Mergers and Collusion

Abstract

This chapter studies firms’ incentives to merge and collude in imperfectly competitive markets. Exercise 7.1 begins with the basic setting of mergers between two firms into a monopoly. Exercise 7.2 extends into the setting of N-firm mergers. We show that when the number of firms that merge is sufficiently high, mergers become profitable as the gain in market power more than offsets output increase of the firms that do not merge, and this is referred to as the “80% rule” after Salant et al. (1983). Exercise 7.3 suggests that when there are three or more firms merging together, the merger is unsustainable because every participating firm has incentives to leave and free ride on output reduction of the cartel to increase its own output and profit levels. Exercise 7.4 finds that firms have stronger incentives to merge when the merged firm benefits from cost-reduction effects. Exercise 7.5 analyzes mergers in a sequential-move game. We report that while a leader has incentives to acquire a follower, those incentives are weakened when the follower market becomes more competitive. To summarize, the existence of outsiders weakens firms’ incentives to merge, unless the merged firm gains significant market power, enjoys cost advantage, or maintains output leadership.