Vertical and Conglomerate Mergers Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Introduction General Electric and Honeywell proposed to merge in 2000 GE supplies jet engines for commercial aircraft Honeywell produced various electrical and other control systems for jet aircraft Deal was approved in the US But was blocked by the EU Competition Directorate this was a merger of complementary firms it is “like” a vertical merger so can potentially remove inefficiencies in pricing benefiting the merged firms and consumers so why block the merger? Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Introduction 2 Vertical mergers can be detrimental if they facilitate market foreclosure by the merged firms refuse to supply non-merged rivals But they can also be beneficial if they remove market inefficiencies Regulators need to look for the balance these two forces in considering any proposed merger Chapter 17: Vertical and Conglomerate Mergers

Complementary Mergers Consider first a merger between firms that supply complementary products 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? Chapter 17: Vertical and Conglomerate Mergers

Complementary mergers 2 Supplier 1 Supplier 2 price v2 price v1 Final Producer price P Consumers Chapter 17: Vertical and Conglomerate Mergers

Complementary producers  Consider the profit of the final producer: this is pf = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q Solve this for Q  Maximize this with respect to Q pf/Q = 140 - (v1 + v2) - 2Q = 0  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: p1 = v1Q1 = v1(70 - v1/2 - v2/2)  Maximize this with respect to v1 Chapter 17: Vertical and Conglomerate Mergers

Complementary producers 2 The price charged by each supplier is a function of the other supplier’s price We need to solve these two pricing equations Complementary producers 2 Solve this for v1 p1 = v1Q1 = v1(70 - v1/2 - v2/2)  Maximize this with respect to v1 p1/v1 = 70 - v1 - v2/2 = 0 v1 = 70 - v2/2  We can do exactly the same for v2 v2 v2 = 70 - v1/2 140 R1 v1 = 70 - (70 - v1/2)/2 = 35 + v1/4 so 3v1/4 = 35, i.e., v1 = $46.67 70 and v2 = $46.67 46.67 R2 v1 46.67 70 140 Chapter 17: Vertical and Conglomerate Mergers

Complementary products 3  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: p1 = p2 = 46.67 x 23.33 = $1,088.81 final producer: pf = (116.67 - 46.67 - 46.67) x 23.33 = $544.29 Chapter 17: Vertical and Conglomerate Mergers

Complementary products 4 Now suppose that the two suppliers merge Supplier 1 Supplier 2 23.33 units @ $46.67 each 23.33 units @ $46.67 each Final Producer 23.33 units @ $116.67 each Consumers Chapter 17: Vertical and Conglomerate Mergers

Complementary mergers 5 Supplier 1 Supplier 2 price v The merger allows the two firms to coordinate their prices Final Producer price P Consumers Chapter 17: Vertical and Conglomerate Mergers

Complementary mergers 6  Consider the profit of the final producer: this is pf = (P - v)Q = (140 - v - Q)Q Solve this for Q  Maximize this with respect to Q pf/Q = 140 - v - 2Q = 0  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: pm = vQm = v(70 - v/2)  Maximize this with respect to v Chapter 17: Vertical and Conglomerate Mergers

Complementary mergers 7 This is the cost of the combined input: the merger has reduced costs to the final producer pm = vQm = v(70 - v/2) The merger has reduced the final product price: consumers gain  Differentiate with respect to v pm/v = 70 - v = 0 so v = $70  Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units  This gives the final product price P = 140 - Q = $105 This is greater than the combined pre-merger profit  What about profits? For the merged upstream firm: pm = vQm = 70 x 35 = $2,480  For the final producer: pf = (105 - 70) x 35 = $1,225 This is greater than the pre-merger profit Chapter 17: Vertical and Conglomerate Mergers

Complementary mergers 8 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 cut 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 Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical Mergers The same result arises 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 c sells product to the retailer at price r per unit no other retail costs: one unit of input gives one unit of output retail demand is P = A – BQ Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 2 Marginal costs c Manufacturer wholesale price r Price P Consumer Demand: P = A - BQ Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 3 Consider the retailer’s decision identify profit-maximizing output set the profit maximizing price  marginal revenue downstream is MR = A – 2BQ  retail marginal cost is r Price  equate MC = MR to give the quantity Q = (A - r)/2B A Demand  identify the price from the demand curve: P = A - BQ = (A + r)/2 (A+r)/2  profit to the retailer is (P - r)Q which is pD = (A - r)2/4B Retail Profit  profit to the manufacturer is (r-c)Q which is pM = (r - c)(A - r)/2B r MC Man. Profit c MR Quantity A - r 2B A/2B A/B Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 4  suppose the manufacturer sets a different price r1 Price  then the downstream firm’s output choice changes to the output Q1 = (A - r1)/2B A Demand  and so on for other input prices r1  demand for the manufacturer’s output is just the downstream marginal revenue curve r MC Upstream demand MR Quantity A - r 2B A/2B A/B A - r1 2B Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 5  the manufacturer’s marginal cost is c Retail Profit  upstream demand is Q = (A - r)/2B which is r = A – 2BQ Price  upstream marginal revenue is, therefore, MRu = A – 4BQ A Manufacturer Profit (3A+c)/4  equate MRu = MC: A – 4BQ = c Demand the input price is (A+c)/2  so Q*=(A-c)/4B (A+c)/2  while the consumer price is (3A+c)/4 Upstream demand  the manufacturer’s profit is (A-c)2/8B c  the retailer’s profit is (A-c)2/16B MC MRu MR Quantity A/4B A/2B A/B (A-c)/4B Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 6 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 transfer price nets out of the profit calculations Back to the example Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 7 This merger has benefited the two firms This merger has benefited consumers  the integrated demand is P(Q) = A - BQ  marginal revenue is MR = A – 2BQ Price  marginal cost is c A  so the profit-maximizing output requires that A – 2BQ = c  so Q* = (A – c)/2B Demand  so the retail price is P = (A + c)/2 (A+c)/2 Aggregate Profit  aggregate profit of the integrated firm is (A – c)2/4B c MC MR Quantity (A-c)/2B A/B Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical merger 8 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 Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Price discrimination Upstream firm selling to two downstream markets different demands in the two markets  the seller wants to price discriminate between these markets v1 v2  set v1 < v2  but suppose that buyers can arbitrage va Market 1 Market 2  then buyer 2 offers to buy from buyer 1 at a price va such that v1 < va < v2 P P  arbitrage prevents price discrimination  if the seller integrates into market 1 arbitrage is prevented D1 D2 Q Q Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers 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? Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical foreclosure 2 Vertical foreclosure may reduce competition offsets benefits of removing double marginalization But for this to work foreclosure has to be a credible strategy for the merged firms foreclosure must be subgame perfect Consider two models of foreclosure Salinger (1988) with Cournot competition Ordover, Saloner and Salop (1990) with price competition Chapter 17: Vertical and Conglomerate Mergers

Vertical foreclosure 3 The integrated firm will not source on the independent market  Suppose that there are some integrated firms and some independent upstream and downstream producers  Profit of an integrated firm is: The integrated firm will not sell on the independent market pI = (PD - cU - cD)qDi  Profit of an independent upstream firm is: pU = (PU - cU)qUn  Profit of an independent downstream firm is: pD = (PD - PU - cD)qDn Chapter 17: Vertical and Conglomerate Mergers

Vertical foreclosure 4  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 Profit from selling internally But this is true: so diverting output from the external market increases profits it earns PU - cU on each unit sold Profit from selling externally  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 > PU - cU requires: PD - PU - cD > 0 so the upstream divisions will not sell externally Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical foreclosure 5 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 discourage non-integrated firms from integrating Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical foreclosure 6 The strategic aspects are considered in Ordover, Saloner and Salop (OSS) suppose there are two downstream and two upstream firms downstream firms make differentiated products upstream firms make homogeneous products both sets of firms compete in prices suppose that U1 merges with D1 suppose also that they credibly refuse to supply D2 then U2 is a monopoly supplier to D2 U2 and D2 set prices reflecting double marginalization so they may well choose to merge also but U1 and D1 can foresee this and may choose not to merge Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Vertical foreclosure 7 The OSS analysis thus far requires that there is no other source of the input supply if there is such a source this will constrain U2’s price may make merger of U2 and D2 less likely Also, U1D1 may try to undermine the merger another way offer to supply D2 undercutting U2 find a price such that U2 and D2 have no incentive to merge so complete foreclosure is avoided Note that there is a timing problem with this analysis U1 and D1 decide whether or not to merge if they do not the market continues as is if they do, they seek to undermine a merger of U2 and D2 but if U1/D1 don’t merge U2/D2 have a strong incentive to merge Chapter 17: Vertical and Conglomerate Mergers

Vertical Merger and Oligopoly Implication: we need to consider a simultaneous model fear of vertical merger by one pair of firms might induce vertical merger by other firms this might lead to a prisoners’ dilemma game vertical merger harms firms benefits consumers and is a Nash equilibrium for the merging firms Consider a (reasonably) simple model two upstream and two downstream Cournot firms downstream demand is P = A – BQ upstream firms’ marginal costs are cU and downstream firms’ marginal costs (excluding the upstream input) are cD Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 2 Competition in three stages stage 1: upstream and downstream firms choose simultaneously whether or not to merge U1 merges with D1 and/or U2 with D2 stage 2: non-merged upstream firms compete in quantities merged upstream firms supply their downstream divisions at marginal cost cU stage 3: downstream firms compete in quantities Three cases: no vertical merger; one vertical merger; two vertical mergers Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 3 Case 1: no vertical merger competition in the upstream market generates an intermediate product price PU so downstream marginal cost is PU + cD Cournot equilibrium output of each downstream firm is q1D = q2D = (A – PU – cD)/3B Cournot equilibrium profit of each downstream firm is  1D = p2D = (A – PU – cD)2/9B Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 4 Aggregate output in the downstream market is derived demand in the upstream market: QD = QU aggregate output is QD = QU = 2(A – PU – cD)/3B in inverse form PU = (A – cD) – 3BQU/2 this is a standard linear demand p = a – bQ with a = (A – cD) and b = 3B/2 So Cournot equilibrium output of each upstream firm is q1U = q2U = [(A – cD) – cU]/(9B/2) = 2(A – cU – cD)/9B The equilibrium upstream input price is PU = (A – cD + 2cU)/3 Profit of each upstream supplier is 1U = p2U = 2(A – cU – cD)2/27B Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 5 Substitute for PU into the downstream equilibrium equilibrium downstream output is q1D = q2D = 2(A – cU – cD)/9B equilibrium profit is p1D = p2D = 4(A – cU – cD)2/81B As expected, output of each upstream firm equals output of each downstream firm Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 6 Case 2: two vertical mergers this is the simplest case each downstream division has marginal cost cU + cD and market demand is P = A – BQ so Cournot equilibrium output downstream is q1D = q2D = (A – cU – cD)/3B and Cournot equilibrium profit of each downstream firm (and so of each integrated firm) is 1D = p2D = (A – cU – cD)2/9B Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 7 Case 3: One vertical merger suppose that U1 and D1 merge from the Salinger analysis the merged firm will not supply the non-merged downstream firm will not buy from the non-merged upstream firm suppose that U2 sets price PU for its intermediate product downstream firm 2 has marginal cost PU + cD downstream firm 1 has marginal cost cU + cD downstream demand is P = A – BQ so equilibrium Cournot outputs are q1D = (A – 2cU – cD + PU)/3B q2D = (A – 2PU – cD + cU)/3B Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 8 Equilibrium downstream profits are 1D = (A – 2cU – cD + PU)2/9B 2D = (A – 2PU – cD + cU)2/9B We know PU > cU so the integrated downstream division has greater output and profit than the non-integrated firm Output of the downstream non-merged firm is demand for the upstream non-merged firm’s output: q2D = q2U so derived demand for the non-merged upstream firm is PU = (A – cD + cU)/2 – 3Bq2U/2 this is linear of the form P = a – bq and upstream firm 2 is a monopoly supplier with marginal cost cU so sets output (a – cU)/2b and price (a + cU)/2 Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 9 this gives the equilibrium upstream non-merged output: q2U = (A – cU – cD)/6B and price PU = (A + 3cU – cD)/4 profit of the non-merged upstream firm is 2D = (A – cU – cD)2/24B using the equilibrium non-merged input price PU then gives q1D = 5(A – cU – cD)/12B q2D = (A – cU – cD)/6B equilibrium downstream profits are 1D = 25(A – cU – cD )2/144B 2D = (A – cU – cD )2/36B The merged division is larger and more profitable than the non-merged firm Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 10 We can now solve the first stage game calculate aggregate profits of an upstream and downstream firm or an integrated firm merger will be suggested if it increases aggregate profit note that all profits have the term (A – cU – cD)/B in common so we can give this term any value so assume that A = 100, B = 1 and cU = cD = 23 this gives the pay-off matrix: Chapter 17: Vertical and Conglomerate Mergers

Vertical merger and oligopoly 11  the perfect equilibrium is (Merger, Merger)  this is a prisoners’ dilemma game  Merger is dominant for both so timing is not important Firms 2 No Merger Merger $360, $360 $202.50, $506.25 No Merger Firms 1 Merger $506.25, $202.50 $324, $324 Chapter 17: Vertical and Conglomerate Mergers

Vertical merger - reappraisal Vertical merger has three effects in this model removes double marginalization reduces cost for a downstream integrated firm and makes downstream market more competitive reduces competitive pressures in the upstream market In the model the first two effects dominate so consumers benefit from lower prices even with only one vertical merger but in equilibrium the firms lose from vertical merger Chapter 17: Vertical and Conglomerate Mergers

Vertical merger – reappraisal 2 Recall the proposed GE-Honeywell merger if this is the only merger then the merged firm gains and the non-merged firms lose appears to be this that guided the EU Competition Directorate but consumers benefit even in this scenario and rivals have a clear strategic response: merge so the EU must have believed that merger by rivals was not possible Or would be strategically prevented by GE-Honeywell and that if the integrated GE-Honeywell gains a monopoly position price will rise Many believe that this was unlikely So the decision remains questionable Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Bring under common control firms whose products are neither substitutes nor complements results in a diversified firm period from 1960s to early 1980s is when many were forms Is there a convincing rationale for this type of merger? if not then probably an accident of history gradually corrected by downsizing and focus on “core competence” Possible rationales: Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Economies of scope but these generally derive from use of common inputs so merged firms should be related in some respect similar markets similar technologies data do not support this hypothesis Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Economize on transactions costs take a specialized machine can produce two goods A and B markets for A and B are concentrated if machine is used to produce only A there is spare capacity then owner may wish also to produce B – conglomeration the owner could also lease use of the machine to a specialized B producer to avoid conglomeration but this has problems negotiating and bargaining over the lease conglomeration avoids these problems particularly important when the asset is knowledge intensive so this motive is reasonable but the assets are common to all the conglomerates products not supported by the data Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Managerial motives conglomeration suits interests of management but not shareholder division of ownership and control of large public corporations monitoring of management is far from perfect so management can pursue its own agenda to some extent suppose management compensation based on firm growth easier to grow by acquisition than internally horizontal merger may be blocked by regulators so grow by conglomeration conglomeration to reduce management risk diversified firm has diversified risk this diversifies the risk that management faces Seems to be supported by the evidence Chapter 17: Vertical and Conglomerate Mergers

Chapter 17: Vertical and Conglomerate Mergers Empirical Application: Vertical Integration in the Ready-Mixed Concrete Industry Ready-mixed concrete made by combining cement in almost fixed proportion with sand, gravel and water. Also, because of high transport costs, concrete markets tend to be very local So, this industry is a good place to test for the effects of vertical integration because the standard modeling assumptions are met and there are a lot of observations Hortaçsu and Syverson (2006) identify 348 local markets for ready-mixed concrete over the years 1963 to 1997 and use these to investigate the effects of vertical integration Chapter 17: Vertical and Conglomerate Mergers

Vertical Integration in the Ready-Mixed Concrete Industry 2 Three Estimates of the Effect of Vertical Integration on Concrete Prices Independent Variable Effect on Weighted Average Market Price (log)   Market Share of Vertically -0.090* -0.086* -0.043 Integrated Firms (0.041) (0.041) (0.039) Market Share of Multiple Plant Firms _ _ _ _ 0.015 0.001 (0.022) (0.024) Weighted Average Total Factor Productivity _ _ _ _ _ _ _ _ -0.293* (0.054) R2 0.433 0.434 0.573 * Significant at five percent level.  Chapter 17: Vertical and Conglomerate Mergers

Vertical Integration in the Ready-Mixed Concrete Industry 2 Implications of Hortaçsu and Syverson (2006) results Vertical Integration appears to lower final prices by anywhere from 4.3% to nearly 9% The effect appears to be due largely to higher productivity in vertically integrated firms But has little to do with the operation of multiplant firms Basic Result: In Ready-Mixed Concrete, Vertical Integration has been good for consumers and firms, alike Chapter 17: Vertical and Conglomerate Mergers