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New Perspectives on Industrial Organization pp 521–566Cite as

Horizontal, Vertical, and Conglomerate Mergers

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Abstract

The immediate and most dramatic way for a company to expand its size and influence market structure is to purchase another company. Historical examples abound. In the late 1800s, Standard Oil Company gained a 90% share of the petroleum market by purchasing more than 120 competitors. In the 1960s, ITT (International Telephone and Telegraph) became a diversified corporation by acquiring 52 domestic and 55 foreign companies, including such well-known businesses as Avis Rent-a-Car, Continental Baking (Wonder Bread), Hartford Insurance, and Sheraton Hotels. By 1968, ITT had become the 11th largest corporation in the USA. The recent financial crisis has forced a number of very large acquisitions. The largest of these occurred in 2008, with Bank of America purchasing Merrill Lynch, a provider of insurance and financial services, for $50 billion and Wells Fargo Bank purchasing Wachovia Bank for $15.1 billion.

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Notes

  1. 1.

    Technically, an acquisition happens when one company buys another. Acquisitions are sometimes hostile (i.e., hostile takeovers). This occurs when management of the targeted firm resists being purchased by the acquiring firm. A merger occurs when companies become a single new company. These are sometimes called “mergers of equals,” because typically the companies involved are of similar size.

  2. 2.

    Notice that product and market extension mergers are related to horizontal mergers, because the firms involved are imperfect competitors in the product extension case and potential competitors in the market extension case. Thus, they can have greater antitrust consequences, as we will see in Chap. 20.

  3. 3.

    This begs the question of how close is close, a question that is difficult to answer in practice. Certainly, vanilla ice cream and strawberry ice cream are close enough substitutes such that a merger between a supplier of vanilla and a supplier of strawberry ice cream would be considered a horizontal merger. But what about a merger between an ice cream parlor and a bakery? Clearly, judgment calls must be made.

  4. 4.

    Antitrust implications are discussed in the next chapter.

  5. 5.

    For a more complete discussion of US merger waves, see Scherer and Ross (1990) and Martin (2007a, b).

  6. 6.

    National and state corporate income tax rates are available from the Tax Foundation, http://www.taxfoundation.org/taxdata/show/23034.html.

  7. 7.

    For early discussions of this problem, see Berle et al. (1932) and Marris (1964). For more recent surveys of the principle–agent problem, see Rees (1985a, b), Eisenhardt (1989), and Shleifer and Vishny (1997).

  8. 8.

    Part of this gain could have been caused by cost efficiencies. For further discussion of this merger, see Scherer and Ross (1990) and Greer (1992).

  9. 9.

    Of course, not all models give the same prediction. In the homogeneous Bertrand model with symmetric firms, a merger short of monopoly will have no effect on prices and profits.

  10. 10.

    More precisely, the following condition must hold for a merger to be profitable, \( m \ >\ n + {1}.{5}\sqrt {{5 + 4n}} /2 \). For example, m must be greater than 80% of n when n = 5 firms, 81.5% when n = 10, and 91.4% when n = 100.

  11. 11.

    This conclusion would also hold in a Bertrand model where firms compete in price instead of output. In the Bertrand case, as long as m < n, the Bertrand price remains at marginal cost. In this model, market power is nonexistent, and a horizontal merger cannot increase market power as long as more than one firm remains.

  12. 12.

    Alternatively, this may occur because the larger firm is more patient in bargaining than the smaller firm, as we discussed in Chap. 3.

  13. 13.

    We postpone our discussion of equity issues until Chap. 19.

  14. 14.

    It involved the 1979 merger between the Xidex and Kalvar corporations, producers of microfilm. This merger was successfully challenged by the Federal Trade Commission. Barton and Sherman (1984) demonstrated that it led to higher output prices and greater market power.

  15. 15.

    For a more complete review of behavioral issues as they apply to finance, see Barberis and Thaler (2003, Farmer and Lo (1999), Lo (2004), and Malkiel (2011)).

  16. 16.

    Dafny (2009) also criticizes the event study approach for failing to correct for endogeneity. With such a correction, he finds that hospital mergers between local competitors lead to higher prices.

  17. 17.

    Other studies include Borenstein (1990) and Singal (1996).

  18. 18.

    A substantial merger was defined as one that increases the Herfindahl–Hirschman index (HHI) by at least 200 points. For example, if a market consists of ten equal size firms, they each have a market share of 10%. If two firms merge, this increases HHI by 200 points (2·10·10). That is, before the merger HHI = 1,000 (10·102), and after the merger HHI = 1,200 (202 + 8·102). See Chap. 8 for further discussion of HHI.

  19. 19.

    These were near median size for mergers of the period. Many involved conglomerate firms that also competed in a horizontal market. They include Proctor & Gamble and Tambrands (in 1997, producers of sanitary products), Guinness and Grand Metropolitan (1997, alcoholic beverages), Pennzoil and Quaker State (1998, motor oil), General Mills and Ralcorp (1997, breakfast cereal), and Aurora Foods and Craft’s Breakfast Syrup Business (1997, pancake syrup).

  20. 20.

    They used a linear programming technique, called data envelopment analysis. This technique of estimating frontier production and cost functions is discussed in Färe et al. (1985, 2008).

  21. 21.

    Complementary goods must also be available to consumers. For example, cameras need batteries, and automobiles need gas and oil.

  22. 22.

    Given that the literature is so extensive, we focus on the main benefits and costs. Other possible reasons for vertical integration include a desire to avoid taxes and regulations. For a more complete description, see Waldman and Jensen (2006, Chap. 16), Rey and Tirole (2007), and Pepall (2008, Chaps. 17–19).

  23. 23.

    This derives from Smith’s (1776) insight that the division of labor is limited by the size of the market.

  24. 24.

    For further discussion, see Thomas (1977) and Langlois and Robertson (1989). Langlois and Robertson argue that Ford was later forced to vertically integrate once again due to the rapid success of its Model T and delays in delivery of key inputs.

  25. 25.

    Another solution would be to have the buyer pay in full before production is begun on a custom good. When it is costly to specify all product characteristics, this creates another problem. The seller has an incentive to cut costs by lowering quality.

  26. 26.

    Much like the welfare analysis of advertising that we discussed in Chap. 15, an increase in service quality is more likely to be welfare improving when it leads to a parallel shift in demand and is more likely to lower welfare when it rotates demand clockwise (Scherer 1983; Comanor 1985). For an excellent survey of this literature, see Waldman and Jensen (2006, Chap. 16).

  27. 27.

    We will see that the most efficient outcome is when all input and output markets are competitive.

  28. 28.

    With three stages and a monopolist at each stage, there is triple marginalism.

  29. 29.

    See Chaps. 3 and 11 for a review of the use of backwards induction to identify the SPNE.

  30. 30.

    This is sometimes called the Chicago School critique of early concerns that vertical mergers can enhance market power. As we discussed in Chap. 1, the Chicago School is skeptical that government policy can produce net social benefits. For further discussion, see Posner (1976), Bork (1978), and Riordan (1998).

  31. 31.

    A variable proportions technology is characterized by a convex isoquant. This implies a certain amount of substitutability between inputs, as with steel and aluminum in automobile production. As the price of steel increases, cost-minimizing manufacturers will substitute aluminum for steel. A fixed-proportion technology implies that inputs are perfect complements and are characterized by right-angled isoquants. This characterizes tires and car chassis. Four tires are used with each chassis, regardless of the relative prices of tires and chassis. For further discussion, see Varian (2010, Chap. 10).

  32. 32.

    This sometimes takes the form of a franchising fee (Caves and Murphy 1976; Rubin 1978). A franchise contract between a wholesaler and retailer frequently gives the retailer the legal right to sell the wholesaler’s product, requires that the wholesaler provide sales training to the retailer, specifies the level of sales effort, and specifies a nonlinear payment contract. Typically, this will include a fixed franchise fee and a split of retail revenues. Contracts such as these are common practice in the fast-food industry, where companies like McDonald’s have a franchise contract with retailers for the right to distribute McDonald’s food.

  33. 33.

    Although often used interchangeably, cement is an input for concrete. Cement is a powered substance made from limestone and clay. Concrete is produced by mixing cement, sand, gravel, and water.

  34. 34.

    This quote is taken from Stelzer (1976, 133). For further discussion of this case, see Waldman (1986).

  35. 35.

    In addition, Ordover et al. (1990) show that vertical foreclosure can harm competition when products are differentiated.

  36. 36.

    Given the benefits of learning, a merger is likely to be cheaper than opening up a brand new store, σ M ≤ σ PE. If they are unequal, this will remain a unique SPNE as long as σ M < 70 and σ PE > 30.

  37. 37.

    For a more complete discussion, see Vernon and Graham (1971), Schmalensee (1973), Blair and Kaserman (1983), and Salinger (1988).

  38. 38.

    In 1970, cigarette ads were as common as beer ads are today. Beginning in 1971, the federal government severely limit cigarette advertising, making it illegal to advertise outdoors and on television and radio (Chaloupka 2007; Iwasaki and V. Tremblay 2009).

  39. 39.

    That is, four outcomes are possible and each is equally likely to occur: (1) no eggs are broken; (2) all eggs are broken; (3) child 1 breaks the eggs but not child 2; (4) child 2 breaks the eggs but not child 1. Thus, there is a 1 in 4 chance that none of the eggs arrive safely.

  40. 40.

    Federal Trade Commission v. Procter & Gamble Co., (1967). For further discussion of this case, see Waldman (1986).

  41. 41.

    For further discussion, see Business Week (November 8, 1976) and Elzinga (1990).

  42. 42.

    When information is incomplete and monitoring costs are high, Thomas and Willig (2006) find that firms will be unwilling to link strategies across markets.

  43. 43.

    In 1988, Clorox produced laundry bleach, wood stain, restaurant equipment, bottled water, and frozen foods. For further discussion, see Levine (1988), Lappen (1988), Shao (1991), and Hamilton (1997).

  44. 44.

    For further discussion, see Newton (2006). For a list of Time Magazine’s top ten corrupt CEOs over the last decade, see http://www.time.com/time/specials/packages/completelist/0,29569,1903155,00.html#ixzz0zSZrWJXl.

  45. 45.

    See Marris (1964) and Mueller (1969) for further discussion.

  46. 46.

    PR Newswire, March 10, 2011, available at http://www.highbeam.com/doc/1G1-251110190.html/print, accessed September 20, 2010.

  47. 47.

    For a review of the psychology literature, see Malmendier and Tate (2008).

  48. 48.

    Bogan and Just (2009) argue that confirmation bias, where individuals attach too much (little) importance on information that confirms (refutes) their beliefs, can also affect a CEO’s merger decision. It is unclear whether this will lead to more or less merger activity.

  49. 49.

    For a review of the evidence, see Caves (1989), Montgomery (1994), Martin and Sayrak (2003), and Mueller (2006).

  50. 50.

    Given fixed proportions, wholesale and retail output are the same.

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Authors and Affiliations

  1. Department of Economics, Oregon State University, Corvallis, Oregon, USA

    Victor J. Tremblay & Carol Horton Tremblay

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Appendix A: The Economics of Double Marginalism

Appendix A: The Economics of Double Marginalism

Here, we formally analyze the economics of double marginalism by considering the problem described in Sect. 18.4.1.5. This is a market for gasoline with a monopoly manufacturer or wholesaler (W) and a monopoly distributor or retailer (R). Gasoline is supplied using a fixed-proportions technology. The total cost of wholesaling is TCW = c W Q, where c W is marginal and average cost and Q is output. The retailer pays the wholesale price of gasoline, and there are no added costs to the retailer of doing business. Thus, the retailer’s total cost is TCR = c R Q, where cR is the retailer’s marginal and average cost. Because there are no added costs of retailing, c R = p W, the wholesale price of gas. The inverse demand at the retail level is linear: p R = a – bQ, where p R is the retail price.Footnote 50 Firms compete in a two-stage game. In the first stage, the wholesaler sets its price. In the second stage, the retailer chooses its output level given the wholesale price of gasoline.

We use backwards induction to identify the SPNE. The problem in the second stage is for the retailer to maximize its profit (π R), given p W. The firm’s profit equation is

$$ \begin{array}{ccccccc}{\pi_{\rm{R}}} = {\hbox{T}}{{\hbox{R}}_{\rm{R}}} - {\hbox{T}}{{\hbox{C}}_{\rm{R}}} \\ = {p_{\rm{R}}}Q - {c_{\rm{R}}}Q = (aQ - b{Q^2}) - {c_{\rm{R}}}Q. \end{array} $$
(A.1)

Recalling that c R = p W, the first-order condition of profit maximization is

$$ \begin{array}{ccccccc} \frac{{\partial {\pi_{\rm{R}}}}}{{\partial Q}} = \frac{{\partial {\text{T}}{{\text{R}}_{\rm{R}}}}}{{\partial Q}} - \frac{{\partial {\text{T}}{{\text{C}}_{\rm{R}}}}}{{\partial Q}} \\ = {\hbox{M}}{{\hbox{R}}_{\rm{R}}} - {\hbox{M}}{{\hbox{C}}_{\rm{R}}} \\ = (a - 2bQ) - {p_{\rm{W}}} = 0,\end{array}$$
(A.2)

where MRR is the retailer’s marginal revenue and MCR is the retailer’s marginal cost. Solving for Q gives the retailer’s best-reply function (Q BR)

$$ {Q^{\rm{BR}}} = \frac{{a - {p_{\rm{W}}}}}{{2b}}. $$
(A.3)

Notice that if the retailer owns the wholesaler or if the wholesale price equals MCW, then this would be the simple monopoly solution.

Next, we solve the wholesaler’s problem. The wholesaler is assumed to be sequentially rational and can look forward and reason back. This enables it to identify the retailer’s best-reply and maximize its profits given Q BR. From the wholesaler’s perspective, Q BR is the wholesaler’s demand. Solving (A.3) for p W gives the wholesaler’s inverse demand: p W = a – 2bQ. Notice that it equals MRR (from A.2). The wholesaler’s profit equation is

$$ \begin{array}{ccccccc} {\pi_{\rm{W}}} = {\hbox{T}}{{\hbox{R}}_{\rm{W}}} - {\hbox{T}}{{\hbox{C}}_{\rm{W}}} \\ = {p_{\rm{W}}}{Q^{\rm{BR}}} - {c_{\rm{W}}}{Q^{\rm{BR}}} = \left( {{p_{\rm{W}}} - {c_{\rm{W}}}} \right){Q^{\rm{BR}}} \\ = \left( {{p_{\rm{W}}} - {c_{\rm{W}}}} \right)\left( {\frac{{a - {p_{\rm{W}}}}}{{2b}}} \right). \end{array}$$
(A.4)

The first-order condition with respect to p W is

$$ \begin{array}{ccccccc} \frac{{\partial {\pi_{\rm{W}}}}}{{\partial {p_{\rm{W}}}}} = \frac{{\partial {\text{T}}{{\text{R}}_{\rm{W}}}}}{{\partial {p_{\rm{W}}}}} - \frac{{\partial {\text{T}}{{\text{C}}_{\rm{W}}}}}{{\partial {p_{\rm{W}}}}} \\ = {\hbox{M}}{{\hbox{R}}_{{p{\rm{W}}}}} - {\hbox{M}}{{\hbox{C}}_{{p{\rm{W}}}}} \\ = \left( {\frac{{a - 2{p_{\rm{W}}}}}{{2b}}} \right) + \left( {\frac{{{c_{\rm{W}}}}}{{2b}}} \right) = 0, \end{array}$$
(A.5)

where MR pW is the wholesaler’s marginal revenue with respect to price, and MC pW is the wholesaler’s marginal cost with respect to price. Solving this for p W gives the profit-maximizing wholesale price. Substituting this value into Q BR and the demand and profit equations gives the other SPNE values:

$$ p_{\rm{R}}^{*} = \frac{{3a + {c_{\rm{W}}}}}{4} \,>\, p_{\rm{W}}^{*} = \frac{{a - {c_{\rm{W}}}}}{2}, $$
(A.6)
$$ {Q^{*}} = \frac{{a - {c_{\rm{W}}}}}{{4b}}, $$
(A.7)
$$ \pi_{\rm{R}}^{*} = \frac{{{{(a - {c_{\rm{W}}})}^2}}}{{16b}}\, < \,\pi_{\rm{W}}^{*} = \frac{{{{(a - {c_{\rm{W}}})}^2}}}{{8b}}, $$
(A.8)
$$ \pi_{\rm{R}}^{*} + \pi_{\rm{W}}^{*} = \frac{{3{{(a - {c_{\rm{W}}})}^2}}}{{16b}}. $$
(A.9)

If the firms were to merge, this would produce the simple monopoly solution:

$$ p_{\rm{R}}^{{**}} = \frac{{a + {c_{\rm{W}}}}}{2}, $$
(A.10)
$$ {Q^{{**}}} = \frac{{a - {c_{\rm{W}}}}}{{2b}}, $$
(A.11)
$$ {\pi^{{**}}} = \frac{{4{{(a - {c_{\rm{W}}})}^2}}}{{16b}}. $$
(A.12)

This demonstrates the principle of double marginalism: compared to a single merged firm, separate wholesale and retail monopolies are (1) less efficient because Q ** > Q *; (2) less profitable (\( {\pi^{{**}}}\, >\, \pi_{\rm{R}}^{*} + \pi_{\rm{W}}^{*} \)), providing an incentive for vertical merger; (3) bad for consumers, because the retail price is lower and production is greater with the merger. Notice too that this problem is similar to the problem of complementary products that we discussed in Chap. 13.

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Tremblay, V.J., Tremblay, C.H. (2012). Horizontal, Vertical, and Conglomerate Mergers. In: New Perspectives on Industrial Organization. Springer Texts in Business and Economics. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-3241-8_18

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