The GE/Honeywell merger and the issue of bundling

1. The GE/Honeywell merger and the issue of bundling

2. The situation To Merge or not to Merge?

3. 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

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

5. 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

6. Is this reasoning economically sound? • Cournot model: internalising a pricing externality • Two monopolists • Complementary goods: jet engines (GE) and avionics (Honeywell) • q = 1 - (p1+ p2) • Coordinated pricing leads to higher profits and to lower prices Welfare increasing

7. Mathematics of the Cournot model Uncoordinated q = 1 - (p1+p2) П i = pi*q = pi – pi * (p1+p2) Maximize profit: ∂ П i/∂ pi = 0 For i = 1: 1 - 2p1 - p2 = 0 For i = 2: 1 - 2p2 – p1 = 0 Substitution gives: p1 = p2 = 1/3 q = 1/3 П 1 = П 2 = 1/9 Coordinated pb = p1+p2 so: q = 1 - pb Profit function of combined firms: П1+2= pb*q = pb - pb² Maximize profit: ∂ П 1+2/∂ pb = 0 1 - 2pb = 0 pb = ½ q = ½ П1+2= pb*q = ½ * ½ = ¼

8. 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

9. Differentiated oligopoly -fixed location of firms- • Four firms: • Two differentiated versions produced of each good • Engines by firms A1 and B1, avionics by A2 and B2 • A firms located at 0, B firms at 1 • Customers distributed uniformly with preference (x1,x2), so distance to A firm is xi and to B firm (1- xi)

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

11. Differentiated oligopoly -pure bundling- • Case 1: each firm acts independently • pA1 = pA2 = pB1 = pB2 = 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) • pA = pB = 1 • П A = П B = ½ • Market evenly split, price and profits cut in half No incentive to bundle

12. Differentiated oligopoly -pure bundling- (2) • Case 3: bundle against components (A firms coordinate their price) • pA = 1.45; pB1 = pB2 = 0.86; pB = 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

13. Differentiated oligopoly -mixed bundling- • Approximate equilibrium prices and profits: • pA = 1.63; pAi = 1.21; pBi = 0.89; pB = 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

14. 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

15. 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

16. 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

17. 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