Conglomerate effects and natural
monopolies
The General Electric/Honeywell case
Erasmus Universiteit Rotterdam
Erasmus School of Economics
Abstract
Since conglomerate mergers tend to improve efficiency and social welfare, some eyebrows were raised
when the European Commission decided to block the General Electric/Honeywell merger. In this
paper, the Commission’s decision regarding the newly defined conglomerate effects will be analysed.
Furthermore, the possibility of a natural monopoly in the aviation market will be investigated. The
Commission’s arguments are convincing, yet the merger could (and should) have gone through under
certain conditions.
Thesis advisor: Dr. J.J.A. Kamphorst
Submitted by: Wouter Jans
Student number: 371557
Date: 26-7-2015
1
Table of contents
Chapter 1: Introduction ______________________________________________________3
1.1: A unique decision_________________________________________________3
1.2: Aim and structure of the paper_______________________________________3
Chapter 2: Defining the conditions_____________________________________________4
2.1: The setting ______________________________________________________4
2.2: General Electric __________________________________________________4
2.3: Honeywell ______________________________________________________7
Chapter 3: Analysing the decision _____________________________________________9
3.1: Grounds of disapproval ____________________________________________9
3.2: GECAS ________________________________________________________9
3.3: GE Capital _____________________________________________________11
3.4: Tying and Exclusion _____________________________________________12
3.5: Competitors ____________________________________________________14
Chapter 4: A natural monopoly? _____________________________________________16
4.1: Suspicion ______________________________________________________16
4.2: Government monopolies __________________________________________16
4.3: Economies of scale and –scope _____________________________________16
4.4: Network Effects _________________________________________________17
4.5: Consequences of a natural monopoly_________________________________17
4.6: Regulation______________________________________________________18
Chapter 5: Conclusion ______________________________________________________20
5.1: The right decision? _______________________________________________20
5.2: Policy advice____________________________________________________20
Bibliography______________________________________________________________21
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Chapter 1: Introduction
1.1
A unique decision
In its decision of 3 July 2001, The European Commission declared the possible concentration
of General Electric and Honeywell to be incompatible with the common market and the
European Economic Area (EEA) agreement. This particular merger case, case M.2220, was
quite special at the time. Firstly, the takeover would result in the largest industrial merger ever
and would cost over $40 billion (Marsden, 2001). Secondly, it was the first time in the history
of competition policy that the European Commission has blocked a concentration of two
American firms while the concentration was cleared by the competition authorities in the
United States (BBC, 2001).
The European Commission’s decision resulted in a fiery debate in both the scientific- and
business environment. This resulted in several papers that analysed the methodology of the
European Commission. One of the reasons why the decision was called into question so often
was the introduction of conglomerate effects that would take place as a result of the
concentration. Besides the traditional horizontal- and vertical effects, a new criterion was
defined by which large mergers across different markets could be assessed.
After the European Commission made its decision to prohibit the General Electric/Honeywell
merger, the decision was contested at the Court of First Instances. The Court of First Instances
was reluctant to accept the Commission’s arguments regarding conglomerate effects. In order
to block a merger on the merits of conglomerate effects, “the Commission must establish that
there is a high probability that anticompetitive effects will occur and not merely that they might
occur”. Since the Court argued that the Commission failed to show this, the Commission’s
decision raised even more controversy. However, besides the conglomerate effects, the merger
was also blocked on grounds of horizontal- and vertical effects. The Court decided that these
effects were sufficient to block the merger after all.
1.2
Aim and structure of the paper
The aim of this paper is to investigate the dynamics of these conglomerate effects and their
implications on total welfare. The first part will consist of a description of the merger case and
its parties, as they form the setting in which the conglomerate effects would take place. The
second part will explain the theory behind the European Commission’s concerns regarding
conglomerate effects. This part will also consider the effects on welfare of the conglomerate
effects. In the third part, the possibility of a natural monopoly within the aviation market will
be explored. The paper will be concluded with policy advice regarding the General
Electric/Honeywell merger and conglomerate mergers in general.
3
Chapter 2: Defining the conditions
2.1
The setting
To completely understand the economics of conglomerate effects, it is important to be familiar
with both General Electric and Honeywell, as well as the markets in which they operate. These
aspects are very important in the analysis because they affect the effectiveness of conglomerate
effects. Because General Electric and Honeywell are both huge enterprises, a merger between
these firms would affect several markets. Although Honeywell and General Electric are welldiversified and global companies, the European Commission blocked the merger as a result of
their concerns regarding the aerospace, avionics and non-avionics industries.
First of all, it is important to consider in what extent the different producers in these industries
can compete with each other. From previous decisions by the European Commission (see
below), it becomes clear that producers of engines have sold and supported their engines
worldwide. In the relevant geographic market, competitive constraints are therefore worldwide.
2.2
General Electric
At the time, General Electric was the largest producer of aircraft engines. The firm sold engines
for a value of around $11 billion in 2000 alone (General Electric Company, 2001). Because
the market for aircraft engines is too broad to analyse easily, the Commission established submarkets as they did in several previous decisions (91/619/EEC: Commission Decision of 2
October 1991 declaring the incompatibility with the common market of a concentration;
Alenia/De Havilland, 1991) (97/816/EC: Commission Decision of 30 July 1997 declaring a
concentration compatible with the common market and the functioning of the EEA Agreement;
Boeing/McDonnell Douglas, 1997) (2001/417/EC: Commission Decision of 1 December 1999
declaring a concentration compatible with the common market and the functioning of the EEA
Agreement; AlliedSignal/Honeywell, 1999). The Commission distinguished three different
markets, all with their own purposes, capacities, flying ranges and players:
1. Large commercial aircraft
The market for large commercial aircraft consist of planes that can carry more than 100
passengers over medium to long (transcontinental) distances. The Boeing 737, world’s
most successful commercial plane, belongs to this market (Falzon, 2013). Boeing and
Airbus are the only producers of airframes in this market. There are only three main
producers of engines in this market: General Electric, Rolls-Royce and Pratt & Whitney.
These firms also cooperate with each other and have created joint ventures for this
purpose. Important joint ventures are CFMI and International Aero Engines. CFMI is
equally divided and controlled by General Electric and the French firm SNECMA.
International Aero Engines on the other hand, is controlled by Rolls-Royce and Pratt &
Whitney. MTU and Aero Engines Corp are also part of this joint venture. The market
for large commercial aircraft is considered as the most important market since it is the
biggest market money-wise.
2. Regional jet aircraft
With city trips growing in popularity, this market has grown rapidly in the last two
decades. The market for regional jet aircraft can be divided further into the markets for
small or large regional aircraft. The commission argued that substitution was not
4
possible among these markets, hence the distinction. Frames for both markets were
produced by four firms: Embraer, Bombardier and BAe Systems. General Electric,
Rolls-Royce and Pratt & Whitney all produced engines suitable for small regional jets.
In the market for large regional jets, Honeywell and General Electric were the only
producers of engines. This is also one of the most important horizontal dimensions of
the merger. A merger between General Electric and Honeywell would result in a
monopoly for these engines.
3. Corporate jet aircraft
The four producers of corporate jet aircraft are Bombardier, Cessna, Dassault and
Raytheon. Corporate jets can be divided in light, medium and heavy jets due to a lack
of substitutability. The engines are produced by General Electric, Honeywell, RollsRoyce and Pratt & Whitney. The Commission were convinced a horizontal overlap
would arise in the market for medium corporate jet aircraft after a merger. After a
merger, a price increase in this segment would be likely.
The market shares for these aircrafts combined were as follows (Vives & Staffiero, 2009):
General Electric
Pratt & Whitney
Rolls-Royce
52,5 %
26.5%
21%
The table below shows how future orders were divided
General Electric
Pratt & Whitney
Rolls-Royce
65%
16%
19%
These tables show that the dominant position that General Electric possesses, is likely to be
strengthened in the future. Its competitors are losing market shares which as a result will limit
their competitiveness on the long run.
The competition in these markets is usually a two-phase process. In the first phase, engine
manufacturers need to have their engines approved for specific airframes before they can
compete with each other. When a new airframe is released by Boeing for example, General
Electric has to develop an engine that meets all technical and safety requirements. A lot of
money is invested in Research and Development to make sure the engines are making the grade.
After extensive research by the airframe producer, one or more engines can be approved for
future use. After the engines are deemed compatible, the second phase of competition sets in.
This more traditional phase of competition begins when airlines are planning to buy new
airplanes for their fleet.
In this second round of competition, the airlines and leasing companies can choose whatever
airplanes they like. While some airlines may opt for the cheapest plane-engine combination to
offer the cheapest flights as possible on the short term, there are a few factors that should be
taken into consideration while selecting both airframes and engines:
-
Economies of scale
5
-
-
Economies of scale is the foremost factor that should be taken into consideration. There
are several forms in which positive returns of scale can be acquired. Besides the
traditional quantity discounts an airline might acquire, the airlines should be aware of
what is called “fleet commonality” in the literature. The total amount and different types
of airplanes has a direct impact on the performance of airlines (Seristo & Vepsalainen,
1997). Having a large number of the same aircraft in a fleet has cost advantages. Airlines
can decrease their maintenance-, servicing- and pilot education costs for example
(Brüggen & Klose, 2010)
Switching costs
Some of the advantages mentioned above can also result in possible switching costs that
become relevant when selecting new planes. If a fleet consists of primarily Rolls-Royce
powered airplanes (that need to be replaced), why would an airlines opt for General
Electric powered airlines? Switching to other planes could prove costly: pilots would
need additional training and spare parts cannot be used anymore. Generally, an airline
will only switch its engine brand if the difference in price is making up for the switching
costs. This can result in additional market power if an engine producer has a large
market share (Klemperer, 1987).
Quality
Airplanes are durable products and are expected to fly for years to come when bought.
Airlines should consider the different levels of qualities among the different planes
(Jiang, 2013). Ceteris paribus, cheaper planes are expected to require more maintenance
than expensive planes. On the long term, cheap planes may cost more due to repair and
maintenance expenses.
The competition in the aerospace industry as a whole is also characterised by its “rounds”. Once
every few decades, a new generation of airplanes is released. During the introduction of a new
platform, it is important for engine manufacturers to get their engines approved and selected for
the new planes. Because these new planes will be an important source of revenues for years to
come, missing out on these new planes can mean a long period without revenues for producers.
Take the Joint Strike Fighter (F-35) for example. This military plane has been in development
for ages and a lot of countries (including the Netherlands) are considering buying it to replace
their current generation of air fighters. The plane is likely to be in service for years to come and
it is unlikely to be replaced anytime soon. It can prove costly to lose this round of competition.
Even more so when money has been invested in developing engines for the platform.
Maintenance, repair and overhaul services are also very important in the plane industry.
According to the Commission (Commission Decision General Electric/Honeywell, 2001, p.
24), an airline would pay around twice the price of the engine for these services over a 25-year
lifespan of an aircraft. The supply of spare parts are a dominant factor in this market. The
original engine manufacturers do not experience heavy competition for the supply of spare parts
for their engines. The manufacturers have also withheld technical data and support in the past.
Possibly to decrease the competition for maintenance, repair and overhaul services
(Commission Decision General Electric/Honeywell, 2001, p. 24). General Electric, RollsRoyce and Pratt & Whitney are all large suppliers of these services. To illustrate the importance
of this market, consider the following transition: in ten years’ time, “GE’s total revenues
evolved from a split of 57 % of sales of original equipment and 43 % of aftermarket services in
6
1990 to 45 and 55 % respectively in 1995, and finally to 33 and 67 % respectively in 2000”
(Commission Decision General Electric/Honeywell, 2001, p. 25).
Another important factor in the aerospace market is the presence of General Electric’s
supporting entities that can influence the competition in the market. As a matter of fact, this is
one of the reasons why the European Commission has prohibited the merger. The supporting
entities are the base of the so-called “conglomerate effects”. If a merger was approved,
Honeywell could also have access to these entities to dominate the markets in which they are
active.
The General Electric Corporation consists of several divisions. One of the most important
division is GE Capital. The division’s assets exceeded the $370 billion mark while earning a
net income of $5.2 billion (GE Capital, 2001). Besides financial services, the division also
provides back-up with regards to investments. GE Capital is active in all kinds of industries,
including the aviation industry. Airlines and aircraft manufacturers can turn to GE Capital if
they need to finance their operations.
The second division that might affect the competition in the aerospace market is General
Electric Capital Aviation Services (GECAS). GECAS is regarded as the largest individual
purchaser of airplanes and has one of the largest fleets in the world. At the time of the
Commission’s decision, around ten percent of all new aircraft purchases were accounted for by
GECAS (Charles River Associates, 2001). Once the planes are bought and delivered to GECAS,
airlines and other firms are able to lease them. Being part of the GE Corporation, it seems
logical that GECAS is biased in its purchase behaviour.
2.3
Honeywell
Honeywell, the other firm involved in the disallowed merger, is a producer of both avionics as
non-avionics. Examples of avionics products are satellite receivers and control systems. The
power supply and landing necessities are examples of non-avionics. Both these product groups
have previously been identified and studied by the European Commission (2001/417/EC:
Commission Decision of 1 December 1999 declaring a concentration compatible with the
common market and the functioning of the EEA Agreement; AlliedSignal/Honeywell, 1999)
(Commission Decision of 25 May 1999 declaring a concentration to be compatible with the
common market; United Technologies/Sundstrand, 1999). In these decisions, the European
Commission divided the market for avionics in two: large commercial aircraft and
regional/corporate aircraft. The market for non-avionics on the other hand, has been considered
as a whole. The Commission has also recognised that these markets operate on a global scale.
That means that the producers in these markets all compete on a worldwide basis.
Similar to the engine market, competition in the avionics and non-avionics markets is often
characterized by two rounds. As explained before, producers of equipment need to have their
products approved before airlines can buy planes with the equipment. However, a distinction
has to be made between buyer furnished equipment (BFE) and supplier furnished equipment
(SFE). SFE are products that are selected by the producers of aircraft. Leasing companies and
airlines may decide on BFE.
The main producers of aerospace equipment ordered in terms of sales
1. Honeywell
7
2.
3.
4.
5.
BF Goodrich
Hamilton Sundstrand
Rockwell Collins
Smiths Industries
Similar to General Electric, Honeywell is one of the biggest player, if not the biggest, in the
markets in which it is active. The difference between the firms is their market approach.
Honeywell does not have supporting entities, but does offer a unique range of equipment. In
contrast to its competitors, the firm is able to supply all avionics equipment in a plane. In
addition to its wide range of products, Honeywell also offers its products in bundles. It is likely
that by tying several products, the firm gained in market power (Whinston, 1990).
Honeywell holds a special position in the market for engine starters. The European Commission
is concerned that since Honeywell is the only large independent supplier of engine starters, a
merger would result in strategic foreclosure of other engine producers. This vertical aspect of
the merger means that as a result of the merger, competitors could be excluded access to engine
starters.
From these sections it has become clear that both Honeywell and General Electric have a strong
market position. In the Commissions opinion, these positions would be enhanced if the merger
was to be approved. Honeywell would have access to the financial back-up of GE Capital, along
with the ability to lease its equipment through GECAS. This in addition with the possibility to
foreclose General Electric’s competitors on the engine markets, made the commission to
disapprove the merger.
8
Chapter 3: Analysing the decision
3.1
Grounds of disapproval
Now that the most important characteristics of the markets are clear, an analysis can be made
of the Commission’s decision to block the proposed merger. After the Commission finished her
investigation, it decided to block the merger on the following specific grounds:
-
-
-
As a result of Honeywell’s dominant position in the market for starting engines, a
merger between Honeywell and General Electric would enhance General Electric’s
(dominant) position in the market for engines for large commercial aircraft. After
integrating this vertical relation, the merged entity could foreclosure other producers of
large commercial aircraft engines.
Secondly, a merger between Honeywell and General Electric would eliminate all
competition in the engine market for regional jet aircraft. Since the firms are the only
producers of these engines, internalizing externalities through a merger would result in
a monopoly position. The merged firm would also gain market power with regards to
corporate jet aircraft. Engine prices are most likely to increase as a result of the merger
(Deneckere & Davidson, 1985) as the markets are characterized by Bertrand
competition (Commission Decision General Electric/Honeywell, 2001, pp. 26, 35, 68).
Finally, the European Commission was concerned that dominant positions would be
created or enhanced due to conglomerate effects. Two types of conglomerate effects
were acknowledged in the decision.
1. After the merger, Honeywell would be able to benefit from the facilities of
GE Capital and GECAS. Similar to what General Electric is doing in the
market for aircraft engines, Honeywell could use supporting entities to gain
market shares in its active markets.
2. The second conglomerate effect could occur if the merged entity would result
to tying and bundling strategies. Since the merged entity would be able to
supply most aircraft components, offering planes with only General
Electric/Honeywell equipment could be an option.
With regards to the vertical and horizontal aspects of this merger: they bring nothing new to the
table and therefore will not be the focus of the analysis. In short, the horizontal effect would
imply that after internalizing the competitive constraints between General Electric and
Honeywell in some engine markets, prices are likely to increase. Both insiders and outsiders
will benefit as a result of reduced competition (Deneckere & Davidson, 1985).These kind of
mergers are blocked on a more regular basis as vertical mergers. As a matter of fact, vertical
mergers can actually improve welfare by solving the double marginalisation problem. As long
as foreclosure does not occur, these mergers can be encouraged most of the time (Motta, 2004).
The conglomerate effects on the other hand, are relatively new defined and much more
interesting to study.
3.2
GECAS
When analysing the first conglomerate effect, it is useful to look at General Electric’s dominant
position in the engine market for large commercial aircraft. This is because the Commission
has the opinion that Honeywell could apply the same strategy to gain market shares in its own
9
markets. What should be clear by now is the fact that General Electric is an enormous presence
in the aviation world. In addition to producing engines, the firm also leases aircraft and
financially supports other parties in the market through GECAS and GE Capital respectively.
Together with the characteristics of the market (see part I), the Commission regards this as an
effective combination to gain a dominant position. The Commission reckons that GE managed
to get this exclusivity thanks to a combination of factors that its competitors could not
reproduce, despite the fact that they were technically capable of supplying comparable engines
(Commission Decision General Electric/Honeywell, 2001, p. 34).
Firstly, the influence of GECAS on the market was analysed by the Commission. The
Commission argued that while GECAS only accounts for a small part (10%) of the total aircraft
sales, its influence is much greater than one would expect while looking at just the numbers. A
market share of around 10% is usually not enough to indicate any market power. However, in
the aviation market, it could prove crucial in deciding long term dominance. There are two ways
in which GECAS plays a factor in General Electric’s dominance. GECAS’ policy of only
buying General Electric-powered aircraft, can serve as an insurance to General Electric. When
developing engines, the firm can be certain that at least some engines are sold GECAS (even
when superior engines are available). In addition to this insurance, GECAS can also affect the
market by influencing airlines’ decisions which engine they should purchase. By leasing only
General Electric-powered planes to airlines and other big firms, it is more likely that they will
also resort to General Electric equipment in the future. In a market where economies of scale
are ever present (in the form of fleet communality, see part I), the ability to ‘seed’ other airlines
with General Electric engines can play a huge part in determining the market outcome in the
future (Fox, 2001). Airlines, pilots and engineers become familiar with General Electric and
are more likely to opt for similar equipment in the future. Both of these effects can help General
Electric while launching a new platform of engines. Whenever a new generation of plane bodies
is released, General Electric is a step ahead of Rolls-Royce and Pratt & Whitney. A dominant
position on the engine market is a direct effect of this mechanism.
The Commission is convinced that Honeywell products will also benefit from this strategy after
the merger. It makes sense that GECAS will also adopt a ‘Honeywell-only’ strategy with
regards to the avionics and non-avionics equipment in the planes that they buy and lease. The
main concern of the Commission is that this strategy allows that General Electric’s dominance
is being leveraged to the markets where Honeywell is active. This concept, called Archimedean
leveraging, shows how a firm can use its modest presence (in this case a 10% market share) in
a unrelated downstream market to gain market power in another market as a result of
influencing decisions in an intermediate market (Reynolds & Ordover, 2002). In the case of the
General Electric/Honeywell merger, frame builders and airlines would be more inclined to buy
General Electric/Honeywell gear as a result of the merger. For Archimedean leveraging to
occur, a few (non-strict) conditions have to be met:
-
The small amount of producers of intermediate products (airframes) can make exclusive
choices regarding the equipment they install in their frames.
Marginal costs are exceeded by product prices for both intermediate producers and
system suppliers. However, all parties have to incur significant fixed costs in the form
of Research and Development.
10
Airlines and aircraft manufacturers should have no preference in equipment prior to the merger.
Whatever type of equipment is the best choice would get installed in the plane. However after
the merger, given that GECAS would apply a Honeywell-only policy, the theory of
Archimedean leveraging states that airframe producers would prefer Honeywell equipment.
The reason for this preference is simple: if GECAS will only buy General Electric/Honeywell
equipped planes, an airframe producer would lose quite some revenue if it does not install gear
from the merged firms. Since GECAS was the largest purchaser of planes at the time (see figure
1 below), producers just couldn’t afford to lose GECAS’s interest. This means that for example
Boeing would deprive itself from sales if it chooses not to install General Electric/Honeywell
gear since GECAS would not be interested. A producer would not do this unless other
equipment manufacturers offer a very good deals that make up for the loss of GECAS sales.
The Commission did not believe that other manufacturers would be able to offer better deals
than they already do. Part I suggests that Honeywell is already very competitive before the
merger and it is doubtful that its competitors can lower their prices without taking losses. On
the other hand, if it does select said General Electric/Honeywell gear to be exclusively used in
a new airframe, airlines and other aircraft purchasers would have no choice but to buy these
combinations of planes and equipment.
Figure 1
3.3
GE Capital
The second supporting entity of the General Electric comes in the form of a financing division.
The Commission reckons that GE Capital can also be a deciding factor in competing in the
aviation market. The existence of the huge financial means of GE Capital can influence the
market in several ways which are discussed below.
Firstly, it allows General Electric (and Honeywell after the merger) to allocate more resources
to its R&D budget in comparison to its competitors. It is likely that the merged firm will be
more competitive on the long run if it has a significant higher R&D budget. Long term
competition is determined by whether or not competitors are developing engines and other
equipment. Given the high risks attached to these projects, access to external funds could be
11
difficult for Rolls-Royce and Pratt & Whitney (Commission Decision General
Electric/Honeywell, 2001, p. 38). Contrarily, General Electric can always rely on the financial
support of GE Capital.
Secondly, the corporation is in a position to financially support airframe producers. GE Capital
has provided financial support to these producers in the form of “platform programme
development assistance” on several occasions (Commission Decision General
Electric/Honeywell, 2001, p. 26). This could increase the chance that General Electric’s engines
are approved for a platform.
And last but not least: General Electric can influence the purchasing behaviour of airlines by
providing financing (loans and equity investments). Small airlines in particular are sensitive to
financing options when building up a fleet. General Electric could help these small airlines
under the condition that they buy General Electric-powered aircraft. This condition would be
extended to Honeywell products after the merger.
Concluding the first conglomerate effect, the Commission feels that GECAS and GE Capital
are at the base of General Electric’s dominant position. According to the Archimedean leverage
theory, the merged firm would be able to leverage this power to markets where Honeywell is
active. This would result into an even more dominant position for the merged firm.
3.4
Tying and exclusion
The second conglomerate effect that might occur is the possibility that the merged firm will
resort to a tying strategy. As the Commission argued in its decision, the fact that the merged
firm could bundle its products would have a big impact on competition (Commission Decision
General Electric/Honeywell, 2001, p. 57). The general concern is that both Honeywell’s and
General Electric’s competitors would have its market shares reduced and leave the market as a
result of shrinking profits.
The Commission established two forms in which bundling would affect competitors. The first
form, mixed bundling, means that the products of the merged form are available through single
purchase (a single GE-engine for example) as well as through bundles (engine and radar
equipment). By offering bundles at reduced prices, the merged firms would be able to lure
customers away from its competitors. Although this seems as a standard business practice, no
competitor is able to match this strategy unless other mergers would take place in the aviation
market (Commission Decision General Electric/Honeywell, 2001, p. 58). Since the providers
of single components can only offer their own products for regular prices, they will most likely
lose market shares. The short term loss in profits as a result of the tying will also affect the
providers of single components on the long run: to be able to compete in the future, the firms
have to invest in R&D. The decrease in market shares and profits as a result of tying will usually
lead to a smaller R&D budget for the merged firm’s competitors.
The second form of tying is called technical bundling. Committing to technical bundling means
that a firm makes its products incompatible with other products. Buyers will be reliant on
products of the same firm to accommodate each other. In this situation it could mean that
Honeywell equipment will only work alongside a General Electric engine and vice versa. For
airlines, this will mean that once they buy General Electric engines, they will have no choice
but to install their planes with Honeywell equipment. This could lead to a lot of problems for
12
the merged firm’s competitor since Honeywell and General Electric are the biggest players on
most of the markets they serve.
Both forms of bundling can lead to market foreclosure (forced marked exit). In the eyes of the
Commission it becomes more difficult for competitors to successfully place products on the
market. Competitors will have to take decisions as to whether, in view of their anticipated
reduced market share and profitability, they are able and willing to continue competing in the
markets where the merged entity is active (Commission Decision General Electric/Honeywell,
2001, p. 58) . As mentioned earlier, a fully equipped General Electric/Honeywell plane is not
out of the question. The question remains: why would the merged firm commit to tying?
The paper Tying, Foreclosure and Exclusion by Whinston has shown that a tying strategy can
lead to competition related problems. A firm with monopoly power in one market can use the
leverage provided by this power to foreclose sales in, and thereby monopolize, a second market
(Whinston, 1990). In the third part of the paper, Whinston describes how a producer of
complementary goods can influence both markets as a result of committing to tying.
Complementary goods are only useful is a buyer combines the product into a set. Due to their
importance, we can assume that engines, avionics, non-avionics and starter engines are
complimentary goods. A plane is essentially a package of several different technologies.
Whinston shows how the monopolist can monopolize the market of the tied good. Similarly to
the Commission’s argument, by tying different goods, the monopolist can foreclose its
competitors’ sales which ultimately leads to exclusion. In the situation of the General
Electric/Honeywell merger, we can regard Honeywell’s starter engines as the monopoly good.
The assumptions in the model from the paper do correspond to the General
Electric/Honeywell situation. The model requires fixed proportions of products to be useful.
This makes sense in our situation since airlines are unlikely to initially buy more than one
starter engine or radar system. Another assumption that is satisfied is the assumption of
economies of scale in production. The model assumes economies of scale which leads to
oligopolistic competition instead of perfect competition. These assumptions lead to a basic
model with complementary goods in which tying is not the best strategy for the monopolist.
The proposition regarding this model states: “If a commitment to tying causes firm 2 to be
inactive, firm 1 (the monopolist) can do no worse - and possibly better – by committing to
producing only independent components”.
The intuition behind this proposition is quite simple; because firm 1 is the monopoly supplier
of product A, it can set the prices reasonably high. If firm 2 leaves the market as a result of
bundling, less B products will be sold and therefore there will also be less sales of A. If firm 1
does not commit to bundling, firm 2 will sell B units and those consumers will need to buy A
to create a bundle. This means that firm 1 generates higher profits when not committing to
bundle. In the General Electric/Honeywell case, this would mean that the Honeywell starter
engines will not be tied to General Electric engines, because the merged firm would generate
more profits if for example Pratt & Whitney could also buy them.
However, Whinston has also developed an extension to the basic model which allows to
analyse tying in a market where products can be repaired after they break down. Since repair
and maintenance play a major role in the aviation industry, this extended model offers a more
reliable analysis. The model offers an alternative use for product B that does not rely on the
purchase of A (for example spare parts for repairs). Firm 1’s monopoly position for product A
13
cannot be exploited as before, because consumers may buy B from other firms independently
of A. It may become attractive for firm 1 to exclude firm 2, since it has no use of a part of
firm 2’s sales and can gain an additional monopoly. By tying A and B into a bundle, firm 1
can once again foreclose firm 2’s sales in the market of B and force consumers to buy A in
case they only need B. In the General Electric/Honeywell situation, this would translate to the
situation where airlines can buy spare parts from competitors to repair equipment from the
merged firm. Replacing Honeywell equipment by other equipment also falls under this
category. By tying, the merged firm can exclude these competitors and force airlines to buy
parts from the merged firm. Looking at these arguments, the Commission’s concerns
regarding bundling seem legitimate.
3.5
Competitors
If the conglomerate effects of the merger will exactly play out the way the Commission
argued, there is no doubt the competition in the aviation market will be reduced. However, is
it safe to assume that the merged firm’s competitors like Rolls-Royce will roll over and
surrender without a fight? The negative effects will only occur if the merged firm’s
competitors do not try fight them.
Some of the merged firm’s competitors are by no means small. Its competitors in the engine
markets, Rolls-Royce and Pratt & Whitney are both active in other industries (car and military
respectively). Being part of the United Technologies conglomerate, Pratt & Whitney should
have the financial back up to invest and compete with the merged firm. It is unlikely that
these big firms will just stand by and watch how General Electric/Honeywell will dominate
the aviation market. A reaction from these firms on the merger can be expected. Setting up a
finance or lease entity might be a bridge to far, but acquisitions or investing to become more
efficient should be something these companies must take a look at.
Another factor that could counter the merged firm’s dominance is the possibility of buyer’s
power. Regardless of the fact that no individual airline has a share of more than 5% of all
aircraft purchases, cooperation between airlines could result in buyer’s power. If several high
profile airlines such as Air France-KLM, United Airlines and Lufthansa Group would buy
their fleets collectively, they would likely have much more say in what engines and
equipment they install. Also, since the merged firm would be extremely reliable of the
airframe producers Boeing and Airbus, surely these firms would have some power to diminish
the merged firm’s dominance.
Cooperation of competitors can also take place in the form of mergers (as is argued by
General Electric and Honeywell). By merging themselves, some competitors should be able to
match the merged firm’s portfolio. Mergers on this scale could take quite some time and it
remains to be seen whether the competitors would be in favour of this process. A less drastic
measure would be a cooperation agreement (or a joint venture) in which competitors will
commit to tying their products. Whether these strategies are successful is not clear.
After the European Commission raised its concern regarding conglomerate effects, it still has
to be determined whether these effects are in fact welfare-reducing. According to the merger
paradox, mergers are typically not profitable for the merging firms in the absence of efficiency
gains (Creane & Davidson, 2004). Since Honeywell and General Electric did in fact want to
merge, were there any efficiency gains that were ignored by the Commission? Would a
14
dominant firm in the aviation market lead to efficient production and lower prices resulting in
higher welfare? These aspects were not considered by the Commission when forming a decision
and will be discussed in the next part.
15
Chapter 4: A natural monopoly?
4.1 Suspicion
Analysing the Commission’s decision, it has become clear that there were legitimate reasons to
block the merger between General Electric and Honeywell. The disadvantages of the merger
are clear: alongside the traditional horizontal- and vertical effects, conglomerate effects are
likely to occur in markets where either General Electric or Honeywell is active. Competition
will be reduced in the medium and long term with raising prices as a result. This will obviously
lead to lower welfare and has to be discouraged.
However, while reading the decision and several papers on this topic, I could not help myself
but to think of the genuine advantages this merger might have. Advantages such as fleet
commonality and cheap production could be so substantial that the aviation market should be
characterized by a natural monopoly. In economic literature, the theory of natural monopoly is
usually described as a market in which, for structural reasons, only one firm can produce
profitably (Mosca, 2008).
4.2
Government monopolies
There are several conditions in which a natural monopoly can be established (Mosca, 2008). In
modern history, governments have been responsible for constructing natural monopolies. Think
of public utilities such as water supply, telecom- and train companies: these firms were
supported by the government while investing in essential facilities like train rails and signal
masts. Before these firms were privatised, they experienced no competition because no private
party could profitably enter the market. The investments needed to enter the market are
substantial and are unlikely to be recovered. Nowadays, most of the firms that were natural
monopolists such as KPN have to share their positions in order to create competition. (NOS,
2014).
4.3
Economies of scale and -scope
Another market characteristic that could lead to a natural monopoly is the possibility of
significant economies of scale and -scope. The production process for a specific good or service
exhibits economies of scale over a range of output when average costs declines over that range
(Besanko, Dranove, Shanley, & Schaefer, 2010). This means that the marginal costs of
production are below the average costs in order to decrease the average costs. In the General
Electric/Honeywell perspective, the average production costs of 300 planes would be lower
than 200 planes. There are several forms of economies of scale. The first and most common
form is the division of fixed costs over a firms output. Production-related fixed costs like
Research and Development costs have to be earned back and are included in the price. The
higher the output, the lower the fixed costs per unit. Other areas where economies of scale might
occur, are warehousing, advertising and the transport and purchase of materials needed to
manufacture General Electric/Honeywell products. Besides economies of scale, economies of
scope should also be taken into consideration. We can speak of economies of scope when there
are cost savings which result from the scope of a firm. In other words, it is less costly to combine
two or more product lines in one firm than to produce them separately (Willig & Panzar, 1981).
Research and Development is once again an area where cost savings can be made. It is highly
likely that technological breakthroughs in the engine department will also result in improving
avionics and non-avionics. Since Honeywell has a wide range of products, it seems the firm
16
already enjoys economies of scope in its Research and Development. Also if a merger were to
go through, production of different devices could be better coordinated with each other. Engines
and (non-)avionics should be integrated and production could take place in the same
manufactories.
4.4
Network effects
Network effects can also lead to a natural monopoly within a market. A network effect implies
that the utility that a user derives from a product depends on the number of other agents that
use the same product (Katz & Shapiro, 1985). In case of a positive network effect, the utility
from consumption increases with the number of other users. A nice example of such a good is
an operating system. The amount of software and updates naturally depend on the amount of
users of an operating system. A highway is an example of a negative network effect. The more
cars on the highway, the less useful it becomes for drivers as a result of traffic jams.
There are three sources of network effects (Katz & Shapiro, 1985). The first network effect is
a strictly physical effect. Like the highway example, the usefulness of a good or service directly
depends on the amount of users. The second network effect works indirectly: the more users a
medium has, the more support it is expected to have. In case of durable goods, the quality and
availability of services will increase. The last network effect is market-mediated. When the
amount of users increases, so will the supply of spare parts and second hand products. This can
also benefit owners since repairs or replacements are likely to be cheaper.
4.5
Consequences of a natural monopoly
In the General Electric/Honeywell merger case, the indirect network effects are most likely to
take place. Fleet communality is an important factor taken into consideration when airlines buy
new aircraft. There are several advantages attached to a uniform fleet. Firstly, pilots will only
have to learn how General Electric/Honeywell aircrafts work. Secondly, engineers and
maintenance workers can specialize in a limited range of equipment, making repairs and
construction more efficient. Thirdly, due to the increased supply on the second hand markets,
repairing costs will decrease. If the merged firm’s competitors cannot match the network effect,
airlines will have an easy decision when ordering new planes.
Figure 2 shows the conditions in which economies of scale – and scope can lead to a natural
monopoly. As a result of cost advantages, the marginal costs are decreasing over the relevant
output range. Once a firm has reached a decent output, its marginal costs are relatively low in
comparison to its competitors. Because the firm is more efficient than its competitors, it can
produce cheaper and gain an even larger market share. When a firm serves (almost) the entire
market, it has become virtually impossible for competitors to compete due to the difference in
marginal costs. If you combine this with the network effect in the form of fleet communality,
the possibility of a natural monopoly in the aviation market seems a real possibility.
17
Figure 2
As good as a natural monopoly may sound, there are also drawbacks to the situation. When a
firm does not experience any competition, it will maximize its own profits by limiting supply
and keeping prices high. In figure 2, this would correspond with the monopolist selling Q(m)
for P(M). If you compare this with the welfare maximizing quantity Q(mc) with price P(mc),
it is a relatively bad equilibrium.
There seems no possibility for other firms to compete with a natural monopolist. Since no
firm in the industry can match General Electric/Honeywell’s efficiency, it is likely to lose the
competition and leave the market. The natural monopolist will lose its competitive constraints
and may raise prices. Opportunities for other firms to enter the aviation market are also
limited. There are several entry barriers a firm has to overcome to successfully enter the
market. A potential entrant has to invest a decent amount of money in engine development
before it can compete with a company that has a lot of experience in the engine market. The
entrant also has to invest in manufactories before it can actually produce engines. Investing
billions before generating any revenue is not very attractive. Also, due to the economies of
scale, the entrant is at a huge disadvantage compared to the incumbent since initial output will
be much lower. The entrant will have higher costs which will result in a higher price. Last but
not least, the positive network effects in favour of the incumbent will make entry less
attractive. Airlines will prefer General Electric/Honeywell aircraft over any other brand. To
overcome this switching cost, an entrant will have to compensate airlines for losing its fleets
communality. The most obvious way to do this, is by asking a lower price for its product than
the competitor (Klemperer, 1987). The problem with this strategy is that the incumbent can
easily match the low price since it is more efficient due to economies of scale and –scope.
4.6
Regulation
If it turns out that a monopolistic market really is the most efficient situation in the aviation
market, this market has to be controlled to ensure that welfare is maximized. Without control,
a monopolist will harm total welfare. Regulating the aviation market could be the solution for
this problem. Controlling the aviation market is nothing new for European authorities. Before
the creation of a single market for aviation in the nineties, the industries were heavily regulated
18
(European Commission, 2014). Since all restrictions were cleared, antitrust authorities have
been investigating the aviation market on a constant basis. Because there are very few suppliers
in the engine- and avionics markets, the risk of collusion between suppliers is relatively high.
Since a natural monopoly would imply only one manufacturer, the costs of investigating the
market for collusion could be spent differently. The funds could be used to monitor the
monopolist and ensure maximum welfare.
19
Chapter 5: Conclusion
5.1
The right decision?
Considering the arguments against the approval of the General Electric/Honeywell merger,
the Commission’s decision to block the merger is quite acceptable. Not only horizontal- and
vertical effects will effect competition in the aviation market, newly defined conglomerate
effects are also expected to take place. General Electric was already a dominant firm prior to
the merger. Should the merger have been approved, it is expected that the merged firm would
have an unacceptable amount of market power.
On the one hand, there are clear advantages towards the merger. Economies of scale and
economies of scope can make the production of airplanes more efficient. If this improved
efficiency can result into lower prices, not only airlines would be better off, also consumers
can get a piece of the pie through cheaper flight tickets.
On the other hand, the merger would take away most competition in the aviation market. The
point is that the merged firm’s improved efficiency is not likely to be matched by its current
competitors. This could result in predatory pricing: low prices on the short term and high
prices after competitors have left the market. The anti-competitive effect will only occur if the
merged firm’s competitors actually leave the market. Since some competitors have substantial
means themselves, it remains the question if they are indeed not able to make up for the
improved efficiency.
5.2
Policy advice
At the end of the line, there might be a possibility to get the best of both worlds. If the
competition authorities would allow the merger on the condition that the merged firm would
accept regular monitoring, predatory pricing can be prevented. If for example the authorities
have a seat on the board of the merged firm, they can make sure the firm will not exploit its
monopoly position. While the firm is allowed to make profits as a reward for the improved
efficiency, regulation should prevent the abuse of a dominant position in order to enhance
welfare.
20
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