Problem set # 4

1. Horizontal mergers - Merger Paradox

Consider a market with n identical firms which produce a homogeneous good at marginal cost
c = 40. Inverse market demand is given by p = 110 − Q, where Q represents total output.
Firms compete a la Cournot.

(a) Identify the Nash equilibrium pre-merger, calculating equilibrium quantities, prices and
profits.
(b) Suppose m + 1 firms merge into one firm which produces the same good at the same
marginal cost c = 40. In this model, a merger is equivalent to the disappearance from the
market of m firms. Calculate equilibrium quantities, price and profits after the merger.
(c) Demonstrate that the outsiders (the firms not merging) always obtain a benefit from the
merger.
(d) Assume that n = 10 and demonstrate that a merger is profitable for the firms involved
only if it involves at least 9 firms.

2. Horizontal mergers and efficiency gains

Consider a market in which three firms produce a homogeneous good. Firms compete in
quantities and the inverse demand function is given by P = 280 − Q, with Q = q1 + q2 + q3 .
Cost functions are given by Ci (qi ) = 80qi + f , with i = 1, 2, 3. Firm 1 and 2 are considering a
merger, knowing that the cost of the resulting firm would be Cm (qm ) = 80bqm + af . Parameter
b ∈ [0, 1] represents the marginal cost reduction resulting from the merger while a ∈ [1, 2]
represents the fixed costs reduction. If for instance a = 1, the merged firm pays fixed costs (f )
only once; if instead a = 2, the fixed costs of the new firm are equal to the sum of the fixed
costs of the two merging firms (2f ).

(a) Identify the Nash equilibrium pre-merger calculating equilibrium quantities, price and
profits.
(b) Assume b = 1 and a = 1. Identify the Nash equilibrium post-merger calculating equi-
librium quantities, price and profits. Calculate the value of f for which the merger is
profitable for the firms involved. What is the effect of the merger on consumer surplus?
(c) Derive the value of f for which total welfare increases and discuss the result given the
preceding result.
(d) Assume now that f = 0 and b < 1. Individuate the Nash equilibrium post-merger calcu-
lating equilibrium quantities, price and profits. Derive the value of b for which the merger
is profitable for the firms involved. Derive the value of b for which consumer surplus
increases with the merger.
(e) A consulting firm has estimated b to be equal to 0.1. Firm 3, which is not involved in
the merger, has contacted the competition authority affirming that efficiency gains are
overestimated and the merger should not be authorized. How can you explain that?

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3. Horizontal mergers and capacity distribution
Consider a market in which three firms produce a homogeneous good. Firms compete in
quantities and market demand is given by P = 100 − Q, with Q = q1 + q2 + q3 . The cost
q2
function of firm i is given by C(qi ) = 30qi + 2ki i where ki represents the quota of total market
capacity detained by firm i. If this quota increases, the marginal cost of firm i decreases.

(a) Consider the initial situation in which each firm has 1/3 of total capacity. Calculate
equilibrium quantities and profits of each firm.
(b) Firm 1 and firm 2 decide to merge. The resulting firm now holds 2/3 of total capacity.
Determine equilibrium quantities and profits of each firm after the merger.
(c) Is the merger profitable? Why?

4. Horizontal mergers and efficiency gains (fixed costs)

Consider the Italian brewing industry in 1996. This is a typical oligopolistic market populated
by a few large firms. In 1996 Heineken wanted to acquire 100% of Birra Moretti’s social capital,
starting a merging process.
Consider the following exercise. Suppose that (as an exemplification) in this market there
are 3 firms: Heineken (H), Moretti (M) and Peroni (P). Suppose also that these firms are
symmetric, they have total cost function T Ci (qi ) = 80qi + F , where i = H, M, P , they produce
a homogeneous good and total demand is given by p(Q) = 160 − Q, where Q = qH + qM + qP .
Firms compete a la Cournot.

(a) Determine equilibrium quantities and price.

(b) Calculate equilibrium profits as a function of the fixed cost F. Which condition should
hold on F so that profits are non negative?

Suppose now that firm H and firm M merge creating “group Heineken” (HM) so that we have a
duopolistic market. The merger allows firms to reduce fixed costs duplication so that the total
cost function of firm HM is given by T CHM (qHM ) = 80qHM + αF , where qHM represents the
merged firm output and the parameter 1 ≤ α ≤ 2 indicates the reduction in fixed costs.

(a) Will the equilibrium price be higher or lower with respect to the previous scenario?
(b) Calculate profits of the two firms.
(c) Let’s assign two hypothetical values to F. Assume first that F is equal to 75: determine
for which value of α the merger is profitable for the two firms. Assume then that F=100:
do you expect that the value of α for which the merger is profitable will be higher or lower
now? Besides calculating the value of the parameter, give the economic interpretation
behind that result.
(d) Consider again F=100. For which values of α is the merger socially efficient? Discuss the
result.

5. Horizontal mergers and efficiency gains (variable costs)

Consider a market in which 3 firms compete a la Cournot. The inverse demand function is

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 given by P (Q) = 120 − 21 Q, where Q = q1 + q2 + q3 represents total output in the market.
Firms are symmetric and have total cost function T Ci (qi ) = 40qi , with i = 1, 2, 3.

(a) Calculate profits of the three firms.

Actually, the CEO of firm 1 is the father of the CEO of firm 2. The two are considering
whether a merger between their two firms would be profitable. The merger between firm
1 and 2 would allow them to reduce their variable costs, so that the total cost function of
the resulting firm would be T C1&2 (q1&2 ) = λ40q1&2 , where q1&2 represents the output of
the merged firm and λ < 1 indicates the variable costs reduction.
(b) Given that the two firms, labeled as 1&2 and 3, keep competing a la Cournot, calculate
the new equilibrium quantities and the equilibrium price.
(c) Calculate the profits of the two doupolists.
(d) Determine the reduction in variable costs (i.e. for which value of λ) the merger would be
profitable for the two firms.
(e) Suppose now that the antitrust authority is interested in protecting consumers, intervening
whenever consumer surplus diminishes. In case λ = 0.45, how would the authority act?
Which condition on λ should hold so that the authority does not oppose the merger?

6. Merger waves
Empirical evidence shows that in some periods mergers and acquisitions are more frequent than
in other periods. One of the explanations of this phenomenon, the so called “merger waves”,
refers to endogenous causes i.e. the fact that a merger between two firms can induce other
firms to merge as well.
This fact can be exemplified by a simple model. Consider n firms competing a la Cournot,
each having total costs equal to T Ci (qi ) = 40qi + 135. The market demand function is given
by P (Q) = 130 − Q.

(a) Calculate firms profits, assuming that the number of firms on the market is n = 4.
(b) Show that in case two of the 4 firms decided to merge (total number of firms would be 3)
they would have no incentive to do it. Assume that the firm resulting from the merger
pays the fixed cost F = 135 only once.
(c) Suppose now that, given the initial 4 firms, despite the merger is not profitable, two firms
decide to merge anyway. Show that, given the first merger, now the two other firms have
the incentive to merge themselves. Continue to assume that the firm resulting from the
new merger pays the fixed cost F = 135 only once.

7. Free-entry
Consider Industry X, where firms compete à la Cournot and produce a homogeneous good.
In the industry, n identical firms operate and their cost function is T C(qi ) = 40qi + F , where
qi denotes the quantity produced by each firm. Observe that, in addition to marginal costs,
firms bear fixed entry costs F amounting to 25. Market demand is expressed by the function
P (Q) = 160 − 2Q, where Q denotes total output produced by firms in the industry.

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 (a) Analytically determine the quantity produced by each firm, total output, price and indi-
vidual profits at the post-entry equilibrium, as functions of n.
(b) Determine the number of firms that will be able to compete in the industry in the free-entry
equilibrium.
(c) What will happen to the number of firms n if fixed costs F considerably increase, shifting
from 25 to 50? Explain.
(d) Now assume that fixed entry costs are again at their starting level, i.e. F = 25, but
grow as the market size grows. What type of costs is this? Explain what happens to the
structure of the industry in case of demand increases and provide a reason for this (no
calculations are required).

8. Free-entry (2)
Consider industry X, where firms compete à la Cournot and produce homogeneous products.
In the industry, n identical firms operate and their cost function is T C(qi ) = αqi2 − 10qi + F ,
where qi denotes the quantity produced by each firm. Observe that marginal costs are not
constant in this case. Market demand is expressed by the function P (Q) = 60 − 2Q, where Q
denotes total output produced by firms in the industry.

ˆ Determine the number of firms that will be able to compete in the industry in the long-run
equilibrium.

Comment on the following statements, explaining why there are true, false or uncertain.

Statement 1
Consider two product markets, market A and market B. Firms produce the same good in both
markets. The demand function is equal to P = 10−Q and firms use the same technology characterized
by constant marginal costs equal to 0 and fixed costs equal to F = 1. In market A firms compete à
la Bertrand, while in market B they compete à la Cournot. In both cases, the good is homogeneous.
STATEMENT TO DISCUSS: Since market size is the same and fixed costs are the same, it is
reasonable to conclude that the level of concentration of the two markets will be the same as well
(answer without doing calculations).

Statement 2
Consider a market populated by five firms. Firms 1 and 2 notify to the competent anti-trust au-
thority their intention to merge. They claim that marginal costs will diminish substantially after the
merger, because the merged entity will gain bargaining power vis à vis supplier and will be able to
negotiate lower input prices. For this reason, according to the merging firms, the merger should be
authorized. Firms 3, 4, and 5, the outsiders to the merger, have supported the claims of the merging
parties. STATEMENT TO DISCUSS: In this case the merger is expected to be welfare beneficial
and should be authorised.

Statement 3
Demand for tyres is given by Q = 14 (26 − p) in country A and by Q = 12 (26 − p) in country B. The

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technology to produce tyres is the same in the two countries and exhibits marginal costs equal to 2
and fixed sunk entry costs equal to 9. STATEMENT TO DISCUSS: We expect that the free-entry
equilibrium in market B is characterised by twice as many firms an in market A.