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1/36 Introduction Merger Waves Merger Causes Merger Effects: Theory ECON 461: Industrial Organization Lecture 23: Mergers 1 Joe Mazur1 Purdue University Friday, March 30, 2018 1Adapted with permission from Stephen Martin’s material. Joe Mazur I.O. Lecture 23: Mergers 1 2/36 Introduction Merger Waves Merger Causes Merger Effects: Theory Outline 1 Introduction 2 Merger Waves 3 Merger Causes 4 Merger Effects: Theory Joe Mazur I.O. Lecture 23: Mergers 1 3/36 Introduction Merger Waves Merger Causes Merger Effects: Theory Introduction We begin our discussion of mergers by defining different merger types. We then turn to an enduring characteristic of mergers: They occur in waves, with a cycle of intense merger activity, followed by a period in which mergers are smaller and less frequent, only for the cycle to repeat. We next discuss some of the factors economists have put forward to explain mergers. In subsequent lectures, we will examine the effects of mergers in more depth. Joe Mazur I.O. Lecture 23: Mergers 1 4/36 Introduction Merger Waves Merger Causes Merger Effects: Theory Types Of Mergers Economists classify mergers as follows: Horizontal: between firms in the same market. Vertical: between a supplier and a customer, for example, between a manufacturer and an (upstream) input supplier, or between a manufacturer and a (downstream) distributor. Conglomerate: between firms that operate in unrelated markets. Joe Mazur I.O. Lecture 23: Mergers 1 5/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Outline 1 Introduction 2 Merger Waves 3 Merger Causes 4 Merger Effects: Theory Joe Mazur I.O. Lecture 23: Mergers 1 6/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves Chronology First Merger Wave: 1893 to 1903 (U.S. Steel, 1901) Second Merger Wave: early 1920s to 1929 Merger Boomlet: late 1940s2 Third Merger Wave: 1964/1965 to 1970/1971 Fourth Merger Wave: late 1970s to late 1980s Fifth Merger Wave: early 1990s, continuing after a brief interruption after 9/11/2001 2Smaller, but worth mentioning as a contributing factor in the passage of the Celler-Kefauver Act of 1950. Joe Mazur I.O. Lecture 23: Mergers 1 7/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves Chronology Source: Scherer (2006) Joe Mazur I.O. Lecture 23: Mergers 1 8/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 The first merger wave was a result of major innovations in three areas. Transportation: the railroad and the steamship turned the United States into a single economic market. The New York Stock Exchange developed into a financial market on which securities could be sold. Permitted business to assemble massive amounts of capital. Created a class of financiers with a personal interest in promoting the amalgamation of previously independent businesses. Corporate law evolved to make the corporation a form of organization that would permit business to manage those vast amounts of capital. Joe Mazur I.O. Lecture 23: Mergers 1 9/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 The means by which horizontal combinations were carried out evolved over time. Cartels (e.g. the Southern Railway and Steamship Association) These were often unstable, as adherence to the agreement could not be compelled. As such, they failed to stabilize the market. Trusts (e.g. Standard Oil) Under the trust form of business organization, shares of stock in constituent companies would be turned over to trustees in return for shares of stock in the trust. The trustees held voting control of the constituent companies, which remained legally independent firms. This ensured against defection. The owners of the constituent companies received dividends on their shares in the trust, so that it was in their own self-interest that the trust should succeed. Joe Mazur I.O. Lecture 23: Mergers 1 10/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 Corporations Early corporations required specific grant of a corporate charter by a state legislature. Such grants indicated specifically what a corporation could and could not do. Early corporations were not allowed to own shares of stock in other corporations. At one time, it was thought that there was no particular need for either state or federal antitrust law to regulate business: If a corporation misbehaved, the state that had granted its charter could simply revoke the charter. For example, in 1872, the Pennsylvania Legislature revoked the charter of the South Improvement Company, which you will recall was a corporation that had been a tool of the Standard Oil Trust in its effort to control the oil industry. Joe Mazur I.O. Lecture 23: Mergers 1 11/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 But it became clear that a corporation could simply move from one state to another. States (following the lead of New Jersey) began to compete to attract corporations and the tax revenue that came with them. The corporation became a flexible form of business organization. Joe Mazur I.O. Lecture 23: Mergers 1 12/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 The firms created in the first merger wave often very nearly monopolized their markets, for example: Standard Oil American Sugar Refining Company (1891) United States Steel Corporation (1901) Monopolization was claimed as an advantage by promoters (e.g. investment banks): The monopolist would be able to stabilize prices; By rationalizing production (e.g. closing outdated plants, getting rid of excess capacity), the monopolist would be more efficient. Hence prices would be stabilized at a lower level than would have been possible without combining operations under a single management. Joe Mazur I.O. Lecture 23: Mergers 1 13/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 Of course, we know now that monopoly power has significant disadvantages. Granting for the sake of argument that cost is lower, price is nevertheless likely to be higher due to the increase in market power. Another critique, not so prominent at the time, is that rivalry is a stimulus to innovation, so that the rate of technical progress may be less under monopoly than under oligopoly. Joe Mazur I.O. Lecture 23: Mergers 1 14/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 The firms put together during this first merger wave suffered varying fates. Those which were successful were almost all in manufacturing. In industries like textiles or publishing, mergers did take place, but the scale of efficient operation was small relative to the size of the market. When the post-merger firm raised prices, rapid entry eroded its market share. Why does a larger scale of efficient operation serve as an entry barrier? Among manufacturing firms created in the first wave, those that survived were the ones that integrated operations under unified, effective management. Joe Mazur I.O. Lecture 23: Mergers 1 15/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 The Standard Oil Company was broken up by the U.S. government after the landmark 1911 antitrust decision. The American Sugar Refining Company broke itself up shortly thereafter. United States Steel still exists today. As it was unable to prevent the entry and expansion of rivals, its market share declined over much of the century following its formation. It diversified into many different product markets. In 1982, it acquired Marathon Oil Company. In 1986, it changed its name to USX Corporation. At this time, steel accounted for about one-quarter of the company’s activity. In 2001, USX Corporation spun off its steel operations, which became an independent company, once again known as U.S. Steel. Joe Mazur I.O. Lecture 23: Mergers 1 16/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 A 1935 analysis by Shaw Livermore of firms created in the first merger wave classified them as follows: 146 successes, of which 130 efficiency-based and 16 to monopoly position or strategic conduct. 28 firms underwent minor reorganizations and survived, without great profitability. 13 mergers where the new management was ousted fairly quickly and the financial and production structure reorganized. 141 failures. In the words of Arthur Stone Dewing, “the trusts turned out ill.“ Joe Mazur I.O. Lecture 23: Mergers 1 17/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 As we have seen in our discussion of the rise of large firms, it was vertical expansion, far more than horizontal mergers, that created enduring positions of market dominance. Standard Oil never really had monopoly control of crude oil production; it controlled refining and distribution. The Corn Products Refining Company (formed in 1906 after a series of unsuccessful horizontal mergers in starch and glucose) integrated backward into purchasing and forward into marketing. The former whiskey trust, the Distillers Corporation, faced bankruptcy in 1895, at which point it closed unproductive plants, purchased two liquor wholesalers, and set up retail distribution outlets in major cities. Joe Mazur I.O. Lecture 23: Mergers 1 18/36 Introduction Merger Waves Merger Causes Merger Effects: Theory The First Merger Wave: 1893-1903 The Second Merger Wave: The 1920s Mergers through the 1960s Mergers in the 1980s and Beyond Merger Waves First Merger Wave: 1893-1903 In most cases, vertical mergers promoted enduring market power where continuous production allowed sharp reduction in cost (whiskey, flour) but required a dependable supply of inputs and reliable outlets to sell production. Where all three were combined under a single effective management, an efficiency advantage was obtained