A merger involves two firms combining to form one larger company; it can occur due to a takeover or mutual agreement.
The pros and cons in summary:
Advantages of mergers
- Economies of scale – bigger firms more efficient
- More profit enables more research and development.
- Struggling firms can benefit from new management.
Disadvantages of mergers
- Increased market share can lead to monopoly power and higher prices for consumers
- A larger firm may experience diseconomies of scale – e.g. harder to communicate and coordinate.
When looking at mergers it is important to look at the subject on a case by case basis as each merger has different possible benefits and costs – depending on the industry and firms in question.
Pros of mergers
1. Network Economies. In some industries, firms need to provide a national network. This means there are very significant economies of scale. A national network may imply the most efficient number of firms in the industry is one. For example, when T-Mobile merged with Orange in the UK, they justified the merger on the grounds that:
“The ambition is to combine both the Orange and T-Mobile networks, cut out duplication, and create a single super-network. For customers, it will mean bigger network and better coverage, while reducing the number of stations and sites – which is good for cost reduction as well as being good for the environment.”
2. Research and development. In some industries, it is important to invest in research and development to discover new products/technology. A merger enables the firm to be more profitable and have greater funds for research and development. This is important in industries such as drug research, where a firm needs to be able to afford many failures.
3. Other economies of scale
Two smaller firms producing Q1 would have average costs of P1. A merger which led to a firm producing at Q2 would have lower average costs of P2.
The potential economies of scale that can arise include:
- Bulk buying – buying raw materials in bulk enables lower average costs
- Technical economies – large machines and investment is more efficient spread over a larger output.
- Marketing economies – A tech firm bought by Google may benefit from Google’s expertise and brand name.
- Examples of economies of scale.
In a horizontal merger, economies of scale can be quite extensive, especially if there are high fixed costs in the industry. For example, aeroplane manufacture is now dominated by two large firms after a series of mergers.
If the merger was a vertical merger (two firms at different stages of production) or conglomerate merger, the scope for economies of scale would be lower.
4. Avoid duplication
In some industries, it makes sense to have a merger to avoid duplication. For example, two bus companies may be competing over the same stretch of roads. Consumers could benefit from a single firm with lower costs. Avoiding duplication would have environmental benefits and help reduce congestion.
5. Regulation of Monopoly
Even if a firm gains monopoly power from a merger, it doesn’t have to lead to higher prices if it is sufficiently regulated by the government. For example, in some industries, the government have price controls to limit price increases. That enables firms to benefit from economies of scale, but consumers don’t face monopoly prices.
6. Prevent unprofitable business from going bust
If a firm has been badly managed, it could find itself going out of business. A merger or a takeover may be a way for the firm to survive and many jobs to be saved.
Cons of Mergers
1. Higher Prices
A merger can reduce competition and give the new firm monopoly power. With less competition and greater market share, the new firm can usually increase prices for consumers. For example, there is opposition to the merger between British Airways (parent group IAG) and BMI. (link Guardian) This merger would give British Airways an even higher percentage of flights leaving Heathrow and therefore much scope for setting higher prices. Richard Branson (of Virgin) states:
“This takeover would take British flying back to the dark ages. BA has a track record of dominating routes, forcing less flying and higher prices. This move is clearly about knocking out the competition. The regulators cannot allow British Airways to sew up UK flying and squeeze the life out of the travelling public. It is vital that regulatory authorities, in the UK as well as in Europe, give this merger the fullest possible scrutiny and ensure it is stopped.”
2. Less choice. A merger can lead to less choice for consumers.
A merger can lead to less choice for consumers. This is important for industries such as retail/clothing/food where choice is as important as price
3. Job Losses
A merger can lead to job losses. This is a particular cause for concern if it is an aggressive takeover by an ‘asset stripping’ company – A firm which seeks to merge and get rid of under-performing sectors of the target firm.
- On the other hand, other economists may argue this ‘creative destruction’ of job losses will only lead to temporary job losses and the unemployed will find new jobs in more efficient firms.
4. Diseconomies of Scale
The new larger firm may experience diseconomies of scale from the increased size. After a merger, the new bigger firm may lack the same degree of control and struggle to motivate workers. If workers feel they are just part of a big multinational they may be less motivated to try hard. Also, if the two firms had little in common then it may be difficult to gain the synergy between the two companies
Evaluation – The desirability of a merger depends upon:
- How much is competition reduced by? E.g. A merger between Tesco and Sainsburys would lead to a significant fall in competition amongst UK supermarkets. This would lead to higher prices for basic necessities.
- How significant are economies of scale in the industry? A merger between Tesco and Sainsburys may enable some economies of scale, but it would be relatively low compared to two oil drilling companies. The fixed costs in oil exploration are much higher. Therefore, there is more justification for a merger in oil exploration than in supermarkets.
- How Contestable is the market? After the merger can new firms still enter or are barriers to entry sufficiently high to deter new firms?
- What are the objectives of mergers? – Are the firms seeking to gain efficiency or are the managers hoping for higher salaries and more prestige in new firms?
Case Studies of Mergers
3 thoughts on “Pros and Cons of Mergers”
In a business class a few weeks ago, we were studying the benefits of mergers as a way for economic growth and change within an industry. However, I appreciated what you said about mergers also being a way for monopolies to be regulated if the government sufficiently regulates pricing. Thank you for the additional information regarding business mergers!
I like that you said that one of the advantages of business mergers is that firms that have been struggling can be saved by new management. I’ll visit my mom this weekend, so I’ll tell her about this information since my godmother can benefit from it. They’re always having lunch together, so my mom can advise my godmother about hiring an M&A consulting service. Thanks for this!