Question

What is the difference between a horizontal merger and a vertical merger? Which type of merger is more likely to increase the market power of a newly merged firm?

Short answer

A horizontal merger is between companies in the same industry as direct competitors, whereas a vertical merger is between companies at different stages of the production process. A horizontal merger is more likely to increase market power because it decreases competition.

Step-by-step solution

Definition of Mergers

A merger refers to an agreement that unites two existing companies into one new entity. There are two main types: horizontal merger and vertical merger.

Horizontal Merger

A horizontal merger occurs between firms that are in the same industry and are direct competitors offering similar products or services. As such, the motivation behind this type of merger is to increase market share, reduce competition, and achieve greater economies of scale.

Vertical Merger

A vertical merger is a merger between two or more companies that operate at different stages in the production process of a specific good or service, often in the same industry. Companies engage in vertical mergers to improve supply chain efficiency, reduce production costs, and gain better access to distribution channels.

Increased Market Power

The type of merger that is more likely to increase the market power of a newly merged firm would be a horizontal merger. This is because these types of mergers directly decrease competition and thus have a higher potential to increase the merged firm's dominance in the market. It is important to note, though, that this could potentially have antitrust implications.

Key concepts

Horizontal Merger

When companies aiming for a stronger foothold in the market opt to combine forces, a horizontal merger often occurs. This involves two firms that are in direct competition within the same industry, selling similar products or services. Imagine two major smartphone manufacturers joining together. This results in a larger entity with a more significant market share.

This strategic move not only diminishes competition but also offers a chance for the merged company to harness economies of scale. By merging, the companies can streamline their operations, negotiate better terms with suppliers due to larger orders, and spread costs over a broader range of products, effectively reducing the per-unit cost of production. One potential risk associated with horizontal mergers is that they can attract scrutiny from regulatory bodies due to the possibility of creating a monopoly, which can limit consumer choices and increase prices.

Vertical Merger

Vertical mergers, unlike their horizontal counterparts, join companies at different stages of production for a particular product or service. It's like a farm teaming up with a restaurant. The farm grows vegetables, and the restaurant sells meals to diners. This combination can create a more unified production-to-sales process.

Companies engage in vertical mergers to control more of their supply chain, cutting costs by reducing the need for outside suppliers and negotiating better terms through internal transactions. This optimization often leads to improved product quality and faster delivery times due to the seamless integration of production steps. Though less likely to raise antitrust concerns than horizontal mergers, vertical mergers can still impact market competition by raising barriers for new entrants.

Market Power

Market power refers to a company's ability to influence the price or quantity of products or services in a market. When a firm can set prices above competitive levels or sustain them without losing customers, it showcases significant market power. A good example would be a popular software company that dominates the market, facing little competition.

Factors Influencing Market Power

• Number of Competitors: Fewer competitors usually mean more market power.
• Product Differentiation: Unique products or services can give a company more sway over the market.
• Customer Loyalty: A strong, loyal customer base can bolster a firm's market power.

Horizontal mergers are particularly noteworthy for this as they can potentially create an entity influential enough to determine market conditions, which might be seen as beneficial by the merging companies but harmful for the market as a whole.

Economies of Scale

Economies of scale are cost advantages that businesses experience when they increase the size or scale of their operation. These benefits come into play when producing goods or services at a higher volume leads to a lower cost per unit. It's akin to bulk buying; purchasing larger quantities often results in lower costs per item.

The concept can be applied in various business aspects, from purchasing to manufacturing, to marketing. Firms can achieve economies of scale through different methods, including spreading fixed costs over a larger number of units, operational efficiencies, and improved bargaining power with suppliers.

While both horizontal and vertical mergers can result in economies of scale, horizontal mergers tend to benefit more directly from this concept since they often lead to an immediate increase in volume and market share, thereby allowing companies to rapidly achieve these cost savings.