GE - Honeywell
Vertical Mergers, Bundling and
Protectionism
Introduction
• On July 3, 2001, the European Commission blocked a $42 billion
merger between General Electric and Honeywell.
• The reason for blocking this merger centered around the economic
theory of bundling.
• On October 22, 2000, this merger was announced. The US Department
of Justice gave it the green light. However, the European Commission
also had to approve it because of the size of the two firms’ Euro sales.
The EC denied the merger on July 3 of 2001.
The Players
General Electric
• One of the largest corporations in the world, grossing over $125 billion
in 2001
• Among many other interests, GE produces aircraft engines both
independently and through a 50-50 joint venture called CFMI with
SNECMA, a French company
• GE competes with Pratt & Whitney and Rolls Royce as well as IAE, a
joint venture between the two
Honeywell
• Produces a basket of aeronautical products including avionics, starter
motors, auxiliary power supplies, engine accessories, wheels, brakes,
etc.
• Does not produce engines, however
• Achieved market prominence through a series of mergers and
acquisitions
• Over half of $23 billion 2001 revenue came from aerospace division
The Case Against
• The EC must prove that the merger would lead to market dominance:
A position of economic strength enjoyed by an undertaking which enables it to
prevent effective competition being maintained on the relevant market by giving
it the power to behave to an appreciable extent independently of its competitors,
customers, and ultimately of consumers.
• Market dominance exists if a firm can price in an anticompetitive manner.
• A strange case because firms were neither competitors, nor did they
have a vertical relationship.
• Instead the Commission focused on potential problems arising from
horizontal integration
The Case Against (cont.)
• The Commission’s rejection hinged on their assertion that because GE
and Honeywell were market leaders in their respective aeronautical
fields, the merger would allow them to bundle complementary products
at unbeatable prices
• Thus, they could price other firms out of business and then assume a
monopoly status
• The Commission denied a proposal that would lower costs to
consumers?
• Yes, because the cause would be pricing efficiencies rather than
production efficiencies, which it viewed as anticompetitive
• Potential increases in consumer surplus were shunned for fear of the
possibility of anticompetitive behavior down the road
Bundling: The Economics
Three Types of Bundling
1. Pure Bundling: Two products are only sold together. They are unavailable
separately.
a. Shoes. You need both a left and a right shoe, but normally you cannot buy
them individually.
2. Tying: One item is available by itself and also in a bundle with another item that is
unavailable alone.
a. New car options. You can pay more for leather seats when you buy a car, but
you can’t go to the dealership and get them a la carte
3. Mixed Bundling: Items are available separately but also as a bundle at a reduced
price.
a. ‘Meals’ at restaurants. Your burger, fries, and Coke cost less together when
you order them as a meal.
Bundling: The Economics (cont.)
• Cournot first considered the concept of bundling.
• Two independent monopolists selling complementary goods could make
more money if they merged or coordinated and lowered their prices. The
price drop of each good would stimulate sales of the other.
• You buy more jet engines because they are cheaper, so now you have
more incentive (and money) to purchase the avionics with which to operate
them.
• This is a Pareto improvement: everyone is better off. More consumers
served and more company revenues.
• Cournot’s example is the horizontal version of double marginalization.
Instead of each firm extracting welfare from the one below it, firms harm
demand for complementary goods through their own high prices.
Problems with Cournot’s model
• The firms are alone in the market. Their merger does not undercut someone
else.
• Instead of simply selling more products, mergers can be used as a weapon
against the competition when more than two firms populate the market.
• Aircraft engines and avionics are only a small percentage of the cost of the
airplane. It is unlikely that cost savings here would prompt manufacturers to
construct very many more planes.
• Firms in this market stand to gain from a merger primarily through conquering
rivals’ market share
• Firms set the same price to all customers.
• Bundling advantages vanish in the presence of price discrimination and
negotiation
• Airplane manufacturers are few and valuable to vendors like GE and Honeywell,
so they have considerable power to negotiate
Bundling Theory
Note: The following information is useful to us as students, but as we will see it will not
be relevant to the case
• Four firms in the market
− Two firms A1 and B1 sell different versions of good 1
− Two firms A2 and B2 sell different versions of good 2
• Like an airplane manufacturer who needs avionics and engines, consumers in the
model must purchase both goods
• Thus, there are four choices
− (A1, A2), (B1, B2), (A1, B2), (B1, A2)
• Consumers will choose the package that best suits their preferences.
• There are three possible market structures:
− All goods sold separately
− A1 and A2 bundle versus B1 and B2 bundle
− A1 and A2 bundle versus B1 and B2 separate
Bundling Theory (cont.)
Case 1: All Firms Act Independently
• This is the baseline. Assume profit is 1.
Case 2: Bundle Versus Bundle
• Profits fall by 50%
• Intuition: Cutting price brings the same number of incremental customers
as when selling individually, so bundle price must equal independent price
in equilibrium
Case 3: Bundle Versus Components
• Bundling reduces profits slightly (~10%)
• Though it gives the bundler an advantage in market share, it comes at the
price of lower profits and it will not do it
Mixed Bundling
• Again, bundling firm sacrifices profits (~3%) for market share
Bundling Theory (cont.)
• The European Commission reached the conclusion that economic incentives
would lead the firm to engage in mixed bundling
• It is a robust conclusion that a firm that bundles has an advantage over rivals
• More tenuous a conclusion, however, is whether a multiproduct firm has an
economic incentive to bundle
• This would depend of the number of products in the bundle, elasticity of total
market demand, relative importance of the products to the consumer, and other
factors.
• To make robust conclusions about the market, our models must likewise be
robust.
• In the end, the Commission’s issue was not the impact of bundling on social
welfare, but its effect on competition in the future
• The Commission believed that this merger would lead to rivals exiting the
market and the merged firms exploiting their dominant position
Market Dynamics
• Can we assume that competitors will not respond in any way to bundling?
− This is unrealistic
− Competitors could coordinate and offer a bundle of their own
− This would reduce profits, but it would also level the playing field
• Firms may fear that the original bundler will use its higher profits to invest in capital
or R&D that will give it advantages in a repeated game
− Customers may drive competition to offer a bundle even against its will
− Customers win in bundle-to-bundle competition
• Remember, customers in this market are powerful and could easily pressure
competitors into offering a bundle
• Advantages to bundling disappear when competitors offer a bundle of their own
− Thus, a bundling firm must expect the competition to follow suit
Negotiating Bundles
• Previous discussion assumes that market prices are uniform to consumers
− In aerospace industry, this is not the case
− Customers have power to negotiate prices with vendors
− Vendors also spend resources to gain information on customers
• They know about their customers’ previous purchases and what kind of
products they are likely to require
− This gives them negotiating power, too
− When customer type is know and prices are negotiable, bundling cannot
lead to higher profits
• If customers want some products from both firms, they won’t bundle
• Imposing a bundle on consumers will force firms to pay for one good’s lost
profits with the money they make on the other
• Firms profit only to the extent that their products are differentiated, which gives
them power over the consumer
• Bundling has little effect when firms have good information because it mitigates
their power over consumers
Empirical Evidence Against GE Dominance and Bundling
•
Initially, the EC claimed GE's dominant position in aircraft engines meant the
company retained a commanding market share of 52.5%
•
Resale of parts drops market share to 41%, which still assumes CFMI is
completely attributed to GE, though it is a joint venture with SNECMA.
•
If half of CFMI is attributed to GE, consideration drops market share to 28%
(excluding planes in production).
•
In reality, CFMI only existed at the time to produce engines for Boeing 737s, so
GE's control of it had no effect on market power.
•
Even if CFMI control did contribute to market power, SNEMCA would have to
agree to bundling, and they have no incentive to aid Honeywell.
•
Ultimately, engine sales are only 20% of total plane sales, which essentially
eliminates the possibility of an engine firm being dominant.
Impracticality of Bundling for GE
•
In the cases cited as relevant by the EC, the "bundling" discounts
were small and probably a result of price negotiation.
•
In fact, the cases that did involve bundling found it useless
in signing purchasers.
•
The only way to "bundle" in GE's situation would be to offer future
discounts on Honeywell parts, but there would be no incentive to do
so once the engine is sold, especially because price negotiation
would take place anyway.
•
In addition to the fact that competitors could fight back by bundling
themselves, planes stay in service for 25 years, so they could stay
in business for quite a while.
Making a Decision
A Check List of Weights and Balances
1. Incentive to Bundle?
2. What is the immediate gain to consumers from lower prices?
3. What will be the impact on competitors?
4. How long do we expect these lower prices to persist?
5. If the rivals exit, what is the expected harm?
Developed by Carl Shapiro and the US Department of Justice
What the EC Considered
1. Incentive to Bundle?
a. Under what circumstance does the combined firm earn higher profits through
a bundled pricing strategy?
b. Did either firm have an opportunity to bundle prior to the combination? If so,
is there evidence that bundling is a common practice in this industry?
i.
If we see bundling, then what is the marginal impact of increasing the
potential scope of the bundle?
ii.
If we do not see bundling, then how do the opportunities created by this
combination create a different incentive to bundle?
Recap: The Issue with the Merger
1. GE-Honeywell Will Engage in Bundling Activities
•
Bundling enables significant price advantages
•
Long-run lower prices will increase market dominance.
•
Increased market dominance will decrease competition
•
Decreased competition will result in increased long-term prices
and decreased long-term consumer welfare
A Remedy: Block Bundling Behavior
Enforce a "no-bundle discount" strategy:
•
Individual price levels must be no greater than the price of a
bundle of the same goods
To aid enforcement, each firm would supply
•
a price list of each good
•
a price list of all bundles of goods
Any discord with the "no-bundle discount" rule would be a violation,
punishable by the EC
Rejected on EC philosophy against Behavioral Remedies
Conclusion
• GE-Honeywell Merger is Blocked
• Block was based on concerns that bundling would flourish,
causing competition to decline
• Claims that bundling would occur were dismissed
• Still the EC ruled that bundling was the primary reason to
stop the merger
A shining example of international protectionism