Why Do Firms Merge?
Is it all about market power? No.
The most serious Economic Forces fans will have realized that Josh did two newsletters in a row. He stepped in for me since I was sleep deprived with baby #2, who we welcomed last week. Baby, Mama, and the whole gang are doing great, and we are all excited that the hair genes were passed on.
Anyways, babies apparently don’t become great sleepers in two weeks, so I’m still in no state to write something intelligent from scratch. (Are you ever? ask the haters.) Next time, I’ll have a new explainer of the theory and evidence of markups. Drop any questions you have about markups in the comments.
But that’s for the future. This week’s newsletter is an edited version of a post that I originally wrote for Truth on the Market, but it fits the Economic Forces vibe.
What should be our prior about mergers?
A recent viral video captures a prevailing sentiment in certain corners of social media, and among some competition scholars, about how mergers supposedly work in the real world: firms start competing on price, one firm loses out, that firm agrees to sell itself to the other firm and, finally, prices are jacked up. (Warning: Keep the video muted. The voice-over is painful.)
The story ends there. In this narrative, the combination offers no possible cost savings. The owner of the firm who sold doesn’t start a new firm and begin competing tomorrow, and nor does anyone else. The story ends with customers getting screwed.
And in this telling, it’s not just horizontal mergers that look like the one in the viral egg video. It is becoming a common theory of harm regarding nonhorizontal acquisitions that they are, in fact, horizontal acquisitions in disguise. The acquired party may possibly, potentially, with some probability, in the future, become a horizontal competitor. And of course, the story goes, all horizontal mergers are anticompetitive.
Therefore, we should have the same skepticism toward all mergers, regardless of whether they are horizontal or vertical. Steve Salop has argued that a problem with the Federal Trade Commission’s (FTC) 2020 vertical merger guidelines is that they failed to adopt anticompetitive presumptions.
This perspective is not just a meme on Twitter. The FTC and U.S. Justice Department (DOJ) are currently revising their guidelines for merger enforcement and have issued a request for information (RFI). The working presumption in the RFI (and we can guess this will show up in the final guidelines) is exactly the takeaway from the video: Mergers are bad. Full stop.
The RFI repeatedly requests information that would support the conclusion that the agencies should strengthen merger enforcement, rather than information that might point toward either stronger or weaker enforcement. For example, the RFI asks:
What changes in standards or approaches would appropriately strengthen enforcement against mergers that eliminate a potential competitor?
This framing presupposes that enforcement should be strengthened against mergers that eliminate a potential competitor.
Do Monopoly Profits Always Exceed Joint Duopoly Profits?
Should we assume enforcement, including vertical enforcement, needs to be strengthened? In a world with lots of uncertainty about which products and companies will succeed, why would an incumbent buy out every potential competitor? The basic idea is that, since profits are highest when there is only a single monopolist, that seller will always have an incentive to buy out any competitors.
The punchline for this anti-merger presumption is “monopoly profits exceed duopoly profits.” The argument is laid out most completely by Salop, although the argument is not unique to him. As Salop points out:
I do not think that any of the analysis in the article is new. I expect that all the points have been made elsewhere by others and myself.
Under the model that Salop puts forward, there should, in fact, be a presumption against any acquisition, not just horizontal acquisitions. He argues that:
Acquisitions of potential or nascent competitors by a dominant firm raise inherent anticompetitive concerns. By eliminating the procompetitive impact of the entry, an acquisition can allow the dominant firm to continue to exercise monopoly power and earn monopoly profits. The dominant firm also can neutralize the potential innovation competition that the entrant would provide.
We see a presumption against mergers in the recent FTC challenge of Meta’s purchase of Within. While Meta owns Oculus, a virtual-reality headset and Within owns virtual-reality fitness apps, the FTC challenged the acquisition on grounds that:
The Acquisition would cause anticompetitive effects by eliminating potential competition from Meta in the relevant market for VR dedicated fitness apps.
Given the prevalence of this perspective, it is important to examine the basic model’s assumptions. In particular, is it always true that—since monopoly profits exceed duopoly profits—incumbents have an incentive to eliminate potential competition for anticompetitive reasons?
I will argue no. The notion that monopoly profits exceed joint-duopoly profits rests on two key assumptions that hinder the simple application of the “merge to monopoly” model to antitrust.
First, even in a simple model, it is not always true that monopolists have both the ability and incentive to eliminate any potential entrant, simply because monopoly profits exceed duopoly profits.
For the simplest complication, suppose there are two possible entrants, rather than the common assumption of just one entrant at a time. The monopolist must now pay each of the entrants enough to prevent entry. But how much? If the incumbent has already paid one potential entrant not to enter, the second could then enter the market as a duopolist, rather than as one of three oligopolists. Therefore, the incumbent must pay the second entrant an amount sufficient to compensate a duopolist, not their share of a three-firm oligopoly profit. The same is true for buying the first entrant. To remain a monopolist, the incumbent would have to pay each possible competitor duopoly profits.
Because monopoly profits exceed duopoly profits, it is profitable to pay a single entrant half of the duopoly profit to prevent entry. It is not, however, necessarily profitable for the incumbent to pay both potential entrants half of the duopoly profit to avoid entry by either.
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Now go back to the video. Suppose two passersby, who also happen to have chickens at home, notice that they can sell their eggs. The best part? They don’t have to sit around all day; the lady on the right will buy them. The next day, perhaps, two new egg sellers arrive.
For a simple example, consider a Cournot oligopoly model with an industry-inverse demand curve of P(Q)=1-Q and constant marginal costs that are normalized to zero. In a market with N symmetric sellers, each seller earns 1/((N+1)^2) in profits. A monopolist makes a profit of 1/4. A duopolist can expect to earn a profit of 1/9. If there are three potential entrants, plus the incumbent, the monopolist must pay each the duopoly profit of 3*1/9=1/3, which exceeds the monopoly profits of 1/4.
In the Nash/Cournot equilibrium, the incumbent will not acquire any of the competitors, since it is too costly to keep them all out. With enough potential entrants, the monopolist in any market will not want to buy any of them out. In that case, the outcome involves no acquisitions.
If we observe an acquisition in a market with many potential entrants, which any given market may or may not have, it cannot be that the merger is solely about obtaining monopoly profits, since the model above shows that the incumbent doesn’t have incentives to do that.
If our model captures the dynamics of the market (which it may or may not, depending on a given case’s circumstances) but we observe mergers, there must be another reason for that deal besides maintaining a monopoly. The presence of multiple potential entrants overturns the antitrust implications of the truism that monopoly profits exceed duopoly profits. The question turns instead to empirical analysis of the merger and market in question, as to whether it would be profitable to acquire all potential entrants.
The second simplifying assumption that restricts the applicability of Salop’s baseline model is that the incumbent has the lowest cost of production. He rules out the possibility of lower-cost entrants in Footnote 2:
Monopoly profits are not always higher. The entrant may have much lower costs or a better or highly differentiated product. But higher monopoly profits are more usually the case.
If one allows the possibility that an entrant may have lower costs (even if those lower costs won’t be achieved until the future, when the entrant gets to scale), it does not follow that monopoly profits (under the current higher-cost monopolist) necessarily exceed duopoly profits (with a lower-cost producer involved).
One cannot simply assume that all firms have the same costs or that the incumbent is always the lowest-cost producer. This is not just a modeling choice but has implications for how we think about mergers. As Geoffrey Manne, Sam Bowman, and Dirk Auer have argued:
Although it is convenient in theoretical modeling to assume that similarly situated firms have equivalent capacities to realize profits, in reality firms vary greatly in their capabilities, and their investment and other business decisions are dependent on the firm’s managers’ expectations about their idiosyncratic abilities to recognize profit opportunities and take advantage of them—in short, they rest on the firm managers’ ability to be entrepreneurial.
Given the assumptions that all firms have identical costs and there is only one potential entrant, Salop’s framework would find that all possible mergers are anticompetitive and that there are no possible efficiency gains from any merger. That’s the thrust of the video. We assume that the whole story is two identical-seeming women selling eggs. Since the acquired firm cannot, by assumption, have lower costs of production, it cannot improve on the incumbent’s costs of production.
Many Reasons for Mergers
But whether a merger is efficiency-reducing and bad for competition and consumers needs to be proven, not just assumed.
If we take the basic acquisition model literally, every industry would have just one firm. Every incumbent would acquire every possible competitor, no matter how small. After all, monopoly profits are higher than duopoly profits, and so the incumbent both wants to and can preserve its monopoly profits. The model does not give us a way to disentangle when mergers would stop without antitrust enforcement.
Mergers do not affect the production side of the economy, under this assumption, but exist solely to gain the market power to manipulate prices. Since the model finds no downsides for the incumbent in acquiring a competitor, it would naturally acquire every last potential competitor, no matter how small, unless prevented by law.
I would argue that my model above is what I’ve called in a paper with Brian Kogelmann a “model as foil.” It is meant as a contrast, or a foil, of the real world, not as a depiction of the real world directly. The model generates a prediction that is completely out of step with reality: complete mergers of all firms. The absurd conclusion then tells us that we need to go back to the drawing board and see which assumption needs to change.
I would argue the assumption that all firms have the same productivity and that mergers do not improve productivity is the problem. We need to take the cost side seriously.
Once we allow for the possibility that firms differ in productivity, however, it is no longer true that monopoly profits are greater than industry duopoly profits. We can see this most clearly in situations where there is “competition for the market” and the market is winner-take-all. If the entrant to such a market has lower costs, the profit under entry (when one firm wins the whole market) can be greater than the original monopoly profits. In such cases, monopoly maintenance alone cannot explain an entrant’s decision to sell.
An acquisition could therefore be both procompetitive and increase consumer welfare. For example, the acquisition could allow the lower-cost entrant to get to scale quicker. The acquisition of Instagram by Facebook, for example, brought the photo-editing technology that Instagram had developed to a much larger market of Facebook users and provided a powerful monetization mechanism that was otherwise unavailable to Instagram.
In short, the notion that incumbents can systematically and profitably maintain their market position by acquiring potential competitors rests on assumptions that, in practice, will regularly and consistently fail to materialize. It is thus improper to assume that most of these acquisitions reflect efforts by an incumbent to anticompetitively maintain its market position.
In other competition policy news, I’m in National Review Online this week, talking about the FTC and price discrimination.
And one more baby photo for good measure. Thanks, readers!