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The GE/Honeywell merger and the issue of bundling

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The situation To Merge or not to Merge?

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The European Commission prohibited the US-merger 2 arguments: Market foreclosure through bundling of GE and Honeywell products Market foreclosure through the vertical integration of Honeywell with GECAS, GE’s leasing arm

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1. The bundling issue What is bundling? When complementary products are offered in a package P bundle < P individual items Why valuable for GE/Honeywell? Integration of an external price effect: Complements A and B: When P engine, Q Honeywell Could be beneficiary for the enlarged GE-group!

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Commission’s Reasoning Post-merger, GE may offer package discounts to customers who buy both GE engines and Honeywell products Prices would Competitors’ profits would Rivals will be unable to finance R&D Forced exit of competitors Result: Strengthening of GE’s dominant position Prices would, consumer welfare would

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Is this reasoning economically sound? Cournot model: internalising a pricing externality Two monopolists Complementary goods: jet engines (GE) and avionics (Honeywell) q = 1 - (p 1 + p 2 ) Coordinated pricing leads to higher profits and to lower prices Welfare increasing

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Mathematics of the Cournot model Uncoordinated q = 1 - (p 1 +p 2 ) П i = p i *q = p i – p i * (p 1 +p 2 ) Maximize profit: ∂ П i /∂ p i = 0 For i = 1: 1 - 2p 1 - p 2 = 0 For i = 2: 1 - 2p 2 – p 1 = 0 Substitution gives: p 1 = p 2 = 1/3 q = 1/3 П 1 = П 2 = 1/9 Coordinated p b = p 1 +p 2 so: q = 1 - p b Profit function of combined firms: П 1+2 = p b *q = p b - p b ² Maximize profit: ∂ П 1+2 /∂ p b = 0 1 - 2p b = 0 p b = ½ q = ½ П 1+2 = p b *q = ½ * ½ = ¼

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Expansion of Cournot necessary Need for expansion of basic Cournot model: GE and Honeywell are not monopolists Dynamics: what are the possible reactions of competitors? Solution: Model of differentiated oligopoly Fixed location of firms Pure bundling and mixed bundling

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Differentiated oligopoly -fixed location of firms- Four firms: Two differentiated versions produced of each good Engines by firms A 1 and B 1, avionics by A 2 and B 2 A firms located at 0, B firms at 1 Customers distributed uniformly with preference (x 1,x 2 ), so distance to A firm is x i and to B firm (1- x i )

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Differentiated oligopoly Cost for consumers: Linear transportation cost: C(distance) = t*d(x) and t=1 Cost of component i is [x i + p Ai] or [(1-x i ) + p Bi ] Find the marginal consumer for each good: V- p Ai - x i = V- p Bi -(1-x i ) x i (p Ai, p Bi ) = ½ + ( p Ai - p Bi )/2 Profit functions: П Ai = p Ai * x i (p Ai, p Bi ) П Bi = p Bi * (1- x i (p Ai, p Bi )) Solution is Nash equilibrium: p Ai = p Bi = t = 1 П Ai = П Bi = t/2 = 1/2

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Differentiated oligopoly -pure bundling- Case 1: each firm acts independently p A1 = p A2 = p B1 = p B2 = 1 П A1 = П A2 = П B1 = П B2 = ½ Market is evenly split, consumers match their bundle and pay a price of 2 Case 2: bundle vs bundle (price coordination) p A = p B = 1 П A = П B = ½ Market evenly split, price and profits cut in half No incentive to bundle

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Differentiated oligopoly -pure bundling- (2) Case 3: bundle against components (A firms coordinate their price) p A = 1.45; p B1 = p B2 = 0.86; p B = 1.72 П A = 0.91; П Bi = 0.32 The A bundle is sold at a discount The A firms gain market share but lose profit Dynamics and reaction of competitors result in lower profits for the merged firm No incentive to bundle

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Differentiated oligopoly -mixed bundling- Approximate equilibrium prices and profits: p A = 1.63; p Ai = 1.21; p Bi = 0.89; p B = 1.78 П A = 0.97; П Bi = 0.40 Profits of the A firm are not an incentive to bundle Gain in market share (up to 55.4%) and fall of the competitor’s profits (-21%) give an advantage Potential to expand market: even if small, it can make bundling profitable There may be an incentive to bundle, but this will not automatically lead to foreclosure

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Bundling in the aircraft industry? Dynamics and possible reactions of competitors make that firms do not always have the incentive to bundle If firms decide to bundle, this will result in lower prices and a raise in consumer welfare The economic theory does not support the prediction that the GE/Honeywell merger will be anticompetitive, because bundling will not necessarily lead to foreclosure

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2. The vertical integration issue Market foreclosure through the vertical integration of Honeywell with GECAS Commission’s Concern: GECAS has a “GE-only policy” Fear that GECAS would extend this policy to Honeywell products GECAS would only buy GE/Honeywell-based airplanes for their leasing activities. Result: Airframers (Boeing, Airbus,…) would face the irresistible incentive to use GE/Hon-components for the aircraft they build so it can be potentially purchased by GECAS. Competing component suppliers squeezed out of the market

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Critics on the Commission’s analysis Not based on equilibrium-analysis. What about the reactions of other market players? Other leasing companies would shift away from GE/Hon products in order to differentiate Competitors can respond by also affiliating with a leasing company Honeywell-only policy is not credible Large quantity of avionics per airplane GECAS would lose flexibility However, vertical integration of products and financial services can lead to market foreclosure

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Conclusion Bundling Will lead to lower prices and higher consumer welfare on the short term But will it necessarily lead to market foreclosure? Vertical integration through GECAS Although Honeywell-only policy not thrustworthy, the combination of financial services with products can be a real threat for competitors Commission based its decision on theoretical potential and not on waterproof economic models European competition law applied in a preventive way

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