Chapter 2: Horizontal mergers in oligopoly
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Mergers are a very important empirical phenomenon and form an important part of firms’ strategies: we see daily merger announcements in the business press. There can be several different motives for mergers. Apart from an attempt to gain market shares and market power, mergers can seek efficiency gains through the combination of different assets, or by getting access to new technologies and know-how; they can also seek to reach new groups of consumers or new geographical markets, showing a desire for diversification; in other cases, mergers can also seek to safeguard access to important inputs. When studying mergers, we have to be cautious because there are different types of mergers that require different theoretical treatments. The first distinction is between conglomerate, horizontal and vertical mergers. In this chapter, we focus on horizontal mergers, that is, mergers between firms that are direct competitors. Conglomerate mergers are mergers that take place between firms operating in unrelated markets, whereas vertical mergers occur between firms operating at successive stages of the production process. Horizontal mergers reduce competition. Mergers whose only aim is to reduce competition (or to gain market power) create the following free-riding problem. The reduction of competition due to a merger works as a public good that benefits all the firms in the industry, while the costs are only supported by the merging parties. This implies that non-merging firms benefit more from the merger than merging firms. Therefore, firms want competitors to merge. This result does not depend on the type of competition being either Bertrand or Cournot, however, the problem is more acute in a Cournot setting, where mergers may turn out to be unprofitable, i.e. the joint profits of the merging firms before the merger are higher than their joint profits after the merger. The explanation is the aggressive response of outsiders, which react to the output reduction by the merging firms by increasing their own output (quantities are strategic substitutes). This point was first raised by Salant, Switzer and Reynolds (1983). This response is so unexpected that it is usually known as the “merger paradox”. It originated a huge literature that tried to obtain profitable mergers in a Cournot setting. For example, profitability of mergers increases if either demand or costs become more convex.

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