Recent developments in Recent developments in (or random thoughts about) (or random thoughts about)

Merger AnalysisMerger Analysis

Luke M. FroebVanderbilt University

Office of Fair Trading, June 19, 2006

AcknowledgementsAcknowledgementsMalcolm Coate, FTCGregory Werden, US Department of JusticePaul Pautler, FTCDaniel Hosken, FTCChris Taylor, FTC

OutlineOutline

I. merger enforcement statisticsII. If merger is answer, what is question?III. Backlash against structural merger modelsIV. Lessons from consummated mergersV. FTC/DOJ Commentary on Horizontal Merger GuidelinesVI. Price-Concentration empirical merger models

Type I ErrorType I Error

1957 P&G1957 P&G--Clorox (Bleach)Clorox (Bleach)

Clorox dominant producer of bleachP&G makes household items, but not bleachFTC challenged merger because– P&G was most likely entrant into bleach– P&G was more efficient than other firms

…still waiting for P&G to enter

2000 Baby Food Merger2000 Baby Food Merger

2000: FTC Blocks $185 MM Merger Deal – Efficiency claims vs. 3 2 merger

2002: Heinz sells off baby food brands to Del Monte, including Natural Goodness

Ultimate fate of brand remains question.

Baby Food Shares Since MergerBaby Food Shares Since Merger

1013Beech-Nut

711Heinz (Del Monte after 12-02)

8073Gerber

Market Shares late 2003

Market Shares mid 2000

Firm

US Baby Food Market Shares

I. U.S. MERGER FILINGSI. U.S. MERGER FILINGS

0

500

1000

1500

2000

2500

3000

3500

4000

4500

500019

81

1982

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Year

Num

ber o

f HSR

Tran

sact

ions

January 2001 System

MERGER INVESTIGATION RATEMERGER INVESTIGATION RATE

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Year

2nd

Req

uest

s as

a P

erce

ntag

e of

Tot

al F

ilin

FTC Merger Challenges, 96FTC Merger Challenges, 96--0303

0

10

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90

2 to 1 3 to 2 4 to 3 5 to 4 6 to 5 7 to 6 8+ to 7+

Significant Competitors

Num

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f Mar

kets

Enforced Closed

US. vs. EC US. vs. EC

US looks tougher than EC– US enforcement85% (2nd requests)

2 1 + 3 2 mergers

– EC enforcement60% (Phase II)Enforced + withdrawn (Mats Bergman)

But US investigates (2nd requests) at lower rate– Actual enforcement may be much closer

Merger Challenge PredictorMerger Challenge Predictor

Malcolm Coate & Shawn Ulrick (FTC), TRANSPARENCY AT THE FEDERAL TRADE COMMISSION: THE HORIZONTAL MERGER REVIEW PROCESS 1996–2003– Antitrust Law Journal, 2005

Demo

II. If merger is the answer, II. If merger is the answer, What is the question?What is the question?

Rule-of-thumb merger analysis– Are customers complaining?– Will merger lead to price increase? – Is there a benign reason for merger?

Most internal documents do a TERRIBLE job of articulating merger motive– Brain-damaged, middle-management?

Do Mergers Move Assets to Do Mergers Move Assets to HigherHigher--valued Uses?valued Uses?

Capitalism 101: Wealth is created when assets move to higher valued uses– Voluntary transactions create wealth

Stock-market event studies estimate 75% of mergers do NOT create value.– Target shareholders gain--but less than

acquiring firms lose– Experience reading internal merger documents

Why is it so hard to document value-creation?

Uplifting Merger Story:Uplifting Merger Story:DellDell--AlienwareAlienware

Companies were competitors, but…– Alienware makes liquid-cooled, high-end gaming

computers– Dell makes full line of computers.

BIG and obvious synergy– Alienware keeps design, design, sales, marketing, and

support of brand in separate Alienware Division– Dell manufactures Alienware machines

III. WhatIII. What’’s wrong with analysis s wrong with analysis based on market shares?based on market shares?

1. No bright line between “in” vs. “out” of market2. Market Shares in market may be poor proxies for competitive positions of firms3. Other mechanisms at work: entry, efficiencies, re-positioning1+2+3 Market shares and concentration are poor predictors of merger effectsAlso, no way to do benefit-cost analysis

Merger Analysis Requires Merger Analysis Requires Predictions about counterfactualPredictions about counterfactualTwo ways to do this.

Natural Experiments, e.g., in Staples-Office Depot case, mergers analogous to differences between one- and two-superstore cities.– Did you hold everything else constant?– How well does experiment mimic merger effect?

Model-based prediction– Model current competition– Predict loss of competition following merger

Bertrand (priceBertrand (price--only) Merger Modelonly) Merger Model

Assumptions: Differentiated products, constant MC, Nash equilibrium in prices.

Model current competition– Estimate demand elasticity– Recover costs from FOC’s (P-MC)/P =1/|elasticity|

Prediction: Post-merger, MR for the merging firms falls as substitute products steal share from each other– Merged firm responds by raising prices – Non-merging firms raise price sympathetically

Structural Model BacklashStructural Model Backlash

How reliable are model predictions?Test merger predictions against real mergers– Yes (Nevo, US breakfast cereal)– No (Peters, 3/5 US airlines; Weinberg, US motor

oil and breakfast syrup)Test model restrictions, i.e., does (p-mc)/p=1/|elas| ?– Yes (Werden, US bread; Slade, UK beer)

Backlash (cont.)Backlash (cont.)

Does model leave out features that bias its predictions?– Static, Price-only competition, MC constant

Research finds that ignoring…– demand curvature can under- or overstate merger effect– retail sector can under- or overstate merger effect– capacity constraints likely overstates merger effect– promotional competition likely understates merger

effect– repositioning likely overstates merger effect

Demand Curvature MattersDemand Curvature Matters

Following slide plots four demand curves between competition and monopoly– Observationally equivalent (same

Q,P,elasticity) at competition– But very different post-merger prices (monop.)

Take-away: big merger effects imply big pass-through rates

Demand Curvature (cont.)Demand Curvature (cont.)

Demand Curvature (cont.)Demand Curvature (cont.)

Recommendation– sensitivity analysis or a conservative form– Compute “Compensating MC Reductions”

(CMCR’s); they depend only on elasticity

Demand Curvature (cont.) Demand Curvature (cont.)

Contract with third party that penalizes merged firm for reductions in output (and rewards for increases)– Payment=CMCR*(Q0-Q)– Contract reduces effective MC to exactly offset

incentive to raise price– Allows realization of fixed cost merger savings

In a static world, Expected[payment]=0

Retail sector mattersRetail sector mattersfor upstream mergersfor upstream mergers

When is retail sector transparent?– Constant or constant percentage markup– two-part tariffs, and retail sector must carry

profitable productsRetail sector earns no profit

When does it affect upstream merger price?– Double marginalization price effect– Two-part tariffs, and option of exclusivity

no price effect

Capacity Constraints MatterCapacity Constraints Matter

Capacity constraints on non-merging firms amplify merger effect– Recognized by Horizontal Merger Guidelines

Capacity constraints on merging firms attenuate merger effect– Much bigger effect– Intuition: if I price to fill the parking lot, how

does profit calculus change post-merger?

Promotional Competition Promotional Competition MattersMatters

Ignoring promotion results in prediction BIAS.– “estimation bias” (estimated demand is too price-

elastic); and – “extrapolation bias” caused by assuming that post-

merger promotional activity does not change (it declines).

Predicted merger effect is too small (5% instead of 12%)– Bias depends on whether promotion makes demand

more or less elastic

ReRe--positioning matterspositioning matters

Berry and Waldfogel, “Do Mergers Increase Product Variety?”

– Radio stations change format post-merger to eliminate overlap– Clear Channel

Country music aims at middle-aged womenClassic rock aims at middle-aged menPop aims at young women

Sweeting “Too much rock n roll,” post-merger:– play lists of merged stations become more differentiated.– merged stations steal share from non-merging stations.– no increase in price of listening (commercials)

ReRe--positioning (cont.)positioning (cont.)Re-positioning by merged firms is more significant than re-positioning by non-merging firms– Similar to effects of capacity constraints.

Merged firms move apart– Pre-merger substitution pattern likely overstate loss of competition.– Non merging firms can do worse following merger– Consumers can be better or worse off

IV. Consummated Merger IV. Consummated Merger

Control Group: Pre-merger periodExperimental Group: Post-merger period

Did price increase?

BIG question: “Compared to what?”– Compared to “control” cities hit by the same

demand and cost shocks– Jargon: “Differences in Differences Estimation”

First difference: pre- vs. post-mergerSecond difference: target vs. control

MAPMAP--UDS (Oil merger)UDS (Oil merger)

Experimental CitiesLansing, MI: 17% + 13% DHHI=442Flint, MI: 23% + 7% DHHI=322

Control CitySouth Bend, IN DHHI=0

DifferencesDifferences--inin--Differences EstimationDifferences Estimation

Consummated Merger Consummated Merger EnforcementEnforcement

Once you have a post-merger price increase…– Can you pin it on the merger?– Crucial role for theory

AND supporting evidence

POLICY QUESTION: what are incentives created by consummated merger enforcement?

V. TheoryV. Theory--based Inferencebased Inference

Posit pro- and anti-competitive merger theoriesWhich one better explains the evidence?

Example: Merger in bargaining markets

Bargaining TheoryBargaining Theory

From Oracle-Peoplesoft trial:

“the area [that] is the most indeterminate in all of antitrust economics where you have negotiations between two parties. There is no determinate theory that predicts the outcome.”

Question: can economics predict effects of mergers in bargaining markets?

John NashJohn Nash’’s s ““Split the DifferenceSplit the Difference””TheoryTheory

Same problem confounded John Nash – Proved any “reasonable” solution would “split

the difference”Theorem: the gains relative to the alternatives determine the terms of any bargainImplication: If I can improve your gain; or worsen your alternative, I get more from you– Example: What happens if a manager offers a

$50 sales incentive to salespeople?

Implications of NashImplications of Nash’’s Theory s Theory for Provider Mergers?for Provider Mergers?

If merger changes alternatives to agreement, it also changes the terms of agreement.Example: Drugs bargaining with PBM to get onto a formulary.– If two substitutes bargain jointly, and no other

substitutes, merged company gets better priceEvidence: – How good are alternatives to merged provider?– Are payors (customers) complaining?

Bargaining Natural ExperimentBargaining Natural Experiment

“Any-willing-provider” (AWP) laws compel managed care plans to include any health care provider willing to accept plan’s terms

Theory: Threat of exclusion induces competition between providers to be included in “network.”

Prediction: Getting rid of threat increases price

Evidence: For states that adopt AWP, health care expenditures increase by 2%

FTC/DOJ FTC/DOJ Commentary on Commentary on Horizontal Merger GuidelinesHorizontal Merger Guidelines

Unilateral Merger effects come in all flavors– Price competition– Quantity competition’– Auctions– Bargaining

How does entry mitigates merger effect?– Entry induced by merger– Entry not-induced by merger

When does an outside alternative become so attractive that the merger is not a problem?

Still ambiguous about which welfare standard we use– Total vs. consumer

One observation about priceOne observation about price--concentration relationshipconcentration relationship

Can changes across markets better predict merger effect than changes over time within a market (caused by entry and exit).– Which kind of variation mimics merger effect?

Cross sectional correlation looks weaker than time time series correlation– Omitted cost variables in the cross section?– Omitted demand variables over time?

ReferencesReferencesFroeb, Luke, If Merger is the Answer, What is the Question? M&A Journal. (March, 2006) (pdf)*Werden, Gregory, Luke Froeb, and Steven Tschantz, Incentive Contracts as Merger Remedies, working paper (pdf)*Werden, Gregory J., Luke M. Froeb and Steven Tschantz, The Effects of Merger Efficiencies on Consumers, European Competition Journal, 1:2 (October, 2005) 245-264. (link)*Werden, Gregory J., Luke M. Froeb, and David T. Scheffman, A Daubert Discipline for Merger Simulation, Antitrust Magazine, 18:3 (Summer, 2004) pp. 89-95.(pdf)Werden, Gregory J., and Luke M. Froeb, Unilateral Competitive Effects of Horizontal Mergers, in Advances in Economics of Competition Law, Paolo Buccirossi (ed.), (Boston: MIT Press), 2005. (pdf)Froeb, Luke, and Steven Tschantz, Mergers among Firms that Manage Revenue, working paper. (pdf)Gandhi, Amit, Luke Froeb, Steven Tschantz, and Gregory Werden, Post-merger Product Repositioning, revise & resubmit from J. Industrial Economics. (pdf)Froeb, Luke and Steven Tschantz, and Gregory Werden, Pass Through rates and the Price Effects of Mergers, International Journal of Industrial Organization, 23 (2005) 703-715. (link)Tenn, Steven, Luke Froeb, and Steven Tschantz, Merger Effects When Firms Compete by Choosing Both Price and Advertising, Owen Working paper (6/20/01). pdfEvans, William, Luke Froeb, and Gregory Werden, Endogeneity in the Concentration-Price Relationship: Causes, Consequences, and Cures, Journal of Industrial Economics, 41 (September, 1993) 1-8.Froeb, Luke, Steven Tschantz & Philip Crooke, Bertrand Competition with Capacity Constraints: Mergers Among Parking Lots, Journal of Econometrics 113(1) (March, 2003) 49-67. (link)Crooke, Philip, Luke Froeb, Steven Tschantz, and Gregory Werden The Effects of Assumed Demand Form on Simulated Post-Merger Equilibria, Review of Industrial Organization, 15(3), (November, 1999) pp. 205-217. pdfWerden, Gregory, and Luke Froeb, The Entry-Inducing Effects of Horizontal Mergers, Journal of Industrial Economics, 46 (4), (1998) pp. 525-543.