Does the Dearth of Mergers Mean More Competition?∗

We study mergers in a duopoly with differentiated products and noisy observations of firms’ actions. Firms select dynamically optimal actions that are not static best responses and merger incentives arise endogenously when firms sufficiently deviate from their collusive actions. The in-centive to merge trades off the gains from avoiding price wars against the gains from a monopoly net of the fixed cost of merging. Depending on the merger cost, there are three merger outcomes: if the cost is low, firms merge immediately, if it is high, they never merge, and, in an interme-diate cost range, there are endogenous mergers for which we derive a number of novel results. First, we characterize the firms ’ shares in the merged firm as a function of firm and product market characteristics. Second, we show that long periods of pre-merger collusion are supported, because collusion is dynamically stable and merging is unstable, with mergers occurring only when collusion has failed, and hence the dearth of mergers need not mean more product market competition. Third, the acquiring firm’s pre-merger returns are first positive and then become negative just before the merger occurs, while the target firm’s returns follow the opposite pattern. Fourth, there are no announcement returns when industry concentration changes due to mergers.