Horizontal merger

1. There are initially three …rms in a homogeneous good industry, each with a
cost function C (qi) = 2qi + F , i = 1; 2; 3, where qi is produced quantity
by …rm i, and F is a …xed cost. Demand for the good is given by

p = 14 Q;
where Q is total output.

(a) Suppose that the …rms choose quantities. Find the Cournot-Nash equi-
librium: quantities, price and pro…ts.
Solution: The pro…ts of Firm 1 are given by

1 = (14 q1 q2 q3 2) q1 F:
 Maximising with respect to q1 yields
@ 1
= 12 2q1 q2 q3 = 0:
@q1
Setting q1 = q2 = q3 and solving yields

q1 = q2 = q3 = 3:
This gives price
p = 14 9 = 5;
and pro…ts

1 = 2 = 3 = (5 2) 3 F =9 F:

(b) Suppose that Firm 1 and Firm 2 merge. Find the new Cournot-Nash
equilibrium. Show that such a merger is pro…table only if F is su¢ -
ciently high.
Solution: Since the …rms produce a homogeneous product, a merger
between Firm 1 and Firm 2 is equivalent to going from a symmetric
triopoly to a symmetric duopoly. Let us denote the merged …rm by m.
The pro…ts of the merged …rm are

m = (14 qm q3 2) qm F:
Maximising with respect to qm yields
@ m
= 12 2qm q3 = 0:
@qm
Setting qm = q3 and solving yields

qm = q3 = 4:
This gives a price
p = 14 8 = 6:
 Pro…ts are given by

m = 3 = (6 2) 4 F = 16 F:
The merger is pro…table if

m> 1 + 2
()
16 F > 2 (9 F)
()
F > 2:

(c) What is the e¤ect of the merger on

i. consumer surplus?
 Solution: Before the merger, consumer surplus was
1
CSbm = 92 = 40:5:
2
After the merger, consumer surplus is
1
CSam = 82 = 32:
2
Thus, consumer surplus goes down (by 8:5).

ii. social welfare?

Solution: Before the merger, social welfare was

Wbm = 40:5 + 3 (9 F ) = 67:5 3F:

After the merger, social welfare is

Wam = 32 + 2 (16 F ) = 64 2F:

Welfare increases (reduces) if

64 2F > (<) 67:5 3F

()
F > (<) 3:5:
2. A homogeneous goods industry consists of three …rms with identical costs
C (q ) = 18q + q 2: Market demand is Q = 150 p.

(a) What is the industry equilibrium (price, output and pro…ts) if the …rms
compete á la Cournot?
Solution: Pro…ts of Firm 1 are

1 = (150 q1 q2 q3) q1 18q1 q12:

Maximising with respect to q1 yields
150 2q1 q2 q3 18 2q1 = 0:
Setting q1 = q2 = q3 and solving yields
q1 = q2 = q3 = 22:
The price is then given by
p = 150 3 (22) = 84:
 Pro…ts are

1 = 2 = 3 = 84 22 18 22 (22)2 = 968:

(b) Consider a merger between Firm 1 and Firm 2. Would this merger
be pro…table? (Hint! Given that the cost function represents plant-
speci…c costs, should the merged …rm use both plants or not after the
merger?)
Solution: Because of decreasing returns to scale, the merged …rm min-
imises the costs of production by splitting total output equally across
the two plants. Thus, the pro…t-maximising problem of the merged
…rm is given by
max = 1+ 2 = (150 q1 q2 q3) (q1 + q2) 18 (q1 + q2) q12 q22:
q1 ;q2
Maximising with respect to q1 yields
150 2q1 2q2 q3 18 2q1 = 0:
Maximising with respect to q2 yields
150 2q2 2q1 q3 18 2q2 = 0:
Solving with respect to q1 and q2 yields
1
q1 = q2 = 22 q3:
6
The maximisation problem of Firm 3 is
max 3 = (150 q1 q2 q3) q3 18q3 q32:
q3
Maximising with respect to q3 yields
150 2q3 q1 q2 18 2q3 = 0:
Simultaneously solving the …rst-order conditions for q1 = q2 and q3
yields
q1 = q2 = 18;
q3 = 24:
The price is then given by

p = 150 2 (18) 24 = 90:

Pro…ts are given by

1 = 2 = 90 18 18 18 (18)2 = 972;

3 = 90 24 18 24 (24)2 = 1152:
The merger is pro…table, since the pro…t of the merged …rm is 2 972 =
1944, which is higher than the sum of the pro…ts of Firm 1 and 2 before
the merger: 2 968 = 1936: Because of decreasing returns to scale,
the merger yields cost synergies by allowing the merged …rm to split
production across two plants. This is enough to make the merger
pro…table.
(c) Suppose that the …rms’cost functions are C (q ) = 18q instead. Would
the merger be pro…table in this case? Explain.
Solution: In this case there are no cost synergies, and we know from
that Salant et al. (1983) result that the merger would not be pro…table.
Before the merger:

1 = (150 q1 q2 q3 18) q1:

Maximising with respect to q1 :

150 2q1 q2 q3 18 = 0:
Setting q1 = q2 = q3 and solving yields

q1 = q2 = q3 = 33:
The price is p = 150 3 (33) = 51 and pro…ts are

1 = 2 = 3 = (51 18) 33 = 1089:

After the merger, the pro…ts of the merged …rm is

m = (150 qm q3 18) qm:

Maximising with respect to qm yields

150 2qm q3 18 = 0:
Setting qm = q3 and solving yields

qm = q3 = 44:
The price is p = 150 2 (44) = 62 and pro…ts are

m = (62 18) 44 = 1936:

This merger is not pro…table, since

m ( 1 + 2) = 1936 2 (1089) = 242 < 0:

3. Consider an industry with four identical Cournot competitors producing a
homogeneous product, facing market demand of Q = 64 p. The cost
function for each …rm is C (q ) = 4q + 100.

(a) Show that a merger between two of the four …rms is pro…table for the
merger participants.
Solution: Pro…ts for Firm 1 are

1 = (64 q1 q2 q3 q4 4) q1 100:
Maximising with respect to q1 yields

64 2q1 q2 q3 q4 4 = 0:
Setting q1 = q2 = q3 = q4 and solving yields

q1 = q2 = q3 = q4 = 12:
The price is p = 64 4 (12) = 16 and pro…ts are

1 = 2 = 3 = 4 = (16 4) 12 100 = 44:

After the merger, the market is a symmetric triopoly. Denoting the
merged …rm by m, its pro…ts are

m = (64 qm q3 q4 4) qm 100:
Maximising with respect to qm yields

64 2qm q3 q4 4 = 0:
Setting qm = q3 = q4 and solving yields

qm = q3 = q4 = 15:
The price is p = 64 3 (15) = 19 and pro…ts are

m = 3 = 4 = (19 4) 15 100 = 125:

 The merger is pro…table if

m> 1 + 2
()
125 > 44 + 44;
which is true.

(b) How does this merger a¤ect consumers’ surplus? How does it a¤ect
total welfare? Explain.
Solution: Before the merger, consumers’surplus is given by
1
CSbm = (48)2 = 1152:
2
After the merger, consumers’surplus is
1
CSam = (45)2 = 1012:5:
2
 So the merger reduces consumers’surplus (because it leads to a higher
price). Total welfare before the merger is
Wbm = 1152 + 4 (44) = 1328:
After the merger, total welfare is
Wam = 1012:5 + 3 (125) = 1387: 5:
So the merger leads to higher welfare (because of the …xed cost saving).

(c) Calculate the welfare e¤ect of a merger between three of the four …rms.
Solution: Suppose that Firms 1, 2 and 3 merger. The market is then
a symmetric duopoly. Pro…ts of the merger …rm are

m = (64 qm q4 4) qm 100:
Maximising with respect to qm yields
64 2qm q4 4 = 0:
Setting qm = q4 and solving yields

qm = q4 = 20:
The price is p = 64 2 (20) = 24 and pro…ts are

m = 4 = (24 4) 20 100 = 300:

Consumers’surplus is
1
CS = (40)2 = 800
2
and total welfare is

W = 800 + 2 (300) = 1400:

Thus, a merger between three of the four …rms implies that total welfare
increases from 1328 to 1400.
(d) From a perspective of total welfare, what is the optimal market struc-
ture?
Solution: To answer this question, we need to calculate total welfare
in the last possible market structure, namely monopoly. The pro…ts of
a monopolist is given by

= (64 q 4) q 100:
Maximising with respect to q yields

64 2q 4=0
()
q = 30:
The price is p = 64 30 = 34 and pro…ts are

= (34 4) 30 100 = 800:

Consumers’surplus is
1
CS = (30)2 = 450
2
and total welfare is

W = 800 + 450 = 1250:

This is lower than in any of the other market structures. The opti-
mal market structure is duopoly (which can be achieved by a merger
between three of the four …rms), which gives a total welfare of 1400:
4. Consider a homogeneous-goods industry consisting of three …rms with
identical cost functions C (q ) = 10q . The inverse market demand is
p = 25 Q, where Q is total output. Firms behave as Cournot competi-
tors.

(a) What is the Nash equilibrium (price, quantity and pro…ts)?

Solution: The pro…ts of Firm 1 are

1 = (25 q1 q2 q3 10) q1:

Maximising with respect to q1 yields

25 2q1 q2 q3 10 = 0:
Setting q1 = q2 = q3 and solving yields
15
q1 = q2 = q3 = :
4
 This gives a price of
15 55
p = 25 3 = ;
4 4
and pro…ts are
55 15 225
1= 2= 3= 10 = :
4 4 16

(b) Suppose that two …rms merge, but the merger does not give rise to
any a¢ ciency gains. What is the new Nash equilibrium?
Solution: A merger without e¢ ciency gains implies going from a sym-
metric triopoloy to a symmetric duopoly. Suppose that Firms 1 and 2
merge. Let’s denote the merged …rm by m. The pro…ts of the merged
…rm is given by

m = (25 qm q3 10) qm:

 Maximising with respect to qm yields
25 2qm q3 10 = 0:
Setting qm = q3 and solving yields
qm = q3 = 5:
This gives a price of p = 25 2 (5) = 15 and pro…ts of

m = 3 = (15 10) 5 = 25:

(c) Check if such a merger is pro…table for the merging …rms.

Solution: The merger is not pro…table because
225 25
m ( 1 + 2) = 25 2 = < 0:
16 8

(d) Suppose instead that the merger produces an e¤ciency gain for the
merging …rms, and the production cost becomes C (q ) = 5q for the
new merged …rm, while the other …rm still produces at C (q ) = 10q , as
before. Calculate the post-merger Nash equilibrium in this case. Is the
merger pro…table for the merging …rms? Is it pro…table for the outside
…rm?
Solution: In this case, the post-merger game is an asymmetric duopoly.
The pro…ts of the merged …rm are

m = (25 qm q3 5) qm:
Maximising with respect to qm yields
25 2qm q3 5 = 0:
The pro…ts of Firm 3 are

3 = (25 qm q3 10) q3:

Maximising with respect to q3 yields
25 qm 2q3 10 = 0:
Simultaneously solving the two …rst-order condition yields
25 10
qm = and q3 = :
3 3
The price is
25 10 40
p = 25 =
3 3 3
and pro…ts are
40 25 625
m= 5 =
3 3 9
and
40 10 100
3= 10 = :
3 3 9
The merger is pro…table if
625 225 2975
m ( 1 + 2) = 2 = > 0;
9 16 72
 which is true. For the outside …rm (Firm 3), the merger is pro…table if
100 225
>
9 16
()
11:111 > 14:063;
which is not true. Thus, Firm 3 is harmed by the merger.

(e) Suppose that the Competition Authority approves mergers it they lead
to a predicted reduction in the market price. Will the above-described
merger be approved under this criterion?
Solution: The price e¤ect of the merger is
40 55 5
p= = < 0:
3 4 12
The price goes down, so the merger will be approved.
(f) Suppose instead that the Competition Authority approves all mergers
as long as the predicted market share of the merged …rm does not
exceed 70%. Will the above-described merger be approved under this
criterion?
Solution: The market share of the merged …rm is
25
3 5
sm = 25 10 = = 0:714 29 > 0:7;
3 + 3
7
so the merger will not be approved according to this criterion.
5. Consider a Cournot duopoly where two …rms produce a homogeneous prod-
uct. Market demand is given by the inverse demand function P = 15 Q;
where Q = q1 + q2. The two …rms have di¤erent production costs: Firm
1 has a cost function C (q1) = q1 + F , while Firm 2 has a cost function
C (q2) = 2q2 + F .

(a) Find the Nash equilibrium and calculate the pro…t of each …rm and the
consumers’surplus.
Solution: Here, the pre-merger game is an asymmetric duopoly. The
pro…t-maxmisation problem of Firm 1 is

max 1 = (15 q1 q2 1) q1 F:
q1
The …rst-order condition is
@ 1
= 14 2q1 q2 = 0:
@q1
The pro…t-maximisation problem of Firm 2 is
max 2 = (15 q1 q2 2) q2 F:
q2
The …rst-order condition is
@ 2
= 13 q1 2q2 = 0:
@q2
Simultaneously solving the two …rst-order conditions yields the follow-
ing Nash equilibrium:
q1 = 5 and q2 = 4:
This gives an equilibrium price of 15 5 4 = 6, so the pro…t of each
…rm is
1 = (6 1) 5 F = 25 F
and
2 = (6 2) 4 F = 16 F:
 The consumer surplus is
1 1
CS = Q2 = 92 = 40:5
2 2
(b) Will a merger between these two …rms lead to any cost savings? If yes,
which type of cost savings?
Solution: This merger leads to both variable and …xed cost savings.
Variable cost savings because the two …rms have di¤erent marginal
costs, which implies that all production will be produced at the lower
marginal cost after the merger. And …xed cost savings because the
total …xed costs reduces from 2F to F as a result of the merger.

(c) Calculate the post-merger outcome and determine the welfare e¤ect of
the merger for the following two cases:

i. F = 0,
ii. F = 10.
Solution: The merger leads to a monopoly with a cost function
given by the cost function of Firm 1 before the merger. The pro…t-
maximisation problem of the monopolist is

max = (15 Q 1) Q:
Q
The …rst-order condition is
@
= 14 2Q = 0;
@Q
yielding
Q = 7:
This yields a price of 15 7 = 8, so pro…ts are given by

= (8 1) 7 F = 49 F:
Consumers’surplus is
1 1
CS = Q2 = 72 = 24:5
2 2
Total welfare is

W = + CS = 49 F + 24:5 = 73:5 F:
Before the merger, total welfare is

Wpre merger = 37 2F + 40:5 = 77:5 2F

If F = 0, the welfare e¤ect of the merger is

W = 73:5 77:5 = 4
If F = 10, the welfare e¤ect of the merger is

W = (73:5 10) (77:5 20) = 6

6. Consider a homogeneous goods Cournot industry with 4 …rms. Demand
for the good is given by Q = 25 p. Each …rm has a marginal production
cost of 5 and a …xed cost of 15.

(a) Find the Nash equilibrium and calculate

i. total pro…ts,

ii. total consumer surplus,

iii. total welfare,

iv. the Her…ndahl Index and the Lerner Index.

Solution: Since this is a symmetric game, we can solve the pro…t-
maximisation problem for one …rm and apply symmetry to …nd the
Nash equilibrium. The problem solved by Firm 1 is
max 1 = (25 q1 q2 q3 q4 5) q1 15:
q1
The …rst-order condition is
@ 1
= 20 2q1 q2 q3 q4 = 0:
@q1
Applying symmertry, the Nash equilibrium is given by
q1 = q2 = q3 = q4 = 4:
This gives a market price of 25 16 = 9, which implies that the
pro…t of each …rm is

1 = 2 = 3 = 4 = (9 5) 4 15 = 1:
Consumers’surplus is
1
CS = (16)2 = 128:
2
 Total welfare is
4
X
W = i + CS = 4 + 128 = 132:
i=1
The Her…ndahl index is

HHI = 4 (0:25)2 = 0:25:

The Lerner index is
9 5 4
L= = 0:44:
9 9
(b) Suppose that two of the …rms merge. Calculate the post-merger Nash
equilibrium.

i. How does the merger a¤ect the Her…ndahl Index and the Lerner
Index?
ii. Is the merger bene…cial for the …rms?

iii. Is the merger bene…cial for consumers? Explain why/why not.

iv. Is the merger bene…cial for social welfare?

Solution: A merger implies that the market structure goes from a
symmetric oligopoly with 4 …rms to a symmetric oligopoly with 3
…rms. After the merger, the pro…t-maximisation problem of Firm 1
is
1 = (25 q1 q2 q3 5) q1 15:
The …rst-order condition is
@ 1
= 20 2q1 q2 q3 = 0:
@q1
Applying symmetry, the Nash equilibrium is given by
q1 = q2 = q3 = 5:
The Her…ndahl index after the merger is
1 2 1
HHI = 3 = ;
3 3
so the merger increases the concentration in the market. The new
market price is 25 15 = 10, so the Lerner index after the merger
is
10 5 1
L= = :
10 2
Thus, the merger also increases the Lerner index. The pro…t of each
…rm is

1 = 2 = 3 = (10 5) 5 15 = 10:
The merger bene…cial for all …rms in the market. Each of the merger
participants has a pro…t increase of 10
2 1 = 4, while each of the
non-merging …rms has a pro…t increase of 10 1 = 9. The merger
is not bene…cial for consumers, because the market price increases.
The consumer surplus after the merger is
1
CS = (15)2 = 112:5
2
Total welfare after the merger is

W = 3 (10) + 112:5 = 142:5

Thus, the merger increases welfare from 132 to 142:5. This welfare
increase is because of the …xed-cost saving generated by the merger.