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Econ 4631- Lecture 2
Pat BajariUniversity of Minnesota
January 2009
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 1 / 29
First readings
1 Chapter 2 of C&P2 Borenstein, Airline Mergers
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 2 / 29
Outline
1 The Neoclassical Model in 5 minutes2 Ownership and Control3 Separation of management and control4 Mergers
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 3 / 29
The Firm and Costs
The neoclassical model of the �rm has the following components:
1 Technology: A �rm transforms capital and labor into output2 Behavioral assumption: The �rm maximizes pro�ts3 Price taking assumption: output prices and input prices are exogenousto the �rm
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 4 / 29
The Firm and Costs
Let q denote the quantity produced, l labor and k capital
Let q = f (k, l) denote the production function
In the neoclassical model, a �rm de�ned by its production function
Let p be the price of q, w the wage rate and r the rental rate ofcapital
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 5 / 29
The Firm and Costs
Pro�ts are de�ned by:
pf (k, l)� wl � rk
First order conditions:
p∂f (k, l)
∂l= w
p∂f (k, l)
∂k= r
Marginal revenue product equals input price
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 6 / 29
The Firm and Costs
Pro�ts are de�ned by:
pf (k, l)� wl � rk
First order conditions:
p∂f (k, l)
∂l= w
p∂f (k, l)
∂k= r
Marginal revenue product equals input price
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 7 / 29
The Firm and Costs
It is a short distance from this calculus to e¢ ciency.
First welfare theorem: Market allocations are e¢ cient, e.g. theinvisible hand works.
Second welfare theorem: Any e¢ cient allocation can be achieved bylump sum taxes/transfers.
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 8 / 29
Ownership and Control
The above model abstracts from many, many important andinteresting details about �rms
A �rst abstraction is that the person who owns the �rm is not usuallythe person operating the �rm
There are three basic forms of ownership in the U.S.
- sole proprietorships (single owner)
- partnerships (multiple owners)
- corporations
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 9 / 29
Ownership and Control
Corporations are most important in terms of aggregate activity
They account for 87 percent of business sales
Propriotorships tends to be small.
The �xed costs of incorporating are non-trivial
If propriotorships are successful, they may eventually incorporate
Partnerships are less common. However, they are the norm in someindustries, e.g. law �rms.
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 10 / 29
Ownership and Control
Why are coporations so dominant:
1 Limited liability- stock holders are not liable for debt with personalassets
2 Financing- the ability to issue shares is a source of cash
Start ups- business model is entry into a high risk/high return industry
Employees �nance the �rm in part by giving their labor at adiscounted rate
The employees receive stock, or options for stock, as part of theircompensation
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 11 / 29
Ownership and Control
3. Diversi�cation
Stock allows ownership to be split up into many small pieces
Shareholders can own stock in many companies
Don�t have all of your eggs in one basket
A presumption of modern economics and �nance is that people arerisk averse.
E.g. 500K with certainty is prefereable to $1 million with .5 probabiliyand zero with .5 probability.
Evidence suggests that consumers demand a quite large premium forassuming risk
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 12 / 29
Debt Holders Versus Stock Holders
Debt holders and Equity holders typically have di¤erent incentives
Example- Table 2 of the text
Debt holders prefer safer projects since they get less of the upside
Debt holders may restrict the actions of the equity holders- bondconvenants
Also, debt holders are the residual claimants to the �rm�s assets
Because of incentive problems, some e¢ cient deals may not get�nanced
Formally modeling these trade o¤s is the province of corporate �nance
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 13 / 29
Debt Holders Versus Stock Holders
A nice example of this is the run on money market funds inSeptember of 2008
Amount in money market funds fell from $3.535 trillion on September9, 2008
Fell to $3.288 trillion ten days later
Money markets involve short term borrowing including commercialpaper (short terms obligations by corporations) and short livedmortgage backed and asset backed securities
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 14 / 29
Debt Holders Versus Equity Holders
During this time, large �nancial institutions borrowed heavily usingmoney markets
The non-regulated part (e.g. Wall Street) was leveraged at rates of33 or 50 to 1
Leverage can allow for spectacular rates of return.
Suppose borrow from money market holders, pay them 4 or 4.5percent
You take the cash from money market holders and use it for trading
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 15 / 29
Debt Holders Versus Equity Holders
Suppose you can earn 8 percent rate of return in trading or otherinvestments
After you get done trading, you have 3.5-4 percent on your leveragedfunds
This is 3.5 percent on 50 times your underlying assets
This is a spectacular rate of return
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 16 / 29
Debt Holders Versus Equity Holders
However, the problem is that the persons running the �rm may betempted to take excessive risk
The borrower, because they have limited liability, cannot lose money
Basic �nance suggests high risk and high return are related
This is like playing heads I (the borrower) win, tails you (the lender)lose
Remark: These risks are all compounded when there is the perceptionthat banks can be bailed out.
Then the incentives of the bondholders to monitor the equity holdersare diminished.
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 17 / 29
Ownership Versus Control
There are similar problems between the owners of a �rm and thepeople who operate a �rm
In corporations, managers are often compensated by options
That is, for a �xed price, they will be able to purchase stocks at afuture date
On the one hand, stock options, make the manager care about the�rms pro�ts
However, the owners of the �rm only get dividends or the ordinaryrate of return on the stock
Managers get the rate of return on the options
The manager may prefer riskier investments, driving a wedge betweenthe incentives of owners and managers
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 18 / 29
Mergers
One important way that corporations grow and evolve is throughmergers
In 2007, $4.5 trillion dollars of announced mergers worldwide
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 19 / 29
Mergers
Why do mergers occur?
1 Di¤erences in e¢ ciency.
Cross �rm di¤erences in productivity explain 30-50 percent of outputin some data sets
2. Complimentarities
Related lines of business and coordination of e¤ortsDelta/NWA non-overlaping markets and complimentary �eets
3. Market power
Merging reduces competition and hence increases prices
4. Managerial incentives
Park (2008), Poorly run big �rms buy poorly run small �rmsHeads I win, tails you lose
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 20 / 29
Mergers
Empirically, mergers on average are a good deal for the acquiredcompany, a bad deal for the purchaser
Shareholders of acquired �rm get 16-25 percent premium
Acquiring �rm -3 percent premium in 80�s and 90�s (why did they doit??)
Overall shareholder value goes up 2 to 7.5 perent
Mergers are also pro-cyclical with stock prices (why buy when theprice is high???)
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 21 / 29
Event Studies
One way to assess if a merger enhances e¢ ciency is an event study
At time merger is announced, look at share price of competitors
If merger will weaken competition, share prices of competitors shouldgo up
If merger increases competition, share prices of competitors goes down
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 22 / 29
Case Study- Borenstein
Question: Did airline mergers in mid-1980�s result in increased ticketprices?
Two mergers- Northwest/Republic and TWA/Ozark
At MSP airport, NW and RC, accounted for 42 and 37 percent of theemplanements
High degree of overlap on routes �ow
In many cases, the only potential competitors on particular routes
TWA carried 57 percent of the tra¢ c from STL and OZ carried 25percent
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 23 / 29
Case Study- Borenstein
Table 1 looks at price changes from 1985-1987
Holding distance �xed, what is the price of the route compared to thenational average
Compared to national average- this controls for nation wide trends
Use distance since this re�ects fuel costs- important operating expense
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 24 / 29
Case Study- Borenstein
Bornstein weights prices by the number of passenger miles �own
The idea is that not all prices are equal
For example, Minneapolis to Chicago is more important thanMinneapolis to Salt Lake City
First period is probably before or during merger negotiations
Second period, agreement reached but before mergers
Third period, a yaer after the mergers took place
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 25 / 29
Case Study- Borenstein
Minneapolis and St. Louis goes from one of the cheaper hubs to oneof the more expensive
11.4 percent change in Minneapolis and 8.6 percent change in St.Louis
Preliminary evidence that the mergers raised prices compared to anational benchmark
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 26 / 29
Case Study- Borenstein
Table 2-Breaks it down by intensity of competition
Markets in which there is less competition has a greater price e¤ect
This was also present in market where NWA/RC did not competehead to head
Borenstein suggests potential competition is important as well asactual competition
Much of the price changes occured from 85 to 86- before the actualmerger
These results are typically "statistically sign�cant"
Results that are signi�cant at the 1 or 5 percent level are used asstandard that you can reject the hypothesis that the e¤ect was zero
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 27 / 29
Case Study- Borenstein
Table 3- Gain in share from non-hub city
Consider the MSP to Chicago route
Fliers from Chicago are less locked into NWA
If NWA gains more in share from Chicago originations than MSPoriginations, this is consistent with it becoming more attractive
This was true for both mergers
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 28 / 29
Case Study- Borenstein
Borenstein argues that airlines competed on load factors
Fewer passengers on the plane when competition was higher
Proxy for service quality
For both TWA and NWA, load factors went up and capacity wentdown on routes that previously had merger partner
Suggests that service quality went down while prices went up
Pat Bajari University of Minnesota () Econ 4631- Lecture 2 January 2009 29 / 29