ChainWhat it assumes · how to break it
Start
Two rival firms in the same market merge, for example two mobile networks combining their customers and networks.
1
As a result, the merged firm can cut duplicated costs, such as head offices and networks, and buy inputs in bulk at lower prices.
economies of scale · purchasing economies
economies of scale · purchasing economies
Best link to attack
Assumes: The two businesses can be combined smoothly.
Assumes: The two businesses can be combined smoothly.
But: Different IT systems, cultures and management styles can make integration slow and costly, and a much larger firm may suffer diseconomies of scale.
2
At the same time, it faces fewer close rivals, so it has more market power to raise price.
market power · concentration
market power · concentration
Assumes: The merging firms were close competitors.
But: If strong rivals remain, the merged firm cannot raise price without losing customers to them.
3
Therefore, average cost falls while average revenue rises, so the gap between AR and AC widens and supernormal profit increases.
supernormal profit
supernormal profit
Assumes: Higher profits are not competed away by entry.
But: If the market is contestable, higher profits attract new firms that undercut the merged firm.
End
The merged firm's profits rise through lower costs and greater market power.
Evaluation chain
- E1However, higher profit relies on the merged firm actually achieving the cost savings it planned.
- E2Because a much larger firm is harder to manage and coordinate, communication and motivation can suffer, leading to diseconomies of scale.
- E3As a result, AC may rise instead of falling, and the costs of combining the two businesses can take years to recover.
- E4So a merger may raise profits less than expected, or even reduce them, where integration goes badly; the gain is largest where the firms are a close fit and savings are easy to achieve.
Another way to attack it: Managers may pursue a merger to grow the firm, which raises their own pay and status, so the deal may be driven by growth objectives with profit a lower priority.
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Questions this answers
- Explain why firms may choose to merge with a rival.
- Assess the likely impact of a horizontal merger on the profits of the merged firm.
- Discuss whether mergers always increase profits.
Diagram
Diagram with AR, MR, MC and AC: show AC shifting down (economies of scale) and AR becoming less elastic, so the supernormal profit area (P − AC) × Q grows.
Reverse and related
Demerger → loss of economies of scale and market power, so profits may fall, though focused firms can cut diseconomies of scale.