Firm Diversification, Mutual Forbearance Behavior and Price-Cost Margins

Allyn D. Strickland

• Publisher: Routledge
• Year: 2018
• Topic: Business
• eBook ISBN:
  9781351335706
• Subtopic: Business General
• Index: Business

Concern over conglomerate mergers increased dramatically in the latter part of the twentieth century. An acceleration in conglomerate merger activity rekindled firms' takeover fears and swamped trustbusters, and attention focused on the political and economic issues surrounding conglomerate mergers. Of particular importance is the possibility that conglomerate mergers may increase aggregate concentration and eventually create a 'zaibatsu' economy. This book, first published in 1984, addresses the issue by examining the mutual forbearance hypothesis. More specifically, do multi-market contacts among diversified firms affect market competition?

CHAPTER I

Introduction

The American economy has experienced three major merger waves in the last century. Although different in character, each merger wave has had a substantial impact on the structure of American industry. The first merger wave, from approximately 1897 to 1904, was characterized by mergers designed to monopolize entire industries. Traditional giants such as United States Steel and International Harvestor achieved dominance in their primary industries in this fashion. The second major merger wave lasted from 1916 to 1929, ending with the stock market crash and the ensuing depression. Many public utility and bank holding companies were created during this period, which also saw an erosion in the market power of monopolists. Mergers among second echelon firms transformed industries such as cement, tin cans, steel and agricultural implements from near-monopolies to oligopolies [Markham (1955), Stigler (1968)].

The final, and most recent, major merger wave began around 1950 and steadily increased in intensity until 1969. This merger wave surpassed the others in both numbers of mergers and in acquired assets [F.T.C. (1969, p. 37)]. It was called the “conglomerate” merger wave due to the high proportion of mergers that were classified as conglomerate. This historical trend toward conglomerate mergers and away from horizontal and vertical mergers is illustrated in Table I. Conglomerate mergers as a percent of total mergers increased from 19.3% during the late 1920’s to 81.6% from 1966–1968. During this same period, horizontal mergers decreased from 67.6% to 7.7%, while vertical mergers increased their share of total mergers from 4.8% to 9.8%.

The conglomerate merger wave was also distinguished by the magnitude of many of the mergers undertaken. Large corporations were routinely acquired by relatively unknown, fast-growing conglomerates. In 1968, 201 firms with assets in excess of $10 million each left the corporate scene through the merger route [F.T.C. (1969, p. 43)]. These large acquisitons enabled firms like LTV and Gulf & Western to climb from outside the top 200 manufacturing corporations in 1960 to positions within the top 50 in 1968 (22nd and 34th respectively). This change in the composition of the leading manufacturing firms is illustrated in Table II which summarizes the merger activity of the 25 most active acquiring firms from 1961–1968.

TABLE I

Percentage Distribution of Mergers by Type and Period, 1926–1968

^* This category includes “pure” conglomerate mergers—mergers in which there is no production or distribution relationship between the products of the acquired and acquiring firms.

SOURCE: U.S. Federal Trade Commission Economic Report on Corporate Mergers, Government Printing Office, Washington, D.C., 1969, p. 63.

This substantial increase in conglomerate merger activity created apprehension among both antitrust officials and academic economists who were unsure of the competitive consequences of firm diversification or “conglomeration.” “Conglomeration” was hypothesized to have adverse consequences for the entire economy as well as individual industries [Edwards (1955), Mueller (1969)]. At the national level, it was feared that conglomeration would concentrate economic power in fewer and fewer decision centers. Economists concerned with this issue have examined the historical trend in the percentage of manufacturing assets controlled by the top 200 corporations. As Table III indicates the trend has been toward increased concentration, though the economic implications of this trend are not readily apparent. Given the current state of economic theory, this issue appears to be more political than economic. Throughout American economic history, the public has associated large corporations with anti-competitive business practices, while enshrining the small businessman as the guardian of our free enterprise system.

At the industry level, conglomerate mergers were hypothesized to add an extra dimension to the elements of market structure and behavior analyzed in traditional models of the theory of the firm [Edwards (1955)]. In particular, conglomeration increases the likelihood of a firm engaging in reciprocity, cross-subsidization, and/or mutual forbearance behavior. If these practices are anticompetitive, competition in an industry may be reduced as the industry’s firms become more and more conglomerate in character.

TABLE II

ASSETS ACQUIRED BY 25 MOST ACTIVE ACQUIRING COMPANIES AMONG THE 200 LARGEST¹ MANUFACTURING CORPORATIONS, 1961–1968

¹ Ranks refer to FTC 200 largest manufacturing companies, except where noted, by asset size.

SOURCE: U.S. Federal Trade Commission Economic Report on Corporate Mergers, Government Printing Office, Washington, D.C., 1969, pp. 260–261.

TABLE III

SHARE OF MANUFACTURING ASSETS HELD BY THE 200 LARGEST CORPORATIONS, 1925–41; 1947–68

¹ Ranked according to asset size in each year.

² Data are not available for the years between 1941 and 1947 because some large corporations did not publish balance sheets for reasons of wartime security.

SOURCE: U.S. Federal Trade Commission Economic Report on Corporate Mergers, Government Printing Office, Washington, D.C., 1969, p. 173.

This thesis will focus on the mutual forbearance behavior hypothesized to be a function of firm conglomeration. The thesis will examine the hypothesis in the context of firm diversification though, since mutual forbearance behavior may result from firm contacts created by vertical and horizontal, as well as conglomerate, acquisitions. The hypothesized anticompetitive consequences of conglomeration are, in actuality, a subset of those associated with diversification in general.

Historically the mutual forbearance hypothesis was first enunciated by Corwin Edwards in 1955, over a decade before the conglomerate merger wave became a major concern of economists. He maintained that:

When one large conglomerate enterprise competes with another, the two are likely to encounter each other in a considerable number of markets. The multiplicity of their contacts may blunt the edge of their competition.… Each may informally recognize the other’s primacy of interest in markets important to the other, in the expectation that its own important interests will be similarly respected [Edwards (1955, p. 335)].

This argument drops the traditional assumption of market independence by asserting that firm profit maximization requires an awareness of rivals, and their interactions, across markets. Firms will recognize each other’s “spheres of influence” by adopting non-aggressive behavior in those markets for fear of retaliation in other markets. This hypothesis thus implies that behavior in one market is conditioned by contacts in other markets.

The crucial step in the creation of mutual forbearance behavior is firm diversification. Through diversification a firm increases the number of its contacts with other firms throughout the economy. These contacts create an awareness among those firms of their common, multi-market interests. Firms recognize that their interdependence is not limited to any single market. This recognition of interdependence will lead those firms to adopt mutual forbearance policies in those markets where they interact. Competition will thus be less than if each firm independently pursued a policy of profit maximization. In this fashion, increased diversification, either through internal growth or outside acquisitions, increases the likelihood of mutual forbearance behavior.

From a public policy perspective, such behavior poses difficult problems for the Justice Department and Federal Trade Commission. The successful prosecution of Section 7 merger cases requires a showing that there may be a substantial lessening of competition “in any line of commerce in any part of the country.” With mutual forbearance behavior, however, it is possible that a proposed merger would not violate Justice Department guidelines or current case law, but would reduce competition in many markets. A substantial lessening of competition may be shown, but not necessarily in the market involving the merger.

The different aspects of mutual forbearance behavior, and their implications for competition, are illustrated by the Consolidated Foods case. Consolidated Foods was a large food manufacturer with some retail operations. In 1965 it entered the Chicago retail market by acquiring 7 Eagle Food Stores and immediately initiating an aggressive price campaign. This action was resented by National Tea, the nation’s fourth largest food chain with 237 stores in the Chicago area. In response, National Tea ordered its stores not to buy Sarah Lee bakery products, which were produced by Consolidated, for one week. At the company’s annual meeting, National Tea’s president had commented that a “large competitor who is also a manufacturer, has come out and murdered prices…and sold so many items below costs” that the firm had been warned: “Tomorrow there will be fewer of your lines on our shelves” [F.T.C. (1969, p. 46)]. Shortly thereafter, Eagle Foods discontinued their aggressive pricing policy and were subsequently sold by Consolidated, who left the Chicago market. According to Consolidated’s president:

We have now concluded that it would be advisable from the standpoint of operating efficiency to withdraw from Chicago and confine our activities to those sections of Iowa, Wisconsin, Illinois, and Minnesota in which our Supermarket business has been historically operated [F.T.C. (1969, p. 469)].

The Consolidated Foods case illustrates how mutual forbearance behavior may affect firm conduct and, therefore, industry conduct and performance. First of all, pricing policies may be less aggressive where recognized interdependence among multi-market firms is substantial. Interdependence from multi-market contacts may strengthen oligopolistic interdependence in a single market, thereby increasing the likelihood of firms adopting a policy of joint profit maximization. Secondly, multi-market interdependence may affect a firm’s entry decisions. Large, diversified firms may only enter industries where “conflicts” with other large, diversified firms would be minimized. Alternatively, they might enter industries where these contacts would be substantial in order to gain leverage over their multi-market competitors. Thirdly, if multi-market interdependence does inhibit price competition, it may lead to an increase in non-price competition. Firms might increase their expenditures on advertising and possibly even research and development as alternative means of competing for market shares. Alternatively, strong interdependence may reduce competition in non-price areas although this seems less likely given the unpredictable payoffs and long lead times associated with those activities. In sum, firm diversification may adversely affect several dimensions of industry conduct through the creation of mutual forbearance behavior among an industry’s firms.

Since the conglomerate merger wave, interest in the anti-competitive aspects of conglomerate mergers has diminished. The few empirical studies in this area have examined the effect of conglomerate mergers on industry concentration [Goldberger (1974), Markham (1973), F.T.C. (1969), F.T.C. (1972)] and the incidence of reciprocity among leading firms [Allen (1975)]. No studies have dealt with the relationship between firm diversification and mutual forbearance behavior. Consequently there is no evidence on the prevalence of this particular activity in the American economy. It is not possible to tell if the cases which have been found constitute the entire problem or are merely the tip of the iceberg.

One major objective of this thesis is the quantification of the number and magnitude of interfirm contacts among the leading firms in the manufacturing sector of the American economy. These firms may interact in both horizontal and vertical capacities. Two firms have a horizontal relationship whenever they meet as competitors. This information can be obtained from Fortune’s Plant and Product Directory which lists every four-digit manufacturing S.I.C. in which a top 1,000 firm (based on annual sales) was active during 1963–1964. This time period was chosen since 1963 was a Census year and industry data is therefore available from the Census of Manufactures.

Vertical relationships exist between two firms when they interact in buyer and/or seller capacities. This information is more difficult to obtain as it requires detailed information about a firm’s customers and suppliers. Such an undertaking requires resources beyond those available to the author. The 1963 input-output tables published by the Office of Business Economics will be used instead to determine “potential” vertical relationships between firms. The word “potential” is emphasized since a vertical relationship may exist between two industries, but not necessarily between two specific firms in those industries. In the fashion outlined above, it will be possible to capture the actual horizontal and potential vertical relationships for a sample of leading firms.

The second major objective of this thesis is to conduct a specific test for one aspect o...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• CHAPTER I. INTRODUCTION
• CHAPTER II. MULTI-MARKET CONTACTS, FIRM INTERDEPENDENCE AND INDUSTRY PROFITABILITY
• CHAPTER III. THE SAMPLE
• CHAPTER IV. HORIZONTAL INTERDEPENDENCE AND INDUSTRY PRICE-COST MARGINS
• CHAPTER V. VERTICAL INTERDEPENDENCE AND INDUSTRY PRICE-COST MARGINS
• CHAPTER VI. HORIZONTAL INTERDEPENDENCE, VERTICAL INTERDEPENDENCE AND INDUSTRY PRICE-COST MARGINS
• CHAPTER VII. CONCLUSIONS
• REFERENCES