Endogenous Merger Under Product Differentiation and Price Competition: The Role of High-Quality Producer

Abstract This paper studies the profitability of a bilateral merger under price competition in the presence of horizontal and vertical product differentiation. One firm produces a high-quality product and the other two firms produce a low-quality product. We show that i) a merger between a high-quality producer and a low-quality producer or ii) a merger between two low-quality producers is always profitable. After the merger of two firms consumer surplus always decreases, but welfare sometimes increases. However, the total surplus for the merging firms is higher when a high-quality producer merges with a low-quality producer than when two low-quality producers merge. We also consider the endogenous merger selection process and show that i) if the quality difference (net of cost) is very high, then the high-quality producer will merge with a low-quality producer and ii) if the quality difference (net of cost) is very low, then the high-quality producer will bribe the low-quality producers to merge. Interestingly, we show that if the quality difference (net of cost) is moderate, then the high-quality producer a) will bribe other firms to merge if it has high bargaining power in the merger negotiation process; b) otherwise will use the profit-sharing scheme and merge with a low-quality producer.