 = $3,600

This merger has benefited the two

firms


Vertical merger (cont.)• Integration increases profits and consumer surplus

• Why?– the firms have some degree of market power

– so they price above marginal cost

– so integration corrects a market failure: double marginalization

• What if manufacture were competitive?– retailer plays off manufacturers against each other

– so obtains input at marginal cost

– gets the integrated profit without integration

• Why worry about vertical integration?– two possible reasons

• price discrimination

• vertical foreclosure


Price discrimination• Upstream firm selling to two downstream markets

– different demands in the two markets

Market 1 Market 2P

Q

P

Q

D1 D2

the seller wants to price discriminate between these marketsv1 v2

set v1 < v2

but suppose that buyers can arbitragethen buyer 2 offers to buy from buyer 1 at a price va such that v1 < va < v2

va

arbitrage prevents price discrimination if the seller integrates into market 1 arbitrage is prevented


Vertical foreclosure• Vertically integrated firm refuses to supply other firms

– so integration can eliminate competitors

suppose that the seller is supplying three firms with an essential input

the seller integrates with one buyer

if the seller refuses to supply the other buyers they are driven out of business

is this a sensible thing to do?


Vertical foreclosure Suppose that there are some integrated firms and some independent upstream and downstream producers

Profit of an integrated firm is:

I = (PD - cU - cD)qDi

Profit of an independent upstream firm is:

U = (PU - cU)qUn

Profit of an independent downstream firm is:

D = (PD - PU - cD)qDn

The integrated firm willnot source on the independent

market

The integrated firm willnot sell on the independent

market


Vertical foreclosure For the independent upstream firms to survive requires PU - cU > 0

The downstream unit of an integrated firm obtains input at cost cU

Buying from an independent firm costs PU > cU

so the downstream divisions will not source externally

Now suppose that an upstream division of an integrated firm is selling to independent downstream firms it earns PU - cU on each unit sold

Divert one unit to its downstream division: this leaves the downstream price unchanged: it earns PD - cU - cD on this unit diverted

PD - PU - cD > 0 for independent downstream firms to survive

PD - cU - cD PD - PU - cD > 0

But this is true: sodiverting output fromthe external market

increases profits

But this is true: sodiverting output fromthe external market

increases profits

so the upstream divisions will not sell externally

> PU - cU requires:

Profit from sellinginternally

Profit from sellinginternally

Profit from sellingexternally

Profit from sellingexternally


Vertical foreclosure (cont.)• Foreclosure happens

– but is not necessarily harmful to consumers• reduces number of buyers in the upstream market

• increases prices charged by independent sellers to non-integrated downstream firms

• but integrated downstream divisions obtain inputs at cost

• puts pressure on non-integrated downstream firms

– provided there are “enough” independent upstream firms the anti-competitive effects of foreclosure will be offset by the cost advantages of vertical integration

• There are also strategic effects that might prevent foreclosure– to avoid non-integrated firms from integrating


Date post:	30-Dec-2015
Category:	Documents
Upload:	brianna-hassett
View:	32 times
Download:	0 times

Section 2: Mergers

Documents