Horizontal Mergers under Yield Uncertainty

We study a horizontal merger in an oligopolistic market in which firms compete on production quantities. Each firm has its own in-house manufacturing facility, and the production is subject to random yield. After the consolidation of two firms, the merged entity can use both manufacturing facilities that belong to the merging firms. It is well known that diversification can reduce the aggregate supply uncertainty of a firm, but this diversification benefit has not been explored in a merger analysis. We model the effects of reduced competition, cost synergy, and supply diversification from a merger and characterize their combined impact on firms' production quantities and expected profits. Our analysis highlights the importance of yield correlation. In the postmerger model, although an increase in yield correlation intensifies end-market competition and lowers the diversification benefit, it can increase the merged firm's expected profit. This is more likely to occur as the synergy effect increases, the number of competing firm increases, and the yield variance decreases. We also compare the premerger and postmerger equilibrium production quantity and expected profit of each firm. We show that there exists threshold levels of cost synergy above (or below) which the postmerger equilibrium profits or quantities exceed their premerger counterparts. We also show that, under yield uncertainty, firms may have an incentive to merge even without cost synergy due to the diversification benefit. With deterministic demand, cost synergy is necessary to justify a merger.