In judging whether a proposed merger should proceed, courts and regulatory agencies weigh two potential effects against each other. The first is market power: a firm’s ability to profitably raise prices above competitive levels without losing enough customers to make the increase unprofitable . Agencies such as the Department of Justice and the Federal Trade Commission predict whether the combined firm will gain enough control to substantially raise prices. The second effect is a positive one. Combining two firms can generate efficiencies (such as through consolidating production or innovative capabilities) that lower the cost of production, potentially passing savings on to consumers. Regulating agencies aim to approve those mergers where the predicted benefits from efficiency outweigh the predicted harm from increased market power.
This process is complicated by the fact that, as the authors in this paper show, firms tend to propose mergers with either large efficiency gains or large market power gains (and rarely deals with neither). This is because firms propose mergers to maximize profits, and both greater market power and lower costs raise profits, so a deal only needs to be large on one dimension to be worth pursuing.
To understand how selecting on a combined threshold can produce a negative relationship between two otherwise unrelated traits, consider college admissions. A college that admits students whose combined essay quality and test score meet a certain threshold will tend to enroll a student body with either high test scores or strong essays. While among all applicants essays and test scores are unrelated (with rare students strong on both), among admitted students the two are negatively correlated, with an admit’s weak essay indicating that his or her test scores must have been high.
In this paper, the authors develop this theory about the makeup of proposed mergers and discuss what it means for antitrust regulation. They build a model of how firms decide whether to propose a merger, starting with a simple case and then reassessing their result under more realistic conditions. They find the following:
- Market power and efficiency gains are negatively related among proposed mergers. This relationship holds under a range of assumptions and is owed simply to the nature of selection into mergers, rather than any overconfidence, bias, or overstated synergies from the merging firms.
- A firm’s existing market position shapes which mergers it finds worth proposing. Firms with existing market power weight additional market power more heavily because a larger share of their profits already comes from markups. Firms in more competitive markets have little pricing power available to gain, and therefore weight efficiency gains more heavily.
- Raising the cost of merging can make the negative relationship even stronger. Costs such as regulatory burden, litigation risk, and review raise the profitability threshold that a deal must clear for firms to consider it worthwhile to pursue. A higher bar squeezes the surviving deals toward the frontier where market power and efficiency trade off most sharply.
This research reveals a challenge for regulators. The mergers of greatest concern tend to offer the least in efficiency gains. The research also shows that regulatory review shapes not only which mergers are approved, but which are proposed in the first place.