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session nine dynamic pricing (II) industry consolidation (ad companies) ………….1 industry consolidation (newspapers) ………….8 spring 2016 microeconomi the analytics of cs constrained optimal microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions AD COMPANIES industry consolidation Consolidation: Omnicom and Publicis ► Omnicom Group Inc. and Publicis Groupe SA said Sunday , July 28th, 2013, they will merge to create a $35.1 billion advertising giant, overtaking current market leader WPP PLC in the industry's biggest deal ever. U.S.-based Omnicom and France's Publicis, the second and third biggest ad companies respectively by revenue, said they will create a new entity called the Publicis Omnicom Group in a merger of equals. Revenue for 2012 (billions) WPP PLC Omnicom Group Publicis Groupe Interpublic Group Proforma Dentsu & Aegis Havas Western Europe $5.80 $3.59 $2.38 $1.44 $0.96 $1.12 North America $5.65 $7.30 $4.12 $3.78 $0.77 $0.73 Rest of World $4.97 $3.32 $1.89 $1.78 $4.68 $0.41 Total $16.42 $14.21 $8.39 $7.00 $6.41 $2.26 Market Share 30.02% 25.98% 15.34% 12.80% 11.72% 4.13% ► We will use this case as a motivation for an analysis of consolidation in an industry in which firms compete in capacities. To keep the setup as simple as possible let’s assume: ● there are three identical firms that compete in the market, index them as i = 1,2,3 ● quantity for firm i is therefore qi, i = 1,2,3 ● marginal cost (in cents) for each firm is MC = 200 ● market demand is P = 800 – Q, where Q is the total quantity supplied by the firm active in the market ► Step 1: we derive the market equilibrium with three firms as described above ► Step 2: we assume firm 2 and firm 3 merge and compute the equilibrium with the resulting two firms in the market ► Step 3: under what conditions is the merged firm better off compared to the un-consolidated situation? 2016 Kellogg School of Management lecture 9 page | 1 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 1: Market outcome with three firms, pre-consolidation ● From the perspective of firm 1: - the residual demand is P = (800 – q2 – q3) – q1 with marginal revenue MR1 = (800 – q2 – q3) – 2q1 - profit maximization for residual demand requires MR1 = MC thus (800 – q2 – q3) – 2q1 = 200 - the solution is immediate as q1 = 300 – 0.5(q2 + q3) [equation 1] ● From the perspective of firm 2: - the residual demand is P = (800 – q1 – q3) – q2 with marginal revenue MR2 = (800 – q1 – q3) – 2q2 - profit maximization for residual demand requires MR2 = MC thus (800 – q1 – q3) – 2q2 = 200 - the solution is immediate as q2 = 300 – 0.5(q1 + q3) [equation 2] ● From the perspective of firm 3: - the residual demand is P = (800 – q1 – q2) – q3 with marginal revenue MR3 = (800 – q1 – q2) – 2q3 - profit maximization for residual demand requires MR2 = MC thus (800 – q1 – q2) – 2q3 = 200 - the solution is immediate as q3 = 300 – 0.5(q1 + q2) [equation 3] We have to solve this system of three equations with three unknowns (q1, q2 and q3). In this particular case, when the firms are perfectly identical we get a symmetric system which implies that q1 = q2 = q3. Say q* is this common value, then q* = 300 – 0.5(q* + q*) with solution q* = 150, i.e. q1 = q2 = q3 = 150 2016 Kellogg School of Management lecture 9 page | 2 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 1: Market outcome with three firms, pre-consolidation ● From the perspective of firm 1 the best response (reaction function) is given by q1 = 300 – 0.5(q2 + q3) ● The solution is q1 = 150 and q2 = q3 = 150, this is point (O) in the diagram q1 ● Price in the market is given by P* = 800 – (q1 + q2 + q1) = 350 ● Profit for each firm is the same and equal to 300 firm 1’s best response to firm 2 and firm 3 actions q1 = 300 – 0.5(q2 + q3) Π* = (P* – MC)q* = (350 – 200)·150 = 22,500 The pre-merger cumulative profit for firm 2 and firm 3 is thus Π2+3* = 45,000 pre-merger 150 (O) 300 2016 Kellogg School of Management lecture 9 600 q2 + q3 page | 3 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 2: Market outcome with two firms, post-consolidation Here we assume that firm 2 and firm 3 merge into firm (2,3) with a resulting marginal cost of MC2,3 = 200. There are two firms in the market now. Let q1 the quantity produced by firm1 and q2,3 the quantity produced by the consolidated firm (2,3). ● From the perspective of firm 1: - the residual demand is P = (800 – q2,3 ) – q1 with marginal revenue MR1 = (800 – q2,3) – 2q1 - profit maximization for residual demand requires MR1 = MC1 thus (800 – q2,3 ) – 2q1 = 200 - the solution is immediate as q1 = 300 – 0.5q2,3 [equation 1] ● From the perspective of firm (2,3): - the residual demand is P = (800 – q1) – q2,3 with marginal revenue MR2,3 = (800 – q1) – 2q2,3 - profit maximization for residual demand requires MR2,3 = MC2,3 thus (800 – q1) – 2q2,3 = 200 - the solution is immediate as q2,3 = 300 – 0.5q1 [equation 2] We have to solve this system of two equations with two unknowns (q1 and q2,3 ). Again the firms are perfectly identical thus we get a symmetric system, which implies that q1 = q2,3. Say q** is this common value, then q** = 300 – 0.5q** with solution q** = 200, i.e. q1 = q2,3 = 200 2016 Kellogg School of Management lecture 9 page | 4 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 2: Market outcome with two firms, post-consolidation ● From the perspective of firm 1 the best response (reaction function) is given by q1 = 300 – 0.5q2,3 while, from the perspective of firm (2,3), the best response (reaction function) is given by q2,3 = 300 – 0.5q1 ● The solution is q1 = 200 and q2,3 = 200, this is point (M) in the diagram ● Price in the market is given by q1 firm (2,3)’s best response to firm 1’s actions q2,3 = 300 – 0.5q1 600 P** = 800 – (q1 + q2,3) = 400 ● Profit for each firm is the same and equal to firm 1’s best response to firm (2,3)’s actions q1 = 300 – 0.5q2,3 300 Π** = (P** – MC)q** = (400 – 200)·200 = 40,000 post-merger The post-merger cumulative profit for firm 2 and firm 3 is thus Π2,3** = 40,000 200 (M) (O) 150 200 2016 Kellogg School of Management pre-merger lecture 9 300 600 q2,3 page | 5 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 2: Market outcome with two firms, post-consolidation ● Looks like the merger does not create a higher profit for the combined firms, i.e. the merger cannot make both the shareholders of firm 2 and firm 3 better off… Π2,3** = 40,000 < Π2+3* = 45,000 ● On the other hand firm 1 is far better off… Π1** = 40,000 > Π1* = 22,500 ● Pre-merger firm 2 and firm 3 together supply a total of 300 units while post merger the supply of the consolidated firm is 200… ● Price increases but not by enough to make for the reduction in supply, and the reason that price does not increase is that much is that firm 1 increases its own supply (from 150 to 200) as an optimal respond to the reduced supply from the new consolidated firm ● The consolidation would increase the profit (for firm 2 and firm 3) if firms have a limited capacity, i.e. cannot increase its supply say above 150. 2016 Kellogg School of Management lecture 9 page | 6 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions industry consolidation MERGER ANALYSIS ► Step 3: Limited capacity, post-consolidation ● Let’s assume for the moment that all three firms have limited capacity of 150. Then the pre-merger market outcome is unchanged. But the reaction function for firm 1 is now slightly changed as shown in the diagram. Since it cannot offer anything above 150 the reaction function is “cut” at 150. ● The solution is q1 = 150 and q2,3 = 225, this is point (L) in the diagram ● Price in the market is given by q1 600 firm (2,3)’s best response to firm 1’s actions q2,3 = 300 – 0.5q1 300 firm 1’s best response to firm (2,3)’s actions q1 = min{150, 300 – 0.5q2,3} P*** = 800 – (q1 + q2,3) = 425 ● Profit for firm 1 is Π1*** = (P*** – MC1)q1*** = = (425 – 200)·150 = 33,500 ● The post-merger profit for firm (2,3) is Π2,3*** = (P*** – MC2,3)q2,3*** = = (425 – 200)·225 = 50,625 200 150 ► When a competitor has a limited capacity the market outcome is altered towards an increase in profit post-merger. 2016 Kellogg School of Management (M) post-merger post-merger pre-merger (L) 200 225 300 lecture 9 (O) 600 q2,3 page | 7 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions INDUSTRY ANALYSIS industry consolidation Newsprint Industry Consolidation ► Industry facts : 31.75% 20.71% 6.83% 5.66% 5.52% 4.68% 3.93% 3.64% 3.00% 2.53% ► Consolidation: ● The economies-of-scale case: Consolidations helps capture economies of scale … ..by reducing overhead per ton, better use of resources This eventually translate into lower prices to customers 2016 Kellogg School of Management ● The market power case: Greater power over buyers, thus higher prices Better management of capacity Price signaling and collusion lecture 9 page | 8 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions INDUSTRY ANALYSIS industry consolidation Newsprint Industry Consolidation ► Capacity management ► The graph is suggestive of deliberate reduction in capacity, resulting in increasing or at least stemming the decline in prices ► But this leaves the following puzzle: Why would a merged firm shut down plants that they were profitable to operate pre-merger? 2016 Kellogg School of Management lecture 9 page | 9 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions CAPACITY ANALYSIS ► Case I: Tight Market industry consolidation ► Capacity management: You have three identical manufacturing units, each producing q. Current price is p0 and you contemplate closing down one unit thus reducing your own supply to 2q. Assume all others are always producing at maximum capacity. close this unit q p ● loss of profit on closed unit at old price ● gain of profit on open units at new price q p demand demand p1 p0 p0 profit gain profit extra profit loss 3q 2016 Kellogg School of Management Q0 Q 2q lecture 9 Q1 Q0 Q page | 10 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions CAPACITY ANALYSIS ► Case I: Tight Market industry consolidation ► Capacity management: in comparing the gain with loss from shutting-down capacity there are two ● Position and shape of demand curve factors to consider: ● Competitors’ cost profiles gain on opened units at new price q p q p p1 “flat” demand “steep” demand p1 p0 gain gain p0 profit extra profit 2q 2016 Kellogg School of Management Q1 Q0 Q profit extra profit 2q lecture 9 Q1 Q0 Q page | 11 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions CAPACITY ANALYSIS ► Case II: Over Capacity industry consolidation ► Capacity management: You have three identical manufacturing units, each producing q. Current price is p0 and you contemplate closing down one unit thus reducing your own supply to 2q. Assume all others are always producing at maximum capacity. close this unit q ● loss of profit on closed unit at old price ● no gain of profit on open units at new price p q p profit extra profit profit demand demand p0 p1=p0 loss 3q 2016 Kellogg School of Management Q0 Q 2q lecture 9 Q1=Q0 Q page | 12 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions CAPACITY ANALYSIS ► Case II: Over Capacity industry consolidation ► Capacity management: in comparing the gain with loss from shutting-down capacity there are two ● Position and shape of demand curve factors to consider: ● Competitors’ cost profiles no gain on opened units at new price q q p p profit extra profit profit extra profit “steep” demand “flat” demand p1=p0 p1=p0 2q 2016 Kellogg School of Management Q1=Q0 Q 2q lecture 9 Q1=Q0 Q page | 13 microeconomics lecture 9 dynamic pricing (II) the analytics of constrained optimal decisions CAPACITY ANALYSIS industry consolidation ► Capacity management: ● orange company has capacity q ● purple company has capacity qL at low cost and qH at high cost ► If the purple firm would close the high-cost facility it would gain P ► If the orange firm acquires purple firm and would close the high-cost facility it would gain O + P qH close this unit p p demand demand gain p1 O p0 q 2016 Kellogg School of Management qL P p0 profit orange profit purple qH Q loss q lecture 9 qH qL qH Q page | 14