Differentiation and Cost Asymmetry: Solving the Merger Paradox

Abstract

This paper investigates the impact of product differentiation and of cost asymmetry on the merger paradox using a Cournot framework. It finds that when all firms share the same costs, two-firm mergers in an n firm market generate at least no profit loss when goods are sufficiently differentiated. This result contrasts with that of Salant, Switzer, and Reynolds (1983) where mergers of strategic substitutes are rarely profitable, and Deneckere and Davidson (1985) where competition among strategic complements yields profitable mergers. Critically, when costs are asymmetric, a merger between an efficient and inefficient firm, with differentiated products, can be more profitable to participants than to excluded rivals. Following this merger, welfare is shown to increase given that the cost asymmetry between insiders is large enough.

Key Words:

• Merger
• Free Rider
• Product Differentiation
• Price Effect
• Incentive to Merge.

JEL classifications:

• L13
• L40
• L41.

Notes

1. In fact, they find that at least 80% of the market needs to merge in order for the merger to be profitable.

2. These papers define the market according to substitutability of goods. In fact, according to European Commission (1997), two goods are defined to be in the same relevant market if they are substitutable. Models within the literature often assume a linear demand curve for each firm producing a different brand. As the price of one brand goes up, demand for another brand goes up by a constant b.

3. The assumption of a fixed number of firms is common in the merger literature. Clearly, profitable mergers can be generated via fixed cost savings in a free-entry equilibrium.

4. Note that this model is comparable to that of Salant, Switzer, and Reynolds (1983) by allowing the demand intercept in their model to equal one and normalizing their marginal costs to zero. This model, however, introduces product differentiation with the inclusion of parameter b. In their model, goods are assumed to be perfect substitutes (i.e., b = 1).

5. It is easily shown that it is beneficial for the merging parties not to close plants after the merger. The proof can be found in Appendix I.