This paper investigates the profitability of horizontal mergers with price dynamics through the differential game approach wherein both the open and closed-loop equilibria are considered. It is shown that the incentive to merge is determined by how fast the market price adapts to the equilibrium level. When prices adjust with a very sticky mechanism, mergers emerge with a small number of insiders, even if firms play open-loop strategies, and total output reduction after a merger is not significant, even in mergers with a large number of insiders. In the case of instantaneous price adjustment, it can be shown that the relationship between the possibility of a merger and market concentration depends on the type of strategy firms play. These findings have important implications for antitrust authorities since: (a) price stickiness creates market conditions that facilitate merger practice, and (b) changes in output may not be a good benchmark for merger assessment in the case of price stickiness.

Introduction

When quantity-setting firms with symmetric cost functions compete in a homogenous product market, a horizontal merger is modelled as an exogenous change in market structure. In such a setting, these mergers reduce the number of competitors in the industry. Accordingly, firms’ market price and market power increase. Although non-participant firms benefit from increased market power, merger profitability is not guaranteed. In the case of linear demand and cost functions, the resulting anti-competitive forces benefit outsiders. Only when their market shares are quite high (at least 80% i.e. almost a monopoly) merging firms will favour the opportunity to merge (Gaudet & Salant, 1992; 1991; Salant, Switzer, & Reynolds, 1983). This threshold will be reduced to 50%, again a considerable market share, provided that the merged entity is not restricted to remain a Cournot player and can become a Stackelberg leader after the merger (Levin, 1990). By considering general demand functions, Cheung (1992) shows that at least half of the industry should merge in order for a merger to be profitable. Assuming an asymmetric organization rather than considering an industry comprising entirely of identical firms, Daughety (۱۹۹۰) argues that in industries where almost less than one-third of firms are leaders, mergers will be profitable if they are leadergenerating. The efficiency argument was first advocated by Perry and Porter (1985) who showed mergers are profitable provided that firms can benefit from some economies of scale.