Chapter 2 Choice between Cartels and Horizontal Mergers

2.1 Introduction

Competition is traditionally seen as a means of attaining efficiency and fairness.

Horizontal agreements in the form of cartels and horizontal mergers in the absence of
efficiencies lead to introduction of horizontal restraint in the market and reduction of
competition2. In fact, they are often seen as alternative ways to coordinate the quantity or
price choices of firms in order to increase the profitability of the firms involved.

Empirical evidence suggests that in industries characterized by cartelist activities

firms resort to mergers when cartels become a less viable alternative. Neumann (2001) argues
that German industries like cement, food processing, machine building, etc. adopted cartelist
activities in order to attain monopolistic power only when mergers were not possible. A
similar trend has also been noticed in the United Kingdom. The Restrictive Trade Practices
Act (1956) which outlawed cartels triggered a wave of merger in the United Kingdom. In
United States, steel and rail-roading, two heavily cartelized industries, resorted to merger at a
substantially greater pace beginning in 1898, when they were banned by the Sherman Act.
Thus one can argue that stricter legal enforcement against a cartel increases the relative cost
of cartel as compared to merger. Consequently, firms resort to mergers. This phenomenon is
now being observed in case of international mergers. Evenett et al (2002), examining the
pattern in duration for 1990s samples of international cartels, observe that joint ventures and
mergers are among the different measures adopted by firms for survival, in cartel-prone
industries when cartel formation is restricted by law. This discussion also has implications for
the development of competition policy in developing economies like India.

The above discussion suggests that it is the development of the anti-trust law which
acted as the driving force compelling industries engaged in cartelist activities to resort to
merger. However, there are other factors that facilitated/ deterred this transition by providing
conditions favorable/unfavorable to them. Economies of scale and uncertainties,

2
Mergers between the competitors are known as horizontal mergers. Horizontal agreement is a broader concept
which includes allocation of customers or territories to different suppliers. It also includes group boycotts as
well as arrangement among buyers to suppress the price of inputs.

11
concentration of firms in the industry, and competitive intensity, as discussed in the next
section, have been dealt in the literature as factors influencing the profitability of cartel and
merger separately. This can also influence the choice between cartel and merger.

In this chapter, we attempt to model the firm’s choice between joining a cartel and
merging taking into account the effect of market structure and industry characteristics and
antitrust law or competition policy. We show that in the absence of any penalty on cartel
firms always prefer to join a cartel to merging, when the latter does not involve any
efficiency gains. We also discuss the impact of antitrust regulation against cartel in both
presence and absence of merger regulation.

The rest of the chapter is organized as follows. In Section 2, we present the

background literature. In Section 3, we present the model. In Section 4, we analyze the
effects of regulation on cartel in both the presence and absence of merger regulation. This is
followed by a discussion on policy implication and concluding remarks in Section 4.

2.2 Review of the background literature

A cartel is a group of formally independent producers, whose goal is to increase their

collective profits by means of restrictive trade practices, for e.g. price fixing, limiting supply,
etc. Although, the primary motive of cartels remains price fixing, it is often defended as being
indispensable for coping with declining demand in industries with sunk cost (Neumann
2001). Further, in case of industries with high ratio of fixed costs to variable costs, cartels are
regarded as a way to avoid entry-induced “ruinous competition” (Posner and Easterbrook
1981).

Horizontal merger is used by companies, producing the same product, for expanding
their operation to increase long term profitability. Mergers occur for a myriad of reasons
ranging from a normal business motive to tendencies of monopolization (Scherer and Ross
1990). Mergers are often resorted to save failing firms and even to take advantage of tax
considerations and economies of scale and scope. Mergers are often expected to infuse
superior management into companies suffering from talent and motivational deficiencies.
Irrespective of the motive, the underlying objective of mergers is always associated with

12
acquiring higher profitability. In this sense, cartels and horizontal mergers serve as
alternatives.

Cartel involves operational difficulties like defection, problem of co-ordination in the

absence of binding contracts, threat of entry leading to dilution of profit and destabilization,
apart from being generally illegal. To avoid these problems associated with cartel, firms often
resort to merger. However, generally cartel and merger are not considered as alternatives
because it is usually presumed that firms would inevitably choose merger over price fixing if
they could since merger avoids a host of problems that cartels face. This argument is not
wholly true. Mergers might also involve diseconomies in the form of high organization costs
which include resistance to change among employees, unclear division of responsibilities,
employment insecurity and conflicts arising from hidden agendas of merging firms. So that as
Bittlingmayer (1985) argues, for some high enough diseconomies from merger and low
enough monopoly gains the preferred choice would be cartel, other things remaining the
same.

The occurrence and effectiveness of cartel and/or merger are also influenced by some
firm and market characteristics. Posner and Easterbrook (1981) point out that the lower the
number of firms on the sellers’ side or in other words higher the concentration of firms higher
is the profit from a given number of firms forming a cartel. They argue that with higher
market concentration cheating can be easily detected and price and market share can be easily
agreed upon. In case of mergers as well, Motta (2004) argues that higher the concentration in
the market, higher will be the market power exercised by the merged firm. He claims that in a
fragmented industry with each firm having tiny market shares, the impact of a merger on
market price tends to be insignificant. However, Kwoka (1989), using a conjectural variation
model, shows that the mergers are more likely to be profitable in relatively competitive
environments, since in industries that are already cooperating merger adds less to the profits
that the firms are already achieving through co-operation. In this context, Stigler (1950) had
argued that if there are relatively many firms in the industry, no one firm plays an important
role in the formation of the merger; and it is possible for the merged firm to expand in a more
gradual process and acquire firms on less exacting terms.

Another important factor that has been given considerable emphasis in the literature is
the impact of the number of firms engaged in a merger or cartel. Salant et al (1983) show that
13
a merger could be privately profitable only if at least 80% of the firms in the industry are
involved in a merger. This was followed by a series of papers that challenged the result3.
Rodrigues (2001) makes an attempt to reconcile these results by arguing that less number of
firms can reap profits from a merger if it involves fixed cost efficiencies. Again Shaffer
(1995) has shown that pre-commitment to collusion in case of merger is an irreversible
decision since the cost of a reversal is very high. Consequently, in case of merger, the merged
firm and the fringe behave as Cournot competitors. This gives an advantage to the fringe and
explains the result obtained by Salant et al. However, in case of cartels, the colluding firms
can credibly threaten the fringe to withdraw from collusion since the fringe prefers collusion
to Cournot competition. This allows the cartels to exercise their dominance over the fringe
and act as a Stackelberg leader. This in turn implies that the cartel involving a sufficiently
small number of firms can be profitable.

The above discussion shows that certain market and firm characteristics affect both
cartel and merger similarly. However, their relative impact could be different which in turn
can influence the choice between the two arrangements. To the best of our knowledge, there
is hardly any literature which examines the effect of these factors on the choice between the
two. In this chapter, we focus on the impact of concentration, economies of scale and
proportion of firms involved in collusion on the profits accruing from cartel and merger. The
literature, so far, has regarded the development of antitrust law as the most important factor4
determining the choice between cartel and merger, which we discuss next.

Stigler (1950), in his attempt to explain the causes behind the great merger wave of
the American industry between 1895 and 1904, observes that the development of the antitrust
law determines the choice between cartel and merger. Trusts5 played a major role in shaping
U.S. business practices during the 1880s. In 1890, Sherman Act was passed to counter
collusive practices, resulting in the transformation of the trusts into a single holding company
through merger. By 1899 over 1200 firms disappeared owing to this consolidation process

3
See Perry and Porter (1985) and Davison and Deneckere (1984)
4
Other factors include ownership structure (see Chandler 1980 , Lamourex 1983, Dankers and Bouwens 2004 ),
uncertainty in cartel due to cheating and bargaining over profit sharing (See Stigler 1964 and Scherer and Ross
1990) and high organization cost and incentive problems in merger.
5
A trust is defined as a combination of firms or corporations for the purpose of reducing competition and
controlling prices throughout a business or an industry.

14
(Dankers and Bouwens 2004). Bittlingmayer (1985) shows that two prominent industries in
the United States namely, iron and steel and railroading6, provide concrete instances where
merger followed cartelist activities after the court decisions of 1897-1898 to ban cartels.

Comparing the business practices in United States and United Kingdom, Hannah
(1979) and Freyer (1992) have argued that the prohibition of cartel practices in United States
in the 1890s has been a key factor in the merger wave at the turn of the century and the
consequent rise of corporate ownership. On the other hand, in United Kingdom permissive
policy towards cartels helped sustaining a more fragmented market structure, until the 1960s,
when the reversal of the policy greatly contributed to the merger wave in Britain.

A tradition similar to United Kingdom was observed in Germany. Kocka (1980)

argues that the leveling off of growth and fall in prices from 1873 to mid 1890s in Germany
led to a rapid increase in the number of enterprises cooperating in cartels or agreements to
restrict output and increase prices. In 1897, the legality of cartels was confirmed by the
highest court of the Reich. The number of cartels increased from four in 1875 to 1200 in
1930. It was only after the end of the Second World War; West Germany banned cartels
under the influence of United States. By this time, cooperation in the form of mergers and
integration had become more important.

The literature suggests that regulation against cartels and mergers have played an
important role in determining the firm’s preference between cartel and mergers in developed
countries like USA, UK and Germany as seen above. This has implications for countries, like
India, where the competition policy is at its nascent stage. Till the 1990s, India had been
experiencing an era of regulation and licensing, characterized by the inhibition of
competition. The reforms introduced in 1991, led to liberalization of the economy which in
turn introduced competition in the market. However, due to the fragmented market structure
characterized by large number of small firms, the Indian industry could not realize the
efficiency ensuing from competition. One of the outcomes of this was increased
consolidation in the form of mergers and acquisitions (Mehta and Nanda 2005). This upsurge
of merger and acquisitions was further facilitated by the policy of delicensing and

6
Mergers in several other U.S industries - cotton oil, sugar, cast iron pipe, oil, meat packaging etc appear to
have been the result of antitrust action taken against cartels in those industries (For details see Bittling Mayer
1985).

15
globalization adopted by the Indian government in 1991 (Beena, 2004). At the same time, the
MRTP Act, 1969, did not provide adequate measures to curtail cartelist activities and other
restrictive agreements before and after the 1991 reforms7. This led to the abolition of MRTP
Act in 1998 and its subsequent replacement by the Competition Act, 2002 (amended in
2007). Thus, in India firm and market characteristics combined with regulatory measures
have played a role in firm’s preference for merger and cartel

With this backdrop, this chapter tries to analyze the effect of regulation against cartels
on the firm’s choice between cartels and mergers under different competitive intensities in
the presence and absence of merger regulations. We also take into account the effect of firm
concentration and number of participants joining the collusion on the effectiveness of the
regulation against cartel.

2.3 Theoretical Model

We develop a model using conjectural variation to compare the profits from merger
and cartel. The conjectural variation model has been widely criticized in the literature for its
inconsistent solution, which in general does not qualify as Nash equilibrium (Friedman
1983). Authors like (Bresnahan 1981) and (Kamien and Schwartz 1983) have elaborated on
the inconsistency in solution and introduced concepts of consistent conjectural variations8.

The conjectural variation model has also been reinterpreted as a reduced form of the
dynamic model9. Rodrigues (2001) uses the model in this spirit, as it helps in building a
continuous measure of competitive intensity. Kwoka (1989) has also used this model in his
analysis of mergers to determine the effect of competitive intensity on profitability of
mergers. He assumes that the coefficient of conjectural variation acts as a measure of the
inter-temporal interactions, though the form of interaction remains unspecified. In our model,
following Kwoka (1989) and Rodrigues (2001), we interpret the coefficient of conjectural
variation as the measure of competitive intensity. We assume that the market structure facing
the individual firms as measured by the coefficient of conjectural variation is given
exogenously and hence it is common knowledge. We assume that the market structure facing

7
For details see De (2005)
8
By consistent conjectural variation we mean conjectures that are consistent with the actual response taken by
the rivals after a quantity (price) decision of a firm (Dockner 1992).
9
See Riordan (1985) and Dockner (1992)

16
the individual firms as measured by the coefficient of conjectural variation is given
exogenously and hence it is common knowledge. The assumption implies that the individual
firms know the nature of competition facing them. In other words, the firms know whether
they belong to a perfectly competitively industry or a highly concentrated industry or an
oligopolistic industry. This is also another way to separate the different forms of market
structures from one another. This simplifying assumption solves the usual problems of
consistency associated with the conjectural variation models.

2.3.1 Model

Consider an industry consisting of n identical firms, producing a homogeneous

product. We assume that there is no entry. The market demand function is given as follows:

P  aQ (2.1)

where P is the market price and Q is the total quantity demanded.

The total cost function of the ith firm is

CTi  cqi  F (2.2)

Here, qi is the quantity supplied by the ith firm; F and c are the fixed and marginal cost

parameters respectively.

The profit of the ith firm is then given by:

 i  a  qi  q i qi  (cqi  F ) (2.3)

where q i  Q  qi
Maximization under Cournot Competition yields,,

17
 a  c  q i
qi  (2.4)
2  i

q i
where i  denotes the conjectural variation, evaluated at equilibrium. The conjectural
qi
variation is interpreted as the expectation of firm i regarding the change in its competitors’
production resulting from a change in its own production level. It is assumed to be an inverse
measure of the competitive intensity in the industry. For instance,   1 , represents the
competitive industry where the first order condition reduces to that of price equals marginal
cost. The case when   0 represents the Cournot model, in which each firm believes that
the other firm’s choice is independent from its own (Varian 1992). Since all firms are
identical, they produce the same quantity, hence, we get

q i  n  1qi (2.5)

Thus, in case of collusion the coefficient of conjectural variation takes the value:

i  n  1 . (2.6)

Then the total quantity produced is given by:

na  c 
Q (2.7)
n  i  1

The profit of the ith firm is then given as

i  1a  c 2
i  F (2.8)
n  i  12

18
2.3.2 Merger

Suppose a subset of n firms, say m  1 firms, merge, where m 1  n . We take

m  1 firms for the ease of calculations. The same results will follow if we take m firms but
the expressions become cumbersome. We make a simplifying assumption that mergers have
no impact on marginal costs10 and the firms’ conjectural variation after merger. The
distinction between the merged firm and other firms depends on the fixed cost efficiencies.

Then the quantity of the ith firm if it merges along with m firms is given by

q iM 
a  c  (2.9)
n  m   1

Therefore, the total quantity demanded is given as:

QM 
a  c n  m  (2.10)
n  m    1

Then, the total profit of the merged firm is

 mM1 
  1a  c 2  m  1 F (2.11)
n  m    12   1

Here 0    m measures the economies of scale to fixed cost resulting from merger.
In case of   0 , the merged firm has fixed cost equal to the sum of the fixed cost of all firms
(involved in merger) had prior to the merger. Thus there are no economies of scale. When
  m , the resulting merged firm has fixed cost equal to those of one of the merged firms.
Here, the firms obtain maximum economies of scale, as the fixed cost of the merged firm
after merger is equivalent to the pre-merger fixed cost of one of the firms, prior to merger.

10
The assumption can be relaxed for the marginal cost, to take into account the case where the economies or
diseconomies of scale from merger get reflected in the marginal cost, which in turn would affect the production,
unlike fixed cost.

19
 Since all firms are identical, each firm has an equal share in the profit of the merged
firm. Therefore, the profit of the ith merged firm is given by:

 iM 
  1a  c 2 
1
F (2.12)
n  m    1 m  1   1
2


Whether a merger is profitable or not depends on the value of  . We define the critical level
of  as that value at which the profit of each firm under competitive fringe is equal to the
profit of each firm under merger.

Profit of a firm acting as the competitive fringe is given as:

F 
  1a  c 2 F (2.13)
n  m    12

Equating (2.12) and (2.13), we get

* 
  1a  c 2 m (2.14)
m  1n  m    12    1a  c 2 m

For    * , merger would be profitable for each merging firm. Hence forth we consider
   * , m

2.3.3 Cartel

Following Shaffer (1995), we assume that after formation of a cartel, the cartel
behaves like a Stackelberg leader11. He argues that the leadership of the cartel is ensured by a
threat by the cartel to not to collude and instead behave as symmetric Cournot oligopolists
unless permitted by the fringe to lead. The threat is credible because he shows that each
fringe member prefers the cartelized outcome to symmetric Cournot. This trait of reversibility
allows the cartel to behave as a leader, while in case of a merger, the pre-commitment to
collusion is irreversible and this explains the absence of leadership in case of mergers. We

11
If a cartel does not act as a leader, then as discussed earlier, the Salant.et al (1983) result follows i.e. the
collusion would be profitable to the members, if at least 80% of the firms in the industry participate.

20
assume that m  1 firms form a cartel and become a Stackelberg leader and the rest, viz.,

n  m  1 firms, remain in the competitive fringe.

From (2.1), we have the demand function as:

P  aQ

The total quantity is now divided as:

m 1 n
Q   qi  q j (2.15)
i 1 j m 2

We calculate the profit of the competitive fringe, i.e. the followers, as:

 m 1 n 
 j   a   qi   q j q k  cq k  F (2.16)
 i 1 j m 2 

Solving the Stackelberg model, we obtain, the profit of a cartel member and a representative
fringe firm as follows:

The profit of the cth firm in a cartel is then given by

a  c 2 c  1 j  1
c  F
2  m  c 2 n  m   j 
(2.17)

The total profit of the cartel is given by:

  m  1 c (2.18)

The profit of the kth firm in the competitive fringe is given by

a  c 2 c  12  j  1
k  F
2  m  c 2 n  m   j 2
(2.19)

21
 Here it is assumed that the members of the competitive fringe form a conjecture about
q j
the behavior of the other firms belonging to the fringe. This is given by:   j . This  j
q k

takes a value in the range  1   j  n  m  2 . For competition,  j  1 and for collusion,

 j  (n  m  1)  1 . The follower firms take the output of the leader as given and hence they
do not have any conjecture about the leader’s output. We further assume that the cth firm
who is a member of the cartel forms two conjectures. Firstly, it forms an expectation about
the reaction of the other cartel members; this is given by

qC
 C = m  1 1 (2.20)
qi
Secondly, it forms an expectation about the reaction of (n-m-1) independent firms, which is
given by

q j 1
 s   (2.21)
qi n  m  j

For profitability of the cartel we require the profit of the individual firm under cartel
to be higher than the profitability of the individual firm belonging to the competitive fringe.

 c   k i.e.

c  1
1 (2.22)
n  m  j

Substituting the value of  c  m , we get

n   j 1
m (2.23)
2

Substituting different values of  j , we get the equilibrium condition corresponding to

different competitive intensities in the market We note here that if   n  m  2 , the

22
inequality given by (2.23) is not satisfied for any m . Equation (2.23) states that for a
sufficiently small cartel each firm in the cartel earns higher profits than each fringe firm.
Hence, the firms are better off forming the cartel and at the same time the fringe cannot free
ride for the cartel.

The next question that arises is whether the equilibrium is stable or not.
The equilibrium is said to be stable12 if it is both internally and externally stable. Following
Shaffer (1995), we define the internal and external stability in the following way. Note that
we derive the stability condition for  j  0 i.e. when there is Cournot competition among the

competitive fringe.

For internal stability we require

 cm 1
  k n  m  (2.24)
m 1

The condition implies that it is not profitable for a cartel member to defect to the fringe. The
equality implies the cartel is weakly internally stable. The above condition gives a real
solution for m , for all n  4 In particular we get,
n
m , for even n  4 (2.24a)
2
n 1
m , for odd n  4 (2.24b)
2
For external stability, we require,
 cm  2
k  (2.25)
m2
a  c 2 c  1 j  1m  2
Where  cm  2  and c  m  1
2  m  1  c 2 n  m  1   j 

The above condition implies that the firm will be externally stable if it is not
profitable for a fringe firm to join the cartel. In our model, the external stability condition
becomes redundant, given the assumption of barrier to entry into the cartel.

12
The definition of stability has been taken from Shaffer (1995), which in turn has been adopted from
D’Aspremont et al (1983) and Martin (1990).

23
Solving for m , when n  4 , we obtain,

n
m for even n  4 (2.25a)
2
n 1
m for odd n  4 (2.25b)
2

Thus, combining (2.24a), (2.24b), (2.25a) and (2.25b), we obtain the following condition for
stability. The equilibrium is stable at
n
m , for any even n  4 (2.26a)
2
and
n 1
m for any odd n  4 13. (2.26b)
2
Next, we compare the stability condition and the equilibrium condition. We observe
that the equilibrium condition and stability conditions do not coincide. However, the
equilibrium is consistent with the internal stability condition. To ensure external stability, we
assume that that once the cartel is formed, the cartel creates some form of barrier to prevent
external entry. Combining this assumption along with the internal stability condition, we
obtain stable equilibrium condition14.

2.4 Cartel and Law

What happens if cartel is illegal according to the law? Assuming so, we need to
analyze the situation when there is a positive probability  p  of a cartel getting detected by
the regulatory authorities and when detected so, each firm participating in the illegal cartel
pays a fine equal to, say X. In such a case the expected profit for the ith firm under the illegal
cartel can be expressed as:

13
For rigorous proof see Shaffer (1995).
14
If we do not invoke this additional assumption, then the equilibrium would be unstable and this would affect
the strategy of the firm choosing between cartel and merger.

24
  a  c 2 c  1 j  1   a  c 2 c  1 j  1 
 E
c p 
 2  m   2 n  m   
 F  X 

 1  p 
 2  m   2 n  m   
 F 

 c j   c j 
(2.27)
In this case, the condition for profitability is given as

 cE   k

4 pX 2m  1  n   j
 
a  c 2  j  1 m  1n  m   j 2
(2.28)

Let m * be the value of m which satisfies the inequality in (2.28). This m * depends on
the market size, marginal cost, industry size, competitive intensity and the expected fine15.
Thus, if the number of colluding firms is less than or equal to m * firms would be interested in
forming a cartel, even when the cartel is illegal. The following analysis holds for those values
of m which satisfy the equilibrium condition given by (2.28).

Next we compare the profit from merger and profit from illegal cartel for the ith firm.
We consider two cases here. In the first case, we assume that there is no regulation for
mergers. In the second case, we introduce merger regulation. Unlike cartels, mergers cannot
occur without being observed. Consequently for mergers, regulation takes a different form. In
our model, we assume that firms have to submit a proposal for merger to the regulatory
authorities. The authorities in turn review the welfare effects of the merger and accordingly,
accept or reject a merger proposal.

2.4.1 No Merger Regulation

We consider the case when there is no merger regulation, which implies that firms are
not required to inform any regulatory authorities about merger decisions. In order to compare
the difference between cartel and merger profit, we define the difference between the merger
and illegal cartel profit as

g i   iM   cE (2.29)

15
We can obtain the stability conditions for this case as well.

25
 In the absence of any fixed cost efficiencies and legal enforcement against a cartel,
the condition for indifference between a cartel and a merger will require:

  1 c  1 j  1

n  m    1 m  1 2  m  c 2 n  m   j 
2
(2.30)

We substitute c  m . We substitute for  to consider the different competitive intensities.

Case (i): Competition    j  1

The firms do not earn any profit from cartel or merger. Hence in this case neither
arrangement is preferable. Rather they might stay as independent competitors earning normal
profits.

Case (ii): Cournot competition    j  0 

1

m  1 (2.31)
n  m  1 m  1 2  m  m 2 n  m 
2

This equality is not maintained for any value of n or m16. The right hand side
expression exceeds the one on the left hand side. This implies that firms will always prefer a
cartel. In this model, we do not introduce any incentive in merger except for the efficiency in
fixed costs. With efficiency in fixed costs, we can obtain cases where the firms will prefer a
merger to a cartel.

Case (iii):   1 . This corresponds to the case when k  n  3 . That is, there is less
competitive intensity in the industry or more collusion.

16
We note that even though a cartel yields higher profit in comparison to the competitive fringe only for
m  m* , the cartel earns a higher profit than merger for any value of m. However, when m  m* , it is difficult
to induce firms to join a cartel, since it is profitable to remain outside.

26
 m 1 1
 (2.32)
41  m  n  m  1 n  m  22 m  1
2

Here again the equality is not maintained for any value of m or n, as in the Cournot
competition case. Comparing (2.31) and (2.32), we observe that, as  rises, i.e. the
competitive intensity decreases, the difference between merger and cartel profitability
increases, shifting the decision of the firm in favor of the latter. Thus, as concentration in the
market increases, it favors cartel more as compared to merger. Although in this case also
merger yields higher profit than cartel in the absence of fixed cost efficiency and expected
fines, but the gap increases.

Note that if there is competition in the market after merger or formation of cartel, then
both the cartel and merger do not earn any profit. The only gain that merger can provide is
through economies of scale to fixed cost. In case the post merger or post cartelized market is
characterized by Cournot competition, then cartel yields higher profit. Further, as the
competitive intensity declines, cartel has a greater advantage to a merger17. In other words,
higher the competitive intensity in the market, higher is the profit accruing to the merger,
except for the case of competitive market. This can be attributed to the fact that as the post
collusion market becomes more and more concentrated merger adds less to the profit,
however, the effectiveness of the cartel as a leader still persists. Consequently, the advantage
of cartel over merger is enhanced.

Thus, one can argue that if formation of cartels is certain i.e. there is no legal
enforcement involved against the cartel, firms will prefer a cartel to a merger. This has
implications for the antitrust policy and calls for a legal enforcement against cartels. Now we
examine how the imposition of a fine can affect the choice between cartel and merger. In
(2.22), we substitute c  m and    j and rewrite the expression for the optimal amount of

expected fine as

  1  
F 
pX  a  c   1 1

2 j

m  1  n  m   j n  m   j  12
(2.33)
   1

17
This is consistent with the result obtained by Kwoka (1989) which says that firms are observed to earn higher
profit after merger, as compared to the pre-merger scenario, higher the competitive intensity in the market.

27
 We examine the effect of change in different parameters on the magnitude of
expected fine, when firms are indifferent between mergers and cartels.

Market Size:

We observe that, other things remaining unchanged, bigger the market size, higher
pX
should be the expected fine on the cartel,  0 . A bigger market size would yield higher
a
profit to each member of the cartel for given number of firms in the industry, given the
marginal cost and number of firms forming the cartel. Consequently, a higher expected fine
has to be imposed for a given probability of detection of cartel.

Marginal Cost:
 pX 
Higher the marginal cost of each firm, lower is the expected fine required   0 .
 c 
This implies if the firms have a high marginal cost then a small expected fine is sufficient to
make the firms indifferent between cartel and merger.

Number of Firms in the industry:

Other things remaining the same, the higher the industry size, i.e. the higher is the
value of n, the lower will be the amount of the expected fine required to make the firm
 pX 
indifferent between a merger and a cartel   0  . As the number of firms in the industry
 n 
increases, the profit from the cartel will decline, which implies less incentive for firms for the
formation of cartel. In such a case, a lower amount of expected fine suffices to make the
individual firm indifferent between a merger and a cartel.

Number of colluding firms:

As the number of firms involved in a cartel or merger increase, the lower is the
requirement of the amount of expected fine to be imposed to make the firms indifferent

28
 pX 
  0  . As the number of firms joining a cartel increases, the cartel becomes less
 n 
profitable. Hence the amount of expected fine also decreases.

Fixed Cost and Efficiency:

The presence of fixed costs in the industry reduces the expected fine required
 pX 
  0  . Similarly, for a given fixed cost, if efficiency increases after merger, then this
 F 
would diminish the requirement of expected fine to make the firms indifferent between
 pX 
merger and cartel   0  . This implies that post merger efficiencies have an effect on the
  
choice between cartel and merger. In fact, this is one clear advantage of merger over cartel, in
the sense that the former can lead to economies of scale. However, an associated point in this
regard is that, the cartel has an advantage over merger in the sense that the former does not
involve any possibility of diseconomies of scale. This point cannot be illustrated in our
model, since we do not consider any possibility of diseconomies of scale. We summarize the
above result in the form of the following proposition:

Proposition 1: Ceteris paribus the amount of expected fine required to make a firm
indifferent between a cartel and merger
a. increases as market size increases,
b. decreases as marginal cost of a firm increases,
c. decreases as total number of firms in the industry increases,
d. decreases as number of firms joining merger or cartel increases,
e. decreases as fixed cost increases for a given efficiency from merger, and
f. decreases as efficiency gains from merger increase, for a given fixed cost.

Competitive Intensities:

Under Competition, there is no incentive for the firms to form a cartel in the absence
of fine. We consider the effect of competitive intensity on expected fine on cartel under

29
Cournot competition   0 and Collusion   1 . Comparing the expected fines we observe
that:

pX   1  pX   0 (2.34)

Thus, as the competitive intensity among the fringe, in the post merger or post cartel
market decreases, the gap between the cartel and merger profits increases and this in turn
increases the requirement of the expected fine to make a firm indifferent between the merger
and cartel. In case of competition, there is no incentive for firms to form a cartel.
Consequently, in this case there is no need for the imposition of expected fine.

Proposition 2: Ceteris paribus,

a. Under Perfect Competition there is no need for imposition of fine on the cartel to
make the firms indifferent between merger and cartel.
b. As competitive intensity increases the amount of fine required to make the firms
indifferent between mergers and cartels decreases.

The above proposition can be presented in terms of Figure 2.1. In the figure, we plot the
amount of expected fine against the competitive intensity, for different industry sizes ( n) and

number of firms joining the collusion m  , taking the market size, marginal cost, fixed cost
and efficiency to be constant. In case of perfect competition among the competitive fringe,
there is no need to impose any fine, hence at   1, pX  0 . As the competition declines,
the amount of expected fine required to make the firms indifferent between merger and cartel
increases. In the figure, we also observe that for a given  and m , as industry size increases,
the amount of expected fine decreases. Similarly, the figure shows that for a given  and n ,
as the number of firms joining a collusion increase, the amount of expected fine decreases.
Under perfect competition, firms do not have any incentive to form cartel and in the absence
of any fixed cost efficiency, they also do not have any incentive to merge. So as seen earlier,
under perfect competition firms would choose to compete with each other. In that case, the
regulatory authorities do not need to impose any penalty against a cartel. As the industry
becomes more and more concentrated, the profit from cartel becomes higher as compared to
profit from merger. Hence the regulator needs to impose higher penalty to make the firms

30
indifferent between merger and cartel. Thus as competitive intensity decreases, the amount of
fine imposed would increase and vice versa. In a concentrated industry it is relatively easier
to form a cartel because there is less co-ordination problem as compared to more competitive
industry. This could be attributed to the fact that collective action problem is easier to be
solved in a concentrated market. However, in case of merger as the industry becomes more
and more concentrated, the rival firm profits at the expense of the merging firms following
the merger paradox argument thereby making merger less profitable. On the other hand in a
more competitive industry co-ordination among rival firms is difficult to manage.

31
 Expected Fine
on Cartel( pX ) n  10, m  4

n  10, m  5

n  20, m  4

n  20, m  5

-1 0 1

Competitive intensity after collusion

among all participants  

Figure 2.1: Change in Expected Fine, with the change in competitive

intensity, industry size and Number of firms joining collusion

32
2.4.2 Merger Regulation

We introduce regulation for mergers. In case of mergers, firms are required to take
prior permission from the regulators. The regulators would permit merger if there is no
decrease in welfare. We consider two cases. In the first case, we assume that the regulatory
authorities adopt a consumer welfare standard and in the second case, we assume that the
regulatory authorities adopt a total welfare standard to review a merger. In our model, it is
assumed that efficiency in merger takes the form of a decrease in the fixed cost. This would
get reflected in the profit of the merging firms but would not get translated to consumer
surplus. Hence a priori one should expect differences in the outcome depending on the choice
of standard (whether consumer surplus or total welfare) adopted to review the merger. Thus,
we would analyze the implication of merger regulation on the penalty on cartel using both
consumer welfare standard and total welfare standard.

Case A: Consumer Welfare Standard

Assume that consumer welfare is measured by the change in consumer surplus in the
pre and post merger situation. In our model, the regulators allow a merger so long as it does
not decrease the consumer welfare.
Consumer surplus is given by

Q
Q2
CS   PdQ  P Q 
0
2

(2.35)

The change in consumer welfare is then given by:

CS *  CS M  CS
(2.36)

where CS and CS M denote pre and post-merger consumer surplus.

33
 When   1 , the difference in consumer surplus in the pre-merger and post-merger
case is zero while for any   1 in this model, the consumer surplus difference is negative
implying that the consumer surplus always falls after a merger in our model. This is attributed
to the fact that efficiency after merger is associated with fixed cost and this does not affect
the quantity produced.

Thus, we observe that in this case only mergers in the perfectly competitive market
would be cleared. However as mentioned earlier, firms will opt for mergers in a competitive
market only if there are fixed cost efficiencies. Further, they do not have any incentive to
form cartel. For all other market structures, the regulatory authorities do not allow a merger.
This, in turn, increases the possibility of cartels, since firms are left with only one option. In
that case, if the regulation against cartel is not strong then, a strong enforcement against
merger actually increases the possibility of cartel formation.

When mergers are not cleared by the regulatory authorities then the optimal amount
of fine would be the one that makes the firm indifferent between cartel and perfect
competition. This is given by
 
( pX ) *  a  c    1
1 1

2
2 
(2.37)
 4m  1n  m    n    1 

Comparing pX in (2.33) and ( pX ) * in (2.37), we get, ( pX ) *  pX . Thus, now regulatory

authorities need to increase the expected fine to deter firms from forming a cartel.

Case B: Total Welfare Standard

We assume that the regulatory authorities apply total welfare standard to review a
proposed merger. Total welfare is defined as the sum of the profit of the merged firm, the
profit of the competitive fringe and the consumer surplus. The regulatory authorities, as
before, compare the total welfare in the pre and post-merger scenario. They allow a merger
only if it does not lead to decrease in welfare.

Pre-merger:
W  n i  CS (2.38)

34
Post Merger:
W M   M  (n  2) F  CS M (2.39)

We define:
W *  W M W (2.40)

Here the sign of W * depends on the amount of fixed cost, for a given level of
efficiency or alternatively, it will depend upon the efficiency, given the fixed cost. Here we
take the first option and determine the amount of fixed cost at which W *  0

*

a  c    1 
2
n 
   
n

nm 
   
n  m 
F   1   1 
 m  1  n    12  2  n  m    12  2 

(2.41)
We note that F * exists only when   0 i.e. the condition for indifference in total
welfare between the pre and post-merger cases requires that there should be some efficiency
involved in merger. We find that F *  0 under perfect competition.

For any F  F * , the regulatory authorities would clear the merger. Thus, it is easier
to obtain a merger clearance if the industry has heavy fixed costs, provided merger leads to a
positive efficiency in terms of fixed cost. Further, as the competitive intensity in the market
increases, the amount of fixed cost that would make welfare in the pre and post-merger cases
equal, would increase. Thus, in this case, a firm would have both alternatives available to it.
And the optimal fine that would be required to make the firm indifferent between merger and
cartel would be

 c  1 j  1   1 
F 
 pX **  a  c 2  
 2  m  c  n  m   j  n  m    1 m  1 
2 2   1

(2.42)
where F  F * , F * given in (2.41)

35
 Next, we consider the case of F  F * . In this case a merger would not be cleared by
the regulatory authorities. Thus, possibility of cartel formation would increase and a higher
amount of expected fine would be required to deter the firms from forming a cartel, as
observed in Case A.
The result from Case A and B can be summarized in terms of the following
proposition:

Proposition 3: When mergers are not cleared by regulatory authorities, the expected fine
required to deter the firms from forming a cartel increases.

2.5 Conclusion

In this chapter we show how the interplay of industry specific characteristics, market
structure and antitrust policy determine the choice between cartel and merger. We show that
in the absence of any penalty on cartels, a firm always prefers a cartel to merger, in the
absence of any efficiency gains from merger. Moreover, the choice between cartel and
merger also depends on the nature of competitive intensity in the market.

Next we examine the effect of a penalty on cartel. We consider two cases here. In the
first case, there is no regulation against merger. We determine the amount of expected fine
that would make a firm indifferent between cartel and merger. We show that nature of
competitive intensity in the post merger market and among the competitive fringe in the
cartelized market has an effect on the amount of fine. In particular, if there is high
concentration in the market, a firm would prefer a cartel to a merger. Our model also shows
that in a perfectly competitive industry, firms have no incentive to form a cartel and firms
merge only if there are economies of scale involved. However, when there is higher
competitive intensity in the market, the firm might prefer merger to cartel.

In the second case, we introduce merger review. We find that if merger is reviewed
using consumer welfare standard, then only mergers in perfectly competitive industries would
be allowed. In that case, firms would opt for merger instead of cartel, if there are efficiencies
in fixed cost. Thus, under perfect competition, mergers would be efficient. For all other
market structures, mergers would not be allowed. Hence, firms have only cartels as available

36
alternative to introduce horizontal restraint, which in turn implies stricter regulation against
cartels. When a total welfare standard is invoked by regulatory authorities, then the
acceptance or rejection of a merger proposal depends on the fixed cost efficiencies. In our
model, we determine a threshold fixed cost which makes the pre and post-merger welfare
levels equal. Any merger proposal involving firms with fixed cost equal to or greater than this
threshold would get a merger clearance provided there exist positive efficiencies. In this case,
firms would compare the profits from cartel and merger, to choose between the two, implying
that the optimal fine should in this case be consistent with the fixed cost.

In this chapter, we observe that regulation against mergers should be coupled with
stricter monitoring and higher fine for cartel. Further, a tougher regulation is required for
industries with lower fixed costs or in industries where efficiency from merger is low, for a
given fixed cost. These results are obtained since we assume efficiency in fixed cost, with no
change in marginal cost after merger. With efficiency in marginal cost, we can obtain cases
favorable to mergers. However, in that case it would become difficult to distinguish the anti-
competitive effect of a merger from its efficiency effect.

As seen in the chapter, we define optimal fine to be an amount which makes the firm
indifferent between cartel and merger/competition. Alternatively, a fine can be imposed in
terms of the effect of a cartel on consumers and this would be a higher amount as compared
to the fine imposed in our model because the gain in profit of the colluding firms in cartels is
less than the loss of the consumers. The chapter shows how regulation and market and
industry characteristics can affect the choice between cartel and merger. One possible
extension of this chapter is to incorporate the effect of legal enforcement on cartel stability
and also considering the effect of collusion on the market concentration.

37
 Notations

Total Number of Firms in the Industry: n

Market demand function: P  a  Q

Market price: P

Total quantity demanded: Q

Total cost function of the ith firm: CTi  cqi  F

Quantity supplied by the ith firm: qi

Fixed Cost: F

Marginal cost: c

Profit of the ith firm:  i  a  qi  q i qi  (cqi  F )

Quantity supplied by all firms other than the ith firm:

q i  Q  q i

Coefficient of Conjectural Variation: the expectation of firm I regarding the change in its
competitor’s production resulting from a change in its own production level
q
It is denoted as i  i
qi
Competitive industry:   1

Cournot model:   0

Collusion: i  n  1

Number of firms that merge or collude: 1

Total quantity demanded after merger:

Total profit of the merged firm:

Economies of scale: 0    m , 0: No Economies of Scale and

: Full economies of Scale

Profit of ith merged firm:

Profit of a representative firm acting as a competitive fringe after merger:

Profit of cth firm in a cartel:

38
Profit of Cartel: ∑

Profit of the kth firm in the competitive fringe after cartel formation:

Probability that the cartel gets detected: p

Amount of penalty imposed on cartel, it is detected: X

Expected profit of cth firm in a cartel:

39