There are a variety of productive assets which, when under the control of existing firms, can effectively prevent the profitable expansion of existing competitors and the entry of new competitors. They include, for example, strong patent protection of products, equipment or productive processes; trade names, brands, and other protected methods of differentiating otherwise similar products and thus of holding consumers’ loyalty; private control of non-reproducible factors of production such as particular sites of land and certain mineral deposits; knowledge of processes which can be kept secret; occasionally even possession of the services of especially gifted, trained, or experienced individuals. A great deal of the so-called monopolistic protection against competition may involve the possession by entrenched firms of ‘assets’ of this kind, and the consequent restrictions on new entry are as much a cause as they are an effect of merger.
Let us now assume that a given firm, Alpha, has decided that expansion in a particular direction would be the most profitable step for it to take provided it can acquire one or more of the types of ‘assets’ just mentioned which are under the control of existing firms. The incentive of the existing firms to sell is obviously different when they can prevent the expansion of a large competitor from what it is if they are faced with the prospect of new competition in any circumstances. Except for firms that are poorly managed or whose owners want to sell out for personal reasons, we must assume that existing firms would be unwilling to sell at a price below the discounted value of an expected profit that will continue to reflect the particular advantages the assets in question confer upon them. We shall assume, too, that these assets are so important that it is not worthwhile for a Beta to sell them without selling out entirely.
If existing owners of Beta know the full value of their firm, apart from any relation it may have to the activities of a potential Alpha, they would not in general be willing to sell at a price below this value. Hence, Alpha must consider Beta, or more accurately the acquisition of Beta’s assets, to be worth more than the full value of Beta to its existing owners. How much more than this full value Alpha would have to pay would depend on Beta’s estimate of Alpha’s maximum price. But when would Alpha believe it profitable to pay more than the full present value to Beta of Beta’s monopoly rights? Under what circumstances would an economic basis for acquisition exist?
Inability to obtain the required assets and thus effect the desired expansion may prejudice the existing position of Alpha or it may merely prejudice the prospects for profitable expansion in the desired direction. For example, in the first case, patent-protected new technology which reduces production costs or improves the quality of products may present a serious threat to a firm’s existing products; or the ability to sell existing products may be hindered by an inability to sell at the same time certain complementary products. In the second case, Alpha may be prevented from using some of its own productive services in directions that would, but for the barred access to a specific technology or the necessity of incurring heavy initial market-creating expenses, be extremely profitable. In either case, a basis for acquisition exists whenever Alpha stands to lose a great deal more by not effecting the acquisition than Beta could expect to make in profits from its own operations. If Beta were in a position to make as much of its monopoly rights as Alpha could, then Beta would not sell at a price Alpha could afford. In the example above, if Beta expected to gain as much as Alpha lost from the impaired competitive position of Alpha’s existing products, the prospective value of Beta would be correspondingly raised. Hence if all Alpha wanted to do was to put itself in Beta’s position, the acquisition of Beta would be profitable only if Beta did not realize the full value of its position, or were, for some other reason, unable or unwilling to hold out for the full price. If, however, Beta cannot with equal advantage undertake the full expansion programme that Alpha could undertake once it had acquired Beta, then, although Beta may be in a strong bargaining position, it will often pay both firms to come to terms. If Alpha is substantially larger than Beta, or operates with a substantially different composition of resources and produces a different collection of products, it may be profitable for Alpha to acquire Beta at a price higher than that representing the present value of Beta’s expected profits.
If a particular expansion programme contemplated by Alpha is frustrated by barriers that could be overcome only by the acquisition of Beta, the cost to Alpha of failing to acquire Beta is equal to the discounted net revenue expected from the new investment over the relevant period less the result of a similar calculation for the next most profitable use of the resources involved in the projected investment programme. The total net revenue expected from any given expansion programme will be larger, the larger the size of the programme (or otherwise a smaller expansion would have been planned). A firm’s expansion programme may, of course, involve fairly long-run plans for a series of outlays over a period of time, and the relevant amount of investment to be considered from this point of view is the total investment actually planned for the entire programme at the time the acquisition of Beta is being considered. The larger the total programme in relation to the size of Beta, the more important becomes the ‘loss’ if Beta is not acquired, and the less becomes the significance of the price of acquiring Beta. In other words, Alpha does not merely want to put itself in Beta’s position, but rather it needs Beta only as a component of a larger programme. At the same time, if Beta is very small in relation to Alpha, it cannot expect to undertake an equal expansion in the same period of time. And even if the managers of Beta hold the theory of growth set forth in this study, and thus believe that over the course of time Beta could reach Alpha’s position, the mere fact that a longer period would be required to make the same total profits reduces their present value. Hence if Beta is motivated by a rational calculation of financial losses and gains, it will be willing to come to an agreement with Alpha.182
Similarly, if Alpha and Beta have been operating with a different collection of resources or producing a different collection of products (though they may be in competition in some product markets), the internal potentialities of expansion for the two firms will be different, and this will be true even if there is no great difference in their sizes. If they have been producing roughly comparable products, Alpha may, for example, have concentrated on the development of a sales organization, while Beta paid more attention to research in and development of production techniques and product quality. Or the composition of their product line may be different but be based, for example, on the same general assortment of raw materials. In both cases, the productive services within each firm, which provide the internal incentives for expansion or determine the response of the firm to external incentives, will differ. Hence it may fall out again that Alpha can plan, not necessarily a more extensive, but perhaps a more profitable expansion programme than Beta can plan, and again there will be a margin for negotiation within which acquisition will be profitable for both firms. If the two firms are roughly the same size, the merger may be effected on roughly equal terms and be more properly classed as a combination of two firms into a new firm than as an acquisition by one firm of the other.
Combination
Where two (or more) firms combine on equal terms thus forming a new firm, the process of expansion conceived of as the growth of a single firm comes to an end; in effect, both firms go out of existence and another firm is created with administrative structure, personnel, product-mix, markets, productive facilities, and financial resources different from those of its progenitors. But although this type of merger creates difficulties for those who like to treat firms as organisms and construct growth curves instead of family trees, it makes only a formal, not a substantive difference to the economics of the problem. After all, any substantial acquisition changes these characteristics of firms in much the same way, and often it is merely a matter of convenience, or personal prestige or manoeuvering, or of the respective reputations of the two firms, that determines wh
ether a given merger will be technically an acquisition of one of them by the other or a merger on equal terms. But if neither firm does in fact ‘buy out’ the other, then we cannot explain the process, as we have in the preceding discussion, by examining the considerations which cause a difference between Alpha’s and Beta’s estimates of the value of Beta. Nevertheless, most of the preceding analysis of the process of acquisition could have centered around the same question posed in a different way: what are the considerations that make two firms more valuable when they are combined than when they are separate? Clearly these are, for the most part, precisely the considerations that make it profitable for Alpha to pay for Beta the price that Beta demands. Put in this way, it can be readily seen that the economic basis for the combination of two firms is much the same as it is for simple acquisition: we need merely omit some of the personal considerations and some of the considerations which arise directly from differences in size or from monopolistic advantages possessed by one of the firms over the other.
No two firms can ever be exactly alike or develop in exactly the same way. Differences may, of course, be negligible in many important respects, and the economist may be justified in treating some firms as ‘identical’ for special purposes. On the other hand—and it would seem more commonly, taking each firm as a whole—differences may be considerable. Even if Alpha and Beta should be in the same general industry, and have started out with the same general structure, productive resources, and products, their processes of growth are apt, by the very nature of the productive services generated within the firm and of competition itself, to lead to differences in quality and type of product, to an emphasis on different classes of consumers and different markets, to the introduction of different processes of production, or to a relative specialization on different stages in the production of the same type of product. These factors, as was pointed out above, are among the reasons why one firm would find it profitable to acquire another, but equally they may provide a basis for a combination of the two firms.
Under these circumstances, there are many reasons unrelated to an extension of monopoly power, why combination may seem an efficient use of resources for both firms. Expansion into the same area—e.g., into the same type of new product-line, or forward for Alpha and backward for Beta—may appear to each firm independently as the most effective way of using its existing productive services. But if both undertook the same expansion, competition between them would be intensified, and this would reduce, or perhaps even eliminate, the profitability of the expansion for each. Expansion into the new area on a combined basis is obviously less wasteful from the point of view of both, and if the proposed expansion bulks large in the total activity of both firms, combination may seem desirable. Such a combination need not be undertaken to protect the combining firms against competition from others but may, in effect, be a merger to overcome the barrier to entry that each presents for the other. A similar basis for combination exists when the two firms possess complementary productive services in the use of the same type of raw material—for example, if they have specialized in different varieties of product or at different stages in the production process. Again, merger may be primarily an economical way for both firms together to embark on a new programme of activity, but the merger need not be so much a method of avoiding a potential competitive struggle between the two firms as they expand as it is a way of obtaining the collection of productive services without which neither firm could enter the new field in any significant way.
The Purchase and Sale of ‘Businesses’ That Are Not Firms
From the point of view of the economics of acquisition in relation to the growth of firms, the acquisition of a ‘going concern’ which is not a legally independent firm, but merely part of a larger firm, may have much the same significance in many respects as other types of acquisition. It makes little, if any difference to the acquiring firm whether the particular productive organization or new ‘business’ that it purchases is technically a subsidiary, a division or merely a ‘product-line’ of another corporation or an independent firm. Nevertheless, the fact that it is possible, and indeed easy, for a firm to sell part of its own organization makes a considerable difference for the behaviour of firms in the process of growth. Of course, a firm has always been able to sell particular individual assets, both tangible and intangible, without disrupting its own operations and organization, but this is not quite the same as being able to sell a piece of itself as a going concern without seriously disrupting either the organization and operation of the going business sold or of the rest of the firm as a whole; the difference between selling individual assets and selling a ‘business’ is important, for, as is well known, the whole is in most cases, though not always, worth more than the sum of its parts.
There is some evidence that acquisitions of whole divisions or subsidiaries of other corporations instead of independent firms are becoming an increasing proportion of the total number of acquisitions.183 The Federal Trade Commission suggests that the increased importance may be due to changes in the tax laws (presumably the introduction of loss carry-over provisions). Why tax laws would encourage this type of acquisition at the expense of others is not clear, but one does not have to fall back on taxation as the explanation, for extensive diversification plus decentralized organization would surely lead to a relatively high number of acquisitions that involve parts of firms.
If in fact there has been an increase in the kind of diversification which leads the large corporations into new basic areas of specialization, we should expect, quite apart from any changes in tax laws, an increase in the purchase and sale of the relatively specialized parts of business firms. Diversification of this kind leads firms into relatively unfamiliar areas of activity by definition. Some mistakes will be made and some expectations disappointed. The obvious way to rectify mistakes is to sell out. It is perhaps reasonable to assume that the more significant the fundamental diversification of large firms, the larger will be the number of ‘mistakes’ and the greater the number of such businesses that will be sold in order to correct mistakes. And the larger the percentage of the total number of firms that are significantly diversified, the greater will be the proportion of such sales in the total number of firms and businesses that are sold.184
Furthermore, the adoption of a decentralized type of organization is characteristic of firms as they grow larger; this type of organization not only makes possible efficient specialization in more than one basic area of production, but also permits the separately organized ‘businesses’ to act in many respects like independent specialized firms185 and often to be bought and sold without disrupting the organization of the parent firm nor significantly altering the self-contained organization of the division. Some reorganization both by the acquiring and selling firms will be necessary, as we have pointed out, but it is likely to be on a scale considerably smaller than would have been involved if the acquiring firm had had to build up the business from within, or if the selling firm had had a thoroughly centralized organization.
The fact that firms can and do sell specialized parts of their activities bears on our analysis in three ways. In the first place, the factors creating an economic basis for merger are somewhat different for this type of sale than for the sale of independent firms; secondly, the process of growth of firms is affected; and finally, a more efficient pattern of diversification may be promoted over the long run.
Economic Basis for the Sale of a ‘Business’
Many of the considerations causing small firms to sell out are clearly not relevant to the decision of a large firm to sell one of its ‘businesses’. Personal positions of owners, tax considerations relating to liquidity of personal estates, financial and managerial handicaps traceable to small size, and similar considerations are rarely significant motives for the sale of a business by a large firm. The small firm, in selling out, obtains cash or securities for its owners. Only where the sale is effected because the owners see better producti
ve uses of their entrepreneurial and productive abilities (rather than merely better ‘placements’ for their funds) are the economic considerations of the sale similar to those surrounding the sale by a large firm of one of its businesses. For, in general, such a sale by a large firm depends on whether there are better alternative uses in production of the productive services available to the firm.
We have seen that the productive opportunity of a firm (and its competitive advantage) is largely determined by the productive services it has at its disposal, and that the internal resources of different firms are not equally suited to all fields of activity. Since the true profit on any particular activity is governed by the opportunity cost of the resources absorbed in it, fields that are highly profitable for one firm will not necessarily be equally profitable for another. The resources absorbed include not only labour, materials, and other purchased inputs, but also part of the permanent resources of the firm, particularly management and engineering staff. Whenever a firm believes that it could put the resources currently absorbed by one of its specialized product-lines to better use in some other field, it may desire to sell the ‘line’, for clearly the firm will be losing money in that business, even if its accounts (which ordinarily do not take into consideration alternative opportunities for the profitable use of resources) show a positive profit. Although assets which have already been acquired and are specific to a particular line of activity have no opportunity cost inside the firm since they cannot be used for other purposes (this may be the case, for example, for trade-marks, patents, licence agreements, specialized equipment, and occasionally even whole factories), they do have an opportunity cost when some other firm would be willing to buy them. In calculating the profitability of a specialized field of production the firm ought, therefore, to take account of the use it could make of the proceeds it might receive if it sold out. Furthermore, it ought also to take account of the alternative return on any additional funds it expects to have to invest if it stays in the field at all.
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