The economic case for mergers: old, new, borrowed, and blue.

Author:Collins, Grainne
 
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Over several years I have worked on a project that looked at the implications for women's work of new technology. (1) Part of this project involved case studies and interviewing female workers every two months for twenty-four months. Even though the project was not directly about mergers, they quickly became a major focus as it became clear how many workers had undergone a merger or takeover during their working life. (2) Time after time I heard stories of how stressful mergers were and how they left workers feeling demotivated and de-skilled. The workers I interviewed told anecdotes about futile control struggles, arbitrary changes of technology or procedures that were often later reversed, lack of clear command lines, and illogical decisions taken with power rather than profits in mind. After the merger they felt their partially situated knowledges had been ignored or destroyed and their trust violated and that it was only after several years that things "settled down." All the women I talked to are close to or at the bottom of their organizations, and from their point of view mergers seemed like corporate suicide.

This article is a discussion of my futile search to find context for their stories within the canon of economics. I looked in particular at three economic paradigms--neoclassical, new institutionalism, and institutionalism--and tried to judge each paradigm's success at explaining the cause, and the success or failure, of mergers. In particular I sought to examine how the three theories coped with knowledge, risk and trust, time lags in moving between organizational forms, and the interaction between the different levels of the firms during the merger that I uncovered in my empirical research.

In many ways mergers do provide a hard case for economic theories. Mergers are a moving target, a state of disequilibrium. Economists of each tradition highlight some features of firms and downplay other aspects. This in turn influences the questions that are posed and the evidence sought for support of their theories. Critical in this selection of features is the stance on methodological individualism on one side and history on the other. However, none of the theories I examine satisfactorily situates the reasons for and the consequences of the major economic phenomenon that is mergers and acquisitions.

Examining the Firm

In a merger or acquisition one firm takes over or joins with another firm to form a new company. The ostensible reason for mergers is the drive to improve shareholder value, profits, or market share. Typically it is argued that mergers are a better and faster way to grow than by organic growth. Julie Froud et al. reported that for some years U.K. companies spent more on buying other companies than they did on plant and machinery (2000). Yet value, however defined, is consistently being destroyed, and mergers fail in more than 50 percent of the cases to increase value (Agrawal et al. 1992; Froud et al. 2000; Hubbard 1999; Scherer 1988).3 Why is this? What happens during a merger that changes a profit into a loss? Given that so often mergers are unsuccessful, why do firms pursue, at an increasing pace, mergers?

Neoclassical Economics

The standard neoclassical economic literature does not examine mergers often, but when it does it treats them in one of three ways: a form of economic pathology, a form of cartelism, or a result of the separation of ownership and control of the company. The idea that mergers are a form of economic pathology arises because of an inability to explain mergers under the standard perfectly competitive neoclassical framework. (4) Neoclassical theory conceives the entrepreneur as a person with global rationality, unlimited and costless information, unlimited computational ability, unlimited time at his or her disposal, and clearly defined ordering of preferences for various outcomes. With all these attributes the entrepreneur pursues maximization of profits by comparing all possible alternatives, establishes the most profitable, and then moves instantly to align structure and strategy. Given complete information and computational ability, any path the entrepreneur chooses is risk-free.

A leap is then made from analysis at the individual level to analysis at the firm level and assumes the firm's actions are those of the entrepreneur. With no mechanism to distinguish between the different levels, the firm is simply taken as a new type of individual pursuing profit maximization (Schrader 1993).

The standard neoclassical orthodoxy is thus: if one firm can reduce costs or increase profits in comparison with its rivals, it will win market share. Therefore, it is unclear why the firms would merge in the first place. If you're more efficient you'll win market share--if you're less efficient you adapt or shut up shop--why merge? In a perfectly competitive world driven by the maximization of profits, mergers are senseless; the more efficient firm would simply achieve total market share without having the expense of buying out a rival. Likewise if one firm has a more profitable process and if information is perfect and all exchange is free of cost, under the assumptions of perfect competition, rational utility-maximizing individuals and firms move instantaneously to adopt the new processes-there is no need to merge. And given the ludicrous assumption of homogenous firms, post-merger firms simply look like pre-merger firms. (5) Hence Edith Penrose's comment that economics tended to treat mergers as economic pathology (1995). Thus a traditional perfectly competitive neoclassical worldview fails to establish a reason for merging or an explanation of the negative consequences of mergers.

Outside perfect competition, firms can increase profits by growing and thus exploiting market share. Increased market power creates a reduction in welfare for the consumer due to loss of consumer surplus, but the efficiency gain may overturn, negate, or reinforce this welfare loss (Williamson 1968; Scherer 1988). An underlying assumption is that mergers are always worthwhile for the firms involved because of the efficiency gains. If they have merged it must be worthwhile because if it were not they would not have merged in the first place. Here the lack of history is telling because there are neither time lags nor information problems; the before and after are collapsed. Profits might fall, share prices might fall, and market share reduce, but owners of firms are correct in pursuing mergers because of the unquantifiable efficiency gains. Firm owners know what is best for their firms, and if we do not see this it is because we are using the wrong criteria to judge success.

Instead of assuming that it "is" and therefore it must be best, another group of neoclassical economists have attempted to explain the conundrum by a closer look at issues of ownership of the firm, in particular, the separation of ownership and control of the firm. Rather than looking to the firm ownership level for an explanation of mergers, the explanation shifts to the management level and their behavior. (6) Managers maximize their own utility function, unchecked by the owners of the firm, instead of the firm's profit function (for example, Meeks 1992; Meeks and Meeks 1995; Chatterjee and Meeks 1995). Therefore mergers are rational at the level of management rather than at the level of the firm. The only check to management action is the necessity to keep shareholders sufficiently happy. The strong point of this third explanation is that it brings in the idea that individuals may be pursuing their own agendas and that these agendas might not be beneficial for the firm (Zalewski 2001 highlights some scandalous cases). So a maximization at one level of the firm does not result in a maximization at another level. This change in emphasis, from the firm to the individual, implies a rejection of reductionism and atomism. However, this point is usually not made explicit.

What this explanation leaves to one side is how the actions of managers may affect the firm negatively. More fundamentally...

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