EC365 Theory of Monopoly and Regulation Topic 4: Merger

1. EC365 Theory of Monopoly and RegulationTopic 4: Merger 2013-14, Spring Term Dr Helen Weeds

2. Routes to monopoly power Monopoly power Collude Exclude Merge

3. What is a merger? • Legal control: > 50% of voting shares • Material influence: ability to influence policy • 25% shareholding (can block special resolutions) • > 15% may attract scrutiny • BSkyB/ITV: BSkyB acquired 17.9% stake in ITV • Newscorp/BSkyB: held 39% already, wanted to increase to 100% • other factors: distribution of remaining shares; voting restrictions; board representation; specific agreements • Includes joint ventures (JVs) • combine operations in one area only • autonomous entity, e.g. jointly-owned subsidiary

4. Motives for merger • Horizontal merger • Market power • towards customers • towards suppliers (monopsony) • Efficiencies and synergies • cost savings • R&D spillovers • Vertical merger (lecture 6): complementary assets • Conglomerate mergers: portfolio effects • Stock market: under-pricing; corporate control

5. Lecture outline • Measuring concentration • Merger in Cournot oligopoly • symmetric firms • asymmetric firms • cost efficiencies • merger policy and case: Staples-Office Depot • R&D joint ventures • Relevant counterfactual • “failing firm defence”

6. Measuring concentration • Symmetric firms • Market share of each firm, s = 1/n, may be used • E.g. 3 firms: s = 1/3 • Asymmetric firms: no unique measure • (r firm) Concentration Ratio: CRr = • Herfindahl-Hirschman index: HHI or H = • Monopoly: CR = HHI = 1 (as %: HHI = 10,000) • Perfect competition: both approx. 0

7. Example: UK supermarkets • Market shares by retail by revenue • (2002/03) sales area excl. petrol • Tesco 26% 31% • Sainsbury’s 23% 21% • Asda (Wal-Mart) 19% 21% • Safeway 15%13% • Morrisons 7% 7% • [Others 9% 6%] • C4 ratio? HHI? • Market: one-stop grocery shopping (stores over 1,400 sq m); local (these are national shares)

8. Use of HHI in merger control • US DoJ “safe harbours”; OFT guidelines

9. Merger in Cournot oligopoly • Simple symmetric case • identical marginal cost c; no fixed costs • linear demand: P = a – bQ • Cournot with n firms • set a = b = 1; c = 0

10. General case • n symmetric firms; 2 merge • Gain to merged firm:  = i(n–1) – 2i(n) • sgn  = sgn[2–(n–1)2]: negative when n > 1+2  2.4 • Competitors benefit from positive externality • merged firm q • competitors q (RFs slope down) • while P

11. Why merge? • Cost asymmetries • merger reallocates output to more efficient plant • Efficiencies / synergies resulting from merger • fixed cost savings • marginal cost reductions • complementary assets • R&D • Post-merger collusion • assess change in critical discount factor 

12. Cost asymmetries • Pre-merger • 2 firms, unit costs c1 = 1, c2 = 4; demand p = 10 –Q • Cournot eqm: • q1 = 4, q2 = 1; p = 5 • welfare: W =  + CS = 16 + 1 + 12.5 = 29.5 • Post-merger: shut down unit 2 • monopoly with c = 1: p = 5.5, Q = 4.5 • welfare: W =  + CS = 20.25 + 10.125 = 30.375 • Despite concentration, welfare goes up • what if W =  + CS, with  = 0.5? Critical ?

13. Concentration and average margin • n-firm Cournot oligopoly • asymmetric marginal costs, ci • lower ci higher equilibrium qi  higher market share si • Relationship between HHI (as fraction, i.e.  1) and weighted average PCM (“Lerner index”) where  = price elasticity of demand (as absolute value)

14. Cost reductions • What if merger reduces costs? • Fixed cost saving • lower F implies  • higher concentration implies P and CS • Marginal cost reduction • effect on P (and CS) is ambiguous • higher concentration • output where MR = MC is altered • NB: Cost savings must be merger-specific

15. Fixed cost saving • Merger to monopoly • (inverse) demand P = 1–Q; marginal cost c = 0 • per-firm fixed cost F (0, 1/9) • Pre-merger (Cournot) • welfare W(n=2) =  + CS =2(1/9 –F) + 2/9 = 4/9 – 2F • Post-merger: eliminate one F • welfare W(n=1) =  + CS =¼ –F + 1/8 = 3/8 –F • Welfare comparison • welfare increases iff F > 5/72  0.07 • what if  < 1?

16. Marginal cost reduction • Merger to monopoly • P = a – bQ; marginal cost falls from c0 to c1 < c0 • look at CS alone ( = 0) • Pre-merger (Cournot): • Post-merger: • CS increases iff • 

17. Figure 1: Marginal cost reduction

18. Merger policy • US: Clayton Act (1914) • “substantial lessening of competition” (SLC) test • UK: Enterprise Act (2002) • replaced “public interest” criteria with SLC test • EU merger regulation (1989/2003) • 1989: “create or enhance a dominant position” • 2003: “significant impediment to effective competition”, including creation or strengthening of a dominant position • captures reduction of competition in an oligopoly industry (without losing existing case law)

19. Assessing a merger (OFT guidance 2003) • Competitive assessment • loss of rivalry, not constrained by other competitors? • entry: sufficient in scope, likely and timely? • buyer power: will this constrain any price rise? • Are there offsetting efficiency gains, benefiting consumers? • Relevant counterfactual • what would happen absent the merger? • e.g. is the target a “failing firm”?

20. Competitive assessment • Are merging firms (close) competitors? • bidding data • diversion ratio: if A raises price, what proportion of lost demand goes to B? (ratio of cross- to own-price elasticity) • Other competitors • does presence of third parties constrain prices? • supply side as well as demand substitution • Framework: “market definition” • set of products which compete closely with one another • aspects: products, geographic market

21. Case: Staples-Office Depot (US 1997) • Product: consumable office supplies • FTC’s market definition: “office superstores” (OSS) • Office Depot (1), Staples (2), OfficeMax (3) • merging parties had >70% share • non-OSS outlets: Wal-Mart, Kmart, Target, etc. • Issue: are non-OSS outlets in the same market? • econometric analysis of prices in local markets (cities) • prices lower where Staples competes with Office Depot than with non-OSS alone (FTC: 7.3%, parties: 2.4%) • prices lower where all 3 OSS compete than where Staples and OfficeMax alone • Competition effect: merger would raise prices

22. Staples-Office Depot: cost savings • Would cost savings offset the (ve) competition effect? • Parties’ claims • large cost savings • 67% pass-through to customers • net effect:  prices by –2.2% • FTC’s claims • 43% of cost savings achievable without merger; some unreliable: actual savings = 1.4% of sales • 15% pass-through • net price effect = 7.3% – 0.15 x 1.4% = +7.1% • District Court ruled in favour of FTC: merger blocked

23. R&D joint ventures • Innovation generates dynamic efficiency gains • Benefits of cooperative R&D • complementary skills/inputs of different firms • R&D involves large up-front costs; high risk • may be too much for one firm alone • Against cooperation • would each firm innovate on its own? • Likely to reduce R&D effort (Team issue) • more competitive product market is desirable

24. Policy towards cooperative R&D • Principles underlying R&D JVs • research would not otherwise be undertaken • must not extend beyond activities necessary for R&D • e.g. joint R&D only; separate production & distribution • treated as a merger (rather than under Art. 101) if JV operates on an autonomous and permanent basis • some concern over networks of JVs involving same party: may inhibit competition / entry • E.g.: GM- Renault-Nissan JV to design a “light van” • Also joint production: large economies of scale • separate labels (Trafic, Vivaro), marketing and sales

25. Counterfactual to the merger • Ideally, we want to compare • future with merger (1) • future without merger (2) • (2) often proxied by actual pre-merger situation • Sometimes using pre-merger is not valid • target will exit the market (it is a “failing firm”) • committed entry or expansion • regulatory changes: market liberalisation; new environmental controls

26. Failing firm defence • Key idea • competition deteriorates even in the absence of merger • relative to this benchmark, merger does not lessen comp. • FFD: a merger which raises antitrust concerns may nonetheless be permitted if • the failing firm would otherwise exit • the acquirer would gain the target’s market share • no alternative purchaser poses a lesser threat to competition (regardless of price) [US; similar principles in EU, UK, etc.]

27. Difficulties in using the FFD • Evidential difficulties • extent of losses?; are losses unavoidable? • e.g. Detroit newspapers: suspicion that firms were fighting “too hard” in order to gain merger clearance • are there other potential bidders? • Predictive difficulties • will losses continue?; will exit occur? • what would happen to market share, assets, etc? • Comparing 2 counterfactual situations • 2 hypotheticals not one

28. Successful FFD cases • Potash: Kali und Salz–Mitteldeutsche Kali (EC 1993) • combined market share 98% • MdK very likely to go bankrupt (supported by Treuhand); 30% fall in demand 1988-93 • market share would go to K&S; no alternative purchaser • Solvents: BASF–Pantochim–Eurodiol (EC 2001) • targets already in receivership • no other buyer; merger would keep capacity in market • Other cases • Detroit News–Free Press: local newspapers (US 1988) • P&O–Stena: cross-Channel ferries (UK 1997) • Newscorp–Telepiù: Italian pay-TV (EC 2003)