Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Advanced Industrial Economics
Prof. Dr. Armin Schmutzler
Socioeconomic Institute
University of Zurich
fall 08
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Assumption 1:
Everybody in the room knows what kind of issues industrial
organization deals with
Assumption 2:
Everybody has been exposed to basic theoretical concepts
(e.g.,Industrial Economics - Bachelor lecture)
Hence:
Introduction will be short
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
General Remarks
The course will
be self-contained in spite of assuming familiarity with basic IO
deal with selected topics rather than attempt to be
comprehensive
focus on theory rather than empirical work
(in spite of some econometrics and experiments)
address both policy and strategy issues
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Main Topics
Ch. 1: Static Oligopoly Theory
Ch. 2: Mergers
Ch. 3: Investment Decisions
Ch. 4: Regulation of Monopolists
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
1.1.1 Goals:
Main source: Shapiro 1989
1
Recall basic tools of oligopoly theory
2
Understand economic intuition behind familiar results
(rather than pure calculation)
3
Provide basis for further analysis
merger policy
investment games
regulation of imperfectly competitive markets
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
1.1.2 Contents
Cournot oligopoly
Reaction functions and equilibrium conditions
Existence, uniqueness and stability
Comparative statics
Economic interpretation
Bertrand oligopoly
Reaction functions and equilibrium conditions
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.1 Overview
The Cournot oligopoly
is the workhorse of oligopoly theory
is simple to use
provides several intuitive results
is an ingredient of many more complex theories of industrial
organization
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.2 Basic Concepts
The market environment
n …rms
homogeneous good
xi output of …rm i
X = x1 + ::: + xn
cost function Ci (xi )
0
marginal costs Ci (xi ) = ci (not necessarily constant)
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Advanced Industrial Economics
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Cournot equilibrium
…rms simultaneously choose quantities
price adjusts to clear the market
hence pro…ts
i
= p(X)xi
Ci (xi )
Cournot equilibrium = Nash equilibrium of quantity game
F.O.C (Reaction curves):
@ i
@xi
p(X) ci
p(X)
where si =
xi
X
and " =
= p(X) + xi p0 (X)
=
ci = 0
si
"
(2)
p(X)
Xp0 (X)
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(1)
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
An important note on reaction functions
Two …rms:
slope of reaction function is determined by
@2 i
= p0 (X) + xi p00 (X)
@xi @xj
decreasing unless p00 (X) very convex
intuition: high output of competitor reduces price, thus makes
own output expansion undesirable
Note:
argument for n > 2 essentially identical
this property will be important later ("strategic substitutes")
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
Does an equilibrium exist?
Friedman, 1971
Yes, if, for all i
ai
@2 i
= 2p0 (X) + xi p00 (X)
@x2i
Ci00 (xi ) < 0
(3)
OK if demand concave and cost function convex
Novshek, 1986
Existence also guaranteed if
bi
@2 i
= p0 (X) + xi p00 (X) < 0
@xi @xj
This condition is helpful for decreasing marginal costs
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Advanced Industrial Economics
(4)
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
Figure: Violation of Existence (discontinuous reaction functions)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
Is the equilibrium unique?
Intuition (for n = 2):
One reaction curve should be everywhere steeper than the
other
Su¢ cient condition (for all i = 1; :::; n)
@2 i X @2 i
+
<0
@x2i
@xi @xj
(5)
j6=i
or for homogeneous goods
often violated (e.g., p
00
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0 and n
jai j > (n
3)
Advanced Industrial Economics
1) jbi j
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
q2
45°
R1(q2)
R2(q1)
q1
Figure: Violation of Uniqueness
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
Is the equilibrium stable?
Issue: does "naive" adjustment process, by which …rms adjust
output in response to the other’s according to its reaction
curve, converge to the equilibrium?
duopoly: R1 has to intersect R2 from above
more generally (Dixit 1986): stability OK if all of the following
hold:
S.O.C hold (ai < 0)
bi < 0
uniqueness condition (5) holds
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
q2
45°
R1(q2)
R2(q1)
q1
Figure: Stability
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.3 Digression: Technicalities - existence, uniqueness and stability
q2
45°
R2(q1)
R1(q2)
q1
Figure: Violation of Stability
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Advanced Industrial Economics
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics
A simple example: Linear Cournot competition
n …rms
homogeneous goods
p(X) = a
X
constant marginal costs ci
Hence:
xi =
a
nci +
P
j6=i cj
n+1
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;
i
=
(a
nci +
(n +
P
2
j6=i cj )
1)2
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics
Thus:
A decrease in ci
increases xi and
decreases xj and
increases X
i
j
An increase in a
increases xi , xj ,
i,
j
Note:
A decrease in ci increases @ i =@xi
An increase in a increases @ i =@xi (i = 1; :::; n)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics
Hence, we ask more generally:
What are the comparative statics e¤ects of increases in
one …rm’s marginal pro…tability?
all …rm’s marginal pro…tability?
Potential sources
Cost reductions
Greater capital stock
Lower taxes
less stringent regulation
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics
Preliminary considerations:
An increase in a …rm’s marginal pro…tability shifts out its
reaction curve
An increase in a competitor’s output reduces own output
Thus (n = 2) higher own marginal pro…tability should
increase own output (and pro…ts)
reduce competitor output (and pro…ts)
but
what if n > 2 ?
what about aggregate output ?
what if both …rms improve ?
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics
q2
45°
R1(q2)
R2(q1)
q1
Figure: Pro…tability increase of …rm 1
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Advanced Industrial Economics
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics: Duopoly case
Duopoly case
With objective functions
F.O.C. yields
1
11
2
21
Hence, with M=
i (x ; x ; ),
i j i
1
12
2
22
1 2
11 22
dxi = (
total di¤erentiation of
1
1
2
2
dx1
=
dx2
1 2
12 21
i j
ij j
j
d
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1
2
d
d
1
2
> 0,
j
i
i
i
j
jj d i )
1
M
Advanced Industrial Economics
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics: Duopoly case
E¤ects of unilateral pro…tability increase
If 11 1 > 0, d 2 = 0:
dx1 =
dx2 =
1
M
1
M
1
1
1
1
1
1
2
22 d 1
2
21 d 1
>0
<0
Total Output:
dX = (
2
21
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2
1
22 ) 1
1
d 1
>0
M
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics: Duopoly case
Pro…t E¤ects:
d
1
=
=
=
@ 1
@ 1
dx2 +
d 1
@x2
@ 1
@p1
@ 1
x1 dx2 +
d 1
@x2
@ 1
1 @p1
@
x1 ( 11 1 221 ) +
M @x2
@
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1
d
1
Advanced Industrial Economics
1
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.4 Comparative Statics: Duopoly case
Thus: indirect e¤ect ( @@x21 dx2 ) is always positive and direct e¤ect
( @@ 11 ) depends on example
d
2
=
@ 2
dx1 =
@x1
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1 @p2
(
M @x1
1
1
1
2
22 )d 1
<0
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
Extensions
E¤ects of industry-wide parameter ( =
1
=
2)
:
simultaneous increase of marginal cost may increase pro…ts for
suitable pro…t functions, if price increase is su¢ ciently large
Oligopoly n > 2 :
unilateral increase of marginal pro…tability of i still increases
xi , i , X and reduces xj , j , for all i 6= j
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.5 The economics of the Cournot equilibrium
Properties of the equilibrium
a) Prices are above marginal revenues and hence marginal costs
(re‡ecting externality of output expansion)
b) The equilibrium is between the competitive equilibrium and
the monopoly solution
c) Higher demand elasticity , smaller mark-ups
d) mark-up proportional to market share
e) lower marginal costs , greater market shares
f) (slightly) less e¢ cient …rms can survive with positive market
shares
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Cournot oligopoly: competition in outputs
1.2.5 The economics of the Cournot equilibrium
What does the Cournot equilibrium maximize?
Recall:
Monopoly maximizes producer surplus:
(X)
Perfect competition maximizes total surplus:
W (X) = (X) + S(X)
Cournot equilibrium maximizes (Bergström and Varian, 1985):
F (X) = (n
1)W (X) + (X) = (n
1)S(X) + n (X)
hence excessive weight on pro…ts (declining in n)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Bertrand equilibrium: competition in prices
1.3.1 Introduction
Though Cournot competition provides "reasonable" results, it is
often assumed that …rms compete in prices (Bertrand competition)
Advantage:
price is a natural strategic
variable
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Drawback:
extreme results for
homogeneous goods
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Bertrand equilibrium: competition in prices
1.3.2 Homogeneous goods
Assume same market environment as for Cournot
1
With constant marginal costs:
a) If …rms are symmetric, unique equilibrium pi = c
b) If …rms are asymmetric, most e¢ cient …rm serves entire
market using "limit price" or monopoly price
2
With increasing returns to scale, an equilibrium in pure
strategies does not exist
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
1.1 Introduction
1.2 Cournot oligopoly: competition in outputs
1.3 Bertrand equilibrium: competition in prices
Bertrand equilibrium: competition in prices
1.3.3 Di¤erentiated goods
p = (p1 ; :::pn ) price vector
pro…ts:
F.O.C:
i
= pi Di (p)
Ci (Di (p))
@ i
= Di (p) + (pi
@pi
ci )
@Di
=0
@pi
Reaction curves have positive slopes if
@Di
+ (pi
@pj
ci )
@ 2 Di
@pi @pj
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c00i
@Di
@pi
@Di
@pj
Advanced Industrial Economics
>0
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.1 Illustration: Migros and Denner
Source: Ungern-Sternberg and Janetti (2007)
January 2007: Migros announces plan to buy 70% of Denner
shares
Market shares 2004 (ACNielsen) in retailing market
Migros 37%
COOP 35%
Denner-Pickpay 10%
rest < 5% each
Merger was permitted with remedies
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.1 Illustration: Migros and Denner
Should the merger have been permitted, permitted with remedies
or prohibited?
Relevant issues in practice
relevant market ?
e¤ect on suppliers ?
e¤ect on entry ?
Here: abstract from these issues, concentrate on welfare e¤ects in
a narrow sense
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.2 Policy background
Source: Farrell and Shapiro 1990
Horizontal mergers between large …rms in the same industry are
subject to competition policy concern, e.g., U.S.:
Clayton Act prohibits mergers that "substantially decrease ...
competition or tend... to create a monopoly"
Hart-Scott-Rodino Act: "Large …rms must report any
proposed substantial merger to the Department of Justice
(DoJ) and the Federal Trade Commission (FTC)"
Merger Guidelines: mergers accepted if ...
Initial concentration level (HHI) or
Change of concentration is small
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.3 Our Concern
When should mergers be allowed?
Is the standard policy approach justi…ed?
Potential Problems:
1
2
Calculation of expected HHI on the assumption that merger of
…rms with market shares generates merger with share s1 + s2
(so that M HHI = 2s1 s2 ) ! but unchanged outputs would
imply absence of externalities and no need for merger policy !
Is there really a reliable inverse relationship between
concentration and welfare?
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.4 Our Concern
Why might an increase in concentration lead to increases in
welfare?
Cournot equilibrium:
large …rms have lower marginal costs
if these …rms obtain higher output share, this saves costs
however, potential price increases from high concentration
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Introduction
2.1.5 Preview of results
Consumer surplus falls (price increase) if merger does not
generate synergies
Su¢ cient condition for welfare-increasing merger:
positive net external e¤ect (on other …rms and consumers)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
An auxiliary result
Idea: Welfare e¤ects depend in particular on how competitors react
to output change of merged entity.
Lemma
In the standard Cournot model, suppose
cixx (xi ) > p0 (X),
i = 1; :::n
(6)
Then an exogenous change of …rm 1’s output leads to a smaller
change of aggregate output in the same direction
Note: (6) is surely met if marginal cost is nondecreasing, i.e. if cixx > 0.
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Proof.
F.O.C.
p(X) + xi p0 (X) cix (xi ) = 0 )
X
dxi
p0 + xi p00
= Ri =
for yi =
xj
0
00
i
dyi
2p + xi p
cxx
j6=i
Strategic substitutes (4) and (6) imply
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1 < Ri < 0.
Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Proof.
Hence
dy1 =
dxi =
X
i6=1
a
i dX
i dX
)
Ri
=
>0
1 + Ri
X
dX(1 +
i ) = dxi
for
|
i
i6=1
{z
>1
}
dxi = Ri dyi () dxi (1 + Ri ) = Ri (dxi + dyi ) = Ri dX
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Advanced Industrial Economics
a
)
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.1 Types of mergers
Approach should allow for all of the following mergers
1
Mergers with no cost e¤ects:
If all …rms have constant and identical marginal costs, merger
is purely anticompetitive
2
Mergers with rationalization potential: cost decreases through
output reallocation
to more e¢ cient …rm or
to exploit scale economies
3
Mergers with synergies
Note: Merger might also increase costs !
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.2 Characterizing price-increasing mergers
Theorem
A necessary and su¢ cient condition for a merger between …rms 1
and 2 to reduce prices is:
p
cM
x > (p
c1x ) + (p
c2x )
(7)
where c1x and c2x are evaluated at pre-merger output levels x1 and
x2 ; cM
x at x1 + x2 ; and p is the pre-merger price.
Equivalently, c2x
substantial1 .
1 M
cx
< p(1
cM
x >p
c1x or cost reduction must be
s1 +s2
)
"
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.3 Mergers with no synergies
Cost function: ci (xi ) = i (xi ; ki ), where ki is fungible capital,
short-run variable cost and i (inverse) measure of knowledge
Types of potential cost savings:
1
Pure Output reallocation (change of x1 =x2 )
2
Capital reallocation (change of k1 =k2 )
3
learning (change of
i)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.3 Mergers with no synergies
De…nition (Merger with no synergies)
A merger with no synergies satis…es
(
)
X
X
M
0
0
c (x) = min
ci (xi )j
xi = x
i2I
i2I
Thus, such a merger may involve:
pure output reallocation
pure capital allocation (in the short term)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.3 Mergers with no synergies
Mergers with no synergies increase prices
Theorem
If a merger generates no synergies, it causes price to rise
Notation:
xi : pre-merger output of merging …rms i = 1; 2
xO : total pre-merger output of outsiders
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.3 Mergers with no synergies
Sketch of Proof:
1
it su¢ ces to show that insiders’total output decreases
2
by revealed preferences, it is impossible that each of the
merging …rms has higher outputs after a merger; thus let
post-merger output x2 < x2
3
by the lemma, maximization of 1 given xO and x2 would
yield
0
x1 x1 and x01 + x2 x1 + x2
4
because post-merger x1 is chosen accounting for externalities
0
on …rm 2, x1 < x1
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
Theorem
Suppose a merger involves no learning. Then, in the long run the
merger raises prices. In the short run, it raises prices if
1
Capital is immobile across …rms or
2
All merging …rms are equally e¢ cient and their long run
production function satis…es CRS
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.4 Mergers without learning
Policy implications
oligopolistic mergers tend to reduce aggregate output
(increase prices), unless learning or scale e¤ects are strong
large market shares or small industry demand elasticity
increase likelihood that merger reduces prices
these factors are often used by competition authorities to
decide about mergers
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Advanced Industrial Economics
2.1
2.3
2.4
2.5
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.5 Mergers with economies of scale
consider a merger between two ex ante identical …rms, each
with market share s
common variable cost function c(x; k)
with economies of scale, reallocation into one facility, with
variable costs cx (:; 2k)
prices will fall if and only if
cx (2x; 2k)
1
s
"
s
cx (x; k)
which follows out of equation (7):
cx (2x; 2k) < cx (x; k) [p cx (x; k)] and (2)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Price E¤ects
2.3.6 Mergers with learning
Merger of …rms 1 and 2
cost function
i '(xi )
non-decreasing marginal costs
can show that, for price to fall, merger must reduce one
s
at least (" jsi )
if s1 = s2 = 0:2 and " = 1, required reduction is 25%
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Advanced Industrial Economics
i
by
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.1 Main Idea
consumers care only about M X,
rivals care only about M XI
e¤ect of M XI can be decomposed into a series of
in…nitesimal changes dXI
assuming that …rms carry out only pro…table mergers, positive
external e¤ects guarantee positive total welfare e¤ects
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.2 Total welfare e¤ects
dW = pdXI
dcI +
X
[p
cix ]dxi
i2O
cI
where
is the insiders’total cost and O is the set of outsider
…rms.
Outsiders’output responses dxi =
i dX
Outsiders’markups (p cix ) = xi p0 (X)
Hence:
dW
= (pdXI + XI dp
dcI )
XI p0 (X)dX
X
+
p0 (X) i xi dX
i2O
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.3 External e¤ects
dW
d
I
=
XI p0 (X)dX +
X
i2O
=
p0 (X)dX where
p0 (X) i xi dX
X
i xi
i2O
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Advanced Industrial Economics
XI
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.3 External e¤ects
Theorem
Consider a change of behaviour by a set of …rms. The net e¤ect on
outsiders and consumers depends only on the e¤ect on insiders’
output, XI : A small reduction
P in XI has a positive net external
welfare e¤ect if and only if i2O i si > sI
Note: If i were 0, output reduction would always have negative
externality
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.4 A su¢ cient condition for positive welfare e¤ects
Theorem
Consider
P a merger among i 2 I with joint market share
sI < i2O i si . Suppose p00 0, p000 0, cixx 0, cixxx 0 for
all i 2 I. Then a pro…table merger that would raise market price,
would raise welfare.
Proof.
See Farrell and Shapiro (1990)
Note: the conditions are fairly innocuous
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.5 Implications for antitrust policy
assuming that privately unpro…table mergers will not be
proposed, proposed mergers should be permitted unless
external e¤ects are su¢ ciently negative
ideal policy should permit mergers in regions A,B,C
obviously, region A (non-pro…table mergers with strong
positive externalities) cannot be implemented
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Welfare E¤ects
2.4.5 Implications for antitrust policy
ΔπI
C
B
D
ΔW - ΔπI
A
45°
Figure: Farrell and Shapiro (1990)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction
Source: Farrell and Shapiro (2001)
In 1997, U.S. Federal Trade Commission (FTC) revised merger
guidelines to deal better with alleged e¢ ciency gains associated
with horizontal mergers.
Farrell and Shapiro build from 1990 paper to evaluate these changes
argue that e¢ ciency gains are implicitly accepted by the merger
guidelines in the statement that most mergers "are either
competitively bene…cial or neutral" (even though they clearly
involve a reduction of direct competition)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction
this position is also re‡ected in the practice that most horizontal
mergers go unchallenged, in particular when HHI < 1000 (similar
outside U.S.!)
! "built-in sympathy for e¢ ciencies"
Hence, Farrell and Shapiro focus on "large" mergers
Main issue: Can a merger that would otherwise be
anti-competitive become pro-competitive because it allows the
merged entity to achieve lower costs by reaching a larger scale than
either party enjoyed pre-merger?
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction
Reasons for scepticism
scale economies can in principle be achieved unilaterally
if scale e¢ ciencies are merger-speci…c, it is unlikely that
consumers will bene…t
Agencies should give greater weight to credible gains of
genuine (and merger-speci…c) e¢ ciencies based upon the
close integration of speci…c, hard-to-trade assets ("synergies
in Farrell and Shapiro-speak")
The bigger an e¢ ciency, the less likely it is to be
merger-speci…c
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction - Example: U.S. drug wholesalers
In 1998, FTC successfully challenged proposed mergers of leading
drug wholesalers McKesson + Amerisource and Cardinal Health +
Bergen Brunswig
with combined market share of 80%, parties appealed to scale
e¢ ciencies
savings through consolidation of warehouses plus reduction in
inventories
savings in volume buying
savings in corporate overhead
FTC response:
most e¢ ciencies would not be passed on to consumers
could be achieved without merger
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction - Example: U.S. drug wholesalers
The FTC Argument:
"However, this Court …nds that evidence presented by
the FTC strongly suggests that much of the savings
anticipated from the mergers could also be achieved
through continued competition in the wholesale industry.
While it must be conceded that the mergers would likely
yield the costs savings more immediately, the history of
the industry over the past ten years demonstrates the
power of competition to lower cost structures and garner
e¢ ciencies as well"
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction - Example: U.S. drug wholesalers
The issues
under what conditions can merging parties who are direct
rivals argue coherently that their merger will accelerate the
achievement of e¢ cient scale and thereby bene…t consumers?
di¤erentiate between "output e¢ ciencies without synergies"
and "synergies" from combining core hard-to trade assets
mergers without synergies are unlikely to bene…t customers
and resulting e¢ ciencies are more likely to be achieved
without merger (Farrell and Shapiro 1990)
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction - Example: U.S. drug wholesalers
The issues
thus concentrate on synergies:
what factors bear on whether claimed synergies are
merger-speci…c ?
how large a synergy is required to overcome anti-competitive
e¤ects ?
General point
conditions that tend to make synergies more merger-speci…c
and more bene…cial to consumers make them more problematic
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.1 Introduction - Example: U.S. drug wholesalers
Logic Tree for Merger-Speci…c E¢ ciencies & Synergies
Figure: Farrell and Shapiro 2001
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.2 Can pure economies of scale be merger-speci…c and save a merger?
The No-synergies theorem
If expanding output would lower …rm’s unit costs, why would
it not expand?
Answer: Fear of price decline
Farrell and Shapiro 1990:
if price e¤ect deters a party from expansion, pre-merger than
this will also be true post-merger
thus, horizontal merger (at least in Cournot oligopoly) can not
lead to higher total output and lower price
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.2 Can pure economies of scale be merger-speci…c and save a merger?
Application to growing markets and declining markets
How general is the no-synergies theorem?
suppose …rms are colluding heavily pre-merger
suppose both are below minimum e¢ cient scale
pre-merger price is based on monopoly price at ine¢ ciently low
scale
merger may lead to combination of output in one facility and
closure of the other
could decrease the price
Note:
pre-merger arrangements as described would presumably be
illegal. Arguments relies on pre-merger interaction to be less
competitive than Cournot
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.3 E¢ ciencies based on genuine synergies
Are claimed synergies merger-speci…c?
a synergy requires that an asset owned by …rm A be combined
with another asset that A does not own but B does
merger speci…city requires that none of the assets can be
readily traded or jointly used without a merger agreement
but note that alternatives might also be problematic
status quo is not conclusive indicator of what would happen
without a merger, but "if an apparent ine¢ ciency has
persisted and been noted for a long time, and other means of
resolving it have been tried and failed, perhaps the e¢ ciency
may be more merger-speci…c than one might have thought"
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.4 Examples of synergies - Coordination of joint operations
British Petroleum and ARCO have jointly operated oil …eld
near Alaska for twenty years
"persistent di¢ culties associated with joint management"
failed attempts to solve problems
! suggests merger-speci…c synergies
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.4 Examples of synergies - Sharing complementary skills: manufacturing and
distribution
After its entry in the U.S. market, Toyota had e¢ cient production
techniques, but no ubiquitous distribution networks. General
Motors had good distribution network, but less e¢ cient
manufacturing
a (hypothetical) merger would have achieved synergies
development of an own distribution network as a more
competitive alternative
If alternatives are costly !
nevertheless merger-speci…c synergy
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.4 Examples of synergies - Improved interoperability
Take two hypothetical producers of word-processing software
A produces a fast but stripped-down processor
B produces a powerful, but hard-to-use package
initially, …rms perceived themselves as being in unrelated markets;
but then realize that users make drafts with product A, then import
features from B
This is complicated, so engineers of A and B work on compatibility
This does not work, because of competitive relation
interoperability would be a synergy
apparently merger-speci…c
!
Problem: fact that e¢ ciencies are hard to achieve without merger is
related to merger’s potential for decreasing competition
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.4 Examples of synergies - Combining a patent with manufacturing and distribution
Firm A has a patent on IQ-raising treatment as only product. No
manufacturing, distribution or brand name. Firm B has the missing assets
If B has no competing products, no competitive concerns, only
e¢ ciencies
If B has a rival product
and other …rms have capacity, but not rival products, this
problematic merger does not have speci…c synergies
and …rm A could build required assets at great costs (and
delay), this would measure synergy
when assets readily traded, no synergy
Essential Point: judgement on merger requires idea about what …rm A
would do without the merger, pure pre-merger analysis is nonsensical
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Advanced Industrial Economics
Introduction
Chapter 1: Static Oligopoly Theory
Chapter 2: Merger Policy
2.1
2.3
2.4
2.5
Introduction
Price E¤ects
Welfare E¤ects
Policy Discussion
Policy Discussion
2.5.5 Will synergies lead to consumer bene…ts ?
recall: without synergies e¢ ciencies:
1
E¢ ciencies seem likely to be substantial and merger-speci…c
only with market power
2
then the e¢ ciencies are unlikely to bene…t consumers
With synergies:
1
while e¢ ciencies may arise without market power, they are
less likely to be merger-speci…c
2
only substantial economies of scale are likely to bene…t
consumers
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Advanced Industrial Economics