The year 2016 was certainly an active year for mergers. In just the month of October, almost $490 billion worth of deals were announced. With regard to new deals, readers are likely to be familiar with the name Spectrum, which is what the firm resulting from the merger between Time Warner Cable and Charter Communications is now called.
When I ask my students what they think about mergers, they frequently reply that mergers between firms in an industry may be good for the firms, but they are bad for consumers. Why? The standard line of reasoning is in three parts. First, it is noted that mergers lead to increased industry concentration, which means a smaller number of firms. Second, a smaller number of firms implies there is less competition among them. Finally, reduced competition implies higher prices and reduced variety for consumers and excess profits for the merged firm.
This line of reasoning has considerable merit to it and many prominent economists, such as Richard Schmalensee of Massachusetts Institute of Technology, have supported this kind of thinking. Indeed, when pondering the desirability of mergers, concerns about the deleterious impacts on consumers also routinely occupy the thinking of officials in the Federal Trade Commission.
The above unenthusiastic thinking about mergers notwithstanding, new research by the economists Haimanti Bhattacharya and Robert Innes shows that mergers can be beneficial to consumers in ways that are not usually contemplated by the lay public.
Professors Bhattacharya and Innes analyze the impact that concentration has on the introduction of new products in the food industry. They demonstrate that contrary to what one would expect, higher levels of concentration lead to a larger number of new products, that is, to greater variety and that some of this increased variety is contributed by small firms. The research shows that small firms introduce new products in the hope that such activities will result in their being bought out by larger firms.
This entry-for-merger behavior on the part of small firms leads to even greater concentration of the industry as the biggest firms buy up their smaller rivals and thereby access the best new ideas and products. Simultaneously, this increased concentration also spurs innovation on new products because entrepreneurs in small firms realize the benefit of pursuing the entry-for-merger strategy. The economist Jeffrey Dorfman rightly notes that this situation leads to a veritable feedback loop in which mergers lead to more innovation which in turn leads to more mergers, and so on.
Observe that this kind of entry-for-merger-driven concentration may give rise to a very dynamic industry with significant innovation. In addition, prices in such a concentrated industry may also be low relative to what would have prevailed in a less concentrated industry with fewer mergers. To see why, note that when innovation is conducted by small firms, only the successful innovators are bought out by their bigger rivals. Therefore, the cost of failed products is borne not by the bigger rivals but instead by those investing in and lending to small firms.
A key point emanating from the research delineated here is that for an entry-for-merger strategy to be successful and hence ultimately benefit consumers, there must not be high barriers either to the entry or to the exit of new firms and products. In the words of the eminent economist William Baumol, the pertinent industry needs to be contestable. In a contestable industry, high concentration does not necessarily imply higher prices, because when large, incumbent firms raise prices very high, this act provides a signal to some firms to enter this high-price industry.
The successful pursuit of this kind of entry-for-merger strategy is not limited to the food industry. The technology entrepreneur Hadi Partovi has argued that many technology startups have located in the Seattle area with the intention of becoming just profitable enough to be bought up by Microsoft.
In sum, mergers do not have to be bad for consumers. Indeed, in some highly concentrated industries, we may see both lower prices and greater innovation. The key point to be mindful of is whether a highly concentrated industry also comes with high barriers to firm entry and exit. This is where consumers are unlikely to benefit from mergers.
Batabyal is the Arthur J. Gosnell professor of economics at the Rochester Institute of Technology. These views are his own.