INDUSTRIAL
ECONOMICS
ASSIGNMENT

HORIZONTAL MERGERS AND
MERGER POLICY

MERGERS and takeovers involve the amalgamation of two or more independent firms under common control and are typically divided into:

1. Horizontal mergers

2. Vertical mergers

3. Conglomerate mergers

HORIZONTAL MERGERS

WILLIAMSON’S FRAMEWORK:

• The issue of appropriate public policy to deal with horizontal mergers is discussed below in a frame described by Williamson.

• If a horizontal merger simply has the effect of increasing the market power of the merged firms, enabling them to raise prices and profits, then a prima facie case against the merger exists.

• Williamson in particular focuses attention on economies or real cost savings as a defense of horizontal mergers.

[pic] (fig.1)

• Assume for simplicity a competitive market with constant costs, AC1, and a market demand curve, D, as shown in the figure.

• In a competitive equilibrium, price is equal to marginal and unit cost, p1, and competitive output is x1.

• Assume that a series of mergers now takes place giving rise to real cost savings which reduce costs to AC2.

• Such costs may arise, for example, from rationalization of production and the exploitation of economies of scale.

• If the merged firms continue to charge price p1 or below then consumers are no worse off and there is a saving in resources in producing output x1 equal to area p1cge. • The merger is therefore strictly beneficial.

• Suppose, however, that the post merger price rises above p1, to say, p2. Output is restricted to x2 and consumer surplus is reduced by area p1bde.

• If the transfer of income from consumers to producers is treated as neutral, then the net welfare loss is area abc i.e. area A1.

• However, cost savings are made on production of output x2 equivalent to area p1bde i.e. area A2.

• Compared with the competitive situation, these savings represent scarce resources freed for alternative uses. • Consequently, the overall net social benefit of the merger is the difference between A2 and A1.

• Williamson points out that this may be positive for comparatively small cost savings owing to merger.

• Hence even small cost savings benefits may offer an important defense for horizontal merger.

Criticisms Of The Williamson’s Model:

➢ First, the argument relies on the assumption that the transfer of income, p2abp1, from consumers to producers is treated as neutral. ➢ Relaxation of this assumption in the direction of weighing consumer losses more heavily will increase the social cost of merger and hence require greater cost savings to make a merger beneficial.

➢ Second, even if the merger produces positive net social benefits, it does not represent an ideal solution. Consumers could in principle bribe the merged firm to produce output x3 at a price equal to AC2, by paying it a sum equal to the monopoly profits area p2ade. ➢ The gross consumer benefit from such a move is area p2afe, giving a net consumer benefit of area adf.

➢ Thus area adf would measure the social costs of a permissive merger policy compared with the first-best optimum of pricing at marginal cost.

LEIBENSTEIN’s CRITIQUE

Williamson’s argument relies on the assumption that mergers give rise to cost savings.
Leibenstein argued that lack of competitive pressures may well cause costs to rise after merger.

➢ Leibenstein has coined the term ‘X-efficiency’ to denote such an effect and has stressed its importance to economic welfare. ➢ The argument is illustrated in the following figure, where initially competitive price is p1 and output is x1.

(fig. 2)

➢ Following a merger, however, price rises to p2 and in addition costs rise to AC2.

➢ In the absence of cost increase, the price effect of the merger is to reduce consumer surplus by area p2acp1, of which area p2abp1 would be a transfer to producers, leaving area abc i.e. area A1 as net welfare loss.

➢ Because of the cost increase, however, producers receive only area p2ade as profit.

➢ On the simplifying assumption that the increase in costs represents a pure waste of resources, area p1bde i.e. area A2 must be added to the welfare loss.

➢ Thus, both the price increase and the cost increase contribute to the reduction in social welfare and the merger is unambiguously bad.

MERGER POLICY

A number of factors must be taken into account where practical merger policy is concerned.

• First, it is necessary in evaluating the costs and benefits of any particular merger to consider Williamson’s weighing and incipiency effects.

• These relate to external effects of the merger within the market concerned. • Thus, a merger of two firms within a market may cause other firms as well, it is better to obtain them by merger or by competition l as the merged firm to raise price.

• Consequently in assessing the costs and benefits of the merger, this more general price effect must be appropriately allowed for (weighted). • Incipiency, on the other hand, relates to the possibility that the merger under consideration might be part of a trend of mergers in the industry.

• In this case a single merger cannot be considered in isolation; rather, the costs and benefits of all mergers must be assessed.

• Second, external effects in other industries should also be considered. The effects of the merger in closely related products should be considered where relevant. • Also, it is quite likely in practice that horizontal mergers of major companies involve amalgamation of a great deal of other business ancillary to the main product under consideration.

• Third, it is necessary to consider the treatment of time n assessing a merger. • A horizontal merger may be a quick way of bringing about cost savings, but such cost savings would eventually be obtained anyway in the absence of mergers, and, so, whether.

CONCLUSIONS:

❖ In a general framework, one would have to allow for complications such as the fact that cost savings of the merger are themselves likely to take time to emerge, and that, in the absence of merger, competition and internal expansion may themselves give rise to market power effects.

❖ A full cost benefit analysis of merger would thus have to take account of the expected stream of costs and benefits over time relative to the expected pattern of events if the merger were disallowed.

❖ In such an analysis it should also be remembered that, if the merged firm restricts output and raises prices, it may attract new entrants to the industry, thereby attenuating the monopoly effects.

❖ It would thus be necessary to consider the threat of potential competition and the height of entry barriers in the industry in assessing the likely effects of the merger.

END