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1 DISCUSSION PAPER SERIES No MERGER PROFITABILITY IN UNIONIZED OLIGOPOLY Kjell Erik Lommerud, Odd Rune Straume and Lars Sørgard INDUSTRIAL ORGANIZATION ZZZFHSURUJ Available online at: and

2 ISSN MERGER PROFITABILITY IN UNIONIZED OLIGOPOLY Kjell Erik Lommerud, University of Bergen and CEPR Odd Rune Straume, University of Bergen Lars Sørgard, SNF Discussion Paper No March 2001 Centre for Economic Policy Research Goswell Rd, London EC1V 7RR, UK Tel: (44 20) , Fax: (44 20) Website: This Discussion Paper is issued under the auspices of the Centre s research programme in Industrial Organization. Any opinions expressed here are those of the author(s) and not those of the Centre for Economic Policy Research. Research disseminated by CEPR may include views on policy, but the Centre itself takes no institutional policy positions. The Centre for Economic Policy Research was established in 1983 as a private educational charity, to promote independent analysis and public discussion of open economies and the relations among them. It is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. Institutional (core) finance for the Centre has been provided through major grants from the Economic and Social Research Council, under which an ESRC Resource Centre operates within CEPR; the Esmée Fairbairn Charitable Trust; and the Bank of England. These organizations do not give prior review to the Centre s publications, nor do they necessarily endorse the views expressed therein. These Discussion Papers often represent preliminary or incomplete work, circulated to encourage discussion and comment. Citation and use of such a Paper should take account of its provisional character. Copyright: Kjell Erik Lommerud, Odd Rune Straume and Lars Sørgard

3 CEPR Discussion Paper No March 2001 ABSTRACT Merger Profitability in Unionized Oligopoly* We examine how a merger affects wages of unionized labour and, in turn, the profitability of a merger under Cournot competition in differentiated products. If unions are plant-specific, we find that a merger is more profitable than in a corresponding model with exogenous wages. In contrast to the received literature, we find that it can be more profitable to take part in a merger than to be an outsider. For firm-specific unions, on the other hand, results are reversed. JEL Classification: J51, L13, L41 Keywords: endogenous wages, merger profitability, trade unions Kjell Erik Lommerud Department of Economics University of Bergen Fosswinckelsgate 6 N-5007 Bergen NORWAY Tel: (47 5) Fax: (47 5) kjell.lommerud@econ.uib.no For further Discussion Papers by this author see: Odd Rune Straume Department of Economics University of Bergen Fosswinckelsgate 6 N-5007 Bergen NORWAY Phone: (47 5) Fax: (47 5) odd.straume@econ.uib.no For further Discussion Papers by this author see: Lars Sørgard Norges Handelshoyskule Helleveien 30 N-5035 BG-Sandviken NORWAY Tel: (47 5) Fax: (47 5) lars.sorgard@nhh.no For further Discussion Papers by this author see:

4 We are indebted to Lars Mathiesen, seminar participants at the CEPR/IUI Workshop on Mergers and Competition in Stockholm, the Third Norwegian Workshop on Labour Markets and Education in Stavern, the Free University of Berlin and the EARIE conference in Lausanne for valuable comments on an earlier draft. We thank the Norwegian Research Council for financial support. Sørgard s research was partly undertaken during a visit to the Department of Economics at the University of California, Santa Barbara, whose hospitality is gratefully acknowledged. Kjell Erik Lommerud thanks University of Bergen and CEPR. Odd Rune Straume thanks University of Bergen. Submitted 30 January 2001

5 NON-TECHNICAL SUMMARY Traditional merger theory has dealt primarily with two questions: firstly, are mergers without cost savings (that is, purely anti-competitive mergers) profitable? Second, if such anti-competitive mergers prove to be profitable, how is the situation for non-merging firms in the same industry affected? The classic result is that anti-competitive mergers are often unprofitable. In the case of quantity competition (Cournot markets) in homogeneous goods, a merger must lead almost to full monopolization of the relevant market before it is profitable. The key intuition is that with constant returns to scale, there is a serious free-rider problem involved. The merging parties have an incentive to reduce their total output, but much of the advantage of the resulting price increase spills over to the non-participants. If one uses the other workhorse of oligopoly modelling, the Bertrand model of price-setting firms, the conclusion of non-profitable anti-competitive mergers is turned around: such mergers turn out to be profitable in this context. However, the free-rider logic still applies: Even though such mergers now are profitable, it is even more profitable to be a non-participant in the same industry as the merger candidates. These results are disturbing. Mergers seem to be an all-important aspect of business life, so does this mean that mergers typically are driven by cost reductions or other synergies, rather than by the wish to achieve market power? If the free-rider problem is so important, firms would be expected to hesitate to enter merger processes, trying to outwait other firms in the industry, but casually one gets the impression that the opposite holds. While traditional merger theories basically have studied how a merger influences the strategic interplay between firms in an industry, the present Paper tries to incorporate also unionized labour as strategic players. How will a merger influence wage setting in merging and outside firms? How does this affect merger profitability? It turns out that the exact modelling of union structure is crucially important. Under one set of assumptions, a merger most likely leads wages to fall enough to make anti-competitive mergers profitable. And notably, it becomes more profitable to be an insider to the merger than an outsider. This might appear to be stating the obvious that if a merger leads to sufficient cost savings for the participants, the merger will be profitable, and it will be more attractive to participate in the merger than not. But note that the cost saving here is not exogenously assumed, but endogenized. This means that we use a model of rational unionism to explain under what circumstances a merger can lead wages to fall sufficiently. We employ a standard linear oligopoly model, with Cournot competition and differentiated products. The unions are assumed to be monopoly unions that

6 have the power to set wages, but that must take the employment decisions of the firms as given. We discuss in the Paper the robustness of our findings when the assumptions of this simple model are altered. The level of unionism proves to be important. We distinguish between plant-specific, firm-specific and industry-wide unions. In the latter case, it proves that mergers have no effect on wages, so the bulk of the Paper discusses a comparison of plantspecific and firm-specific unionism. Plant-specific unionism is precisely the case where mergers most likely lead wages to fall so that anti-competitive mergers become profitable. A merger will probably lead the merged unit to cut back its total output (one cannot be totally sure about this in the current context, as opposed to what is predicted by the standard model). Unions might want to cushion the drop in employment by lowering wages. But the most important effect is that the merged unit is now able to pit two isolated unions against each other in a fight to get a higher share of the merged entity s total production. This is typically very wage dampening. In most instances, the wage drop will be sufficient to make anticompetitive mergers profitable. The exceptions are when unions care very much about employment or when products are very differentiated. Unions that are almost solely employment-oriented will set a wage very close to the competitive level anyway, so there is not much room for wage drops after a merger. Differentiated products offer unions some protection against being pitted against one another, since moving production from one plant to another will after all produce quite a different product. The wage in the outside firm can increase or decrease, but it turns out that the wage will always fall more in the merged firm than in the outsider firm. This means that anti-competitive mergers not only tend to be profitable, but it is more attractive to be an insider than an outsider. This result holds as long as unions are not too employment oriented. Again, strong employment orientation on the part of the unions means that advantage from a wage drop is small, because wages were low even to begin with, before the merger. Firm-specific unions produce almost completely opposite results. Firm-specific unions imply that as a firm merges, their unions merge too. This means that competition among unions in the oligopoly is reduced, as we move from a situation with three independent unions to two unions. This tends to imply that wages in the merged unit go up after merger, and it is even more unlikely that an anti-competitive merger is profitable here than in a non-unionized framework. Mergers are now profitable only when products are very differentiated and unions very employment oriented. The free-rider problem reappears: mergers are always more profitable for an outsider than for a participant.

7 Since union structure is so important for the results, we need a discussion in which assumption is more relevant. International mergers often lead to a merger between firms without a merger between unions. This could imply that firms seek out international rather than domestic merger possibilities, because international mergers have a discipline effect for unions that domestic mergers have not. Also, in some countries, a very decentralized bargaining structure combined with product differentiation might mimic what we have dubbed plantspecific unionism. We think that our analysis is important for empirical work. The results on how mergers influence wages have so far been very unclear, and we suggest that distinguishing clearly between the cases where one should expect wage drops and where one would expect wage increase would be clarifying. We intend to delve more into the policy consequences of the model in a sequel Paper. Wage drops lead to lower prices, so mergers are less of a competition problem (but perhaps more of a problem from a distributional viewpoint). Even though each merger might, however, be less of a problem from a competition viewpoint, the wage drop might induce more anti-competitive mergers, so that merger policy in fact becomes more important.

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