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1.1. Industrial economic analysis
The analysis of the incentive and the effects of the horizontal merger in our
economy has been heavily discussed in the industrial economics literature. The main
discussing points are related to the variation of the aggregate profits of the merging firms
and the remaining firms (firms outside the mergers that compete in the industry), the
equilibrium prices, and the consumer welfare. Looking at different papers we were able to
understand that the benefits of merging, and so the incentive to do it, largely depend on the
type of market competition (Bernard or Cournot), on the structure of the industry, and the
type of firms involved in the merger. Some early theoretical work has been made by
Williamson in his article Economies as an Antitrust Defense: The Welfare Trade-offs
(1968), in which analyze a merger that leads to an economic advantage due to the
synergies and the saving costs, but meantime increases the market power of the merging
firms and so increases the price of the good. In this case, the net welfare effects depend on
the entity of the two phenomena, and to see a positive effect the reduction of the costs must
exceed the price increase. Steiner (1975) adds to the literature that mergers should increase
the aggregate profit of the merging firms even if there is an absence of cost efficiency
derived by economies of scope or scale.
Moving on to research based on the industrial organization model the results are not
very clear and sometimes counterintuitive. For instance, taking into consideration the
oligopoly model of Cournot, where the competition is based on the output and the
assumptions are that the firms have the same marginal cost and undifferentiated products,
mergers may reduce aggregate profits of the merging firms due to less production of the
new firm if compared to the pre-merger production of the two firms combined (Salant et al,
1983). This will benefit the remaining firms, which at this point will increase their output.
Unless there are important synergies in the merging firms that leads to efficiency and costs
saving, also the equilibrium price will increase, so even though the total profits of the
industry will rise, the merged firms will decrease them, considering that their share of the
market has decreased. So, under the Cournot model analysis seems impossible to
understand the desirability of conducting a merger, and we agree with Deneckere and
Davidson (1985) when they wrote: “We argue that failure to explain the desirability of
mergers results from almost exclusive attention to quantity as the basic strategic variable
under the firm's control. We feel that price is a much more natural strategic variable than
output”.
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To better analyze the mergers with an industrial organization model, we consider
closer to the reality and specifically closer to the industry of our interest, the digital sector,
the Bertrand model, in which the competition is based on the price and the goods are
differentiated between firms. Looking at the literature that has explored this topic we can
see a different result, more similar to the reality: under certain plausible conditions on the
demand system, mergers in a price-setting game are always beneficial to exist members
and become more profitable as the size of the merger increases (Deneckere and Davidson,
1985). In addition, we can see that without important cost synergies post-merger
equilibrium prices exceed their pre-merger levels. Moreover, the post-merger equilibrium
profit of the merged firms and non-merged firms exceeds the aggregate of the pre-merger
equilibrium profits, damaging the consumers (Federgruen and Pierson, 2011). Another
important point regards the profitability of the remaining firms: in both Cournot and
Bernard methods, the remaining firms will be benefitting more than the merging firms in
terms of profit if there are no efficiency gains given by the merger. With these results,
firms will be interested in favoring other mergers and act as free riders, creating a possible
outcome where no firm decide to merge to increase its market power. In reality, we do not
see the same situation and the paper of Brigo (2003) allows us to understand why firms
may still be interested in being insiders (as opposed to being witnesses to a merger) even
when market power is the sole motivation for the merger. This can happen under two
circumstances: there are some efficiency gains in the merger so that the merging firms will
become the most benefitted firms in the new equilibrium, or there is a pre-emptive merger,
where the decision to merge is motivated by the uncertainty about future events. Finally, a
paper from Fridolfsson and Stennek (2005) illustrates the reason why a merger could
happen even if it is unprofitable for the merging firms, sustaining the theory of the pre-
emptive merger exposed by Brigo. The paper shows that even if a merger reduces profits
compared to the initial situation, it may increase profits compared to the relevant
alternative, in this case, witness a merger with the rival firm. The article exclaims also that
there are several cases in the real world that pre-emption is sometimes the primary motive
behind a merger or an acquisition of a competitor, and results show that strategic motives
may be strong enough to induce firms to have unprofitable mergers. In summary, we can
say that, in an oligopoly, a firm will be interested in merging even if for sole market power,
and doing so, will reduce competition, increase the equilibrium price, and reduce the
welfare for the consumers.
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1.2. Market power effects
Market power represent an important reason for horizontal and vertical acquisition
it does that because give the ability to the firm to manipulate the market price, control its
profit margin, and obstacle potential new entrants into the market. Market power happens
often when we have a market with a near-monopoly situation, in which few firms have the
ability to control the landscape, and it is take into consideration from Antitrust in approval
of M&A, considering that many countries have laws dedicated to limit a firm market
power. In this we see how market power can affect not only the prices, but also the wages,
in addition we see the dangerous correlation between market power and political power,
and finally the possibility for a firm to exploit market power to behave in anti-competitive
way.
Prices and wages
We have seen from the industrial organization literature that the horizontal mergers
and acquisition increase the market power of the firm, this situation has been confirmed
also by a survey of Weinberg (2007), in which examine the price effects in several
horizontal mergers, concluding that in most of them the results are an increase in market
power and a reduction in consumer welfare. The market power effects of a horizontal
M&A are sort of contrasting the positive effect given by the efficiency gains, and the trade-
off between these two variations is crucial to understand what the impact on the consumer
welfare may be. Now, considering a pre-emptive acquisition, done with the only purpose
of maintaining the dominant position and create market power in the industry, it is crystal
clear where the balance of the trade-off will tip. But market power does not only mean an
automatic decrease of competition and increase in the prices, but it also has a broad
spectrum of potential effects that could have a larger impact in the long run. Starting from
the definition of the term, market power means that a firm in an oligopolistic or
monopolistic economy, thanks to a high share of the market, can influence the price at
which it sells its goods to increase the profit. Have the possibility to influence the price,
means that the firm will have, under certain limitations, the upper hand in the market, and
if one day it decides to increase the price of the goods, the consumers will have few
resources to contrast it and most of the time they will just accept to see their consumer
surplus evaporate.
But the capacity of affecting the prices is just one of the effects that a firm with
market power could exercise, for instance, market power enables the firm to exploit
workers by paying lower wages than they would accept in a market with perfect
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competition. While a research paper in the 90s (Nickell et al., 1993), by studying 800
British manufacturing companies, exposed that product market power has some positive
impact on wages and this impact it enhanced in large firms, we found a more recent and
interesting report of Bivens et al. (2018), published by the economic policy institutes,
which is trying to explain the influence of market power over the American wages and,
thus it goes without saying, the results are completely different. The paper shows the need
to explain the gap between the productivity of the workers and their wages, focusing not
only on the product market power but also on the labor market power. The research shows
that both labor and market concentration is negatively correlated with wages, but the
extension of the effect is limited and not enough to fully explain the productivity-pay
divergence.
Figure 1 - Compensation gap and explanatory factors in USA
As we can see in Table 1, the erosion of labor’s share in the latest years 2000-2014
has become particularly high (46.3%), and it is responsible for lowering real median hourly
compensation by roughly 0.5 percent each year relative to net productivity. The erosion,
however, cannot be explained by the impact of the explanatory factors, which shows a loss
in labor’s share of income in the same period of only 0.5%. Even if the market
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concentration is not the sole cause of the gap between wages and productivity, some recent
studies give particular attention to this phenomenon. Specifically for the labor market
concentration, we are moving toward a situation closer and closer to a monopsony, a
market where few buyers of labor accompanied by a lack of credible competition from new
entrants give employers the ability to set wages lower than they would be in a competitive
market (i.e., lower than their workers’ marginal value product), reducing the power of
workers. Azar et al. (2017) and Benmelech et al. (2018) have expended great efforts to
study the effect of concentration in the labor market, using data that directly measure the
degree of concentration, allowing to better estimate the impact of labor market
concentration on wages. Both papers suggest that we have concentrated markets, the anti-
competitive effects of concentration on the labor market could be important, and increasing
concentration is associated with lower wages. In addition, the analysis made by Azar et al.
could be used to incorporate labor market concentration concerns as a factor in antitrust
analysis, this could be useful when we are going to see what antitrust can do to limit
mergers that create market power. These studies confirm what was exposed by Stiglitz in
his book, namely that there is a huge asymmetry of market power in favor of the employers
and that market power enables firms to push wages below what they would otherwise be.
Political power
Market power often means political power. It is important to not underestimate the
strict correlation between these powers because it could lead to a very unfair market, where
the larger firms with market power can protect themselves by influencing the politics and
its decision. For example, in a concentrated market like in the USA, the big companies can
influence the decision about taxation and trade policies, favoring less than adequate tariffs,
or diminishing the utility of the workers’ union, and destroying the workers' bargaining
power. One of the main methods used to affect politics is lobbying. An interesting working
paper by Cowgill et al. (2021) examines the connection between lobbying and industry
concentration. The hypothesis is that incumbents lobbying politicians to erect barriers to
entry to protect their market power and if lobbying creates economies of scale, an increase
in market concentration should lead to an increase in lobbying activities. The paper shows
the importance of a merger in affecting lobbying efforts, exclaiming that the merged firm
will spend more on this activity as compared with the efforts spent from the pre-merger
situation, considering that it will have more market power to influence the decision. In this
case, we see a sort of a vicious circle of lobbying and market power, in which M&A
activities act as a bonding agent, allowing better coordination in taking decisions among
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the merging firms. Without the control of the antitrust, this connection between market and
political power could create a one-way road towards monopoly or strict oligopoly. The
biggest firms could decide to merge with the aim of increase their market power and its
profit, then it could increase the lobbying activities to influence the politics to protect its
activities and subsequently merge again to further gain market power, killing the
competition and creating a market super-concentrated without business dynamism and
certainty of its dominant position. Of course, this is an extreme consideration, but it
enables us to understand the dangerousness of the link between these two powers.
While there are several empirical analyses concerning the market power effects on
prices and wages, it is more difficult to find something more practical than theories about
the relationship between political influence and economic power. The main reason for this
lack of analyses is the complexity of measuring the effect and the extent of the political
activity. One empirical research about this argument was made by Salamon and Siegfried
(1977) considering two broad sets of factors in the US: the nature of the political system
and the structure of the economic sector itself. The results show that in the American
political system the large corporations have more incentive for political activism compared
to the consumers and the large scale enterprises have political advantages under their
control over sizeable quantities of several crucial political resources: money, expertise, and
access to government officials (Golembiewski and Olson, 1966). Furthermore, concerning
the structure of the economic sector, the paper found that the larger size firms yield greater
political power.
Anti-competitive behaviours
We have just seen how firms exploit market power to have higher profits, reduce
costs, and influence politics. These situations allow them to have a dominant position in
the market, but they want also to keep the machine working in this way, and in order to do
that they need some barriers to protect them from the competition. Besides political
influence, the big companies found always new innovative ways to lessen the competition,
for instance, predatory pricing, pre-emptive acquisitions, and patent misuse. Normally, in a
competitive environment is rare to see anti-competitive behaviors, but this changes
completely when a firm has an extended market power that allows it to curve the market in
its favor. The main goal of these anti-competitive tactics is to create a barrier to entry so
that the new entrants will not be able to “steal” a share of the market. With predatory
pricing, for example, a dominant firm can sacrifice its profit in the short term by cutting the
prices and forcing away the new entrants, and once this happens, the firm can re-raise the
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price closer to monopoly levels, harming the consumers. In our economy, with large multi-
industry firms, the big companies can resist longer with prices under the cost line and
losing money in one industry by draining profits by the other industries. At this point, is
clear that this tactic could lead to a non-competitive market and decreasing consumer
welfare, for this reason, the predatory pricing strategy has severe legal restrictions in
several countries, like in the U.S.A. and the EU. The main problem regarding the predatory
pricing policy is that the line between competitive pricing and predatory pricing is not
always so obvious to allow the court to interfere in the market.
But among the different methods available for the firms to deceive the competition,
we want to further dwell on the pre-emptive acquisition strategy. As we said before, this is
strategy corresponds to an acquisition of a potential future threat, made with the objective
to avoid the raise of competition. While not every pre-emptive acquisition is done only to
lessen competition but, for example, could be done to acquire new technologies or skills,
this method could be an important technique to create barriers, especially if we have a
market situation where the potential competitors prefer to be acquired by a large sum of
money as compare with entering in competition with the dominant firm. Another reason
why a big firm will conduct a pre-emptive acquisition is to cleverly avoid antitrust
regulation, considering that the acquired firms are small enough to pass the antitrust
scrutiny and they are only a potential threat, difficult to quantify. Pre-emptive acquisitions
could forestall competition but also slow innovation. For instance, a firm could buy a
potential competitor with interesting new technology and then shut it down right after the
acquisition, blocking the innovation. We are going to see now specifically in the digital
industry how market power and pre-emptive mergers can affect the innovation process.
1.3. Effects in the digital industries
After looking broadly at the effects that market power has in our economy, we want
now to focus on the impact of horizontal and pre-emptive mergers and acquisitions in a
specific sector relevant to the purpose of this paper: the digital industries. The M&A
activity has been very present in the last period in these industries: the five big tech US
giants (Google, Amazon, Facebook, Apple, Microsoft) acquired 175 companies in the
2015-2017 period, and most of them were young and innovative start-ups (Gautier and
Lamesch, 2021). This situation has recently raised some concerns about the possible
implication for our economy, especially concerning the effects on the competition and the
innovation. Regarding competition matters, we can easily say that when many M&A
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happens, the market becomes more concentrated, this is especially the case of Amazon,
which is estimated to have accounted for almost 40 percent of all 2019 e-commerce sales
in the U.S., and Facebook and Google, which together account for over 60 percent of U.S.
digital ads spending (Katz, 2020). Katz exposes that in these industries there are strong
increasing returns, such as network effects and collection of big data, that create
competition for the market rather than in the market, where firms compete by innovating to
attain temporary market dominance. This can limit the number of competitors and lead
toward a monopoly market.
A firm in order to enter and compete for the market must: have a strong innovative
product, with higher quality compared to the incumbent firm, to outweigh its disadvantages
on scale and network; or using a two-base strategy, meaning that the firm builds up a base
of users in an adjacent market, creating a network effect, and then it moves to the
incumbent market by offering the new service to that base of users (for some
commentators this was the strategy pursued by Instagram and WhatsApp before their
acquisition by Facebook). Through pre-emptive mergers, the incumbent firm can try to
avoid the growth of firms as a rival for the market, by acquiring the new entrants whenever
it seems to have potential innovative technologies that can easily become a threat or when
it has a large base of users in an adjacent market. In accordance with Marino and Zábojník
(2006), in a sector where the competition is for the market, the so-called Schumpeterian
competition, mergers seem to be profitable even if ensuing entry is rapid, namely that the
incumbent firm will prefer to merger even if it knows that a new potential entrant is
already trying to enter in the market. It is possible that are these the motives why we are
seeing an intense activity of M&A made by the leading digital firms, to maintain the
dominant position in the market they proceed with several mergers, also acquiring
potential entrants that do not constitute an actual threat at the moment of the acquisition.
While this situation is leading to a very concentrated market, with a strong impact
on competition, the effects on innovation are more difficult to analyze. Rasmussen (1988)
exhibits a positive effect on innovation given by the merger’s activities, the so-called entry
for a buyout, i.e. when a firm enters the market with the sole purpose to induce the
incumbent to acquire it. This strategy can motivate, from the entrant’s point of view, an
important reason to create innovation, but also leads to inefficient entry, where new
ventures try to enter with a close substitute to the incumbent’s product, creating a little
value for the customers (Bourreau and De Streel, 2020). Even if the entrepreneurs can be
motivated to create innovative goods, to understand if the innovation becomes useful for
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the consumers is important to see what the incumbent firm does with the acquired
technology. Going back to the research of Gautier and Lamesch, described at the start of
this chapter, they observed that in more than 60% of the analyzed acquisition the acquired
products and services were discontinued under its original brand name, and this happened
more often looking at Facebook and Apple. In the paper, they argue that there are three
reasons to do that: the product is not as successful as expected, the acquisition was not
motivated by the product itself but by the target’s assets or R&D effort, or by the
elimination of a potential competitive threat. While they were not able to address which of
these explanations was applicable to the acquisitions, they found that most of the start-up
acquisitions were discontinued right after the purchase, and this could mean “killer
acquisition”, an acquisition in which the incumbent acquire innovative targets solely to
discontinue the target’s innovation projects and preempt future competition (Cunningham
et al, 2021). Some secondary effects that we are seeing recently in our digital market and
that can severely impact our lives are the correlation between market concentration,
information, and privacy. While we will not linger on this subject because is beyond the
scope of our paper, digital companies such as Facebook, Amazon, and Google have the
power and the ability to influence and distort the information, opinion, and votes, and
collecting data about the customers, often infringing privacy policies. This situation could
dramatically impact our democracy and the evidence is confirmed by recent studies in
which they analyze the distortion effects of some mechanisms like the search engine
manipulation effect, the search suggestion effect, and the filter bubble.
We hope that this overview on the possible effects of horizontal and pre-emptive
M&A on our economy made it clearer the importance of the risks that we can run into if
we leave the market without regulation. This is especially true within the digital industries,
where the market power combined with the economies of scale, network effects, and
collection of big data could influence utterly our economy and our democracy. Considering
this premise, what are we are going to do in this paper is trying to analyze, via Crunchbase
and some other sources, the acquisition activity of some of these big tech companies,
specifically Facebook and “its Chinese brother” Tencent, while we will see an overview of
Amazon, Google, Alibaba, and Baidu. But before jumping at our database analysis we will
try to understand why the Antitrust law is not able to better scrutiny the M&A activity of
the big tech firm and what it could do in the future to prevent acquisitions that lead to a
more concentrated market with abuse of dominant position.
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