Are all mergers and large firms against the public interest?

 Economic theory holds that competition between many small firms, with no barriers to entry or exit and an homogenous product, is an ideal state. This is because the consumer will be sovereign in such a situation, and each individual firm will face an horizonal AR and MR line corresponding to the market equilibrium price. In order to exist and make normal profit, a firm will therefore push costs down to the lowest average cost or leave the market, which is also the point where average cost will equal marginal cost and marginal revenue. This will result in allocative and productive efficiency and create an incentive for anyone with innovative ideas to temporarily push costs lower, making an abnormal profit. In the long run, however, since perfect knowledge and perfect information might exist in such circumstances, every supplier will copy the original breakout firm, and customers will gain more goods at a lower price because of the increase of supply.

In this perspective, mergers—either in the form of the voluntary union of two firms, or the hostile takeover of one by another—would be bad because they would raise barriers to competition. Larger firms would develop economies of scale. Economies of scale are ways in which larger firms can drive down long run average costs and hold them to their lowest long run point across a range of output.

A larger firm might develop such economies by raising market barriers, creating ‘bottlenecks’ of raw materials or components if the merger is vertical, dominating retail and wholesale markets, spending on the fixed costs of marketing and advertising in ways that small firms could not compete with or raise legal barriers. They might attract more finance and be able to create specialisations for workers and managers that raise productivity. All of this would result in lower AC and higher AR, thus increasing profit but at the expense of allocative and productive efficiency for the economy. When competition was removed or reduced, such large firms could then start to price-discriminate or simply to exploit the dependence of consumers on their product.

It would therefore seem unarguable that large firms should not be allowed to arise, and if they do, that they should be broken up.

The proposition is arguable, however. For instance, a firm which is large in a domestic market might be small in a global one. Revenue for the national economy in the form of taxes, and investment and sales incomes from abroad, might be a consequence of allowing the development of large, merged firms in a domestic market, if global players were not subject to barriers. Equally, if a market were contestable but imperfect, in which products were differentiated, and the public preferred the product of one company, being able to make higher profits and to buy others to assimilate and concentrate technology might be a good outcome for society. Larger companies tend to be easier to regulate, and if they produced items that gave rise to negative externalities, larger companies might have more resources in the form of retained profit to control or restrain those externalities.

Some companies are also intimately connected to the economic system. Competitive banks, in theory, are a good thing, but in practice, secure banks which can afford to reject insecure customers or business practices are better for the economy. There might also be circumstances in which a strategically or environmentally sensitive industry might better suit to several merged companies making satisfactory abnormal profits whilst being regulated than an uncontrollable number of small companies making normal or near-normal profits but leaving the market at critical times. The British gas industry, for instance, suffered from the creation of conditions in which companies were encouraged to ‘de-merge’ and prevented from merging under a price cap once wholesale prices for gas rose. This was because the apparent competition gave way to small companies going bust, forcing customers onto oligopolistic providers.

Large firms do not last forever. IBM, through merger and technological innovation based on abnormal profit being diverted to research, was once the largest company in the world. It delivered much greater technological development than a market of much smaller developers with less cash could have. Allowing small technological producers to merge into, or to be bought by, IBM, was good for the United States and the world. Eventually, technology and diseconomies of scale ‘fixed’ any temporary welfare or allocative downsides and created a whole new market of small software producers, which followed the same pattern, and then app and search companies, which also followed the same pattern.

 It is therefore obviously not the case that a blanket belief in small companies as good for everyone is correct. So long as larger companies are not allowed to engage in regulatory or political capture, or to maintain barriers to market contestability forever, merger and the threat of takeover are probably nearer to incentives to develop and progress than they are to distortions which allow for exploitation.