Horizontal Mergers with Free-Entry: Why Cost Efficiencies May Be a Poor Defense and Asset Sales a Poor Remedy

Abstract

I analyze the effects of a merger between two firms in a differentiated-goods duopoly. I make the crucial assumption that the industry is at a free-entry equilibrium both before and after the merger. In particular, I allow for the possibility of entry subsequent to the merger. Not surprisingly, this possibility improves the effect of the merger on consumer welfare. In fact, for reasonable parameter values, I show that consumer welfare may actually increase as a result of the merger. More importantly, I show that post-merger entry dramatically shifts the perspective on cost efficiencies as a merger defense and asset sales as a remedy. Post-merger consumer welfare may be lower when the efficiencies generated by the merger (lower marginal cost) are greater. The reason is that greater efficiency gains decrease the probability of post-merger entry to an extent that may outweigh the beneficial effects from cost-savings passed on to consumers. Likewise, by selling stores to their rival, merging firms effectively buy off the potential entrant, that is, dissuade it from opening new stores, an effect that is detrimental to consumers.