The limited liability effect: Implications for anticompetitive horizontal mergers

• Published date: 01 December 2020
• Author: Bernard Franck,Nicolas Le Pape
• Date: 01 December 2020
• DOI: http://doi.org/10.1111/jpet.12441

J Public Econ Theory. 2020;22:2082–2102.wileyonlinelibrary.com/journal/jpet2082

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© 2020 Wiley Periodicals, Inc.

Received: 18 February 2019

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Accepted: 16 March 2020

DOI: 10.1111/jpet.12441

ORIGINAL ARTICLE

The limited liability effect: Implications for

anticompetitive horizontal mergers

Bernard Franck |Nicolas Le Pape

CREM‐CNRS, Université de Caen

Normandie, Caen, France

Correspondence

Nicolas Le Pape, CREM‐CNRS, Université

de Caen Normandie, Esplanade de la Paix,

14000 Caen, France.

Email: nicolas.lepape@unicaen.fr

Abstract

We consider an industry including both leveraged

and unleveraged firms engaged in a sequential

decision‐making process. At the first stage a firm and

its bank, considering the production cost uncertainty

and the probability distribution of the random shock,

evaluate a bankruptcy risk; at the second stage firms

engage in Cournot competition. By introducing an

additional upstream stage we examine how in-

centives to merge with competitors are altered when

shareholders of leveraged firms are protected by the

limited liability. We demonstrate that a merger in-

creases the probability of bankruptcy for the merged

firm if the merger involves only leveraged firms, but

this probability decreases if the merger involves at

least one unleveraged firm. The welfare loss asso-

ciated with anticompetitive effects of mergers is lower

when the coalition gathers unleveraged firms rather

than leveraged ones. Consequently, we argue that in

evaluating proposed mergers Competition Autho-

rities should take into account the financial structure

of both merging firms and outsiders.

1|INTRODUCTION

During the 1990s M&A activities and businesses bankruptcies in the United States were negatively

correlated (Rahaman, 2010). A possible explanation could be that firms suffering from financial

distress consider a merger as an alternative to bankruptcy. When one party cannot stay afloat by itself,

the incentive to engage in a horizontal merger increases. This paper tries to explain theoretically why,

for firms confronted with some significant financial distress, the benefit from an increase in market

power generated by a merger could stem not only from higher expected revenue, but also from a

decrease in the expected probability of bankruptcy. The airline industry is a convincing illustration of

the bankruptcy/merger alternative. The restructuring of the industry during the 1980s generated a

wave of horizontal mergers between airline companies characterized by various degrees of financial

health. In their analysis of airline mergers from 1985 through 1988, Kim and Singal (1993) highlight

that in many cases the acquired firms were in financial distress

1

before the merger (Frontier Airlines,

People Express, Eastern Airlines, Jet America and Muse Air). In the premerger situation, financially

distressed airlines were more aggressive in the product market in the sense that, to attract new

customers, they initially set prices below theindustryaverage.Withregardtothepost‐merger

situation, Kim and Singal (1993) compare the impact on prices according to the financial structure of

firms engaged in the merged entity. They show that when a financially distressed firm merges with a

solvent buyer, the remaining airlines become more collusive since the insider and the outsiders

operating on the same route increase their fares (by around 40/45%). By contrast, in the case

of mergers between financially safe firms the anticompetitive effects are low, and fares tend to be

unchanged (efficiency gains arising from these mergers counterbalance the increase in market

power).

In this paper we consider a merger decision for firms confronted with an exogenous harmful

shock. We build a model of Cournot competition where firms produce a homogeneous output

and face uncertainty over production cost.

2

First, firms decide to merge or not; then firms with

debts agree with their bank on the expected bankruptcy risk; and finally all competing firms set

quantities. The debt contract involves an estimate of the expected risk of failure (the firm faces a

random cost). The probability distribution of the shock, assumed to be identical for all firms, is

common knowledge and allows for the evaluation of an expected risk of failure. The choice of

the levels of debt and production determines the threshold of the shock above which the firm is

solvent. Because of limited liability leveraged firms have incentives to implement product

market strategies that increase returns in solvent states. Thus when firms rely on debt this

distorts the firm's value optimization program at the output market stage. Debt financing

induces shareholders, protected by limited liability, to promote aggressive production strategies.

We examine the consequences of horizontal mergers according to the financial structure of

firms by introducing an additional upstream stage in the game: initially, firms decide to merge

or not with rivals. We evaluate the profitability of mergers between leveraged firms and prof-

itability when the mergers concern unleveraged firms.

Since the mid‐1980s increasing attention has been given to the interactions between a firm's

financial structure and product market decisions.

3

Under Cournot competition a firm becomes

more aggressive toward its competitor (i.e., produces more) when it is indebted (see for instance

Brander & Lewis, 1986; Glazer 1994, Showalter, 1995). This result refers to the commitment

value of the debt to subsequent output strategies and may be explained in the following way:

because shareholders benefit from the limited liability when they run a leveraged firm, they

choose a level of production without taking into account potential losses realized in case of

default. Consequently, raising debt induces firms to pursue more aggressive output strategies

1

The firm is classified as financially distressed if reports in the financial press indicate financial problems such as debt

postponement.

2

If we chose to randomize demand like Socorro (2007), all firms would be simultaneously bankrupt in the case of a

severe enough shock, which is of course very unrealistic.

3

For a survey of the literature on the relation between corporate finance and product market competition see, for

instance, Tirole (2006, Ch. 7) or Maksimovic (1995).

FRANCK AND LE PAPE

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