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On the price effects of mergers with freer trade
International Journal of Industrial Organization 6 (1988) 233--246. North-Holland
ON THE PRICE EFFECTS
OF MERGERS
WITH FREER
TRADE*
T h o m a s W. R O S S Carleton University. Ottawa. Canada K I S 5B6
Final version received July 1987 This paper uses two models of imperfect competition to explore the price effects of mergers in an economy moving toward free trade. In a model of a domestic dominant oligopoly, mergers of domestic firms can have greater or smaller effects on price after tariffs have been reduced. With an international oligopoly, lower tariffs will serve to mitigate the price-raising effects of domestic mergers but to enhance the price effects of mergers that reduce the number of foreign firms. The implication is that freer trade may not always serve as a good substitute for an active competition policy.
1. Introduction Free (or at least freer) trade is a h o t topic in a n u m b e r of places these days. As the next r o u n d of G A T T negotiations begin, the talk in m a n y capitals is of lowering tariffs to e x p a n d trade and, it is hoped, to stimulate growth in the world e c o n o m y , C a n a d a and the U n i t e d States have gone so far as to a p p o i n t teams that are a t t e m p t i n g to negotiate a bilateral free trade agreement. F e w economists will dispute the fact that freer trade will raise national i n c o m e by allowing nations to capitalize on their c o m p a r a t i v e advantage. F o r certain smaller economies, there is a n o t h e r benefit said to a c c o m p a n y freer trade. W i t h reduced tariffs foreign firms will be better able to c o m p e t e with domestic firms for d o m e s t i c markets. This added c o m p e t i t i o n should, particularly in m o r e c o n c e n t r a t e d industries, serve to lower prices paid by domestic consumers. In a sense then, freer trade is seen as a substitute for a strong c o m p e t i t i o n policy. There are a large n u m b e r of cases in which this a r g u m e n t is doubtless correct. F o r example, if foreign firms are competitive and the d o m e s t i c price is set at the world price plus the tariff (i.e., domestic firms are price takers), reducing the tariff m u s t lower domestic price and will p e r h a p s cause s o m e *This paper originated in research done for the Bureau of Competition Policy, Consumer and Corporate Affairs Canada, and the author is grateful for the Bureau's financial support. He also wishes to acknowledge useful discussions with Michel Andrieu, James Brander, Richard Brecher, Avinash Dixit, Shyam Khemani, Benoit Long, Roger Ware and Robert Willig and several helpful comments from two anonymous referees. Aslam Anis provided valuable research assistance with this work. 0167-7187/88/$3.50 © 1988, Elsevier Science Publishers B.V. (North-Holland)
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ZW. Ross, On the price effects of mergers with freer trade
rationalization of the domestic industry. Such gains from trade arguments are, by now, very familiar. However, what if either (or both) the foreign or the domestic firms were not perfect competitors? Now the distortion due to imperfect competition is added to that due to the tariff. Those familiar with the theory of the second best will be aware that unusual things can happen when one market imperfection is added to another. Will domestic price necessarily fall as the tariff is reduced? Will domestic welfare rise? ~ These questions are important to our understanding of how competition policy should be designed and enforced when tariffs are being reduced. It may not be the case that freer trade necessarily substitutes for competition policy in all markets. If it does not, we would like to know where we should direct our attention. This is not an indictment of free trade. Rather, it is an attempt to determine the conditions under which movements toward the first-best will require an active competition policy as well as a relaxing of the barriers to trade. This paper represents part of a larger, ongoing project to study the degree to which lower tariffs do serve to improve the performance of domestic markets. In this essay, our concern is with mergers. Specifically, we would like to understand whether lowering the tariff will help to discipline merger activity; that is, to discourage mergers for market power. The kinds of effects from mergers that we can expect to observe will clearly depend upon the organization of the domestic industry. Here we employ two different models of the home market, in the hope that many real noncompetitive markets will resemble one, if not the other. The first considers the domestic industry to be an oligopoly facing a competitive fringe supply from foreign firms. This model is studied in the next section. The second is also a model of oligopoly, but one in which foreign firms are full members, not part of the fringe. This will allow us to consider mergers that reduce the number of foreign firms as well as those that eliminate domestic firms. This is done in section 3. Section 4 offers some concluding remarks.
2. Dominant domestic oligopoly One point that the new International Trade-Industrial Organization literature has made very clear is that in a world with nations and borders between them, some countries may be better off with imperfect rather than perfect competition. If a nation is a net exporter of a commodity, a price above marginal cost will generally maximize domestic surplus. This suggests ~These questions are related to those posed in the strategic trade policy literature. See, for example, Brander and Spencer (1981, 1984), Dixit (1984), Helpman and Krugraan (1985), Kierzkowski (1984) and Krugman (1979). In these papers, the focus is typicallyon optimal trade policy when markets are imperfectly competitive.
T.I~. Ross, On the price effects of mergers with freer trade
235
that in a non-cooperative game played against other countries, a nation may have an incentive to help make some markets less competitive, through assistance in forming cartels (particularly export cartels), or perhaps by other means such as by offering export subsidies. For a national merger policy this means that the simple welfare analysis offered by Williamson (1968) is missing something. Fig. 1 reproduces Williamson's famous diagram. Two firms in an industry are planning to merge and this merger will have two effects. One is to create a more efficient enterprise with average costs of cl rather than the Co costs each firm had been incurring. The second is to reduce competition in the market, raising price from Po to pl. Area A plus area B represent the consumers' surplus lost due to the higher price while areas A + E - C correspond to the additional profits to the firms. The net social benefit of the merger then equals the sum of these two effects: net b e n e f i t = - - ( A + B ) + ( A + E - C ) = E - ( B + C ) . If some consumers are located in other countries (or the firms are partially foreign owned) and we decide to give foreign agents less weight in our welfare function, we have a more complicated problem. To the extent that some consumption is done in other countries, the domestic damage done by higher prices is reduced. More market power producing mergers would pass the net domestic benefit test. On the other hand, when firms are partially foreign owned, the value of the added profits is reduced, so we will reject more mergers. To be slightly more formal, let ~ represent the proportion of consumers' surplus received by domestic consumers and fl the share of profits that
Pl
A
P0 co el'
XI
X0 Fig, 1
236
TW. Ross, On the price effects of mergers with freer trade
remain in the country. The net domestic social benefit of the merger is then net domestic benefit = - ct(A + B) + fl(A + E - C)
This expression makes it clear that, other things equal, greater domestic ownership and lower domestic consumption raise the net domestic benefit of mergers. Of course, in order to evaluate these areas we need to be able to determine the size of the price increase and the extent of the efficiencies created by the merger. It is only the first of these that we explore here. Specifically, we want to know how lowering tariffs will affect the price changes brought about by the concentrating effects of mergers. Put still another way - in a free trade regime are mergers more likely to be efficiency motivated rather than driven by market power considerations? To begin the formal analysis we adapt the dominant firm model due to Saving (1970). Here, the dominant entity is a domestic oligopoly and the competitive fringe is composed of foreign producers. The domestic oligopolists will be allowed general linear conjectures that will permit their behaviour to range from competitive to collusive. The foreign firms will be price-takers in the domestic market, supplying out to their full marginal cost schedules, where 'full' means inclusive of any tariff. Our analysis here, and in the following section, really focuses on the effects of asymmetric cost changes in imperfectly competitive markets. Our application is to an international trade problem, but other applications may prove interesting as well. This work is then also seen to be related to Seade's (1985) work on the effects of symmetric cost changes (due to taxation) on price in an oligopoly. The oligopoly problem is familiar, except that the demand curve the Nmember oligopoly faces will be residual, determined by subtracting foreign supply, M(p,t), from total domestic market demand D(p). We assume the tariff, t, is specific, so we may write M(p, t ) = M ( p - t ) and we also assume that d M / d p = M ' > O . Thus, we can express residual demand as R(p, t) = D(p) - M ( p - t),
(1)
and we denote the inverse of this demand by
p =/-t(x, t),
(2)
where X is the total oligopoly output. The derivatives of this inverse residual
TW. Ross, On the price effects of mergers with freer trade
237
demand will be 1 1 HX=R---~p=D,_~4.
(3)
-M' H, =-DT--__I ~ >=O,
(4)
where subscripts denote partial derivatives. The typical oligopolist will choose its output xl to maximize its own profit as given by
~=(p-c)xi.
(5)
To simplify the analysis, we assume constant marginal costs of c per unit. 2 I m p o r t a n t to the solution of this problem is the firm's conjecture regarding rivals' responses to changes in its output. We allow these firms general linear conjectures, which we denote by k, and we assume them to be c o m m o n for all N firms. Thus k - ~ , l , i ( d x f f d x O , Vi. The value k takes may, however, depend upon the number of firms in the oligopoly. As k = - 1 will produce Bertrand competition and k = N - 1 perfect collusion, we might expect k to fall with a large number of firms, i.e., k'(N)<_<_O. We shall a d o p t the convention that the measure of oligopolistic coordination ( l + k ) / N should not rise with increases in N. This requires that N k ' < _ ( l + k ) . A negative k' will obviously satisfy this condition, but so will small positive values? Choosing x~ to maximize (5) yields the first-order condition p - c + xiHx(1 + k ) = 0 .
(6)
If the firms are identical we can solve for the equilibrium markup, m, using x ~ = X / N and (6) to get p-c (l+k) m-----=-p Nr '
(7)
where r is the (absolute value of the) elasticity of the residual d e m a n d curve, r = - pRn/R, SHaving rising marginal costs would not qualitatively affect these results, Also, an anonymous referee has correctly noted that residual demand curves will likely be kinked. Since the analysis below is local and deals with infinitesimal changes in tariffs this is not, in general, a problem. However, it could matter if changes are substantial. 31n a related context Buffie and Spiller (1986) invoke the same convention, To see why this is sensible, look at eq. (7) below, which gives the equilibrium profit margin where r is the elasticity of demand. If (1 +k)/N grew with N this would mean that entry would lead to higher margins. Our assumption here then is simply saying that more firms should lead to lower prices.
238
T.W.Ross, On the price effects of mergers with freer trade
It will be important for us to know how changes in tariff rates will affect this elasticity. Let r, represent this derivative
rt =
- p R R p t + pRpRt Re
From (1) we can see that Rp~=M" and R r = M ' , where M" is the second derivative of the fringe supply curve. Letting e = p M " / M ' , the elasticity of the slope of this foreign supply curve, we can simplify this further to -M' rt = ~ (e + r).
(8)
This result suggests that falling tariffs could raise or lower the elasticity of demand faced by the dominant oligopoly. The elasticity term e will carry the sign of M", and it is entirely possible that M" is negative and large enough in absolute value that rt>O. 4 Though the falling tariff shifts the residual demand curve inward, if M" is negative, it will also make it steeper. If this second effect is great enough, the elasticity may actually fall. Now we consider the effect of a merger of two firms on the m a r k u p (7). If a merger between two firms were to produce a large increase in price, it could be privately profitable to the firms involved even if the efficiency gain was small (or even negative). If a lower tariff can moderate this price increase, it will tend to discourage mergers that do not reduce costs, Here we will assume that the merging firms expect to see some efficiency gains as well as market power advantages. Indeed, Salant, Switzer and Reynolds (1983) have shown that in some quantity games like this, mergers for market power alone may not be profitable; that is, the combined enterprise m a y end up with lower total profits than the merging firms had earned before uniting. To make things simple here, we will assume that the efficiency gain comes about through a reduction in fixed costs, so that the marginal costs in (7) will not change, Some further justification for the use of this model m a y be in order here. This is, without a doubt, the simplest model of the price effects of mergers one could imagine. Critics of Salant et al. (1983) have argued that it is 4This effect on the elasticity of a reduction in tariffs is described in Ross (1986a). It implies that falling tariffs can actually lead to higher domestic prices, though domestic firms are still clearly worse off. To see that this is possible consider the case of a single domestic firm maximizing H=(p-c)R(p,t). Total differentiation of the first-order condition (p-c)Rp+R=O reveals that for price to rise with a falling tariff the following condition must hold: (p- c)M" + M' <0. The second-order condition requires (p ~-c)(D"- M") + 2(D'-M') < 0. Obviously there is come conflict between these conditions, but rewriting the second as [(p-c)D"+D']-[(p-c)M"+M']+(D'-M')
T.W. Ross, On the price effects of mergers with freer trade
239
unreasonable to believe that, after the merger, the new enterprise will act just like all the others so that an N-identical-firm oligopoly has simply become an (N-1)-identical-firm oligopoly. Recent work with more complicated models [e.g., Perry and Porter (1985) and Deneckere and Davidson (1985)], has addressed this concern with some interesting results. Nevertheless, for the purpose we have here, the simple model seems an interesting place to start. Recall that we are not really studying the motives for merger directly, nor are we focusing on the level of the price change that will result. Though some would argue that this model predicts too great a change in output and price after a merger, there is no such obvious bias in its prediction about what concerns us here: how will lower tariffs alter the price effects of mergers? We let m stand for this markup, (p-c)/p, and we again recognize that k may be a function of the number of firms. Differentiating (7) with respect to N then we get dm dN dm
N r k ' - ( 1 +k)r N2r 2 '
or
1
= N2 r [Nk' - (1 + k)].
(9)
Applying the convention discussed earlier, we know that the expression in brackets is nonpositive, so that dm/dN is also nonpositive. Notice that the less competitive is firm behaviour (as reflected in a larger k) and the more sensitive cooperation is to the number of firms (i.e., the more negative is k') the larger the effect on the markup of a reduction in N through merger. Lowering the tariff will affect the magnitude of this price increase through its effect on r, the elasticity of the residual demand. The second derivative d2rn/dNdt will carry the opposite sign to that of dr/dt. As long as (e + r ) > 0, the lowering of the tariff will increase the elasticity of the residual demand curve and dm/dN will rise (i.e., become a smaller negative number). In such an environment, the lower t does serve to help screen out mergers that depended largely on their market power effects to be profitable. Should e be negative and larger in absolute value than r we can get surprising results. In this case dr/dr will be positive and a lower tariff will lower dm/dN further. Mergers will then have larger price effects, so they will require smaller efficiency gains to make them profitable for the merging firms. It may seem very unlikely that (e + r)< 0, particularly for a small economy, given that the import supply function may in many markets be thought to
T.W. Ross, On the price effects of mergers with freer trade
240
become very elastic at high domestic prices. Then e > 0 and (e+r) must be strictly positive. Nevertheless, these results are still of quite general interest. They tell us that the ability of free trade to discipline merger activity will be affected by the magnitude of (e + r). Even if it is always positive, it may still range considerably from low levels in sectors of the economy protected from large-scale foreign entry (e.g., some service industries) to very high levels in industries with large volumes of trade (e.g., the steel industry). Therefore, before concluding that free trade protects us from the build-up of domestic market power, we need to know something about these elasticities.
3, International oligopoly We turn now to consider an alternative market structure that will allow us to contrast the effects of foreign and domestic mergers, This model of international oligopoly has been used in earlier research on trade policy. The work that is closest in spirit to that here is by Ordover and Willig (1985), who studied the effects of the number of foreign firms and of the presence of export subsidies on the price effects of mergers. In this model of international oligopoly there are n domestic firms and n* foreign firms with marginal costs of c and c*, respectively. We will let domestic demand be linear (10)
p=a-bX,
where X = n x + n * x * , the total supply and x and x* represent, respectively, the outputs of individual domestic and foreign firms. Domestic and foreign firms will be allowed to have different conjectures about rivals' reactions, represented by k and k*, but for simplicity here we will make them constants (i.e., not functions of n and n*). Profits before fixed costs for typical domestic and foreign firms will be, respectively, 17= (p - c)x, 17" = (p - c*)x*,
and the first-order conditions for profit maximization dH dx = p - c + x ( - b ) ( 1
dH dx* = p - c + x * ( - b ) ( 1
+ k)=0,
+ k*) =0.
(11)
(12)
T.W, Ross, On the price effects of mergers with fleer trade
241
Substituting for the demand function (10) and the adding-up condition X = nx + n ' x * we can reduce the equilibrium conditions to two equations in
two unknowns, x and x* b(1 + k + n)x + bn*x* = a - c , bnx + b(1 + k* + n*)x* = a - c*,
or in matrix form
bn
Ir lo[a- ]
,,.. b(l+k+n*)JLx* j
a--c* '
(13)
Using Cramer's Rule we can solve (13) for x and x* (a-c)(1 +k* +n*)-(a-c*)n* X=b(l + k+n)(1 + k * + n * ) - b n n * ' x*-- ( a - c * ) ( l + k + n ) - ( a - c ) n b(1 + k + n)(1 + k* + n*) - bnn*"
(14) (15)
For convenience, let B - b ( l + k + n ) ( l + k * + n * ) - b n n * , the denominator in these expressions. Note that B > 0 , and that we shall assume that this solution implies positive values for x and x*. The effect on price of a domestic merger will be simply d p = d__ppd X = _ b dX dn dX dn dn"
(16)
Recalling that X = nx + n'x*, we can write
x=L B {hi(a- c)(1 + k* + n * ) - ( a - c*)n*] + n* [(a -- c*) (1 + k + n) - (a - c)n] }, which simplifies to X = L [ ( a - c) (1 + k*)n + ( a - c*) (1 + k)n*]. /J
(17)
Tw. Ross, On the price effects of mergers with freer trade
242
Differentiating (17) and collecting terms dX
1
~n=-B(l + k * ) ( a - b X - c ) , dX 1 ~-~ = ~ (1 +k*)(p-c)>O.
or
(18)
If the merger involved the purchase of a domestic firm by a foreign firm (or the reverse) and it was the foreign enterprise that stopped selling domestically we would have, analogously, dX 1 dn* = B (1 + k ) ( p - c*).
(19)
C o m p a r i n g (18) and (19), we see that a merger with a domestic rival will have a bigger effect on price t h a n a merger with a foreign firm if dX
dX
(1 + k*)(p - c ) > (1 + k) ( p - c*). That is a domestic firm, other things equal, would tend to prefer a merger with another domestic firm if domestic firms have lower costs a n d / o r m o r e competitive conjectures (lower k). 5 How will lowering tariffs affect the derivatives (18) a n d (19)? W o r k i n g with (18) we get dZX dn dc* = -
b(1 +k*) d X B
dc*'
and from (17) we can determine that
dX/dc* =
(1 + k)n* B
(20)
~A referee correctly points out that this analysis does not really allow us to predict which operation will be dosed if a foreign and a domestic firm merge. Certainly the decision will take into account the price effects described here, but it could also turn on market share effects, the extent to which the foreign firm was serving other markets (e.g,, its own domestic market) and the nature of the efficiencygain realized in the merger. It is by no means clear that the higher marginal cost plant will be the one closed.
T.FERoss, On the priceeffectsof mergerswithfreer trade
243
Combining these last two equations, we find d2X b(1 +k)(1 +k*)n* dn dc* = B2 > 0, and therefore, d2p dn dc* =
b2(1 + k)(1 + B2
k*)n* <0.
(21)
Eq. (21) tells us that as c* falls due to the lower tariff, dp/dn (a negative number) rises (i.e., becomes smaller in absolute value). This implies that changes in n will have smaller effects on price. Specifically, it means that mergers reducing n will not result in price increases as large as they would have been. 6 Thus, lower tariffs will again help screen out some mergers largely intended to increase market power with little efficiency gain. 7 Interestingly, mergers involving foreign firms work differently. It is easy to see why they might since lowering tariffs make foreign firms more competitive, so reducing their number through merger might now be more harmful. Still at work, however, is the force already described, that is, the remaining foreign firms are also more competitive. To see which effect dominates we begin by differentiating (19) to get d2X, (l+k) F dn*dc . . . . B k -
b dX
]
d-~c*-I .
(22)
Substituting (20) into (22) yields d2X = dn* dc*
(l~k)I1
b(1Bk)n*]
k)b . . . . --~ k(l+k+n)(l+k*+n*)-nn*-(l+k)n*],
(1 + -
and finally
d2X dn* dc* "--
b(l+k*)(l+k)(l+k+n) B2
<0.
(23)
60rdover and Willig (1985) have an essentially identical result in an export subsidy context. 7In the previous section we focused on the effects on the profit margin, m, because the form of (7) makes it particularly easy to work with, (It is not difficult to solve for the effects on prices, though it is more cumbersome.) Hero, in section 3, it is actually simpler to work directly with the effects on price.
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T.W. Ross, On the price effects of mergers with freer trade
The price derivative will then be d2p bZ(l+k*)(l+k)(l+k+n)> dn* de* = B2
0 '
(24)
A comparison of (21) and (24) provides some interesting results. In (21) we see that lower tariffs, by making foreign firms more vigourous competitors, will serve to mitigate the price effects of mergers that eliminate a domestic firm. Notice that the denominator in (21) is a positive function of n, the number of domestic firms, so that this beneficial effect of lower tariffs will be greatest when n is small, which is when we expect to need it. Expression (24) reveals that a merger eliminating a foreign firm will have a greater effect on price with lower tariffs. This is simply due to the fact that, with reduced costs, foreign firms will each have a larger market share; thus, eliminating one firm withdraws more output from the market. Since its denominator is a positive function of n*, the value given by (24) will be biggest for small values of n*. As we might expect, this means that as n* gets large, tariff reductions will have a smaller impact on the price effects of mergers eliminating foreign competitors. Combining these results we can see that reducing tariffs will have the most positive effects on merger activity when the number of foreign firms is large. All of this suggests that those with responsibility of reviewing mergers should recognize the potentially significant differences in welfare effects between mergers with other domestic firms and mergers with foreign firms. While lowering the tariff will discourage mergers for market power with domestic rivals, it will encourage such mergers with foreign rivals. It is important to recognize that what we have done here in no way represents a full evaluation of the benefits and costs of mergers or of the effects of tariff reductions on these benefits and costs. Our focus has been restricted to the incentives of selected pairs of firms to merge to earn benefits of two types: a lump-sum efficiency gain and a somewhat higher final price due to the elimination of a competitor, s While the first of these benefits represents a social gain, the second is a cost. Our specific interest lies in the effect of tariff reductions on these price-elevating effects of mergers; a fuller inquiry might explore the nature of the efficiency gains.
Conclusions This paper represents an attempt to begin to test the popular notion that freer trade wilt be a powerful substitute for a domestic competition policy 8These private benefits should be distinguished from the industry benefits from mergers. In this model the efficiencygain has no direct effect on other firms, but the output reduction that comes with the merger will raise price and deliver benefits to all other firms in the industry. As a whole, the industry profits will be enhanced by merger activity as long as mergers have no negative efficiencyeffects.
T.W. Ross, On the price effects of mergers with freer trade
245
(particularly) in a small economy. We have used two different models of imperfect competition to understand how lower tariffs will affect the price elevating properties of mergers. In some cases the lower tariff did serve to control price increases, but in others it did not. Mergers can indeed have greater effects on price after tariffs have been reduced. These results have obvious implications for those responsible for reviewing mergers for possible anticompetitive effects. It is important to recognize what this paper has not done. 9 We have not provided any real model of the decision to merge. Thus we cannot make predictions regarding whether or not a merger wave would follow a movement to free trade. This is, however, an interesting question. It is not uncommon to hear commentators suggest that free trade will force many domestic firms to merge to build up to the scale necessary to compete with large foreign enterprises. Though this may seem a sensible enough conjecture, an economist is forced to wonder why, if there were economies to be realized, these mergers had not been effected long ago. In many countries anti-merger law is too weak to be an explanation, so what else could be going on? Why would many inefficiently small firms continue to co-exist in a market? Explanations may be available that apply to selected markets. Government regulation may have hampered efficient restructuring of some industries. Consumers' desire for diversity may have led to product differentiation in others. Admitting foreign brands by lowering tariffs means that the optimal number of domestic brands will fall (perhaps via mergers) so that each can realize greater economies of scale, Finally, it may be the case that a more competitive market might encourage managers in an agency relationship with owners to seek out and effect mergers that they may have avoided in the past. This effect is not clear, however, and needs to be properly modelled. 1° In addition to exploring this question of the incentive to merge and testing these results empirically, the work done here on the price effects of mergers could be further developed. Efficiency gains could be more formally modelled, and heterogeneity of the firms could be introduced, perhaps along the lines of Perry and Porter (1985). Other models of imperfect competition, monopolistic competition for example, could be studied. Finally, a full welfare analysis that allowed domestic firms to export and to be partially foreign-owned would make a useful, though nontrivial, contribution to the literature. 9The discussion in the next few paragraphs is expanded upon slightly in Ross (1986b, pp. 19-24). l°Perhaps along the lines of Willig (1986). Willig studies the effect of competition in the output market on the internal managerial slack of firms.
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T,W.. Ross, On the price effects of mergers with freer trade
References Brander, J. and B. Spencer, 1981, Tariffs and the extraction of foreign monopoly rents under potential entry, Canadian Journal of Economics 14. Brander, J. and B. Spencer, 1984, Tariff protection and imperfect competition, in: H. Kierzkowski, ed., Monopolistic competition and international trade. Buffie, E. and P. Spiller, 1986, Trade liberalization in oligopolistic industries: The quota case, Journal of International Economics, Feb. Deneckere, R. and C. Davidson, 1985, Incentives to form coalitions with Bertrand competition, Rand Journal of Economics 16, Winter. Dixit, A., 1984, International trade policy for oligopolistic industries, Economic Journal 94 (Suppl.). Helpman, E. and P. Krugman, 1985, Market structure and foreign trade (MIT Press, Cambridge IL), Kierzkowski, H., ed., 1984, Monopolistic competition and international trade (Clarendon Press, Oxford). Krugman, P., 1979, Increasing returns, monopolistic competition and international trade, Journal of International Economics 9. Ordover, LA. and R.D. Willig, 1985, Perspectives on mergers and world competition, Discussion paper no. 88 (Woodrow Wilson School of Public and International Affairs, Princeton University) Mar. Perry, M. and R. Porter, 1985, Oligopoly and the incentive for horizontal merger, American Economic Review 75, Mar. Ross, T., 1986a, Movements towards free trade and domestic market performance with imperfect competition, CIORU working paper, no. 86-08 (Carleton University), Oct. Ross, T., 1986b, Merger policy with freer trade, CIORU working paper no. 86-07 (Carleton University), Oct, Salant, S., S. Switzer and R, Reynolds, 1983, Losses from horizontal merger: The effects of an exogenous change in industry structure on Cournot-Nash equilibrium, Quarterly Journal of Economics 98, May. Saving, T., 1970, Concentration ratios and the degree of monopoly, International Economic Review 11. Seade, J., 1985, Profitable cost increases and the shifting of taxation: Equilibrium responses of markets in oligopoly, Warwick economic research papers, no. 260 (University of Warwick), April. Williamson, O., 1968, Economies as an antitrust defense: Welfare tradeoffs, American Economic Review 58. Willlig, R., 1986, Corporate governance and product market structure, Mimeo. (Princeton University).
ON THE PRICE EFFECTS
OF MERGERS
WITH FREER
TRADE*
T h o m a s W. R O S S Carleton University. Ottawa. Canada K I S 5B6
Final version received July 1987 This paper uses two models of imperfect competition to explore the price effects of mergers in an economy moving toward free trade. In a model of a domestic dominant oligopoly, mergers of domestic firms can have greater or smaller effects on price after tariffs have been reduced. With an international oligopoly, lower tariffs will serve to mitigate the price-raising effects of domestic mergers but to enhance the price effects of mergers that reduce the number of foreign firms. The implication is that freer trade may not always serve as a good substitute for an active competition policy.
1. Introduction Free (or at least freer) trade is a h o t topic in a n u m b e r of places these days. As the next r o u n d of G A T T negotiations begin, the talk in m a n y capitals is of lowering tariffs to e x p a n d trade and, it is hoped, to stimulate growth in the world e c o n o m y , C a n a d a and the U n i t e d States have gone so far as to a p p o i n t teams that are a t t e m p t i n g to negotiate a bilateral free trade agreement. F e w economists will dispute the fact that freer trade will raise national i n c o m e by allowing nations to capitalize on their c o m p a r a t i v e advantage. F o r certain smaller economies, there is a n o t h e r benefit said to a c c o m p a n y freer trade. W i t h reduced tariffs foreign firms will be better able to c o m p e t e with domestic firms for d o m e s t i c markets. This added c o m p e t i t i o n should, particularly in m o r e c o n c e n t r a t e d industries, serve to lower prices paid by domestic consumers. In a sense then, freer trade is seen as a substitute for a strong c o m p e t i t i o n policy. There are a large n u m b e r of cases in which this a r g u m e n t is doubtless correct. F o r example, if foreign firms are competitive and the d o m e s t i c price is set at the world price plus the tariff (i.e., domestic firms are price takers), reducing the tariff m u s t lower domestic price and will p e r h a p s cause s o m e *This paper originated in research done for the Bureau of Competition Policy, Consumer and Corporate Affairs Canada, and the author is grateful for the Bureau's financial support. He also wishes to acknowledge useful discussions with Michel Andrieu, James Brander, Richard Brecher, Avinash Dixit, Shyam Khemani, Benoit Long, Roger Ware and Robert Willig and several helpful comments from two anonymous referees. Aslam Anis provided valuable research assistance with this work. 0167-7187/88/$3.50 © 1988, Elsevier Science Publishers B.V. (North-Holland)
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rationalization of the domestic industry. Such gains from trade arguments are, by now, very familiar. However, what if either (or both) the foreign or the domestic firms were not perfect competitors? Now the distortion due to imperfect competition is added to that due to the tariff. Those familiar with the theory of the second best will be aware that unusual things can happen when one market imperfection is added to another. Will domestic price necessarily fall as the tariff is reduced? Will domestic welfare rise? ~ These questions are important to our understanding of how competition policy should be designed and enforced when tariffs are being reduced. It may not be the case that freer trade necessarily substitutes for competition policy in all markets. If it does not, we would like to know where we should direct our attention. This is not an indictment of free trade. Rather, it is an attempt to determine the conditions under which movements toward the first-best will require an active competition policy as well as a relaxing of the barriers to trade. This paper represents part of a larger, ongoing project to study the degree to which lower tariffs do serve to improve the performance of domestic markets. In this essay, our concern is with mergers. Specifically, we would like to understand whether lowering the tariff will help to discipline merger activity; that is, to discourage mergers for market power. The kinds of effects from mergers that we can expect to observe will clearly depend upon the organization of the domestic industry. Here we employ two different models of the home market, in the hope that many real noncompetitive markets will resemble one, if not the other. The first considers the domestic industry to be an oligopoly facing a competitive fringe supply from foreign firms. This model is studied in the next section. The second is also a model of oligopoly, but one in which foreign firms are full members, not part of the fringe. This will allow us to consider mergers that reduce the number of foreign firms as well as those that eliminate domestic firms. This is done in section 3. Section 4 offers some concluding remarks.
2. Dominant domestic oligopoly One point that the new International Trade-Industrial Organization literature has made very clear is that in a world with nations and borders between them, some countries may be better off with imperfect rather than perfect competition. If a nation is a net exporter of a commodity, a price above marginal cost will generally maximize domestic surplus. This suggests ~These questions are related to those posed in the strategic trade policy literature. See, for example, Brander and Spencer (1981, 1984), Dixit (1984), Helpman and Krugraan (1985), Kierzkowski (1984) and Krugman (1979). In these papers, the focus is typicallyon optimal trade policy when markets are imperfectly competitive.
T.I~. Ross, On the price effects of mergers with freer trade
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that in a non-cooperative game played against other countries, a nation may have an incentive to help make some markets less competitive, through assistance in forming cartels (particularly export cartels), or perhaps by other means such as by offering export subsidies. For a national merger policy this means that the simple welfare analysis offered by Williamson (1968) is missing something. Fig. 1 reproduces Williamson's famous diagram. Two firms in an industry are planning to merge and this merger will have two effects. One is to create a more efficient enterprise with average costs of cl rather than the Co costs each firm had been incurring. The second is to reduce competition in the market, raising price from Po to pl. Area A plus area B represent the consumers' surplus lost due to the higher price while areas A + E - C correspond to the additional profits to the firms. The net social benefit of the merger then equals the sum of these two effects: net b e n e f i t = - - ( A + B ) + ( A + E - C ) = E - ( B + C ) . If some consumers are located in other countries (or the firms are partially foreign owned) and we decide to give foreign agents less weight in our welfare function, we have a more complicated problem. To the extent that some consumption is done in other countries, the domestic damage done by higher prices is reduced. More market power producing mergers would pass the net domestic benefit test. On the other hand, when firms are partially foreign owned, the value of the added profits is reduced, so we will reject more mergers. To be slightly more formal, let ~ represent the proportion of consumers' surplus received by domestic consumers and fl the share of profits that
Pl
A
P0 co el'
XI
X0 Fig, 1
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TW. Ross, On the price effects of mergers with freer trade
remain in the country. The net domestic social benefit of the merger is then net domestic benefit = - ct(A + B) + fl(A + E - C)
This expression makes it clear that, other things equal, greater domestic ownership and lower domestic consumption raise the net domestic benefit of mergers. Of course, in order to evaluate these areas we need to be able to determine the size of the price increase and the extent of the efficiencies created by the merger. It is only the first of these that we explore here. Specifically, we want to know how lowering tariffs will affect the price changes brought about by the concentrating effects of mergers. Put still another way - in a free trade regime are mergers more likely to be efficiency motivated rather than driven by market power considerations? To begin the formal analysis we adapt the dominant firm model due to Saving (1970). Here, the dominant entity is a domestic oligopoly and the competitive fringe is composed of foreign producers. The domestic oligopolists will be allowed general linear conjectures that will permit their behaviour to range from competitive to collusive. The foreign firms will be price-takers in the domestic market, supplying out to their full marginal cost schedules, where 'full' means inclusive of any tariff. Our analysis here, and in the following section, really focuses on the effects of asymmetric cost changes in imperfectly competitive markets. Our application is to an international trade problem, but other applications may prove interesting as well. This work is then also seen to be related to Seade's (1985) work on the effects of symmetric cost changes (due to taxation) on price in an oligopoly. The oligopoly problem is familiar, except that the demand curve the Nmember oligopoly faces will be residual, determined by subtracting foreign supply, M(p,t), from total domestic market demand D(p). We assume the tariff, t, is specific, so we may write M(p, t ) = M ( p - t ) and we also assume that d M / d p = M ' > O . Thus, we can express residual demand as R(p, t) = D(p) - M ( p - t),
(1)
and we denote the inverse of this demand by
p =/-t(x, t),
(2)
where X is the total oligopoly output. The derivatives of this inverse residual
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237
demand will be 1 1 HX=R---~p=D,_~4.
(3)
-M' H, =-DT--__I ~ >=O,
(4)
where subscripts denote partial derivatives. The typical oligopolist will choose its output xl to maximize its own profit as given by
~=(p-c)xi.
(5)
To simplify the analysis, we assume constant marginal costs of c per unit. 2 I m p o r t a n t to the solution of this problem is the firm's conjecture regarding rivals' responses to changes in its output. We allow these firms general linear conjectures, which we denote by k, and we assume them to be c o m m o n for all N firms. Thus k - ~ , l , i ( d x f f d x O , Vi. The value k takes may, however, depend upon the number of firms in the oligopoly. As k = - 1 will produce Bertrand competition and k = N - 1 perfect collusion, we might expect k to fall with a large number of firms, i.e., k'(N)<_<_O. We shall a d o p t the convention that the measure of oligopolistic coordination ( l + k ) / N should not rise with increases in N. This requires that N k ' < _ ( l + k ) . A negative k' will obviously satisfy this condition, but so will small positive values? Choosing x~ to maximize (5) yields the first-order condition p - c + xiHx(1 + k ) = 0 .
(6)
If the firms are identical we can solve for the equilibrium markup, m, using x ~ = X / N and (6) to get p-c (l+k) m-----=-p Nr '
(7)
where r is the (absolute value of the) elasticity of the residual d e m a n d curve, r = - pRn/R, SHaving rising marginal costs would not qualitatively affect these results, Also, an anonymous referee has correctly noted that residual demand curves will likely be kinked. Since the analysis below is local and deals with infinitesimal changes in tariffs this is not, in general, a problem. However, it could matter if changes are substantial. 31n a related context Buffie and Spiller (1986) invoke the same convention, To see why this is sensible, look at eq. (7) below, which gives the equilibrium profit margin where r is the elasticity of demand. If (1 +k)/N grew with N this would mean that entry would lead to higher margins. Our assumption here then is simply saying that more firms should lead to lower prices.
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It will be important for us to know how changes in tariff rates will affect this elasticity. Let r, represent this derivative
rt =
- p R R p t + pRpRt Re
From (1) we can see that Rp~=M" and R r = M ' , where M" is the second derivative of the fringe supply curve. Letting e = p M " / M ' , the elasticity of the slope of this foreign supply curve, we can simplify this further to -M' rt = ~ (e + r).
(8)
This result suggests that falling tariffs could raise or lower the elasticity of demand faced by the dominant oligopoly. The elasticity term e will carry the sign of M", and it is entirely possible that M" is negative and large enough in absolute value that rt>O. 4 Though the falling tariff shifts the residual demand curve inward, if M" is negative, it will also make it steeper. If this second effect is great enough, the elasticity may actually fall. Now we consider the effect of a merger of two firms on the m a r k u p (7). If a merger between two firms were to produce a large increase in price, it could be privately profitable to the firms involved even if the efficiency gain was small (or even negative). If a lower tariff can moderate this price increase, it will tend to discourage mergers that do not reduce costs, Here we will assume that the merging firms expect to see some efficiency gains as well as market power advantages. Indeed, Salant, Switzer and Reynolds (1983) have shown that in some quantity games like this, mergers for market power alone may not be profitable; that is, the combined enterprise m a y end up with lower total profits than the merging firms had earned before uniting. To make things simple here, we will assume that the efficiency gain comes about through a reduction in fixed costs, so that the marginal costs in (7) will not change, Some further justification for the use of this model m a y be in order here. This is, without a doubt, the simplest model of the price effects of mergers one could imagine. Critics of Salant et al. (1983) have argued that it is 4This effect on the elasticity of a reduction in tariffs is described in Ross (1986a). It implies that falling tariffs can actually lead to higher domestic prices, though domestic firms are still clearly worse off. To see that this is possible consider the case of a single domestic firm maximizing H=(p-c)R(p,t). Total differentiation of the first-order condition (p-c)Rp+R=O reveals that for price to rise with a falling tariff the following condition must hold: (p- c)M" + M' <0. The second-order condition requires (p ~-c)(D"- M") + 2(D'-M') < 0. Obviously there is come conflict between these conditions, but rewriting the second as [(p-c)D"+D']-[(p-c)M"+M']+(D'-M')
T.W. Ross, On the price effects of mergers with freer trade
239
unreasonable to believe that, after the merger, the new enterprise will act just like all the others so that an N-identical-firm oligopoly has simply become an (N-1)-identical-firm oligopoly. Recent work with more complicated models [e.g., Perry and Porter (1985) and Deneckere and Davidson (1985)], has addressed this concern with some interesting results. Nevertheless, for the purpose we have here, the simple model seems an interesting place to start. Recall that we are not really studying the motives for merger directly, nor are we focusing on the level of the price change that will result. Though some would argue that this model predicts too great a change in output and price after a merger, there is no such obvious bias in its prediction about what concerns us here: how will lower tariffs alter the price effects of mergers? We let m stand for this markup, (p-c)/p, and we again recognize that k may be a function of the number of firms. Differentiating (7) with respect to N then we get dm dN dm
N r k ' - ( 1 +k)r N2r 2 '
or
1
= N2 r [Nk' - (1 + k)].
(9)
Applying the convention discussed earlier, we know that the expression in brackets is nonpositive, so that dm/dN is also nonpositive. Notice that the less competitive is firm behaviour (as reflected in a larger k) and the more sensitive cooperation is to the number of firms (i.e., the more negative is k') the larger the effect on the markup of a reduction in N through merger. Lowering the tariff will affect the magnitude of this price increase through its effect on r, the elasticity of the residual demand. The second derivative d2rn/dNdt will carry the opposite sign to that of dr/dt. As long as (e + r ) > 0, the lowering of the tariff will increase the elasticity of the residual demand curve and dm/dN will rise (i.e., become a smaller negative number). In such an environment, the lower t does serve to help screen out mergers that depended largely on their market power effects to be profitable. Should e be negative and larger in absolute value than r we can get surprising results. In this case dr/dr will be positive and a lower tariff will lower dm/dN further. Mergers will then have larger price effects, so they will require smaller efficiency gains to make them profitable for the merging firms. It may seem very unlikely that (e + r)< 0, particularly for a small economy, given that the import supply function may in many markets be thought to
T.W. Ross, On the price effects of mergers with freer trade
240
become very elastic at high domestic prices. Then e > 0 and (e+r) must be strictly positive. Nevertheless, these results are still of quite general interest. They tell us that the ability of free trade to discipline merger activity will be affected by the magnitude of (e + r). Even if it is always positive, it may still range considerably from low levels in sectors of the economy protected from large-scale foreign entry (e.g., some service industries) to very high levels in industries with large volumes of trade (e.g., the steel industry). Therefore, before concluding that free trade protects us from the build-up of domestic market power, we need to know something about these elasticities.
3, International oligopoly We turn now to consider an alternative market structure that will allow us to contrast the effects of foreign and domestic mergers, This model of international oligopoly has been used in earlier research on trade policy. The work that is closest in spirit to that here is by Ordover and Willig (1985), who studied the effects of the number of foreign firms and of the presence of export subsidies on the price effects of mergers. In this model of international oligopoly there are n domestic firms and n* foreign firms with marginal costs of c and c*, respectively. We will let domestic demand be linear (10)
p=a-bX,
where X = n x + n * x * , the total supply and x and x* represent, respectively, the outputs of individual domestic and foreign firms. Domestic and foreign firms will be allowed to have different conjectures about rivals' reactions, represented by k and k*, but for simplicity here we will make them constants (i.e., not functions of n and n*). Profits before fixed costs for typical domestic and foreign firms will be, respectively, 17= (p - c)x, 17" = (p - c*)x*,
and the first-order conditions for profit maximization dH dx = p - c + x ( - b ) ( 1
dH dx* = p - c + x * ( - b ) ( 1
+ k)=0,
+ k*) =0.
(11)
(12)
T.W, Ross, On the price effects of mergers with fleer trade
241
Substituting for the demand function (10) and the adding-up condition X = nx + n ' x * we can reduce the equilibrium conditions to two equations in
two unknowns, x and x* b(1 + k + n)x + bn*x* = a - c , bnx + b(1 + k* + n*)x* = a - c*,
or in matrix form
bn
Ir lo[a- ]
,,.. b(l+k+n*)JLx* j
a--c* '
(13)
Using Cramer's Rule we can solve (13) for x and x* (a-c)(1 +k* +n*)-(a-c*)n* X=b(l + k+n)(1 + k * + n * ) - b n n * ' x*-- ( a - c * ) ( l + k + n ) - ( a - c ) n b(1 + k + n)(1 + k* + n*) - bnn*"
(14) (15)
For convenience, let B - b ( l + k + n ) ( l + k * + n * ) - b n n * , the denominator in these expressions. Note that B > 0 , and that we shall assume that this solution implies positive values for x and x*. The effect on price of a domestic merger will be simply d p = d__ppd X = _ b dX dn dX dn dn"
(16)
Recalling that X = nx + n'x*, we can write
x=L B {hi(a- c)(1 + k* + n * ) - ( a - c*)n*] + n* [(a -- c*) (1 + k + n) - (a - c)n] }, which simplifies to X = L [ ( a - c) (1 + k*)n + ( a - c*) (1 + k)n*]. /J
(17)
Tw. Ross, On the price effects of mergers with freer trade
242
Differentiating (17) and collecting terms dX
1
~n=-B(l + k * ) ( a - b X - c ) , dX 1 ~-~ = ~ (1 +k*)(p-c)>O.
or
(18)
If the merger involved the purchase of a domestic firm by a foreign firm (or the reverse) and it was the foreign enterprise that stopped selling domestically we would have, analogously, dX 1 dn* = B (1 + k ) ( p - c*).
(19)
C o m p a r i n g (18) and (19), we see that a merger with a domestic rival will have a bigger effect on price t h a n a merger with a foreign firm if dX
dX
(1 + k*)(p - c ) > (1 + k) ( p - c*). That is a domestic firm, other things equal, would tend to prefer a merger with another domestic firm if domestic firms have lower costs a n d / o r m o r e competitive conjectures (lower k). 5 How will lowering tariffs affect the derivatives (18) a n d (19)? W o r k i n g with (18) we get dZX dn dc* = -
b(1 +k*) d X B
dc*'
and from (17) we can determine that
dX/dc* =
(1 + k)n* B
(20)
~A referee correctly points out that this analysis does not really allow us to predict which operation will be dosed if a foreign and a domestic firm merge. Certainly the decision will take into account the price effects described here, but it could also turn on market share effects, the extent to which the foreign firm was serving other markets (e.g,, its own domestic market) and the nature of the efficiencygain realized in the merger. It is by no means clear that the higher marginal cost plant will be the one closed.
T.FERoss, On the priceeffectsof mergerswithfreer trade
243
Combining these last two equations, we find d2X b(1 +k)(1 +k*)n* dn dc* = B2 > 0, and therefore, d2p dn dc* =
b2(1 + k)(1 + B2
k*)n* <0.
(21)
Eq. (21) tells us that as c* falls due to the lower tariff, dp/dn (a negative number) rises (i.e., becomes smaller in absolute value). This implies that changes in n will have smaller effects on price. Specifically, it means that mergers reducing n will not result in price increases as large as they would have been. 6 Thus, lower tariffs will again help screen out some mergers largely intended to increase market power with little efficiency gain. 7 Interestingly, mergers involving foreign firms work differently. It is easy to see why they might since lowering tariffs make foreign firms more competitive, so reducing their number through merger might now be more harmful. Still at work, however, is the force already described, that is, the remaining foreign firms are also more competitive. To see which effect dominates we begin by differentiating (19) to get d2X, (l+k) F dn*dc . . . . B k -
b dX
]
d-~c*-I .
(22)
Substituting (20) into (22) yields d2X = dn* dc*
(l~k)I1
b(1Bk)n*]
k)b . . . . --~ k(l+k+n)(l+k*+n*)-nn*-(l+k)n*],
(1 + -
and finally
d2X dn* dc* "--
b(l+k*)(l+k)(l+k+n) B2
<0.
(23)
60rdover and Willig (1985) have an essentially identical result in an export subsidy context. 7In the previous section we focused on the effects on the profit margin, m, because the form of (7) makes it particularly easy to work with, (It is not difficult to solve for the effects on prices, though it is more cumbersome.) Hero, in section 3, it is actually simpler to work directly with the effects on price.
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T.W. Ross, On the price effects of mergers with freer trade
The price derivative will then be d2p bZ(l+k*)(l+k)(l+k+n)> dn* de* = B2
0 '
(24)
A comparison of (21) and (24) provides some interesting results. In (21) we see that lower tariffs, by making foreign firms more vigourous competitors, will serve to mitigate the price effects of mergers that eliminate a domestic firm. Notice that the denominator in (21) is a positive function of n, the number of domestic firms, so that this beneficial effect of lower tariffs will be greatest when n is small, which is when we expect to need it. Expression (24) reveals that a merger eliminating a foreign firm will have a greater effect on price with lower tariffs. This is simply due to the fact that, with reduced costs, foreign firms will each have a larger market share; thus, eliminating one firm withdraws more output from the market. Since its denominator is a positive function of n*, the value given by (24) will be biggest for small values of n*. As we might expect, this means that as n* gets large, tariff reductions will have a smaller impact on the price effects of mergers eliminating foreign competitors. Combining these results we can see that reducing tariffs will have the most positive effects on merger activity when the number of foreign firms is large. All of this suggests that those with responsibility of reviewing mergers should recognize the potentially significant differences in welfare effects between mergers with other domestic firms and mergers with foreign firms. While lowering the tariff will discourage mergers for market power with domestic rivals, it will encourage such mergers with foreign rivals. It is important to recognize that what we have done here in no way represents a full evaluation of the benefits and costs of mergers or of the effects of tariff reductions on these benefits and costs. Our focus has been restricted to the incentives of selected pairs of firms to merge to earn benefits of two types: a lump-sum efficiency gain and a somewhat higher final price due to the elimination of a competitor, s While the first of these benefits represents a social gain, the second is a cost. Our specific interest lies in the effect of tariff reductions on these price-elevating effects of mergers; a fuller inquiry might explore the nature of the efficiency gains.
Conclusions This paper represents an attempt to begin to test the popular notion that freer trade wilt be a powerful substitute for a domestic competition policy 8These private benefits should be distinguished from the industry benefits from mergers. In this model the efficiencygain has no direct effect on other firms, but the output reduction that comes with the merger will raise price and deliver benefits to all other firms in the industry. As a whole, the industry profits will be enhanced by merger activity as long as mergers have no negative efficiencyeffects.
T.W. Ross, On the price effects of mergers with freer trade
245
(particularly) in a small economy. We have used two different models of imperfect competition to understand how lower tariffs will affect the price elevating properties of mergers. In some cases the lower tariff did serve to control price increases, but in others it did not. Mergers can indeed have greater effects on price after tariffs have been reduced. These results have obvious implications for those responsible for reviewing mergers for possible anticompetitive effects. It is important to recognize what this paper has not done. 9 We have not provided any real model of the decision to merge. Thus we cannot make predictions regarding whether or not a merger wave would follow a movement to free trade. This is, however, an interesting question. It is not uncommon to hear commentators suggest that free trade will force many domestic firms to merge to build up to the scale necessary to compete with large foreign enterprises. Though this may seem a sensible enough conjecture, an economist is forced to wonder why, if there were economies to be realized, these mergers had not been effected long ago. In many countries anti-merger law is too weak to be an explanation, so what else could be going on? Why would many inefficiently small firms continue to co-exist in a market? Explanations may be available that apply to selected markets. Government regulation may have hampered efficient restructuring of some industries. Consumers' desire for diversity may have led to product differentiation in others. Admitting foreign brands by lowering tariffs means that the optimal number of domestic brands will fall (perhaps via mergers) so that each can realize greater economies of scale, Finally, it may be the case that a more competitive market might encourage managers in an agency relationship with owners to seek out and effect mergers that they may have avoided in the past. This effect is not clear, however, and needs to be properly modelled. 1° In addition to exploring this question of the incentive to merge and testing these results empirically, the work done here on the price effects of mergers could be further developed. Efficiency gains could be more formally modelled, and heterogeneity of the firms could be introduced, perhaps along the lines of Perry and Porter (1985). Other models of imperfect competition, monopolistic competition for example, could be studied. Finally, a full welfare analysis that allowed domestic firms to export and to be partially foreign-owned would make a useful, though nontrivial, contribution to the literature. 9The discussion in the next few paragraphs is expanded upon slightly in Ross (1986b, pp. 19-24). l°Perhaps along the lines of Willig (1986). Willig studies the effect of competition in the output market on the internal managerial slack of firms.
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