Dynamic efficiencies of the 1997 Boeing‐McDonnell Douglas merger

• Author: Wei Zhao,Yonghong An
• Published date: 01 September 2019
• Date: 01 September 2019
• DOI: http://doi.org/10.1111/1756-2171.12291

RAND Journal of Economics

Vol.50, No. 3, Fall 2019

pp. 666–694

Dynamic efficiencies of the 1997

Boeing-McDonnell Douglas merger

Yonghong An∗

and

Wei Zhao∗∗

We evaluate the welfare effects of the 1997 Boeing-McDonnell Douglas merger in the medium-

sized, wide-body aircraft industry. We find that the merger led to lower prices. To explain the

price drop, we developa dynamic oligopoly game with learning-by-doing. We quantify the welfare

effects of the merger by incorporating both increased market power and merger efficiencies

from accelerated learning-by-doing. Our dynamic analysis indicates that net consumer surplus

increased by as much as $5.14 billion, whereas a static model ignoring efficiencies of learning-

by-doing predicts a $0.92 billion loss.

1. Introduction

A fundamental question in antitrust practice is how to evaluate the impact of mergers on

consumer welfare. A merger can lessen competition and harm consumers, but it can also bring

efficiencies that reduce costs, for example, by generating economies of scale in production.

Antitrust policy balances the loss of competition with the efficiencies of the merger. Measuring

the loss from mergers has been well studied in the literature, for example, Nevo(2000). However,

the empirical literature on quantifying efficiencies in merger evaluation is limited. In this article,

we provide empirical evidence that dynamic efficiencies are realized after a merger and quantify

the welfare effects of these efficiencies.

Specifically, we evaluate the welfare effects of the 1997 merger between Boeing and

McDonnell Douglas in the aircraft industry, where dynamic efficienciesmight have occurred due

to accelerated learning-by-doing. Our analysis focuses on the market for medium-sized wide-

body (hereafter, “medium-sized”) aircraft. Pre-merger, Boeing and McDonnell Douglas were

∗TexasA&M University and Nankai University; y.an@tamu.edu.

∗∗Competition Economics LLC; wzhao@c-econ.com.

We are grateful to the Co-Editor, Aviv Nevo, and three anonymous referees for their exceptionally helpful comments.

Zhao is extremely indebted to his advisors Joseph E. Harrington, Jr., PrzemyslawJeziorski, and Richard Spady for their

continual guidance, support, and encouragement. We are both grateful to C. Lanier Benkard for making the labor input

data of the Lockheed L-1011 available and to Edmund S. Greenslet, publisher of The Airline Monitor, for numerous

inspiring discussions about the aircraft industry and the merger. We would like to thank Lanier Benkard, Jiawei Chen,

YingyaoHu, Elena Krasnokutskaya, Yiyang“Ellen” Li, Haizhen Lin, Yao Luo, Xun Tang,Michael A. Williams, Jonathan

Wright, Ruli Xiao, and participants in seminars at Johns Hopkins University for their helpful comments, discussion, and

suggestions. All remaining errors are ours.

666 C2019, The RAND Corporation.

AN AND ZHAO / 667

the first- and third-largest producers of civilian jets, respectively. Their merger was approved in

August 1997, with Boeing acquiring McDonnell Douglas. After the merger, only Boeing and

Airbus remained as major competitors in the global market for large commercial aircraft. The

primary impact of the merger on market structure was the elimination of McDonnell Douglas,

whose only wide-body product in production was the MD-11, a medium-sized aircraft. Shortly

after the merger, Boeing shut down production of the MD-11.

We begin our analysis by investigating changes in aircraft prices. During the five years

after the merger, the medium-sized aircraft produced by both Airbus and Boeing experienced

significant price drops. Meanwhile, the prices of other wide-body aircraft declined only slightly,

and the prices of narrow-body aircraft rose. Our analysis shows that the annual decrease in prices

for medium-sized aircraft was $2.36 million largerafter the merger than before it. Focusing only on

the post-merger period, the prices of medium-sized aircraft annuallydropped $4.46 million more

than the prices of all other aircraft. Wealso find that this patter n disappeared sevenyears after the

merger. These results suggest that the merger generated efficiencies that reduced marginal costs

for medium-sized aircraft; the efficiencies were the most prominent for medium-sized aircraft

and large enough to offset the effects of increased market power.

To further explore the merger’s dynamic efficiencies,we propose a dynamic oligopoly game

to describe the market for medium-sized aircraft. We incorporate into the model learning-by-

doing, a common dynamic force relevant to industry performance. Multiproduct firms compete

in an infinite-horizon dynamic game. In each period, a firm chooses howmuch to produce of each

product. The production decision affects both current and future profit stream through its impact

on the firm’s experience level. Experience accumulates due to learning and depreciates due to

forgetting. We model learning-by-doing in a way that the unit production cost is a decreasing

function of experience. Moreover,a fir m’s production is allowed to have spillover effects in terms

of experience accumulation from other products of its own and its competitors. In each period,

firms decide on production given the state variablesof firms’ experiences, the stochastic realization

of market size, and an unobserved characteristic of products. We focus on the Markov-Perfect

Equilibrium of the game.

In the dynamic setting, just like in a static model, the Boeing-McDonnell Douglas merger

may hurt consumers because reduced competition creates an incentive for Airbus and Boeing

to restrict production and raise prices. However, the merger may also generate efficiencies in

several ways. First,there may be an immediate benefit of lowering the marginal cost for Boeing’s

products because of an experience transfer from McDonnell Douglas after the merger. Second,

future experience might be shared more effectively between different products within the same

firm (within-firm spillover) than across differentfir ms (across-firm spillover),bringing costs down

after the merger.Third, Boeing’sdecision to shut down MD-11 production shortly after the merger

could havetwo effects. On the one hand, fewerproducts mean less variety, which makesconsumers

worse off. On the other hand, there would be more demand for other medium-sized aircraft, for

example, Boeing 777 (B777). More production leads to faster experience accumulation, lower

unit cost, and lower future prices, all of which make consumers better off.

We employ a multistep procedure to solve the dynamic game and simulate the equilibrium

prices, quantities, profits, and consumer surplus. First, we model demand using a nested logit

model and estimate the parameters using two-stage least squares (2SLS).

Next, we estimate the total variable cost function, the learning curve, and the state transition

process of experience using the data on the Lockheed L-1011. Our estimates indicate existence of

substantial within-firm spillover:b uilding four aircraft of differenttypes is as helpful in experience

accumulation as building one aircraft of the same type. The cross-firm spillover is estimated to

be negligible.

Finally, we solve the dynamic game based on the estimated demand and cost parameters, and

evaluate the efficienciesof the merger using the simulated paths of consumer welfare. We consider

three different scenarios: (i) the merger occurs and MD-11 production is shut down shortly after

the merger, which is what actuallyhappened; (ii) the merger occurs with continued production of

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