Was Mr. Hewlett Right? Mergers, Advertising and the PC Industry Michelle Sovinsky Goeree 1 Preliminary, please do not cite. March, 2005 (First Version June 2002) Abstract In markets characterized by rapid change, such as the personal computer industry, con- sumers may not know every available product. Failing to incorporate limited information and the strategic role of informative advertising into merger analysis may yield misleading results regarding industry competitiveness. This is of particular importance when accessing the welfare impact of mergers. I use the parameters from a model of limited consumer in- formation to (1) estimate the effect on profits and consumer welfare from mergers and (2) to examine the role of advertising as it relates to market power and the implications for an- titrust policy. The methodology used to evaluate the impact of mergers follows Nevo(2000), but incorporates limited information and strategic choices of advertising. I simulate post- merger price and advertising equilibria for the Compaq-HP merger and for a hypothetical merger. I decompose the change in prices into changes due to increased concentration and changes due to the influence of advertising. The results indicate advertising can be used to increase market power when consumers have limited information, which suggests revisions to the current model used to access the impact of mergers in antitrust cases. JEL Classification: L15, D12, M37, D83 Keywords: merger analysis, informative advertising, discrete-choice models, product differ- entiation, structural estimation 1 This paper is based on various chapters from my 2002 dissertation. Special thanks to my dissertation advisors, Steven Stern and Simon Anderson, for their guidance. I am grateful to Gartner Inc. for making the data available, and specifically to Sandra Lahtinen. I also gratefully acknowledge financial support from the University of Virginia’s Bankard Fund for Political Econ- omy. Address for correspondence: Claremont McKenna College, 500 E. Ninth Street, Claremont, CA 91711 (email: [email protected]) 1 Introduction On May 7, 2002 Hewlett-Packard (HP) Company launched the new Hewlett-Packard with an ad titled “We are Ready.” The new Hewlett-Packard is a result of a merger with Compaq Computer Corporation, the largest ever in the information technology sector. The $19 billion deal has drawn a lot of media attention for a number of reasons. Investors and rival firms are interested in its impact on shares and profits. Consumers are interested in the effect on prices. Regulators are interested in its implications for competition in an already concentrated industry. Originally proposed in June 2001, the merger prompted a bitter battle between Hewlett and Packard family interests and corporate executives. It was ultimately approved by a slim majority of shareholders (only 3%). Many HP shareholders opposed the deal because they thought the time lost in absorbing Compaq and incorporating cost synergies would distract from winning new orders at a time when the market was slowing. Walter Hewlett, whose father cofounded HP, launched a court battle against HP arguing the merger would result in lost profits in the long run. As further evidence of his conjecture, Hewlett pointed to his competitors, “We believe that HP stockholders should be concerned when competitors, like SUN, Dell, and IBM don’t object to a transaction that is supposed to add value to HP.” Meanwhile, the Federal Trade Commission (FTC) voted unanimously to approve the merger. Likewise, the European Commission approved it without placing any conditions on the two companies, saying “A careful analysis of the merger. has shown that HP would not be in a position to increase prices and that consumers would continue to benefitfromsufficient choice and innovation.”2 The analysis used by antitrust authorities to evaluate the impact of mergers is based on a model which assumes consumers are aware of all products for sale when they make their purchase decision. However, it is reasonable to think consumers may have limited informa- 2 “HP-Compaq Merger Wins European Approval,” NewsFactor Network, Feb.1, 2002. 1 tion regarding the products available, especially in markets characterized by a high degree of change such as the PC industry. Price elasticities calculated under the assumption of full information may yield misleading results regarding the degree of competition in the market. Incorrect conclusions regarding the competitive effects of a merger could lead antitrust au- thorities to approve a merger which has negative consequences for consumers. Goeree (2002) showed that assuming consumers are aware of all products in a market characterized by rapid change generates estimates of product-specific demand curves that are biased towards being too elastic. This is of particular importance when considering the welfare impact of mergers, one of the primary stated interests of the FTC when examining mergers. The goal of this empirical work is twofold: (1) to estimate the effect on profits and consumer welfare from mergers when consumers have limited information and (2) to examine the role of advertising as it relates to market power and the implications for antitrust policy. The methodology used to evaluate the impact of mergers is based on previous work,3 but allows for limited information and strategic choices of advertising. I use the estimated parameters from a structural model of informative advertising4 to simulate post-merger equilibrium price and advertising levels. I calculate the effect of mergers on the profits of merging and non-merging firms as well as the cost-synergies necessary to offset losses. I decompose the change in prices and markups into the changes due to increased concentration and the changes due to the influence of advertising. Perhaps surprisingly, the results suggest the latter effect is the strongest. The post-merger equilibrium results indicate advertising can be used to increase market power, which suggests revisions to the current model used by the FTC to determine market power in antitrust cases. I examine both the HP-Compaq merger and a hypothetical merger between IBM and Dell.5 Considering a merger between these two firms is of interest for two reasons. First, 3 For example, see Baker and Bresnahan, 1985; Berry and Pakes, 1993, Hausman, Leonard and Zona, 1994; and Nevo, 2000. 4 See Goeree (2002) for more detail. 5 While the merger is supposed, IBM and Dell entered into a $16 billion cross-licensing agreement in 2 IBM is the world leader in sales of non-PC’s, while Dell is the world leader in sales of PC’s. They focus on different aspects of the computer industry. As a result, cost synergies are expected to be lower than those between HP and Compaq. Secondly, and more directly related to the topic of this research, IBM and Dell have very different ad-to-sales ratios. IBM is a high-advertising intensity firm, while Dell is a low-intensity firm. In contrast, HP and Compaq are thought to have more cost synergies and are closer in their ad-sales concentration. Comparison of the outcomes from the two very different mergers yields insight into the role that advertising plays in this industry and how firms use it when industry concentration increases. The remainder of the paper is organized as follows. In the next section, I present an overview of the PC industry and discuss the data used in estimation. In section 3, I describe the model used in the counterfactual merger simulations. In section 4, I discuss the impact of mergers on welfare and profits, the role that advertising plays as concentration increases, and the implications for antitrust policy. 2 Trends in the PC industry and Data The PC industry, as we know it today, has been growing since 1971 when Intel introduced the first microcomputer. It utilized the 4004 microprocessor, an integrated circuit able to process four bits of data at a time (hence the ‘4’s). Intel was the first to imbed all components of a computer — central processing unit (CPU), memory, and input-output controls — on a single chip. The advantage was that, simply by changing the external program, the same device could be used for a multitude of projects. The first generally available microcomputer, the Altair 8800, was on the market only four years later. It retailed for $439, which made it affordable, but it was not easy to use. The kit required assembly and software was not available. Two young hackers tackled the second problem and began the process of writing software. The language was the Beginners All-purpose Symbolic Instruction Code, BASIC, 1999. The agreement will last until 2006 and calls for broad patent cross-licensing between the two firms and collaboration in the development of product technology. 3 and the hackers were William Gates and Paul Allen. Three years later Steve Jobs and Steve Wozniak introduced the Apple II. The first PC that was both affordable and usable. It had 4K RAM, built-in BASIC, color graphics, and sold for about $1300. Apple controlled the market until IBM introduced the (modestly named) “PC.” The PC featured a modular design so that pieces could be added easily. It soon surpassed the Apple II in popularity and allowed IBM to dominate the market for several years. In 1984, Apple introduced the first generation Macintosh during a SuperBowl commercial. The new Macintosh came with a graphical user interface and a mouse, which made it easy to use. As a result, sales of the Macintosh boomed. Competition and technological improvement has continued to spur innovation, and the PC industry has seen numerous product introductions in the past years. Due to the fre- quency with which new products are brought into the market, consumers may not be aware of all products offered. Indeed every year over 200 new PCs are available from the top 15 firms alone.