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ECONOMICS 3200MLecture 4

January 26, 2011

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Mergers & Acquisitions

• Objective: Maximize shareholder wealth– Benefits (advantages) must outweigh premium paid to

acquire control of assets

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Mergers & Acquisitions

• Increase market power– Eliminate competitor benefits all surviving firms in industry

– Long-run possibility of reducing competition given Schumpeterian competition?

• Cost improvements – economies of scale, scope, internalization, access to lower cost inputs

• Bargaining leverage with suppliers, distributors (complete product offerings)

• Acquire superior talent

• Undervalued assets because of poor management, limited distribution capabilities – leverage competitive advantage

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Mergers & Acquisitions

• Diversification to reduce business risks– Ability of shareholders to diversify at lower cost and more

completely

– Hedging against various types of business risks – economic shocks, interest rates, currencies, commodity shocks

• Eliminate excess capacity– Benefits all competitors – why not wait for company’s assets to be

liquidated?

– Does capacity disappear when companies eek bankruptcy protection?

• Tax advantages – tax losses, transfer pricing across countries with different tax rates

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Competition

Schumpeterian competition and dynamic efficiency

• Competition that counts is not price competition, but competition from new products, new technology, new sources of supply, new types of organization

• Dynamic change and efficiency gains result of strategic behaviour and risk-taking (decision-making under uncertainty – absence of full information) – technological change, productivity growth

• Pursuit of economic profits (above-average returns on investment) motivates risk-taking

• Investments anticipate payoffs commensurate with the risks (probability of failure) – VC model– Small number of winners in each time period/round

– Monopoly power short-lived because of dynamic nature of competition

– Strategic behaviour to solidify monopoly position

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Competition

• Experiment: 10 players with same stakes and equal chances of winning each game (draw a number from an earn)– Within short period of time, one or two players will have amassed

large stakes and others will have little left

– Eventually one ends up with entire stake

– In this experiment: Pr (winning) = h (luck) [probability of winning is a function of luck only]

• In real world: Pr (winning) = h (management talent, strategy, luck)– Talent in short supply, thus expect each industry to be dominated

by one or two companies

– Financial performance = h (management talent, strategy, luck)

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Markets

• Defined by rules

• Imagine a game without rules

• In absence of rules set and enforced by “government”, players will establish and enforce own rules– Consider illegal activities – illegal because of

rules– Drugs, loan sharking, prostitution– Power critical

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Rent Seeking

• Governments set and enforce rules– Lax enforcement as good as no rules except for

reputation effects

– Governments change rules periodically• Winners and losers

• Rent seeking to influence rule makers and enforcers of rules– Persuade governments to change rules in one’s favor

– Costs vs. expected benefits

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Competition• Carlton & Perloff : “Even though perfect competition is rarely, if ever,

encountered in the real world, we study the perfect competition model because it provides an ideal against which to compare other models and markets.”

• Assumptions:– Homogeneous, perfectly divisible product– Perfect information (consider Internet again)– Price takers– Zero transactions and search costs (eBay)– No externalities– Free entry and exit– No entry barriers– U-shaped ATC– No advantage– Equilibrium: no economic profits, D/S– Entry/exit process

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Competition

• Price determination– Some degree of market power for each firm because of search costs

– High degree of substitutability – firm elastic demand curve

– How is initial price point established?

• Long-run equilibrium– Economic profits or losses as signal for entry/exit – definition of

economic profits

– Rate/speed of adjustment – how long does it take to get from short-run to long-run?

– Perfect information, zero transactions costs and free entry and exit

• Incentives to innovate – technological change– Perfect information, zero transactions costs and free entry and exit

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Competition

• Contestability– “If there is free entry into and exit from a market instantaneously

(no sunk costs), firms have an incentive to enter whenever price exceeds average cost. Markets with free instantaneous entry and exit are called perfectly contestable.”

– Assumes no sunk costs, zero entry/exit costs, reactions of incumbents, possible competitive advantages of incumbents, speed/number of entrants

– Solid waste collection – competitive bids every year• Relocation costs, experience, lobbying

– Airline industry – city-pairs assumed to be contestable• Start-up costs, competitive advantages of incumbents’ networks

• Porter Air and City Centre Airport

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Competition

• Barriers to entry– Absolute cost advantages of incumbents– Access to customers – access to distribution channels,

switching costs– Access to inputs, technology – role of patents– Product differentiation – importance of reputation,

brand names– Scale of entry and capital requirements– Exit costs– Strategic behaviour of incumbents – reputation of

incumbents– Number of potential entrants

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Competition

• Scale, speed of entry– Information re. economic profits

– Information re. production, distribution, consumer tastes, etc.

– Access to inputs at same prices as incumbents, including access to capital and management talent

– Start-up costs – sunk costs

– Time required to enter – develop strategies, acquire facilities and resources

– Actions of other potential entrants

– Actions of incumbents

– Willingness of external investors to finance entry

– Expected growth

– Excess capacity

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Monopoly

• Assumptions:– No price discrimination– Quality known by consumers– Substitutes available– Entry barriers

• Profit maximization pricing:– MR=MC [PM/MC] = [( +1)/] ( is the absolute value of the

price elasticity of demand)– Price-cost mark-up – Lerner index of market power– Relative mark-up inversely related to price elasticity of demand– Constant elasticity of demand: = ; therefore constant mark-up

• [PM/MC] = [+1]/ • Rule of thumb pricing – constant mark-up over costs where MC

approximated by AC

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Monopoly

• Profit maximization pricing over time:– Price elasticity in long run may differ from price elasticity in short

run

– Case of oil:• Inelastic short-run demand

• Elastic long-run demand as substitution possibilities expand

• Greenhouse gas emissions and carbon tax – initial level of tax

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Monopoly

• X-inefficiency– Absence of competitive pressures to minimize costs

– In competitive markets inefficient firms cannot survive

– Agency problem, not a problem of monopoly

– Incentives to innovate, invest in new technology

– Carlton & Perloff: “A firm in a market with many firms can observe what other firms are doing [assumes information freely available]. It can observe, for example, whether its own costs of production are above or below the market price. Because the market price reflects the efficiency of the other firms in the market, a competitive firm knows that it can improve its production efficiency if its costs of production are high relative to the market price [how does it survive?]. In contrast, a monopoly has no other firms to look at [other firms in other industries – who supplies the technology and production equipment?] and may have no other standard by which to judge how efficiently it is operating.”

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Monopoly

– Creating future competition• Recyclables – aluminum

• Substitutes – oil

• Durable or fashion products – defer purchases– Planned obsolescence

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Monopoly

• Multi-product monopoly

• N products: Qi (i = 1,….,N)

• N prices: Pi

• General case: interdependent demands, interdependent costs– Pi = Pi (Q1, Q2,…….., QN)

– Ci = Ci (Q1, Q2,…….., QN)

• Case 1: independent demands and costs– Pi = Pi (Qi)

– Ci = Ci (Qi)

– N separate monopolies with first-order profit-maximization condition:

– [(Pi M – MCi)/ Pi M ] = [1/ii]

– Mark-ups can vary across products

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Monopoly

• Case 2: dependent demands, independent (i.e. separable) costs– Pi = Pi (Q1, Q2,…….., QN)

– Ci = Ci (Qi)

– If all products i and j are substitutes: Dj / Pi > 0, then

[(Pi M – MCi)/ Pi M ] > [1/ii]

• Increase in Pi increases demand for Qj

– If all products i and j are complements: Dj / Pi < 0, then

[(Pi M – MCi)/ Pi M ] < [1/ii]

• Decrease in Pi increases demand for Qj

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Monopoly

• Case 3: independent demands, dependent costs– Pi = Pi (Qi)

– Ci = Ci (Q1, Q2,…….., QN)

– First-order condition: MR1 = MR2 = …. = MRN = MC

– Discriminating monopolist model

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Monopoly

• How does a monopoly come into existence?• Superior management – development and execution of successful

competitive strategies and creation of large entry barriers and/or reputation for retaliation against entrants

• Luck – innovation, access to key input • Superior management and/or good luck

– Special knowledge to produce new or better product that other firms cannot imitate at comparable costs or prevented by patents

– Special knowledge about production/organization technologies to produce existing product at lower cost than competitors

• Depending upon size of cost advantage and industry demand, monopoly price may be independent of costs of ex-competitors or price may be determined by limit pricing

• Monopoly granted by government – natural monopoly, policy decision (LCBO), political cronyism, rent-seeking

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Monopoly

• Rent-seeking: monopoly profits create incentive to invest in order to win/gain profits/rents

• Schumpeter: Destructive competition

• PV of monopoly profits depends upon discount rate, expected time horizon for rents, magnitude of expected rents

• Duration and magnitude of future rents depend upon rent maintenance activities and their success

• Competition through private or public markets – innovation (risk-taking), strategic behaviour, lobbying

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Monopoly• Maintaining a monopoly

– Rent seeking – lobby for protection (regulation of entry, trade barriers)– Lobbying to influence legislative outcomes and benefit company

• Competition in political markets – campaign contributions• Hire officials from regulatory agencies or other areas of government – create

expectations of future payoffs in form of attractive job opportunities

– Strategic behaviour • Creation of entry barriers: limit pricing, predatory pricing, switching costs,

vertical controls• Develop new competitive advantages

– Patents, copyright or trade secrets to maintain information advantage– Difference between advertising/other forms of sales promotion, sales

commissions, payments to retailers for distribution, and bribes or lobbying?

• Objective to generate/maintain economic rents gain a competitive advantage