Research by Dirk Hackbarth and Bart Taub shows the potential to merge in the future increases competition prior to merging. Hence–in contrast to the conventional view–mergers can indeed be pro-competitive.
According to the market power doctrine, the concentration of output among firms in an industry is a measure of market power in that industry. More market power is synonymous with monopoly: prices increase and output falls, to the detriment of consumers and to society at large. (This conclusion holds even allowing for the possibility that consumers are also shareholders who nominally benefit from the higher profits stemming from this monopolistic behavior.)
The conventional view is that anticompetitive mergers increase industry concentration and hence increase market power, harm competition ex post, and therefore need to be carefully reviewed and possibly restricted by regulators. Hence, regulators, such as the Antitrust Division of the Department of Justice or the Federal Trade Commission, have the mandate to prevent situations that “excessively” transfer welfare from consumers to firms via buildups of dominant positions or firms with disproportionate market power, including mergers perceived to be anticompetitive.1)See https://www.ftc.gov/enforcement/merger-review
Are these policies effective or desirable? We take a dynamic approach and find the answer to be No in both cases.
To reach these conclusions we built a dynamic, noisy collusion model that captures firms’ optimal output strategies prior to a merger. To cleanly identify the effects of anticompetitive mergers, we abstract away from other common aspects of mergers that can obscure purely anticompetitive effects: these include operational or financial synergies. Operational synergies can stem from higher growth or lower costs: for example, by combining hubs, routes, and gate slots, two airlines might be able to operate more efficiently and reduce costs to consumers. Financial synergies can result from tax savings, increased debt capacity, or improved returns: for example, by pooling their portfolios of loans, two banks might better diversify risk and thus be able to offer lower interest rates to mortgage customers. These synergies would bias a model in favor of mergers; by eschewing them we build in a bias against mergers. We thus focus only on the desire of firms to collude prior to merging or potentially to merge if collusion fails.
The conventional view fails to account for dynamics. Firms in our dynamic model are forward-looking, aware that they are in a dynamic cartel-like situation, but are unable to directly observe the actions of the rival firm, which would enable them to enforce the cartel. The inability of each firm to observe the other firm’s output reflects the real world: regulators punish firms that directly track and coordinate with each other’s actions for market power purposes.
|Our conclusion is thus the exact opposite of the conventional view that mergers are harmful for society: making mergers more difficult (i.e., costlier for the firms) is actually harmful to society, because it strengthens the ability of firms to punish each other and enforce the cartel.|
Because they are blocked from observing each other directly, firms are unable to punish their rival for directly perceived deviations from collusion–that is, for producing too much in order to realize temporarily higher profits at the expense of the other firm. The inability to directly observe and punish deviations therefore requires a tacit collusion arrangement, in which firms attempt to observe each other indirectly–via prices. This indirect observation is imperfect, however, because prices are affected by random influences, in addition to the effects of the firms’ output choices.
Because of the random influences a firm can mistakenly appear to produce too much output. Under the tacit collusion arrangement this triggers a punishment in which the rival firm increases output, thus driving down prices and so harming the deviating firm: there is a price war, resulting in low profits for both firms. It is the fear of this price war that sustains the tacit collusion arrangement in the long run.
The potential to merge weakens those punishments, because it prematurely terminates them under terms that are an improvement over the price war for the firm that is being punished. Instead of the price war, the deviating firm gets a share in the monopoly that the firms form when they merge. Because the potential for punishment is concomitantly reduced, the trepidation about aggressively producing output in contravention of the interests of the cartel arrangement is reduced: there is more competition, resulting in more output and lower prices. Our conclusion is thus the exact opposite of the conventional view that mergers are harmful for society: making mergers more difficult (i.e., costlier for the firms) is actually harmful to society, because it strengthens the ability of firms to punish each other and enforce the cartel.
In addition to this fundamental result, we also show that pre-merger collusion is dynamically stable: episodes of collusion are long-lasting, and price wars are unusual and brief. Because mergers occur in the face of an incipient price war, mergers are therefore rare–pre-merger collusion is the normal state of the firms.
Empirical studies of collusion typically focus on mergers and post-merger outcomes, not pre-merger collusion. Our results on the stability of pre-merger collusion suggests that the collusion detected when firms merge might be just the tip of an iceberg of pre-merger collusion that might not have been fully recognized.
The model’s implication of a dearth of mergers is consistent with the stylized facts. There are about 7.5 million firms in the U.S., and there are, on average, 10,000 mergers each year, with the incidence of merging averaging out to less than 0.3 percent per year.
Although the monopoly gains stemming from merging harm consumers in the long run, the enhancement of pre-merger competition benefits consumers in the short-run and those benefits dominate the losses to consumers from the later formation of the post-merger monopoly. This is because discounted expected losses from post-merger increases in market power are small if mergers are rare and hence the contemporaneously pro-competitive effect of the potential for mergers exceeds those losses if firms spend most of their time in pre-merger competition. This gives further impetus to a regulatory policy that is therefore a bit counterintuitive: reduce barriers and costs of merging in order to harness the pro-competitive effects of mergers.
Regulators have historically divided in two camps: the first, the “coordinated effects” camp, views market power, and the impetus to reduce it via regulation, as stemming from conscious collusion by firms in a concentrated market. The second, the “unilateral effects” camp, views market power as mainly stemming from a single firm dominating a market rather than from conscious collusion, perhaps because single-firm dominance is easier to prove in practice.
|Even if a coordinated effects approach is appropriate ex post, regulators could better promote consumer welfare by facilitating mergers through lowering frictions, such as barriers, costs, and expenses formally or informally placed by merger regulation.|
The unilateral-effects camp has until recently been the dominant view. Recent convincing evidence of rising concentration, however, has revived arguments that tacit collusion is a bigger concern than previously thought, suggesting that regulators should revert back to bringing coordinated effects cases to regulate markets, and in particular, to block mergers.
Our results inform this debate, suggesting that, even if a coordinated effects approach is appropriate ex post, regulators could better promote consumer welfare by facilitating mergers through lowering frictions, such as barriers, costs, and expenses formally or informally placed by merger regulation, such as the merger guidelines of the US Department of Justice or the European Commission.
Dirk Hackbarth is a Professor of Finance and an Everett W. Lord Distinguished Faculty Scholar at the Boston University Questrom School of Business, where he teaches courses in Financial Economics.
Bart Taub is a Professor in Finance in the Adam Smith Business School at the University of Glasgow.
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