Mergers and Acquisitions

  • When firms in the same (relevant) market merge, the industry becomes more concentrated; this can lead to higher prices via

    • unilateral effects, single firm dominance

    • coordinated effects, collective/joint dominance

  • efficiency defence

  • vertical and conglomerate mergers lead to concerns about foreclosure and range (portfolio) effects

  • efficiency offence

  • Remedies

  • European practice

Unilateral effects in horizontal mergers

  • When firms produce substitutes, incentive to raise price after merger

  • When firms produce complements, incentive to reduce price

  • Factors affecting unilateral market power:

    • industry concentration, market shares merging firms, entry, buyer power, failing firm defence

  • Mergers in the new economy

  • Bidding markets

  • Effect of horizontal merger on price

    • Consider a city with three grocery stores \(A,B,C\)

    • Now \(A\) and \(B\) merge and there are no efficiency gains

    • Then we expect the price to go up:

      • Before the merger if \(A\) considered a price rise, it realized that some of its customers would go to \(B\) (and \(C\))

      • but now the loss of customers to \(B\) is no longer bad for the merged grocery’s profits

    • Hence there is less reason to keep prices low and we expect prices to go up

      • If \(A\) and \(B\) sell complements, we expect prices to go down because now \(A\) takes into account that a lower price increases the sales of \(B\)

  • Factors influencing the likelihood of a price rise

    • industry concentration: if there a 100 firms in the industry with equal market share and two of them merge, the effect on the price is minimal

    • market shares of merging firms: if two small firms merge, this has a smaller effect than when the two biggest firms in the sector merge

      • In the US a screening is used on the Herfindahl index and the change in this index; Motta page 235

    • But market share and concentration is not sufficient:

      • High concentration may be due to intense competition (see market share)

      • It does not capture the “closeness” of competition within a relevant market:

      • If there are 4 firms in a market \(A,B,C,D\) and most consumers of \(A\) say that their second choice would be \(B\) and consumers of \(B\) have \(A\) as their second choice, then a merger between \(A\) and \(B\) is more likely to lead to higher prices than when consumers consider each of the other three a good alternative

      • Sometimes the diversion ratio is calculated to capture this: diversion ratio from \(A\) to \(B\) is the proportion of sales lost by \(A\) when \(p_A\) increases that are captured by \(B\)

    • Ease of entry: if it is easy for new firms to enter, merged firm cannot raise price as it will attract entrants into the industry; if “hit-and-run” entry is possible, no reason at all to worry about the price effects of a merger

    • US guidelines consider entry to be a check on the merged firm if entry can affect prices in the relevant market within two years

    • Demand factors: can consumers easily switch away to a new product if the price goes up? If switching costs are low, demand is relatively elastic and scope for price increase limited

    • Buyer power: If the merged firm supplies a limited number of powerful buyers, the scope for price increase is limited as well (e.g. buyers can threaten to switch supplier; sponsor the entry of a new supplier; vertically integrate with a supplier to secure their own supply)

    • Failing firm defence: suppose a firm is about to go bankrupt and another firm takes over this firm, then one can argue that the take over cannot be anticompetitive since the firm would have exited the industry anyway: merger has no effect on the number of firms active in the market

    • Intuitively, it seems a waste to let the failing firm’s assets idle after it leaves the industry

    • In Kali-Salz three criteria were formulated for a failing firm defence to be valid:

      • acquired firm would in the near future have been forced out of the market if not taken over by another firm (failing firm)

      • there is not an alternative buyer of the failing firm that causes less anti-competitive concern (then a merger with this firm would be preferred from a competition policy point of view)

      • acquiring firm would get failing firm’s market share if it is forced to exit (if not, i.e. if sales of the failing firm would be distributed equally over the other firms in the market, exit of this firm may keep concentration lower than the take over)

  • Mergers in the new economy

    • In sectors that are characterized by a high degree of innovation and network effects, there are two considerations which make the framework above less relevant:

    • Is competition best described as “in” the market or “for” the market:

      • If competition is “in” the market, the analysis above applies

      • with competition “for” the market, concentration measures are less informative: if network effects cause one standard to prevail in a market, high market concentration is not very informative

      • concern here is whether the merger leads to a standard being adopted that is not efficient; e.g. suppose there are three standards in the market produced by resp. firms \(A,B,C\), each with market share \(1/3\)

      • now firms \(A\) and \(B\) merge and decide to make their products compatible

      • the increase in the network of \(AB\) can “tip” the market in favor of \(AB\) even though the \(C\) standard could be superior

      • merger of \(AB\) should be abolished in this case

    • Is the sector characterized by price competition or product competition? In the latter case the worry is not that the merger will lead to higher prices but to a lower rate of innovation as firms reduce R&D (instead of reducing production)

  • Bidding markets

    • An example of a bidding market is the construction sector where firms bid for projects, like parts of the construction of the Betuwe lijn, the high speed train connection between Amsterdam and Paris etc.

    • Here concentration is also not very informative as it does not capture the “closeness” of firms in the following sense

    • suppose that there are 10 firms \(A,B,C,…J\) with equal market shares and \(A\) and \(B\) want to merge

    • If it is the case that for each project won by \(A\), firm \(B\) was the second lowest bidder and similarly for projects won by \(B\), firm \(A\) was runner up

    • then the merger of \(A\) and \(B\) should be expected to lead to bigger price increases than in the case where any of the other 8 firms was the second lowest bidder.

Coordinated effects in horizontal mergers

  • Merger may change market structure such that it becomes easier for firms to (tacitly) collude

  • Although merger does not allow a single firm to raise its price, collectively it may become easier for firms to raise price

  • Difference with unilateral effects is that with unilateral effects the merged firm can increase its price (no matter what competitors do), with coordinated effects price rise is only profitable if other firms raise their price as well

  • Test for coordinated effects:

    • internal factors

    • external factors (see the list of factors facilitating collusion)

    • how does merger change things?

  • Internal and external factors:

    • Internal factors: are characteristics in the industry such that firms are able to reach a tacit understanding to limit competition and sustain this

      • small number of firms

      • cross ownership between firms

      • orders arrive with high frequency

      • demand is stable

      • transparency in the market, e.g. due to the use of RPM or information exchange is easy (organized by trade association)

      • goods are homogenous

      • firms are symmetric

      • multi market contact

      • excess capacity

    • External factors: do the firms collectively have market power to raise prices:

      • ease of entry: if it is easy for new firms to enter, existing firms cannot profitably raise their price; collective dominance is not a concern

      • supply-side substitutability

      • large buyers that can counteract price increases due to collective dominance

      • maverick firm that does not want to collude but instead behaves aggressively (think of Easy Jet, Easy Cruise etc.)

  • How does the merger change things?

  • Even if all the (internal and external) factors above point to the possibility of collusion, this is not enough to forbid the merger on the basis of collective dominance

  • One should also argue why before the merger tacit collusion was not feasible while after the merger it is:

    • merger may create firms that are more symmetric than before (in terms of production capacity, marginal costs, portfolio of products etc.) and hence facilitates collusion

    • merger removes the maverick firm from the market by acquiring it; firm that blocked collusion before disappears and hence collusion is easier to sustain

Efficiency defence

  • If the merger leads to a reduction in marginal costs, there is a tendency for firms to price lower (monopolist with lower costs chooses a lower price as well)

  • If the reduction in marginal costs is big enough, this can dominate the market power effect of the merger and lead to lower prices

  • Sources of efficiency gains after a merger: economies of scale and scope; reallocation of assets to more productive uses within the merged entity; learning from the other firm’s best practice; reallocating output over plants to reduce costs

  • There are some problems with this efficiency defence:

    • It is easy to promise efficiency gains by firms, but in practice they are usually not realized (competition authority lacks the information to verify the claims of efficiency gains)

    • As noted above, if the efficiency gains lead to a more symmetric structure in the industry it may facilitate collusion

    • if the efficiency gains can also be realized without the merger, they cannot be used as a defence of the merger

  • Under a consumer welfare standard the efficiency gains need to be bigger to justify a merger than under a total welfare standard, as in the former case the price has to actually decrease after the merger for consumers to benefit (consumer surplus to increase)

  • Under a total welfare standard reductions in fixed costs (by eliminating the duplication of overhead costs) can also justify a merger while this cannot happen under a consumer welfare standard (as fixed costs have no effect on the price of existing firms)

  • If efficiency gains are big enough, other firms in the industry will lose from the merger; hence competitors complaining about a merger is often suspicious; competition policy should not protect competitors

Vertical mergers

  • A vertical merger like vertical restraints can raise welfare by internalizing externalities between upstream and downstream firms (like double marginalization)

  • But such a merger can also lead to a reduction in welfare, e.g. when it leads to (partial) foreclosure (see vertical restraints) and thus raises rivals’ costs

  • Even in cases where the vertical merger would lead to efficiency gains for the merged firm, the Commission has held this against the firms: efficiency offence

  • underlying idea is that the cost advantage leads to the exit of competitors and hence to higher prices in the long run

  • However, before such a predatory pricing theory makes sense, one needs to show that prices can go up after the other firms have left (e.g. there must be high barriers to entry etc.)

  • further, the other firms can perhaps merge as well or reduce their costs in other ways

  • Instead of prohibiting the merger on the basis of efficiency offence one can also allow the merger and use Article 102 later on to prevent the abuse of a dominant position

  • Principle here should again be: vertical merger is no problem as long as there is enough inter-brand competition

Conglomerate mergers

  • merger between two firms that are neither in the same relevant market not vertically related

  • Think, for instance, of a firm \(B\) brewing beer merging with a firm \(C\) producing crisps

  • Commission has identified the following range/portfolio effects:

    • merged firm is attractive to retailers as it offers a range of products

    • merger leads to economies of scale and scope

    • merger creates possibilities for tying and bundling

    • merger increases the threat of refusal to supply

  • First two effects mainly harm competitors, not competition; other firms should try to get similar advantages

  • Fourth argument does not make much sense as the outside options for the retailers (in either beer or crisps) have not changed

  • Tying and bundling can be a problem if one of the firms holds a monopoly (or at least dominant) position in its market; as shown here it is then possible (under conditions) to leverage market power from one market to the next

  • Commission has used this type of argument in the Tetra Laval/Sidel case (where the Commission argued that the merger would have allowed Tetra Laval to leverage its dominance in carton packing and equipment to achieve a dominant position in the market for plastic bottling machines)

  • CFI has criticized this decision as Commission did not show that merger created overwhelming advantage for Tetra Laval nor that competitors were not able to respond to merger by creating similar advantages

  • Commission also used this portfolio power theory to prohibit the GE/Honeywell merger that had already been cleared in the US by the DOJ; in the US the decision was interpreted as protecting competitors instead of protecting competition

Remedies

  • Commission can allow a merger, prohibit it or allow the merger if certain remedies are adopted

  • Two categories of remedies:

    • structural remedies: merging firms are forced to sell some assets (e.g. divest some products or divisions)

    • behavioral remedies: merging firms commit themselves not to engage in certain (abusive) practices or to license a certain technology to rivals

  • Structural remedies can be used to solve portfolio problems or reduce excess capacity available to the merged firm

  • disadvantage: merged firm divesting assets has an incentive to sell to weak competitor who does not form a serious threat; CA lacks information to see whether assets go to the right firm; if divestiture turns out to be a mistake, hard to turn back

  • Behavioral remedies require continuous monitoring by CA or independent party

European practice: Merger Regulation

  • When firms want to merge, they have to notify the Merger Task Force (if the merger has a Community dimension, otherwise firms go to the national CA)

  • Within one month from the notification the Commission decides whether the merger is cleared right away or whether further investigation (Phase II) is needed

  • Phase II investigation can last 4 months; three possible outcomes: cleared, cleared subject to remedy, prohibition of merger

  • If merger is prohibited, firms can appeal Commission’s decision at CFI

  • However, appeal can take up to three years; usually even if firms win in the European Courts, commercial rationale for merger has disappeared

  • Europe used to have a dominance test for mergers; however some mergers can be welfare reducing (and should thus be prohibited) even though they do not create or strengthen a dominant position

  • The US, Canada, Australia, New Zealand, UK have SLC test (substantial lessening of competition)

  • Commission introduced in 2004 a new Merger Regulation (for horizontal mergers) based on a similar idea that merger should not “significantly impede effective competition”

Summary

  • Horizontal mergers and acquisitions can raise prices (and reduce consumer welfare) through either unilateral or coordinated effects

  • Firms can defend the merger by claiming that marginal costs will go down to such an extent that prices will actually fall

  • Other ways to argue that the merger will not lead to higher prices include: low concentration, merger involves two small firms, low entry barriers, consumers can easily switch to other suppliers, strong buyer power, failing firm defence

  • Vertical mergers, like vertical restraints, can create efficiencies that lead to lower prices

  • However, vertical mergers (again, like restraints) can also lead to foreclosure and higher prices

  • Even when there are efficiencies the Commission sometimes holds this against firms as an efficiency offence

  • Conglomerate mergers can be bad for welfare because of portfolio effects if the merger creates the possibilities for bundling and tying

Exercises