Mergers and Vertical Relations

One potential answer is that a merger can lead to more efficient pricing and better service to consumers. This is a situation of two firms producing complementary goods such as tires and bicycles. Similarly, a merger can provide cost savings by improving information flows within the post-merger organization or eliminating wasteful duplication.

If the primary motivation for mergers is to rationalize complementary production or reduce costs, it will likely benefit society and firms.

However, some mergers may also aim to create legal cartels, potentially leading to monopolistic behavior that could harm consumers and competition.

A merger between two or more firms operating in the same market is called a “horizontal merger.” If two firms merge in a triopoly, it turns the industry into a duopoly, and if duopolist firms merge, the industry becomes a monopoly.

a) If the demand function is linear and firms have identical cost structure, then Cournot oligopoly equilibrium is found by

q1=q2=…..=qn= perfectly competitive market quantity/ n+1 .

 Perfect competition quantity is calculated by equating , and therefore found as:

P =8 – Q = 0.8 → Q = 7.2

Consequently, Cournot duopoly quantities will be

q1 = q2 = 7.2 /3 = 2.4

Substituting the value of Q1 in the demand function, price is given by

P = 8 – 2(2.4) = 3.2

b) When the two firms merge, market becomes a monopoly and new quantity and price are given by

Q = perfectly competitivemarket quantity / n +1

Q = (8 − 0.8) /2 = 7.2/2=3.6

P = 8 – 3.6 = 4.4

The HHI is a measure of market concentration calculated by summing the squares of the market shares of all firms in the market. Antitrust policy-makers tend to use the HHI index when objecting to a merger on the grounds that the level of concentration in the market would increase unacceptably.

The HHI is calculated as:

HHI​=40²+30²+15²+15²

HHI=1600+900+225+225=2950

The HHI is calculated as:

1. HHI​=50²+50²

HHI=2500+2500=5000

2. HHI​=90²+10²

HHI=8100+100=8200

3. HHI​=40²+30²+30²

HHI=1,600+900+900=3400

4. HHI​=32²+22²+21²+13²+112²

HHI=1024+484+441+169+=2118

HHI can be used as a simple summary statistic of market concentration. The US antitrust convention is multiplying the index by 10000 so that the HHI takes a value between 0 (which implies perfect competition) and 10000 (which implies monopoly).

 In line with the results we found above, if we rank the markets from the most competitive to the least competitive; 4-3-1-2.

Merger paradox: In a symmetric Cournot game, all the gains from a horizontal merger, if this horizontal merger is not a merger to monopoly, are captured by non-mergers so that the merger harms the merging firms.

Upstream firm: An upstream firm is a manufacturer that deals primarily with the exploration and initial production stages of the product.

Downstream firm: A downstream firm is a retailer that buys from manufacturers and sells products to consumers.

Vertical integration, refers to a business strategy where a company decides whether to produce certain inputs for its products internally (within the same firm) or to buy them from external suppliers. In this context provided, it involves the decision-making process of an automobile company regarding whether to manufacture various parts, such as seats, engines, headlights, and wheels, within the company or to outsource them from other firms.

Examples of "Transaction Costs":

 The process of finding low-cost suppliers and negotiating contracts with them incurs both time and money.

Unexpected situations, such as a supplier going bankrupt, a rival firm making a better offer to the supplier, or the supplier being acquired by a competitor, introduce uncertainties and potential disruptions to the supply chain.

The supplier may cut the supply or even shut down in these cases. These are all examples of the costs of transacting through the market, namely “transaction costs.”

When a company chooses to buy inputs from other firms (suppliers), it incurs certain costs and risks. Examples include the need to find low-cost suppliers, the time and money spent on search and negotiation, and the potential for unexpected situations such as supplier bankruptcy, rival firms making better offers, or supplier acquisition leading to disruptions in the supply chain. These collectively are referred to as "transaction costs."

Vertical integration helps a firm avoid transaction costs by producing inputs within the firm rather than buying them externally. However, it may only be feasible to produce some inputs within the firm. Producing all inputs internally could make the firm extremely large and costly to manage. The relative size of transactions and managerial costs will determine the boundaries of the firm and the degree of vertical integration.

Vertically related firms (an upstream and a downstream firm) merge because of two main reasons: benefitting from (cost) synergies and internalizing negative externalities. In the first case, a merger can help reduce costs so that the merged firm can gain a competitive advantage over its rivals, which may positively affect consumers. In the second case, if the upstream and downstream firms have market power in their respective markets, both will restrict their outputs to make more profit without considering the effect of output restriction on the other firm. This will cause a problem called “double marginalization.” A merger in such a case solves the double marginalization problem and makes both producers and consumers better off.

Double marginalization: Double marginalization is a vertical externality that occurs when two firms with market power in the same supply chain apply a margin to their prices. Thus, it refers to the distortion caused by the successive markups of independent firms within the supply chain.

In terms of social welfare, integrating the two vertically-related monopoly firms benefits everyone because the merger results in lower prices, increased consumer surplus, and higher total profits. More goods are sold at a lower price, contributing to a positive impact on consumer welfare.

The figüre 6.4 (Figure 6.4 Double Marginalization, page 188) illustrates the gains from the merger by showing the redistribution of the retailer's profit (refɡ area) to consumers as post-merger consumer surplus. Additionally, consumers gain the area “fɡi”. The manufacturer experiences a doubling of profits from the “wrɡy” area to the “wrib” area. These changes more than offset the retailer's loss of profits (the refɡ area)

Vertical restraints refer to restrictions on competition in vertical agreements between firms operating at different levels of production.

Basically, there are 4 different types of vertical restraints. These are;

Resale price maintenance (RPM): “RPM refers to any attempt by an upstream manufacturer or distributor to control the price at which the product is resold, after the original sale contract”.

Territorial Restrictions: Territorial restriction can simply be defined as the division of downstream markets into a set of territorial monopolies, each assigned to one retailer.

Exclusive Dealing: An exclusive dealing contract requires that the retailer sells only the manufacturer’s brand from which it is purchasing. It is generally imposed by an upstream manufacturer to a downstream retailer or an intermediate producer.

Tying: Tying occurs when a manufacturer requests the buyer of one product to purchase all the requirements of another product from the same manufacturer.

Tying occurs when a manufacturer requests the buyer of one product to purchase all the requirements of another product from the same manufacturer.An example is the sale of motion picture projectors together with movies made by the same company.

The rationale behind signing contracts that limit retail competition, despite the potential benefits of reduced double marginalization through retail competition, is explained by the presence of a horizontal externality. In situations where the product is not a perfect substitute at different retailers (e.g., due to location differences), the promotion and services provided by one retailer benefit others in the vicinity.

For example, if an automotive brand dealer puts the brand banners on billboards, this could increase the demand for all brand dealers in the vicinity. Similarly, suppose a phone dealer offers information about a phone to its customers. In that case, these customers can purchase the phone from another dealer that does not provide such service but offers the phone at a discount. For every retailer of a particular brand, there is a temptation to enjoy a free ride on the services provided by other sellers of the same brand, and retailers will likely keep the level of such services very low. Therefore, manufacturers may limit retail competition to solve the free-riding problem in services.

Exclusive selling and territorial arrangements aim to limit intra-brand competition between downstream dealers. In these arrangements, the manufacturer agrees not to sell the product through other retailers. This could involve granting exclusive rights to a single retailer or signing agreements with multiple dealers that restrict other dealers from selling within a specified distance. The upstream firm imposes these restrictions to control the distribution and sales of its products.

Yes, Apple is one of the world-famous examples of vertical integration. Apple exemplifies vertical integration through its control over the production and distribution of its products. Apple develops its own hardware, software, and services, enabling more control over the supply chain and the ability to shape products according to the company's vision. Additionally, Apple owns retail stores, further indicating its control over product distribution and customer experience.