Chapter 13 Imperfect Competition and Firm Strategy 26 Consider a decision facing you as a manager on whether to commit to an expensive research and development project that will reduce profits over the near term but which is expected to more than offset this loss with higher profits in the future. Should you be fearful that investing in this project will, because of the reduction in current profits, drive the price of your stock down, making your corporation more vulnerable to a hostile takeover? The answer is probably no, especially if your estimate of the long-run profitability of the R&D project is correct. There are two good reasons for believing this. First, the obvious fact that price-earnings ratios vary widely between different stocks provides compelling evidence that stock prices reflect more than current profits. Second, studies indicate that a corporation’s stock price generally increases when the corporation announces increased spending on investment, and generally decreases when a reduction in investment spending is announced. 19 A study by Brownyn Hall found that, over the period 1976-85, the firms taken over by other firms did not have a higher R&D to sales ratio than did firms in the same industry that were not taken over. 20 There is no reason for managers to become short sighted because of the threat of a hostile takeover. Indeed, the best protection against a takeover, hostile or otherwise, is to make decisions that increase the long-run profitability of the corporation, even if those decisions temporarily reduce profits. What about the fact that once a corporation is taken over it is sometimes broken up as the acquiring firm sells off divisions, often profitable divisions? Isn’t this disruptive and inefficient? There is no doubt that takeovers are disruptive, particularly when they result in parts of the acquired firm being spun off. But disruption is not necessarily inefficient. Indeed, any economy that hopes to be efficient has to motivate rapid responses to changing circumstances, and those responses are necessarily disruptive. Making the best use of resources in a world of advancing technologies, improved opportunities, and global competition requires continuous disruption. The alternative is stagnation and relative decline. Many of the mergers that took place in the 1960s and 70s created large conglomerate structures that, even if efficient at the time, soon ceased to be efficient. Increased global competition began rewarding smaller firms with quicker response times to changing market conditions. Technology reduced the synergies that might have existed at one point by having different products produced within the same firms. It became less costly for firms to buy inputs and components from other firms, thus increasing the ability to specialize in their core competencies (in the vernacular of earlier chapters, transaction costs fell). In many cases these changes made the divisions of the corporation worth more as separate firms than as parts of the whole. Many managers, however, prefer to be in charge of a large firm than a small one and are reluctant to divest divisions that are worth more by themselves or as part of another organizational structure. This extant managerial reluctance of the 1960s, 1970s, and into the 1980s was partly responsible for the depressed stock prices that corporate raiders were able to take advantage of by buying a 19 John J. McConnell and Chris J. Muscarella, “Capital Expenditure Decisions and Market Value of the Firm,” Journal of Financial Economics, vol.14 (1985), pp. 399-422. 20 Hall’s study is discussed by the Jensen article cited in footnote 3. Chapter 13 Imperfect Competition and Firm Strategy 27 controlling interest in conglomerates and then increasing their total value by spinning off some of their divisions. 21 Another complaint about the spinning off of divisions and downsizing that often accompanies takeovers is that workers are laid off. The claim is made that while stockholders may come out ahead, they do so at the expense of workers who lose their jobs. There is evidence that hostile takeovers do result in reductions in the work force. But the questions we want to consider are the following • Is this a valid criticism of takeovers? • Which workers are most likely to be laid off and how big is the cost to the workers when compared against the gain to shareholders? The fact that workers are laid off after hostile takeovers is consistent with the view that these takeovers promote efficiency. The most natural thing in the world for managers to do when sheltered against the full rigors of competition is to let the workforce grow larger than efficiency requires. This is most evident in what are often referred to as “bloated government bureaucracies” (a fact that is partially attributable to the absence of the takeover option). But the same thing can and does happen in private corporations, though generally to a lesser degree. Economic progress occurs most rapidly when there are strong pressures to produce the same output with less effort, to lay off workers when they are no longer needed. This often causes dislocations in the short-run, but in the long run it increases the availability of the most valuable resource (human effort and brainpower) to expand output elsewhere in the economy. So a strong case can be made that one of the advantages of the market for corporate control is that it increases the pressure on managers to keep the size of their workforce under control. If there were an active market for the control of government bureaucracies, where bureaucracy raiders could profit from the savings realized by eliminating redundant government jobs, does anyone doubt that these agencies would be run more efficiently – with far fewer workers? Some of the efficiencies derived from hostile takeovers (and therefore some of the benefits to corporate shareholders) are the result of workers losing their jobs. But what is the extent of this loss, and which workers are most likely to be laid off? To address this question, 62 hostile takeover attempts (50 of which were successful) from 1984-1986 were examined. 22 According to this study, layoffs were common, but seldom exceeded 10 percent of the workforce, and were typically far less than that. Also, it was estimated that the probability of being laid off was 70 percent higher for white-collar workers than for blue-collar workers. The jobs of managers, not those of workers on the line, were 21 Others have explained the advantages of moving toward more smaller and more focused firms in terms of improved, more efficient capital markets that have made it attractive for firms to substitute reliance on external capital markets for internal capital markets, which favor multi-division firms. See Amar Bhide, “Reversing Corporate Diversification,” Journal of Applied Corporate Finance, Summer 1990, vol. 3 (Summer 1990), pp. 70-81. 22 See Sanjai Bhagat, Andrei Shleifer, and Robert W. Vishny, “Hostile Takeovers in the 1980s: The Return to Corporate Specialization,” pp. 1-72 in Martin N. Bailey and Clifford Winston (eds.) Brookings Papers on Economic Activity (Washington, DC: Brookings Institution; 1990). Chapter 13 Imperfect Competition and Firm Strategy 28 most at risk. In addition, layoffs at targeted firms that were not taken over were greater (as a percentage of the workforce) than those in firms that were taken over. This suggests that the threat of a takeover provides a strong incentive for efficiencies even when no takeover actually occurs. Takeover Defenses Even if it is accepted that hostile takeovers are generally efficient, it doesn’t follow that there should be no corporate defenses against such takeovers. Ideally there should be some resistance to takeover offers, but not “too much.” Neither efficiency nor the interest of stockholders would be enhanced if the managers of a corporation simply acquiesced to the first takeover bid that offered more for the corporation’s stock than the current price. The first bidder is not necessarily the one best able to improve the performance of the target corporation, and therefore the first bidder is not necessarily the one who can make the best offer. By being able to mount some defense against hostile offers, corporate managers can stimulate an aggressive auction that results in a winning bid that more accurately reflects the value of the corporation. On the other hand, efficiency and the interests of shareholders can be harmed if the defenses against takeover bids are too impenetrable. If a takeover looks impossible, no one will make the effort to acquire control of even the most poorly managed corporation. Also, a significant investment is involved on the part of an outsider to determine the potential for improving the management of a target corporation and the maximum price that can be paid for its stock and still make the takeover pay. There is little motivation to incur the cost of this investment unless it gives those who do so a bidding advantage. So takeover defenses that go “too far” in requiring the initial bidder to make his information generally available can discourage takeover efforts to the point of reducing the amount of the winning bid. No one can know exactly what is the best defense against a hostile takeover from the perspective of efficiency. Obviously the most efficient defense will vary from situation to situation. But some types of defenses that managers can mount seem to be more efficient than others. Interestingly, there is evidence that bringing litigation against bidders increases the amount that is ultimately paid for the stock of the target corporation, assuming that the target corporation loses the case. 23 Managers of the target corporation can also defend against a takeover by offering to repurchase the stock acquired by a raider at a premiums; a practice known as greenmail. Some studies indicate that greenmail imposes significant negative returns on shareholders of the target (repurchasing) firm, but other studies indicate that greenmail can result in small gains for the repurchasing firm’s shareholders. 24 Managers of the target corporation will want to be careful, however, if 23 Recall, unless otherwise indicated the studies cited are discussed in Jarrell, Brickley, and Netter, “The Market for Corporate Control: The Empirical Evidence Since 1980.” 24 Michael C. Jensen and Richard S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics, vol. 11 (1983), pp. 5-50; and Wayne H. Mikkelson and Richard S. Chapter 13 Imperfect Competition and Firm Strategy 29 considering a policy of greenmail, since any gain to shareholders probably comes by encouraging others to attempt a takeover in the hope of extracting greenmail. Paying greenmail on a consistent basis is obviously not a way of promoting the long-run profitability of a firm. A very effective way for managers of a corporation to defend against a takeover is through what is referred to as poison pills. A poison pill describes a rule that allows shareholders of the target corporation to acquire additional shares at attractive prices, which serves to dilute the stock holding of the acquiring corporation. Although there are different types of poison pills, studies indicate that they are in general harmful to the wealth of the target corporation’s shareholders. 25 Managers can also protect themselves against takeovers by lobbying for legislation that reduces the chances that a takeover will be successful. Such legislation imposes a variety of regulations on takeover activity, but the studies that have been done suggest that, in general, they reduce shareholder wealth. The stock price of firms typically declines relative to the general stock prices when the state in which they are incorporated passes anti-takeover legislation. 26 Obviously, the interests of managers and those of shareholders are not in perfect alignment in the case of takeovers. But there are possibilities for overlap that are worth noting. A justification for a controversial severance-pay contract for top managers is based on the desirability of reducing management opposition to takeover bids that benefit shareholders. Top corporate managers are commonly granted what are referred to as golden parachutes, which provide them with handsome compensation when they leave the corporation. Such compensation can be particularly useful in cases where top managers have to invest heavily in knowledge that is highly specific to the corporation, and therefore worth little elsewhere. Golden parachutes can also encourage executives to take greater risks, given that they know that they will receive a significant severance pay package if the risks they take result in losses and they lose their jobs. 27 The argument is that when these managers are offered generous severance pay they are less likely to oppose a takeover offer that promotes efficiency and increases shareholder wealth. Golden parachutes help bring the interests of top managers more in line with those of their shareholders. But as with all incentives, care has to be exercised. Golden Ruback, “An Empirical Analysis of the Interfirm Equity Investment Process,” Journal of Financial Economics, vol. 14 (1985), pp. 523-553. 25 Paul H. Malatesta and Ralph A. Walkling, “Poison Pill Securities: Stockholder Wealth, Profitability, and Ownership Structure,” Journal of Financial Economics, Journal of Finance, vol. 20 (1988), pp. 347-376. 26 Michael Ryngaert and Jeffry Netter, “Shareholder Wealth Effects of the Ohio Antitakeover Law,” Journal of Law, Economics, and Organization, vol. 4 (1988), pp. 373-383. 27 In the absence of some form of handsome severance pay package, managers may be inclined to take too little risk, or less risk than the stockholders may want them to take. The stockholders can have diversified portfolios of stocks and companies over which they can spread their risks. Managers, on the other hand, can have a fairly narrowly invested portfolio, given that their talent, one of their biggest investments, is typically invested in one firm. Without some incentive to do otherwise, managers may be inclined to protect their investments by investing their firm’s assets in safe ventures. Chapter 13 Imperfect Competition and Firm Strategy 30 parachutes should not be so lucrative that they make an executive indifferent about keeping his or her job and losing it. 28 Like all arrangements, golden parachutes can be poorly designed and abused. It may make sense to provide golden parachutes to no more than just the CEO of a corporation and a few members of the top-level management team. Typically, a significant number of managers are involved in facilitating a smooth transfer of control. But there is no reason to extend golden parachutes to managers not involved in such a transfer. Also, while golden parachutes can be too stingy to promote the shareholder interests, they can also be too generous from the shareholders’ perspective. Ideally, golden parachutes will be provided only to those managers whose responsibilities are relevant to a takeover, and the severance compensation provided will be tied to premiums in share prices generated by the takeover. There is at least tentative support for the proposition that golden parachutes promote the interests of shareholders. According to one study of corporations that adopted golden parachutes, corporate stock increases an average of about 3 percent when the adoption is announced. One interpretation of this result is that the golden parachutes increased the connection between the interests of shareholders and managers. It is possible, of course, that part of the increased stock value resulted from the belief that the announcement indicated that management was expecting a takeover bid and wanted to protect themselves against it. * * * * * The primary point of this chapter is that many so-called “hostile” takeovers are not really hostile, at least not from the perspective of the owners of the corporation being taken over. Throughout the chapter, we have suggested that hostile takeovers promote efficiency by encouraging managers to behave as good agents for their stockholders. The efficiency of hostile takeovers will surely remain subject to debate. And certainly no serious person would argue that all hostile (or even friendly) takeovers are efficient. Mistakes are made in the market for corporate control that, after the fact, leave all parties worse off. So the debate over hostile takeovers will continue, and so will hostile takeovers. Of course, from the perspective of most managers, the fact that hostile takeovers will continue is more important than the debate over their efficiency. But the best way for managers to protect themselves against unwelcome attention in the takeover market is to do a good job enhancing the long-term profitability of the firm. And this is probably the best argument in support of the efficiency of hostile takeovers. Even if every hostile takeover that is attempted was itself inefficient, the fact that they can and do occur creates a strong incentive for managers to manage firms efficiently on behalf of their shareholders. 28 For a more detailed discussion of golden parachutes, see Jensen, “The Market for Corporate Control.” Chapter 13 Imperfect Competition and Firm Strategy 31 Concluding Comments Although the analysis of imperfect competition tells us something about the working of real-world markets, it does not answer all the questions economists have asked. The theories presented here have not done a good job of predicting the consequences of imperfect competition. Thus our conclusions regarding the pricing and production behavior of firms in monopolistically competitive and oligopolistic markets are tentative at best. Economists seeking to make solid, empirically verifiable predictions about market behavior rely almost exclusively on supply-and-demand and monopoly models. Although predictions based on those models may sometimes be wrong, they tend to be easier to use and may be more reliable than predictions based on models of imperfect competition. Predictions aside, it is important to remember that most markets are imperfect. In the Manager’s Corner for this chapter, we tried to show how markets for goods can be affected by the market for capital. Indeed, the two markets are intrinsically bound up together. The competitiveness of the capital market – including the market for entire firms – will act as a discipline on managers who might believe that they can take advantage of their discretionary authority. Capital markets also induce managers to find the most cost-effective methods of production. Review Questions 1. Under what circumstances could a monopolistic competitor earn an economic profit in the long run? 2. To achieve the efficiency of perfect competition, must a market consist of numerous producers? If not, what other conditions are required? 3. How does the number of producers in a market affect the chances of forming a workable cartel? 4. How do the costs of entering a market affect the chances of forming a workable cartel? 5. Must a monopolist employer share the monopoly profits with the managers and workers? If not, why not? If so, what does the “profit sharing” do to the monopolist’s output level? Prices? 6. Should antitrust law attempt to eliminate all forms of imperfect competition? Why or why not? 7. “In an economy in which resources can move among industries with relative ease, a cartel attempting to maximize short-term profits will sow the seeds of its own destruction.” Explain. 8. How would a cartel in a market for a network good collude on price? Explain. Chapter 13 Imperfect Competition and Firm Strategy 32 9. Suppose that the managers of a firm allowed their internal departments to act as little monopolies or suppose that the managers paid their workers more than the labor market would bear. What would happen in capital markets? To the firm? 10. Would you expect government-run organizations to be more or less efficient than privately owned firms? Explain your answer with reference to capital markets. CHAPTER 14 Business Regulation If anyone can find such a thing as an “unregulated industry,” he can sell it at a profit to the Smithsonian. George Champion ame an industry that has not, in some way, been under the authority of a government regulatory agency at some time. At the start of the century such a task would have been relatively simple. Today, with government extending its activities in all directions, it is not. Almost every economic activity either is or has been, at some time in the past, subject to some type of regulation at one stage in the manufacturing, wholesaling, or retailing functions. The list of federal regulatory agencies virtually spans the alphabet -- FAA, FDA, FEA, FPC, FRS, FTC, ICC, NTHSA, OSHA, SEC – to say nothing of the various state utilities commissions, licensing boards, health departments, and consumer protection agencies. As a result, it is much easier to list regulated industries than to name an unregulated one. Air transport, telephone service, trucking, natural gas, electricity, water and sewage systems, stock brokering, health care, taxi services, massage parlors, pharmacies, postal services, television and radio broadcasting, toy manufacturing, beauty shops, ocean transport, legal advice, slaughtering, medicine, embalming and funeral services, optometry, oyster fishing, banking, and insurance—all are regulated. Regulation was in the 1960s and 1970s, especially, one of the nation’s largest growth industries (although there was something of a “recession” in regulations in the 1980s). Why have people been willing to substitute the visible foot of government for the invisible hand of competition? Explaining regulation -- why and how it happens -- is a major challenge to economists. 1 Although several insightful theories have been proposed, statistical tests of those theories are incomplete and are at times based on crude data. Some instances of regulation or changes in regulatory policy cannot be explained by current theories. At best, we can only review what is known about regulation and project the economic results. Today regulatory agencies are increasingly criticized by economists, businesspeople, consumers, and consumer advocates. The major concern is the extent to which regulation is designed to benefit the regulated industry. Some critics want more regulation, others less, depending largely on how they view the process of regulation. 1 The major alternatives are reviewed in James C. Bonbright, Albert L. Danielsen, and David R. Kamerschen, Principles of Public Utility Rates, 2 nd ed. (Arlington, VA: Public Utilities Reports, Inc., 1988), Ch. 2. N Chapter 14 Business Regulation 2 To understand the controversy surrounding regulatory policy, we must first understand the theory. This chapter begins with a brief description of several major federal regulatory agencies and then proceeds to the various theories. Major Federal Regulatory Agencies Federal regulatory agencies have existed for about a century. From their origins and functions we can learn much about the regulatory process. The four broad sectors of interstate commerce that have been regulated, in some cases for almost one hundred years, are communications, energy, transport, and urban services. Most regulating commissions—consisting of 3 to 7 members, typically appointed but sometimes elected—try to achieve basic economic goals of efficiency, and promoting certain social- political goals, including safety. Beyond setting minimum and maximum prices, government regulations often control the entire rate structure of an industry. They may limit entry into the industry or stipulate what services and goods will be provided at what levels, and to whom. Regulatory approval is required to offer new services, or to expand, modify, curtail, or abandon a particular service. In short, regulation can -- and often does -- pervade all dimensions of production and distribution. The Interstate Commerce Commission (ICC) The Interstate Commerce Commission (ICC) was established n 1887 to deal with unfair business practices in the railroad industry. By the latter half of the nineteenth century, railroad companies had overbuilt and were engaging in cutthroat competition through customer rebates and price discrimination. In self-defense, several companies had formed a cartel to divide the market and set prices. The ICC was established to protect both consumers and small competitors and was supported by both the railroad and their customers. Since then, the ICC’s regulatory authority has been expanded to cover all motor carriers except airplanes engaged in interstate commerce—mainly trucks, boats, and buses. In the past, the commission has been authorized to set minimum and maximum rates. It is also responsible for ensuring adequate service. The seven members of the commission are nominated by the president and approved by the Senate for a term of seven years. No more than a simple majority of the commissioners may belong to the same political party, and a commissioner may be removed for “just cause,” including conflict of interest. Some muse that while regulation has tended to favor those who are regulated at the expense of consumers, even the regulated industries have been harmed by regulation. One economist put it this way: Chapter 14 Business Regulation 3 A good way to understand what has happened [to railroads] is to imagine a business that is prevented from adjusting its prices to changing market conditions and from negotiating with its customers. Furthermore, imagine that the business is not permitted to decide how much of its principal inputs to purchase, how much it will pay for them or even how to use them, and it may not decide where it will operate. Worse yet, imagine that it faces strong competitors who are not encumbered by similar constraints. It would be surprising if such a business survived at all. This is only a slight exaggeration of the railroads’ position before 1980. 2 For decades now, economists have advocated reducing the ICC’s power. Finally, in 1980 the trucking and railroad industries were partially deregulated. Although the ICC no longer sets truck rates and routes, it still controls market entry through its authority to issue licenses. The Federal Trade Commission (FTC) The independent five-member Federal Trade Commission (FTC) was an agency established by Congress in 1914 to enforce the antitrust laws, especially the Clayton Act. The Antitrust Division of the Department of Justice is the other federal antitrust enforcement agency dealing especially with the Sherman Act. FTC commissioners are appointed and serve seven-year terms. To carry out their duties, they are given the power to probe through corporate records and summon corporate executives to hearings on unfair competitive practices. They can also issue formal complaints and order a company to cease its illegal acts. For example, state bar associations once restricted lawyers from advertising their services. The FTC ordered a halt to such restrictions on the grounds that they thwarted competition. The Reagan administration tried to reduce the regulatory power of the FTC by cutting its budget—a ploy resisted by Congress. In the early 1980s, however, FTC decisions began to reflect the free market views of its new chairman, James C. Miller, a Reagan appointee who later served as the head of the Office of Management and Budgeting. The Federal Communications Commission (FCC) The Federal Communications Commission (FCC), established by the Communication Act of 1934, regulates telephone, telegraph, and broadcasting companies. Its seven commissioners, who are appointed for seven-year terms, set rates for interstate telephone and telegraph services and issue licenses to radio and television stations. The FCC determines who can engage in broadcasting, and it prescribes the nature of broadcast services, the location of radio and television stations, and the areas they serve. Licenses are issued for three years, after which the station’s programming is reviewed for license renewal. To ensure renewal, a station must engage in some public-service broadcasting. 2 “The Track Record,” Regulation No. 1 (1987): 23—24. . But there are possibilities for overlap that are worth noting. A justification for a controversial severance-pay contract for top managers is based on. imperfect. In the Manager’s Corner for this chapter, we tried to show how markets for goods can be affected by the market for capital. Indeed, the two markets