4. On allowing mergers of big companies who are competitors-they should never be approved!

Big companies who are competitors merge all the time in all countries. In almost all cases, this is bad for the country. Here's how to see this.

The most common argument used by companies to get approval from the Government (FTC, etc.) is that a larger company will be better scale, and economies of scale will lead to lower costs, which they will pass along to the customer in the form of lower prices.

They are telling only half of the story. The economies of scale may work to reduce costs, but they are not going to pass along the cost savings to the customer or the consumers! They will just keep the extra profit themselves. On the other hand, by merging, you have less competition in the marketplace, which in effect raises prices. That is the real reason why companies want to merge.

The price of something is decided by the market demand. If a company is able to lower costs, it will keep the extra profit to itself. It will lower prices only when 1) there is competition, and/or 2) they believe that lower prices will lead to much larger volume, leading to  the net dollar value of the revenue (price x volume) being much larger than before. Since no one can be sure that the volume will increase on lowering prices, and it will need extra investment and hassle on the company's part to increase volumes, the safest bet is to keep prices unchanged; and that means they will just keep the extra cost savings to themselves. Only a foolish businessman passes along their extra cost savings to the customers; the intelligent one just keeps it himself!

The main reason why companies want to merge is to reduces competition, and therefore in reality increase prices for the consumers. The  less the number of competitors in a sector, the less the downward pressure on prices. It is also easier to collude and raise prices when there are 2 to 3 actors in a sector than when there are 10 to 20. Mergers always will result in higher prices for the consumers. They should never be approved.

The only exception where mergers can be approved is when the product is international-e.g. crude oil, copper, etc. Since there are many big competitors in other countries, it makes sense for commodities which are easily shippable worldwide to have large players at home as well. But this should be done only if we can buy foreign goods easily and there are no undue restrictions on imports (to take advantage of lower prices outside our country, if some company outside offers lower prices). In many cases, there are significant barriers to imports; therefore, mergers in general are bad for the country's consumers.

But here I just wanted to point out the fallacy of the argument of economies of scale: lower costs-lower prices...it is simply economies of scale and lower costs, but that does not imply lower prices for the consumers. Those are two different things-lower costs are a benefit of economics of scale. But what lowers prices in the marketplace is competition. The producers always want to lower their costs, reduce competition in the market and therefore raise prices, and increase their profit margins from both ends (cost go down because of economies of scale, prices in the market go up because of less competition); and they use bogus arguments to get the Governments and anti-monopoly organizations to approve  their mergers.

Prices are decided by the market, and do not depend at all on the costs. Market price (the sales price) and cost of production of a product are entirely independent of each other-this point is missed by most economics types, and even men of business. You may make plastic monkeys for a cost of $90 and may want to sell them to me for $100, a reasonable profit, but that doesn't mean I will buy them.

Generalizing this, if you produce something at cost X and I want to pay only Y for it (at a given volume V of units sold), and if Y is less than X, you will go bankrupt as a company, and that is not my problem. I as a consumer care only about my dollars, and will only pay Y for your product. It is your job to make sure that X is less than Y, your profit is (Y-X)*V. But note that Y has no relationship to X, Y is decided by the consumers, the marketplace, the market; X is decided by the producer, the capitalist who brings the product into the market. Y is reduced by more competition, that's the surest way to lower prices for consumers, which should be the goal of the economics and anti-competitive agencies, or governments in general. Lowering X does not necessarily mean that Y will be lowered. When companies merge, they may be able to lower costs (overlapping departments of marketing are cut down, etc.) but even if they are not successful in lowering costs, they will definitely benefit by increasing Y, because they will not be forced to bid against each other in the marketplace.

I can't stress enough that the costs of producing a product have nothing to do with the prices you get in the market for that product-prices are decided by the consumers, costs are decided by the skill of the company. Consumers (or the customers, if the company sells to other businesses, B-B sales) are the deciders of prices. Managing costs is your problem, not theirs. The consumers will buy less if goods are priced higher-and if you want to keep the volume at a fixed level (e.g. 1000 units a day) the ultimate pricing of those products will be decided by the consumers for that volume. If you increase the price, you will necessarily reduce the volume. I give this simplistic example to explain the concept involved; but I hope you can see clearly that costs are an internal part of the company, whereas final prices are an external dynamic, determined by the marketplace, and companies have no bearing on them directly, except that all companies make competing offers in the marketplace. Indeed, getting rich in life means that you can sell products at a very high price at a good volume, and that those products cost really low to produce. The statement "costs determine prices" is false, if a company tells you that they are raising prices because their costs are rising, it is a lie; they are raising prices because they can. After all, if they knew that they could raise prices without sacrificing volume, they would have done so already, increasing their profit margins.

Next time a trade body like the FTC of your country approves a merger, tell them this! Almost all countries in the Americas, both North and South, have a problem in the banking, telecom, transportation and pharma sectors. The telecom monopolies are really horrible for the country's consumer. This is why Carlos Slim is so rich-he has little competition, and Mexico has given him a license to screw over all Mexicans by having little or no competition. Any time you have fewer than five or six actors in a place for a sector, they essentially combine to raise prices. This was explained well by Smith; and instead of simply never allowing this to happen at the first place, or at least not encouraging it by allowing mergers, governments regularly approve mergers even when very few actors are present, to the vast detriment of the consumers/customers.

Competition and presence of many actors lowers prices for consumers. Mergers do the exactly the opposite.

An easy way to see all this is the extreme case-that if mergers were good for consumers, we should allow all mergers and should only have one company in each sector!  If companies were as nice as they would like you to believe when they say stuff like "we will pass on the cost savings to consumers/customers" and knowing that, in general, the economies of scale do lead to lower costs for two companies which merge, it necessarily means that the extreme case of just having one company do everything is the most efficient for everyone: the costs are the lowest because of massive economies of scale, the company is going to pass on all these low costs to the consumers in the form of lower prices, and everyone will be happy getting the products at the cheapest possible price. This extreme case of just one company doing everything is the same as everything owned by the government, which we all know is contrary to lower prices (or abundance of products, which is the same thing). The extreme case of mergers is therefore clearly a disaster for the consumer. Therefore, if there are five companies producing a product, and you allow two to merge based on the logic that increasing cost savings of the merger of these two companies (and them passing along these cost savings to the  consumers) will lead to lower prices in the marketplace, why not merge all five of them and have the costs even lower? If a merger of all companies into one company is bad for the market, as should be obvious, any time you push the market closer to that by allowing two to merge, you are in effect increasing prices for the consumers by lowering competition.

In situations where there are only a few big companies left, it is not a bad idea to have a state-owned (central government or regional government owned) company exist side by side. In small countries like Chile and Canada, there are four or five large companies in important sectors like transportation, banking, telecoms, etc. The presence of a state actor is a good solution. This is also true in critical services like health-care, where a large state actor always lowers prices for the consumers-by providing the confidence that they will be taken care of when they really need help. Companies always find ways to collude and raise prices of goods and services, and the government can't possibly keep up with the newer and newer ways they find of doing this (they do give them fines when they find out they have colluded; but it is always too late). It is best to have a state owned enterprise in such cases. The privates can exist side by side with the state owned enterprise; I don't see a problem with that. But the presence of a state owned actor helps the consumers a lot. In Chile, the state owned Banco del Estado is by far the biggest of all banks (there are about 5 independent banking companies). The state backed health insurer, Fonasa, has about 80% of the market share; all other privates, about 5 in number, share the rest of the 20%. Consumers do prefer a state actor even when free choice is provided in critical services like banking, healthcare, etc. This point is lost on free market lovers; the presence of a state owned actor in addition to private actors is a good thing for consumers, and can only help in lowering prices.

Vertical mergers

What I have written above is for horizontal mergers, where two companies who are direct competitors in a given sector are looking to merge. What about vertical mergers, where you buy your suppliers or your customers if they are companies themselves? Cost savings in such cases are doubtful-as I have already covered here. In addition, they are equally bad for the consumers eventually, because any time you are decreasing competition and the marketplace has less players, whether it be the final companies who sell to the consumer or intermediaries who sell to consumer companies, you effectively raise prices in the vertical supply chains. The goal should be to have many companies at all levels of the supply chain-the system is far more competitive in that case.

Division of labor works vertically. Benefits of economies of scale (horizontally, by mergers, growing a company) are overestimated

Many people do not realize that division of labor works vertically, not horizontally. A simple example of a baker who makes bread will suffice. The bakery buys flour from the flour mill, who in turn buys raw wheat from the farmer. There are three vertically integrated businesses here: The farmer, The flour mill, and the bakery. They are normally done at different parts of the country, and can even be done in different parts of the world (you can import wheat or flour). The division of labor as talked about by Smith is this. If all three operations were combined under the same roof you would see the division of labor easily, but just because they are in different parts of the country or world does not mean that it is not division of labor or is less efficient.

If you combine these operations of the farmer, flour mill and baker, you will not reduce your overall cost; it is likely you will increase it. Each specializes in what they do best.

You often hear from economics and business folk that bigger companies have lower costs because of higher economies of scale, because of the same fixed capital distributed over a larger stock. This is not true.

Fixed capital is a small part of most businesses, even for capital heavy businesses like mining or car production. Most of the capital is still employed in circulating capital (materials) or labor. Furthermore, the fixed capital itself scales up as you increase the size of the factory. You need more buildings, more machines, more office space for the workers, etc. etc. as your factory size increases. The idea that the same fixed capital is used as the factory size increases is not true.

But division of labor and economies of scale work vertically, and even if you have a large factory of producing something, you depend on many supply chains to make things work.

This article is closely related to whose side the government must take-the consumer's or the producer's? It must always be the consumer. Here's the article which explains this.