10.05 notes

• Mergers

– if price competition (Mssr. Bertrand) then uninteresting as a strategic problem: if you’re in a 5-firm industry, going to 4 firms doesn’t eliminate the challenge of avoiding price wars. 

» it also won’t change the price that the market leader posts in trying to hold together tacit collusion. after all, post-merger you will have excess capacity [price competition isn’t relevant unless you have excess capacity!] and lots of pressure to sell a lot to pay down merger-related debt. if the lead firm tries to raise price, you’ll face a huge temptation to hold your price and pick up market share and profits at their expense

» absent a price change, after a merger all you have is a bigger firm, not a more profitable one.

» yes, going from two firms warring with each other to one single firm does stop price wars and improve profits. however, even a weak-kneed antitrust authority will find it hard to approve the formation of an outright monopoly.

– so our quantity competition story is the relevant one

• n-opoly

– in our duopoly case, two firms reacted to each other’s output in a way that led to positive profits but at an output level higher [and price lower] than a monopolist would charge

› in particular an increase in price by your rival [synonymous with lower output] would lead you to increase output [muting the price increase]

– so if we have 10 identical firms, and 2 merge, then that merged firm will have too much output for a 9-firm market, and will raise price ← → lower ouput. 

› as a result, the 8 firms outside the merger will each see a higher price, and because they’d initially been at a profit-maximizing strategic equilibrium, their response to a higher price is to increase output a bit, but not so much as to fully offset the higher price. they thus see their profits increase

= meanwhile the new firm has 2/10ths of the market, but in equilibrium should have only 1/9th of the market. it continues to shrink output.

= the question then is whether its profit with 1/9th of the market is bigger than the pre-merger profits of 2 firms each with 1/10th of the market

– the bottom line is that such mergers do not make sense

› here, manipulation of our duopoly model to make it an n-opoly model gives

p = a – b(qus + [n-1]qothers) leads to 

c = MR = a – 2bqus – b[n-1]qothers. 

with symmetry q* = qus = qothers so we eventually get q* = (1/[n+1])•([a-c]/b)

single firm profits are then (1/[n+1])2•([a-c]/b)2 

› so the total profit of the two firms pre-merger is:

 2 • (1/11)2 • ([a-c]/b)2 

= once they reach the post-merger 9-firm equilibrium profits will be

(1/10)2 • ([a-c]/b)2 

› but  2 • (1/11)2  > (1/10)2 !! so post-merger profits fall – merging does not make either cents or sense

› see the textbook for a table of multiple cases; this calculation is fairly general

• so why mergers?

– managerial firms where execs want a merger for reasons of power and empire, or because they earn bonuses from the merger, or … other non-economic reasons.

– stock markets that mis-price merged firms

= they may misperceive the benefits of a merger [“cost savings” “market power”]

» think of the many dot.com firms that never deliver promised profits … Amazon, Twitter, Tesla … but everyone knows are great things

= pre-merger firms may have different multiples [the P/E ratio of stock price to earnings] for very good reasons, such as different debt structures, and the market gives the new post-merger entity the higher of the two multiples

• merger waves then make some sense: such mis-pricing is pervasive

• legitimate reasons: cost savings

– such savings are always touted, seldom realized

› Daimler-Chrysler merger: common designs didn’t happen, purchasing teams buying for Europe versus the US could find few savings on steel, copper, glass etc. meanwhile setting up a common accounting system was very costly. so in the end no savings were realized.

= furthermore, the new owners weren’t superior managers, indeed they made mistakes that cost $600 million in profits just by mandating that Chrysler handle the launch of a new model year for their minivan in the same way that Mercedes did for a high-end luxury vehicle.

= in sum, CEO Jürgen Schrempp lost billions of euros for his shareholders on this and other acquisitions (including Mitsubishi Motors and various commercial vehicle and aerospace ventures). Chrysler alone resulted in a US$30 billion loss (purchase price less sales price), not counting financial losses and a lower Daimler stock value

– exception: buying poorly-run firms or firms in trouble and turning them around

› hard to do in practice: investment bank turnarounds zoom away … into brick walls, that is, failure rates are very high

= mergers of equals leave the “good” firm with too few resources to restructure

› some firms do however growth through small, targetted acquisitions

= Teleflex in cable-related businesses, buying engineer/founder ventures where the original managers want out due to age or lack of the right skill set

» can keep a team of experienced “integration” specialists who can install modern management information and accounting systems, leverage parent-company R&D skills and supplement marketing

= boat steering systems, car brakes & throttles, surgical devices. for them, they can deliver synergies while adding one more similar business line