Merger Analysis Of Vodafone Airtouch And Mannesmann Ag Economics Essay

The case on merger between two competing firms- British telecommunication firm, Vodafone Airtouch and German cellular provider, Mannesmann AG- shall be my highlight of this report. In short, this case illustrates a hostile takeover by Vodafone. Vodafone initiates the merger as it sees it as an opportunity for the firm to expand in a rapidly changing communications technology environment in Europe at that point in time. Initially, Mannesmann rejected the proposal. However, in a twist of event, it was eventually left without a choice but to merger with Vodafone. Third parties were enraged as they view this move as anticompetitive. They argued that the merging entity would gain dominant market power, raise barriers to entry and reap economies to scale which they could only dream of. The case was brought forth to the European Commission which only allow for the merger to succeed after Mannesmann de-merge with Orange and also after Vodafone ensured that it will enable third party non-discriminatory access to the merged entity’s integrated network so as to provide advanced mobile services to their respective customers. The Commission viewed these undertakings as sufficient to remove the competition concerns linked to the inability of third parties to provide competitive seamless pan-European mobile services.

In this report, I’ll analyze the economic benefits, how merger impacts upon consumers and/or producers benefit, as well as, the total welfare. I’ll also touch on how merger has the potential to reduce competition and finally, the reasoning of the competition authority’s decision that leads to the success of the merger.

ECONOMIC ANALYSIS

The merger between Vodafone is Mannesmann is considered to be a horizontal one since both companies operates within telecommunication industry. The merger of the two entities reduces the number of competing firms by one and at the same time, increases the industrial concentration. In theory, a reduction in number of firms competing reduces supply whilst increasing prices of the good which is deemed to be harmful to consumers. The concept of improving/diminishing consumer surplus is further discussed later in the report.

It is not always true that fewer firms and higher prices necessarily translate into higher profits for the merging firms. For instance, profitability of each firm is ¼ in a four-firm industry. So, profits of two individual firms simply add up to ½. Now, three firms remain after the merger of two. We observe a decline in profitability from ½ to 1/3 for the merged firms. And although higher industrial concentration improves sales, this increase in sales is not enough to offset the rise in prices charged. Profitability still declines making the merging firms worse off. Thus, charging at price equals to marginal cost provides no incentive to merge unless all firms in the industry merge to form a monopoly.

Having mentioned the above, merger doesn’t only take place only when all firms merge. In reality, cases such as Vodafone/Mannesmann showed that mergers can lead to cost reduction. The efficiency that arises could be strong enough to drive this merger. Firms will want to produce at the minimum point of the AC curve where they’ll be producing efficiently. They avoid duplication of fixed costs when they consolidate management and not employing two people to perform an identical task. By doing so, the firms are able to lower their cost of labour. In addition, both firms are only required to pay a fixed cost such as land and operating facilities, only once after the merger. Effectively, a cost saving of the fixed cost will increase profits, providing an incentive to merge especially when they increase their prices. Hence, the firms may do away with redundant labour, assets and facilities.

As we know, a merger would lead to a rise in price as lesser firms are left competing in the industry. Firms are better off with a higher price imposed on consumers and when they gain from higher producer surplus. The opposite applies for consumers who are worse off when prices increase. When the increase in producer surplus outweighs the decrease in consumer surplus, total welfare is said to have increase.

However, when the merger reduces marginal cost for Vodafone and Mannesmann, the merged firms may pass on such lower cost to their consumers in the form of lower prices. Lower prices are generally beneficial to consumers. As consumer surplus rise, there will be a subsequent increase in total welfare.

Moreover, there might again be cost efficiencies which explain why merged firms can incur a lower marginal cost than the two pre-merger firms. Synergies can be easily exploited between the merging firms. Each firm knows what the other firm is capable of doing and thus, they only produce goods and services that give them the competitive advantage. Overall, a fall in marginal cost would mean cost saving that facilitates profitability. This profitability, in turn, promotes merger.

Price, P

P2

P1 = C1

C2 Demand, D

0 Q2 Q1 Quantity, Q

Figure 1: Diagram illustrating welfare effects of a cost reducing merger (Adapted from lecture slides)

From Figure 1, there is no producer surplus when price equals to cost (P1 = C1). Firms are only earning profits while producing at Q1. At this stage, consumer surplus resides in the area under the demand curve and above the C1 horizontal cost curve. After the merger between Vodafone and Mannesmann, lesser firms are left competing and therefore, price increases from P1 to P2. Consumers are gradually worse off with the rise in price. Now, their surplus is reduced to the area under the demand curve and above P2. The area enclosed within P2, P1 and Q2 is the surplus that is transferred from consumer to producer. On the other hand, the triangular areas under the demand curve, but bounded within Q1, Q2 and P1 signifies the deadweight loss. This deadweight loss refers to the surplus that is no longer gained by consumers and producers.

Concurrently, there could be synergies between the merging firms that enable cost saving. This cost efficiency lowers cost from C1 to C2. Firms are better off. As shown in Figure 1, the area enclosed within P2, C2 and Q2 represents total producer surplus after the merger. The area within C1, C2 and Q2 is the surplus gained by producers from synergy that render better opportunities to grow margins.

Looking at the above, we see that it is beneficial for firms to merge as they incur producer surplus. Total surplus improves as a result of a rise in producer surplus.

Moving on, we shall consider competition with regards to the merger between Vodafone and Mannesmann. Assuming that there’s no cost saving, a rise in price due to merger will ultimately erode consumer surplus substantially, to a point where losses to consumer outweigh gains to producers. From the producer’s point of view, this may provide an incentive for them to seek excuses to merge. They may falsify information to convince competition authorities to approve merger.

Taking the impact of merger into account, competition authorities have to critically decide on whether to approve a merger especially those which involve large firms like Vodafone and Mannesmann. Such decision process will require them to get hold of accurate information which is not always easy to obtain.

One main concerned of competition authorities is the size of the merged firm. Markets dominated by large firms tend to further inflate prices and force down consumer’s welfare. With reference to the case at hand, competition authorities were initially reluctant to grant merger to both firms. They were concerned that merger between the two large firms will turn out disastrous as they are already producing beyond Q* due to their sheer size. Approving their merger would only mean that these firms operate beyond the MES. Firms that merge at this stage face diseconomies of scale when cost is driven up as they continue to increase output along the AC curve.

Cost, C Average Cost, AC

MES

0 Q* Quantity, Q

Figure 2: Diagram illustrating Minimum Efficient Scale (MES) on the AC curve.

Rival firms strongly disapprove Vodafone’s proposal to merge with Mannesmann as they view the move as being anti-competitive. They argued that the merged entity will be able to provide exclusive services on a seamless basis because the merged entity has the integrated network that such services require. In the proposal, however, Vodafone claimed that if an interconnected network did develop it would not give rise to competition concerns, both because there will be scope for such networks to develop, and because there will be other routes for operators to ensure fair competition within the telecommunication industry. In any event, Vodafone considers that other operators will be in a position to provide “seamless” services on the same scope in the near future.

COMPETITION AUTHORITIES’ DECISIONS

The Commission’s investigation has shown that with the complexities involved in agreeing on the modification on the existing network configuration, centralised management solutions and cost and profit allocation will make it exceedingly difficult for third parties to replicate. In addition to the uncertainty as to the replication of the merged entity’s network by means of the right combination of mergers, this process would be extremely costly, time consuming and fraught with regulatory delays given the need for regulatory approval. This is supported by the significant number of failures over the past years in building similar solutions in related markets within the framework of joint ventures or strategic alliances.

The merged entity would be the only mobile operator able to capture future growth through new customers who would be attracted by the seamless services offered by Vodafone/Mannesmann on its own network. Rival firms which could not offer a comparable service to attract enough market shares will find themselves losing out in the competition. Furthermore, given their inability to replicate the new entity’s network, competitors will have, at best, i.e. if they are allowed access to Vodafone’s network at all, significant costs and performance/quality disadvantages given its dependency on Vodafone/Mannesmann. The merged entity’s power to refuse third parties’ access to the its network or to allow access on terms and conditions entrench the merged entity into a dominant position and diminishes third party offerings.

What’s more, customers would generally prefer Vodafone/Mannesmann to other mobile operators given its unrivalled possibility to provide advanced seamless services across Europe. This reinforces the merged entity’s position in the industry as a dominant player.

And through its unrivalled large customer base and position, Vodafone/Mannesmann will be in a unique bargaining power against handset manufacturers to negotiate design functionalities unavailable to competing operators. Customizing handsets make it more difficult for roamers from competing mobile operators to take advantage of the advanced pan-European services available over Vodafone’s network. Again, competitors lose out if the merger were to be approved.

Upon investigation the Authorities revealed that the merged entity would face stiff competition from other operators and will not enjoy a dominant purchasing power in the long run. They agreed that the merged entity will be a strong buyer in the market for mobile handsets and network equipment, but there remain many other comparable incumbents competing in the market. So, the merged entity would not achieve the necessary buying power to become dominant on the market.

In the light of the above the authorities concluded, “… the notified transaction does not lead to the creation or strengthening of a dominant position in the global markets for mobile handset and mobile network equipment as a result of which effective competition would be significant impeded in those markets.” Meaning to say, the authorities do not view the merger as a significant threat since it’s powers would have been neutralized by other relevant competitors within the industry.

Further precautions were taken in ensuring fair competition within the industry as seen in the demerger of Orange with Mannesmann. This move aims at diluting the powers of Vodafone and Mannesmann after the approval of their merger. It is a well-received decision as it removes the competitive overlaps in the United Kingdom and Belgian markets of telecommunication services.

Besides Vodafone has, on its own account, pledged to enable third party non-discriminatory access to the merger entity’s integrated network that includes undertakings which cover exclusive roaming agreements, third parties’ access to roaming arrangements, third parties’ access to wholesale arrangements, standards and SIM-cards and a set of implementing measures aimed at ensuring their effectiveness. On top of that, it has proposed to set up a fast track dispute resolution procedure in order to solve disagreements in the mentioned aspects and also to reduce its anticompetitive stance. The undertakings as well as demerger is thought to be justifiable since it eliminates the competition concerns linked to the inability of third parties to provide similar competitive seamless pan-European mobile services.

CONCLUSION

In conclusion, Vodafone’s proposal to merge with Mannesmann is seen as an anticompetitive threat to other telecommunication service provider. Rival firms were concerned that the merger would bestow substantial market power to the merged entity. Thus, they were strongly against the merger proposal. However, after much consideration by the competition authorities, they concluded that the merger would not inflict much threat due to the presence of a number of strong, large and powerful buyers in the market which prevent Vodafone/Mannesmann from achieving dominant position on the provision of the related services. Moreover, the demerger of Orange with Mannesmann will erode market power of the merged entity. Furthermore, Vodafone submit undertakings that allow third parties access to its networks. Following the implementation of these undertakings, third parties will be in a position to offer competing advanced pan-European mobile services which also prevent the emergence of a dominant position on the provision of these services. The possibility to offer similar services in competition with Vodafone will, in turn, also develop incentives for third parties to develop competing networks. Therefore, the authorities approved of the merger between Vodafone and Mannesmann.

To some extent, I disagree that the merger should be approved. The authorities’ argument that the presence of comparable incumbents will be sufficient in reducing market power of the merged entity comes across as weak to me. Only few of such incumbents operate within the telecommunication industry. Thus, it’s influence on the merged entity’s market power is almost negligible. Vodafone/Mannesmann could still operate like a monopoly by setting high prices and reducing output while erecting barrier to entry to deter competition. Consumer welfare would be greatly harmed as a result of the merger.

On the other hand, I support the merger as it encourages innovations. In today’s competitive society, only the strongest emerge as champions. Therefore, rival firms may invest in Research and Development (R&D) in creating an innovative communicative technology or network system that gives it a competitive edge over Vodafone/Mannesmann existing resources. This encourages a forward-looking competitive that benefits society as a whole. Producers gain as it may develop ideas to increase efficiency while consumers may gain from perhaps cheaper pricing that is passed on to them from lower production cost incurred by producers.

APPENDICES

European Competition Commission, http://ec.europa.eu/competition/mergers/cases/decisions/m1795_en.pdf, assessed on 11 November 2010

Kendall (2010), Markets, Competition and Regulation Lecture Notes Session 8: Mergers; and Session 9: Competition Policy

Merger Control and Remedies Policy in the E.U and U.S: the case of Telecommunications Mergers, http://www.cerna.ensmp.fr/Documents/GLB-TelecomMergerRemedies.pdf, assessed on 12 November 2010

United Kingdom Competition Commission, http://www.competition-commission.org.uk/rep_pub/reports/2003/475mobilephones.htm#full, accessed on 15 November 2010

Europa Press Release Rapid “Commission clears merger between Vodafone Airtouch and Mannesmann AG with conditions”, http://europa.eu/rapid/pressReleasesAction.do?reference=IP/00/373

http://news.bbc.co.uk/2/hi/business/630166.stm, assessed on 16 November 2010