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Review of Industrial Organization

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30.10.2018

When Efficient Firms Flock Together: Merger Incentives Under Yardstick Competition

verfasst von: Jonas Teusch

Erschienen in: Review of Industrial Organization | Ausgabe 2/2019

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Abstract

Local monopolists that are regulated by yardstick competition frequently merge with their peers. However, economic theory provides little guidance for merger analysis. In contrast, the theoretical model in this article shows that there can be room for strategic firm behaviour even in a setting where firms are many and collusion is not sustainable. Specifically, the article derives conditions under which firms propose welfare-decreasing mergers to avoid competition with efficient peers and establishes when peer effects discourage firms from implementing socially desirable mergers. Efficient peers flock together whereas inefficient firms remain independent, unless peer effects are counteracted by efficiency effects.

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Even in the absence of formal yardstick competition, local monopolists tend to perform better if regulatory agencies, courts, or consumers can observe other firms that provide a comparable service under similar conditions (Kumbhakar and Hjalmarsson 1998; Wallsten and Kosec 2008; Bloom et al. 2015).

A notable exception is Ofwat (2015).

“Eon deal with RWE set to transform German energy sector” Financial Times. 11 March 2018.

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Escaping yardstick competition is arguably easier by using political and judicial means, as in Belgium (Agrell and Teusch 2015).

Discriminatory yardstick competition means that a firm’s own cost does not affect its price. Under hybrid and uniform yardstick competition on the other hand, a firm’s own cost affects its revenue allowance (see Sects. 5.2 and 5.3).

As yardstick competition is modelled as a finite-horizon game, given that regulatory periods often only last for four or five years, tacit collusion cannot emerge (Belleflamme and Peitz 2015)—in contrast to models of yardstick competition that use a repeated-game framework (Chong and Huet 2009).

A rationale for the existence of \({\overline{c}}_i\) could be regulatory, judicial, political, or public oversight of the firm’s activities that imply some limit to the amount of spending that the firm can undertake without facing backlash. Alternatively, one may view \({\overline{c}}_i\) as the historical cost level, and \({\underline{c}}_i\) the cost level that results after some optimal cost-reducing investment as in Shleifer (1985). Notice that the cost side of my model is more general than Shleifer’s because I do not impose any restrictions on functional form.

Whether the regulator knows \(q_i\) ex-ante is not important: The information asymmetry problem is created by the regulator’s lack of knowledge regarding the \({\mathbf {{\underline{c}}}}\).

Full knowledge of other firms’ parameters is for convenience. All that is strictly necessary is that firms expect to break even and that they have sufficient information to evaluate merger profitability.

This generalises to downward sloping demand functions unless in the exceptional case where monopoly prices are lower than the regulator’s price cap (see Appendix 1.2).

This effect depends on the existence of sufficiently positive outsider profits before the merger. If an outsider’s participation constraint was binding before the merger, any price decrease would lead to the outsider’s exit as its participation constraint would no longer be met.

The figure is drawn for the three-firm case, but a larger industry size would merely make the slopes less steep.

This is naturally a partial comparison of the two forms of yardstick competition. In practice other factors not modelled here such as the normative power of using a best-practice scheme or a regime’s vulnerability to collusion could have important ramifications for choosing one yardstick regime over the other.

Merger effects are, however, also affected by the distribution of production possibilities across firms. If all firms are identical, there cannot be welfare losses under either regime. But the two regimes differ with respect to which firms matter: Under A, all outsiders matter in principle and perverse incentives for efficiency-decreasing mergers are a possibility for all merger combinations where insiders are, on average, more efficient than outsiders before the merger (Proposition 2). Under B, the effect size depends only on cost differences between Firm 1 and Firm 2. The more similar (different) are the two firms’ production possibilities, the smaller (larger) is the potential for welfare losses.

Ex-post data is not yet available.

As the regulator’s pricing rule (6) is based only on a firm’s unit cost, network size does not affect equilibrium prices. The equilibrium price changes that are derived in Sect. 4.2 thus remain valid.

The analysis presumes that, while demand is elastic, it is not sufficiently elastic such that the regulator’s price cap ceases to be binding because monopoly prices are lower (hence firms find it optimal to set those). In the latter case, merger incentives would not be distorted as the unconstrained monopolists would have nothing to gain from manipulating an unbinding regulatory constraint through mergers.

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Titel: When Efficient Firms Flock Together: Merger Incentives Under Yardstick Competition
verfasst von: Jonas Teusch
Publikationsdatum: 30.10.2018
Verlag: Springer US
Erschienen in: Review of Industrial Organization / Ausgabe 2/2019
Print ISSN: 0889-938X
Elektronische ISSN: 1573-7160
DOI: https://doi.org/10.1007/s11151-018-9670-8

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