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Mergers

Types of Mergers Horizontal Merger - this is a merger between two competing companies in the same industry Vertical Merger – this is a merger between two firms at different stages of the production process Why Might Firms Merge? Economies of Scale: both in production and in things like R&D/administration/marketing… Economies of Scope: synergies between two firms Higher Prices: can result in horizontal mergers by reducing competition through

- creating or strengthening dominant position, resulting in greater market power

- diminishing competition in oligopolistic markets by eliminating competitive constraints

- changing the nature of behaviour in oligopolistic markets to allow firms to co-ordinate their actions

Antitrust authorities are concerned with the possible anti-competitive effects of mergers. Consumer welfare or “economic efficiency” ?

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EU Merger Policy Merger Regulation gives the European Commission the exclusive power to investigate mergers with a "Community dimension". EU merger Control Regulation No 139/2004: a new substantive test of whether a merger should be challenged or not.

Article 2: any merger that will “significantly impede effective competition, in the common market or in a substantial part of it” is to be blocked.

EU criteria now closer to the US practice, where mergers are prohibited if they would result in a “substantial lessening of competition”.

Augments the previous legislation, which prohibited mergers that create or strengthen a dominant market position

Dominance remains an important concept, but now includes oligopolistic markets where the merged company may not be dominant.

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Dominant Firm: can act on the market without having to take account of the reaction of its competitors, suppliers or customers e.g. can increase its prices above those of its competitors without fearing any loss of profit. Likely effects: higher prices, a narrower choice of goods or scarcity.

It is not illegal for a firm to hold a dominant position on the market but the firm is disciplined under Article 82 of the Rome Treaty, which “prohibits the abuse of a dominant position within the common market or a significant part of it, in so far as it may affect trade between Member States.” However, acquiring a dominant position by buying out competitors is in contravention of EU competition law. Mergers assessed as to whether or not they enhance the market power of companies and, subsequently, likely have adverse effects for consumers in the form of higher prices, poorer quality products, or reduced choice.

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EU merger guidelines (2004/C 31/03) outline two ways that horizontal mergers may impede effective competition (similar to the US horizontal merger guidelines):

(i) by eliminating important competitive constraints on one or more firms, which consequently would have increased market power, without resorting to coordinated behaviour (non-coordinated or unilateral effects)1

(ii) by changing the nature of competition that raises

prospects for coordination (coordination effects) i.e. merger results in collective dominance.2

How do Merger Studies Proceed?

1. Notification

2. Defining a market 3. Preliminary ‘screening’ using market shares and

concentration analysis within defined market 4. Competitive assessment of the merger

1 This may arise for example when merging firms have large market share; merging firms are close competitors; customers have limited means of switching suppliers; etc (see EU merger guidelines No 26 – 38). 2 The EU merger guidelines outline three necessary conditions for sustainable coordination (i) ability to monitor coordinating firms and whether they are keeping agreement (ii) credible ‘punishment’ deterrent mechanism if there deviation is detected (iii) reactions of outsiders (current / future competitors) not in coordination can not jeopardise expected gains from coordination.

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2. Defining a Market

This delineates market boundaries, within which the analysis of competition may take place. Based on product characteristics and on geographic area The Relevant product and geographic market is primarily examined with respect to demand side substitutability. Measures of market concentration will depend on the definition of the market. Market definition is important, as too broad a definition or too narrow a definition (in terms of what products or geographical areas to include in the merger analysis) can lead to wrong conclusions. e.g. too narrowly defined may indicate dominance where there is in fact none. Too broadly defined may incorrectly infer competition and no dominance A market is defined as a group of products and a geographic area such that a hypothetical profit maximising firm (a hypothetical monopolist) not subject to price regulation, would impose a small but significant and nontransitory increase in price (SSNIP), 5-10 per cent, assuming that the terms of sale of all other products is held constant.

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3. Calculating market shares within a market

Antitrust authorities have an initial screening process to determine which mergers should be further investigated. Section III of the EU merger guidelines outline specific market share and concentration levels where the Commission is likely to have, or not, competitive concerns – ‘screening’ Market Shares - very large market shares (50% or more) may in

themselves be evidence of the existence of a dominant market position.

- Mergers where post-merger market share are not

likely to significantly impede effective competition (as indicated where the market share of the undertakings concerned does not exceed 25%). This does not apply where the proposed merger is likely to give rise to co-ordinated effects.

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Concentration

Screening process is primarily dictated by the degree of concentration in the market and the change in concentration post-merger.

A concentrated market is one with a small number of firms with large market share Implicit in the use of concentration is a mapping from market structure into market power…….. i.e. Greater concentration is used as an indication of the market power of firms Measuring Market Concentration: Firmi market share = sizei / total market size (where size can be measured in terms of revenue sales, output, assets…..) 1. Concentration Ratio CRn is the n’th firm concentration ratio – this measures the combined market shares of the top n firms in the industry e.g. CR4 measures the sum of the market shares of the top 4 firms in the industry

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2. Herfindal-Hirschmann Index (HHI) – this is the measure that is preferred in the screening stage of mergers

HHI = ∑1

2is

i.e. the sum of the squares of firm market share, which

gives proportionately greater weight to larger players

in the market (Thus, if data are unavailable for very small firms

in the market the HHI of market concentration will still provide a

good representation of overall concentration.

HHI ranges from close to zero to 10000 (in the case of

monopoly).

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Company 1992 1990 1988 1986 1984 1982Warner Bros. 20 13 11 12 19 10Buena Vista (Disney) 19 16 20 10 4 4Twentieth Century Fox 14 13 12 8 10 14Columbia 20 14 10 9 16 10Universal 12 13 10 9 8 30Paramount 10 15 15 22 21 14TriStar (Merged w/ Columbia 1988) 7 5 New Line 2 4 MGM/UA 1 3 10 4 7 11Miramax 1 1 Orion 0.5 6 7 7 5 3All Others 0.5 2 5 12 5 4 CR4 73 58 58 53 66 68CR8 98 94 95 84 91 96HHI 1607 1246 1239 1068 1337 1638 Source: Adams&Brock, The Structure of American Industry, page 202.

1992

CR4 =20+20+19+14 = 73

CR8 = 20+20+19+14+12+10+2+1 = 98

HHI = (20)2+(20) 2+(19) 2+(14) 2+(12) 2+(10) 2+

(2) 2+(1) 2 + (1) 2 + (0.5) 2 + (0.5) 2 =1607

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The HHI in Merger Screening ‘non-interventionist’ thresholds based on the level and change in the HHI post-merger provide a screening rule as to whether mergers are unlikely to be anti-competitive and so do not justify investigation. The post-merger HHI normally assumes the current market shares of the merging parties remains the same….. (this may be naïve….)

Table 1: EC and US Screening Thresholds

HHI ∆ HHI

EC Screening Thresholds

Competitive Concern 1000 - 2000 > 250

Competitive Concern > 2000 > 150

US Screening Thresholds

Competitive Concern 1000 - 1800 > 100

Competitive Concern > 1800 >50

No Competitive Concerns for HHI < 1000 for any ∆ HHI

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Are other criteria other than the level and change in the HHI post-merge e.g. the presence of a regulatory entry barrier or very high customer switching costs; a merger involving a new/potential entrant with miniscule market share or a maverick firm; or a history of collusion or other competitive concerns in the market but….

Table 2: US Data for Fiscal Years 1999—2003 on Individual Relevant Markets in Cases in

which the Agencies Challenged Mergers

Change in the HHI Ex-Ante Merger

HHI 0-99 100-199 200-299 300-499 500-799 800 -1,199

1,200 -2,499 2,500+

0-1,799 0 17 18 19 3 0 0 0

1,799-1,999 0 7 5 14 14 0 0 0

2,000-2,399 1 1 7 32 35 2 0 0

2,400-2,999 1 5 6 18 132 34 1 0

3,000-3,999 0 3 4 16 37 63 53 0

4,000-4,999 0 1 3 16 34 30 79 0

5,000-6,999 0 2 4 16 9 14 173 52

7,000+ 0 0 0 2 3 10 44 223

Total Cases 2 36 47 133 267 153 350 275

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Advantages of HHI in screening:

Good measure of market concentration (gives proportionately greater weight to larger players)

Data unavailability of small firms is not a big problem

Allows antitrust authorities to assess pre-merger and expected post-merger concentration levels and define various zones as to likelihood of anticompetitive effects

Main advantage: Use of HHI as an indicator of market power is theoretically motivated at least in the case of homogenous goods

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Aside: HHI as an indicator of market power in Homogenous Goods Market structure ranges from the extreme of monopoly to that of perfect competition with no market power and marginal cost pricing. Intuitively, one might expect that as the number of firms increase in the market, price will decline toward marginal cost. Non-cooperative Cournot oligopoly N firms in the industry each setting output qj as simultaneous players. Each firm j profit function and first order condition for profit maximization is written in equations (1) and (2) respectively,

∑=

=−=N

jjjjjjj qQqCqQPq

1

where)()()(π (1)

0)( =−+=∂

∂jjj

j

j qMCPqdQdP

qπ

(2)

Each firm’s mark-up can thus be written as the following Lerner index,

ηjjj s

Qq

PQ

dQdP

PMCP

=−=−

. (3) where sj is the firm j market share, and η denotes the industry demand elasticity.

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If N identical firms, each has an identical market share of 1/N and the price-cost mark up is inversely related to the number of firms in the market. The price-cost mark up under Cournot oligopoly with homogenous goods can be shown to be directly and positively linearly related to the HHI: higher concentration as measured by the HHI yields higher price-cost mark ups. From equation (3) we can write the average price-cost margin in the market as,

ηηHHI

2

==⎟⎟⎠

⎞⎜⎜⎝

⎛ − ∑∑ j

j

j

jj

s

PMCP

s (4)

Thus, use of market concentration as measured by the HHI in merger analysis has a well founded theoretical motivation for homogenous good industries with each firm producing only one good. One can expect greater market power to result from the proposed merger of two or more firms in such a market. Whether this raises real competitive concerns depends upon the level of the post-merger concentration and the change in the HHI as a result of the merger. Hence, the general zones outlined in the previous section when deciding whether or not to investigate a merger.

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Disadvantages of HHI in screening: F. Mariuzzo, P.P.Walsh and C. Whelan, "EU Merger Control in Differentiated Product Industries”, in Recent Developments in Antitrust Theory and Evidence, Edited by Jay Pil Choi, MIT Press December 2006

The post-merger HHI assumes the current market shares of the merging parties remains the same….. (this may be naïve….)

Key disadvantage - in the case of differentiated products, market power may bear no relation to concentration or the HHI.

So screening on this basis may result in the investigation of mergers that will have little anticompetitive effects (Type II error) – or the failure to investigate mergers that can have big anticompetitive effects (we consider this issue now) (Type I error).

Differentiated Products Industries:

Firm size is no longer a good approximation of the ability to mark-up price over cost.

Market is now made up of a number of products that are differentiated, either by location or some product attributes. Some products are more similar than others.

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The competitive constraint on a firm’s pricing is now determined by the degree of substitutability between the various goods in the market. Market may consist of a number of different ‘segments’ (differentiated by geographic location, or by product characteristics)

‘Segments’ encompass a group of products/brands that are very substitutable with lots of strategic interaction, but are independent of, or tend not to, compete with products/brands in other segments

Things become even more complex in the case that firms produce multiple products in the market.

The problem here has little to do with market definition, but rather the complex way in which firms operate within a market:

firms may specialise in producing goods with very similar attributes, …… or have a portfolio of goods with very different attributes, …….and may or may not operate alongside other multi-product firms producing similar or different goods. They may be present or dominant in certain segments of the market, and absent in others.

The HHI for the market tells us little about the underlying structure of such markets or the market power of firms. Why?

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Sutton (1998): Differences in firm size emerge due to firms operating over different segments in the market – big firms operate over many different product attributes/locations, while small firms specialise in just a few/one.

Implications for market power? Firms ability to mark-up prices is determined by localised within segment competition

It is possible that small firms can extract as high a mark-up as larger firms in a market - if the small firm is specialising in a segment where it commands a high share of that segment – thus, although small in the overall market, the specialist firm may be big within a segment and thus have market power

Thus, firm size in a market is not a good indication of market power in differentiated products industries

Using HHI to screen may result in the investigation of mergers that will have little anticompetitive effects – or the failure to investigate mergers that can have big anticompetitive effects

e.g merger between 2 firms with small output market share….. will have little impact on the HHI and will not be investigated under screening thresholds

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BUT… if these 2 firms are very specialised into different geographic / product segments…… then, although small in size in the overall market, they may be large within specific segments and have large market power….. so the merger may have big implications for market power….

Rather than using market shares in screening notified mergers, it is more desirable to use a simple structural model to estimate the market power of firms, that incorporates all the complexities of multi-product firm behaviour and market segmentation in differentiated industries.

Thereby, screening on the basis of predicted levels and changes in market power (rather than market size or concentration) as a result of a merger, rather than on the basis of size.

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3. Competitive assessment of the merger Once it has been decided to investigate a merger, examine the likely impact of merger on effective competition in the market, i.e.

I. Does the merger lead to a “unilateral”

exercise of market power? i.e. does the merger eliminate important competitive constraints on one or more firms, which consequently would have increased market power, without resorting to co-ordinated effects…..

II. Does the merger lead to “coordinated interaction”

i.e. does the merger change the nature of competition such that it increases the prospects for co-ordination

III. Other Competitive Effects

And then policy needs to weigh up all the possible effects of the merger, to decide whether or not the merger is desirable

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I. Does the merger lead to a “unilateral” exercise of market power? i.e. does merged firm find it profitable to raise price, irrespective of actions of other participants in the market?

4 main steps in this analysis…

1. Examine market structure in detail

- concentration (merged firm share compared to other firms in the market)

- stability concentration over time

- level of vertical integration

- cost and technology factors

- product differentiation

- level and intensity of R&D

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2. Examine effect of merger on behaviour of merging party

(note degree of substitutability between products and ability of merged firm to unilaterally increase price)

3. Examine reactions of existing competitors

4. Examine reactions of customers

Any switching costs that prevent consumers from switching away from merged party in event of price increase by them…..

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II. Does the merger lead to “coordinated interaction” Refers to either tacit or explicit collusion that results from the merger – requires that firms can reach agreement on terms of coordination (e.g. common price, stable market shares, territorial restrictions) profitable to all, and have ability to detect and punish deviations from these terms

1. Identify whether market is characterised by factors conducive to collusion

2. and whether post-merger conditions are conducive to detection and punishment of deviations?

(see lecture on Factors conducive to collusion) - Number of competitors - transparency of market conditions - homogeneity of product - homogeneity of firms - multi-market contact (presence of same firms in

other markets) - entry barriers - trend in demand (cyclical models of collusion) - unpredictability in demand (imperfect monitoring

models of collusion)

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III. Other Competitive Effects 1. Entry –

Would merger have significant impact in timely period?

Is entry profitable at existing (or lower) prices and thus likely to occur? (Barriers to entry important here….)

Would entry return prices to pre-merger levels, thus deterring merged parties from increasing price in the first place?

2. Efficiencies

Would these compensate for price increase?

What is the nature of potential efficiencies?

3. Failing Firms

If part or all of merging assets are certain to exit market if the merger did not take place, then merger is unlikely to be anticompetitive.