AN EMPIRICAL STUDY OF THE CAUSES AND CONSEQUENCES OF MERGERS IN THE CANADIAN CABLE TELEVISION INDUSTRY by DAVID PATRICK RONALD BYRNE A thesis submitted to the Department of Economics in conformity with the requirements for the degree of Doctor of Philosophy Queen’s University Kingston, Ontario, Canada December, 2010 Copyright c David Patrick Ronald Byrne, 2010 Abstract This dissertation consists of three essays that study mergers and consolidation in the Cana- dian cable television industry. The first essay provides a historical overview of regulatory and technical change in the industry, and presents the dataset that I constructed for this study. The basic pattern of interest in the data is regional consolidation, where dominant cable companies grow over time by acquiring the cablesystems of small cable operators. I perform a reduced-form empirical analysis that formally studies the determinants of merg- ers, and the effect that acquisitions have on cable bundles offered to consumers. The remaining essays develop and estimate structural econometric models to further study the determinants and welfare consequences of mergers in the industry. The sec- ond essay estimates an empirical analogue of the Farrell and Scotchmer (1988) coalition- formation game. I use the estimated model to measure the equilibrium impact that economies of scale and agglomeration has on firms’ acquisition incentives. I also study the impact entry and merger subsidies have on consolidation and long-run market structure. The fi- nal chapter estimates a variant of the Rochet and Stole (2002) model of multi-product monopoly with endogenous quality and prices. Using the estimated model I compute the impact mergers have on welfare. I find that both consumer and producer surplus rise with acquisitions. I also show that accounting for changes both in prices and products (i.e., cable bundle quality) is important for measuring the welfare impact of mergers. i Dedication To Marisia, for always understanding, encouraging, and loving me in all that I do. ii Acknowledgments I am very grateful for my supervisors, Chris Ferrall and Susumu Imai for giving me their time, patience, advice, guidance, and encouragement over the course of my Ph.D. I have also benefitted from the continual support of Allan Gregory and Roger Ware during my six years at Queen’s. I am thankful for funding from SSHRC’s Doctoral Canada Graduate Scholarship, and from the Province of Ontario’s Ontario Graduate Scholarship. For their many helpful comments and suggestions, I thank the seminar participants at Mount Allison University, the University of Toronto, Queen’s University, Simon Fraser University, the University of Alberta, HEC Montreal,´ Carnegie Mellon (Tepper), University of Melbourne, Analysis Group (Chicago), the 2009 CEA Annual Meetings, and the 2009 CIREQ Ph.D Students Conference. I have also had very helpful discussions with Victor Aguirregabiria, Branko Boskoviˇ c,´ Sacha Kapoor, Arvind Magesan, Shannon Seitz, Ryan Webb, and Jan´ Zabojnik.´ Finally, I thank for my wife, parents, and brothers for their continued love, encourage- ment and patience. iii Table of Contents Abstract i Dedication ii Acknowledgments iii Table of Contents iv List of Tables vii List of Figures ix Chapter 1: General Introduction . 1 Chapter 2: Cable Television in Canada: Historical and Empirical Perspectives 5 2.1 Historical Overview . 6 2.2 The Dataset . 11 2.3 Descriptive Statistics . 14 2.3.1 Market Structure . 14 2.3.2 Cable Prices and Packages . 17 2.4 Determinants of Acquisitions . 25 2.5 The Effect of Acquisitions on Cable Bundles . 28 iv 2.5.1 Results . 29 2.5.2 Endogeneity of acquisitions . 33 2.6 Summary . 35 Chapter 3: Quantifying Merger Incentives in the Cable Television Industry . 38 3.1 Related Literature . 42 3.2 Empirical Motivation . 43 3.3 Model . 46 3.3.1 Environment . 46 3.3.2 Sub-Period 2: LSA Profits . 48 3.3.3 Sub-Period 1: Acquisition Game . 51 3.3.4 Equilibrium . 56 3.4 Empirical Implementation . 57 3.4.1 Likelihood . 58 3.4.2 Reducing Dimensionality . 60 3.5 Findings . 61 3.5.1 Parameter Estimates . 61 3.5.2 Economies of Scale, Density, Deregulation and Acquisi- tion Activity . 65 3.5.3 Merger and Entry Policy Experiments . 69 3.6 Concluding Remarks . 72 Chapter 4: The Welfare Effects of Acquisitions in the Cable Television Industry 73 4.1 Related Literature . 77 4.2 Model . 79 v 4.2.1 Overview . 79 4.2.2 Demand . 80 4.2.3 Supply . 83 4.3 Empirical Specification . 84 4.3.1 Estimation . 85 4.3.2 Computational Details . 88 4.3.3 Identification . 89 4.4 Estimation Results . 91 4.5 Welfare Effects of Acquisitions . 96 4.6 Conclusion . 101 Chapter 5: Conclusion . 103 Appendix A: Tables and Figures . 113 vi List of Tables 2.1 Trends in Market Structure . 15 2.2 License Ownership and Subscribership of Large Firms . 16 2.3 Master Files and Census Data Summary Statistics: 1990-1996 . 21 2.4 Trends in Cable Prices and Channel Offerings . 23 2.5 Prices and Packages of Large and Small Firms . 24 2.6 Determinants of Mergers . 27 2.7 Relationship Between Acquisitions and Prices, Channel Counts, Market Shares and Channel Costs . 31 2.8 Tests of Whether Acquired LSAs are Representative . 33 2.9 Estimation Results by Large and Not Large Buying Firms in Two-Bundle Markets 35 3.1 Variable Profit Function Parameter Estimates . 62 3.2 Fixed, Acquisition and Entry Cost Parameter Estimates . 65 3.3 Counterfactual Experiments Predictions . 67 3.4 Merger Fees and Entry Subsidies Policy Experiments . 70 4.1 Parameter Estimates . 92 4.2 Model Fit . 94 4.3 Welfare Effect of Mergers . 97 4.4 Decomposition of Merger Welfare Effects . 101 vii A.1 Region Definitions . 113 A.2 Variable Sources and Definitions . 114 A.3 License Ownership and Subscribership of Large Firms - All Years . 116 A.4 Welfare Effect of Mergers (Unacquired LSA’s) . 117 viii List of Figures 2.1 Geographic Market Ownership: 1986 . 18 2.2 Geographic Market Ownership: 2004 . 19 3.1 LSA Buyout Counts . 44 3.2 Firm Buyout Counts . 44 3.3 Number of Non-Basic Channels . 45 3.4 Revenue per Subscriber . 45 3.5 Affiliation Cost per Subscriber . 45 3.6 Profits per Subscriber . 45 3.7 Model Predictions . 68 3.8 No Density Economies . 68 3.9 No Policy Change . 68 4.1 Quality vs. Channels (Basic) ............................. 96 4.2 Quality vs. Channels (Non-Basic) .......................... 96 4.3 CS Gains vs. Urban Density . 99 4.4 Merger-Induced Changes in Marginal Costs . 100 A.1 Sample Reporting Form for Broadcast Undertakings . 118 A.2 CRTC Decision 89-46 . 121 ix A.3 CRTC Decision 95-476 . 122 x Chapter 1 General Introduction This dissertation consists of three essays that empirically study the determinants and wel- fare effects of mergers in the Canadian cable television industry.1 The first essay provides context with a historical and empirical overview of the industry. It opens with an in-depth discussion of technological and regulatory change from the first Canadian cablesystems in the 1950’s to present-day debates related to competition and the technological convergence of cable and telephone companies.2 The essay then presents the dataset that I constructed to carry out the study. These data consist of a rich panel containing information on cable company entry and exit, acquisitions, subsidiaries, cable company prices, market shares, channels, costs, and demographics at the local cablesystem level 1I use the words acquisition, merger and buyout interchangeably throughout this dissertation. The focus is on acquisitions however, where there is a selling firm that ceases to exist following a merger. That is, I do not study “mergers of equals.” 2Cablesystems roughly correspond to the cities, towns and villages of Canada. Law (1999) succinctly defines a “cablesystem” as follows: “A cablesystem is the cable network around one local head end. The head end is the location of the equipment that receives the signals that are sent down the cable to the subscriber. Head end apparatus can include devices such as satellite dishes, large antennas for the reception of over-the-air broadcasts, fibre optic links, video relay equipment, and microwave towers.” 1 from 1986 to 2004. Using these data, I present various summary statistics and empirical patterns of interest that together tell a story of regional consolidation in the industry, where dominant cable companies grow over time by acquiring the cablesystems of small cable operators. By 2004, distinct regional clusters of cablesystems exist in Western Canada, Ontario, Quebec and in Atlantic Canada. These basic findings are complemented by two reduced-form analyses that respectively focus on the determinants of mergers and the effect acquisitions have on prices and channels offered on cable tiers. First, I estimate a Poirier (1980) bivariate probit model that predicts the probability that two firms merge. I find that larger differences in firm size (measured by number of subscribers nationally), and geographic proximity of the cablesystems owned, have a positive non-negligible impact on the probably that a merger occurs. Second, I conduct a regression analysis that looks at the relationship between cable prices, the number of channels offered and whether a cablesystem has been recently acquired. I find that acquisitions have little impact on cable prices and channels in rural markets where only basic cable is offered. In larger, more urban cablesystems with both basic and non-basic cable, the results suggest that basic prices and non-basic channels distinctly rise following an acquisition. The second essay further analyses the determinants of acquisitions in the industry. I develop a model of license ownership that predicts the evolution of profit-maximizing en- try and acquisition decisions by firms over time, starting from an initial allocation of cable television licenses.